Thursday, October 30, 2008 9 comments

Some Slides From Grant's Fall 2008 Investment Conference

I don't have much access to Jim Grant (newsletter costs $800+; oriented towards professionals; etc) but one thing I like about him is the fact that he is a contrarian who isn't scared of going against the crowd. In fact, from what I can gather, he has been a contrarian for almost 30 years. One funny thing about Grant is that he is a value investor and hence says not to pay attention macro very much. Yet most of his writings are regarding macro items :)

Well, I have never been to any of his investment conferences but they also seem like an off-the-wall mix of views from various individuals. Some slides from the Fall 2008 conference are posted on his website. I haven't gone through all the slides from everyone but perhaps the two most interesting ones are from Jim Chanos of Kynikos Associates (perhaps the most successful short-seller on the Street) and Jim Grant.


Thoughts by Jim Grant

As he has mentioned in some of his recent interviews, Jim Grant is making a bullish case for select mortgage bonds while being bearish on bonds from retailers. In the presentation he points out that the yields on Lowe's, Target, Walgreen, and Costco unsecured bonds are around 5% to 8%, while select AAA-rated junior RMBS tranches are yielding 15% to maturity. Small investors and non-professionals don't have access to any of these, let alone try to value these things, but there is some important insight in this.

Something closer to home for me are the bond insurers. My thinking, as well as that of many others, is that the losses implied by the market are way too high. If a value investor, who was also very contrarian and bearish on housing for years, thinks that some mortgage bonds are worth risking capital on, it's good news to me. For all I know the bond insurers may have poor underwriting skills and ended up insuring the absolute worst, but barring that extreme scenario, it's reassuring to hear that Grant thinks that some of those AAA-rated tranches, which is the main thing bond insurers insured, are actually projecting unlikely scenarios. (However do note that the bond insurers have other serious problems, including collateral posting needs for their investment portfolio, and the fact they also have insured exposure to auto loans, student loans, and so forth.)


On another note, I'm sort of thinking of taking a position in Sears Roebuck Assurance Corp bonds (if my broker allows it; it's not easy for me without paying high commissions.) Grant clearly expects the situation to deteriorate--or at least doesn't think the 7% yield compensates for the risk. How bad will the situation get? Would a 15% yield be enough?


Similar to my thinking, Jim Grant also points out how GDP growth is nothing like the Great Depression yet people are throwing around that word. However, I do expect asset prices to do poorly even if the economy doesn't fall off a cliff.


Thoughts by Jim Chanos

The Jim Chanos presentation seems to recap some of Grant's past bearish calls. I think the interesting point are the last few slides where he outlines his bearish scenarios. I think a lot of commodity superbulls will completely disagree with him.

In general, Chanos is bearish on the infrastructure play. Jim Chanos thinks that Dubai is a bust waiting to happen. I share a similar view. You know it's a bubble when people build artificial ski slopes in the middle of a desert. Only too much wealth and exuberence would lead to something ridiculous like that.

He also thinks that China will falter and points out how most of the growth is in fixed infrastructure. He says that rebuilding previous poor construction is not really growth. I'm somewhat bearish on China for similar reasons but I do not think it's as bad as he says. Yes, a big chunk of the growth is due to fixed infrastructure spending. But I also see new industries, new technologies, and new tools being developed. They are also building some world-class companies. So I'm not as bearish as him.

My big concern is the political system. As far as I'm concerned, if you run capitalism along with a totalitarian state, you end up with fascism or what some call corporatism. Until I see some positive move on the political front, I would be very concerned. Things can fall apart any minute.


Jim Chanos makes the prediction that the collapse of paper assets will filter into so-called real assets. He thinks the commodity supercyle and emerging market decoupling are myths. I agree completely. I have never believed in the commodity super-cycle since valuations made little sense to me. The decoupling theory was just as dumb given that the emerging markets depend heavily on developed countries for their exports.


Overall, I am not as bearish as Jim Chanos when it comes to emerging markets. I actually think we are seeing once in a 300-year growth in some of these countries. So there is some real, sustainable, growth in some of those countries. The question is how these countries behave when the face an economic slowdown or recession, which are typical in a capitalist system.

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Random Articles For The Day

Some articles...



  • US GDP growth comes in at -0.3% (Bloomberg): I'm playing around with a contrarian macro call for a better economic growth than the market is pricing in. I don't have a firm view yet but I'm thinking that economic growth is not going to be terrible (worse than 2000 or 1990 recessions but not probably not as bad as 1974.) The problem with a GDP call is inflation. I'm still not leaning one way or another when it comes to future inflation.
  • Critical thought about hedge funds in Canada (The Globe & Mail): Good thing the unsophisticated public--you and me--can't invest in what passes for hedge funds these days. At least when it comes to Canada, it's quite correct to say that many so-called hedge funds have nothing to do with hedging (most have high positive correlation to the index) and simply leveraged bets on resource companies.
  • Hartford Financial, an insurer, facing problems (MarketWatch): This just goes to show how overrated American executives are. Aren't insurance companies supposed to be conservative? Guess not. First we have the bond insurers. Then the big one, AIG. Now, it looks like Hartford, a once-not-so-tiny insurer, is facing potential capital shortfalls (it's actually so bad that management can't even tell how much capital it has.) One would have thought that insurers would build a business model that accounts for capital market disruptions. If there is any positive to the current crisis, I suspect it is the ridiculous compensation for executives and the tendency for many in North America to place management on pedestals.
  • Pension shortfalls starting to appear (The Globe & Mail): It looks like some Canadian pensions are facing minor problems now that the stock market has fallen. Warren Buffett rarely makes general long-term calls but one of his most powerful was his multiple warnings that pension obligations are not adequately accounted for. I think everyone realizes that government pension plans are totally messed up (I am expecting a big political clash between the old and the young within the next 20 years.) But my feeling is that the market and investors don't extend that view to corporate pensions. If you are a long-term investor in North America (or countries with sizeable pension obligations,) this will have a huge impact. The key point Buffett made was that pension administrators and executives were assuming too high of a return from their assets. Well, if their assets fall and don't rise (or don't rise as the project,) there will be shocks. I'm not a legal expert I believe pension obligation take higher precedence over shareholder or bondholder obligations so keep that in mind.
  • Some Government officials question the IRS tax rule promoting bank mergers (Bloomberg): I never really understood the merits of the tax rule change that promoted bank mergers and some politicians are questioning it as well. Recall that this was the change that let Wells Fargo buy Wachovia (Wells Fargo wouldn't have bought it without the tax benefit.) It's too late to change anything but I really don't know why such a change was made out of the blue. Let me also say that I am not a fan of the Bush-Paulson-Bernanke strategy of trying to save the system by creating 'super' banks. It seems very much like a short-sighted strategy to pass the problem to the future. Recall that one of the reasons a country like Iceland had problems was because the banks were much larger than the country. No one could take anything the Icelandic government or central bank said seriously. USA is nowhere near that but it at the rate that it is going, I wonder. I also question the wisdom of (implicitly) claiming that the larger you are, the stronger the system is. One of the reasons Morgan Stanley collapsed was because its balance sheet hit $1 trillion (due to leverage) and there was no way anyone could have a grasp of the inherent risk.
  • GMAC may convert to a bank (The Globe & Mail): I have nothing against GMAC but I'm sure this is not what the US government or its taxpayers had in mind with their bank aid plan.
  • Ambac wants to tap the Treasury bailout (Ambac): Not sure what to make of this. This will clearly help the bond insurers but it isn't what you would find in the 'Book of Capitalism'. One thing though about helping the bond insurers is that you get more bang for the buck with them than with banks (who may not lend the monetary benefit they receive.) Ambac and other bond insurers will likely post very poor numbers next week but the question is whether they have sorted out their collateral posting requirements, and manage the losses on the insured portfolio.

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Wednesday, October 29, 2008 2 comments

Federal Reserve Cuts Rates to 1%

FedRes cut rates by 0.5% today, taking the rate to Japan territory of 1%. I think this is a mistake. But the effective rate, as well as market expectations were for a rate cut, so the FedRes has little room to maneuver. Contrary to some mistaken views, the FedRes actually tends to follow the market rather than lead it.

The following chart shows the effective fed funds rate over the last 30 years. (Note that the effective rate is not the same as the target rate but it is the goal of the FedRes to perform open market operations to influence the effective rate. So for our purposes, it's almost the same as the target rate.)




