Wednesday, December 31, 2008 0 comments

Happy New Year to all the Bulls & Bears

It has been a rough year but fret not, a new year is upon us...

To All My Fellow Bulls & Bears

Happy New Year!!!

All the best to you & your family
And wishing a prosperous financial year for all...

(source: picture from Frankfurt stock exchange (modified))

Monday, December 29, 2008 9 comments

America to disintegrate by 2010... or so says one man

If there were awards for making black swan predictions, I think one gentlemen from Russia has everyone beat when it comes to the political category. In a prediction that rivals the best--or worst?--of science fiction writers, we have a Russian analyst forecasting the breakup of USA. I'm sure you are thinking that you have heard that before, not just once or twice but at least ten times. But, unlike prior "forecasters," this individual is predicting not only a major collapse of USA, but for it to happen by 2010. Yes, make no mistake, Americans only have 2 more years of peace and prosperity. After that, they'll be happy to know that they will be under the influence some distant forces as outlined in the map below:

For a decade, Russian academic Igor Panarin has been predicting the U.S. will fall apart in 2010. For most of that time, he admits, few took his argument -- that an economic and moral collapse will trigger a civil war and the eventual breakup of the U.S. -- very seriously. Now he's found an eager audience: Russian state media.


Mr. Panarin posits, in brief, that mass immigration, economic decline, and moral degradation will trigger a civil war next fall and the collapse of the dollar. Around the end of June 2010, or early July, he says, the U.S. will break into six pieces -- with Alaska reverting to Russian control.

Prior apocalyptic predictions have involved the southern states falling to Mexico; Hawaii being lost; and Alaska reverting to Russia or to Canada. So none of that is surprising. But it's news to me that someone thinks that China would have influence over the west coast. The western states have little to do with China and once China figures out how liberal those states are, they may not want any part of it :)

Canadians will be happy to know that, after most prior forecasters predicting Canada to be invaded by USA, the opposite is expected to happen. Canada is somehow expected to have influence over the mid-west states. Europeans need not fret. One might have thought that European influence had been declining for the last 100 years, but not according to this analyst. Europe somehow manages to get the north-eastern states to join the EU (it should be noted that some on this side of the world are forecasting the EU to fall apart so it will come down a race I guess.) I personally have always considered the north-eastern states to be more attractive to Canada (although the conservatives in Western Canada would disagree ;) ) so maybe we can swap the mid-west for the north-east. I hear Europe is running out of room so I'm sure Europeans will find the less densely populated states of Iowa, Nebraska, Ohio, and the like more attractive. Home state of Warren Buffett should be some sort of trophy, no?

So, if you are an American, I think it's about time to start stocking up on guns, food, and gold. I guess I might have to hold off on the bearish gold idea ;)

Getting the macro call right and ending up with a disastrous portfolio

You can see why value investors such as Warren Buffett don't spend too much time making macroeconomic predictions. It's quite easy to be correct with the macro call yet end up with poor investment returns. Part of the reason is the inability to nail the timing. The other, obviously, is poor asset selection.

An example of what I'm talking about is the International Harry Shultz Letter, which is some obscure newsletter that has posted a disastrous 70%+ loss. I wanted to highlight this letter, not because I have any strong negative opinion of the letter itself. Rather, there are a few important observations.

But over the past 12 months through November, Schultz is down a heart-stopping 76.05% by Hulbert Financial Digest count, vs. negative 36.68% for the dividend-reinvested Dow Jones Wilshire 5000.

This loss has wiped out Shultz's strong post-2000 run, when he benefited from the gold and commodities boom. Now, over the past 10 years, the HFD shows the letter achieving an annualized loss of negative 8.73%, even worse than the negative 1.16% annualized loss for the total return DJ-Wilshire 5000.

And it's an unpleasant arithmetical fact that even future triple-digit gains (which aren't impossible) will not dig Schultz out of this hole.
(But, if you're a new investor starting at the bottom, who cares?)

The reason I pick Schultz: the extraordinary prescience he showed in predicting what he called a "financial tsunami" well over a year ago. See Oct. 19 column.

I don't have access to either the letter in question or the Hulbert Financial Digest, which tracks newsletters, so I have no idea what is actually contained in the suggested model portfolio. If I had to guess, based on some articles about this letter over the years, I would imagine it was heavily overweight junior gold mining and oil companies, with a bias towards foreign holdings. Needless to say, the US$ rally has clobbered many, with many likely posting 20% or 30% loss from the US$ appreciation alone (some of the worst, of course, are the commodity currencies such as the Canadian dollar, Australian dollar, and so on.)

So the first thing to keep in mind is that currencies can make or break your portfolio. This is doubly so for 'super-charged currencies' which are those that rally sharply due to some macro trend (e.g. commodity currencies due to commodity bull market in the last 8 years; US$ in the late 90's due to dot-com bubble; select Asian currencies during the mid to late 90's.) The unfortunate thing is that the currency collapses precisely when your macro case, and hence your portfolio, falls apart. For instance, investors in the Asian Tigers in the 90's did not just lose money off bad bets in Asia but also lose a huge chunk on currency losses. Similarly, right now, commodity investors paid a big price, first when commodities collapsed, and, second, when the commodity currencies also fell sharply. (Currency moves may be reverse but sharp moves, such as the recent appreciation of the US$ and the Yen may signal a new macro trend.)

The second thing to realize is that you can lose huge gains in a short period of time. Vetern investors are probably aware of this but newbies, such as myself, never put enough thought into this. The International Harry Shultz Letter had huge gains going into the year--shouldn't be a surprise if he was overweight materials, energy, and gold--but is down so much that it won't recover even if you post a few spectacular returns (unless you dollar-cost-average.) As recently as September, it seems to have posted a 17.82% annual return in the last 5 years versus 7.85% for Dow Jones Wilshire 5000. Right now, it is -8.73% versus -1.16% for the Dow Jones Wilshire 5000 over the last 10 years (not sure abou 5 years.) That's a huge swing. The up-to-September numbers are Warren-Buffett-like returns; the current returns are, well, the less said, the better.

An implication of the above point--I think everyone already knows this--is that it is very difficult to tell skilled investors unless you look at the long-term. The letter in question posted 17%+ per annum for 5 years and many would have considered the letter writer to be talented. Yet the collapse seems to indicate otherwise. Bear markets are what separates the best from the rest, so we'll get a good idea of who is truly talented once this bear runs its course. I am still uncertain of a some of the investors I refer to in this blog, and whom many others hold in high regard, such as William Ackman, Jim Rogers, and so on.

It should be noted that commodities, which really have little to do with subprime mortgages, or bad credit, are one of the hardest hit. Either we are seeing extreme irrational selling, or we are seeing the bursting of a bubble. I think it's the latter but my opinion isn't strong enough for me take a position (besides, I got burnt with my bearish commodities bet over the last 2 years so once is good enough :( )


Proposed US infrastructure spending not working in the environment's favour

It looks like the proposed infrastructure spending of the Obama administration is not going to help the environment or improve energy efficiency. Although those were never the goals, some, including me, were hoping that it would improve energy efficiency and battle pollution. It looks like some states are simply going to be promoting urban sprawl (source: Bloomberg):

Missouri’s plan to spend $750 million in federal money on highways and nothing on mass transit in St. Louis doesn’t square with President-elect Barack Obama’s vision for a revolutionary re-engineering of the nation’s infrastructure.

Utah would pour 87 percent of the funds it may receive in a new economic stimulus bill into new road capacity. Arizona would spend $869 million of its $1.2 billion wish list on highways.

While many states are keeping their project lists secret, plans that have surfaced show why environmentalists and some development experts say much of the stimulus spending may promote urban sprawl while scrimping on more green-friendly rail and mass transit.

“It’s a lot of more of the same,” said Robert Puentes, a metropolitan growth and development expert at the Brookings Institution in Washington who is tracking the legislation. “You build a lot of new highways, continue to decentralize” urban and suburban communities and “pull resources away from transit.”

Admittedly, a lot of this always comes down to an ideological battle between urbanites and rural dwellers. I have to admit that I'm biased, given that I live and breathe city, so I tend to favour public transportation or mass transit over rural roads or highway projects. Mass transit would be more energy efficient and environmentally friendlier than promoting urban sprawl. However, any sort of urban plan can take a long time since they tend to be far more complex and it wouldn't really be much of a short-term stimulus.

I'm not sure what the Canadian government's stimulus plan is going to end up looking like. I just hope that they allocate most of it to mass transit given that population growth is projected to be stronger in urban areas. Canada probably should also spend some on ports and border crossings. The economic situation in Canada is not supposed to be as grave as in some parts of the US--who really knows though*--so the Canadian government should consider long-term plans that improve energy efficiency and reduce pollution. No need to rush into some mega-spending project like the US government is pursuing.

