Democrats and Taxes

This might be a bit behind the times, but still, I have to wonder: how can anyone take the Democrats seriously when they suggest that paying taxes is a civic duty, since it is clear that they do not believe that this duty applies to themselves?

Perhaps they assume that most people are cheating and underpaying because they do: they just assume most people cheat at least as much. After all, leftist fascism is at least well intentioned.

For a humorous commentary on exactly the kind of people I mean, listen to Tom Lehrer from 1964.

Like many in the investment blogging community, I am generally a liberatarian. I have voted for the Libertarian Party, although I often think it to be a bunch of wackos - but at least they stand on principle, if often incoherently. I am generally against government schemes to "help" people, because inevitably the politcally weak are fed to the politically powerful. This is done in the name of helping the economically "weak", though in actual fact this isn't necessarily the case either.

Billionaires with Bad Advice (pt 1)

When someone makes it on the Forbes Billionaires list, people tend to take his or her thoughts on business seriously. This is even more the case when that same person became rich by owning a money management firm. Indeed, Forbes takes Kenneth Fisher’s view of the markets so seriously that it has made him its longest running columnist and commentator in its history. Forbes and certainly its readers should rethink the confidence they have placed in him.

Fisher’s latest commentary contains statements that are patently untrue and are likely to mislead investors in ways that will be quite damaging to their portfolios, so I have to respond.

Fisher regularly offers a free commentary to the investing public (“A suprising prediction by Kenneth Fisher”) which is used as a marketing tool for his asset management firm. (It is offered at no cost for answering a short questionnaire about how much money you have and how much 3rd party management interests you). His latest commentary attempts to explain why an investor who has his money with Fisher’s firm should continue to keep it there and fully invested, in spite of the dramatic losses such an investor has sustained following Fisher’s advice. He resorts to two basic claims arguing for remaining fully invested. One is simply false the other is questionable.

The first is a claim about how markets recover. The information implies that markets always recover over a reasonable amount of time and that the long term trend of the market is up. This is simply not true, as anyone who invested in Japan in 1989 can tell you. After the 1929 US market crash, the market took 25 years to regain its high, but at least it spent most of that stretch of 25 years well above the lows it made in 1932. What Japan suggests is that following a massive credit bubble, asset prices can keep falling indefinitely. 20 years after the Nikkei index peak, the market is still making new lows (prices are back to the same levels they were over 25 years ago). In fairness, the US has a few fundamental advantages that suggest that a true Japan scenario is unlikely. On the other hand, the US is also confronted with challenges Japanese firms did not have to deal with: Japan’s struggles to maintain output happened against a backdrop of robust global growth which supported profitable exports.

The key takeaway for the prudent investor is that counting on rising markets is dangerous. Big falls in asset prices do not guarantee that investments will produce satisfactory returns going forward. Lower prices do suggest higher earnings yields, provided that earnings mean-revert. Keynes had it right. “’We simply do not know” if earnings will return to previous trend growth. In Japan, they did not, which is why the market continues to languish more than 80% below its highs. Investors must be wary and continue to be selective in their investment choices as permanent loss of capital is still possible. The focus must be on “return of capital” more than on “return on capital”. They should keep a bias for “cash on the table” in the form of steady, well-protected dividends from firms that have non-cyclical earnings streams, coupled with solid balance sheets that could be financed from operating cash flow.

Warren Buffett's Letter

Warren Buffett had his worst year ever in 2008. This is not surprising, since it was the worst year for the stock market in Buffett's investing life. Personally, I found the letter thinner on content than usual. There were not pithy observations on accounting rules, nor a simple explanation of the credit markets nor the currency markets. Even his discussion of Berkshire's businesses seemed a bid weak. Only in his explanation of his derivates book did his explanation of his thinking on how to price assets really shine. Nevertheless, I take four points from his letter.

1. Even investing geniuses are still human. Buffett acknowledges many mistakes this year, some are sins of commission and some of omission. As James B. Stewart of Smart Money observes, even Buffett can get caught up in the euphoria. I also made two sins of omission in 2008: not selling Bank of America stock when they acquired Merrill Lynch and not selling Bassett furniture immediately when it became clear that my outlook for the economy (that it would be dismal and that consumer durables would be particularly hard hit) was correct.

In the first case, I liked the strength of the commercial and retail banking franchise of BoA, and assumed that they had an idea of how to integrate Merrill Lynch retail broking and wealth management into their branches, which would be both cost saving and revenue raising at the same time. They may yet execute such a plan, but I suspect that the real hope was to vertically integrate along the asset backed security value chain: originating mortgages, bundling and selling Mortgage Backed Securities (MBS) all in house. That this will be difficult, if not impossible in the short term, is obvious, to say nothing of the credit quality of the combined balance sheet.

In the second case, I was simply blinded by my own assessment that BSET trades for far less than the value of its assets. Indeed, at this point, BSET may be more valuable dead than alive. The real problem was a conditional liability that I missed in the financial statements. Bassett has largely guaranteed their franchisees' leases, and this is a very large number. If, as the market clearly believes likely, many franchisees default, Bassett will be left to find a new tenant, or take over (loss-making) operations directly. Since retail storefronts are now a dime-a-dozen, the probability is quite high, that the company will be left holding the bag for a large amount of non-performing real estate. Ouch. Still, the new store format to which they are migrating does indeed seem to be helping sales, and with a strengthening dollar, the imported furniture that they sell may enable them to maintain margins and supported by cash flows from their investment portfolio, they may get through the next 24 months and recover. One can only hope.