As you can see from the chart, we have hit the levels of 2004. It should be noted that some, particularly the hard currency advocates, argue that the low rates in 2004 was what led to gigantic bubbles, not just in housing but also in junk bonds, emerging market stocks, commodities, art, collectibles, and many others. Although I think he puts way too much emphasis on FedRes actions, as Jim Grant would say, we are basically doing the same thing that put us in this mess in the first place.

The current rates are similar to the 40's and the 50's. I don't believe rates ever hit 1% in the early 1900's or late 1800's (but note that a US central bank did not exist back then and interest rates weren't quite the same.) The really big question, especially if you are macro-inclined, is whether this is going to lead to inflation. And if yes, then what assets are likely to appreciate.

Remember that even if you had correctly called the massive liquidity injections by Japan in the 90's, you may not have anticipated this capital flowing elsewhere. Right now, a lot of goldbugs, among others, expect inflation (particularly in commodities) but I am still not sold on that. If someone had called Japanese assets to appreciate, or even commodities there to increase in Yen terms, they would have been completely wrong. You would have had to anticipate the outflow of Japanese liquidity or else you would have suffered massive losses. In other words, you had to have called the Yen carry-trade. I do not expect a US$ carry-trade to develop since US assets are still attractive, and USA is still the most capitalist (large) country out there. However, it is a possibility that must be entertained. For instance, gold has been absolutely crushed in the last few months and the market clearly does not anticipate inflation.



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Canada's Tax-Free Savings Account

Canada is introducing a new tax-free method for savers starting in 2009. It is called the Tax-Free Savings Account (TFSA). It complements the already-existing RRSP method. There are numerous differences between the TFSA and the RRSP so they don't necessarily compete against each other.

Unlike with an RRSP plan, you do not get a tax deduction for contributing to the plan. But you can withdraw from the plan at any time and do not pay taxes for any capital gains, dividends or interest income earned. The amount is also limited to $5000 per year. For further information check out one of the following links:

Article from The Globe & Mail
Department of Finance overview (note: refer to CRA for final details)
ING Direct Top 10 FAQ (I'm not recommending ING but like the brief FAQ)

Appropriateness of the plan depends on the details of an individual and do not construe anything I say to be investment advice, but I would say that this is an ideal plan if you need to save money for a short-term or medium-term purchase (e.g. car, vacation.) It is also likely more attractive to low income people since not getting the tax deduction upon contribution is not as important if you have a low tax rate.



The Canadian TFSA plan moves a step somewhat closer to one of the radical suggestions by Warren Buffett. I remember Buffett saying--I think this was in a Washington Post opinion piece but not sure--that the ideal tax system would be where savers are not taxed, except upon conversion of savings to consumption. Whether one approves of his plan is up to one's ideology but it is consistent with the view that investments improve society in the long term, while consumption is usage of assets for current enjoyment. His suggestion was to let anyone save as much as they want without being taxed. But when the saver withdraws from the savings fund, they will be taxed. The TFSA does not tax you at all so it's only half of the strategy but if you think of sales tax (PST, GST, gasoline tax, cigarette tax, etc) as being a tax on consumption then it is getting close to it.

(One of the big flaw's with Buffett's suggestion is that there is nothing to guarantee that your country will be helped. It's possible for investors to invest elsewhere so, unless you limit investments to the local country (an almost impossible task,) it will help the world as a whole rather than the country. But since government expenses are paid by the country, the tradeoff won't be supported by most citizens.)

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Tuesday, October 28, 2008 0 comments

Risk Arbitrage Thoughts: BCE, Huntsman, Q9 Networks

Thoughts on some risk arbitrage items...


BCE Saga

Well, it looks like there is another lawsuit against the BCE buyout. This time, some shareholders are suing BCE because it cancelled the dividend. Sounds like a frivolous suit to me. Maybe it's about time that some of these investors realized that companies are not obligated to pay dividends.

The Globe & Mail also has some notes on various, conflicting, views on the BCE takeover from analysts. On top of the credit crisis, the sheer size of the takeover makes financing a legitimate threat to the deal.


Huntsman Buyout

One of the big M&A deals that was embroiled in a legal battle was the Huntsman buyout by Hexion Specialty Chemicals. It was moving forward after the court ruled in favour of Huntsman. Well, it looks like the banks are now refusing to finance the deal. It will go to the courts and it remains to be seen what comes of this. Again, like most of the recent spate of M&A legal battles, precedents and long-term rulings are being made by the courts.

If you are ever engaged in risk arbitrage, it's important to consider failures and decisions from the courts.


Q9 Networks Buyout

Andrew Willis of The Globe & Mail speculates that the wide arbitrage spreads are not necessarily indicative of deal failure. He refers to the Q9 Networks buyout (a Canadian deal) where the spread was 24% on the day the deal completed. He alludes to the fact that a lot of hedge funds are exiting the risk arbitrage market.

I was wondering the same thing a while back when I asked out aloud whether the BCE spread is due to forced exit of arbitrage funds or whether it is actually indicative of the actual outcome. I didn't know the answer at that time but now I'm of the opinion that the spreads have little to do with the actual risk. This thinking is what led me to take a position in Puget Energy (I wasn't confident with the wide spread before.) None of this is to say that these deals won't fall apart, but the risk-return is favourable. Remember, in a cash-starved world, those with cash get to call the shots. Risk arbitrage funds generally relied on leverage to boost their returns and would have faced huge margin calls lately given that nearly all assets have collapsed 30% or more--including many that were considered "safe" and "attractive" a few months ago. If you are sitting on the sidelines with cash, you can enter a risk arbitrage position with practically no competition from these funds.

Risk arbitrage was very lucrative a few years ago (I wasn't really participating much back then.) But it turned into a disaster over the last year. Now, I feel that it is back to being attractive. As always, ideal deals are the strategic buyouts rather than the financial buyouts.

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Talk About Short-Covering

Want to see short-covering taken to the extreme? Check out what happened to Volkswagen, a German automobile manufacturer:

Volkswagen briefly became the world's biggest company by market value on Tuesday, as short sellers continued to pile into the stock on weekend news Porsche had bought up much of VW's remaining free float.

Shares in the German car maker hit an intraday high of €1,005.01, valuing the company at €296.06-billion euros ($370.4-billion) based on ordinary stock, more than that of world number one company Exxon Mobil Corp's $343-billion market value at Monday's closing price.

The shares later eased back to stand 25.4 per cent higher at €652.00 at 1103 GMT, after tripling in the previous session.

Porsche said on Sunday it held over 74 per cent of VW, prompting a panic among short sellers who had sold VW shares in the hope of buying them back at lower prices.


Here is the chart of the action:



What just happened is unbelievable. Stuff like this happens all the time but is rare for large-cap stocks. Every single European hedge fund must have had the same shorting strategy. I guess now we know why relative value arbitrage funds have done so badly. The short Volkswagen & long Porche strategy has completely backfired.

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Monday, October 27, 2008 1 comments

Random Articles For A Monday

Some articles some of you may find interesting...

  • Has a trading mentality taken over the capital markets, business community, and government? (The Globe & Mail): An essay by the CEO of Thomson Reuters, Geoffrey Beattie, presents his opinion on the matter. He makes some fine points on the differences between a short-term mentality and a long-term one. I agree with most of the opinion but feel that an important point is missed. It is important to remember that this is not a North American problem; neither is it a capitalist problem. Some people like to say that countries like China have a longer term plan, but they don't. China, and others, are following a short-sighted policy on par with America. If you think about China's low currency peg or the ignorance of environmental problems, not to mention the disastrous one-child policy, you'll see that they share a lot with the executives, leaders, and politicians in America and Europe.
  • Simple illustration of structured products (Bloomberg): If someone wants a quick graphical overview of what a CDO is, or how an SIV fits into the crisis, check out this illustration. There is also this accompanying article.
  • Japanese cross-shareholdings starting to bite banks (Economist): Japanese banks looked clean--they did steer clear of the toxic American mortgages--but they face a uniquely Japanese problem. A lot of companies in Japan have sizeable cross-shareholdings and the banks have to mark them to market. As the Japanese stock market falls, banks' capital is declining astronomically.
  • Newspaper circulation keeps dropping in America (The New York Times): Not exactly surprising but newspapers probably have a good idea of how the buggywhip manufacturers must have felt. About 2% decline in print for several years, with steeper declines in the last year, is hard to absorb (do note that some of the decline is due to tactical circulation cuts by the papers.) To make matters worse, online advertising seems to be flat and can't make up the print decline.
  • The shrinking hedge fund industry (The Economist): A good article providing a historical overview of the industry, along with the current woes faced by hedge funds. One thing people forget is that it is not just banks that are heavily leveraged; it's also hedge funds. A lot of the selling of late likely has little to do with financial institutions or investment banks, and are, instead, likely to be coming from hedge funds. Even if the financial institutions de-lever, we need to wait for the hedge funds to de-lever as well. On top of seeing asset price declines, hedge funds are also getting clobbered by unwinding of various carry trades.