(* Canada's economy is a tough read right now. Unlike the US, the housing bubble may not be as large, with it being possibly limited to Alberta and BC, and certain dwellings such as condos in Toronto. Canadians are also slightly poorer (lower incomes, higher taxes, many goods slightly more expensive than in US) so the credit bubble may not be as bad (although wealth alone does not limit leverage.) On the other hand, a big chunk of Canada's growth in the last 10 years has come from the commodity boom. If this is a permanent commodity bust, as I think it may be, some commodity industries will contract. Yet, half of the country, particularly the manufacturing and service-oriented Ontario and Quebec, would benefit from lower commodity prices. The weaker Canadian dollar, if permanent, would also help the economy (while hurting savers.) So, it's going to be interesting to see if Canada does worse than the US over the next 3 years. It's not clear to me if Canada should be undertaking a massive stimulus.)

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Saturday, December 27, 2008 10 comments

Contrarian investment possibilities

One should never be contrarian for the sake of being contrarian! Nevertheless, I do find it helpful to list a bunch of contrarian positions and think about them. Here are some contrarian positions one can take right now. The items below may conflict with each other and should only be used as a thought exercise. I urge readers to leave any additional ideas they have in a comment.

(Positions that interest me are bolded.)

Contrarian Investments

  1. US government bonds (short)
  2. US corporate bonds (long)
  3. real estate (long)
  4. commodities (long)
  5. gold (short)
  6. US$ (short or long): Depending on one's outlook, I think one can argue that either a short or a long position would be contrarian (since the market doesn't seem to favour it strongly either way.) I would consider a bullish (long) bet to be more contrarian since I notice more people questioning the strength of the US$, particularly due to the FedRes and government spending plans.
  7. Distressed sectors, particularly homebuilders, select American and European banks, and retailers (long)
  8. Underperforming sectors, such as newspapers, forestry companies, automobile-related (long): As opposed to the aforementioned distressed sectors, these ones have been undergoing long-term declines even before the economic and credit crisis unfolded. Companies in this category may be facing secular declinines that may be the end of their industry so one needs to be really careful.
  9. large caps (long): Not a major contrarian call but large caps have been performing poorly over the last decade compared to almost all other asset types. Jeremy Grantham speculates that high quality US large caps will outperform the lower quality large caps and small caps over the next 7 years.
  10. China (long)
  11. Emerging markets, such as Brazil, India, Turkey, Eastern Europe (long)
  12. Beaten-down emerging markets, specifically Russia, Vietnam, Thailand, Iceland (long): Countries which have seen large currency devaluations, such as Russia and Iceland, are the most contrarian.

I'm sure I'm missing some but these are what came to mind now.

Friday, December 26, 2008 1 comments

My view of the crisis and trade imbalances

The New York Times has an article touching on the imbalances that we observed in the decade. It's a story told largely from the perspective of Ben Bernanke. I see some bloggers taking issues with the article and, although I don't have a strong view on the article itself, I think the criticism by some bloggers is simplistic and impractical. I will refer to two thoughts to illustrate some issues that is missed.

Housing is not the main problem!

The first blogger I want to refer to is Paul Krugman, who takes issue with the notion that the housing bubble was only known in hindsight. He correctly points out how he, as well as several others, were warning about the housing bubble for years. It would have been preferable if the housing bubble didn't inflate as much as it did, but we are not looking at the possibility of a depression because of that.

I think he, as well as many others--some prominent commentators, some not so prominent--are missing the core problem. My view is that the core problem is not housing! It is a big problem and possibly the largest real estate bubble in US history, but we have had many housing bubbles in the past with good subsequent recoveries.

It is also not, as some mistakenly believe, a subprime mortgage problem. The subprime market in the US is something like $700 billion and banks alone have wrote off more in losses than that.

The real problem, I would argue, is the mispricing of risk. The situation is bad because almost all risk was underpriced. I really wish it was limited to subprime real estate or real estate in general, but that's not the case at all. If it were, spending about $500 billion to, maybe, $2 trillion (depending on your recovery assumptions, inflation assumptions, and so forth) would easily solve the problem. Yet, the US government alone has spent almost a trillion (depending on how you count the capital injections) and the problem is as bad as it was 6 months ago or even 1 year ago.

Risk was completely mispriced. Something that is very detached from real estate, say investment grade corporate bonds, were underpriced as well. Corporate bonds of non-housing-related companies would not sell off to the degree they have if this was a housing problem.

If you are an investor, I think it is extremely important to realize that the core problem is the mispricing of risk. The underpricing of risk also, not surprisingly, led to increase in debt usage. After all, if cost of debt was low, market participants are inclined to use greater amount of debt.

What has happened because of the underpricing of risk is that the market has lost trust in financial institutions, asset prices, economic numbers, and even some governments. What this means, in my view, is that, if you are taking a bullish view and are macro-inclined (if you are bottom up, you may not care about macro,) then you need to realize that a housing recovery will not necessarily result in the good old days. This is one reason I am maintaining my bearish view of the economy; but unlike some I am not superbearish and am not expecting a depression. I really don't see cyclicals, such as commodity businesses, retailers, and auto manufacturers recovering quickly. Some of the bloggers I read, along with reader or forum posters, are gearing up to take strong pro-growth bets (such as betting on oil) but I'm concerned about the outcome of that.

So, I would say that even if the housing bubble wasn't as large, we would be facing similar issues.

Trade War

I would also like to refer you to Yves Smith of Naked Capitalism who seems to favour a trade war with China. As she correctly points out, the imbalances were driven by various issues such as the undervalued renminbi peg to the US$. I would argue that the trade war that she is calling for would end up in a total disaster. We would probably end up worse off than now. On top of a trade war being very risky, it is totally impractical even 5 or 6 years ago.

It is also very easy for one to say what should happen but that's not how the free market works. It's easy for everyone to say that Americans (and Canadians too) have been living outside their means and consuming too much. But no one can imlement a plan to rectify that. The consumers are just actors in a free market and they will act in their interest. If someone is offered cheap credit, they will take it. If investors are willing to finance the lifestyle of someone, they would take it. The market forces are far more powerful than any government!

People, including prominent economists such as Stephen Roach of Morgan Stanley, had been warning about the trade imbalance for years but it is impossible for any invidual or government agency to rectify it. Only market forces can fix these problems and we are seeing the forces at work now.

Tuesday, December 23, 2008 1 comments

Bad news for bond insurers: Analyst sees up to 10 municipal bankruptcies

They have been given up for dead but the bond insurers are still limping along. However, there is some bad news on the horizon, although I'm not sure if any of the bond insurers are impacted. Bloomberg reports that an analyst predicts as many as 10 municipal bankruptcies in the upcoming year with more the following year:

The accountant who predicted the nation’s largest municipal bankruptcy says as many as 10 insolvencies will roil the $2.7 trillion U.S. market for state, county and city debt next year as public finances worsen amid calls for federal aid to state and local governments.

John Moorlach said in 1994 that Orange County, California’s leveraged investing strategy could wreck its finances. The county went bankrupt about six months later after losing $1.6 billion.

As many as four cities in the Golden State and six others nationwide may seek court protection from creditors next year under Chapter 9 of the bankruptcy code, the section devoted to municipal governments, Moorlach said in an interview.

Some of the ones cited seem to be tiny so their impact will be minimal. Even if defaults were fairly high, insurers will likely get higher recoveries or ownership of assets (such as sewage systems, roads, streetcars, and the like.) In contrast, losses on residential real estate, especially the CDO-squareds, can result in losses close to 100%.

Similar to how the stock market swooned after the bond insurer problems with real estate bonds surfaced, I suspect further problems with municipal bonds will likely cause another big sell-off in the stock and bond markets. If American municipalities and states start defaulting in a high number, the US economy will be in far worse state than I have ever contemplated.


Cheery thoughts from Marc Faber... Not!

Investors expecting some good predictions for next year may be dissapointed to hear Marc Faber predict a catrastrophic economy next year. However, I think there is some inconsistency in Faber's predictions. He is expecting bad things all around yet is bullish on all the cyclicals such as commodities. He also seems to favour emerging markets, which seem like a bizarre bet if you are bearish on the world economy. Faber keeps dodging the China question. He keeps saying that the situation could get worse but doesn't come out and say to short China. He also seems to favour gold mining companies, such as exploration companies.

He thinks the markets are likely to rally since they are oversold but doesn't expect it to be anything significant. For what it's worth, Faber relies on technical analysis for these calls and I tend to dimiss it for the most part. Oversold or overbought has little relevance to my thinking.

I think the 'inflationists' are going to be wrong. I don't have a strong opinion or evidence yet but I have a bad feeling. I'll post my views after I have formulated by thoughts for the next year.

Sunday, December 21, 2008 7 comments

One of the big stories of 2009: Crude Oil

Crude oil is going to be a big story in 2009--for both investors as well as for the economy. I'm staying as far away from oil as possible but it is an interesting situation for investors.