So, sins of omission, but perhaps I shouldn't take it too hard.

2. Buy and hold of passive investments doesn't really work, even for great investors. Buffett has suffered huge declines on his public investments, including American Express, Coca-Cola, Burlington Northern and others. Many are treasured firms whose stock he has owned for years. It begs the question: if the best investor of all time cannot make money "buying and holding" then what should the rest of us do?

In my own portfolio, I have one "permanent" holding, and it is Colgate-Palmolive. This is a stock whose forward dividend yield is now at almost 3%, which continues to raise its dividend by 10% or more per year, which continues to repurchase stock in huge quantities and whose investor-friendly activities are backstopped by rising earnings that I project to be over $4.20 per share in 2009 (providing a dividend coverage ratio of 2.38). Plus, the stock is in a recession-proof business and has avoided making big acquistions. In short, it is the perfect investment.

But I have also watched the value of that investment decline from $80 a share to $56 (I purchased in the low $40s, so I have still had decent returns). Admittedly, at $80 a share in early 2008, it was a bit pricey at 20x forward earnings. Plus, it trades at 10x book (but earns about 90% on book). Why didn't I sell?

The truth is, Buffett has a good reason to have "permanent" holdings. In most cases, his ownership stake is so large and his portfolio so carefully monitored that he would have difficulty disposing of his positions. If Buffett is selling, after all, how exceptional can the value be? Retail investors, myself included, lack this rationale. Even if we hold a few blocks, and few of us do, our transactions are unlike to affect the markets, unless the stocks involved are very thinly traded. So, I conclude that the focus on "permanent" holdings, indeed the very idea of "buy and hold" is mostly the result of a desire for reassurance. Psychologically, we want to believe that we are "right" and that means keeping that which we own.

At these prices though, I am looking to add to my CL holdings, not reduce them. I still believe this is a $100 stock in 24 months, unless equity valuations completely implode, which is possible, but then, it will simply mean that I will have a rising annuity with higher yields than most bonds and insurance products. Not too shabby. More on this in another post.

3. Management counts. The secret of Buffett's success has always been in his ability to recruit the right people. As a investor, he has sought in most cases to have them in situ. He does mention that he has developed a few of his best managers, though obviously they were already natural talents.

As a passive investor, I pay a huge amount of money to professional managers who run my businesses for me. How they do it is probably the single biggest determinant of success or failure. But here, I think point one still applies. Even great managers make mistakes. Ken Lewis is a natural deal-maker - it is how he built BoA into the powerhouse that it is. He made a mistake buying Merrill, and sadly, this was a mistake that was driven by ego.

Lewis always wanted to show the New York crowd that a hick from North Carolina was at least as good as they were. They always looked down on him for building a commercial and retail bank, since everyone in banking knows that the "big swinging dicks" of banking are all "investment" bankers. Acquiring Merrill was Lewis' way to do it. But Lewis' careful and steady build-up of a leading commercial/retail bank was stupendously profitable. Even the disaster with Countrywide was manageable given the strength of the cashflows from the retail network. It remains to be seen if a universal bank can truly be made to function - the economics and compensation may simply be too far apart. For the forseeable future, though, Lewis will be out of dealmaking and will instead have to focus on operations. Is he the right manager for that?

4. Panic and fear are my friends. In spite of my losses on a few securities, I managed to liquidate most of my holdings in April of 2007, when the Dow was at 12,500. I missed the October top, but I have not regretted sitting in cash, where my interest earned actually afforded my a mild gain in 2008. Now, I sit confidently and wait for values to keep coming my way, confident in the meantime that I can suffer no major permanent impairment to capital. Low interest rates now make solid dividend yielding stocks the ideal area to look, though this does expose one to at least temporary capital loss.

In January, I did reenter the market, buying HELE aggressively, only to suffer another loss. However, the stock trades at a clear discount to intrinsic value and I may very well purchase more soon. The problem is, there are even more attractive values now than there were in January.

So, while I believe that the economic bottom will be reached at the earliest sometime in 2010, I continue to watch for individual values, knowing that the market is likely to continue downward movement due to panic selling of index funds by retail investors. I look forward to having a chance to make some significant gains in the next few years.

A Bad Year. A New Year. Where do we go from here?

Well, I have continued to be relatively silent about the markets, because I believe that successful investing requires insight and I haven't had much until this past week.

First off, let me start by saying that I hope everyone had a relaxing holiday period. I have been on a nearly forced vacation for the past three weeks, but return to my "normal" life as a management consultant on Monday. My girlfriend already started working this week, which has given me a chance to really catch up on reading, particularly reading about the markets. It is a fun time to read, because everyone in the commentariat has an opinion (guilty as charged). So without further ado let us get started.