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A Sign Of New Entrants To The Global Capitalist System

Eureka! We have further signs of new entrants into the capitalist system. It's always a good sign. First step is to participate in the capital markets. The next step is to learn that the free market does not mean that everything only goes up. Unfortunately many are tripped up after the first step:

But in Kuwait, the government has taken a less hands-on approach, angering investors who sued without success to temporarily close the bourse.

On Sunday, traders walked off the floor of the bourse for the second time in less than a week.

Investor al-Fadhli said about 40 brokers left the exchange, walking to the nearby seaside Seif Palace, calling on the prime minister for more government intervention.


Yes folks, as unlikely as it may seem, some investors are suing to close the exchange. I presume the strategy here entails burying your head in the sand, literally, and happily pretending that asset prices have not declined. And you thought the Americans started a bad trend, now blindly duplicated by several other countries, of banning short-selling of some stocks. I'm pretty confident that investors in America are unlikely to pursue to the Kuwaiti strategy simply due to a lack of sand ;)

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A Bear Turns Bullish (Sort Of)

I have no idea if Krishnamurthy 'Nandu' Narayanan is just lucky or is actually talented. If you go by The Globe & Mail stories on the investment manager's thoughts over the last year or two, you would notice that he actually expected the credit bust. He had been bearish for a while--I believe he is primarily a short-seller but not sure--but seems to be bullish (at least on Canada right now):

The Smartest Man, when delivering his prophesies, did not sugar-coat them. “This could potentially make Long-Term Capital [the financial crisis of 1998] look like some kind of walk in the park,” he predicted. “The reckoning has started.” No soft landing this time: It could even be “like the Great Depression of this century.” He said these things not last week, not last month, but on July 26, 2007. That day, the Dow Jones industrial average closed at 13,473.

...

“I think we're ending the financial crisis now,” he said. “There will be countries, like the U.S., that will go into recession. But this need not be a global recession. And there are some encouraging signs on that front.”


If you have any macro inclination, one of the big calls right now is how bad the economic slowdown will end up being. I'm not as optimistic as Nandu and think the whole world is going to slow down. However, unlike many, I actually don't think the US economy will do that badly. My guess right now is that the US recession will be worse than the 2001 recession and more likely to be similar to the 1982 or 1974 recessions. What I see, though, is poor performance for investors. Don't ever forget that the stock market do poorly even if the economy is good, and vice versa. For instance, the economic slowdown starting in early 2000 was not that bad but US stocks were off around 30%.

Read the rest of the article for his general views. He seems to be bullish towards the cyclicals (such as commodities) and emerging markets with trade surpluses (such as Singapore, Malaysia, and Thailand.) He also seems bullish towards India whereas I think it is one of the worst emerging markets for the short to intermediate term (I don't like India because it is running fiscal deficits, has a current account deficit, has very high corruption, and the economic system is not very "free".)

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Friday, October 24, 2008 1 comments

Random Articles For The Day

Some random stuff for the day...


  • One bright spot for Icleand... tourism (BusinessWeek): Iceland got a $2 billion loan from the IMF so that should stabilize things somewhat. Some of their industries will do extremely well, assuming their finances and access to credit is decent, given the massive collapse in the currency. One such industry is tourism.
  • Emerging market debt problems (BusinessWeek): One of the last remaining bubbles is the emerging market debt bubble. Many emerging markets were priced as if defaults were a rare thing. The graphic accompanying the BusinessWeek article highlights the following danger regions: Baltics (Lithhuania, Latvia, Estonia), Ukraine, South Korea, Pakistan, Turkey, Persian Gulf, and Eastern Europe (Hungary.) One thing about a publication like BusinessWeek is that it is generally backward-looking and reports the problems faced right now. In contrast, a publication like The Economist is forward-looking and often speculates on potential future problems (some of which may end up being wrong.) In any case, here are some articles from The Economist looking at the present situation: EM conditions & Eastern Europe. One thing I don't get is why Russia is having serious problems when it is one of the few countries with a current account surplus and a large reserves.
  • PNC take-under of National City Corp (MarketWatch): If anyone wonders why investors are fleeing the banks, one such reason is situations like this. PNC is buying out NCC bank at below-current-market prices. NCC stock promptly plunged 20% upon the news and is likely dragging down all the other regional banks as well. There was only a few days in the last month that NCC traded at or below the takeover price. What is happening is neither right nor wrong; it is what it is. Anyone investing in financials need to seriously consider the possibility of a take-under or government nationalization. One can argue that these institutions would be bankrupt otherwise, but it still means that valuations mean very little.
  • How cheap can valuations go? (Geoff Gannon): Geoff Gannon wrote one of the best articles on long-term valuations a few years ago. Do check it out when you get some time. One of the key points to understand is what Geoff says is the following: "Stocks are not inherently attractive; they have often been attractive, because they have often been cheap." It's always scary to realize how high valuations were in the last 20 years compared to history. Fortunately, this is good news for me or others if they are lower class without much money and/or you are young because we can buy assets at lower prices (and our portfolio size is small relative to income/savings.) Always remember that lower prices imply higher returns in the future.

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Montpelier Re Reports 3Q 2008 Results

In line with the hurricane losses it announced earlier, Montpelier reported its 3rd quarter results:

Montpelier Re Holdings Ltd. (the "Company") reported an operating loss of $55 million (or $0.65 per share), which excludes net investment and foreign exchange gains and losses, income taxes and extraordinary gains, for the quarter ended September 30, 2008. The Company’s operating loss reflects a combined net financial impact from Hurricanes Gustav and Ike of $130 million, which is in line with our prior announcement.

The Company reported a net loss of $142 million (or $1.69 per share) for the quarter ended September 30, 2008. The Company’s net loss reflects $27 million of net realized losses, $48 million of net unrealized losses and $13 million of net foreign exchange losses. The Company noted that, as a result of the adoption of FAS 159 in January 2007, it reports virtually all of its net unrealized investment gains and losses, whether considered temporary or permanent, as a component of net income.

Fully converted book value per share was $16.61 as of September 30, 2008, a decrease of 8.5% for the quarter and 5.8% for the year, inclusive of dividends.


Not great results but it's reasonable given the low hurricane losses. It's difficult to say what the actual situation happens to be given that around half of the reported losses are unrealized portfolio losses. It's not clear if these mark-to-market losses will reverse. The stock has totally collapsed this year (although it's up today) but I don't think it has anything to do with the performance.

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Thursday, October 23, 2008 2 comments

China's Real Estate Bubble Finally Bursts

(Photo by Keith Bradsher for The New York Times)

[The New York Times reports that only 50 of the 780 apartments above have been occupied]


Bears like Stephen Roach, an economist, were saying there was a real estate bubble in China almost 3 years ago. Well, it took a while but I think we can safely say that the bust has finally arrived.

China’s real estate bubble has turned into a bust in many cities, complicating the government’s effort to manage an economic slowdown here.

As China’s real estate boom slows, construction projects are stalled for lack of financing.

The pain is obvious in Liu Shirong’s apartment development. Mr. Liu, a shy electrical engineer doesn’t mind living in a complex where only 50 of 780 apartments are occupied and the swimming pool is eternally empty. “I have peace and quiet at night,” he said.

But the vacant apartments are a nightmare for the mainly speculative investors who bought them a year ago. And nearby, only one of the two dozen towering cranes was still in operation on a recent afternoon.


Did someone say "speculative investors"? Isn't that an oxymoron?

The government has been trying to cool the bubble for years but seems to have failed. Now that it has failed on the way up, it is trying to redeem itself by smoothing the collapse. An unenviable task. Ask the US government. Or the Irish government. Or the British government. Or... you get the point.


In my opinion, there are two big bubbles in China. One is so-called fixed infrastructure (real estate, roads, bridges, etc.) The real estate bubble does not seem as large as in America, Ireland, UK, Spain, or in numerous other countries. The other is manufacturing. There are just way too many factories (many of them inefficient and obsolete) and I suspect there will be a consolidation phase fairly soon. I really, really, hope that if it ever comes to this that it will be a smooth transition but if the manufacturing bust is severe, it might mean the end of the Chinese Communist government.