Oil & The Economy

One of the reasons the economy hasn't done as badly as some of the pessimistic forecasts from early in the year was because of the massive decline in crude oil. Calculated Risk estimates that the decline in oil provides around $20 billion per month in extra disposal income (compared to prior spending.) This is equivalent to almost 1/4 of the big stimulus package that is being proposed. If you add in the decline in other commodities, you can see how big of a stimulus this has provided in this recession.

The decline in oil (and other commodities) is, of course, bad for the oil industry (and related industries.) Roughly speaking, decline in oil is good for USA because it is a big user; but it is bad for the oil producers, whose economies are getting clobbered. One just needs to look at Russia and Brazil to see how the free market benefits some and hurts others. As for Canada, decline in oil is neutral in my opinion. Canada is a big producer of oil but almost half (or more) of the economy is manufacturing and services that are big users of oil. So it is a wash of sorts.

Oil & Investors

For investors, it has been a wild ride but the really volatile period could still be in front of them. So far oil has trended with it continuously going up for a while and then continuously declining of late. If I had to guess, I would say that oil will enter a volatile period where it goes up and down 20% every few months (this is similar to my view of the broad stock market as well.) Like most nasty bear markets, it is likely that both bears and bulls will either lose big or gain big (if they can time things properly.) Some investors are thinking of going long now and it's an interesting proposition.

From a contrarian point of view, if you are bullish, the analyst estimates are not in your favour. Analysts still seem to be too bullish as you can tell by the following chart from Bespoke Investment Group:

Analysts seem to think that oil will rebound to $60 by next year and hit $100 by 2011. The ideal contrarian position would be when analysts are bearish, as nearly all of them were 5 years ago, but it's too late for that. Oil, like most commodities, is very volatile and there is nothing to say it won't hit $60 but I find it unlikely. That's around a 100% gain from current levels and without a big macro bet, such as the China bet, it's hard to see anyone pushing up prices to that level.

If we leave the analysts, who always lag trends, and look at the market itself, we see the following futures curve, courtesy

I only plotted a few months but you can get more data from Do keep in mind that a normal commodity market should be in contango (i.e. future price should be higher than current price to account for opportunity costs, storage costs, etc.) Right now, the futures prices are quite bullish, with a price in the $50's by next year, and $70 by 2013. Having said that, I don't think one should rely on the futures market very much.

There are a lot of people, including central bankers and other prominent individuals, who look at futures markets as some sort of predictor of the future. I am not in that camp. As far as I'm concerned, futures are almost next to useless and generally just extrapolate current views far into the future. If anyone looked at oil futures a few years ago you would have noticed that they were wildly off. Similarly, early this year, distant futures were pricing in very high prices (although if I recall, the futures price never hit the high spot prices around $147.)

So to sum up, it's easy for oil to rise significantly in a short period of time, but the market consensus is still too bullish in my eyes.

Saturday, December 20, 2008 0 comments

Nature of bear markets

(source: Globe Investor magazine, December 18, 2008.)

Cool pic. Anyway, Globe Investor magazine, the Globe & Mail's insert, has a brief summary, written by Dan Hallett, on the nature of bear markets. Unfortunately, the attached table is very small and hard to read on high-resolution monitors. In any case, here are the key points he makes:

1. Bear markets are common.

Canada has seen six bear markets in the last 39 years. That’s one every 6.5 years or so. The accompanying table shows that U.S. stocks have seen 15 bear markets over the last 137 years – an average of one every nine years.


2. Clustered bear markets are the norm.

...Notice that many past bear markets started shortly after stocks fully recovered from the previous decline. Most investors’ experience has, until this year, been the exception to the notion of clustered bear markets. The crash of 1987 was fully recovered by the summer of 1989. After that, the United States didn’t have a real bear market until 2000.

3. This bear market started in 2000.


4. Diversification can save your ass(ets).

Even if you can see a bear market coming, there are always surprises...

The best place to hide has been in government cash and bonds. In the Great Depression, for instance, U.S. stocks fell nearly 90 per cent and spent 15 years under water. But a portfolio of 60 per cent U.S. stocks and 40 per cent U.S. government bonds spent just over six years in the red. There are two reasons for this.


5. This bear will hibernate again.

The average U.S. bear market spent nearly three years recovering from its lows. This bear market is worse than average and the race downward has been much faster than a typical bear decline.

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Stephen Roach sees weak growth

One of my rules in investing is to be skeptical of economists' predictions. Economists generally don't consider valuations when making proclamations. They also tend to be influenced by peers and have a habit for looking backwards quite often. Nevertheless, since I am macro-oriented, I do think it's worth paying attention to the general picture that is put forth by an economist.

One of the economists I was influenced by in the past was Stephen Roach of Morgan Stanley. He was a bear for a long period of time. So much so that he was "promoted" and sent off to head their Asian operations. You never heard much from him after that, of course. Another bear at Morgan Stanley, Andy Xie, who I think is too extremist and is often wrong, was fired around the same time period a few years ago for claiming that a big chunk of Singapore wealth comes from the Chinese and Indonesian organized criminals, corrupt politicians, and other nefarious sources. Xie was very bearish on China and has influenced my thinking. Who knows if I'm right but I have been bearish on China for years primarily due to the thinking of these two economists. I also because bearish on commodities a few years ago due to their influence and that has mostly been a poor strategy in the last few years. Roach was one of the first ones I encountered, who was skeptical of the de-coupling theory and often remarked how a big chunk of the Chinese economy was dependent on foreign exports (I think most commodity bears, which included me, never believed in de-coupling.)

A lot of what Stephen Roach was saying a few years ago has come true. However it has taken a long time--too long to be profitable for an average investor. He was also wrong along the way, including one of his comments early this year that China may "export" stagflation. This seemed like a bizarre call from him, given that he has continuously warned for years of potential overcapacity in China, as well as overconsumption in USA. If the current state is too much production and too much consumption, when things turn sour, it was unlikely you were going to have overall inflation (although inflation in certain industries, or certain regions of the world, is always possible.) What was more likely is a decline in production and decline in consumption. This is what we are seeing right now, although I don't think too many knew that a contraction in credit would be the cause (I personally was guessing that an economic collapse in China, which results in China dumping products on the world market, would be the cause.)

Anyway, Bloomberg has a short interview with Stephen Roach and he touches on some current issues.

The Bubbly Treasuries?

Stephen Roach says that all of Asia is in recession or slowing down significantly. I think one just needs to look at the stock markets in those countries and see how investors are marking down future profit expectations. I am still bearish on emerging markets because there is a small probability of China facing some economic problems that may mutate into political problems. As world trade slows down--it will never grow like it has in the last few years--there is risk for more suffering.

When it comes to the purported Treasury bond bubble, he is not so sure that bonds are going to collapse. He doesn't seem to have a strong opinion but he pointed out that many who shorted Japanese bonds a decade ago were "washed out" in the end. I share similar sentiments as Roach. US government bonds seem like a bubble but if we enter a situation like Japan, with low growth, or continuously entering mild recessions/deflations, bonds can rise more than many imagine.

I also feel that shorting bonds is not as contrarian as it seems. From a market point of view, it is contrarian. That is, huge sums are being parked at super-low yielding Treasuries so you are going against the market. However, I feel as if the mainstream is also thinking as if bonds are a bubble. I mean, when mainstream media contemplates if Treasury bonds are a bubble, I don't feel it's very contrarian. Even some amateur bloggers (not the contrarian blogs but the momentum/trader blogs) are contemplating shorting US government bonds, I don't get too comfortable with that position. (What I would consider more of a contrarian position is something like shorting gold right now. I'm not recommending it and I haven't thought about it, but notice how very few, either the mainstream media or the bloggers, are talking about such a position.)

On TARP...

Roach prefers the original TARP plan, whereas I don't. He thinks the credit market lockup will only be solved when assets clear. He expects the government to help by purchasing assets but I have indicated in the past how that won't work too well (unless you purposely overpay for assets i.e. transfer wealth from taxpayers to shareholders and investors.) There is no way the government knows what the assets are worth. I mean, just look at how AIG's original bailout was supposed to be something like $15 billion (management claimed that was their collateral posting need) yet it has turned out into a monster plan of over a $100 billion.

I personally think the credit markets are going to take a while, maybe an year or more, to start functioning well. One flaw with a lot of the thinking is that many analysts and investors don't seem to realize how badly risk was underpriced in the last few years. I see a lot of people plotting charts of various spreads, bond yields, and so forth, in the last 5 years and pointing out how things are still very high. Well, if they take those charts back by a few decades, those yields are not high at all. For instance, I see many referring to CDS on various corporate bonds and pointing out how they are high compared to 5 years ago. Well, CDS was irrationally low 5 years ago so some of what we see may be, as shocking as it might be, normal.

USA Similar to Japan?

