Tuesday, June 30, 2009 0 comments ++[ CLICK TO COMMENT ]++

Amazingly Chinese gasoline costs more than in America

I find it quite surprising that gasoline in China is slightly more expensive than in America. From a Marketwatch story:

At just over $3 a gallon, Chinese motorists will now pay about one-eighth more for a fill-up than Americans, who were paying an average $2.66 a gallon last week, Reuters reported.

This is actually quite surprising to me. The gross national income per capita at PPP is 48,850 (in the hypothetical international dollar) whereas China is listed at 5,370 in Wikipedia. I'm not sure how the Chinese can afford gasoline at a price similar to America.

Fuel prices have historically been subsidized in China and the government has been reducing subsidies over the years. It's not clear how much is subsidized or what fuels are subsidized. Gasoline prices in China would likely be much higher without the subsidies.

One should keep in mind that there is huge discrepancy in wealth between rural Chinese citizens and urban ones so the incomes would be much higher for the urban dwellers. Fuel efficiency of cars in China are also likely much better than in America. But even then, it's amazing that people spend so much of their income on gasoline in China.

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Jim Grant Bloomberg Interview...stays bearish on govt bonds

A fairly good interview with Jim Grant was conducted by Bloomberg yesterday. Grant is given time to elaborate on some of his views so it's worth watching the video.

I am still not convinced that high inflation is imminent and is the most probable scenario. Yes, you have a lot of prominent investors betting supposedly on the inflation case (although one can never be sure how much they are betting.) But I'm still in the low-inflation/mild-deflation camp (i.e. one that expects a Japan-like scenario more so than a USA-in-the-70's scenario).

Jim Grant follows the Austrian Economics school and that school emphasizes total credit when looking at the money supply. I wish he had gone into his thinking on how credit will expand with looming debt destruction all around. He sort of touched on the topic but he didn't compare the money creation of central banks against the credit destruction. His view that the amount of money being pumped is unprecedented in the post-war era is correct. However, the amount of wealth destruction is also unprecedented. I don't have access to Grant's newsletter but if someone has access to his writing and can summarize his views on how credit will contract, feel free to leave a comment.

Given my mild view of inflation, it shouldn't surprise anyone that I don't share the view of Grant that the bond market may have entered a long bear market. It's a really hard call and I am not confident enough to invest money but my feeling is that any long-term bearish bond call is premature. A long-term bond yield of around 4%—10-year is currently around 3.5% and 30-year is around 4.3%—is a reasonable rate. It is only too low if inflation was high. If inflation was low or moderate, 4% yield is not unusual from a historical point of view.


Russia bans casinos from most of the country

In what seems like a really bizarre policy, Russia is set to ban gambling from most of Russia. Casinos will be limited to some remote regions and shut down elsewhere. From The New York Times:

One of the largest mass layoffs in recent Russian history is to occur on Wednesday, and the Kremlin itself is decreeing it, economic crisis or not.

The government is shutting down every last legal casino and slot-machine parlor across the land, under an antivice plan promoted by Vladimir V. Putin that just a few months ago was widely perceived as far-fetched. But the result will be hundreds of thousands of people thrown out of work.

And in a move that at times seems to have taken on almost farcical overtones, the Kremlin has offered the gambling industry only one option for survival: relocate to four regions in remote areas of Russia, as many as 4,000 miles from the capital.


The gambling industry here does not have the loftiest of reputations, and many Russians will not grieve for it. Still, many of the 40 or so casinos in Moscow sought in recent years to behave more respectably, even as hundreds of slot-machine parlors retained a seedy, enter-at-your-own-risk feel.

The gambling industry says the ban will leave more than 400,000 people without work in Russia, at a time when it has been hard hit by the economic downturn: the World Bank predicts the economy will contract by 7.9 percent this year. The government has put the figure at 60,000 people, though industry analysts say that is absurdly low.

Vladimir Putin is billing this as an anti-vice policy. No doubt the Christian conservatives will love it but is that really the reason for the ban?

The New York Times suggests that it is an attempt to penalize Georgian immigrants but I'm not sure I buy that. The article says, "His plan was announced during a spy scandal between Russia and its neighbor Georgia, and the timing suggested that Mr. Putin was in part seeking to wound the Georgian diaspora here, which is said to have an influential role in the industry." I doubt that the government would shut down gambling everywhere just to punish the Georgians. Besides, I doubt that Georgians are the main owners of the casinos.

My guess is that the government is attempting to crush organized criminals. Like most countries, casinos are a dubious business—recall how Charlie Munger, Buffett's partner, suggested that gambling is generally a dirty business (although I suppose Las Vegas would disagree.) This is doubly so in Russia, which was once ruled by the Russia mafia. I suspect this is Putin's final step in his grand plan to flush out the mafia.

Having said all that, speaking as liberal who is very libertarian on many issues, I am against any government trying to regulate gambling. Not only does it never work (it'll go underground), the government should be focusing on more important issues.


Bernard Madoff sentenced to 150 years in jail for the biggest scam of all time

Bernard Madoff at his sentencing

Verdict in the biggest scam of all time...The Globe & Mail picks up an AP story:

Convicted swindler Bernard Madoff was sentenced to 150 years in prison Monday for fraud so extensive the judge said he needed to send a symbolic message to those who might imitate his fraud and to victims who need relief.

Applause broke out in the crowded Manhattan courtroom after U.S. District Judge Denny Chin issued the maximum sentence to the 71-year-old defendant, who said he sought no forgiveness and knew he must live “with this pain, this torment, for the rest of my life.”

Speaking after his sentencing, Mr. Madoff acknowledged the betrayal he perpetrated and the suffering he caused his investors and his family. “I cannot offer an excuse for my behaviour,” he said. “How do you excuse betraying the trust of investors who entrusted me with their life savings? How do you excuse lying and deceiving your wife who stood by you for 50 years and still stands by you?”

Sunday, June 28, 2009 15 comments ++[ CLICK TO COMMENT ]++

The great stock market crash - 1929 to 1932 (very long post)

I see quite a number of individuals comparing the current stock market crash to the one that started in 1929. I feel that many are performing the comparison without even knowing what happened from 1929 to 1932. You may have seen several charts floating around on blogs that plot the current crisis to the crash that started in 1929. I think it's worthwhile to look at that comparison but it is very important to understand what happened in the 1930's as well. I think the current period is quite similar to the early 30's but one needs to understand why the market fell so much back then. It would be a serious mistake to assume the same thing will happen now, unless you believe similar events will unfold.

I thought it is worthwhile to analyze a chart of the Dow Jones Industrial Average in that time period. Like many complex events, no one really knows exactly why something happened or what was driving the market so what I say should be taken as my opinion. It's a very long long post and hopefully it's benefitial to some.

The Approach

There are three aspects of any business environment that one can look at. You can look at the economic world; you can analyze asset prices (say the stock market or the bond market); and you can concentrate on the political environment. Some like to think that all three are correlated but they rarely are, and I never consider them as being similar.

There isn't one right way to look at the investing world. Some, such as Austrian Economists and their followers, seem to ignore the political aspects. For example, someone like Peter Shiff or Jim Rogers, who seem to share AustEcon thinking, rarely consider the possibility of the Chinese government collapsing because they are unable to keep the economic growth going; or how it is literally impossible to let whole sectors of the American economy collapse without serious political backlash from the voters.