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Jim Rogers Interview on CNBC Europe; Plus My Thoughts On Commodities

I haven't seen Jim Rogers being challenged by many people for his polemic attacks but here is a clip where he is called to task. Thanks to A Jim Rogers' Blog for the video mentions. Do check out that blog for a few other clips, or other info about Jim Rogers.


I think Jim Rogers is being very hypocritical when he says that financial institutions should be allowed to collapse, while saying that the problem in the 1930's was that money wasn't funnelled to the banks while bank runs were under way. A lot of people who take positions similar to Jim Rogers--Jim Grant is another--seem like the modern day Herbert Hoover or Andrew Mellon. I agree that the economy hasn't been cut in half (it isn't even down 10%) but the credit bust is fairly large. Some already claim that letting Lehman Brothers fail was a mistake and I'm not sure what would happen if AIG, Goldman Sachs, Morgan Stanley, Wachovia, potentially UBS, potentially Royal Bank of Scotland, and others, were allowed to fail.

(BTW, I'm not advocating giving out free money (recall that I was against the original Paulson plan to hand out free money by purposely overpaying for assets.) Rather, I'm talking about government injecting capital for ownership stake--an equitable strategy for both shareholders and taxpayers.)


I have been bearish for commodities for a few years now, and hence missed the big boom as well as the big bust. However, I was bullish on commodities a few years ago due to influence from, none other than, Jim Rogers and Marc Faber. In fact, more than 70% of my portfolio was oil&gas or gold stocks, but I sold too early and didn't really make much. I still think there is some merit to a bullish commodity call but I'm not sure if Jim Rogers is correct with his oil call. He says that oil has dropped 40% on several occasions in the last few years, only to bounce back up. But what if doesn't bounce back up? Oil is already up 500%+ from the bottom and chances of it going up another 500% (assuming US$ doesn't fall off a cliff) are slim. If you are entering oil right now, you better be sure that it is going to do well.


The commodity area that warrants a deeper look--this is the area that Rogers and Faber are most bullish on--is soft commodities (agriculturals.) Historically, agricultural commodities have been a total disaster (actually all commodities have, but agriculturals are the worst.) Agricultural commodities have been deflating for over a 100 years! I remember looking at an index of soft commodities and it is basically a downtrend for something like 50 to 100 years (if I look deeper into this sector I'll try to pull up some charts and write about it.) One of the reasons for the bear market in agriculturals is due to the revolution in farming, where crop yield has increased significantly due to fertilizers, machinery, and so forth. The bear market is so bad that very little farming would exist in America and Canada if it weren't for government subsidies (prices are actually artificially held up right now.)

But it may be different this time. Yes, I realize these are the 4 most dangerous words in investing :). The secular thesis--this is a super macro call--for agriculturals is the view that citizens in developing countries will be moving up the value chain and eating a richer diet. This seems far more likely than the conventional view that everyone in these countries is going to own a car soon*. I have been thinking lately of making investments (possibly in mid to late 2009) to profit off this macro thesis. If I do more research, I'll post my thoughts. Some examples of investment possibilities (not that I have access to all; it's just ideas): Russian farms; farmland in general; agricultural commodity ETF/ETN; agribusiness stocks (eg. Bunge, Archer Daniels Midland); fertilizer stocks; Canadian or American agricultural companies (eg. Viterra). One problem is that diets vary across the world so what is needed in China may not be grown in Canada.


(* Car usage will remain low in developing countries for several reasons. One is pollution. Many of these countries are heavily polluted without heavy automobile use. If everyone started driving cars, people are literally going to die of pollution. Another reason is that infrastructure is so bad in many countries that car ownership will not take off until roads, gas stations, mechanic workshops, etc are built. Otherwise, the traffic jams would just be unbearable.)

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Wednesday, October 22, 2008 0 comments

CNBC Interview with Martin Whitman, Jean-Marie Eveillard, and Charles Royce

CNBC conducted an interview with value investors Martin Whitman, Jean-Marie Eveillard, and Charles Royce. Check it out...

Segment 1
Segment 2
Segment 3

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Currencies Can Make Or Break Risk Arbitrage

If you are doing risk arbitrage, you need to be careful with currencies if you'll be receiving compensation in foreign currencies or foreign shares. Professionals will hedge the currencies but small investors often can't afford to do so.

I'm located in Canada so changes in US$ vs C$ can wipe out all my gains. Anyone following my investment "career" :) will recall how I lost money in C$ terms on my US bond position last year even though it posted positive gains in US$. This wasn't a risk arbitrage position but the problem is very acute for risk arbitrage since the gap you are working with tends to be small and you have no chance of waiting to recoup.

The following graphic depicts two takeover deals I have mentioned on this blog: BCE and Fording Canadian Coal Trust. In the BCE deal, shareholders will be paid a fixed amount in Canadian dollars. In contrast, the Fording deal involves receiving a fixed US$ amount (along with a small stake in Teck Caminco.)



You'll notice that there is a 15% gap (relative to late July.) This is almost the entire profit potential in these deals (unless you bought during a huge plunge in the shares, or at some other time period.) In this case, the Canadian dollar declined significantly--this was a massive move for a currency and quite unusual--so Americans getting paid in Canadian dollars would see their profit reduced. For instance, American risk arbitrageurs on the BCE deal will end up worse than they probably thought back in July. Of course, this is just one slice of time. Canadian dollar strengthened last year so it depends the situation would have been opposite. The point, though, is that M&A involving foreign currencies is kind of risky.

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Added to position: Puget Energy (PSD)

Hope this doesn't blow up since I'm running out of free capital. Anyway, I added to my Puget Energy (PSD) risk arbitrage position. The stock is trading as if the deal won't be completed. If this were a normal market, the downside risk here is very close to zero; but given the market conditions, the stock can drop anywhere from 5% to 25% if the deal collapses. From an analyst report I read, if the buyers walk away, Puget Energy will be paid what amounts to around $1 per share (about 4% or one year worth of dividends.) So the break fee isn't anything major.

Purchase price: $22.18
Investment time frame: short

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This Is More Than A Housing Bust...But Good Time To Invest

UPDATE: Gurufocus also has a post looking at potential future returns. I think it's worth checking that out, along with Geoff Gannon's more nuanced look.


It's very important to keep in mind that we are not just facing a housing bust. The problem is much bigger and is essentially a credit bust. The media and some in the market seem to be concentrating on the housing market but huge swaths of the credit market won't return--ever! If you follow this thinking, the implication is that a recovery in housing will not necessarily improve the economy or your investments. Don't get me wrong: housing is very important. But it's only a big piece of the crisis. Nevertheless, it's starting to be an attractive period for investments.

Many also seem to ignore the fact that risk premium was unsustainably low over the last 5 years (conversely, this means asset prices were unsustainably high.) This means that some of the spreads/yields/etc won't return to what they were 2 or 3 years ago. If anyone is waiting for things to go back to what they were a few years ago, they are going to be waiting forever.

None of this means that you should or should not invest. All it means is that one should be conservative and consider the implications of a credit bust. For example, there was a takeover premium built into the market in the last few years. The heavy activity from private equity, sovereign wealth funds, and foreign buyers meant that the market was pricing in a premium. Right now, you cannot bank on these strategic buyouts. Or even if you did, you cannot assume the buyout premiums will be anywhere near what they were before.

As Warren Buffett has alluded to, it is actually a good time to invest since valuations are becoming very attractive. Geoff Gannon has a good write-up pointing out that the DJIA has finally hit valuations consistent with the long-term average. It's a good article and I urge everyone to read it.


In every year from 1996 through 2007, the Dow was more expensive relative to its normalized earnings than it had been in any year from 1935 through 1995. The closest comparison was 1965. But every year: ’96, ’97, ’98, ’99, 2000, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 was more expensive than ’65.

As a result, historical return data from the 20th century was an inappropriate guide for expected returns on an initial investment made at any point from 1996 – 2007.

We were in unchartered territory.

Not any more.

Yesterday, the Dow dropped below 8,750. That number is the point at which the Dow would be trading at the average 15-year normalized P/E ratio for 1935-2005. In those seven decades the Dow posted a compound annual point gain of 6.6%. Back it up ten years to 1995, the last year before the paradigm shift I wrote about and you still get annual point growth of 6.2%.

So at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.


