Saturday, January 24, 2009 3 comments ++[ CLICK TO COMMENT ]++

Miscellaneous Articles for the week ending January 24, 2009

Some items you may find worthwhile...

  • Leveraged or inverse ETFs are dangerous (Morningstar): I mentioned this before but this Morningstar article does a good job illustrating how inverse and/or leveraged ETFs can behave unexpectedly. We are talking about inverse ETFs posting negative returns while the actual index it shorts is down for the year. Very important to read if you are use inverse or leveraged ETFs. [further comment below]
  • John Thain out at Bank of America (The Globe & Mail): This story has made its rounds but it wasn't a big surprise to see John Thain being fired by Ken Lewis. I have been critical of the John Thain situation, not because I have any opinion of his work, but for the fact that Merrill Lynch board of directors, and hence shareholders, paid him around $50 million (with potential of more than $100 million per year based on stock performance) simply for accepting the job at Merrill Lynch. It was hard to see what sort of job he would need to do to earn his pay (Of course, the fact that he didn't do a good job and the stock collapsed with massive losses for shareholders made the point moot in the end.) In any case, the firing is an interesting situation. Thain was perhaps disingeneous in keeping the massive losses at Merrill Lynch away from Ken Lewis; but he probably did a good job for the shareholders of Merrill Lynch in getting Bank of America to buy it out at a good premium without BAC ever realizing that Merrill Lynch was on the verge of posting a massive $15 billion loss.
  • One analyst sees TSX P/E rise to 30.3 (National Post): It's obvious to anyone investing for a while but one should always keep in mind that the P/E ratio is more complicated than it seems. In some cases, a high P/E means valuations are low; while in other cases it's the opposite. A big chunk of the TSX is composed of cyclical sectors such as materials and energy, so its P/E will actually rise significantly during recessions. This is certainly the case in the last decade due to very high, unsustainable, earnings from commodity businesses.
  • Warren Buffett PBS interview (ValuePlays): Nothing new per se but always good to hear Buffett's of the great Americans of all time...will miss him when he's gone... (Recommended although nothing new)
  • Jeff Matthews sees Berkshire posting its all-time large book value loss (Jeff Matthews Is Not Making This Up): Good write-up about Buffett picking up the Morningstar CEO of the year award...the thing, though, is that this will be Buffett's worse year of his investing career (in terms of book value loss.)
  • Inside look at the worker environment at Zappos (Fortune): Some of you may have encountered Zappos!, which is an online retailer primarily dealing in shoes. Readers with an interest in entrepreneurship may want to read this article to see a laid-back work environment.
  • Some don't see progress from Satyam scandal (Fortune): India is one of the most corrupt countries on earth--and I hate to say it because I come from that part of the world, albeit not from India. So a corporate fraud scandal is actually an opportunity to clean up the system. But this Fortune article implies that progress will be limited. The Satyam case seems to be theft on a grand scale--the criminal chief executive originally said that it was due to losses that were masked which seems to be a lie, especially given how the business process outsourcing industry actually has good profit margins--with family founders looting up to a billion dollars from shareholders through as many as 100 side businesses.
  • Some Peter Schiff foreign stock picks (Fortune): I am not a fan of Peter Schiff but some readers may find him interesting. For anyone that hasn't heard of him, he's an extreme superbear who is very similar to Jim Rogers in ideology (Austrian Economics with extreme distaste of central banks and governments in general) and investing picks (commodities, gold, foreign stocks, bearish on US$, bearish on US stocks.) You can find the main article about him here. [further comment below]
  • What is going to happen to banking? (The Economist): One of my readers actually e-mailed me to say he was dumping my RSS feed due to my severe criticism of excessive de-regulation and claim that greed from shareholders/owners was a cause of the financial crisis (sucks to be me ;) but it's about time some people took responsibility for their own culpability in this crisis.) The interesting thing is that, those who were totally in favour of lax regulation, low taxes, high compensation for executives, low capital gains taxes, etc, are caught in a tough situation and won't admit their culpability. They know that the banking system will collapse if the governments they were criticising don't bail them out. It's an interesting dilemma. One of my loyal readers, ContrarianDutch, is, also, critical of government nationalization but I see no alternative. Sharing ContrarianDutch's view, The Economist magazine says "As a capitalist newspaper, we reject a deliberate policy of wholesale nationalisation." But I claim that the fate of many banks is outside their hands. Death is near. Executives and shareholders are starting to realize this...
  • The trade imbalance problem (The Economist): The story of 2009, as I have claimed, is going to be China. Economists and casual observers have been warning about the unsustainable trade imbalance, particularly between USA and China. We will get a final solution to this problem soon. Investors' fates rest on the outcome. (Highly recommended reading for macro-inclined investors) [Further comment below]

