Wednesday, February 20th, 2013
The possibility of going over the fiscal cliff produced many dire predictions and also served as a theme for many New Year’s Eve bashes but like Y2K at the end of the last century, it did not cause the expected severe dislocation. What was a cliff has become more of a slope and now the discussions on both the political and investment front concern navigation and not preparing for a fiscal tsunami. Lost in all the noise at the end of last year was some encouraging news on the state of the global economy. The featured article in Bloomberg Markets year-end issue is entitled “A Case for Optimism,” and points out that the trade and current account imbalances which grew prior to 2008 and helped trigger the global recession are correcting faster than expected. As we all well know, the US and Europe consumed too much, went deeper and deeper into debt while China manufactured, exported and accumulated more than $1 trillion in US Treasury bonds. In 2007 the US current -account deficit which measures trade balances and income from foreign investments was 6% of GDP while China’s surplus stood at 10.1%. At a tense meeting held at a beach resort in South Korea in 2010, an agitated Treasury Secretary Tim Geithner lobbied the world’s central bankers for an agreement which would commit the largest economies to keep their surplus or deficit at 4%. To say he was greeted with the Group Of 20 version of a Bronx cheer is an understatement. Large exporters China and Germany wanted none of it and the German Finance Minister added some insult to injury when as a parting shot he lectured Geithner on the virtues of promoting “a market economy rather than a command economy.” Yet two years later the targets are being met: the US even as it suffers a budget crisis and has yet to address entitlement reform will according to the IMF have a current account deficit of 3.1% in 2013, effectively cutting in half the 2007 number while China will reduce its surplus to 2.5% down from 10% in 2007. More importantly if the IMF forecast is correct, the 4% surplus to deficit targets for the largest economies will hold through 2016. Some and perhaps most of the initial correction is a function of weaker demand in the US and Europe and China being better than expected at fostering domestic consumption. However there are two components in the US which are encouraging: the US is manufacturing more because of lower energy and labor costs. According to rather conservative projections, the US by 2015 will have a significant edge in production costs over Germany and Japan (15% and 21%) especially as a result of the boom in natural gas. Another equally significant but less noticed factor is the lower cost of capital.
Most if not all of the media coverage about lower US interest rates is focused on the Fed responding effectively initially to a global economic crisis and then to a weak recovery. We see reports about resulting lower mortgage rates for those who can get a loan and the problems of savers coping with non-existent bank deposit yields. Charles Schwab, a pretty devout free market capitalist, even wrote an Op-Ed in the Wall Street Journal calling on the Fed to raise interest rates in order to rescue senior savers. But here is a noteworthy item not receiving much fanfare: a few days ago investment managers (myself included) received an email from a bond underwriter with information about a new large debt offering from IBM: a senior note with a five year maturity at an interest rate of 1.25%– a record low for one of the most closely watched US companies for trends in the broader economy. In its most recent earning report IBM’s profits and revenue again exceeded expectations, and as reported in the Wall Street Journal the CFO sounded a positive note both about the quarter and future prospects. He noted that much of the growth in earnings came from software where profit margins are the highest and that IBM, best known as a mainframe computer company spent $11 billion on acquisitions and $19 billion on research and development, trends which he expects to continue. So how did IBM finance their earnings growth? Large companies accomplish this through their cash on hand or raising capital through a stock or debt offering. In the last quarter of 2008, however, raising capital was not the easiest task given the tremulous state of the credit market. IBM issued a ten year note at 7.625% at a time when their stock price was below $100. Their investments in R&D and acquisitions have paid off handsomely, and now they will be able to continue that game plan in a recovering economy (albeit slowly) at 1.25% and the stock is above $200. No wonder the CFO smiled a bit more than usual at the press conference. This of course did not capture public attention as much as Apple’s recent precipitous stock drop because of a slight revenue miss, but it is worthy of attention and similar stories of the ability to finance growth on the cheap as the global economy begins its recovery will be an important investment theme.
Tuesday, July 31st, 2012
Second quarter 2012 Investment Commentary
“Uniform-gate: They were really made in China!
In a rare show of bi-partisanship, (with emphasis on the “show”), Senate Majority leader Democrat Harry Reid and House Speaker Republican John Boehner both loudly condemned the US Olympic Committee and fashion designer Ralph Lauren when it was discovered that the 2012 US Olympic Team uniforms were manufactured at a factory in China. At his news conference Senator Reid bellowed that these “outsourced uniforms should be burned.” Congressman Boehner was more restrained but pronounced it a bad choice.
The outrage from the congressional leadership is comical at best, but a closer look at the Ralph Lauren Company is quite revealing. The Senator and Speaker should not be surprised that the leading US brand name apparel companies do operate globally. A recent research report on the Ralph Lauren Company was full of praise for its “China manufacturing presence,” which gives it a competitive edge, and may have saved the US Olympic team some money. Perhaps Senator Reid should take a look at his computer, I-phone or even the components of the car (no doubt a GM or Ford product) which carts him around in DC and Nevada. What might be worth railing against about “Uniform-gate” is the US Olympic Team wearing uniforms manufactured by a company where shareholders have about as much input as the population of North Korea. Founder and CEO Ralph Lauren controls 75% of the voting power of the company while owning just 1% of the common stock: he owns 90% of the B shares voting stock which does not trade publicly. Facebook has a similar structure which contributed to their badly botched IPO. Officially Mr. Lauren is paid a salary of $1.3 million, but in 2010 he managed to end up with about $28 million in his designer pocket from benefits he grants to himself through a board he controls: holding 90% of the voting power he can appoint 10 of the 12 directors. According to Morningstar Research the firm also pays for Lauren’s personal travel which came to over $500,000 in 2010 and “he has used company employees for his personal use in the past.” Wonder what that means…exactly. So here is a more important question which should have been addressed by Messrs Reid and Boehner: why does a US firm which lacks any semblance of reasonable corporate governance and is run as a personal fiefdom by its founder in a way that would make Rupert Murdoch envious receive the contract for the US Olympic Team Uniforms? As is the case with many other issues our political leaders seriously lack the ability to see the forest or even look at the right trees.
Typical Sound and Fury Not Signifying Too Much
It is fair to say that for the past three years, financial markets have over reacted on the downside to fiscal indecision and continuing economic uncertainty in the US and the threat of more sovereign debt bailouts in Europe. Conversely the expectation of further credit relief as a result of these ongoing problems produces over reactions on the upside. Despite the Federal Reserve flooding the credit markets with cheap money, it does not seem to end up on the hands of people who can use it. The US economy is limping along at less than 2% growth which is too slow for a meaningful recovery, and new business formations are hampered by both regulatory and economic qualms. So during the summer the economy and the financial markets will likely plod along at a slow snail’s pace which will be seen as progress by some and failure by others. As a former Fed governor aptly put it at the recent Jackson Hole economic pow-wow: “Yes, the Fed still has bullets, it always does and can buy anything it wants. But it may be unable to hit the target.”