So, at current valuations, you are looking at around 6.5% per year. Anyone that invested in the 80's or 90's might be dissapointed but that's what we are looking at. But it's also better than the return in the last 10 years, which is very close to 0%. Of course, if you are a good stockpicker then your returns will be much higher...



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Ambac CEO Replaced

This is probably bad news, with earnings almost around the corner (likely in first week of November,) but Ambac replaced its CEO. This is never a good sign and remains to be seen if there are any negative surprises when they release earnings. However, it should be noted that Michael Callen only took over the job as an interim CEO so it isn't as surprising as it may seem.

The CEO position is being taken up by the Chief Risk Officer, David Wallis. There is good and bad in this. I have been dissapointed with the risk control at Ambac over and I recall David Wallis saying that the situation was under control back in late 2007. Yet the whole thing fell apart later on. That's the bad aspect to this. The good news, if any, is the fact that he will be intimately familiar with the insured risk. Going with someone outside the firm who is not familiar with any of these complex securities would have been risky. Recall how AIG hired an executive from outside the firm and it completely collapsed due to (easily understood) collateral requirement. Clearly the new CEO didn't understand the complexity of the insured securities.

The total disintegration of the bond insurers is not necessarily a surprise given what has transpired in the world. I remember someone saying that if the credit market blows up, the monolines would be toast but they were the last worry in such a situation. Well, it looks like a huge chunk of the financial world has indeed blown up. If someone had told me that Ambac would be lingering on while Bear Stearns, Lehman Brothers, and AIG would collapse, I wouldn't have believed it.

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Tuesday, October 21, 2008 0 comments

Dividend Investors Hit Hard

Focusing on dividend stocks works out in the long run (in terms of passive strategies) but dividend investors have been hit really hard over the last couple of years. The following chart plots a popular dividend-oriented ETF (DVY) against the S&P 500 (other ETFs, mutual funds, and indexes have similar returns.) Dividend payouts are not shown but I doubt that they can make up the capital losses in the last year or two.



Typically dividend stocks hold up in bear markets but that hasn't been the case this year. In fact the dividend ETF dropped far more than the S&P 500 in the early part of the year. The reason is fairly obvious in hindsight: the collapse of almost all financial companies. A lot of the big dividend payers over the last 25 years have been financials. Even if you had used a tough screen looking at consistent dividend payers that have been paying for 20+ years, with sold earnings growth, you wouldn't have avoided the losses.

In fact, this quarter is shaping up to be a once-in-50-years type of scenario:

Dividend payments by companies in the Standard & Poor's 500 Index may plunge 10 percent this quarter, the biggest decline since 1958, as bank failures and slowing economic growth stifle payouts, S&P said.


This is all the past and the long-run will likely be better for dividend stocks but it just goes to show how the bear has mauled almost everyone, including those purporting to follow a "safe" strategy. In fact, there is one remaining big risk for dividend investors: commodity businesses. Apart from financials, a huge chunk of the dividend issuers have been commodity businesses, such as oil&gas companies. If commodities enter a long-term correction (it's uncertain right now,) it's quite possible to see dividend investors hammered again; this time from yet another segment of payers that were considered safe and cash-flow rich...

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Gross Abuse of Property Rights In Argentina

Well, maybe it's not a surprise given that it's Argentina but here is an example of total disregard for property rights:

Argentine stocks plunged 13 percent Tuesday after the government announced plans to nationalize nearly $30 billion in private pension funds.

The government of President Cristina Fernandez said that it had to protect retirees as stocks and bonds fall amid the global financial crisis. But her political opponents called it a naked scramble for cash to prop up falling tax revenue.

...

The nationalization would allow the government to pay off millions of dollars in debt and finance stalled infrastructure projects starved for credit, a former finance minister Miguel Kiguel told Buenos Aires-based television station TodoNoticias.

...

Argentina’s private accounts were created in 1994 under President Carlos Menem, who embarked on a wave of privatization in Argentina during his 1989-1999 terms.

The pension funds are controlled by the BBVA Banco Frances, a unit of BBVA of Spain; HSBC Holdings; the insurance company MetLife Inc.; and ING Groep along with other local funds.

Argentines contribute $4.6 million to the funds every year. About one-fourth of Argentina’s 40 million citizens are affiliated with the private funds.


Although the amount in question is small and likely to be ignored by most citizens and investors, the damage to property rights is large and long-lasting. Time to start crying for Argentina...

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Iceland...An example of the unfolding shift to the left

I consider myself left-leaning so I don't mind it but many investors may not like it. I'm talking about the likely shift across the world towards left-wing econopolitical ideals. Iceland is a sign of things to come as I suspect that you will see monumental shift in their politics for the next 20 years.

More than any of its Nordic neighbors, Iceland under Prime Minister Geir Haarde imbibed the economic policies of Margaret Thatcher and Ronald Reagan -- state-asset sales, light regulation and corporate growth abroad through debt.

Now that the hangover has arrived, many of Haarde's countrymen want his Independence Party-led coalition to pay the price for turning one of the world's wealthiest countries per capita into a beggar state staving off depression.



Goverments don't control economies but they do influence it. The capitalist strategy has completely backfired in Iceland and it's hard to see them continuing down that path. It's sad to see one of the wealthiest countries completely disintegrate. It happens quite often in Asia and Latin America but the governments are highly corrupt or totalitarian in those countries. In contrast, when it comes to Iceland, it's hard to blame some dictator or tyrant.

Iceland was ranked fifth- wealthiest in the world per capita in the UN 2007/2008 Human Development Index. Now, it's facing shortages of imports including food and clothing. Controls on foreign currency payments have been enforced to favor imports of fuel, medicine and food.

The value of Iceland's currency has evaporated and an economy that outgrew the U.S. and euro region every year since 2004 at the least faces a prolonged recession, if not a depression. The economy may shrink more than 10 percent with inflation reaching 75 percent in months, says Danske Bank A/S Chief Analyst Lars Christensen.

The country's main stock index has lost 90 percent of its value, most of it in the past week or so, more than double the decline in neighboring Nordic countries like Norway and Sweden.


Iceland is still worth considering as an investment opportunity for those with access and high risk tolerance. The stock index collapse looks bad but that's because a big chunk of the banks in the index ended up being valued at zero. It's somewhat similar to the 2001 version of Argentina (recall how there were riots in the streets of Argentina; it refused to pay government debt to foreigners; its presidents--multiple within a short period of time if I recall--were sacked; and its currency collapsed.)

The IMF is set to intervene in Iceland but it's not clear what they can do, other than provide money. Unlike many other cases of IMF intervention, Iceland basically follows IMF strategies already.

My opinion is that a similar shift in politics will likely occur in USA. This is the end of the Great De-regulation that has been popular over the last 25 years. It's quite possible for Democrats to sweep the US elections.

As someone who is in favour of free markets, this will be a setback. But at the same time, we have seen what happens in markets with very little regulation (or where individuals and businesses side-stepped the regulations.) The extreme free-market supporters will say that excessive regulation was what led to the mess. Or they will blame central bank actions. But it's difficult to see how that's the cause when most of the mess seems to lie with private actors, often circumventing government regulations (eg. banks and their SIVs; banks using monoline bond insurers to arbitrage capital requirement differences; investment banks leveraged to the max; hedge funds living only off borrowed money (otherwise they won't make enough to sustain their business); etc.)

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Monday, October 20, 2008 1 comments

An example of high probability, low return, risk arbitrage: Fording Canadian Coal Trust (FDG; TSX: FDG.UN)

A reader e-mailed me and asked about taking a position in the Fording Canadian Coal Trust (FDG; TSX: FDG.UN) takeover. I never took a position for various reasons (I describe this takeover below) but what I want to do is to point out how there are two types of risk arbitrage deals: the high probability, low return ones; and the low probability, high return ones. The thinking behind each is quite different.

Anyone following this blog would notice that, with the few I have dealt with, I tend to take seemingly high risk arbitrage positions. You know, deals that the market doesn't think will close easily. I'm just a newbie and still trying to figure out what works for me, but so far I like the low probability, high return deals. I usually look at deals with wide spreads (preferably 10% total, or say 20% to 40% annualized.) Such wide spreads essentially means that the market doesn't think the deal will be likely to close.