Roach thinks that USA is somewhat similar to Japan in the 90's. He mentions that Japan had two bubbles, real estate and stocks, and USA also had two bubbles in real estate and credit. He says both countries had weak regulatory and political management over that period. He also, ominously, says that the bust has infected a greater part of the US economy than what happened in Japan. That is, the bust in the US has hurt the consumer, which is the largest portion of the economy.

I am not as pessimistic as Roach. I think USA is much better off than Japan. Some of the reasons include a more free market economy, stronger corporate balance sheets, better demographics, and more diversified economy. Nevertheless, the US economy will not grow like it did in the 80's and 90's, and asset markets, particularly real estate and stocks, are unlikely to do as well as the in 90's.

Likes Infrastructure Spending

Roach likes the infrastructure plan of the Obama administration. He thinks US consumption is way too high, something like 72% of world GDP growth(?), and needs to come down. The re-balancing that Roach has been talking about for years is finally occuring. But I'm not sure how efficient the infrastructure capital programs will be.

I'm not an American so it's not my taxes at risk but I'm still not too sure about the Obama administration infrastructure spending plan. The problem is that it is a desperate move to do something, anything, before it's too late. Given how many states and municipalities are cash-strapped, I wonder if anyone can afford to maintain any newly-built infrastructure.

I'm pretty sure that a lot of the spending is going to go into some lame project with questionable long-term benefit. Ideally, it would be better if they spent the money on a long-term plan. For instance, it would be better to spend billions building a few nuclear reactors since it is almost certain that energy use would be higher in 20 years than now. But these projects take too long to plan, and could take years for workers to re-train, so the government is looking for a quick stimulus.

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Friday, December 19, 2008 0 comments

Opinion: Some thoughts on the Legg Mason Annual Press Symposium

Thanks to reader hpm for referring me to the transcripts of the December 3rd Legg Mason Annual Press Symposium. The format was that of a roundtable, with Bill Miller being one of the participants. I would put this low on the list of reading materials given that there wasn't much insight--at least for me. Anyway, I have some dissenting views on some of the points that were mentioned. Several individuals are quoted below so don't assume all the words are from Bill Miller.

On Asset Values

MILLER: The problem is collateral values and asset values. That's housing and all of the related securities relating to that, and all the securities out there in the system. You know, if the stock market were back where it was a year ago, there wouldn't be a recession. You know, things would be looking fine. Wealth would be up, you know, everything would be looking okay.

So I think it's getting collateral values stabilized and rising. And, you know, Ken and I had a discussion about this, this morning. The Fed's been extremely creative, but they haven't accomplished the job yet, so they haven't done enough yet to do that, and I think there's more to go in that.

I have some serious issues with this thinking. What if some of these assets were in a bubble? What if some assets will never go up to what it was? I think Bill Miller, and others, may be making a mistake overlooking the possibility that some assets were inflated. Regardless of what anyone does, certain amount of wealth destruction would occur. The bond market looks irrational but it may actually be marking down these assets and looking at big losses on some of these assets.

Government To The Rescue?

MACK:And Bill was just, you know, just saying that - - . I mean, what more from each of you, and it looks like all of you are looking to the government to solve this economic problem, instead of the economy, itself, in some respect, at least - - stage of this evolution. So
what more does the government need to do, to give you confidence that, in fact, that the economy is going to...

I think the panel is misguided in believing that the government can solve some of these problems. I sort of alluded to this in a prior post about Bill Miller but to repeat, I think he is too optimistic and putting way too much faith in the government. This is a serious risk that Bill Miller is taking. I think it is far more prudent to be skeptical or stay neutral. Just remember, a lot of people who entered the market early this year, when some, including Miller claimed it was the bottom in financials, have been burnt badly.

Why The FedRes Was Slow

MILLER: I agree they're doing a lot more now, but it's a mystery to me, and I would gather to the markets, why they haven't done even more than that already because it's very clear what needs to be done, and it looks like they're waiting to see if the measures they've taken will be sufficient because they don’t want to take more dramatic measures, and that's certainly an institutional, psychological constraint, but it seems to me they ought to keep the objective in mind, which is, you know, to get the system flowing again, and not worry too much about precedent.

It's pretty obvious why they are cautious. First of all, they are running out of ammunition. Rates have been dropping faster than any of the plunges experienced by one Wile E. Coyote. The situation is becoming more political so the laissez-faire, some would argue reckless, behaviour of Paulson and Bernanke, among others, will be tougher in the future. Getting support from Congress and Senate is tough (witness the TARP bailout bill which initially failed.) If they choose not to get money from the Treasury, they need to print money, which they have been cautious about. Do keep in mind that gold is still hovering over $800. If the FedRes went any faster, there is the risk of a run on the country itself (i.e. on the US$).

High Bonds Yields

UNRECOGNIZED VOICE: Well, distressed [referring to bonds] because of these forced liquidations, or are they distressed because of financial stress? If they're, and I think that's put up there, distressed because of financial reasons, then, 1931. If they're distressed because there's forced selling, then, that'll end.

This is a good point and worth thinking about. Why are bond yield spreads so high (although on a raw yield basis, they are not that high)? If bonds are correct with their prices, then we are looking at a very nasty economic scenario. But if it is due to forced selling, it's not so bad.

Extreme Government Intervention?

MILLER: I think the issue here is mostly political psychological, and not economic because, you know, there's not an investor on this panel, and there's not, you know, if you talk to Warren Buffet, there's virtually no investor out there who doesn’t believe there are extraordinary long term values in credit, in equities, across the States. The issue is, and so, from my standpoint, purely economically, the Fed should buy everything in sight.

They should - - the Hong Kong - - buy stocks. Buy junk bonds because the taxpayer is going to make a killing on that, and all they're doing is just taking, you know, future tax receipts and putting them to work, and if I were the treasury, I'd issue like - - 100 year bonds. Sure, issue 100 year bonds. Issue all the bonds you can at 70 basis points, and go buy Hersh's dividend paying stocks. The taxpayers will make a killing on that.

So that's, you know, that's sort of a radical thing, but, A, that would solve the problem, and B, it would make economic sense, but it's politically, obviously,
very difficult.

I have to disagree with Miller here. I know there are a lot of people who share similar views as him, including the Japanese government, which is planning to buy stocks on their markets. I'm a liberal and in favour of far more government intervention and regulation than most on the right. But even I would have to say that it is not the job of a government to become a hedge fund and start buying stocks for profit. Even if Buffett, who I respect and thinks has a good handle on bottom-up valuations, thinks valuations are attractive, I would not want the government attempting to buy stocks (or other assets such as junk bonds or corporate bonds.) There are many problems with this.

First of all, it distorts the pricing signals of markets. One of the beauties of a free market is that it provides signals on its own. They are not always correct but it's not controlled by one person or party.

Secondly, if the government started buying stocks, among other assets, it will essentially nationalize business. This further propagates the strategies of the fake free marketers, who tend to believe if private profit on the upside and government bailout on the downside. Coversely, it also takes us further towards the strategy of Communists who think governments can run certain businesses better than the private sector.

These actions also increase corruption in society. We can already see how the criminals and the fraudsters were drawn to some of the prevalent bubbles of the last few years (housing and Wall Street (particularly secrutization of assets) are good examples.) Who decides which stocks to buy? And why? Why buy S&P 500 instead of S&P 600 (small caps)? Does anyone seriously want Barack Obamba (or Stephen Haper in Canada) and his cabinet (Treasury secretary in the US; finance minister in Canada) deciding which stocks or bonds to buy? Or how many clear-thinking people outside the Wall Street crowd want a central banker to decide what to buy? In case many haven't forgotten, just imagine if Alan Greenspan, who can't see a bubble, even if he was slipping downhill, was at the helm decide which stocks to buy? It wouldn't surprise me if he bought up every single stock until its P/E hit 20.

Lastly, this is nothing more than a transfer of wealth from the average citizen to the wealthy. Roughly 10% of the wealthiest in America own 85% of the stock market. Bailing out this wealthy crowd while indebting future generations is not a sound strategy for anyone not named Mr. Wealthy.

The Unfolding Mark to Market Disaster

MILLER: The one thing which completely baffles me, from a policy standpoint, is the issue of market to market accounting, and not the issue of the transparency. I'm all in favor of showing the values on the balance sheets of the banks, more transparency, that whole thing.

The issue is tying capital requirements to trading prices of the securities, and, you know, the whole thing about the so-called fair value accounting standards - - the former head of the FDIC said if we had these standards in 1982 or 1990, we'd have zero banks, and every bank would be nationalized. So why they persist in this, why they don't say, you know, we're going to continue to show the marks, but we're not going to require - - have capital requirements tied to those - - . We'd take a moratorium to study that for some period of time.

That would make just a monstrous difference, I think, and the whole thing is sort of a semantic muddle, in the sense of they call it fair value accounting. The fair value of an asset is the present value of the future free cash flows of the asset. That's what the value is. The price of the asset and the value, there are no necessary relationship, and the price, as, again, all people in the panel believe, the prices of most of these assets are way, way out of fair value.

