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

The Credit Crisis in Song

This is hillarious and well done.

I will start off by saying that I did not write this and am claiming no credit for it. A friend sent it to me (she didn't write it either).

I have added a link to a YouTube version of the song, in case you want to get the various melodies and changes into your head.

.. sing along to the tune of Bohemian Rhapsody

Is this the real price?
Is this just fantasy?
Financial landslide
No escape from reality

Open your eyes
And look at your buys and see.

I'm now a poor boy
High-yielding casualty
Because I bought it high, watched it blow
Rating high, value low

Any way the Fed goes
Doesn't really matter to me, to me

Mama - just killed my fund
Quoted CDO's instead
Pulled the trigger, now it's dead
Mama - I had just begun
These CDO's have blown it all away
Mama - oooh
I still wanna buy
I sometimes wish I'd never left Goldman at all.

I see a little silhouette of a Fed
Bernanke! Bernanke! Can you save the whole market?
Monolines and munis - very very frightening me!

Super senior, super senior
Super senior CDO - magnifico

I'm long of subprime, nobody loves me
He's long of subprime CDO fantasy
Spare the margin call you monstrous PB!

Easy come easy go, will you let me go?
Peloton! No - we will not let you go - let him go
Peloton! We will not let you go - let him go
Peloton! We will not let you go - let me go
Will not let you go - let me go (never)
Never let you go - let me go
Never let me go - ooo
No, no, no, no, no, no, no, -

Oh mama mia, mama mia, mama mia let me go
S&P had the devil put aside for me
For me, for me, for me

So you think you can fund me and spit in my eye?
And then margin call me and leave me to die
Oh PB - can't do this to me PB
Just gotta get out - just gotta get right outta here

Ooh yeah, ooh yeah
No price really matters
No liquidity
Nothing really matters - no price really matters to me

Any way the Fed goes..

Did JPM get a good deal with Bear Stearns?

On the surface, it seems like JPM walked off with a great deal. As of the last reported period, ended November 30, 2007, Bear had $11.4bn in Equity and an asset base of $395bn. With 113mn shares outstanding (184 issued less 71 mn treasury shares) the company had almost exactly $100 book value per share and $349 in assets per share.

If we throw in an extra billion for the actual value of the Manhattan HQ, which was (probably generously) estimated at $8 per share, the company had $108 in equity/share. JPM must have stolen the company, right?

JPM was able to by the company for less than 2% of tangible book as of Nov 30. Not only that, they were able to get the Fed to pretty much guarantee the balance sheet, so there should be few write-downs, right? Couldn't the Fed have allowed Bear to work off its balance sheet problems and have allowed the company to go on, rather than let JP Morgan make a vulture killing?

I think we shall see that JPM got a decent price for the company but this might not be as good a as ideal t first appears. It is worth noting that several other players, including J. C. Flowers, who has made himself a billionaire by purchasing distressed banks, took a look and decided to walk. Perhaps they could not have gotten the Fed's guarantee. It is also worth noting that the folks who decided to sell were among the firm's largest shareholders and were among those who will feel the loss most personally as their equity and their options are essentially wiped out.

Bear was carrying massive leverage under which small losses would wipe out shareholder equity. Furthermore, its operating businesses were experiencing massive reductions in volumes and coupled with the growth of the balance sheet and the interest associated with it, Bear was going to find itself having difficulty meeting its fixed charges. This is a pernicious problem with banks - once under distress it becomes virtually impossible to do the additional business required to earn the money to repay the obligations. JPM itself wanted to make sure that it would have no goodwill writedowns that would raise speculation that its own balance sheet would become impaired. Thus, doing a business at a hefty discount to an uncertain book value was the only way to get this deal done.

We need to go deeper into the financials to understand why Bear could no longer continue as a going concern. Against a bankruptcy, $2/share doesn't seem so bad, actually. I believe there is every reason to believe that the actual book value of Bear is much lower than the annual report suggests.

First, let's look at the balance sheet. Like all banks, Bear uses generous amounts of leverage. Investment banks, in particular, use high leverage because they hold assets for very short periods of time - they underwrite securities, they do not hold them as investments.

High leverage is what enables banks to make good profits on small margins. For instance, if your assets are earning 1.1% (on total asset value), after interest payments, but you only own 10% of the assets with equity, you get to keep the full earnings, turning a 1.1% return into an 11% return.

But on the downside what it means is that you can be wiped out with a small loss.

Bear had this to say about Leverage in its own 2007 Annual Report (pg 52). You can find the entire report at the www.sec.gov or get it here from Yahoo! Finance.