Others, such as value investors, tend to ignore macro elements and they generally concentrate on asset prices. Sometimes this works but sometimes it doesn't. For instance, Warren Buffett staked a huge chunk of his, and Berkshire Hathaway's, wealth on Wells Fargo, which can easily be nationalized. Buffett keeps saying that the banks will earn their way back but what if they can't (if interest rates rise and spreads decline)?

As a macro-oriented investor, I look at all three and probably put too little emphasis on asset prices (although one of my goals is to put more effort into valuation and security analysis in the future.) So, I'm going to look at the crash of 1929 largely from a macro point of view. I am also going to look at it from the stock market's point of view.

The Great Crash

Like almost any critical period in history, there isn't a consensus on what happened in the 1930's. I mean, there are still some, who are fans of hard currencies and are generally anti-government, still blaming the 1930's on government intervention, when the government wasn't even that big back then, and the 20's were considered to be the glory days of unfetterd capitalism. So, there can easily be disputes. Even speaking in hindsight after many decades, when stock prices change, one can never be sure what is driving it.

I have chosen to analyze the period based on what Russell Napier has mentioned in his book. I chose Napier's suggestions because, first of all, I have his book and it discusses the period from an investor's point of view, and is easily understandable by a layperson like me. There are many economic textbooks written about the period but only economists who are trained in the field will understand them. Furthermore, those books also tend to debate economic policies and economic theories whereas I am more interested in what was driving stock prices.

The chart below illustrates the stock market crash that started in 1929, annotated with some events I felt were key (click on chart to enlarge.) I pulled the DJIA chart from Yahoo! Finance (since that's the only free one I have access to) but I should note that Yahoo's charts are sometimes slightly incorrect. The crash is primarily annotated based on what Russell Napier described in his book Anatomy of the Bear. There is also some minor discrepancy in the chart and the numbers from the book, which I suspect is probably because the chart might be plotting weekly or monthly prices, whereas the book probaby uses daily numbers (it is also possible that the numbers from the book include dividends whereas the chart does not.) I don't think the small differences detract from the arguments I make.

Basic Observations

The stock market from 1929 to 1932 is memorable for the size of the losses incurred by investors. The market, as measured by DJIA, dropped 89% from peak to trough and basically destroyed anyone who owned stocks. However, many don't realize that the crash wasn't as bad as it seems. First of all, there was an unbelievable 100%+ rally within an year, starting in late 1932 (I will discuss this below). This rally sort of saved many investors, especially those dollar-cost-averaging or re-deploying their dividends back into the market. Secondly, the period was marked by severe deflation so the losses in real terms were less than they seem. As crazy as it may seem, depending on how you measure, my understanding is that investors in the 1970's did worse than those in the 1930's in real terms.

The crash in 1929 is also generally thought to have provided an early signal for the Great Depression, although my opinion is that this seems more like a myth. The initial crash was typical after major bull markets, and many would not have foreseen a severe depression based on the crash alone. In fact, the stock market was rallying by 1930 and very few investors expected anything overly negative on the horizon.

I - The Crash

Speaking as a present-day observer, the 1929 crash isn't really a surprise, at least to me. It was inevitable! By the end of the Roaring 20's, valuations were so high that stocks made little sense for new capital deployment. It was similar to the stock valuations in the latter 1990's. Either stocks were going to collapse quickly or they were going to enter a multi-decade bear market. The initial crash of 1929 simply took down valuations to more attractive levels.

Contaray to some people's beliefs, the Federal Reserve did not seem to have pursued a loose credit policy before the crash. A lot of the excesses of the 1920's were built up by the private sector—largely private corporations. This is similar to the present crash, which I believe was due to, primarily, actions of private market actors. In the current crisis, it is largely consumers whereas the high indebtness was with corporations in the 1930's.

What turned a large, although not unexpected, crash, into the worst one ever seen, was likely due to the banking crisis.

II - First Banking Crisis

Russell Napier points out that banks failed all throughout the 1920's due to the suffering farming sector—USA was switching from an agricultural country to an industrial one—and increasing banking competition. Based on his writing, it seems that everything fell apart in 1930 after the public lost faith in bank deposits.

It seems that the trigger for a total loss of faith in the banking system may have been the collapse of the Bank of the United States. This was a FedRes member bank that was founded all the way back in 1791 (so it survived 139 years including the Long Depression!). When it failed, it was also the largest bank failure in American history. Given how there was no deposit insurance at that time (FDIC deposit insurance only started in 1933 with the Glass-Steagall Act), you can imagine how the public would panic if the largest bank failed. This wasn't some rural no-name bank; it was the largest bank located in the heart of New York City. To make matters worse, the Federal Reserve, as well as the politicians at that time, did very little—they were largely following the libertarian-oriented free-market policies of letting the market take care of itself, which was the norm for the prior few hundread years.

Russell Napier, in his book Anatomy of the Bear, argues that the 1930 recession turned into a depression largely due to the contraction of the money supply due to runs on the banks (I'm re-typing the quotation so any spelling mistakes are mine):

Before the public's withdrawal of its money was over, the deposit-currency ratio would be reduced to levels not seen since the end of the 19th Century. Given the operation of the fractional reserve banking system, where banks had to maintain cash balances much smaller than their deposit base, this drain of cash from the banks had a very negative impact. In this period the banks needed to reduce deposits by $14 in order to make $1 available for the public to hold as currency. (p95)

You can see how powerful the deflationary effect would be if the banks had to cut lending $14 for every $1 that a depositor took out. There were clearly excesses in the late 20's so lending probably should have gone down. But a drop of 14x deposit withdrawal is extreme.

You can see how the bank run problem was mitigated during the current crisis by pumping a huge amount of liquidity into the banking system. On top of deposit insurance keeping depositors at bay and preventing their loss of faith in the banks, the central banks of the world have managed to avoid a major liquidity crunch at banks by providing liquidity to almost anyone that wants it. I don't think bank runs, en masse, was likely in the US but it was definitely a possibility in places like Ireland and Britain. However, if Citigroup, which eerily parallels the Bank of the United States in 1930, collapsed, I think a run on all the major banks was a possibility.

Even with the serious failure of banks and the declining public faith in the banks, investors probably still considered the early 1930's as a normal bear market. Although bank failures are somewhat rare these days, they were pretty common in the prior centuries. On top of a lack of deposit insurance or anything resembling true insurance, banks never had enough (short-term) liquidity to cover their desposits. Even during the heydays of the gold standard, banks were practicing fractional reserve banking as far as I know. This meant that they always loaned out more than their deposits. So, citizens always took on a risk unlike anything a modern depositor would be familiar with.

Investors clearly thought the 1930 bank runs were a typical, although severe, situation, not too dissimilar from the past. They bid up the stock market in the early part of 1931, even after the major failures started in late 1930. Unfortunately for anyone investing in 1931, the unprecedented wealth destruction happened past this point, after the initial stock market crash and the onset of the banking crisis.