Nevertheless, despite the continued kicking-the-can down the road monetary fixes-or maybe because of them-the markets are holding their own but the performance is not earnings driven which is worrisome. The investment index that is most meaningful for our clients is the 60% equity/40% bonds Vanguard Balanced Index which is up 5% through June 30. The S&P 500 is ahead by 8% but that reflects a huge gain for Apple which is now the largest component of the index, followed by Microsoft which had a 17% gain in the first six months. The Dow Jones Industrials which does not include Apple but is heavier on energy is ahead 5.3% through June 30. Finally, showing that the first six months of 2012 have been difficult to navigate, the FPA Crescent Mutual Fund, the five plus gold star best of breed balanced fund for the past 3, 5 and 10 year periods according to Morningstar showed a very paltry 1.8% return through June 30.
So how to invest in a 2% growth environment? For the past four years, the same argument has been made for investing in high quality dividend paying stocks and high yield corporate bonds: they are the best houses in a lousy neighborhood and the alternative, getting paid almost nothing from Treasury Bills and CD’s at the bank is not going to cut it. Select municipal debt also offers a viable alternative but much of that is being called and re-issued at lower rates. The current yield on a 5 year Treasury is 0.66% and the 10 year is 1.53%. The drum beat argument for owning stocks and corporate debt has not changed much recently although some investment analysts are now arguing that the dividend paid by a blue chip company such as Johnson & Johnson backed by the world wide demand for band aids might be more reliable than the Treasury note backed by the full faith and credit of the USA. China will continue to need band aids; whether they will need US Treasury bonds to the same extent is debatable. The J&J credit rating is still AAA and after raising their dividend, something they have done pretty consistently since Hoover was President, the dividend yield currently stands at 3.7%, more than double that of the ten year US Treasury note. The comparatively attractive dividend yield of stocks and Exchange Traded Funds can be enhanced by strategic covered option strategies that we continue to employ at JMR. The ability to generate consistent cash flow from investments that are not tied to a stagnant domestic GDP will be the heart of the matter for investors and in the long run more important than who is elected in November. In the meantime let us all enjoy the Olympics and those sporty designer uniforms!
Sunday, June 24th, 2012
My letter appeared in the Wall Street Journal in response to an Op Ed, “Rules for America’s Road to Recovery,” by John Taylor, Professor of Economics at Stanford University. Professor Taylor has written extensively on the financial crisis that began to 2007 and argues that the low interest rate policies of the Federal Reserve as well as the excessive residential lending by Fannie Mae and Freddie Mac were the main causes of the housing bust and ensuing global recession. He has been against the most recent quatitative easing policies of the Federal Reserve (The Dangers of an Interventionist Fed, Wall Street Journal 05/29/12), and argues that a stable tax policy rather than temporary tax cuts and stimulative measures is the best way to achieve economic growth. In “Rules for America’s Road to Recovery,” Professor Taylor argues that a potential recovery is languishing due to regulatory uncertainty caused by ObamaCare and the Dodd-Frank financial reforms and that what is needed are more predictable, rules based monetary and fiscal policies. His arguement draws on the work of Austrian eonomist Friedrich Hyaek, who argued that central banks such as the Federal Reserve must take actions in an understandable and predictable manner and that deviation from such as strategy “creates uncertainty and hinders prospertity.”
WALL STREET JOURNAL LETTERS TO THE EDITOR 06/12/12
The Bumps on America’s Road to Economic Recovery
John B. Taylor says in “Rules for America’s Road to Recovery” (op-ed, June 1) that Hayek traces the “rule of law” back to Aristotle and Cicero, but Aristotle was a devoted student of Plato who preferred a “rule of the wise.” The difference between the two philosophies is telling, in that Western civilization evolved from the former and Eastern despotism the latter. The rule of law that Mr. Taylor describes is essentially one of secure property rights, which weren’t the product of philosophers, but custom, such as the British common law or the Twelve Tables of early Roman law.
Let’s not forget that the people who promoted the various bailouts were on both sides of the aisle. No one thought any other course of action was warranted. Has anyone forgotten Treasury Secretary Hank Paulson, a Republican, getting down on his knees to beg House Speaker Nancy Pelosi, a Democrat, for stimulus money? One might also recall Federal Reserve Chairman Ben Bernanke’s comments, since he was hardly a Democrat, when questioned why he would endorse action he previously questioned. He said, “Well, as you know, there are no atheists in a foxhole.” Mr. Bernanke’s metaphor is more apt than Mr. Taylor’s simile.
Prof. Taylor cites “regulatory uncertainty” as one of the causes of “persistent high unemployment and our feeble recovery from the recession.” He argues that prospective employers facing a complicated tax code and a lack of a “rules based system” have pulled in their horns. Yet we are also suffering from ill-advised and detrimental regulations that aren’t at all uncertain. This is especially true in California.
Steve Malanga (“How California Drives Away Jobs and Business,” Cross Country, Oct. 15, 2011) quotes Andrew Puzder, CEO of California-based CKE Restaurants, which operates 3,000 eateries nationwide. Mr. Puzder called his company’s home state “the most business-unfriendly state we operate in.”
As Mr. Malanga notes, “CKE, which runs Hardee’s and Carl’s Jr., has stopped opening restaurants in California, where the regulatory process can take up to two years. But it plans to open 300 in Texas, where the start-up time can be six weeks and opening costs $200,000 less than in California.”
At the Federal level we have Sarbanes-Oxley. Unfortunately complying with the statute has impeded capital formation to such an extent that there is a bipartisan effort under way to repeal parts of it so that new companies, other than the Facebooks of the world, can raise capital and contribute to job formation.
Marc A. Roth
President, JMR Capital Management
Tuesday, February 28th, 2012
After Mitt Romney reluctantly exposed himself and his 13.9% tax rate by releasing his returns for the past two years he reignited the debate over what is called the carried interest exemption. For a couple of days it was even front page news, until it was very nicely bumped off page one by the surprising and more compelling story about Jeremy Lin, the Harvard educated, undrafted Asian-American point guard now leading the re-surging Knicks to victory in five straight games. Although it cannot compete with one of great sports stories of the decade, the carried interest exemption also deserves our attention for several reasons, one of them being who supports it and who wants to see it end.