2008 Review

2008 will go down in history as one of the worst years in market history. Apart from the collapse of the NASDAQ in 2001, the (American) markets have not seen a year like this since the Hoover Administration. Emerging markets, extolled by the commentariat between 2004 and 2007 as "risk reduction" through greater diversification and protection against a weak dollar, turned out to have even worse years than the US, with the BRICs, (Brazil, Russia, India and China) all suffering massive declines - Russia dropped near 80% or so. Since the dollar has recovered, the losses, in dollar terms are worse still. Dollar terms matter, because most readers of this blog have their expenses and more importantly, their liabilities in US Dollars. In all, I have heard estimate of $30 trillion were lost. I cannot verify this number, but if 1000 points on the Dow is a good proxy for $1 trillion in market value, then the US is down $6 trillion since the October 2007 highs. [Note: found the source for the $30 trillion, Bennett Sedacca via John Mauldin]

The year has been particularly bad for banks and for those who work for them. Investment banking is all but dead; since there is no market for most corporate paper - whether debenture, asset-backed, convertible, preferred or common. There was exactly one flotation of high-yield paper in Q4 of 2008. Likewise, commercial lending is supine. Most small- and medium-sized firms are simply not creditworthy. Those that are are mostly looking to reduce the outstanding balances on their loans and credit lines. Sure, these have to be renegotiated on a regular basis (every 3-5 years normally) but the fees from this are tiny, and many firms are reducing the size of the lines to cut the fee expense.

Trading, which has been the lifeblood of many heretofore profitable financial institutions is a mixed bag. The incredible volatility in the markets means that there is real opportunity to make big money in trading (if you know what you are doing). On the other hand, most of the risk management strategies that had been used, swaps and other "exotic" derivatives, are now extremely expensive. But much of the leverage that made trading so profitable is being bled out of the system. Trades that make you a fraction of 1% per year aren't so attractive at 10x leverage as they are at 30x.

Asset management doesn't look good either. Many, many investors are discovering the pain of "relative performance" or "benchmark" performance. They are paying bonuses to managers who are "only" losing them 30% instead of 44%. And they are pulling their money out, becoming convinced that maybe buying and holding is not always the best strategy, except for asset managers for whom it generates nearly annuity-like management fees. Of course, even where investors are not pulling out their cash, the balances are declining, which means lower Assets-under-Management (AuM, in industry parlance). I have good friends in the Asset Management business, and I know they and their firms are struggling. Sure, the pure-play asset managers will still make money, but bonuses will be much smaller than expected and asset gathering will be difficult as long as investors fear losing money in the markets.

But the trouble didn't stop with banks, or stocks. Bonds (excepting sovereign debt) also performed miserably. Investors appetite for loaning money to anyone, reinforced by an investing environment where debt coverage ratios and debt equity ratios are moving in the wrong direction, saw flight from anything with default risk.

Even alternative asset classes are getting clobbered - this article notes that Venture Capital is basically dead, since the two most common exits - flotation and sale - are both crippled by a lack of buyers. Equity floatation is nearly impossible and without financial buyers in the mix and even most strategic buyers looking to improve the asset quality of their balance sheets, high prices that produce the 20%+ returns are hard to come by.

Hedge funds, particularly those based on "quantitative" strategies that make estimate of fair value of an asset based on the value of other assets - and of course, apply healthy leverage - have imploded left and right. And that was before Maddow's Ponti scheme emerged.

Elsewhere on main street, housing has continued to decline with the anticipated recovery date pushed back again and again. Now I increasingly see that my prediction of price declines into 2011 are becoming more accepted. The reason is based on two factors - 1) most real estate is purchased with debt and 2) people do not like to make leveraged purchases of assets declining in value. After all, as Lehman Brothers showed us, leverage cuts two ways and even small declines in the value of the asset can quickly wipe out the equity in a leveraged investment.

Thus, demand for such assets does not increase until buying becomes attractive compared to other alternatives - in housing this means - prices will only stop falling once it becomes far more attractive to own than to rent. So far, prices have fallen enough to restore the historical ratio of housing and rental prices, instead, owning has to offer a very attractive rental yield before there is a sufficient margin of safety for most investors/buyers to make such an investment.

Consumption is way down - whether on gasoline, consumer durables or even basics. The commentariat seems dismayed by the fact that even Wal*Mart, a discounter, had a bad Xmas season, suggesting that other retail chains will do far worse (how can SHLD still trade at 20x earnings then? True, it is trading at a discount to book and it does have lots of cash, but I think this is the Eddie Lampert premium. The margins and returns are awful and the core operating business is worthless). But I digress.

John Mauldin, whose columns have become a must read for over 1 million of his subscribers, notes that all of the economic indicators look bad. .

Personal performance 2008
There is a saying in German which goes says that anticipation in the best form of happiness and that schadenfreude is the most beautiful form of happiness. "Vorfreude ist die beste Freude, aber Schadenfreude ist die schönste Freude". It is funnier in German, because the words for anticipation and schadenfreude share the same root.

It was with more than a bit of schadenfreude (glee, one might say) that I was relating to a banker friend that my personal performance in 2008 was actually positive. There were only two places to be, actually, cash and sovereign debt. I can congratulate myself for having had the smarts to be in one of the two, but before I really count myself a genius, I must admit that I picked the inferior one. CASH has long been a favorite because I believed that asset prices were simply too high and that there was no reason to take any risk of capital loss while waiting for a good time to move my money back into cheaper assets.