III - Second Banking Crisis

The second banking crisis, which is sort of a continuation of the first one, basically destroyed any hope of recovery for the banks. Although it's hard to pin a cause, the second crisis was probably made worse by the failure of Austria's main private bank, Credit-Anstalt. This failure caused serious banking problems in Austria and Germany, and capital controls were enacted. US bank deposits in those countries were frozen and this, as Napier asserts, may have weakened the confidence in the balance sheets of American banks.

The FedRes cut interest rates but it did not expand liquidity to its member banks. This was a serious mistake and essentially defeated one of the key reasons for the existence of a central bank. That is, central banks are supposed to increase liquidity during stressful times and shrink them when not needed (if you didn't have a central bank with its own currency, then everything would be rigid, as is the case under a gold standard.) If you didn't care about expanding or shrinking the money supply at opportune times then you probably don't even need a central bank.

To make matters worse, the gold exchange standard that USA was on at that time caused all sorts of weird, detrimental, actions to be taken. For instance, Napier points out that the FedRes actually raised rates in October of 1931 to halt the outflow of gold. Imagine the whole banking system is falling apart, and the economy is shedding jobs, and you tighten money supply. There was major inflow of gold into USA in the early part of 1931 as a safe haven (due to banking crises in Europe among other things) but gold started fleeing America after United Kingdom went off the gold standard.

The combination of a drain on gold reserves and currency withdrawals further exacerbated pressure on the commercial banking system, which was compounted by rising interest rates. The Federal Reserve acted as the gold standard dictated, raising the discount rate from 1.5% to 3.5% in October with a view to halting the drain of gold from the country. Commercial banks once against rushed to dump assets in the scramble for liquidity. Now, for the first time in the recession, even the price of government securities declined. Investors who expected that government bonds would provide nominal returns in a deflationary period were now in for a major surprise.

Government bonds, as should be expected, were in a bull market until that point (corporate bonds, however, were in a bear market.) The increase in interest rates, and consequently increase in government bond yields, seriously hurt the balance sheet of banks, who owned a lot of government bonds. The rigid nature of gold in forcing the FedRes to raise rates in the thick of an unfolding banking crisis and serious recession probably started the beginning of the end of gold. USA went off the gold exchange standard in 1971 but it is really the Great Depression that sealed gold's fate.

The stock market had no chance during the second banking crisis. It fell 56% and the economy kept deteriorating. I do not know the sector performance in this period but it would not surprise me if every sector got killed and there was probably nowhere to hide.

IV - Gold Drain

The Dow dropped another 50% in 1932. Russell Napier argues that the final collapse in the Dow was due to investor concern over gold:

The final blow to the market, which accounts for a quarter of the entire bear run, was primarily due to a renewed drain on gold from the US...The burgeoning fiscal deficit, it [The Wall Street Journal] argued, convinced foreigners that US adherence to the gold standard was under threat. However, it is more likely the Federal Reserve's move to large-scale open-market purchases of government securities caused foreigners to take fright. Still, there was a heady cocktail of reasons for foreigners to be selling US dollars in early 1932. Barry Eichengreen argues that devaluations elsewhere threatened to erode America's current account surplus.

Foreigners are usually the last ones to partake in bubbles and the last ones to exit crashes. Right near the bottom, it seems foreigners unloaded US$-denominated assets because of concern over the gold backing. UK, Canada, France, and others had gone off the gold standard and investors were wondering if America was the next one.

In the end, the sell-off due to concern over gold didn't matter much. The market rallied almost to the pre-sell-off level by the end of 1932. USA also never went off the gold standard until 1971 so foreigners bet incorrectly.

V - The 1932 & 1933 Super Rallies

The latter part of 1932, as well as 1933, were marked by events that have left a lasting impact on world history. Not surprisingly, given the massive suffering due to the economic depression, there were some crazy things that unfolded.

It is not clear to me what caused the massive rallies in 1932 and 1933. Russell Napier also looks at the issue and I don't really find any satisfactory answer. The stock market had two, roughly 100%, rallies during that period. The overall gain from the bottom to late 1933 was in excess of 100% and this ranks as the strongest—if you look at the amount and the time it took—bull market in history. The market largely went flat after 1933 but it is amazing if you think about a 100% rally for a broad index (the NASDAQ went up 100% in 1999-2000, but that is a narrow index consisting mostly of technology and bio-technology companies.)

Although the economic situation improved somewhat in 1933, this was still in the thick of the Great Depression, which was not to end for more than a decade (this is a good example of how the stock market is not perfectly correlated with the economy.) One of the things that is obvious is that stocks were extremely cheap in 1932. In terms of the CAPE (cyclically adjusted 10-year P/E), valuations in 1932 were near all-time lows and similar to what they were in two other major bear market bottoms, 1920 and 1981. But why the sudden buying in 1932 and 1933?

Franklin Delano Roosevelt, whom many liberals including me, consider one of the greatest politicians of all time, in any country, was elected during that period. Napier looks at his election and doesn't believe the market was influenced by his election. If anything, the market should have feared someone who was a socialist of sorts and was claiming that bankers and investors were the root cause of the problem. One would have thought that when Roosevelt said, in his inauguration speech, that "The money changers have fled from their high seats in the temple of our civilization" that Wall Street would have sold off sharply. Yet, the stock market kept going up.

It is possible that the market was taking a bullish view of Roosevelt and his policies given how if he didn't save capitalism, even with his socialist policies, America looked doomed. The Republicans ran out of ideas and probably couldn't have done much to restore confidence, given their disastrous strategies in the first few years of the (initial) recession. We also had a terrible event over in Europe with Adolf Hitler becoming Chancellor of Germany in March of 1933. Although Hitler was a strong capitalist and was probably favoured by some in America for his ideology, it is possible that the market favoured having a so-called "socialist" like Roosevelt in power rather than a fascist or a communist.

Another possibility is that the market may have rallied, especially the big rally in 1933, because of the devaluation of the US$ against gold. FDR banned private ownership of gold, except for some trivial amount, and de-valued the US$ against gold by 44%. He still kept USA on the gold exchange standard in foreign dealings. Such a de-valuation can cause stock markets to rally in nominal terms. It's not clear if something like that contributed to the rally.

Markets are mysterious and the massive bull market from 1932 to 1933 has to go down as one of the biggest mysteries. The economy certainly did not improve sufficiently to justify those 100%+ moves.

Final Note About That Period

One of the common things one hears is that the market hits a bottom with high volume. In other words, bottoms are thought to be marked by capitulation, consisting of high volume. Some also argue that volatility and panic measurements are high near the bottom.

Well, the 1932 bottom was not marked by any capitulation. As you can see from the volume at the bottom of the chart, volume consistently declined from the 1929 peak. The bottom was marked by very low volume. It's also worth keeping in mind that dollar volume (i.e. value of the transactions) was much lower at the bottom (since price is lower, the same volume yields a lower dollar value.) Regardless of how you look at it, interest in stocks kept declining until the very bottom.

I'm not a trader and don't buy or sell based on volume; but just saying that major bear markets can also be marked with disinterest and low volume.

How Does The Present Compare?