First, some background. The rationale behind the carried interest exemption is that people who put capital at risk should be encouraged to do so within the context of a progressive tax code. So Mitt Romney’s firm Bain Capital, other private equity firms, along with venture capitalists and other investors take early stage risky stakes in the future Google’s and Facebook’s. Or in the case of private equity firms, they often reconstitute the management and capital structures of older companies that are not realizing their value and need to go through a process of creative destruction in order to do so. The vehicle of such investments are typically investment limited partnerships, limited liability companies (LLC) or convertible preferred stock, so the term carried interest refers to the structure of the investment, and not to interest in the usual sense of a bond coupon or savings rate. The exemption has been a fairly hot potato in the US Congress since it does initially benefit wealthy and well placed investors, or those who were decried as “the malefactors of great wealth” by President Teddy Roosevelt at the beginning of the prior century and “the fat cats on Wall Street,” by the current occupant of the White House. The argument advanced by these initial beneficiaries is that the successful investments of Bain Capital, such as Staples have created thousands of jobs, foster long term benefits for the US economy through business formations and without the favorable tax advantage investors would be less inclined to put their capital at risk.
Yet there are some surprising voices raised in favor of eliminating the benefit. A very loud one is that of Rupert Murdoch, the controversial CEO of News Corp which owns Fox News and the Wall Street Journal. While both Fox News and the editorial page of the Journal strongly support continuing the exemption, Rupert himself rails, or more specifically “tweets” against it, calling the exemption “a racket that makes fund managers rich.” And in an even more populist vein, the publisher of the Wall Street Journal might be mistaken for Dennis Kucinich, Senator Bernie Sanders or perhaps candidate Ron Paul when he said (tweeted) that “both parties need to stop selling out to Wall Street.” Other fat cats who share Rupert’s view on ending the carried interest exemption are New York Mayor Michael Bloomberg and less surprisingly Warren Buffett, whose secretary, who we all now know pays taxes at a higher rate than the Oracle of Omaha, sat in the Presidential box during the most recent State of the Union speech as the Commander in Chief made his pitch for the 30% millionaire tax.
Rupert Murdoch’s acerbic comment that the carried interest exemption is “a racket that makes fund managers’ rich” also helps to explain why it is still on the books, and it might be more accurate for Rupert and others to tell Congress to stop selling out to Greenwich, CT and Route 128. Since 2007 a bill to eliminate the exemption has passed the House four times but does not make it through the Senate. The Republican Senators who are against it get some needed help from the Democratic Senators who represent the states with the highest concentration of hedge fund and private equity managers—New York, Massachusetts and Connecticut—namely Chuck Schumer, John Kerry and before his retirement, Christopher Dodd. As if often said in the investment business: Follow the Money. Another Democrat against the bill has been Warren Buffett’s home state Senator and friend, Ben Nelson, who seems to want Warren’s tax rate to stay lower even if Mr. Buffett does not. Now that some heat has been generated by the Romney returns, it will be interesting to see how the future votes on the exemption play out. Senator Schumer has said that he will “reconsider” his position and there might be some other egg-on-my face reconsiderations. Representative Jim Himes, a Democrat, and former Goldman Sachs Investment Banker, whose district includes Greenwich and Fairfield, CT, noted that it is “difficult to see how a mutual fund manager pays ordinary tax rates but the manager of a private equity firm doesn’t.” The private equity manager and venture capitalist might argue, however, that they are putting their capital at risk to further business formation—and there is something to be said for that argument. A Hedge Fund manager who trades stocks and bonds of public companies and receives a performance based management fee is a different matter, and as Representative Hines said about his constituents, it is difficult to see why they should be treated differently than mutual fund managers or investment advisors who manage separate accounts and do the same thing. Hopefully there might be a way to make a distinction between at risk capital and collecting management fees in future versions of the bill. Meanwhile, Bernie Madoff who sits in a prison cell for the next 150 years if necessary for orchestrating a Ponzi Scheme with separate accounts can at least claim that he never benefitted from the carried interest exemption.
Saturday, February 4th, 2012
Mark Twain made the above remark in 1888 after visiting Germany and first hearing Richard Wagner’s music. As with many of Twain’s humorous observations, his assessment of Wagner embodies an idea that has much wider application to many areas and is a useful way to view what took place in the financial markets in 2011.
In 2011 the S&P 500 behaved like a schizophrenic yo-yo, making double digit moves in both directions and ending the year essentially where it started. Much of the market turmoil was linked to the debt crisis in Europe, the downgrade of US Government obligations from Triple A and the lack of constructive actions both in Europe and the US Congress to address the growth of deficits and the lack of growth in the economy. In the middle of the summer it looked as if Euro-zone might implode as the sixteen constituent countries, especially the two wealthiest, Germany and France, could not agree on a way to restructure Greek sovereign debt and avoid a disorderly default with Italy, Portugal and Spain possibly waiting in the wings. At the same time the US Congress could not agree on a constructive agreement to manage our own debt ceiling and growing deficit. These problems and trends are not going to change simply because the calendar has added a digit. Yet now we stand at the end of January 2012 with the sense that implosion in Europe is probably off the table and that some green shoots which had appeared in the US during the past year with respect to job creation and perhaps even residential housing are heading in the right direction. The deficit still grows but if there is little confidence in Congress, there is a consensus that the financing of the deficit is in the more competent hands of Ben Bernanke and the FRB. So after much turmoil or as Angela Merkel might say “Sturm und Drang,” the US equity market recovered in the final quarter to end the past year flat and has begun 2012 with a strong opening month. This is far different outcome than in past traumatic years. Moreover in 2011, Richard Wagner’s The Ring of the Niebelungen enjoyed new and inventive productions playing to sold out houses first at the San Francisco Opera and currently at the Met. So not surprisingly Mark Twain had it right on a few fronts at once.
Despite the equity market ending the year flat, a survey of investment returns reflects the difficulties of navigating through the volatility. Some high profile mutual fund managers such as Steve Leuthold whose Core Fund has consistently beaten the S&P and returned 8% annually over the past 10 years dropped over -5% and fared less well than the aggregate actively managed fund average return in 2011 which was down -3.3% . The place to be in 2011 was the Treasury market, but even Bill Gross at PIMCO, the most influential fixed income manager on the planet, sold his Treasury holdings before their big rally occurred in response to the chaos in the Euro-zone. A year such as 2011 often brings out the index and closed-end fund advocates such as John Bogle the founder of Vanguard, who created the first S&P 500 Index Fund in 1975 and Princeton Economist Burton Malkiel, author of A Random Walk Down Wall Street. Not unexpectedly we usually hear them leading the table pounding against active management. Yet Bogle and the other index asset allocators have been rather quiet and Professor Malkiel has published some Wall Street Journal Opinion Pieces advocating investing specifically in cash flow generating dividend stocks and for long term upside allocating some money to emerging markets. The word “closed end fund,” which was at the heart of the gospel according to Burt in his well known random walk theory does not even appear.