Balance sheet leverage measures are one approach to assessing the capital adequacy of a securities firm, such as the Company. Gross leverage equals total assets divided by stockholders' equity, inclusive of preferred and trust preferred equity. The Company views its trust preferred equity as a component of its equity capital base given the equity-like characteristics of the securities. The Company also receives rating agency equity credit for these securities. Net adjusted leverage equals net adjusted assets divided by tangible equity capital, which excludes goodwill and intangible assets from both the numerator and the denominator, as equity used to support goodwill and intangible assets is not available to support the balance of the Company's net assets. With respect to a comparative measure of financial risk and capital adequacy, the Company believes that the low-risk, collateralized nature of the items excluded in deriving net adjusted assets (see table) renders net adjusted leverage as the more relevant measure.

Bear argues that comparing the gross balance sheet to shareholder's equity (what I would consider normal) unfairly reflects the position of several assets that are cash or equivalent and which *could* be used to reduce borrowings. A fair point is that preferred stock, particularly in distress, should be considered equity capital because dividends can be suspended and because in this case the preferred is not redeemable at the option of the holder (thus Bear has no obligation to actually pay this debt. For our convenince Bear makes the adjustments to the balance sheet and summarized them in the follwing table.

As we can see, Bear's leverage rates increased from 25x, a not uncommon figure, to 33x. Even if we add the additional value of the real estate, we only bring the leverage down a bit. Adjusted, of course, this number becomes lower at around 19x. This was not simple misfortune on the part of this bank. Moreover, there is also this "nugget", also from pg 52 of the 2007 Annual Report:

Given the nature of the Company's market-making and customer-financing activity, the overall size of the balance sheet fluctuates from time to time. The Company's total assets at each quarter end are typically lower than would be observed on an average basis. ... At November 30, 2007, total assets of $395.4 billion were approximately 12.2% lower than the average of the month-end balances observed over the trailing 12-month period, while total assets at November 30, 2006 were approximately 0.5% higher than the average of month-end balances over the trailing 12-months prior.

So the actual leverage ratio during the year was even higher than is here represented.

It may be yet worse - another gem from the section on Off Balance Sheet Arrangements, on pg 61- "[the] Company reflects the fair value of its interests in QSPEs on its balance sheet but does not recognize the assets or liabilities of QSPEs". QSPEs are Special Purpose Entities which hold various mortgage backed paper. While the company may not have to repurchase the paper, (thus avoiding the need to consolidate the entity) we have no idea how much risk the company is really taking - what is the actual exposure here? Fine that the balance sheet reflects earnings or losses through 30 November, but what happened in December, January and Feburary as housing and the mortgage market continued to decline and foreclosures set post-war records?

Even without this exposure the high leverage ratios from on-balance sheet positions mean that a loss of somewhere bewteen 3-5% would be enough to wipe out the equity on the balance sheet. Considered under those terms, even JPM might not be buying much above actual value. Another way of saying that is that 3% of $400bn is a $12bn loss, against which Bear has equity of $11.4bn.

It was a systematic mismangement of the balance sheet. As recently as 2003 the balance sheet was half the size at $212bn. Not only did they allow asset volume to explode (while it was obvious that asset quality was declining), they failed to ensure that equity would even keep pace, because during the extremely difficult 2007 they still found cash to pay $172m in dividends AND repurchase $1.6bn in stock ! Had that money remained on the balance sheet, the company would have at least maintained its already high 25x leverage ratio affording it some extra cushion. Given the fact that the company was still buying back stock in October and November well after the crisis began in August, rather than shoring up the balance sheet it becomes clear that the company was simply out of control.

This might have been salvagable, were Bear capable of continuing to book high fees and unload some of the paper. But then we look at what is happening to revenue.

Fee income is suffering because of writedowns in the fixed income underwriting category. Revenue declined by 36% from over $9bn to under $6bn. Substantially all of that decline came from reversals in the fixed income segment, but as we entered 2008 it was clear that revenue from other key sources - serving as a prime broker to hedge funds, securities underwriting, merchant banking and the like were likely to decline further. Moreover, further writedowns in fixed income were a near certainty.

Income did even worse - declining by nearly 94% to a paltry $193mn. This meant that income before operations (including interest income) just covered fixed charges. Since this year is sure to result in worse top line development, it will no longer be possible to meet fixed charges. This could alone be a $2bn or 20% hit to equity with no prospect of "riding out the storm".

JPM, with its stronger balance sheet has a better chance of doing so. But in the end, there might not be much value left for JPM to acquire.

What I was trying to say

In my last post was that the meltdown of Bear Stearns threatens the entire financial system. This was the reason that the Fed had to intervene to arrange the sale of Bear.