However, a better strategy would have been to buy Treasuries, which have rallied, and on which I could have earned a nice capital gain. (An even better strategy would have been to short the market and use the proceeds to buy Treasuries, but ... hindsight is 20/20). However, at the time, I could not tell if deflation or inflation were likely to be the bigger problem. I certainly did not expect that the Federal Reserve would act to reduce long term rates so aggressively, and I did not want to take the interest rate risk associated with 10- or 30- year government paper.

So, it was nice to be up, if only fractionally. I earned over 2.5% on my holdings of (now FDIC insured!) money markets and managed not to lose too much on my few equity positions. I outperformed the market by over 40% with less risk! Talk about generating alpha!

I must admit that my equity positions were hardly winners. Both of my big losers were stocks I purchased and held in part as hedges against my cash position. My own view was that the markets would tank. But in the event that I was seriously overreading events, I decided that I would hold some investments that would perform well in a mild recession/strong recovery environment backstopped by, in the first case, a strong operating business nad in the second, by a strong investment portfolio worth more than the company itself.

First, I badly stumbled with Bank of America. I have been savoring the massive yield for the past several years. I rationalized holding it by looking at relative performance, rather than at the facts on the ground. To date, the company has not had a loss making quarter, even when it has taken huge write downs. But the truth is, deciphering the balance sheet of any financial institution today is a lot of guesswork. As such, earnings estimates are really more estimated than usual. So, rather than sell at $52 in August of 2007 when I seriously thought about it, I still hold it at $14.

My other mistake was of a similar mold, BSET. This is a struggling furniture maker (that's a redundancy, right?) whose strength is mostly that they have a massive investment portfolio that they can use to ride out the downturn. The stock, now trading at $3, trades for much less than the value of this investment portfolio. At the time, the company appeared to be looking to undertake several investor-friendly steps to return cash in the form of a special dividend and buybacks. They are also in the process of overhauling their retail network with a new concept that has shown significant progress, or was showing it before the fourth quarter.

The company may very well survive the downturn. It has an established brand name, knows its customer base, has developed an attractive "mass-customization" design studio (pick your style, pick your size, pick your fabrics) as a retail concept and has cut expenses, if not ruthlessly. It also has ample financing from its still large investment portfolio and its share of profits from a major real estate investment. The company trades at a significant discount to assets. Further, assets are understated, because the company carries the value of its real estate holdings as a net liability, because of dividends in excess of profits from the real estate partnership.

But the company competes in an extremely difficult segment - consumer durables - where spending is largely discretionary and strapped consumers are simply not doing major remodelling, so the core business is likely to struggle for some time yet. And there are the contingent liabilities for the retail rentals for its franchisees.

I should consider selling both of these investments - but I believe the prospects for both are not that bad. BAC is consolidating the industry. Much will depend on how effectively it integrates the Merrill Lynch asset management business with the retail banking where it is already dominant. BSET would be worth much more than $3 per share if it were simply to exit the furniture business, except that it cannot do so, because of the status of its franchisees.

I brighter (or perhaps less dim) spot was CL. Colgate is still my favorite stock purchase ever. This company, though it trades at 10x book, is still a value. Dividends can be increases by 8-12% practically forever. Indeed, with a dividend of 40 cents per quarter and earnings of $1 per quarter, the company would still earn its dividend a decade from now while hiking payouts 10% each year, even if earnings growth were zero. Since it also buys back stock regularly and has seen growth in most markets, including growth in share, while being able to raise prices, earnings will likely continue to grow by about 8% per share nearly indefinately, supporting dividend increases of 10% or more, also indefinately. If the yield on the stock remains constant at 2.5% and the dividend increases 10% per year, this is a near "risk-free" 12.5% return. It amazes me that the stock is not at $100, but I believe it will be there before the end of 2010.

Conclusions and outlook

First, 2008 has taught us that fundamentals matter. Diversifying is simply not an adequate risk management strategy, because in major crisis periods, all markets tend to move together - down. And the possibility of suffering major and permanent loss of capital is large.

Second, relative performance can kill you. If the first rule of investing is "don't lose money" and the second rule, is "don't forget rule number 1" then investors must think in terms of absolute returns. This means, unfortunately, that some years, we may "underperform" incredibly frothy speculative markets. But the old saw about the correlation of risk and return, usually used to encourage risk-averse investors to move further out the risk curve, must be inverted. Taking more risk can kill you - and systemmic risk in particular - can wipe out a portfolio. Every risk, every position, needs to be constantly evaluated to determine if the upside is adequately backstopped by a margin of safety.

Third, markets have done a poor job of "pricing-in" events. As early as February 2007 it was clear that the financial markets were going to have problems. I exited the markets largely later that spring. Even after the extreme stress of August 2007, the markets made new highs in October! Earnings estimates continue to decline for the S&P500 for 2009, although, most people are still believing that things will improve in about six months. This has been the argument since 2007! The nice thing about this is that it means that we can profit from these "inefficiencies".

Fourth, markets do not always go "up". Japan made new post-bubble lows this year. Stock prices in Japan have returned to levels not seen since the early 1980s. Read this carefully. We are talking about having no capital gains in over 25 years. Investors who purchased the index in the 2nd half of that decade are still underwater, by as much as 80%. Of course, investment yields in Japan are so strong, who needs capital gains .... oh, wait.