As for the best strategy for investing in 2012, we would combine Professor Malkiel with Shakespeare. Specifically the line repeated several times by Iago in his scene with the wealthy Venetian Rodrigo in the first act of Othello: “Put money in thy purse.” Now of course Iago, one of Shakespeare’s truly maniacal villains is hardly offering investment advice, rather he wants Rodrigo to sell his lands to get more liquid and then Iago will separate Rodrigo from his money. But let us not shoot the messenger. The advice to generate cash flow from your portfolio is an excellent idea. According to a white paper from the Investment Institute in 2010, historically 44% of stock returns over time frames of five or ten years and longer have come from dividends rather than appreciation, and in 2011 the number was higher. Further Shakespearean wisdom on navigating a tumultuous investment environment comes from Rosalind, the heroine of As You Like It. Rosalind spends most the play disguised as a boy in order to evade detection after her father has been deposed. She finds this a problem since some young women fall in love with her, one of these being a shepherdess named Audrey who is spurning the attention of her own diligent suitor. Rosalind’s advice to her is quite simple—the fellow in front of you is as good as it will get: “Sell when you can, you are not for all markets.” This sage investment advice along with a cash flow oriented strategy is something we do our best to implement at JMR Capital through a variety of investment vehicles. Although some of the “it might be 2008 all over again” fears are currently on the back burner, we are not completely out of the woods and it would be a mistake to expect stock returns to derive from significant price gains through multiple expansion. Stocks are cheap according to the historic S&P multiple of sixteen times earnings (they are currently between twelve and thirteen) but they more than likely could stay that way unless the global economy picks up significant steam. As Professor Malkiel points out in his WSJ article of January 5, 2012, good quality stocks are the best house in a bad neighborhood. He notes that if you buy 10 year Treasury bonds now with a 2% yield to maturity, you know exactly what you will earn, and that is hardly a satisfactory return. So there is a good possibility that cash on the sidelines at the end of 2011 could find its way into dividend paying high quality stocks, and our strategy will be to “put money in thy purse” through those kind of investments including high yield bonds, but to the chagrin of the buy-and-hold advocates, it is a good idea to listen to Rosalind be aware that not everything is for all markets and know that adjustments to even the best ideas and strategies will serve us all well in the long run.
Wednesday, May 4th, 2011
ENJOY THE MIXED SIGNALS
In his widely anticipated press conference on April 27th-the first ever by a Fed Chief-Ben Bernanke uttered the word “inflation” thirty-one times. Not far behind was his use of the word “transitory” to describe almost everything, including inflation, unemployment and the slow, bumpy pace of the recovery. In response James Grant, the often acerbic and highly respected publisher of the Interest Rate Observer remarked: “Paper money is transitory.” That certainly holds true for the value of the dollar which last week hit a three year low against major currencies. Most have praised the Fed Chief for his response to the financial meltdown and his ability to “make bullets out of thin air.” Yet as several commentators have pointed out, not everything Mr. Bernanke mentioned in his press conference can be transitory, especially the level of US Government debt. Legendary investment manager, Seth Glickenhaus, still managing over $1 billion at age 97 began his career during the Great Depression and provides some much needed perspective. Mr. Glickenhaus-a self described “optimistic pessimist”– simply noted last week that, “We have far more debt than we can pay back.”
Nevertheless, the equity markets during the first quarter of 2011 and through April largely shrugged off these concerns with the S&P rising 5.4% for the first quarter and adding another 2.8% in April. What lurked behind the good returns during 2010 continues so far in 2011: political unrest and turmoil in the Middle East and the time bomb of debt in Europe and the US. The confusing tug of war between headline grabbing geo-political events, macro economic concerns and improving corporate balance sheets in the US still shows no sign of abating, and is reflected in the monthly returns: January and February were both positive, showing 2%+ gains, but during March the S&P went below it’s starting point for the year and only after a furious charge in the second half of the month ended flat. US unemployment remains high and home prices remain low, European countries try to implement austerity programs without restructuring sovereign debt; but for the time being the financial markets appear to be forgiving on those two issues. On the currency front, however, the markets have been less forgiving with the dollar substantially weaker as the mounting US debt issuance creates fiscal anxieties. It is always important to remember that much of the money flowing in and out of US equities and bonds comes from outside the US. Since the beginning of the year the dollar has declined more than the S&P has gone up which is not an attractive proposition for foreign investors. Currency hedging is complicated and expensive and it adds an additional layer of risk. Having worked with institutional investors in London in the 1980′s and ’90′s, it is clear that hedged or not, they need to be convinced that the growth prospects of US companies like Apple and Caterpillar will offset the decline in the dollar. This has been the case for the past couple of years, but will it continue? Inflation fears have also entered the picture in China, India and other emerging markets, and perhaps contributed to some of the strong performance this past quarter in commodities, energy, and precious metals. Still the main driver is supply and demand, and at a high profile investment meeting in Los Angeles, some of the largest Private Equity investors say they are still very sanguine about putting money to work in China, emerging markets, mining and energy. Despite all of the caveats the appetite for equities and risk assets moves along apparently unfazed by upheaval around the globe and lack of convincing growth at home. But to quote Arthur Miller’s line in Death of a Salesman, “Attention should be paid,” to market volatility and the weak dollar in the form of appropriate diversification, opportunistic investing and risk management.
They live off the income of their income. Mary McCarthy, The Group 1963
Mary McCarthy’s satiric novel The Group (1963), far ahead it’s time in many respects, follows eight Vassar friends from their graduation in 1933 (the year McCarthy herself graduated) through their intermingled lives, love affairs and ensuing complications. Out of the eight, six are from families on the Social Register. All desire independence from parental guidance and interference in life style, romance and politics, but do not mind the attachment when it comes to funding their post-graduation experiments in self-absorbed living. Mary McCarthy, who grew up poor after her well-to-do parents died in the 1918 flu epidemic, and made her own way successfully in tough circumstances enjoys calling out the discrepancy. The fictional family cited in the quotation has gained wealth and prominence through success in the steel alloy industry, and their daughter Helena, the class valedictorian is an outspoken liberal who spends the family money freely and much to her parent’s chagrin decides to teach nursery school. “Did we send her to Vassar to teach finger painting?” her exasperated father asks.
There is an old joke in Switzerland about someone who attends a prestigious social gathering where no one will speak to him. One of the newer guests asks why and is told in a hushed whisper, “Of course no one speaks to him. He spends his capital.”
