Some articles for the week ending April 25 of 2009

Some articles, in no particular order, that may be of interest...

  • Current recession close to being the worst since the 60's (The New York Times): According to some indicators, our the recession in the US is on par to be one of the worst since the 60's. The question is, will it linger on? (Further comment below)
  • Andrew Mickey interview with John Calamos, a convertible bond investor (Q1 Publishing; via SeekingAlpha): I don't know the track record of either of these guys but I ran across this insightful interview regarding convertible bonds. As I have remarked before, convertible bonds are arguably the ultimate security for distressed investment. They generally give you the upside of equity and the downside of bonds. Unfortunately many companies haven't issued them in the last decade (possibly because financing cost of straight bonds was really low in the last 5 years; and it leaves them open for hedge funds to aggresively short-sell shares while owning the convertibles.)
  • Liquidity vs solvency for the banks (Bronte Capital): A rundown of the differences between liquidity problems and solvency problems faced by banks.
  • (Recommended) Seth Klarman partnership letters (Noise Free Investing): Thanks to GuruFocus for bringing to my attention to the posting by Noise Free Investing of Seth Klarman's partnership letters from the 90's. I don't know much about Seth Klarman and I don't really follow him—it's virtually impossible to know what he is investing in and why—but I'll see if I can get some insights from him. One of the things about value investing—this may be why Buffett never wrote a book—is that the core principles are so "obvious" that I find little to learn after a while. You can continuously read and learn about financial statement analysis or accounting but that may or may not help investing. Anyway, I'm more macro-oriented so I tend to read a lot more articles and books on macro stuff (as you can tell by reading this list of articles.)
  • John Mauldin's view of the investing world (Part 1 & Part 2—may require e-mail sign-up but you can access it free here (part 1) and here (part2) ) (Thoughts From the Frontline): John Mauldin presents his views on what caused the financial meltdown and what he sees in the future. I don't agree with some of his econopolitical views—he is very hypocritical when he says that tax re-distribution, not mention carbon taxes or increased government spending is bad, while advocating huge sums being thrown at failed and possibly insolvent financial firms—but conservatives are in a tough bind right now. Unfettered capitalism has come unglued and their strong support for the Bush administration policies in the last 8 years has been a complete disaster (and I'm not talking about political issues but the economic ones.) (Further comment below)
  • Inflation vs Deflation vs Stagflation (BusinessWeek): "Will the real 'flation please stand up?" asks Businessweek. A quick and simple summary of the three bearish economic scenarios. (Further comment below)
  • Women gain influence in Iceland (Spiegel Online, through BusinessWeek): Perhaps it's fitting; women are gaining greater influence in Iceland, with the possibility of the first female PM being elected soon.
  • Japan and its "communist" island of Hime (New York Times; thanks to Naked Capitalism for original mention): To the horror of most conservatives everywhere, liberals always have a soft spot for socialist ideals—I think this is because most liberals value egalitarianism. However, ignoring the economic side and simply looking at the political side, you can see in this article why almost all socialist-like systems have turned into disasters with essentially monsters ending up as leaders. Reading this article, you can see, in a subtle manner, how Hime became totalitarian day by day. For instance, the fact that the same family has held the mayor position for 49 years shows the flaws of the system. Perhaps this family is virtuous and great but what happens after them? All it takes is one Stalin, who obviously would not seem evil initially, to become mayor and it's all over! Almost any country can collapse if a corrupt and evil leader takes over. So, I say we should be short selling Hime ;) (The emphasis on liberties by America, particularly it's political apparatus and The Constitution, is what separates America (and a few others like it) from shooting stars like China, India, Russia, Vietnam, Brazil, United Arab Emirates, and so on. Investors may make more money in the latter countries but it will likely prove unsustainable in the long run. It is extremely difficult for a single party to rule America for a long time.)

Will this be the Worst Recession Since the War?

A New York Times article by Floyd Norris compares the current recession against those since the 60's using the coincident indicator. The following graphic summarizes the current state:

The question is will this be the worst? Generally the recession that started in 1973 is considered as the worst in the last few decades.

According to the graphic, the current recession is already the worst (since the 60's) based on employment and industrial production. It is possible that this may turn out to be the worst in terms of manufacturing and trade sales but I'm not sure if personal income will decline as much as in 1973-1975.

What is different about now, compared to all the other ones shown, is that we are genuinely facing a deflationary bust. Barring some hyperinflationists who dismiss deflation, we are in one of the rare periods where deflationary forces are stronger than the inflationary ones. In contrast, the two other severe recessions, 1973-1975 and 1981-1982, involved inflationary pressures. Right now, I personally don't think there is much inflationary pressure. In contrast, we have deflationary pressure all over the place—such as potential overcapacity in China; continuously available cheap labour force in developing countries; potentially still-unaccounted-for losses in commerical real estate, credit card loans, CLOs, corporate bonds; and so on. As a reminder, The Economist made the following comment about deflation this week:

The threat of deflation remains. German producer prices fell more quickly than expected in March. And the retail-price index in Britain fell by 0.4% year on year in March, its first drop since 1960.

Sure, the contraction in Britain, or the collaspe in Germany, or even in America, may be temporary. But it may also turn into something that lasts longer than the consensus expects.