The long and short is that we are in an incredible investing environment in which fortunes can be made and lost. Decisions will have long lasting and incredible impact. In part two, I will discuss the outlook for 2009.

Blodget says bubbles are rational

Henry Blodgett, a man whose greatest accomplishment was making a trend call on Amazon in 1998, has done it again. He substitutes narrative for analysis and now explains to us that the bubble was rational.

After constructing a list of possible culprits for bubble-mania (a list which includes mortgage brokers, real estate agents, Wall Street bankers, the SEC, and Alan Greenspan), he then lays the blame on the public - in his word "us". He excuses all of his straw-men with the following:

Everyone else on that list above bears some responsibility too. But in the case
I have described, it would be hard to say that any of them acted criminally. Or
irrationally. Or even irresponsibly. In fact, almost everyone on that list acted
just the way you would expect them to act under the circumstances.

He argues that every individual participant in the market had a specific aim, and that participating was a means to that end (and was therefore rational). He points out that buyers wanted houses (though in many cases so they could sell them to some other fool who would pay even more), agents wanted commissions, brokers wanted fees, and so on and so on. Playing the game was "rational" - and only the buyer had a real interest in predicting the future of the housing market (since he was the one who would have to pay for the asset, albeit over 30 years).

But what he overlooks, largely because his article is an act of narrative, not one of analysis, is the investor PURCHASING the loan in the form of a bond. What was irrational, ultimately, was that Mortgage Backed Securities (MBS) would always offer the same default risk as a government bond for substantially higher yield. This was idiotic. The price of the asset against which the security was secured (the house) in relation to the intrinsic value of the asset (the potential rental income of ownership) was already becoming strained in 2003-2004 in most markets. To believe that liquidation at anything approaching par would be possible, or that borrowers would really follow historical trends when it was obvious that an orgy of buying was pushing prices higher, was simply not rational.

True, the rating agencies wanted to rate bonds (because they wanted fees), but relying on the recommendation of a third party to do your homework for you - for free - now that is what I call irrational.

Eight Years of Agony

Hard to believe that eight years after the highs of the markets in 2000, we are again below those levels on all three indices. True, the DOW remains near its 2000 peak of 11722, while the S&P500 is about 20% below that level and the NASDAQ, well, the less said the better. Eight years on the index remains at less than half of the 5000 level it achieved in March of 2000.

How can this be? Earnings, which are supposed to drive valuations, have increased meaningfully since that time. Moreover, many companies have much stronger balance sheets than they did before. I would point to four factors - financials, changes in index components, fear about the economy and inflation.

Over the past 10 years or so, financial stocks have represented about 20% of the S&P500s capitalization. As industrial firms and manufacturing, the old staples of the index, declined in market value banks and financial firms came to dominate the index. Financial stocks have been crushed. It is therefore no surprise that the indices have also been punished.

The financial crisis continues to rage with an evolving sense that the whole system is rotten.
What first seemed an isolated problem in a few narrow classes of assets - CDOs and other structured finance products - have metasised throughout the sector. The reality is that while the owners of structured finance might have appeared to be narrow, hedge funds, pension funds wealthy investors - all of them seeking income yield unlike most individual investors - structured products were sold backed by all manner of securities, which drove the prices of those assets above reasonable levels (Greenspan's "conundrum") and encouraged massive leveraging, which, sadly, was rewarded not by the lower prices that increased risk should have produced, but by higher prices as people piled in to ride the wave of asset price appreciation. More on this in a moment.


The second factor is the way the indices have changed. This is most evident in the NASDAQ and is a major reason why the price levels there have not rebounded with profitability. Stop to consider that when one of the profit measures of an index is performed it considers the profitability of all the components - this is logical. But if many of your components were money losing companies and they go bust, your index sees a profit improvement, even though the remaining companies may not really be more profitable than they were before. Sadly, this is exactly what has happened in the information technology sector. The composite index has seen strong profit growth mostly through an "addition by subtraction [of a negative]". The remaining companies, however, have not demonstrated strong profit growth and their prices therefore linger. Think MSFT, a company that is struggling to change from being a fast growth company into one that basically operates a franchise with modest growth potential.

The third factor is of course fear about the economy. If overall economic activity declines, future profitability will likely be lower. Marginal companies, in particular will find the going difficult. And many traditional policy supports such as lower taxes and easier money seem more foolish than helpful given the massive red ink of the US Federal Government and the surge in global prices. Thus, the economy seems set for a cycle of lower growth - possibly below the rate of productivity growth - which leads to unemployment (or fear thereof) and therefore lower consumption and lower economic activity and so on - the classic downward spiral. The only upside in this is that lower spending likely means lower prices for consumers, since output capacity that exceeds demand may lead to lower prices to clear the market (though it may also lead to reductions in capacity and massive write-offs: think Ford and GM). The other upside is that employed people may have the chance to save and repair household balance sheets, if falling asset prices don't overwhelm saving efforts.

Falling asset prices are of course, the biggest concern of policy makers. Sadly, these same people never worry about asset prices increasing too much. People throughout the world have been able to rely on higher asset prices and the high internal rates of return on savings to consume. As I write this, I realize how illogical it is - high rates of return should encourage investment and low rates consumption, but the reverse has happened. There must be a Ph.D. in this somewhere.