This post was triggered by those trying to compare the present to the Great Depression, so how does the present compare? Well, this is just my opinion right now and I may change it at any time, but here is how I see things:

If one considers the present as being somewhat similar to the 1930's, we are probably at the point after the first banking crisis. Things are not identical, of course, but, similar to 1931, the market isn't really overvalued right now. It isn't undervalued either. Similar to the past period, we have seen a major banking crisis, with the solvency of major international banks being called into question. We are also seeing a credit bust similar to the 1930's, except now the weak balance sheet lies with the consumer, whereas it was with corporations in the 1930's. We have also seen a stock market crash comparable to the early portions of the 1929-1932 crash. There is also a collapse in trade, although the present world trade might be larger and more important than in the past.

My opinion is that we are probably after the first banking crisis on that chart. Our banking problems are somewhat similar to the first banking crisis. There are some elements of the second banking crisis (such as the global nature of it) but it's not yet quite comparable.

Yet, I think the sequence of events is slightly different. I think we had something similar to the first banking crisis of 1930 before we had a stock market crash. I think our stock market crash, which I say happened in October of 2008, happened after our banking crisis, which was unfolding all throughout 2007 and 2008.

In terms of valuations, the period after the first banking crisis is probably similar to the present. Stocks weren't that cheap after the first banking crisis, in 1930, but the market did mark down the excessive valuation from the late 1920's. Similarly, coming to the present, the market has got rid of the high valuation of the last few years but it isn't cheap.

Some superbears plot the current stock market against 1929 and literally imply that we have another 50%+, on the downside, to go. I actually don't think it is helpful to have such a view. There is no reason to expect the present to be anywhere like the past. As I have suggested above, there were a lot of mistakes made by central bankers and politicians which have been corrected this time around. Yet, can the superbears be right? Can we end up with similar outcome?

I hate to say it but I think we can certainly end up with huge stock market losses under some, low probability, scenarios.

One of my big concerns is valuation. Admittedly this is something that is in the eye of the beholder and keep in mind that I'm just a newbie who really doesn't have a good track record of estimating valuations. The fact that the market is not cheap does not mean that it has to fall further. In fact, Warren Buffett, writing in The New York Times back in October of 2008, has suggested that the market is attractive at the October levels. But my view is that it is not cheap and hence further declines is a possibility. Again, I'm not saying it will happen but, just that you should think about the possibility.

If the market were to completely collapse, like in 1931, something resembling the second banking crisis must occur. We can get another major banking crisis if banks take losses from assets other than residential real estate (my feeling is that the market has largely accounted for losses from residential real estate.) I'm thinking assets such as commercial real estate, credit card loans, and so on. Delinquincies and losses are rising in these assets but they seem within expectations so far. If losses are very high in these asets, companies like American Express or GE Capital may face serious problems and may even go bankrupt. A second banking crisis may also erupt if, say Eastern European banks collapse. My impression is that Eastern Europe is somewhat small and containable. But you just never know. Ironically, similar to the failure of the Austrian bank, Credit-Anstalt, back in 1931, it's possible that Austrian, along with Swedish and maybe German, banks may fail if Eastern Europe collapses.

Again, I don't expect it, but something equivalent to the gold drain in 1932 would be a run on the US dollar. Foreigners are already getting nervous about the US$, with some, such as the Chinese, even supposedly considering a purely fictional currency by the IMF, the Special Drawing Rights (SDR) (John Maynard Keynes suggested a similar IMF currency and, although Americans may not want it now, it is probably better for America in the long run if SDRs were used instead of US$.) A rapid US$ sell-off would be similar to the concern over the gold backing in 1932 and cause chaos. Unlike the gold sell off, I'm not really sure what someone would exchange the US$ for. Nevertheless, if someone is looking for events that can trigger a similar outcome as the prior period, this is one.

Another event that may cause severe harm is a trade war. The Smoot-Hawley tariffs in the 30's were thought to have done serious damage to world trade and, if something similar is enacted, we may face a huge collapse in world trade—way beyond what we have seen so far. As I have speculated before, a comparable action to the Smoot-Hawley tariffs would be if China devalues their currency. The damage caused by Smoot-Hawley wasn't necessarily the tariffs contained in the legislation. Rather, the damage came from the start of trade wars and subsequent tariffs enacted by many other countries. The problem is never the tariff itself—there are many tariffs, taxes, duties, etc enacted and repealed every year—but the potential for a trade war.

To sum up, I don't think we are looking at anything like the 1930's. Expecting stocks to follow the path in the 30's is too simplistic of a view. However, one should keep in mind that some adverse events can materialize.


Sunday Spectacle XV

Saturday, June 27, 2009 0 comments ++[ CLICK TO COMMENT ]++

Is this the end of the run for branded consumer goods?

Branded consumer goods have had a good run. They have done exceptionally well for the last few decades. In fact, one can argue they have been in a bull market of sorts since the 1950's—basically since the American post-war consumer boom started. Branded consumer goods companies also tend to have high ROE, supposedly strong moats, and are thought to be shareholder-friendly (they pay out a lot of their earnings as dividends.) But are we seeing the beginning of the end of their strong performance?

One of the arguments I often have with so-called value investors is their heavy reliance on branded consumer goods companies such as Kraft, P&G, Colgate-Palmolive, and so on. My feeling is that many pick those companies because they are influenced by Warren Buffett. I haven't seen many make any forward-looking bullish macro case for them (but then again, value investors usually don't try to make macro forecasts.)

I ran across a story from The Globe & Mail discussing how shoppers are becoming more frugal. I have seen similar stories elsewhere and I'm wondering if this may be the start of a trend. On top of declining consumption, private labels—these are store brands, sometimes called "no-name" products, with similar products at much lower price points—may be taking away market share.

William McComb, chief executive officer of Liz Claiborne Inc. calls the phenomenon the “savvy shopper syndrome”.

“It's not a matter of what can [a consumer] afford to spend, it's what's the price that she can get it at,” Mr. McComb said at a recent retail conference.

“And that's something that just emerged out of nowhere,” he added.

Sales of private label products are also soaring, putting more pressure on brand-name makers to cut prices or spend heavily on marketing.

Retailers are also slashing the number of brand names they carry in order to make room for their own varieties.

This week, U.S. grocery store giant Kroger Co. reported a 13-per-cent increase in quarterly profit thanks mainly to a big jump in sales of its private label offerings.

The newspaper story is kind of biased. It only looks at opinions from frugal shoppers and so it may be somewhat misleading. Nevertheless, one just wonders if this is the start of a trend.

The real question is not what happens during the current recession (although short-term investors would probably pay attention to that.) Instead, what really matters is whether American shoppers have permanently changed their shopping behaviour. Will they avoid paying a higher price, and instead, move to the cheaper private-label brands? It remains to be seen. I'm somewhat bearish on branded consumer goods companies and would be careful at current valuations (most of them have consistently traded at above-market multiples for the last few years.) The risk is not that these companies will go bankrupt but that their profit margins will contract.


Some that are bullish on branded consumer goods companies argue that a lot of the income is foreign and there is growth potential in emerging markets. It is generally true that these companies depend quite a bit on foreign sales. Yet, I remember looking at several of them a while ago and I noticed that they still depend heavily on the developed world. Even when off-shore sales were more than 50%, a lot of it came from Europe and Japan, two areas seeing weakness. If the core market declines, they will face issues no matter how well the (smaller) foreign markets are.