In Thomas Mann’s novel The Magic Mountain (1924) the protagonist Hans Castorp goes to visit his tubercular cousin Joachim at a sanatorium in Davos. Long before Davos became the annual gathering place for global economic ministers, it was best known for expensive ski resorts and sanatoriums-a destination for the very healthy or the extremely ill. Hans Castorp, orphaned at an early age has been raised by a wealthy, very prudent and straight-talking uncle who imparts the following advice to his nephew about the inheritance he will receive:
Hans, my boy–you really don’t have that much—the lion’s share of my money stays in the business. What belongs to you is invested quite nicely and will yield a secure return. But it’s no fun nowadays trying to live off interest unless one has at least five times as much as you have, and if you fancy living a nice life here in the city, like the one to which you’re accustomed, then you’ll have to earn a tidy sum yourself—take note of that my boy.
Sage advice for any era and especially now when the challenge of living off interest income in the current Fed engineered low rate environment has become a source of concern. Thomas Mann’s own life experience in his early years was close to the fictional family cited in Mary McCarthy’s novel who “live off the income on their income.” But during his teens the family shipping business went bust, mostly on account of bad management (recounted in his first novel, Buddenbrooks), so he certainly knew both sides of the coin.
On the front page of the Wall Street Journal of April 4 we find the following headline: Fed’s Low Interest Rates Crack Retirees’ Nest Eggs. The Federal Reserve has kept interest rates low to stimulate the economy but most of those benefits have accrued at the corporate level with many of the Fortune 500 boasting great looking balance sheets. But this is hardly a boon for the fastest growing demographic in the US, people north of 55 years of age, who typically self-identify as savers rather than investors. With short term rates down to zero per cent their CD’s and savings accounts have been producing a net negative return for the past couple of years which not surprisingly is having a noticeable impact on this group’s spending. Most investors see continuing low rates as a positive signal, but last year Charles Schwab wrote an Op Ed for the Wall Street Journal, Enough With the Low Interest Rates (10/02/10) urging the Fed to raise rates so that the legions of retired savers would not suffer. As is often said, “Be careful what you wish for.” According to the more recent article, some of the savers wanted to have it both ways and are now in trouble according to a debt counselor in a retirement village in Florida: “In some cases…retirees took out mortgages and ran up credit card debt on the assumption that their interest income would help cover the payments…Older people tend to hide their troubles as long as they can. People are very prideful.” While recognizing the differences between today’s retirees and the literary examples cited above, all are in the position of needing to do something to change their respective modus operandi and learn to adapt to changing circumstances. In the case of savers needing to replace what had been predictable yields and streams of income, they will need to become investors and expand their horizons in order to generate yield that used to be more readily available.
And finally, the US and its allies were ecstatically praising the bold and successful operation by the Navy Seals that killed Osama Bin Laden just a few months before the 10th anniversary of 9/11. To what extent this disables Al Qaeda remains to be seen, but it will likely significantly eradicate the financial support for the terrorist network which came from Bin Laden. Whatever it’s broader meaning the impact on the US and global financial markets will be negligible-far less, for example than last quarter’s GDP report which showed growth at a disappointing 1.8% and testifies to the bumpy and uncertain pace of the recovery. One hopes that this report-to use Chairman Bernanke’s favorite word, is indeed “transitory.”
Sunday, February 20th, 2011
THE YEAR IN REVIEW
The Dow Jones Industrial Average is flirting with staying above the 12,000 mark for the first time since June 2008 and the S&P 500 is doing the same with 1300 (the S&P gets less face time in the headlines but is the more significant of the two benchmarks). It is worth noting that the last time the Dow was at 12,000, oil was $130 per barrel, gold was $650 an ounce, the 10 year Treasury bond yielded 4.2%, and the unemployment rate was 5.7%. Real estate prices had retreated from their 2007 highs but were still for the most part irrationally exuberant and anyone breathing could get a loan. All of these metrics are now substantially lower with the exception of gold and unemployment. Daily fare in the financial press, Bloomberg Television and CNBC is the meteoric rise in commodity prices and whether the main culprit is inflation fears coupled with political instability or
demand in rapidly growing emerging markets. It is fair to say that all do play a part. There is, however one factor that is not debatable and that is the demand created by the exponential growth of commodity based exchange traded funds.
Before the creation of the most actively traded commodity ETF, the SPDR Gold Trust (GLD), an individual investor who wanted to own gold had buy coins or bullion through an intermediary who charged a substantial markup or take a shovel and pan out to the mountains. There were the futures markets but there were many complications for individual investors so the Chicago and NYMEX trading pits remained largely the territory of large hedge funds and institutional investors. But then along came the commodity and futures based ETF’s which allowed granny to play with the big dogs and go long or short almost any asset known to man. The democratization of the investment universe is by and large a very good trend. But it is important to proceed carefully and with knowledge of what you actually own in the every expanding ETF world. Brokerage houses and the SEC which require a fair amount of financial disclosure to trade options, including prudent hedging strategies in IRA’s require none at all to trade ETF’s correlated to the most volatile and highly leveraged futures contracts. Still to date the most activity in the ETF commodity asset class has centered on gold. How did this happen? As a recent Bloomberg News article recounts, a sea change occurred when James Burton, the former head of CalPers agreed during a round of golf in the UK to become CEO of the World Gold Council which spearheaded the creation of the gold ETF as a means for “the man in the street who would buy a lot of gold if he could find an easy way.” When Mr. Burton was head of CALPERS, the investment portfolio he oversaw, according to the Bloomberg article, did not own an ounce of gold. When GLD, the ETF he created to buy and hold gold bullion for the “man in the street,” made its debut on the NYSE in 2004, the price of gold was $330 per ounce. It ended 2010 at $1390.
During 2010 the S&P as measured by the widely held SPDR ETF or SPY gained approximately 12.8%. Since we are discussing the ETF explosion, SPY was the progenitor of all the others. Despite the double digit gain there was a disconcerting and volatile ebb and flow to the year. In the first quarter the S&P gained roughly 4.75% only to give back 11.8% in the second quarter. On June 30, the S&P stood at 1030, down 7.6% from the beginning of the year and then produced a whopping gain in the ensuing quarter of 10.6% but struggled in the fall. On November 30 the S&P stood at 1180, which was 5.82% ahead of where it started the year. In one of the more unusual December’s on record the S&P gained another 6.5%. From the June 30 low of 1030, the S&P closed the year at 1257 for a valley to peak gain of 22% in the final six months. Such gyrations more often than make for a challenging investment landscape going forward. When the S&P was losing almost 12% the problems in Greece, Ireland, a weak Euro, concerns about entitlement costs and an uncertain domestic regulatory environment were to blame. Conversely when the S&P was rising by double digits, credit was given to upside earnings surprises in financials and technology, a favorable US election outcome and hoped for regulatory certainty. Past experience should raise plenty of caution flags on that front. When the dollar was weak, that meant better export conditions for the likes of Apple and Caterpillar. But when the dollar strengthened that was confirmation that QE 2, the Federal Reserve planned purchase of $600 billion worth of Treasury bonds, which by definition will be inflationary, was a good way to kick the can down the road. So we end the first decade of the new century with a confusing but robust fourth quarter when everything-stocks, commodities and the dollar all went up.