But they have a pro-cyclical policy that requires banks to, in essence, take and blow holes in their capital base at the bottom, when they need capital, and then, by the same standard, write their capital up when the securities up at the peak of a cycle, and then, so their returns on capital collapse, and they'll be under pressure to put that money to work when asset values drop. That's just a lunatic policy and why they persist in that, I have no idea.

I stopped harping on this point because, I think, many realize it was a disaster. As I said almost an year ago, when all is said and done, mark to market accounting would be flagged as one of the worst accounting policies in human history. Efficient market proponents, who still seem to dominate academia and the accounting professions, will take a massive body blow. Only the rating agencies would suffer a bigger blow once the verdict is in.

Unfortunately it's too late to do much on this front. Those in power really won't do anything. Or else they will lose face and, it seems to me, that's all they have.

Cash On the Sidelines?

LEECH: But there is, I think, net cash and margin accounts now, for the first time in history. You have money market funds that are at so much - - you can buy almost half the stock in New York Stock Exchange. So there's a huge amount of cash sitting out there on the sidelines.

I have seen this being mentioned before but I'm not sure how true this is. Is there actually a large amount of cash sitting on the sidelines? I also wonder if this is a misleading statistic that doesn't account for debt and asset losses. For instance, if Americans have $1000 in cash but increased their debt by $1000 in the last few years, it may not be as good as it seems.

If the cited cash figure is indeed correct then this is bullish for asset markets.

One Scary Thought

OTTER: I'm sorry, Jack Otter [phonetic] from Best Life. Bill just pointed out something that, in a way, is a little bit scary, which is that so many asset managers think everything is really cheap right now. And to quote Jeremy - - , again, you know, he said the - - Ball in 1930 was really well attended, but by '34, not many people showed up for it.

This was a question from the audience but I share similar concerns. Perhaps I'm overly conservative due to my losses from Ambac but whatever it is, how can we be sure that we are not looking at 1930 right now? For those not familiar, the stock market plunged around 48% by 1930 but it rebounded and then continue collapsing, only to seal its fate as the worst bear market (if you adjust for inflation, the 70's bear market was worse for investors supposedly.) I'm not predicting a Great Depression or anything like that (unless we get trade war or a physical war) but what seemed cheap in 1930 turned out to be a disaster. Similarly, 1974 was the bottom but stocks basically went nowhere until 1982. We will know if the situation is bad when bears start taking losses.

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US government saves automakers... for a few months

The Bush administration has decided to save the American automakers after all.

The bailout is contingent on further compromise from other parties but I am still doubtful that this will save them. It will avoid imminent collapse and buy a few months but, if auto sales don't pick up--there is no sign of it picking up--then these companies will still face big problems in 3 or 4 months. To see how bad the situation is, consider the fact that Toyota, generally considered to be the best-run and strongest automaker, is expected to post its first loss on operations in its history. Toyota has big problems with the Yen but even then, if Toyota it getting whacked then the Big Three are in a far worse shape.

Having said that, is is possible for sales to pick up at the Big Three as oil prices keep sliding. But this is no long term solution...


Are bubbles good?

Dubai, in all its glory...

It goes without saying that, after every bubble bursts, someone justifies bubbles and claims that they are good for society. Daniel Gross who wrote the book Pop!: Why Bubbles Are Great For The Economy--I haven't read it--wrote an article for Slate justifying the benefits of bubbles last year. I don't have a strong opinion on this topic. I need to think a lot more about it. My gut feeling right now is that bubbles are bad because they are inefficient. However, I also know that certain activities would have never occurred without the mania inherent in bubbles. For instance, the present state of the Internet, which relies on very cheap communications, would have, instead, taken decades without the dot-com bubble. Without the various railroad and canal bubbles, America would not have expanded to the western states. Thus, the question, in my mind, comes down to whether the inefficient allocation of capital is worth it, in order to realize a larger-than-life accomplishment.

Well, now we have The Economist tackling the topic. It's an interesting article, well worth reading on your free time. It goes over the current real estate bubble in Dubai and points out how the Florida real estate bubble in the 1920's led to the establishment of Florida, and Miami, as a tourist destination. Here's a sample:

The fireworks could be seen from space (allegedly), putting China’s Olympic displays to shame. Hollywood celebrities studded a guest-list of 2,500 people. Kylie Minogue, a diminutive Australian singer, cavorted in a gold and black corset designed by Jean-Paul Gaultier. Guests consumed an estimated 1.7 tonnes of lobster.

The launch party for the Atlantis hotel in Dubai on November 20th was a perfect, noisy finale to the world’s latest age of excess. But its loudest echoes—the man-made islands, the iconic hotels, the overheated property market, the celebrities and the sun—are from another, more distant time: south Florida in the 1920s.

The summer of 1925 was mania time in Miami. Speculators descended on the city, hungry to buy land in the hottest property market in America. Salesmen swarmed to meet them. “Bird dogs” (youngsters looking to make their way in the industry) scanned the new arrivals at Miami’s train station and steered the most promising prospects to their bosses’ offices.

The heart of the boom was Flagler Street, clogged with traffic and tourists. Would-be buyers were put in the hands of “binder boys”, named for the binders in which sales were recorded. Transactions were swift and shoddy. Buyers had to put down only 10% of the purchase price for the lot they were buying to close a deal; further instalments were payable when the sale was legally recorded. Many new owners had no intention of waiting that long. In another echo of modern-day Dubai, they wanted simply to flip their property, which often had yet to be dredged from the ocean, on to the next man. Some bits of land were sold and resold several times during a single day.

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Thursday, December 18, 2008 2 comments

Japanese government considering buying stocks

Well, the Japanese government is considering buying shares on their stock exchange:

Japan's government said Thursday it is submitting a bill to parliament allowing for the purchase of 20 trillion yen ($227 billion) in stock to help stabilize the Japanese stock market, Kyodo news reported. Under the bill, the Banks' Shareholding Acquisition Corporation, originally created in January 2002, would resume buying shares from banks and other entities, the Japanese news agency reported. The bill would be introduced early next month "with an eye to implementing the measure by the end of March," the report quoted lawmakers as saying.

Needless to say, the notion of a free market is kind of dissapearing by the minute. Japan is further along the deflation cycle and is simply following strategies put forth by mainstream economists such as Ben Bernanke (recall that one of the later tactics, after others fail, is to buy, first, bonds, then, potentially, stocks.)

I am not familiar with the economic implications of the Japanese stock buying tactic but I am not in favour of it. Perhaps it's a selfish desire since I'm near the lower class but whatever it is, I would prefer if the government dropped money out of helicopters onto the poorer section of society instead. Buying shares simply transfers wealth from the citizens to the wealthy since the top 30% of wealthy tend to own 70% of assets in nearly all countries (for reference: in America, the top 10% own 85% of stock market wealth. The middle class' wealth is concentrated in real estate. Have to dig up Canadian numbers but I believe they are similar with a bit better distribution.) Such an action also opens up room for gross corruption, depending on which companies are bought and who gets to decide. We have already seen the decision by the Bush administration to prop up AIG, while others seem to have been rejected without any public explanation.

Buying shares also distorts the free market and sends all the wrong signals. Trying to read the situation from market price movements will become next to useless in Japan.

Having said all that, this is not without precedent. The Hong Kong government started buying shares en masse in 1998 and actually turned a profit on it. I am not well versed in history but I think this is the first time a government managed to successfully intervene in a major stock market of a developed country. Unfortunately for Japan, the stock market is way too big so the ultimate impact is uncertain.

One positive thing working in the Japanese government favour is that their stocks appear to be undervalued. Most of their stocks are trading below book value. Valuation is obviously in the eye of the beholder but buying shares trading below book, even though the book value may not be reliable, tends to be a conservative strategy. I think value investors, even if they may not approve of the tactic, would probably agree that there is a high chance of Japan turning a profit on its "investment".

I hope this doesn't set a bad precedent and result in other countries buying shares on their markets too (most likely country to do something similar is Russia.) Some readers of this blog may like it since they can profit from it but it is a dubious tactic for the economy. If the Japanese government was really concerned about stock prices, it is far more effective to make Japanese companies shareholder-friendly. They can start by getting rid of their cross-shareholder structures and treating shareholders as owners of the company. Not only would you prop up the share prices, it would actually have a positive impact on the economy.


Good note on contrarian investing

Financial Post--WSJ of Canada--has a good note on contrarian investing. The content mostly seems to come from a Citigroup analyst note but it's interesting to me. I think relying on some wild guesses at a party to form theses can result in incorrect results. But nevertheless, the analyst seeems to capture some insight. I think some of what is described describes some of my investing, thinking, and behaviour this year. Let me highlight some interesting things and throw in my opinion as well:

Before I say anything, it should be noted that the verdict is still out on many of the investments. Some people have posted large share price losses but they may be irrational "quotational" losses. In contrast, others have posted real losses. We probably won't know what the final outcome is for several years.