Thursday, June 25, 2009 11 comments ++[ CLICK TO COMMENT ]++

Dr. Black Swan - Is Nassim Nicholas Taleb overrated?

(Illustration by unknown artist. Blowing Up by Malcolm Gladwell.The New Yorker, April 22 & 29.)

Nassim Nicholas Taleb is a controversial man these days. Some of it probably comes from the envy of others, but some of the criticisms are quite valid. For those not familiar, he is, without a doubt, Mr. Black Swan. He successfully profitted off the stock market crash, and has suggested that investors understate risk. Not just once or twice, but almost perpetually.

I haven't linked to any of his works or commentary because his investing style isn't suited to me—he is essentially a trader and I am not—and I don't think his views can be successfully executed in the long run, at least when it comes to small investors. Some traders may profit from his strategies but it is a painful strategy. From what little I know of Taleb's work, I think most of it is useful for academics, risk officers, executives, policymakers, and the like.

I was writing this post a few days ago and Blogger lost my post (didn't save properly :( ). The original post was more critical of Nassim Nicholas Taleb. The current one, upon some reflection, will be more neutral.

Writing for The Big Money, Mark Gimein criticizes the strategies of Nassim Nicholas Taleb and suggests he is overrated. It's a good article capturing the key flaws of Taleb's strategy:

But the failures of the Niederhoffers and AIGs do not translate to a validation of Taleb-style catastrophism because these two approaches turn out to be linked. They are mirror images. In noncatastrophic times, the Niederhoffers and AIGs make money consistently and quietly and then end up losing it conspicuously and painfully. The Talebs make money rarely, amaze everyone because they do it when everybody else is getting killed—and so make it easy to forget about years of steady losses. Over the long run, the anti-catastrophists often do fairly well (if they don't get too greedy and make bets that cost them all their money in even a small market drop). But it is the catastrophists, a la Taleb, who look smarter. If you're always planning for crisis, you look like a genius when it does come.

I think there is some merit in the criticism levelled at Taleb. Betting against some outlier events, usually by buying way-out-of-the-money options, seems like a dumb strategy. But when it does work—it will work once in a while—you look like a genius.

Taleb and his team probably price the odds better than the competition. Even then, the problem I have is the following. What if the outlier doesn't materialize for a long time. You can easily bleed to death. What if the outlier occurs in year 11 but you are bankrupt by year 10?

Taleb, as Gimein suggests, is betting against investors like Victor Niederhoffer (you may recall him from the entertaining New Yorker article, The Blow-up Artist by John Cassidy, I linked many months ago.) Niederhoffer blew up twice and has basically been washed out permanently, like the captain of the ship that ran into Moby Dick. I'm not sure if Niederhoffer is a good opponent of Taleb, given my impression of Niederhoffer as a pure speculator. But what if Taleb is betting against more seasoned veterns?

Left unsaid by many is how Taleb is also indirectly betting against Warren Buffett. At least I think so. Recall how Buffett was writing long-dated put options on various stock indices. Well, Taleb is buying long-dated options as well. I'm not saying Taleb is directly buying what Buffett is writing—Buffett's options are probably purchased by some insurance company or pension fund—but the positions are opposite each other. The price also matters but let's say that neither Buffett or Taleb and grossly mispricing the options. (There are some differences* but I don't think they detract from my comparison.)

Now, whose view is right? Buffett is essentially saying that he is willing to write a put option on a stock index, at the right price, because he believes the market will go up. Is Taleb saying that the market will go down? Not quite. Contrary to popular opinion, Taleb doesn't bet on a bearish case per se. Even some of the bears who are fans of Taleb don't understand that he isn't a bear like them. Rather, Nassim Nicholas Taleb bets on the possibility of something adverse, that no one imagines, may occur. In Blowing Up, the excellent Malcolm Gladwell article for the New Yorker, Gladwell says the following about Taleb's thinking:

The men at the table were in a business that was formally about mathematics but was really about epistemology, because to sell or to buy an option requires each party to confront the question of what it is he truly knows. Taleb buys options because he is certain that, at root, he knows nothing, or, more precisely, that other people believe they know more than they do. But there were plenty of people around that table who sold options, who thought that if you were smart enough to set the price of the option properly you could win so many of those one-dollar bets on General Motors that, even if the stock ever did dip below forty-five dollars, you'd still come out far ahead.


Taleb's hero, on the other hand, is Karl Popper, who said that you could not know with any certainty that a proposition was true; you could only know that it was not true. Taleb makes much of what he learned from Niederhoffer, but Niederhoffer insists that his example was wasted on Taleb. "In one of his cases, Rumpole of the Bailey talked about being tried by the bishop who doesn't believe in God," Niederhoffer says. "Nassim is the empiricist who doesn't believe in empiricism." What is it that you claim to learn from experience, if you believe that experience cannot be trusted?

Taleb is essentially saying that you cannot be sure of anything, let alone be confident that the stock market is going to be higher in 10 or 20 years. Warren Buffett, on the other hand, is betting that the stock market is indeed going to be higher or at least not any lower (Buffett will lose money if the market has declined at expiry of option. Strictly speaking, the market has to decline more than the amount Buffett would earn by investing the premiums that are paid up-front.)

Is Taleb wrong here? If Mark Gimein's dismissal of Taleb's strategy were correct, Taleb has to be wrong with his thinking here. That is, Taleb is incorrect is suggesting that we can't be certain of the future. So who is the loser here: the option buyer who bleeds constantly, or is it the option seller who gets blown up once in a while? Regardless of what one thinks of Taleb's strategies or his persona—some view his as somewhat arrogant—one has to commend him for introducing the unpredictability of fat-tail events into our investing lives. I don't necessarily think small investors benefit from this; but those at hedge funds, investment banks, and the like, should think about Taleb's suggestions. In addition to reading his books, anyone interested may also want to check out the academic paper suggested by some commentator for The Big Money article.

* Buffett and Taleb aren't taking as much of an opposite bet as Niederhoffer and Taleb were positioned. First of all, Taleb is a trader and hence can be short-term-oriented whereas Buffett is long-term-oriented. So it's possible for both of them to lose money or both to make money. Buffett also wrote European options whereas Taleb likely uses American options (for those not familiar, European options can only be exercised on a specific date, whereas American options can be exercised at any time before expiry.) It is far more difficult to profit off crashes if one uses European options (since the fallen price may recover by the expiry date.) It is not clear to me if Buffett would consider writing American options to be a sound strategy (if Buffett would never write long-dated puts on a major index using American options, then Taleb and Buffett may be on the same page.) In the grand scheme of things, though, Buffett and Taleb can, indeed, be considered as taking opposite positions.


Jim Rogers not shorting anything or buying anything

“I have no shorts for one of the first times in my life,” Rogers, a co-founder with George Soros of the Quantum Fund, told Reuters TV in Singapore. “On the other hand I don't see much to buy.”

The above quote from a Reuters story picked up by the Globe & Mail sort of shows the current state of the market. I don't follow Rogers closely but I can't recall him not buying, or shorting, something over the last 5 years. I think this is a sign that the market is neither overvalued nor undervalued.