Leveraged and/or Inverse ETFs

This is something I had brought up before but it's always worth revisiting. As you may or may not know, the widely popular leveraged and/or inverse ETFs return the daily leveraged and/or inverse return. If you invest in an ETF or ETN that is a 2x S&P 500, it will return 2x the daily return. What this means, in practice, is that the result over the long run, say in one or two years, generally isn't what you would "expect." That is, a 2x long ETF will not produce 2x the underlying index return in an year. The vast majority of the time, the returns will be something that is "unexpected." As crazy as it may seem, a short ETF and a long ETF of the same underlying index can both be negative over an year! This was actually experienced by many who shorted the financial stocks last year and ended up losing money even though the underlying index was down as well! The most important thing to realize, if you are using one of these vehicles, is that the long-term return depends, not only on the direction of the underlying index, but also in the path it takes. The core reason is because investment returns are geometric (e.g. something that falls 33% (say from $15 to $10) requires a 50% gain ($10 to $15) to go back to that level.)

Paul Justice of Morningstar has an excellent article illustrating how the long-term returns are almost "non-sensical" compared to what these ETFs are advertised as. I urge you to read his article but here is a hypothetical table that he produced to illustrate the outcome of various 1x long, 1x short, 2x long, 2x short, e.t.c., securities:

In the table above, the hypothetical oil index starts at $35, goes to $60 and then collapses back down to $30. Starting with $100 in a 1x long index results in a final value of $99.56 for a -0.44% return. What would one expect the inverse ETF to post? How about the 2x long or 2x short?

How about the 3x long and 3x short funds? Well, it may be hard to believe but the 3x long fund actually posts a return of -34.02%, while the 3x inverse fund posts -57.79%!!! Yes, the actual (1x long) index is only down -0.44% while the 3x long and 3x short funds post massive losses.

I know some blog readers have said in the comments that they are considering using some of these vehicles, such as the long oil ETF or the short Treasury bond ETF, among others. I have personally looked at the short gold ETF (there are a few US ones and a Canadian one in Canada as well.) It is absolutely essential that you think about the path that your bet might take. Without thinking much, I think the short Treasury ETF (such as TBT) is probably safe since bonds aren't as volatile (although one should be prepared for anything given the current investment environment.) The dangerous ones are the commodity ETFs or the leveraged ETFs, such as the 2x or 3x ones. I would be very careful about using the 2x or 3x ETFS, either long or short; and any short ETF in a volatile sector like commodities.

Peter Schiff

I don't mean to be arrogant--who am I anyway?--but I think Peter Schiff is overrated. Some on the web speculate that his clients didn't do too well last year since foreign markets collapsed more than the US markets even though his predictions came true. Nevertheless, he has been correct in some of his superbearish views.

He clearly seems to have believed in the now-discredited decoupling theory. This was a theory followed by many commodity bulls, including Jim Rogers I would imagine. I was always skeptical of the decoupling theory since it didn't fit my macroeconomic view. For instance, the fact that USA was consuming a big chunk of exports from China, which in return was consuming a lot of commodities and semi-finished goods from the rest of Asia, Latin America, and Australia, essentially meant that the whole system was tightly linked cycle. If there was a crack in one of the links, the whole thing was bound to fall apart. And, indeed, that is what happened. It seemed illogical to be making superbullish bets on commodities and foreign markets while expecting the collapse of the US economy.

I'm also linking his article because he has some foreign stock picks--you don't see too many foreign stock picks so it may be of interest to many. Unfortunately he seems to favour foreign small-caps and, unless one does a lot of research and understands the foreign operating environment, it can be very dangerous. I don't have a strong interest and hence won't be looking at it now but the most attractive one from the list is Singapore Petroleum (BTW do not rely on dividend yields or P/Es for cyclical companies--their earnings will collapse a lot as the economies of the world slow.) I have no idea if there are price controls in the regions that Singapore Petroleum serivices--many Asian countries control fuel prices--but it is worth checking out as a long term bullish bet on Asia--perhaps something to look at if you think Asian economies are going to recover.

(Regardless of the fact that I don't agree with his ideology, I have to say I respect his father, who seems to be in jail due to his refusal to pay federal taxes. I don't agree with his position at all but it's sad to see someone jailed for refusing to pay taxes. One would think US law enforcement would have better things to do. Unlike many wealthy individuals who avoid paying taxes due to greed, Irwin Schiff seems to be genuinely driven by his ideological opposition to the IRS. I can see why the government jailed him--they don't want him spreading his, supposedly illegal, messages and inciting a revolt against the IRS--but the whole situation is kind of pathetic when you think about it.)