The reason that any element can bring down the system now is the interdependence of the players. The rise of structured finance, which enables risk to be sliced into various pieces and traded between banks, funds, insurance firms, investors, the government, corporations, farmers, travellers - in short, everyone - means that the failure of any large player inevitably weakens everyone else.

Derivatives essentially function like insurance - enabling the buyer to receive protection from specific risks (like having one's house burn down or having to make payments in currencies other than those in which a firm earns its revenue) at a cost - an insurance premium. Likewise, the seller function as an insurer, taking on that risk in return for consideration (the premium paid). If the seller decides to lay off some or all of that risk, they seek reinsurance, by assigning the contract (selling it) or by purchasing an offsetting position. This can be done for all or part of a position.

The problem is that as the risk becomes dispersed throughout the financial system, those at teh center, the investment banks and their large clients - hedge funds and insurance firms, and some corporations - find themselves counterparties to everyone. If one fails, the insurance that they have offered becomes worthless, forcing the insured to recognize a loss from an exposure they had believed to be hedged. Once that loss appears, equity of the counterparties can be quickly wiped out and more selling and liquidation ensues.

In a very real sense, what structured finance has done is not only spread the risk widely, it has meant that when any sector has a major problem the effects are impossible to isolate, because, at the end of the day, through the banks, everyone becomes a counterparty to everyone else, and failure at one bank is enough to bring down the system.

I point out that this is not news, though many seem to be surprised by it. In 1998, LTCM, having suffered a $5 billion loss, nearly had its equity wiped out and it stood to default on over $100bn in trades. The effect of the write-downs on the markets would have been huge.

Why does this happen? Well, insurance is based on estimates of what is likely to happen. Most of the time, it's a good bet for the insurance company. They reliably collect premiums that are more than adequate to offset small losses on in the position taken. However, sometimes really big events happen and when they do there is a surprising amount of correlation among assets, particularly financial assets and particularly among assets of similar classes. This means that if you regularly issue insurance against a specific type of default - all of your claims are likely to come at the same time. This would be OK, were it the case that the insurer had the assets in place and that those assets were sufficiently liquid to ensure that conversion to cash to pay claims didn't lead to greater imbalance and higher losses.

Virtually no firm, and certainly no investment bank, which operate with massive leverage, has the balance sheet necessary. It requires huge stores of cash - and cash is not a big earner. High returns on equity and the big bonuses that come with them aren't earned with cash. If you own 1/3rd of the company and live in a nice house in Omaha, you might not care that much about holding cash (especially if you operate with an underwriting profit, in which case the cash is free), but if you work in NYC and are competing to have your kids get in the most prestigious pre-school and you rely on annual performance bonsuses to pay for your lifestyle then you don't want lots of cash sitting around. You need to keep dealing and generating fees.

This is not to knock the investment banks. Generating fees is a very good idea, since those profits can be used to offset the loses (if you can continue operations).

But what I want to caution against is the belief that the risk models used to predict the insurance payoffs are good. Even Alan Greenspan, a fan of structured finance - and asset bubbles - admits that overreliance on models is a problem. This is because of the Rumsfeldian "unknown unknowns" which are impossible to model, no matter how good we get at modeling "known unknowns". Worse, the moments that the models will be most useless will be precisely those moments when insurance is most needed, that is during crises when traditional risk measures, such as Value-at-Risk (VaR) that depend on predicting the correlations among a series of risks, will break down.

I posted the first, unedited, and considerably less clear explanation, because I wanted to share my thoughts at the time. There has been evidence that my thinking on this was pretty good - the bank is selling for much less than its close on Friday (even I didn't think it would essentially go for liquidation value) and because I predicted more problems. The WSJ already hinted at problems at Lehman (though, thus far, it's speculation - on my part as well).

The Times of London is also insinuating that several leveraged hedge funds are near to collapse. This would also not surprise me. Leverage, so great on the way up is even more deadly on the way down. Long periods of being rewarded for taking increasing risks and getting paid less and less (but still getting paid) to take them inevitably leave one naked. And the tide is rushing out.

As an investor, I remain patiently on the sidelines. Right now, there is panic selling, knives are coming out and I'm not real interested in trying to catch it - never was that coordinated. The deleveraging that is underway will dramatically change the investing climate that we have come to know. It will truly be unlike anything we have seen in my lifetime.

Most of the old rules will be out of the window. I think there is still a great deal of reason to expect deflation and not inflation. As an investor, preparing oneself to thrive regardless of which scenario occurs is very tricky, but as always - the first rule is Hippocrates: "do no harm".