Contrarian investors may have done really well when the tech bubble burst, but similar strategies haven’t fared very well since 1997 and 2008 was another poor year for their track records.

They likely called the top in global trade growth but probably gave back the gains attempting to predict the bottom in financials. Meanwhile, contrarian asset allocators should have done far better, since they would have been bearish on risk assets a year ago.

I have only been investing (seriously) for a short period of time but, from my historical knowledge, I agree with that point made above. A lot of so-called contrarians making specific calls have done poorly whereas they did well back in 2000. A good example is someone like David Dreman who got clobbered in the current meltdown. Dreman posting huge losses is kind of shocking because he is a diversified investor and was holding stocks in many different sectors.

The contrarian asset allocators have definitely done really well. A good example is Jeremy Grantham who not only called the housing bust and the stock market bubble--he called the rally from 2003 the biggest sucker's rally in history--but seem to have side-stepped major losses (do note that he is a strategist and he doesn't really run a particular fund so it's a bit unfair to compare against others.)

I think the problem for many contrarians this time around was the fact that there were misleading signals all around. In the late 90's, the tech bubble was obvious and you just had to avoid it (along with growth stocks of any sort.) In the current meltdown I think almost all contrarians, including a dumb guy like me ;), knew housing was a bubble and bursting. Contrary to what many think, housing actually peaked in 2005 (not 2007!) so a contrarian call on that wasn't hard. Housing stocks also peaked somewhere around that time (this is why Bill Miller was buying housing stocks in 2006.)

I think many contrarians, especially the top down ones, also were aware of the low risk premium investors were willing to accept. I think where we went wrong was with the magnitude of the impact. Even Jeremy Grantham, who called it correctly, was surprised at how bad the situation was. I suspect others like Marc Faber, who had the general picture right, likely suffered sizeable losses (I have no idea what Marc Faber invested in but he was bullish on emerging markets, particularly Vietnam and the like, and wouldn't have made it out alive from EM).

Contrarians appear to be better at macro calls such as sector, regional and asset allocation moves, Mr. Buckland said.

I think this is true but it is also false in some sense. Of the contrarian-type investors I follow, they tend to have an easier time making a macro contrarian call but very few can get the timing close enough to be low risk. Macro contrarian calls are easy because, at times, valuations make no sense and you can go against the crowd. For instance, the long US bonds are in a bubble and it's easy to say that they will decline because bond yields are near(?) all-time lows, but timing is really tough.

Right now, contrarian asset allocators are likely buying equities and selling government bonds. Meanwhile, contrarian stock pickers should be buying financials and selling pharmaceuticals and biotechnology.

As a result of low equity valuations, Citigroup is more willing to back the contrarian asset call than the contrarian stock call right now. “Contrarian stock pickers probably need a turn in the global profits cycle, which we do not expect until 2010,” Mr. Buckland said.

This makes no sense to me. If you are a contrarian, you are supposed to be ahead of the consensus. Waiting for the profit cycle to turn seems to defeat the whole point of going contrarian. I completely disagree with the strategy here. I actually think stockpickers are better off right now than macro investors. Macro is a minefield right now because there are no obvious under or over-valuations (other than some limited ones such as the US bonds.) In contrast, stock valuations are getting attractive by the day and, if you go with some of the works of David Dreman, contrarian stocks should perform well in bear markets even if news is bad. As examples, Pulte Homes (PHM) and Toll Brothers (TOL), two of the leading homebuilders in the US, are actually up around 15% for the year while the S&P 500 is down 40%. Who would have thought that two of the leading homebuilders would be doing so well in the middle of a housing bust, not to mention a credit bust? Anyway, stockpicking is the way to go right now.

His market-neutral contrarian buys the worst and sells the best ten performers from the previous year, with a universe of the 250 largest global stocks. This approach has produced a positive return in only four of 11 years, while the return was only meaningful in 2000. In fact, if $100 was invested in this strategy in 1997, an investor would have just $33 remaining.

For example, a contrarian bull would have bought Royal Bank of Scotland this year as it lost more than a third of its value in 2007. However, it has fallen more than 85% in 2008. Likewise for Fannie Mae, which fell 41% in 2007 and more than 95% this year. Home Depot Inc. has lost 33% and roughly 8% in the past two years, respectively.

On the bear side, however, the performance of the ten stocks likely shorted by contrarians have fallen 47% compared to a 43% decline for the global market, Mr. Buckland noted, adding that this and more has been given back on the bull picks.

I'm not into mechanical strategies but this one clearly hasn't done well in the last decade. This sounds somewhat like the Dogs of the Dow strategy, which actually has a decent track record.


Articles to peruse on a Thrusday

Mostly macro stuff...

  • Seth Klarman Interview at Harvard Business School (HBS): Thanks to for bringing this interview to my attention. Some people put Seth Klarman a step below Warren Buffett when it comes to value investing but I have no idea. It's really hard to say how good, or bad, any of these guys are when they run opaque funds and all we know is some quoted return. For instance, I'm still uncertain of Edward Lampert's skills. Anyway, Seth Klarman is one of the few value investors who actually seems to follow Benjamin Graham's principles fairly closely.
  • Oil keeps sliding (MarketWatch): Near-term futures contracts breached the $37 mark and analysts are lowering their estimates. From a long-term contrarian point of view, analysts cutting estimates is good.
  • Semiconductors seeking bailouts (BusinessWeek): It's not only the auto industry that is seeking bailouts. The semiconductor industry, particularly in Taiwan and Korea, are seeking bailouts as well. On top of potentially starting a trade war, bailouts will simply continue the overcapacity and prolong the slump for the whole industry. As I alluded to in a prior post, semiconductors are like railroads in the 1800's: extremely benefitial to society, changed humanity, but terrible investments with most railroads going bankrupt. Commodity businesses are really tough--one reason Buffett doesn't generally invest in them.
  • Free trade likely to take a backseat in the future (The Economist): World trade is going to become less freer in the medium term. Already there are talks for bailouts, strategic devaluation of currencies, and so on.
  • Solar industry starting to suffer (BusinessWeek): The ironic thing about alternative energy is that it really needs the oil industry to do well. Or another way to say it is that the alternative energy industry needs high oil prices. This is certainly the case with the solar industry, which has never been economic (in contrast, wind power is economic if carbon or heavy pollution were taxed.)
  • 2008 Japan Good Design awards (BusinessWeek): fun...won't help you with investing ;)
  • Top counterfeit items (BusinessWeek): fun...might make you a criminal ;)
  • Playboy of the Eastern World? (The Economist): hmm...not quite as erotic as the title would make it out to be ;)

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Wednesday, December 17, 2008 0 comments

Globe & Mail interview with Stephen Jarislowsky

I don't know much about Stephen Jarislowsky but have read some stories about him in the past. He primarily seems to be an activist investor but I thought it's worthwhile for anyone reading this blog to check out his interview with The Globe & Mail. He is a deflationist whereas I'm still in the disinflation camp.

Here are some excerpts:

Q: Some market seers say that what we're seeing is a revisiting of the tough investing environment of the 1970s.

It's nowhere near like it. At that time, we went to inflation and high interest rates. Now we're going to deflation and we already have very low interest rates. This is a 1929 bubble-and-balance-sheet recession. We are going to see the lowest valuations in stocks since the Depression.

Q: How does a balance-sheet recession differ from a plain, run-of-the-mill kind?

In an ordinary recession, demand for goods is less and commodity prices come down. A balance-sheet recession is where you have a big bubble, and everybody and his brother has to de-lever in order to become really solvent again. By that, I mean they have to get debt off their balance sheet. The more everybody [reduces debt], the deeper the recession becomes, unless it's counteracted by fiscal spending.


Q: In a deflationary environment, what should investors be doing to protect themselves?

[Deflation] makes money more valuable. What you do, basically, is you go into cash or [corporate] bonds with good spreads. When the deflation stops, hopefully as a result of government fiscal policy, you have to leave the cash and go into the cheap stocks. That could take another two, three years.


Can the free market create an identical bubble from one that just burst?

How likely is it for a recently burst "bubble" to inflate again in a short period of time (on its own without government intervention)? The bubble I'm talking about is none other than the oil bubble.

Let's for the sake of argument, since some still claim oil was not in a bubble, assume that oil was in a bubble whose low was marked in 1998. Commodities are very volatile and I agree with Jim Rogers that 50% corrections are nothing special in commodities. But the current correction is way more than 50% and seems more remniscent of a blow-off. Now, one of the popular arguments made by oil bulls, as well as many leading analysts, is the notion that oil is going to rise rapidly once the world economies start growing faster in the future. Is that likely?

I have been bearish on commodities for a few years and been mostly wrong but still maintain my views for the most part. I don't think many of the commodities are in a bubble at current prices but I am not bullish either.