Looking ahead it is not viable to see all of these trends continuing-certainly with the dollar we can’t have it both ways. Some of the problems of 2008, high unemployment and budget deficits still persist at home and abroad, plus inflation worries loom large in China and other rapidly growing economies. Many of the upside earnings surprises in 2010 were based on weak comparisons from the prior year. That will not be the case going forward, and whether we might actually get some real growth remains to be seen. But in some cases the 2010 act will be quite hard to follow especially for financial companies that will not be doing all of things they used to do and charging less for many of the others. In hindsight, 2010 ended up being a good year to throw a dart at the S&P 500; 2011 is starting off well and has the “January effect” working in its favor. Most market forecasts remain very bullish for 2011 with equity mutual funds seeing the first influx of new cash in a few years as small investors take money out of bond funds. Government and high grade bonds which had a great decade do not look terribly appetizing with interest rates sitting at 25 year lows and the Fed committed to priming the pump. But these factors argue for being careful where you throw the darts and for sticking with a cash flow generating, total return oriented portfolio management discipline as the preferred way to navigate a difficult environment.
Stocks: The Best House in a Lousy Neighborhood
Bill Gross Likes Stocks screamed the cover story on the August 2010 issue of Bloomberg Magazine. Despite the earth shattering import of this news, it did not really cause much of an uproar. Mr. Gross has managed the largest fixed income mutual fund on the planet for over two decades and has won the fixed income manager of the year award so many times it should be renamed the Bill Gross Award. His bond and interest rate commentary can move markets and he predictably appears on the financial stations as the expert on the latest move by the Federal Reserve. Despite his shocking viewpoint about the equity market, he is seldom if ever asked about his take on the S&P or stock sectors he prefers. Not too surprisingly his preference is for carefully selected dividend paying stocks with good growth potential and the investment funds that hold them -and he will find no disagreement here.
“First, let’s kill all the lawyers!” Shakespeare, Henry VI,
A New York Times article on the travails of the Greek economy noted that in addition to its sovereign debt problems, the cradle of Western civilization is mired in arcane regulations that stifle business formation with many restrictive laws still on the books from the 19th century. Not surprisingly, despite its credit problems Greece is a great place to be a lawyer and boasts the highest number of lawyers per capita worldwide with one for every 250 people. Not far behind is the USA with one lawyer per 270, and a very large chunk of those can be found in California, where regulatory and fiscal comparisons with Greece, according to some, are not so far fetched. In absolute numbers the US has roughly 50% of the lawyers in the world. Spain, Italy and the UK are also in the top ten of lawyers per capita. Perhaps we are seeing an important benchmark which might bear closer scrutiny: India is not to be found among the top ten in lawyers per capita and does China have any lawyers at all?
As The World Turns: Thoughts On What May Lie Ahead
For 54 years beginning in April 1956 a popular daytime TV soap opera called AS THE WORLD TURNS was a small scale embodiment of a belief in what is termed American Exceptionalism. The show sponsored and produced by Proctor and Gamble, a leading US global brand, began with a spinning globe and some corny organ music then dissolved to the fictional setting, the center of the world–Oakdale, Illinois. This “we are the world” viewpoint was not inconsistent with the view held by most Americans during this period. An example of this type of continuing jingoism is that the baseball World Series still remains a contest between two US professional teams even though many of the players hail from elsewhere, particularly Latin America. Maybe at some point down the road the World Series will be played like the World Cup. But the world has turned and to get a sense of what this may portend, New York Times Op Ed columnist David Brooks points out that the US will need to adjust from assuming that we are still the center of things:
In the 20th century, America was the Big Dog Nation. We had more money, more resources…and we could outcompete our rivals by pouring in more talent, greater investments and more resources. In the 21st century, the US will no longer be the Big Dog. Human capital will be more broadly dispersed…To thrive, America will have to be the crossroads nation where global talent congregates and collaborates.
Many of the best companies in the US such as Google, Apple, Nike and Caterpillar anticipated these changes and have effectively taken advantage of the disbursement of human capital. At this writing the attention of the world is focused on the monumental transition taking place in Egypt. The success of the youthful revolutionaries in Tahir Square was attributed to a Facebook page created by a Cairo born and educated Google marketing executive Wael Ghnonim after he was detained for twelve days by the government. As Fouad Ajami, Director of Middle East Studies at Johns Hopkins observed, “No turbaned ayatollah stepped forth to summon the crowd– a young Google executive energized this protest.” David Brooks’ charge for the US to become a “crossroads nation” appears to be alive and well: two US technology companies enabled a momentous change in a country seeking democratic institutions and demonstrate how human capital is being broadly dispersed. Significant and challenging investment opportunities will no doubt evolve as a result.
Sunday, November 7th, 2010
We are in the midst of confusing, challenging and some might say perilous times. In such periods many people including heads of state often look to the works of Shakespeare for some guidance. So taking that cue we shall seek out some Shakespearean words of wisdom that might help us better navigate a difficult investment environment. Here are some examples.
There are more things in heaven and earth, Horatio, than are dreamt of in your philosophy…Hamlet Act 1, Scene 5
Horatio, Hamlet’s closest friend and fellow student at the University of Wittenberg, has just witnessed the end of Hamlet’s initial conversation with his father’s ghost. Horatio has not actually seen the ghost (he’s not entitled to do so), only Hamlet’s reaction to it. Wittenberg was known at the time as a center of Rational Philosophy and Protestant Humanism. Hamlet and Horatio would have engaged in studies and debate about Aristotle and natural phenomena: a talking ghost demanding his son take revenge on a libidinous uncle was definitely not part of that discussion. Hamlet, however, has just been jarred out of his comfort zone and lets Horatio know that in no uncertain terms.