Tuesday, June 23, 2009 7 comments ++[ CLICK TO COMMENT ]++

The Atlantic's Paul Samuelson Interview

But you know, people say, 'greed has suddenly increased.' But it isn't that greed's increased. What's increased is the realization that you've got a free field to reach out for what you'd like to do. Everybody would still like to retire with a satisfactory nest egg in real terms. And the tragedy of this unnecessary eight-year interlude is that much of what has been accumulated is gone and gone forever. And no amount of pumping is going to bring back into reality what were ill-advised overextensions of bridges to nowhere and housing developments for which there was no effective demand.
— Paul Samuelson On the Current Crisis

Unless you are an economist or were around for several decades, you may not be familiar with Paul Samuelson. Anyone left-leaning will probably know him more than the general population since he may be the most influential Keynesian economist outside John Keynes. Certainly I am not that familiar with him and, since his dominant influence was in a prior era, I can't say that I have been influenced by him.

Paul Samuelson is a somewhat controversial person to conservatives and is an enemy of the right. He is very left-leaning—far more than Paul Krugman who is hated by many on the right. Samuelson is not perfect and did make some mistakes in his life, including a way-too-optimistic view of the Soviet Union (a lot of liberals completely misread the Soviet Union in the 60's and 70's.)

He was essentially the counter-balance to Milton Friedman's libertarian-oriented economics in America (although Samuelon's peak was likely behind him by the time Friedman became really influential.) Like most people on the left, including me, Paul Samuelson is also not a fan of Ayn Rand.

I came across an excellent two-part interview of Paul Samuelson by Conor Clarke of The Atlantic (part 1 here & part 2 here.) If you are left-leaning, it's a must-read; if you are a centrist or on the right, you may want to check it out as well but it may be painful ;) The entertaining interview covers Samuelson's views on the current crisis, what he thinks went wrong, and whether Keynesianism has defeated monetarism. Samuelson is 94 years old so he provides insight that only someone that was alive during the Great Depression is able to.

(I must congratulate Conor Clarke for doing a good job with this interview.) Click through to view my opinion on some of what Samuelson said. I will be quoting extensively (hope I don't break any laws :) since, this may be one of Samuelson's last interviews :(

Keynesianism Rises from the Ashes

Conoor Clarke: So is it time for the Keynesians to declare victory?

Samuelson: Well I don't care very much for the People Magazine approach to applied economics, but let me put it this way. The 1980s trained macroeconomics -- like Greg Mankiw and Ben Bernanke and so forth -- became a very complacent group, very ill adapted to meet with a completely unpredictable and new situation, such as we've had. I looked up -- and by the way, most of these guys are MIT trained; Princeton to MIT or Harvard to MIT -- Mankiw's bestseller, both the macro book and his introductory textbook, I went through the index to look for liquidity trap. It wasn't there!

One of the reasons Keynesian views are becoming popular is because it is one of the approaches that seem to deal a lot with concepts like liquidity traps. Paul Krugman has been talking about it for a while now. Even Greg Mankiw has come around to admitting that we may be looking at a liquidity trap.

Maybe I'm biased but I think Keynesnianism will become popular over the next decade or longer. I suspect monetarism is dead and this is especially true if we are stuck with near-zero interest rates and low-inflation/mild-deflation. But it'll be a new kind of economics with greater influence from behavioural psychology.

The 1930's

Well, let me give you a bit of boring autobiography. I came to the University of Chicago on the morning of January 2, 1932. I wasn't yet a graduate of high school for another few months. And that was about the low point of the Herbert Hoover/Andrew Mellon phase after October of 1929. That's quite a number of years to have inaction. And I couldn't reconcile what I was being taught at the university of Chicago -- the lectures and the books I was being assigned -- with what I knew to be true out in the streets.

My family was well off but not rich. I spent the four years I was an undergraduate working on the beach. And it wasn't because I was lazy; it was because my freshman class would go to a hundred different employers and wouldn't get a nibble. That was a disequilibrium system. I realized that the ordinary old-fashioned Euclidean geometry didn't apply.

And I applauded when the major members of the Chicago faculty -- maybe even a few years before Keynes's general theory -- came out with a petition to have a deficit-financed spending without taxation in order to create a new increment of spending power. And I was for that. And Franklin Roosevelt, who was not a trained economist, and who experimented and made a lot of mistakes, in his first days, by good luck or good advice got the system moving. It was in a sense an easier problem because the pathology was so terrible.

He would go to Warm Springs Georgia. And that county -- a pretty sizeable one, this is the old south -- there were maybe three to ten people with enough income to file an income tax return. So, when along came the WPA, the PWA, and a little later the Reconstruction Finance Corporation, you could be very sure that those monies spit out by government-- not from airplanes in the air, sending newly printed greenbacks, but essentially the equivalent of that -- would be spent.

I don't know if you know the name, the professor E. Cary Brown wrote kind of the definitive article in the American Economic Review on what had been accomplished by deficit spending that was sustained. And his numerical findings were that there were no miracles -- it was about what you'd expect -- but it worked. And so I developed I guarded admiration for Keynes. And I say guarded because I don't think he understood his system as well as some of the people around him did.

One of the unfortunate things I notice is that a lot of those in the liquidationist camp never experienced the 1930's or never gave thought to the human suffering under liquidationist policies. Jim Rogers and Jim Grant, among others, rarely ever talk about whether the policies they support will ever be supported by more than 1% of the population or whether the system will survive (unlike Weimar Republic which disintegrated into Nazi Germany.) This is probably why Austrian economists will never be elected to power—they ignore the 'political' in 'political economy'. Don't get me wrong: I actually support most of the issues than AustEcons promote when it comes to liberties and trade; but I have little sympathy for their concern over deficts during a depression or their call to let the whole financial system collapse.

If you read what Samuelson says here—his entire college class unable to find work; a big county in the state of Georgia with, roughly, just 10 people with decent income—you can see why fiscal spending was needed and how most of FDR's actions were constructive.

Milton Friedman

Samuelson: ...And when I went quarterly to the Federal Reserve meetings, and he [Milton Friedman] was there, we agreed only twice in the course of the business cycle. .

Conor Clarke: That's asking for a question. What were the two agreements?

Samuelson: When the economy was going up, we both gave the same advice, and when the economy was going down, we gave the same advice. But in between he didn't change his advice at all. He wanted a machine. He wanted a machine that spit out M0 basic currency [aka monetary base] at a rate exactly equal to the real rate of growth of the system. And he thought that would stabilize things.

Well, it was about the worst form of prediction that various people who ran scores on this -- and I remember a very lengthy Boston Federal Reserve study -- thought possible. Walter Wriston, at that time one of the most respected bankers in the country and in the world fired his whole monetarist, Friedmaniac staff overnight, because they were so off the target.

But Milton Friedman had a big influence on the profession -- much greater than, say, the influence of Friedrich Hayek or Von Mises. Friedman really changed the environment.

Interesting to see the contrast between various economic theories. For what it's worth, my opinion as an non-economist is that I think Keynesian supporters make a mistake when things are going up (i.e. good). There is a temptation to spend too much (by the government) and print too much money (by the central bank). So no one is perfect in my eyes.