I bring up this topic because I find it interesting that people think that the free market is going to cause another bubble in the same area right after it bursts. The bullish argument is mainly pinned on the view that capacity reductions and the non-renewable nature of oil will create shortages when the world economy does pick up. Let's ignore the argument that world growth will be lower in the future than the last 10 years (at least that's my view--decline in world trade and decline in leverage seals that IMO.) I wonder, why wouldn't the market--the companies themselves, as well as investors and speculators--price in the future increase? Everyone knows that capacity is being destroyed. So wouldn't the market factor all that into account?

I think the arguments of the bulls make sense if oil is undervalued. Who knows what price indicates oil is undervalued but let's roughly say $22 per barrel (the long term real price of oil over the last 130+ years.) Until prices come somewhere near that, I find it hard to believe that oil can run up past $140 again (note: I'm talking in real terms. If the US$ declines significantly then prices will go up but that's just an illusion.)

For now, I will maintain my slightly bearish view and watch how the oil bulls prosper or fail...


Opinion: Difficult to see how the Big Three can survive without restructuring in a bankruptcy court

I can't see how the Big Three--that's GM, Ford, and Chrysler for foreign readers--can survive without restructuring within a bankruptcy court. Any restructuring would require two items to be addressed: employee costs and reduction in brands. I don't see how those issues will be solved without bankruptcy court help.

The right tends to scream about the high employee costs and suggest that lowering wages will fix everything. Of course, this is nothing more than simplistic thinking akin to claiming that tax cuts will solve all the economic problems. The fact of the matter is that wages are high--way too high--but they only make up around 10% of the cost of a car. The New York Times illustrates the case of Ford, which has total costs of around $71 per hour (includes benefits, pensions, etc) versus $49 for Japanese companies. However, the Big Three cut deals with the UAW in the last few years to lower costs in the future. Ford is expected to have a cost of around $53 per hour in the future.

But even if wages were brought in line with the Japanese manufacturers, there is still the other big problem.

The other problem is that these companies need to shrink. I'm not an expert on cars but my impression is that there is overcapacity in automobile manufacturing. Too many car companies producting too much--and we haven't seen any Chinese or Indian manufacturers enter the market either (they may in 10 years.) Furthermore, the American manufacturers are losing market share and will likely never get it back. The American car companies used to dominate but that's not the case anymore (GM had the largest market cap in the world in the 60's if I'm not mistaken. Right now, ExxonMobil has the largest market cap and imagine when GM was as dominant as modern-day ExxonMobil.) As the author of the NYT article alludes to, Americans just stopped buying their cars in the same quantity:

That’s because labor costs, for all the attention they have been receiving, make up only about 10 percent of the cost of making a vehicle. An extra $800 per vehicle would certainly help Detroit, but the Big Three already often sell their cars for about $2,500 less than equivalent cars from Japanese companies, analysts at the International Motor Vehicle Program say. Even so, many Americans no longer want to own the cars being made by General Motors, Ford and Chrysler.

My own family’s story isn’t especially unusual. For decades, my grandparents bought American and only American. In their apartment, they still have a framed photo of the 1933 Oldsmobile that my grandfather’s family drove when he was a teenager. In the photo, his father stands proudly on the car’s running board.

By the 1970s, though, my grandfather became so sick of the problems with his American cars that he vowed never to buy another one. He hasn’t.

Detroit’s defenders, from top executives on down, insist that they have finally learned their lesson. They say a comeback is just around the corner. But they said the same thing at the start of this decade — and the start of the last one and the one before that. All the while, their market share has kept on falling.

It would be difficult for these companies to drop brands outside bankruptcy courts since dealers and suppliers would not want to downsize. Dealerships depend on certain brands and it would not be in their interest to give up their livelihood. Only in bankruptcy can you force parties to negotiate.

Whatever happens, the situation is going to be painful for everyone involved. The Big Three are a big chunk of the economies of states such as Michigan and provinces such as Ontario (Canada). With or without bankruptcy, there are going to be massive layoffs all along the supply and retail chains.

Tuesday, December 16, 2008 1 comments

Random Articles For A Tuesday

Some articles some may find worth checking out:

  • FedRes targets a hard limit of 0% to 0.25% (MarketWatch): Monetary policy has run out of ammunition. FedRes will try unorthodox strategies but their impact is uncertain. Fiscal policies will start having a much greater impact from now on so the actions of governments, rather than central banks, will significantly impact investors going forward.
  • Will we see high inflation if government stimulus works? (Financial Post): I am not sold on the inflation case. Anyone calling for quick re-flation--this is the consensus of commodity bulls, including some quoted in the article--will be in for a surprise. Betting against the bond market is very risky, since it tends to be correct most of the time (recall how the yield curve was inverted a few years ago and was indicating a potential economic weakness, while everyone thought it was a bogus signal due to foreign central bank purchases.)
  • Nortel bondholders bailing out (The Globe & Mail): For Canadians, Nortel is the skeleton hanging in their closets. Unlike many other dot-com stars, it has neither gone bankrupt (e.g. nor survived and solidified its position (e.g. Cisco). Telecom equipment manufacturers are struggling--tales of woes from Alcatel-Lucent is quite common--and this looks like the end game for Nortel.
  • Bad derivative bets happen in China too (Financial Post): We have seen quite a few American and Canadian firms lose big on derivative bets lately--particularly bad bets on commodity prices or currencies. Well, Chinese companies are not immune, with some terrible bets on Australian currency movements that have blown up badly: "The 'foreign exchange accumulator' contracts were highly risky, reportedly structured so that a 10% drop in the Australian currency would amount to a 150% loss to the holder of the contract. The bets went sour as the value of the resource-driven Aussie dollar sank by more than 40% in the face of slowing demand for Australian minerals."
  • Semiconductor sales expected to drop 16.3% next year (The Globe & Mail): When I was more of a newbie than I am presently, I thought semiconductors were a growth industry. I mistakenly compared semiconductor companies, such as Intel, against growth companies such as Microsoft. Took a while to realize that semiconductors are cyclicals and need to be treated like other cyclicals such as oil&gas companies. Intel is actually pretty good but others such as AMD, ATI, Nvidia, and so on, are extremely cyclical. My opinion is that semiconductors are somewhat like the railroads in the 1800's. High-tech...has a big influence on society...but terrible investments.
  • BusinessWeek's 25 worst investments of 2008 (BusinessWeek): A collection of some of the worst investments of the year. It's a mixed list with some specific stocks being highlighted along with whole industries. As an investor, especially a concentrated investor who only has a few holdings, you definitely do not want to be on a list like this but, alas, I end up on it :( I would fall into the "bond insurers" and "insurers" category (although my P&C re-insurer, Montpelier Re, held up for the most part.) Ignoring risk arbitrage, I did very little this year (only purchased one infamous investment that shall remain nameless, although it's hard to miss the big letters clearly visible on the left ;) )

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Monday, December 15, 2008 0 comments

Latest problem for AIG -- Not Christian enough

The latest problem, albeit a minor one, AIG is facing is a seemingly frivolous suit claiming it is not Christian-enough due to its support of some Islamic financial products:

A Michigan man is challenging the bailout of American International Group Inc., claiming it is illegal because the insurer has financial products that promote Islam and are anti-Christian.

The lawsuit was filed Monday in federal court in Detroit by the Thomas More Law Center, which pursues cases on behalf of Christian causes.

The lawsuit says AIG offers financial services that comply with Sharia principles. It says the government is violating the Establishment Clause of the First Amendment with billions of dollars of aid for AIG.

The clause prevents the U.S. government from endorsing a religion.

I think this suit will be thrown out because it can apply to almost any multinational company since they tend to tailor their products for the local market, which can include supporting religious customs. It's not clear if AIG's products in question are offered in the USA as well.

I personally think the Sharia-compliant products are nothing special. After all, a bank is not going to forgo interest--it is simply going to charge more in a lump sum or in some other means. I'm an atheist and I don't have much of an issue with products like these (regardless of religion.) Some Canadian banks were also planning to roll out Sharia-compliant products (not sure where that stands.) Milking the clueless theists is perfectly cool in my books. These schemes suck a bit of wealth from the theists and transfer it to the atheists and agnostics ;) It's no different than social investors who are willing to pay more or earn lower returns in order to support their personal views. By refusing to invest in sin stocks, it enables the sin stock investors to profit a bit more. Everyone, including me, has their own personal ethical, moral, and social views and following your conscience requires you to pay up.


Sign of the tough times: Even National Lampoon execs accused of stock manipulation

Another day. Another stock manipulation charge. This time against National Lampoon. Yes, that name does ring a bell doesn't it? Could it really be what I think it is? Why, yes, it is none other than the company that holds the rights to the infamous college movie from the late 70's: Animal House. I'm not into that type of movie and think it's overrated but many would disagree with me. In any case, clearly their movies haven't been generating much money lately, given that the executives are being accused of illegally propping up the stock price:

Federal prosecutors in Philadelphia have filed charges against the chief executive officer and other executives at National Lampoon Inc. [NLN-A], saying they tried to inflate the company's stock price.