Although one may view such deals as risky from an arbitrage point of view (since they are less likely to close) I tend to favour them because it is actually safer from an investment point of view! What I mean by that is the following. If a high probability deal collapses, the loss tends to be massive. The share price will fall significantly (of course, this depends on takeover premium built into the stock and a few other details.) In contrast, low probability deals have lower losses. If i was satisfied with the merits of a business, holding a position with a small loss is acceptable to me. (do keep in mind that one shouldn't blindly look at spreads since higher spreads may actually be a far worse situation. It's kind of like junk bonds. Most junk bonds are junk, as Buffett would say, but a junk investor tries to pick a good junk bond, not just the highest yielding one.)

I don't know how good my strategy will end up being but I'm sticking with it for the time being. My thinking goes against what a typical risk arbitrage fund undertakes. A typical risk arbitrage fund generally undertakes high probability, low return positions and uses leverage to magnify that. A typical arbitrage fund also sells out of their position at the outcome of the deal (if you can hedge then everyone should exit the deal regardless but I'm talking about cases where you can't hedge.) I'm not saying all funds are like that but that's the typical modus operandi.

In contrast to a risk arbitrage fund, I don't use leverage and I am willing to hold a stock if the deal fails. The latter point of being able to hold a stock is probably what gives me an advantage over a pure risk arbitrage fund and allows me to consider these lower probability events. This also means that I place quite a bit of emphasis on whether I would want to hold a stock.

I don't think there is anything wrong with pursuing high probability, low return positions. For some investors, this will work out nicely. Do note that this strategy involves competing against the risk arbitrage funds. Whatever you pursue, make sure you are clear on what your strategy is.


A High Probability, Low Return Deal

Teck Caminco is buying out Fording Canadian Coal Trust (FDG; TSX: FDG.UN). This used to a higher return play a few weeks ago but it is presently a high probability, low return deal. I didn't calculate the numbers today but when I looked at them late last week, the potential return was around 6% to 7% with almost certain success within the month.

Although I would take a position if the return was around 10%, this is the type of deal I don't like. Although a failure is extremely slim, if it does fail, you are talking about a massive loss. I can see the stock dropping 50% (Fording is one of the top performers this year and is up around 100% this year--in a nasty bear market where almost every commodity stock has been slaughtered.) Unless you were a commodity bull and a fan of coal or steel (which is what it is used for,) it would be difficult to recoup such a big loss. It's also not clear if you can adquately hedge this position.

There are also a few other issues with this deal. One is the fact that the payout is in fixed US$ (plus some shares of Teck Caminco) so Canadians are exposed to currency risk. Given the way currencies have been moving lately, half the 6% or whatever you earn might be wiped out by currency changes (assuming you don't hedge--generally expensive or difficult for small investors.) The other wrinkle with this deal is that the deal is structured as a sale and distribution to shareholders, which is taxed as regular income (rather than the lower taxed dividends or capital gains.) So anyone holding the shares of Fording until closing will pay regular income taxes (but if you sell before the deal closes, or if this is in a tax-sheltered retirement account, it's not an issue.) Anyway, I would still take a position in Fording at a good price (say 10% return or very close to close).


The key point I wanted to make in this post is to point out the high probability deals from the low probability ones. Don't assume that the high probability, low return ones are not worth it (after all, Buffett took a risk arbitrage position in Dow Jones last year--I thought the deal would fail.) Both can work but I think the strategy is somewhat different for each.

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Marc Faber October 20th Bloomberg Interview

One might be bored of reading too many Marc Faber references lately on this blog but Bloomberg has a lengthy interview that captures his present world view. I think it's well worth checking out for those not familiar with Marc Faber; and for those familiar, well, there are some nice insights as well as his investment thoughts. I personally think he is less useful during bear markets (I consider bears to be useful during bull markets and bulls to be interesting during bear markets--I know, the opposite of most people.)

In any case, here is a summary of his key points. I don't think it does justice to his colour commentary ;) but for those short on time...


(bullet points are in no particular order)


  • Is out of the market for the most part: He says he is mostly in cash, with gold behing his largest holding (equities less than 10% of portfolio.) He views gold as more of an insurance holding.
  • Market oversold and sees potential for a rally but no new (real) highs: I'm not into technical analysis but Marc Faber does use it. He says market is oversold and can rally but doesn't think there will be any new highs (in real terms.) If the government prints lots of money--so far it hasn't in my opinion--the market can hit new nominal highs but in real terms it won't go anywhere.
  • Gold may not do well near-term: Points out that gold has held up reasonably well compared to equities or commodities. Sees the potential for rotation out of gold into commodities, if commodities rally.
  • World world in recession: Doesn't buy Chinese numbers and thinks that China would be lucky to post 5% GDP growth (versus the 9% reported by government.) Same for India. He says the whole world is literally in a recession.
  • Credit bubble in USA; investment bubble in emerging markets (EM): This (i.e. investment bubble in EM) is an important point that seems to have been missed by many EM and commodity bulls over the last few years. I have stayed away from EM mainly due to this view. There may not be a debt bubble in many (but not all) emerging market nations, but there are bubbles in real estate, manufacturing, buildings, and so on. If you are investing in EM, you better be prepared for any blow-ups in one of more of these bubbles. For instance, anyone investing in China (or doing a bullish commodity bet based on China-to-da-moon theory) needs to be able to handle any shocks from a limited collapse in manufacturing.
  • EM cyclical and will underperform during slowdowns: Pretty much obvious to anyone with any sense of history. EM is very cyclical given that those countries depend heavily on manufacturing or resource extraction. EM wil outperform USA during booms and underperform during busts. I remember quite a few dissing US returns in the last few years without realizing that EM returns are more volatile.
  • Reason for US$ strength: Faber claims that the main reason for the US$ strength is due to the shrinking current account deficit (people like me claim that the main reason is due to capital flight to safety.) He says that the shrinkage in US current account will be bearish for assets and bullish for US$. The current account deficit injects liquidity into the system and pushes asset prices higher (the case in the last 8 years or more). A shrinking current account sucks capital out of the system (what's happening now.)
  • Not a big fan of central banks or governments: LOL that's an understatement. He blames central banks and governments for many of the problems. Marc Faber follows Austrian Economics but I have to point out that part of the problem is that, contrary to what anti-Keynesians claim, governments have a habit of trying intervene when things are bad but not when times are good. If you were to follow Keynesian view of government intervention, you should only be helping when things deteriorate, and step back when things are booming. Yet no one does that; so I would claim the process hasn't bee executed well.
  • Thinks bailout of LTCM was a huge mistake: Says that some of the core problems are due to the bailout of LTCM. This is an interesting insight not mentioned by many. I agree with him here. If you are a free market guy to any appreciable degree, you should let firms fail due to their mistakes (except in extreme circumstances--this is where I stray from pure free-market supporters.) As Faber alludes to, by saving LTCM, a signal was sent to market players saying that leverage was great and if you ran into problems someone would bail you out. Marc Faber says that the problems (if you let firms collapse) wouldn't have been as large back in 1998 as now.
  • World wealth contracted by almost 50%: It's actually amazing when you think about it: the world's wealth dropped by almost 50%. Many readers may only be thinking about stocks, but remember that bonds, commodities, real estate, among others, have also declined substancially. This is history-making stuff. We are talking once in a hundread year stuff. The fact that the stock market is down 20% for the year isn't a big deal (it's a nasty bear market that comes around every 10 years or so.) But it is rare for huge swaths of wealth, not related to the stock market, to tumble 30% to 50%. Even the lowly currencies of the word, who one might have thought would not move much, have had some massive declines.
  • Workers less affected than the wealthy: This is a very interesting point and is perhaps why I, who is more of a worker than an investor, am less concerned than many others. Faber speculates that most of the suffering will be borne by the wealthy, who generally control most of the wealh in any country. He expects the workers to be affected less. I believe this is especially true given that (i) this is a financial, not an economic, crisis, and (ii) most of the wealth accrued to the wealthy and investors in the last 10 years.
  • Bullish on corporate bonds: Now for some investment picks... He likes corporate bonds, some of which yield 15%. I agree with this suggestion. The corporate balance sheet, not just in America but most places, is very good. Of course, I'm not talking about the over-leveraged companies from the LBO boom, but, rather, the typical corporation.
  • Bullish on Singapore assets: He mentions a bunch of Singapore assets that he likes, some of which are trading at 1/3 of net asset value. I don't know if I have the names right but he suggested some Singapore securities: REITs in general, Thai hold?, Metroholding, Hiflux?, Faose?, banks in general... he also suggests Turkish fund?... It's not clear what he was referring to but he said whatever you buy, you will likely do well in 10 years (I'm not sure if this was a reference to his picks or just investments in general.)