During the past two years many investors have been jarred out of their comfort zones, or certainly should have been. Belief in the equity culture along with the sanctity of real estate investing has been badly damaged, perhaps permanently. Yet the same philosophical debates about buy and hold strategies for the long run versus active management still go on as either/or propositions. The passive index Modern Portfolio Theory (MPT) proponents still claim that what successful investing is all about is capturing the return of respective asset classes, that the only drag on performance is fees and that risk management strategies and trading disciplines used by active managers provide no lasting benefit. The academic evidence notwithstanding, investors who held the S&P and other broad based domestic market indices for the past decade have indeed successfully captured that asset class but have not made any money doing so: something akin to asking Mrs. Lincoln how she enjoyed the play. Nevertheless, the largest domestic equity fund is still the SPDR S&P 500 Fund, followed by the Vanguard Total Stock Market Index fund. It is interesting that the economists who devised MPT hail from the University of Chicago, where the business school is named for one of the theorists who built a mutual fund empire based on its teachings. The University of Chicago is described by its founders as being modeled on a German University so it might be the closest domestic approximation we have to Hamlet and Horatio’s University of Wittenberg. Hamlet’s experience of being jarred out of his comfort zone by events out of his control and seeing things differently as a result is instructive for investors. Perhaps a comparable case in point is the August 2010 Bloomberg Investment Magazine cover article about Pimco’s Bill Gross, the manager of the largest bond fund in the US and probably the most respected fixed income investor on the planet. The article is entitled “Why Bill Gross Likes Stocks: The Pimco Bond King says it’s time to Buy Equities.” Did the bond guru see a ghost? To some of his followers, Mr. Gross is making as jarring a pronouncement as Hamlet. Not surprisingly, on both CNBC and Bloomberg Television, Mr. Gross still holds court as the resident bond market expert and is rarely, if ever, asked about equities. The Bloomberg article appeared this past summer as nervous institutional investors pushed Treasury yields to lows not seen in 30+ years and the Investment Company Institute reported that for fifteen straight weeks retail investors had yanked their money out of equity funds and placed it in bond funds, presumably a lot of it going into the Pimco Mutual Funds managed by Mr. Gross. But Mr. Gross, like Hamlet is saying that he has been jarred out of his comfort zone, is looking beyond his “philosophy” and we should all pay some attention to this.
“Put money in thy purse…” Othello, Act 1, Scene 1
This phrase is repeated several times in the play’s opening scene by Iago and directed at the clueless wealthy Venetian Rodrigo. Spiced with some lurid bedroom depictions of Othello and Desdemona, Iago uses the phrase as a patter song as he manipulates Rodrigo’s hopeless love for Desdemona. It is also a way for Iago to enrich himself and advance his pursuit to destroy Othello. Rodrigo has little else to do in the play other than provide Iago with steady source of funds. Although neither man’s motivation has much to do with investment advice, Rodrigo does admit that he is getting no cash flow from his lands and will sell them.
Many investors in land and commercial real estate can easily empathize with Rodrigo. But they should have been aware of the pitfalls. A much larger contingent with a similar problem are the countless numbers of people getting little or no yield on their Treasury Bills and cash deposits in what will likely be a protracted low interest rate environment. In a recent Op-Ed piece in the Wall Street Journal, Charles Schwab admonished the Federal Reserve to raise interest rates and stop penalizing savers and retirees (“Enough With the Low Interest Rates!” October 2, 2010).
Despite his treacherous motivation, there is something to be said for Iago repeatedly reminding us of the importance of cash flow especially in uncertain and volatile market conditions. Ultimately all investments turn out to be yield plays and there is ample accumulated research over good market times and bad that higher yielding stocks and corporate bonds outperform the competition with less volatility. In other words cash flow is king and has been for a very long time. Increasing cash flow through dividends, bond interest and option selling is a prudent and proven means of both enhancing returns and practicing risk management. In the 19th century some of the great actors playing Iago were injured by objects thrown by audience members outraged by his villainy. But let us not shoot the messenger: Iago had it right and is promoting a sound investment strategy.
“But mistress, know yourself, for I must tell you…Sell when you can, you are not for all markets.” As You Like It, Act III, Scene 5
The play’s heroine, Rosalind, has disguised herself as a young boy called Ganymede so that she may move freely after her father, known as Duke senior, has been banished by his younger brother. The disguise is a fine idea except that young women fall in love with “Ganymede” which puts Rosalind in a difficult position since she is pursuing her own love interest and must also maintain her disguise. In Shakespeare’s time women were not permitted to act in the theater so we would have had a young boy actor playing a young woman who disguises herself as a young boy; hence the play on words in the title. One of Rosalind’s ploys to deflect the unwanted attention and advance her own interests is to provide impromptu relationship counseling as in the example cited above. In no uncertain terms the disguised Rosalind tells Phoebe that she should accept the proposal of the good hearted shepherd Silvius whom she has been treating badly. In other words: be realistic-it’s not going to get better than the fellow standing in front of you. Not unexpectedly, Rosalind’s directive takes a while to sink in.
The advice is more than pertinent for a wide range of investors who like Phoebe tend to have inflated opinions of themselves and their abilities, or are determined to remain out of touch with market realities. Back in 1980′s when there was a vibrant and often overheated IPO market, in road show after road show CEO’s would often chime the same refrain: “You know, we really don’t need the money we’re getting from this offering.” Such remarks were aimed to assure investors that the company was a viable entity. But that begged the question of why are you standing in front of us trying to raise capital? Occasionally a CEO would speak honestly and answer, “in all honesty, we’re raising money because we can.” That was a sanguine appraisal since for the past decade the IPO market has been effectively non-existent and only functions for large and already successful companies like Google who raised $1.6 billion at an offering price of $85 per share in 2005 without the aid of an investment banker managing the syndicate. Oracle Computer, by contrast raised $31 million in its IPO in 1986 at a share price of $15—an offering that would be difficult if not impossible to replicate since a $30 million deal is now considered too small and more significantly Oracle in 1986 was nothing like Google in 2005. Both companies today are worth about the same ($30+ billion).
The challenge to remain realistic based on the environment at hand also has application to those of us further down on the food chain with respect to investment management. Baron Nathaniel Mayer Rothschild, arguably the most successful banker and investor of his era once noted the key to his success: “I never buy at the bottom and I always sell too soon.” At any level it has always made very good sense not rely on one’s perceived prognosticating ability for success. Benjamin Graham, the founder of modern value investing who was Warren Buffet’s mentor had a guiding principle that made sense in 1934 in his book Security Analysis and perhaps even more so today: “The essence of portfolio management is the management of risks, not the management of returns.”
Monday, April 26th, 2010
Sadly, except for Duke students, alumni and maybe not even 100% of them, the Butler Bulldogs did not produce the storybook ending in the NCAA Men’s Basketball Final when their star player’s last second half-court shot bounced off the rim after coming tantalizingly close to going in. Before the game, billed everywhere as a David versus Goliath event, the New York Times produced a graph which showed the disparity in relative wealth and stature between the two opponents. Based on their respective student enrollments, both schools fall into the midsize private university category. But that is where the similarities end. Duke’s endowment is over $6 billion while Butler’s weighed in at $165 million; the Duke basketball budget is over $13 million while Butler spent slightly over $1 million. One sports commentator noted the Butler figure is less than Duke’s phone bill. That is likely a stretch but maybe Butler’s total budget is on par with Duke’s travel bill since taking multiple trips to Madison Square Garden from Durham, NC versus bus rides from Indianapolis to Muncie does add up. Regarding Butler’s final shot, there was this telling comment by a Duke player: “the shot was up in the air, for what, about 3 hours–everyone was sure it was going in.” So even the victorious participants seemed slightly disappointed not to see the storybook ending.