Los Angeles-based National Lampoon owns the rights to the “Vacation” and “Animal House” movies, among others. Prosecutors charged seven people with conspiracy and securities fraud on Monday.

Prosecutors said the company manipulated prices by paying kickbacks to people to buy and hold stock. Authorities said that activity created the illusion of market interest.

One of the risks of investing in microcaps and smallcaps is the potential for market manipulation, insider trading, and such dubious schemes. These things can happen to any company but is less of a concern with large caps. If you wanted to drive up the stock of a large-cap by 5%, you may need to spend hundreads of millions of dollars; in contrast, a typical executive or a board member, who is almost always wealthy, can easily manipulate microcaps and smallcaps to their liking.


While we are on the topic of Bernard Madoff...Getting scammed: The Rae Cowan story

Frauds tend to be revealed during the bursting of bubbles; no one asks questions when everyone is intoxicated with money when times were good. The Bernard Madoff case will go down in history as the worst scam in modern American history. Fortunately, most of the losses are accruing to the wealthy, who can afford to take losses, and to "sophisticated" institutional and hedge fund investors. I'm not trying to unsympathetic to the victims but the damage won't be as heartbreaking as cases such as Enron, where working class and middle class lost nearly their whole life savings. There will be indirect impact on everyone but it should be largely contained to those who blindly gave their capital to Madoff and his associates.

It should also be noted that some speculate that some of Madoff's investors thought he was doing something illegal but didn't realize that allying with the devil doesn't guarantee your success. These investors are thought to have assumed that Madoff was profitting from insider trading or front-running and wanted in on the scheme. Cassandra of Cassandra Does Tokyo and John Mauldin of Thoughts From The Frontline have mentioned this thinking among some (Mike Shedlock of Mish's Global Economic Trend Analysis also has some info.)

So far no word on his associates and others who were part of the scheme but details will surely come out once the police and the SEC start digging. One thing about American officials is that, they may not prevent all crimes from happening (who can?) but they are very tough on white collar crime. In developing countries, the wealthy and the well-connected can get off easily, even for murder. Even countries like Canada have generally been accused of being a safe haven for white collar criminals. You can't say the same about US authorities. (However, my opinion is that US law enforcement is weak in other crimes such as their habit of granting asylum or easy passage for war criminals, tyrants, drug dealers, politicial allies who committed crimes against humanity, and so forth. USA is a popular destination for serious criminals of all sorts.)

Anyway, I would like to refer you to the scam involving of Rae Cowan, an investment advisor/portfolio manager. The Globe & Mail does an excellent job detailing this case from last year. This is a very small Canadian case with limited losses but it does give you an inside perspective on what can happen. I suspect the Madoff case is similar but on a very large scale. None of this has anything to do with improving your investing skills but if you want some light reading, check out the article. Here is an excerpt:

THE PRESSURE WAS BUILDING. For weeks he'd been fending off questions from anxious clients who were worried about their investments and the whereabouts of the cheques he used to send so regularly.

And these weren't ordinary clients. They were his father, mother, aunt, friends from high school, college buddies. Many of them had been counting on him for years to manage their life savings. They included people like Altaf Hussain, who was relying on Cowan to help put his daughter, Aisha, through university. And Cowan's 62-year-old aunt, Charlotte Munro, who had entrusted her nephew with $200,000 and depended on him to keep sending $750 a month to supplement her $1,200 monthly pension. And Judie Benyei, who needed Cowan to ensure there was enough money to pay the bills at her octogenerian aunt's nursing home.

How could he tell them he'd made some bad bets on the currency markets and that most of the money was gone? How could he explain that he was down to his last $700 and that the Lamborghini, the Porsche and the pricey condo in a trendy Toronto neighbourhood were all for show?

He couldn't.

So he took the elevator down from his ninth-floor condominium to the parking garage. He ran a hose from the exhaust pipe of his Lamborghini and placed it through the window. Then he got in and turned on the engine.

It was Monday, Nov. 26, 2007. Rae Cowan was 36 years old.

Sunday, December 14, 2008 0 comments

Agriculturals and a flaw in thinking

I have no strong bullish view when it comes to commodities but I do feel that soft commodities (agriculturals) may do better than the industrials or energy in the future. I want to refer you to an article in last month's Globe Investor magazine presenting a bullish argument for agricultural commodities, and highlight a flaw in the thinking. The article is Canadian so it refers to Canadian securities but agricultrual bulls and bears may still want to read it (although nothing earthshattering was discussed.)

The biggest flaw commodity bulls can make--and I see them doing this all the time--is the following:

No matter how deep or protracted the economic downturn becomes, the world’s population will still need food on the dinner table each night. So, for some, it’s been a bit of a curiosity that grain prices have been halved in recent months as equities tanked and economies contracted.

Tight bank credit and a splurge of investor redemptions forced many hedge funds and other speculators to quickly liquidate their futures positions in the sector. But the supply and demand fundamentals that drive these markets remain largely intact.

Unlike other commodities, such as copper and oil, the agriculture sector feels little impact from gross domestic product fluctuations, because consumption depends more on factors such as population growth and biofuel development.

Some analysts suggest grains and oilseed prices may have fallen victim to a herd mentality of selling commodities across the board. And many believe the commodities are poised for a rebound.

Before I say anything, I think it's ok to follow that thinking for momentum and growth investors. But if you are a value investor or a contrarian, it is fraught with peril. It is also risky if you are a macro investor.

I see many commodity bulls following the thinking I highlighted in the quote above. That is, people always argue that 'everyone needs to eat food' and that the current sell-off is due to herd selling.

Regarding the first point, you could have said that about almost any commodity over the last 100 years. People have always needed to eat food, and food consumption has actually grown with the population explosion, yet agricultural commodities have been a horrible investment in the long-run. The same thing applies to oil, with oil consumption increasing all throughout the 80's and 90's while oil prices kept falling--this is with a powerful cartel purposely cutting production too (if this was more of a free market and OPEC did not exist, oil prices would have fallen much lower.) I will note that, in the long run, oil has retained a real price of around $22 (source: WTRG) whereas agricultural commodities have completely collapsed over the century.

What matters to any investment, assuming you are not a momentum-type investor, is price! It doesn't matter if people still buy more of the product if the price was too high in the first place. The argument that the fall in agricultural commodity prices is due to herd selling is meaningless in the grand scheme of things. One can just as easily argue that if the selling is due to the herd, then the price ascent was due to the herd as well. That is, the price wouldn't have gone up in the first place if the herd didn't push it up.

I don't have a strong bearish view--I used to a few years ago but not now--but, just because grains are down 50% doesn't necessarily mean that it is an irrational price. I lean towards the bearish side because I am concerned about a potential implosion in China (some analysts are expecting 3% GDP growth for early next year--an unthinkable scenario.) However, that is a low probability macro call on my part. If you are bullish on these commodities, you need to check with fundamentals and see what can be attributed to irrational selling and what is sustainable in the market place.

Agriculture ETFs Differ Significantly

If you are investing in agriculture, it is important to realize that a big chunk of it is localized (similar to natural gas.) That is, the food consumed in one part of the world may be different from what is produced in another part of the world, and this may not change for many decades. For instance, let's say you are bullish on Chinese food consumption. Well, depending on various factors, such as taste and cost, it is quite possible for rice and pork consumption, two of the popular items there from what I understand, to rise significantly while, say, corn and wheat may not see similar increases. The following chart illustrates the differences between the various agricultural commodity indexes:

As you can see, the differences are quite significant. Typically, competing indexes for stocks or bonds are quite similar. The difference between the worst and the best index, although not insignificant, is not something to kill yourself over. For example, whether you invest in Russell 2000 or S&P 600 or Dow Jones Wilshire small cap ETF--all these are small cap ETFs--they end up producing similiar, although not identical results. In contrast, commodity ETFs can yield wildly differing returns. Although correlations between all commodities, not to mention between commodities and stocks, has been high in the last 5 years, individual commodities, especially soft commodities, have historically performed independently of others. Each commodity has its own cycle, with some peaking long before others. For instance, just because sugar went up does not necessarily mean that wheat will go up as well--even though they are both agriculturals.

I would argue that anyone betting on agricultural commodities should spend a lot of time thinking about which specific commodities are likely to do well. Picking the right index will likely produce a radically different outcome. This is especially true over the super-long-run, which is what many commodity bulls are looking at. Of course, if you are not confident with your commodity calls, you can bet on commodity stocks either directly (eg. agriculural companies) or indirectly (eg. farm equipment manufacturers, fertilizer companies). Stocks are much more correlated and you can make a blind "bulish agriculture" bet and not worry about whether corn is going to do poorly compared to sugar, or whatever.

I am still neutral to bearish on commodities and would wait and see if China can survive through this recession without a political crisis.