Alan Greenspan & New-Classical Economics

The craze that really succeeded the Keynesian policy craze was not the monetarist, Friedman view, but the [Robert] Lucas and [Thomas] Sargent new-classical view. And this particular group just said, in effect, that the system will self regulate because the market is all a big rational system.


And this brings us to Alan Greenspan, whom I've known for over 50 years and who I regarded as one of the best young business economists. Townsend-Greenspan was his company. But the trouble is that he had been an Ayn Rander. You can take the boy out of the cult but you can't take the cult out of the boy. He actually had instruction, probably pinned on the wall: 'Nothing from this office should go forth which discredits the capitalist system. Greed is good.'

However, unlike someone like Milton, Greenspan was quite streetwise. But he was overconfident that he could handle anything that arose. I can remember when some of us -- and I remember there were a lot of us in the late 90s -- said you should do something about the stock bubble. And he kind of said, 'look, reasonable men are putting their money into these things -- who are we to second guess them?' Well, reasonable men are not reasonable when you're in the bubbles which have characterized capitalism since the beginning of time.

Conor Clarke: But now Greenspan admits he was wrong.

Because we had, instead of three standard deviations storm, a six standard deviation storm. Well, we did have something unprecedented. I think looking for scapegoats and blame can be left to the economic historian. But, at the bottom, with eight years of no regulation from the second Bush administration, from the day that the new SEC chairman -- Harvey Pitt -- said 'I'm going to run a kinder and gentler SEC,' every financial officer knew they weren't going to be penalized.

Self regulation never worked as far as macroeconomic events -- whether we're talking about post-Napoleonic War business cycles or the big south sea bubble back in Isaac Newton's time, up to today's time. The pendulum just swings back in the other direction.

The problem with self-regulation is the same problem with communism. That is, some will be greedy and start abusing others while enriching themselves. It will work if everyone was virtuous but if the mortgage lenders were willing to accept knowingly fraudulent applications just so that they can make a quick buck, and if the investment bankers were willing to sell those mortgages knowing that they will make a killing and even if their firm goes down, well, they still keep their earnings.

Unfortunately, I think governments are going to end up over-regulating and hurting the economy in the process. But there is no way around this. The public is not going to put up with all the crazy financial shenaginans that have occurred. The US government hasn't done anything drastic yet but if there is another blow-up, say in the CDS market, watch out.

The Current Situation

And this is the main thing to remember. Macroeconomics -- even with all of our computers and with all of our information -- is not an exact science and is incapable of being an exact science. It can be better or it can be worse, but there isn't guaranteed predictability in these matters.


On the other hand, I think the popular view -- if I count noses -- is that by the end of this year even, or by 2010, recovery will have set in. That's a very ambiguous thing. Things could get better -- things could even get better such that the National Bureau committee that officially dates these recessions will say that the recession officially ended in something like December 2010. That could be misleading, because it could be completely consistent with continuing decreases in employability, an adverse balance of payments, and a move of both the consumer section and the investing section towards non-spending -- towards saving and hoarding. I don't think we would enjoy a lost decade, like the two lost decades the Japanese had.

My feeling, and I hate to say this, is that we will likely face a long slump. I call it the 'Long Recession' although many are calling it the 'Great Recession'. It's difficult to be optimistic when you realize how the economy was really weak after the dot-com bust and, if it weren't for the housing bubble, the economy would have been posting very low growth numbers for the entire decade. (Hardest hit will not be America; it will be the developing world.)

On Government Spending

Conor Clarke: I have a couple of questions about the current debate. Do you think large fiscal stimulus should be controversial? And would you like to see more of it? Would you like to see a second or third stimulus, depending on where you start counting?

Samuelson: Well, in the first place, the E. Carey Brown analysis stressed that one shot spending gives you only one-shot response. It's gotta be sustained. The way we got out of the 1929 Great Depression in the US -- and this happened not only in the US but also in Germany and each place in which there was almost a third unemployed --- was heavy deficit spending. It was not clever Federal Reserve policy, because early on the Federal Reserve had shot its bolt when we came near to liquidity trap.

I'll speak from some experiences. My father in law was president of a national bank in Vernon, Wisconsin, population 4,100 as of the last Census. His was the only bank in the first week after Roosevelt's bank holiday that was allowed to reopen. Why? Well, he knew every borrower and he knew better than they did what they could afford and what they couldn't afford. And so he came into the situation with a clean balance sheet.

You think 'Great, because we preserve the monetary supply in the system, right?' Not great. Because the average person did not go out spending and lending freely. He bought treasury bills for as little as half a percent per annum. So the system was frozen without these supplementary expenditures, where the WPA competed with the PWA and with the reconstruction finance corporation. For really depressed situations, unorthodox central banking is needed.

We're almost getting there. In one of Greg Mankiw's articles, he said that maybe when the interest rate gets down to zero and it's threatening to be negative, you should give a subsidy with it. Well, that's what fiscal policy is!

It's amazing to me that many are already complaining about government deficits. If the economy goes into a long slump, deficits won't even matter. People will literally save all their money and put it into government bonds yielding almost nothing. This is what has been happening in Japan for more than a decade and, as Samuelon describes above, this is what happened during the Great Depression.

I am not necessarily saying that we are at the stage of Japan or USA in the 30's but it is a possibility. If you have been reading articles lately, you'll know that American savings have been going up. Furthermore, some numbers seem to indicate that a greater portion of American government bond issues are being purchased by Americans. (In addition, if we enter a long bear market in stocks, then you will see even more savings being funnelled towards government bonds regardless of yield.)

Run On The Dollar?

By the way, I don't want you to think that I think that everything for the next 15 years will be cozy. I think it's almost inevitable that, with a billion people in China wide awake for the first time, and a billion people in India, there's going to be some kind of a terrible run against the dollar. And I doubt it can stay orderly, because all of our own hedge funds will be right in the vanguard of the operation. And it will be hard to imagine that that wouldn't create different kind of meltdown.

I'm not as bearish as Samuelson and think a run on the dollar is unlikely, even in 15 years.

First of all, even if the dollar declines substancially, it can be handled by the marketplace. I mean, the US$ already lost something like 30% from the early 2000's to the late 2000's and we handled it quite well. So another 20% or 30% drop or even 50% can be handled.

Secondly, Samuelson is overlooking the fact that countries like China and India pursue mercantilist policies. A lot of the imbalances is due to those policies. It will be difficult for these countries to dump the dollar without massive repercussions. For instance, if China dumps the dollar, it's possible that more than 50% of its manufacturing sector will implode instantly. So, if someone like China were to dump the dollar, it will be either gradual and/or will be after their local economies have been well developed (say China hits the level of South Korea, which will probably take 50 more years.)

On Bubbles & Rationality

Sameulson: And I'm not sure most of the people that get caught up in the middle of a bubble can be described as irrational. It seems pretty rational to buy a house and flip it in the next few weeks at a profit when that's been happening for along time. It works both ways.

Conor Clarke: The crowd mentality is maybe not rational.

Sameulson: Well, let's put that differently. It's not optimal. It's what it is. You have to cope with people. Now, if all the people had gone to the Wharton School and become very sophisticated that doesn't mean the society in which they lived and operated would be incapable of having a business cycle or bubbles. They're self generating.