The fourth factor is inflation. This is showing up in specific commodities and affecting consumers spending patterns. There is significant substitution toward fuel, heating oil, natural gas and electric expenditure. That money has to come from somewhere and it appears that it is coming from other consumer purchases, particularly in durable goods where outlays can often be deferred for years. Of course, higher inflation also discourages savings and the higher costs of living, unless offset with higher wages, may also be accomodated by lower savinsg, so as to keep consumption consistent.

Inflation, apart from its "real" economic effects, also has another affect on asset prices. Hint: it is not good. High inflation leads to demand for high earnings yields and that means low P/Es for stocks. Note: stocks are usually sold as an inflation hedge, since companies can raise prices and therefore increase earnings. But the problem is, when inflation increases, the value of a dollar of future earnings decreases and it is a struggle to keep earnings growing fast enough to offset the higher discount rate demanded by investors.

To keep it simple - remember that the value of a growing perpetuity is

Dividend/(Discount rate - Growth Rate)

this is the famed "Gordon Growth Model". In theory if the discount rate and the growth rate increase the same amount the value of the perpituity remains the same. However, when inflation is rising, r tends to increase faster than g, so the value of the perpetuity declines.

Recent history offers a compelling example - in 1964 the Dow stood at 766. After 18 years and strong absolute earnings growth - in 1982, the Dow stood at 781. This was because P/Es had collapsed due to inflation. It didn't hurt that earnings took a beating during the nasty 1982 recession.

So - eight years into this cycle, could we be stuck at this level for another decade? Well, let's not forget that the index cycled up and down around this level, hitting 500 and 1000 many times in between. But doesn't this feel like a similar situation to where we are today?

So what to do. Well, one option is to purchase true inflation-fighting investments. Stocks don't do that well against inflation because CapEx expense increases at least as fast as earnings. Returns on Book can plummet. But investments like real estate (I know, real estate? am I crazy!) and commodities are proven inflation fighters. My problem with commodities is that they don't offer current income, so it is pure speculation on price movements. I have to claim ignorance here.

That leaves stocks and bonds. Bonds, unfortunately, get killed in high inflation cycles. Long Treasuries were trading at 15 - 15! - in 1981. Short maturities don't offer yield high enough to prevent the decay of price power. For me, that leaves equities.

But - this is the key - what kind. We must look for current yield, as yield appears to be the only return available to us. We must therefore look for companies with solid yields and a high probability of an increase in dividends goign forward.

These are boring companies, mostly, but their prices will exhibit less volatility and their yields provide a good floor against sudden price drops. Price decreases, actually, are opportunities to dollar cost average your dividends into the stock. A good example is CL.

Also look for stocks that trade a low ratios to book value. Book value is often a good indicator of intrinsic value. Because assets are held on the balance sheet at the lower of cost or market, companies that trade near book are likely to have large phantom equity that you as the shareholder can obtain. Rather than purchase an income stream whose value is questioned by the market, you get real assets that are available now. Good examples here are BSET and HELE.

On the more speculative side, I believe that there are some values in the financial sector, but it will be difficult to determine which banks are relatively safe. The insane leverage of the investment banks makes them all suspect, but the money center banks (excepting Citi, which is a basket case) have been pummelled. Personally, I still believe that BAC is the strongest of the large banks. It continues to make money even after the writedowns (though it has not earned its dividend and may need to reduce it). In a world where finding creditworthy borrowers is the problem, banks will have to offer services and other values to attract those borrowers.

BAC is uniquely positioned to offer the help of a local branch and a local agent who can help people shopping for a mortgage, real estate investors and other small and medium sized business owners looking for financing. Investment banks will be pummeled because large businesses will not have the financing needs they had before. Why float new issues when you don't need new capacity? Easier to finance low CapEx from cashflow. Competition for deals will be amazing and fees will likely be reduced. Commerical banking will be the most profitable part of the industry and here the BoA footprint is a real advantage.

That is how I see it going forward and now you know what I am looking for: firms with solid balance sheets that trade near book value (and will be less immune to multiple contraction) that pay dividends that are reliable and likely to be increased.

The End of the Euro?

Jim from The Depression of 2006 has started a very interesting conversation on the return of the Deutsche Mark. I have been arguing that the Euro is here to stay and that it has benefitted Europe in many ways, not least, through higher efficiency and by making cross border consolidation of industries easier, since currency arbitrage is no longer necessary, at least within Europe.

But this article is another piece of "evidence" that there is dissastifaction with the project. So I wanted to address it.

Jim and others have taken the view that the Euro is a real drag on competitiveness, particularly for Germany, a country that is heavily dependendent on exports. Germans often complain about prices under the Euro, calling it der Teuro, which is a pun on the German word for expensive, which is teuer (pronouced toi´-er). The German pronunciation of Euro is Oi´-ro, so it rhymes.

I countered that the actual influence of the higher Euro on finished goods prices was not that large, because a stronger Euro was making raw materials relatively less expensive. Raw materials are a major factor in the price of automobiles and other high-end export products. The higher Euro primarily creates a price disadvantage in labor costs - this is not nothing, but a 50% increase in the value of the Euro does not translate into a 50% cost change, more like 15-20%.