Trade Imbalance and the Not-so-obvious Solution

(Illustration by Bill Butcher for The Economist)

Economists had long feared that America would ruin itself on foreign borrowing. The current account, which measures the balance of investment and saving, has been in the red every year since 1992. Until 1997, the annual saving shortfall was modest but it grew steadily thereafter, reaching a peak of $788 billion, or 6% of GDP, in 2006.


An unsatisfying implication of the literature on the saving glut is that it paints America as a tragic victim of forces beyond its control (though some of the authors insist this is not their belief). The emerging markets’ need for insurance, in its many guises, drives them to export capital to America (and to similar places, such as Britain). America, by implication, has no choice but to make room for it.

In fact, Asian savings may have provided the rope; but America hanged itself. The macroeconomic forces that drove the capital flows were hard to reverse. But what made them so devastating was that they were met by microeconomic failures...

I was first introduced to the dangerous trade imbalance in the US by Stephen Roach of Morgan Stanely in 2005 or 2006. He was very early and was obviously "wrong" as the bull market continued and very few seemed to care about the expanding trade deficit of USA.

Now, perhaps a bit too late to incorporate it into our investing, we are seeing the global imbalance problem rearing its ugly head. To make matters worse, the wealth destruction in America has made the situation far worse than it seemed to most, including me. Consumers, who were the main debtors benefitting from the trade deficit, seemed to be ok, but not great, a few years ago. But given the collapse in virtually all assets, but especially real estate and stocks, which will not recover to their prior highs for decades (assuming no high inflation,) American households seem to be in bad shape. If one thought American households were able to finance their debt 2 years ago, that seems less true now.

Needless to say, it's hard to say what the final solution to all this will be. My opinion right now is that we will be in a long slump. No depression but slow growth for a while. I'm planning to quote him in more detail but if you want a heads up, you can read Jeremy Grantham's latest letter (source: ValuePlays,) in which he presents his thoughts on the current situation... and they ain't pretty.

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3 Response to Miscellaneous Articles for the week ending January 24, 2009

January 25, 2009 at 6:36 AM

Good piece by Grantham. I mostly concur. Yet I miss a reference to the troubles in Europe.

2007 was the year US subprime blew up. 2008 was the year of secondary explosions in every asset market under the sun. 2009 looks set to be the year of continung secondaries in the political sphere and Europe has deteriarated with alarming rapidity.

And the irresponsible idiots that rule us find it more important to set up the thought police then come up with a sensible response to the economic crisis... Just great.

January 25, 2009 at 5:40 PM

Yeah, good article by Grantham. I have been trying to figure out how the losses compare to past blow-ups and Grantham finally provides an answer: losses will be worse than the Great Depression but better than Japan's.

Grantham has pointed out, in the past, that the British real estate bubble is monstrously large, even compared to the American one. I try to forecast future macro outcomes, sometimes to my detriment, but Europe is really cloudy right now (whereas I have my guesses on what will happen in North America, Asia, Middle East, etc.)

(not sure what your thought police comment refers to??)

Although you are finding the political apparatus in Europe a bit slow, I think it's really difficult to have a simple, quick, solution. Since there are so many different countries in vastly different positions, it will take a while to see some unified action. For instance, Spain's desires will differ, and may even conflict, those of, say, Germany's. ECB is in a tough spot, and the individual governments are too.

January 26, 2009 at 5:18 PM

The fragmentation of Europe is indeed very real and I agree it will inhibit an effective response. There is no "perfect" solution to this mess and possibly not even a good one, only bad and horrible ones. But having the monetary and fiscal authorities paralyzed by diverging interests is definitely in the "horrible" category in my opinion.

The economic situation is deteriorting rapidly, and at the fringes the riots have begun... Yet the ECB is saying it may not have the authority to engage in quantitative easing, is signalling a halt in rate cuts instead of a rapid slashing to zero and the countries that can afford it are showing little sign of boosting domestic demand in a big way. In other words, it looks like Europe will be allowd to slide into a much deeper recession then necessary and will rely on the US and possibly Asia to salvage the world economy. Not good at all if you ask me, especially not with the political landscape as fragile as it is. Many elections are due in the 2010/2011 timeframe and if nothing decisive is done the poltical class looks set to face a disgruntled unemployed impoverioshed electorate.

My "thought police" comment refers to:

1. the Dutch government being hellbent on ramming a law that severely resticts freedom of speech through parliament while almost completely ignoring the deepest recession since WWII.

2. The Amsterdam Sharia (sorry, appellate) court ruling that Wilders, a rather outspoken Dutch politician, is to be prosecuted for "offensive speech". And reading the motivation, they are basically saying they want him prosecuted for having "wrong" thoughts. Blistering idiots.

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