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Saturday, October 18, 2008 1 comments

Capitalism Is Dead... Long Live Capitalism



Probably one of the best cartoons from Kal.

While some on the left are calling for the end of capitalism, we have some on the far-right (American Libertarians/traditional conservatives/free market supporters) saying the current mess is mostly the government's fault. I personally don't buy that view but if someone is in the mood for a critique of the current system from an extremist, Austrian eocnomist, view, check out Jim Grant's latest piece in The Wall Street Journal. I just don't see how he can pin the blame on the central bank (The book hasn't come out yet but my impression is that his forthcoming book will blame the central bank actions.) I'm trying to dig up some information from the 1800's to illustrate how terribles things were when gold or silver backed currencies, there was no central bank resembling the present ones, and deflation was the norm. It's amazing that so many libertarians and conservatives who were in favour of extreme de-regulation of markets don't want to take responsibility for the mess. It's so bad that some even start blaming Fannie and Freddie for the subprime mortgage losses, while purposely ignoring the fact that the GSEs never were players in subprime.

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Friday, October 17, 2008 2 comments

Warren Buffett Bets On America... Finally

(Illustration by Brad Holland for The New York Times)


It took a while but Warren Buffett finally considers American equities attractive. Warren Buffett wrote an opinion piece for The New York Times today and he is buying American equities for his private account. This is a big shift from Warren Buffett, who says he has been holding US Treasuries in his private account. There isn't anything insightful in his essay for any value investor or a contrarian but I recommend reading it. In fact, the most important thing to me is not his comments but the fact that this is a powerful signal. It's one thing for some guy off the street to be saying stocks are cheap; and it's another when someone great like Buffett says so.

I hate to insert my views into an opinion piece but here are some brief thoughts...

(source: Buy American. I Am., By Warren E. Buffett. October 16, 2008. The New York Times)



This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.


That's a pretty powerful endorsement for US stocks. Admittedly Buffett is not comfortable with foreign stocks so he always had some bias for US stocks. But nevertheless, it signals to me that a hardcore value investor like Buffett, who always looks for cheap prices, feels that valuations are finally attractive.

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.


I share the same view as Buffett. However, if I may play Devil's Advocate, it should be noted that Buffett will be wrong if we enter a deflationary depression like Japan did in the 90's. Even the very best companies in Japan have suffered in the last decade. I have been in the disinflation/deflation camp for a few years now but even I think the Japan scenario is unlikely. As John Hussman has remarked, notice that many of those expecting a depression were the ones who were superbullish a few years ago. For example, you'll notice that many who were calling for $150 to $200 oil due to a boom are now superbearish and think the world is going to end.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.


This is probably the greatest mistake you can make right now. The time to unload stocks was 6 months to an year ago. For instance, I have been bearish on oil for almost two years now and never would have considered oil&gas stocks worth owning. However, I would be the first one to say that it is not worth selling such stocks right now. The valuations are so low that even it is hard to be a bear on that sector anymore. If I had to make one decision, I would rather buy oil&gas right now than sell.

(Do note that I am not making a bullish case on oil&gas here. I don't have a strong opinion right now, except for some really beaten down E&P junior or maybe Russian oil&gas stocks, some of which are supposedly trading below cash i.e. net-nets (but I'm not sure how reliable accounting is). I'm just saying that selling is not a good decision anymore, unless you were certain your company was severely overvalued.)


Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts...Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.


Buffett is talking about short-term securities but even worse are US long-term bonds. That's probably the biggest bubble right now. As Marc Faber has alluded to, anyone buying a 30 year bond with a 4% yield is just asking for financial suffering. It's hard to think of too many greater mistakes than locking in their money for 30 years at 4%. At least those "investing" in short-term T-bills with 0.5% yield are only doing it for the short-term.

I share similar views as Buffett. However, it should be noted that his views will be wrong if we enter a deflationary collapse of some sort. Clearly the consensus, hence market view, is that we are going to enter such a scenario. Otherwise, you wouldn't get anyone giving away their hard earned money at 0.5% for the next 3 months.

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Thursday, October 16, 2008 1 comments

Central Banks Can't Target Asset Prices; Reversion To The Mean May Not Work

I ran across a blog entry at Aleph referring to a Bloomberg story suggesting that some believe asset prices should be targetted by central banks. Mark Thoma also tackles this topic in a SeekingAlpha post. IANAE (I'm not an economist) but here is my layperson perspective on this.


The Bloomberg story is a bit narrow and concerned with asset bubbles due to excessive credit (basically the current problem.) But if we generalize it and consider asset bubbles in general, I would say it's impossible for central banks to target asset bubbles. I quote a WSJ blog entry last year dealing with this topic so you may want to check that out. It's impossible to know what is in a bubble ahead of time. For instance, consider some of the recent scenarios.

People like me entertained the possibility that commodities were in a bubble, yet we have many others who are confident that commodities are not in a bubble. So which is it? The answer, of course, is that we don't know right now. But in 10 years we will. If commodities collapse and don't rise back up then the recent environment was clearly a bubble. Until then, it's hard to say.

Similarly, consider the technology bubble in the last 90's. Right now, everyone accepts the view that technology--more accurately TMT or technology, media, and telecommunications--was in a big bubble by 2000. But could anyone have known in, say, 1996 or 1997 that there was a bubble developing? The answer would have been negative. Consider the following table from Bespoke Investment Group showing the sector share of the S&P 500 (source: SeekingAlpha):



I will note that market cap does not necessarily reflect the actual share of the economy but I'm just using it as a crude approximation. What you would have seen in 1997 is a situation where technology is around 12% of the S&P 500. It was much lower in the past so you actually may have felt it was in a bubble. You would have seen the whole industry booming, with shares of companies like Microsoft seemingly rising every month, in a bubble-like fashion.

If governments had a policy of targetting bubbles, they may have crushed the technology sector in 1996 or 1997. Yet that would have been a disastrous policy for the country. What you were observing was not a bubble in formation but the emergence of a new set of industries. Technology was clearly in a bubble by 2000 but I would argue it was not in 1996 or 1997. In fact, even after the tech bust, the technology share of S&P 500 never went back anywhere near the 12% in 1997 (it has stayed above 15% all throughout the 2000's and likely may for decades.)

I hope you can see why it's hard to tell what is a bubble in advance or while you are in the middle of it. Similar to the technology scenario in the 1990's, it's very difficult to say if commodities are in a bubble. Remember that this is coming from some guy who was bearish on commodities for the last few years and even put his money on the line (too bad it didn't create much wealth : ). As bearish as I have been, it's difficult to say if this is a long-term bubble. Emerging countries have been developing rapidly so we may be witnessing the creation of new industries. Or we may not; all this could just be hype. We just don't know.

I hope that sort of illustrates why bubbles are hard to identify. The commodities example is a very good one. No one really knows if oil at $140 is a bubble or if $100 is a bubble. Given the reality of the situation, I don't believe any government body can target assets. If they do so, they will kill off every emerging industry that can actually create wealth for the country.

Reversion To The Mean Can Be Misleading

The technology example above, along with the data from Bespoke Investment Group, clearly illustrates why reversion to the mean can be misleading. If you were looking at technology in the mid-90's, you clearly would have thought it would decline. Technology was a smaller part of the economy and the stock market before the 90's. You may have thought it would revert to the mean and shrink. Needless to say, you would have been completely wrong. Not only did technology expand, it's one of the largest sectors of the stock market and the US economy.

What is more likely to revert to the mean are valuations, not the share of the market. Technology may be 15% of the market cap now versus around 6% in 1990, but it's difficult to argue that it will decline back to 6%. Instead, valuation metrics such as P/E, P/BV, and so forth, are more likely to revert.


(One other item one should keep in mind is that the definition of sectors and industries changes over time. Radio would have been high-tech back in the 1920's but that's not the case now. Looking forward, businesses related to alternative energy may either end up being slotted into technology, or industrials, or utilities (the result can make a huge impact if there is a boom in this area.))

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Wednesday, October 15, 2008 1 comments

Marc Faber Interview

Thanks to Naked Capitalism for pointing me to an interview of Marc Faber being conducted by Australian television. True to form, Marc Faber is expecting a lot of gloom, boom, and doom.

Marc Faber is an extremist and his comments often border on extreme doom. And I'm not even talking about the current crisis. He is always superbearish so some of his views are ridiculous. For instance, I'm sure that even he doesn't seriously believe that US government debt should be rated junk, as he claims. Nevertheless, he presents non-mainstream views and I'm a big fan of him (even though his timing is off at times.) It's a good read if you want to hear bearish views.