This, of course, is still an issue, but there are other positives that offset some of this decline. First, Europeans are experiencing higher purchasing power - energy costs, food costs and other basic materials, not to mention imports of equipment like computers and software from the US have become less expensive. The higher purchasing power allows Europeans to increase aggregate consumption, meaning that more economic growth can be driven by the home market. Overall, I argue (and most economists and business leaders would agree) that the Euro has been a net positive.

Politics, of course, is something else. Focused on Germany, I largely neglected the other side of the coin - the Mediterranean economies, Italy, France, Spain, Portugal and Greece. An article in Forbes argues that they desire to pull out of the Euro, because they are prevented from using their traditional strategy for restoring economic balance: currency devaluation.

Andre Sapir, a major insider at the EU, has published a paper on the European Social Models, which argues that there are really four different economic models offered in Europe. Each model offers certain strengths and weaknesses, though some more strengths and some more weaknesses. A key factor is that the Mediterraneans have traditionally resorted to devaluation to escape structural problems in their economies, such as demands for high wages from relatively unproductive union workers. Because it enforces a consistent monetary policy (and one that reflects the desires of the "Continentals" - Germany, Belgium, Luxembourg as well as Austria and France) it essentially runs counter to the political situation in Spain, Italy and Greece, and that they may chose to leave. (Note that the Nordics and Anglo-Saxons largely avoided joining the Euro altogether).

The argument in Forbes essentially says that if they were to leave (certainly if France were to pull out) the Euro as a currency would collapse, and Jim would be right, we would have a new Deutsche Mark. (Though, were this to happen, I believe the Germans would still engage in policies such as fiscal displine an a positive balance of payments that would ensure the Mark would be strong, not weak).

I still think this outcome unlikely, in spite of the glacial progress of European integration. More and more, that integration is leading to substantial gains. Moreover, many of the countries, particularly Germany and Austria and to a much lesser extent France, have made real strides in improving the productivity of their economies. A collapse of the Euro would invite many other changes which are generally well received in Europe. It would ask whether the common market should really be maintained, or whether the Schengen system (which allows for free movement of people, i.e. the ability to work outside of one's home country) should be continued and on what scale. All of which would lead to reduced, not enhanced, opportunity for Europeans.

Economic nationalism is rearing its ugly head in many places, the US presidential election, particularly in places like Pennsylvania, which has seen a decline in manufacturing employment (much of which has moved South, not offshore, or simply been automated out of existence).

Globalization is not an inexorable trend. Largely global markets in the late 19th century, which coincided with massive gains in labor productivity and also purchasing power, were undone in the period 1915-1935, especially 1930-1935, when international trade declined by over 30%. The outcome was predictable. With the loss of global markets, local surpluses of goods, services and commodities could not reach needed customers and prices, employment and investment fell precipitiously. At the same time, consumers could no longer tap global sources of supply, so local shortages resulted in higher prices and lower consumption.

I remain optimistic that Europeans will keep the Euro. I find it much better than changing currencies all the time (how many Austrian shillings to the dollar again?) and it creates a sense of a broader European market, rather than a series of small national ones - a sense which is slowly becoming a reality. I am even getting used to the 1 and 2 Euro coins, though, as an American, I still believe change should be for amounts smaller than a basic currency unit.

The article has some advice on what to do if you want to speculate on a disintegration of the Eurozone. I have no better suggestions, but I will point out that the devaluation that is anticipated would be bad for commodity prices (in US dollar terms). But it is a bit early to go short on commodities over anticipation of the demise of the Euro.

Posting Delay

Sorry all, I have been unable to post due to some technical difficulties.

But I have found an interim solution, so I will return to normal posting now.

Housing Analysis: You read it here first

I relgiously read two of John Mauldin's weekly newsletters, Thoughts from the Frontline and the Outside the Box E-Letter. Last Friday, in FrontLine, he mentioned two deep analyses of the housing market, both Powerpoint™ presentations. Based on his recommendation I read them both. One slide, from John Burns Real Estate Consulting made me particularly proud, because of this chart:

A few weeks ago, in my own reading of the housing tea leaves I produced and published this chart:

When I published this analysis, readers of this blog were quick to comment on my view that it is necessary to see a significant overshoot to the downside in order to offset the long and excessive overshoot to the upside. This follows from the very definition of a trend line. A trend line is defined using a statistical process known as ordinary least squares (OLS). What this does is draw a line through the data set such that minimizes the total distance between the square of the actual data (the Y-value) and the trend line, for every X-value in the data set. Squares are used to eliminate negative values. In other words, we try to find the line that has the least “error” – that one which does the best job of estimating what the Y -should be for any X-value.

In a good data series with a strong trend, we can often “free-hand draw” a trend line through a data series because visually we see that the line must be roughly “in the middle” that is – that error of underestimation (where the actual data is above the trend line) must roughly equal the amount of overestimation (where the actual data fall below the trend line). That is, the point at which there is the least “error” in estimation.

Drawing a trend line through a data set is easy (actually, we can draw multiple trend “lines” as many trends are better described by curves, such as compound interest projections). The question is – does the trend line matter: that is, is the relationship a significant one.