I don't think many of us, either as citizens, investors, workers, management, or politicans, really know how to handle deflationary threats. That is what makes this episode more challenging in my eyes. This is also what makes the present investing world totally different from most of history.

The consensus—certainly in the last few months—and probably most readers of this blog probably don't share my concern for deflation. I suspect many are more worried about inflation. Even if that were the case, I do recommend that you keep an eye on deflation and perhaps read up on the Great Depression or Japan.

The Three Bears: Inflation, Deflation, and Stagflation

BusinessWeek has a very basic overview of the three bearish scenarios that can decimate investors' portfolios. There isn't much in the article but, since I lean more towards deflation, I found it interesting that Gary Shilling suggests that technology is an attractive area. This is the first time I have heard him say that (usually he suggests the long bond or cash.)

Although not as knowledgeable as Gary, I have also felt, for other reasons, that technology may be a good sector for the next decade. There are some obvious contrarian reasons for considering tech—such as the fact that many companies have been in a long bear market and have gone nowhere in the post-bubble period—but I also feel that many technology companies may handle deflationary periods better since they tend to operate in industries where end-user prices are continuously falling. Yet, I never considered what Gary has suggested here as a bullish reason for technology i.e. companies will consider technology purchases to increase productivity in a world where deflationary forces persist.

Gary's view makes a lot of sense, assuming we do end up in a slumping world with bouts of deflation everywhere. My, admittedly distant and ill-informed, impression of Japan, a country that is the classic case of modern deflation, is that it has endorsed technology in the last two decades to a greater degree than one would expect. Partly this is due to their culture; and partly it's because of their aging population. However, it is possible that it may also be driven by deflation. (Japanese stocks (even technology companies) haven't done too well but I believe that is due to poor corporate goverance, poor government policy, and severe overvaluation of stocks in the late 80's.)

Of course, even if one is bullish on tech, figuring out which companies actually improve productivity versus ones that don't, will not be easy. Gary Shilling mentioned semiconductors but that's an ugly industry with overcapacity and low profit margins. I'm thinking that the ideal one would be something that provides a tool or a service that clearly lowers the costs of the end product or of doing business. Anyway, this is a macro thesis for me to investigate and I'll keep everyone posted.

Some Thoughts on Mauldin's Essays

I agree with some of what Mauldin is saying but disagree with others. I share Mauldin's view that, contraray to the Austrian Economists' desire, 20%+ unemployment is far worse than 10% for a few years. Nevertheless, I think Mauldin is too critical of liberal policies while ignoring hundreads of billions thrown at the failing financial firms. This shouldn't be surprising, though, since Mauldin makes a living off hedge funds, institutional investors, and others who are dependent on these failing financial firms.

I think most of his description of what happened is correct. His description of the collapse of credit is how I, who isn't an economist, look at the world as well. This is also why I lean towards deflation more than inflation.

But although I have been critical of mark-to-market accounting, I think he puts too much emphasis on it. Some of the key implications, such as the impact of reduced consumption in USA on the rest of the world, is also not covered.

I am less concerned about inflation than Mauldin. However, there is a risk of high inflation if government chooses to pursue it. Mauldin suggests that the Democrats may replace Bernanke with someone who is more left-leaning and less of a fiscal conservative. That is a definite possibility that might shift the environment towards inflation. Recently it has also emerged that Ben Bernanke has made some questionable judgements in the Bank of America buyout of Merrill Lynch. He might be shown the door if this turns into a huge crisis and Obama isn't able to control it. It's too early but this could very well turn into a huge scandal. Henry Paulson seems to have shifted the blame onto Bernanke. I have been supportive of Bernanke in the past and think he is the ideal person to handle the current situation so I hope he is allowed to finish the job. Timothy Geithner may also come under attack if the Bank of America crisis isn't contained since he may have played a role at the New York Federal Reserve. The problem here is that the Federal Reserve and the US Treasury asked Ken Lewis, CEO of Bank of America, to do something to the save the country while hurting his own shareholders. It's not clear who is telling the truth but it seems to me that Ken Lewis almost bankrupted his $100+ billion company in order to follow orders from the Federal Reserve. It appears that Ken Lewis may have done something illegal by not disclosing material changes to shareholders. Whether this turns into a huge crisis will depend on what the SEC says and how the courts will rule on the likely shareholder lawsuits that will be filed. Interestingly, all this started with New York Attorney General, Andrew Cuomo, probing an unrelated issue relating to Merrill Lynch bonus payments, and it seems to have opened up a can of worms.

Going back to Mauldin, he thinks that Irving Fisher will win out in the end but my feeling—a possibly biased view :)— is that Keynes will probably win out. I have a feeling that theories and solutions of someone like Robert Shiller, who follows in the tradition of Keynes to some degree, will become the staple for the next few decades. In particular, Shiller's view of irrational behaviour driven by 'animal spirits', a concept originally popularized by Keynes, will likely gain great influence in economics. I suspect that psychology will be incorporated into mainstream economics that is taught and practiced. In the grand scheme of things, this makes a lot of sense to me because economics is a social science and hence shares more with psychology than the hard sciences or mathematics.


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