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Mutlimedia Rundown

Here are some multimedia clips consisting mostly of interviews over the last few months. A lot of it is not new and has made the round in media and blogs but I'm repeating them here in case someone missed it.



  • Donald Coxe (Financial Sense Newshour with Jim Puplava): For those not familiar, Donald Coxe is a commodity superbull who had been bullish on commodities for many years. He shares his views on the current situation. I don't agree with all his views, but it's interesting to hear his take on agriculturals. If I were to bet on commodities, I would go for the soft commodities (agriculturals.) Donald Coxe, Jim Rogers, and Marc Faber are all bullish on them so that's a good sign. This seems a safer bet than industrial commodities or oil&gas, most of which are already up almost 200% to 500% within 10 years.

  • Jim Grant (Financial Times): There are no libertarians in a crisis... except for Jim Grant that is. (original mention: The Big Picture)

  • Paul Volker (Charlie Rose on PBS): Thinks the situation is bad. (original mention: Calculated Risk)

  • Warren Buffett (Charlie Rose on PBS): Very good interview, and, given his age, we may be seeing one of Buffett's last.

  • Jim Rogers retro (Charlie Rose on PBS): If you want to catch an old-school interview with Jim Rogers, you can't beat this. We are talking about 1995. Jim Rogers was as bullish on China back then as now. Remember he was making this call before anyone even thought China would amount to anything. People always remember Jim Rogers was his commodity call but what will cement his position as one of the top macro investors is his China call. Assuming China doesn't completely fall apart, it will likely crush returns on all other investments. Commodities may boom and then collapse but countries can literally grow for centuries.

  • Riverside conversations with Jim Rogers and Marc Faber (VPRO/Amago): If anyone wants to know when I started respecting Marc Faber (and Jim Rogers to some extent,) it was around the period in early/mid 2000's. I considered the Riverside Conversation series as some of the best discussions I had ever encountered as a newbie investor. I don't know if all the videos work (some are in Realvideo which I didn't test but the last one in Windows media seems ok) and they are very poor quality but if anyone has time to kill, check these out. The views may be dated so don't assume everything that is discussed holds but if you want to know why some people like me like the seemingly 'eccentric and evil' ;) Marc Faber or the 'never short of polemics' Jim Rogers, you may find these videos insightful. (original mention: Financial Sense)

  • George Soros (Bill Moyers on PBS): Haven't watched this yet but I'm coming around to some of his thinking. His notion of reflexity is starting to make a lot of sense to me. His explanation of how reflexity may be playing a role with oil seems plausible. (The New York Review of Books touches on this issue when reviewing his latest book.) The key point he seems to be making is that, contrary to the popular conventional view (mostly from the Chicago economic school,) markets do not necessarily towards equilibrium. Furthermore, an important point he makes is that the markets themselves have the power to affect the fundamentals (this is contrary to the conventional view that fundamentals such as supply and demand primarly drive the markets and not the other way around.) (original mention: The Big Picture)

  • The Spiral (Going Private): Now for some humour... Hilter and his financial meltdown. Check out all the videos on the site. Anything that injects MBIA into the situation deserves some kudos. If I'm not mistaken, the video is from the feature film Downfall, aka Dr Untergang (I haven't seen it but it's on my list.) (original mention: The Big Picture)


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Tuesday, October 14, 2008 0 comments

Massive Captial Injections and Partial Nationalization Underway

Free market proponents may not like it but governments of the world have taken almost-unprecedented action to inject capital into major banks. Many feel that there is few other alternatives, other than letting the banks collapse. You can get more details at your favourite media source so I'm not going to repeat that story except to provide a summary of the key moves courtesy The New York Times:



There are several elements and they keep changing so it's hard to say what the final situation is. My impression is as follows:

Although the details of the plans differ, we are seeing a global effort. This should increase confidence in the system and was essential. If only America did something while Europe and others did nothing, the impact would may not be significant.

The US government is forcing the leading banks to accept capital injections. Dilution for shareholders amount to around 20% of book value (depending on the bank in question.) The thinking behind the forceful move is the belief that these plans won't work if everyone doesn't participate. If some banks shore up their capital while others don't, there will still be fear of a collapse.

The market, including investors in the affected banks, seem to like the move. The shares of the affected companies are up anywhere from 3% to 13%, even though there is sizeable dilution involved. There is a possibility that the market was pricing in worse scenarios so the dilution may be minor. Short-sellers are still absent from the market--at least new ones--so it's not clear if this is a bogus rally or not.

I'm left-leaning and ok with government intervention when needed but this is basically the end of modern banking. The banking revolution is over. I suppose, like most revolutions, it ends up worse than anyone expects. If what I am saying is true, then investors need to be cognizant of the fact that future investment returns may be nothing like that past 20 years. (Note: I'm just talking about the developed world. The developing world, and banks with exposure there, are still in their infancy.)

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Congratulations to Paul Krugman

Congratulations to Paul Krugman for winning the Nobel prize in economics. Strictly speaking, there isn't a Nobel prize in economices but the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel is considered to be the unofficial Nobel prize in this field. I'm not an economist and don't really understand or agree with much of it but here is what he is being cited for:


The Royal Swedish Academy of Sciences has decided to award The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2008 to Paul Krugman (Princeton University, NJ, USA) for his analysis of trade patterns and location of economic activity.

Patterns of trade and location have always been key issues in the economic debate. What are the effects of free trade and globalization? What are the driving forces behind worldwide urbanization? Paul Krugman has formulated a new theory to answer these questions. He has thereby integrated the previously disparate research fields of international trade and economic geography.

Krugman's approach is based on the premise that many goods and services can be produced more cheaply in long series, a concept generally known as economies of scale. Meanwhile, consumers demand a varied supply of goods. As a result, small-scale production for a local market is replaced by large-scale production for the world market, where firms with similar products compete with one another.

Traditional trade theory assumes that countries are different and explains why some countries export agricultural products whereas others export industrial goods. The new theory clarifies why worldwide trade is in fact dominated by countries which not only have similar conditions, but also trade in similar products – for instance, a country such as Sweden that both exports and imports cars. This kind of trade enables specialization and large-scale production, which result in lower prices and a greater diversity of commodities.

Economies of scale combined with reduced transport costs also help to explain why an increasingly larger share of the world population lives in cities and why similar economic activities are concentrated in the same locations. Lower transport costs can trigger a self-reinforcing process whereby a growing metropolitan population gives rise to increased large-scale production, higher real wages and a more diversified supply of goods. This, in turn, stimulates further migration to cities. Krugman's theories have shown that the outcome of these processes can well be that regions become divided into a high-technology urbanized core and a less developed "periphery".


Ignoring radicals such as Noam Chomsky, Paul Krugman is probably public enemy #1 of American "conservatives" these days. I suspect liberals are happy with the pick, whereas conservatives would question the pick. The prize is supposed to be for economics but a lot of people pass judgement based on a person's political stance. To me, this is especially true in economics because economics is intertwined with politics.

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Sunday, October 12, 2008 0 comments

Can Governments Actually Afford to Back Their Banks?

One of the popular strategies these days is for governments to announce that they are backing the deposits in their country. I approve of the government strategy since we need to prevent bank runs that were the norm in the 1900's or earlier (or in modern day developing and undeveloped countries.) However, as investors and savers, the question is whether there is any merit to any of this. Can these governments actually back up their deposits?

The Economist examines this topic, and produces the following chart plotting debt and deposit as a percentage of GDP (as usual, click on chart for a bigger picture):



That chart looks scary. We can easily see how Iceland has little ability to do anything given the size of the exposure. I also remarked recently that Switzerland is another country that may face potential difficulties (I questioned whether a bullish bet on the Swiss Franc, as Jim Rogers seems to favour, is a smart bet.) Well, I never knew that Britain and Ireland were just a tad bit worse than Switzerland (using the measures on the chart.)

Overall, as the article makes clear, governments should be able to weather any problems given that investors tend to flee to government bonds during times of stress. Nevertheless, I would avoid potentially disastrous moves to capitalize on government promises. For example, there were stories early in the week of savers shifting their savings to Irish banks after Ireland promised to back the deposits (this was before other European governments followed suit.) Well, if there is one thing to be learned from the current crisis, it's that one shouldn't blindly chase yield. All those chasing Irish banks are taking extra risk for very little return. Just to be clear, I do not think Ireland or any other country is going to have difficulty backing their banks. But I just don't think it's worth betting money on that.

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