But an earlier March event, in its own way no less mad than the basketball tourney, the Academy Awards did give us a David prevailing over Goliath triumph when The Hurt Locker soundly trumped both Avatar and Up in the Air– the prognosticators favorites heading into the event. Similar to the Duke/Butler comparison, The Hurt Locker cost $15 million to make which sadly remains its gross even after the Awards. This number probably approximated the catering bill for Avatar which did garner a few Oscars, so the real loser at the Academy Awards was definitely Up in the Air, a movie with the mega-star George Clooney playing a likeable road warrior who spends his time flying around the country terminating management level employees. Quite a timely subject and ten years ago it would be hard to imagine this movie seeing the light of day, but desparate times call for desparate measures and the title of the movie aptly describes where we stand in the investment cycle in both literal and figurative terms. After the stock market’s breathtaking ascent in the second half of 2009, we had a continuation in the first quarter of 2010 with the Standard and Poor 500 increasing 5.3%. Yet the road was bumpy with averages falling over 5% during February on worries about a China slowdown and then a Greece meltdown. Interest rates except in Greece and other similar entities reamined largely in check and the Barclay’s Aggregate Bond Index (formerly known as the Lehman Index) rose 1.7%. Yet despite increasing optimism about corporate profits, recently increased consumer spending, and some interesting merger activity, it is hard to be unabashedly sanguine going forward. While the stock market may soon approach it’s pre-Lehman levels, housing and commercial property prices will likely take a far longer time to retrace theirs. A well placed real estate attorney told me that most of downtown San Francisco is effectively in foreclosure since eye popping loan to value disparities will need to be confronted as many loans are due to be renegotiated in the next few years. Indeed the Wall Street Journal’s HEARD ON THE STREET recently discussed the issue with reference to banks such as Wells Fargo , whose stocks have soared, but who have a high number of such loans on their books: “Even seemingly healthy loans where payments are up to date can end up hurting banks. Key Bank recently sold a repossessed Illinois mall for about 65% of the face value of the $37 million of debt against the property, even though it is nearly fully occupied.” (April 12, 2010).
Still there is enough good news on the corporate front both macro and company specific that has trumped such concerns for the time being. The closely watched ISM (Institute for Supply Management) Index, a monthly survey of over 400 US companies in 20 industries, registered a significant upside surprise in March. This is madness we all welcome since the latest numbers indicate GDP growth of 5-6% going forward. Normally GDP growth leads to domestic job growth although in our current predicament this logical expectation may not be a slam dunk. One of the reasons is that many doubt that the US Dept of Labor unemployment figure, hovering at just under 10%, reflects the reality of the job market since many people have stopped looking or have taken part-time work and do not show up on the monthly reports. The ranks of “consultants” have swelled and as the old joke goes, a consultant is a guy who knows how to make love a hundred different ways but lacks a girlfriend. The real unemployment number is likely closer to 15% and some commentators even worry that the encouraging news from the ISM will bring many of the under-employed back to seeking full time work which could even increase the the 10% number. Yet after the debacle of the financial meltdown and the ensuing recession, seeing likely GDP growth of 5%+ less than a year later is something to be welcomed by all.
Anton Chekov, the Russian physician turned dramatist, once noted that a revolver placed on the mantle in the first act must go off in the third. So what we will be waiting to find out is which of the revolvers on the mantle will be the one to go off and have the most lasting resonance. Will it be the recovery we are now beginning to see spurred by the ISM numbers and merger activity, or will it be a continuing downward spiral in housing, commercial real estate and real employment and the reckoning that results from our government continuing to kick the can down the road. As we wait for the ending of the play with Chekov’s warning in mind we should remember that most plays (including his) have four acts. So there will be more to follow after we hear our revolver and in the meantime we will remain Up in the Air. This is not an argument to run to the sidelines or take an ostrich approach. Rather it is a recognition that in an uncertain investing environment it makes good sense to be cautious, hedged, agnostic and above all, opportunistic.
Thursday, December 17th, 2009
SPANKING THE FAT CATS
Yesterday President Obama held a meeting with the “too big to fail” CEO’s where he admonished the bankers who received TARP funds to start lending their dough “in the national interest.” Both sides of the aisle have weighed in on this issue-the left decrying the TARP recipients paying their profitable trading desks bonuses built on back of taxpayer money while the right saying that the bailout reeked of socialism and that the banks should manage their own affairs for better or worse.
But let us say you are running one of these banks and you look at the landscape. Banks are in the business of buying and selling money, and like anyone else they want to buy low and sell high. Banks are getting (i.e. buying) money at pretty close to zero given the current level of short term rates via the Federal Reserve. So they should do well lending that money to small businesses and real estate buyers -all of whom agree that getting a loan is about as easy as running a marathon with your legs tied together. If you are paying close to zero for your money and can lend to a business or real estate buyer at 5 times that or better, isn’t that a favorable risk/reward-even if some of the loans don’t work out as planned? That is true, but the banks have a greater carrot dangling in front of them and that is the yield curve. The math is far from complicated. Here they can pick up 4.3% buying a 30 year Treasury or make a 30 year mortgage loan to a homeowner at around the same rate with a questionable asset the bank may end owning. Since there is a lot of that stuff in house already, there is not a whole lot of incentive to increase the inventory. They can hire loan officers and appraisers to determine the credit worthiness of the borrower and the asset-something which will generate positive press, or have their fixed income traders click boxes on their Bloomberg screens and make loans to the US Treasury. Yes and these traders may get a year-end bonus for doing their jobs profitably which involves using leverage and derivatives. And if Obama says you guys have to start lending, the bankers can say, “Guess what, Mr. Prez-we’re lending to you.” So as long as the yield curve looks the way it does at present, and the Fed and the Treasury Dept have not indicated otherwise, there is not a great incentive for the banks to lend, except to avoid a deluge of real estate bankruptcies through workouts and debt for equity swaps—that is the elephant in the room.
There is of course, a long history of US President’s spanking fat cat bankers. In the early years of the 20th Century, President Teddy Roosevelt often railed against the “corporate malefactors of great wealth,” although after 1907 Financial Panic he had no problems when the malefactor in chief—JP Morgan used his leverage with his fellow fat cats to rescue the US financial system from imminent collapse. That famous meeting at the Morgan mansion led to the formation of the Federal Reserve. The next Roosevelt made similar statements but kept mum when the bankers were doing what the current Goldman Sachs CEO called “God’s work.” Like President Obama, TR certainly would have said he did not “run for office to be helping out a bunch of fat cat bankers on Wall Street.” But the rest is and will be history.