In the case of home sales and their growth over time, the answer is yes. Home sales volume, over the long term, is driven by household formation which itself is remarkably stable, though it certainly has gone through periods of faster and slower expansion, thus residential real estate sales growth over time is remarkably stable (note that the growth rate is the slope of the trend line). Home sales growth is a geometric series with respect to time, however, so there should be a curve sloping upwards, the problem is, the growth rate itself is so small (At less than 1% per year) that even over long periods of time the series may appear to be linear.

Nevertheless, not to get carried away, what is important to realize is in order for housing to bottom, sales must remain below trend for some time. This is not what policymakers are suggesting. Rather, they are trying to find ways to support bubble-era prices in a post-bubble environment.

One suggestion has been for the Federal Government to purchase and demolish undesired homes so as to reduce inventory. Incidentally, this policy is not without precedent in major cities that have fallen on hard times. Philly and Buffalo both have crews who perform demolitions, though sadly, there are so many homes that the crews have multi-year backlogs.

While I think this to be a good idea in cities that clearly have far too many homes to support the population that actually wants to live there, I think it should be done at the local level, since it was local planning boards who approved the building of the homes in the first place. Local taxpayers will suffer the demolition costs, but they are also the ones who will benefit from the presumably higher prices that derive from having fewer homes for sale (and fewer abandoned homes in the neighbourhood). I see no reason to make residents of Omaha pay for demolition to support home prices in Las Vegas.

But attempts to manage inventory is trying to fix the wrong problem. The issue with sales (and ultimately prices) is that there are relatively few buyers. Very few people have anything like an incentive to purchase a home, given that buying a home represents a huge premium to renting. Moreover, very few people can come up with a substantial down payment required to purchase a home in the absence of home price appreciation. But reducing inventory will likely make the problem worse.

Reducing inventory is an attempt to maintain artificially high prices – but who would or could pay those prices? Even the people who “purchased” the homes, using questionable financing let us not forget, could not afford those homes. At best we will exacerbate the problem of poor affordability at worst we could reignite bubble lending and more building.

Do you see, as our politicians do not, that keeping prices high means that the only option for purchasing is to continue to rely on low-down payment financing and hope for future appreciation (i.e. bubble thinking)? The higher prices remain, the larger the down payment required to obtain a conventional mortgage. Why do we want to make it harder for people to purchase a home?

The best option is to see a reduction in prices. Only a revaluation of owned real estate with respect to rented real estate can encourage buyers to make the switch from renting to owning or to purchase an additional property with the intent of renting it. This could, begin to help us lift that trend line.

Conclusion

Housing sales will be down for years. The fundamentals are against home purchase, though there is some potential in trade up now, if you can sell your own home. First time buyers are still priced out of the market and will be discouraged by falling prices to risk hard-saved equity. Moreover, lenders will be insistent on having lower LTV so as to ensure adequate protection for their own loans. The lack of buyers cannot be materially improved by policy moves, though it can be materially impaired by them.

I also recommend that you sign up for John Mauldin’s newsletters here and that you read the presentations here and here.

Just remember, you read it at the Strategic Investor first.

End of Month Review

It has been a week since I last posted, for which I apologize. I want to cover a few topics with this post, which is technically a violation of the rules of good blogging, but it just doesn’t make sense to have a bunch of really short posts.

First, I would like to thank all of you who have been visiting. March 2008 is, by my standards, the most successful month in the history of this blog. Daily traffic has been rising along with inbound links and this blog now ranks in the upper half of finance blogs in TopBlogSites, an improvement of about 100 positions inside of a month. Even more satisfying to me, the frequency of comments has increased as well. My goal is continously to improve the quality and value of the content here. More on how I plan to do this in a following post.

Second, I want to criticize a few points in my most recent Bear Stearns post. Given the willingness of JPM to quintuple its bid to $10 per share, one can only conclude that, indeed, the $2 bid was too low. If I were being obstinate, I might argue that the need to increase the bid so dramatically was the result of a negotiating mistake. JPM agreed to guarantee the debt of Bear (beyond the guarantees of the Fed) without being certain that they would consummate the deal. Thus, JPM apparently faced the possibility of guaranteeing the debt while Bear was free to find other suitors. The new arrangement involves issuance of new equity to JPM, which means that it gets to vote on its own deal – just wait until the lawyers get a hold of this one. Still, there was clearly enough “margin of safety” in the deal to add $8 per share, about $900 million based on 113 million shares outstanding. So I was wrong.

Third, the results of our first poll are in. The question was who was most likely to succeed Warren Buffett as the chief investment manager of Berkshire Hathaway, since increasingly this seems to be the focus of the Board. Several candidates were proposed, all of whom have money management experience. It’s a tie. There were only two votes, one for Eddie Lampert and one for J Christopher Flowers. Since it’s a tie, I guess I will have to break it. I think they are both candidates, but Lampert’s investing style and breadth of investment focus better suit Berkshire’s portfolio. Flowers, a brilliant investor, is too focused on the financial sector. His focus is what makes him successful. He might be an ideal manager of the insurance business, but Berkshire already has that talent available in house. I vote for Lampert.

Finally, I want to discuss my posting schedule. It is my objective to publish something every day the markets are open, but it is difficult to do meaningful analytical writing at that pace. For the month of April, I will endeavor to publish four days of the week - Monday through Thursday, though some weekend posting is also likely.

Again, thanks for reading and responding, it makes this blog much, much better