Conor Clarke:So are people utility maximizing and rational and can we make sense of interpersonal comparisons of utility in a mathematical way?

Sameulson: No. But you know, people say, 'greed has suddenly increased.' But it isn't that greed's increased. What's increased is the realization that you've got a free field to reach out for what you'd like to do. Everybody would still like to retire with a satisfactory nest egg in real terms. And the tragedy of this unnecessary eight-year interlude is that much of what has been accumulated is gone and gone forever. And no amount of pumping is going to bring back into reality what were ill-advised overextensions of bridges to nowhere and housing developments for which there was no effective demand.

Interesting way of looking at bubbles. Samuelson is suggesting that the individuals partaking in a bubble aren't necessarily irrational—they are just un-optimal.


Certainly, some of the reasons the Chinese have stuck with huge amounts of reserves in very low interest rate US assets has been to keep the export led program that they espouse in existence. They can still succeed there by taking the reserves out of prime zero-interest stuff and putting it in our general stock market and so forth, the way Dubai and some of the other countries are beginning to do. So I think we've got -- in the long term -- a lull in our favor, but it's a lull in our favor that, rationally, is probably not going to persist.

Instead of a run on the dollar, what Samuelson suggests above (i.e. China possibly starting to buy American stocks instead of Treasuries) is probably what will happen. This process will be slow and I don't think it will be equivalent to a 'run on the dollar'. I interpret a run as occuring really quickly whereas the described process can take a long time.

Last Word of Advice to Economists

I'll let Samuelson finish off this long post by giving the last word on what economists should be doing (By the way, it's a point that I think is applicable to investors as well. If you have time to kill, you should read history)...

Conor Clarke: Very last thing. What would you say to someone starting graduate study in economics? Where do you think the big developments in modern macro are going to be, or in the micro foundations of modern macro? Where does it go from here and how does the current crisis change it?

Samuelson: Well, I'd say, and this is probably a change from what I would have said when I was younger: Have a very healthy respect for the study of economic history, because that's the raw material out of which any of your conjectures or testings will come. And I think the recent period has illustrated that. The governor of the Bank of England seems to have forgotten or not known that there was no bank insurance in England, so when Northern Rock got a run, he was surprised. Well, he shouldn't have been.

But history doesn't tell its own story. You've got to bring to it all the statistical testings that are possible. And we have a lot more information now than we used to.


A couple of thoughts on that World Bank report

The excuse given for the market sell off yesterday was the bearish World Bank economic outlook. Media is always looking to pin any market movements on some story so one can never be sure what the real cause may have been.

One might be tempted to lump the World Bank analysts into the group containing IEA and EIA (two energy agencies) as official members of the 'late to the party' club. Yet, I noticed two things that are quite surprising to me.

The first thing that stands out is how badly the developing world is forecast to be doing:

Developing countries are expected to grow by only 1.2% this year, after 8.1% growth in 2007 and 5.9% growth in 2008. When China and India are excluded, GDP in the remaining developing countries is projected to fall by 1.6%, causing continued job losses and throwing more people into poverty.

The 1.2% GDP growth for developing countries is terrible. The developing world tends to have higher population growth so these are the types of numbers that can cause crises—not just economic but also political. Even 6 months ago, which is not that far back, I doubt many would have ever forecast a sub-2% growth rate for the developing world. Remember, the developing world, for the most part, has little exposure to the financial crisis. That is, there are very few banks in the developing world, except in Eastern Europe, that are going bankrupt.

I am somewhat bearish and expect mild deflation so the World Bank numbers aren't a big surprise to me. When I heard the announcement yesterday, what was surprising, however, was that they revised down their estimate from April (or thereabouts.) Think back to April. That was when things looked really bad. This was before the green shoots started popping from the ground. Everything was going down and everyone was bearish. Yet, the current estimate is worse than what was made back then. It's pretty amazing to me that the current estimate was revised down from what was made in the dark days of April. It's possible that the World Bank is lagging badly but I suspect that's not the case. Instead, things are indeed quite bad and possibly even worse.

Having said all that, the stock market probably prices in most of this. My view is that the market is neither expensive nor cheap, and it can go sideways for a long time.


Work-sharing and the resultant deflation

One of the key elements that will dictate the outcome in the inflation vs deflation debate will be employee wages. For those outside North America, it should be noted that wages really haven't grown much in the last decade (in contrast, wages have been growing fairly strong in most of the undeveloped and developing world—I'm not too sure about Europe.) This is one of the reasons inflation in America and Canada has been quite low even with big increases in commodity prices, healthcare costs, and so forth. I'm just bringing this up because it shows that there is already a default deflationary force. The real question is whether this outlook has changed more towards inflation or deflation.

Notwitstanding the strike by municipal workers in Toronto and the potential worker boycott of Ontario's liquor board (both of them likely to increase wages when resolved), the current climate is starting to exert a downward force on wages in Canada. The following story from The Globe & Mail points out the increasing use of work sharing:

When its tractor sales to Russia plunged this spring, Buhler Industries Inc. BUI-T faced three tough choices: fire 90 of its workers, shut down its tractor-making plant for four months, or put its affected staff on a three-day week.

It chose the latter. As of this month, 200 Winnipeg-based workers no longer work Mondays and Fridays. Under a federal program, they collect up to 55 per cent of their salary through employment insurance for the two days they're not working. It means a drop in pay - but they're keeping their jobs.

Speaking as a low-level worker, I favour job sharing. Instead of someone losing their job, at least they will have some income. It may also help businesses in avoiding the loss of skills learned by their employees over the years. Job-sharing is supposedly common in Europe but is rare in North America. America, in particular, has generally always laid off workers outright and job-sharing is not that common (note that job-sharing may be common for those going on maternity or paternity leaves, and the like, but I'm not talking about those special situations; I believe it was also a bit more popular during the Great Depression in America.) That's why this is big news in my eyes. This is just one story, and it's in Canada, but I have seen similar ones in the press recently.

Regardless of what one thinks of the tactic, sharing a job, or reducing the hours, or similar policies, exert a massive deflationary force. The decline in income is substantial and the worker is almost certain to curb expenditures, hence hurting consumer consumption and providing less taxes. So far work-sharing is limited so it remains to be seen if it gains popularity.

Monday, June 22, 2009 0 comments ++[ CLICK TO COMMENT ]++

Political risk in M&A illustrated

The above chart of Verenex Energy (TSX: VNX) shows how M&A arbitrageurs need to carefully consider political risk. This was an M&A deal I was tracking closely and was thinking of investing in it if the return was 20% or more (it never hit my required level.) The stock is off around 20% right now and was down as much as 30% on news that Libyan authorities are investigating it.

Verenex is a small oil & gas exploration company operating in Libya. China National Petroleum Corporation offered to buy the company. The Libyan national oil company had right to match any offer and Verenex was waiting for approval from them. Well, taking a page out of the Russian government playbook, Libyan authorities are investigating the legality of Verenex's qualification for the field it purchased about four years ago:

Collectively, the two letters advise that legal authorities in Libya are investigating allegations that Verenex was improperly pre-qualified to bid in the EPSA IV first bid round in January 2005, under which Verenex acquired its rights to Area 47 in Libya. The letters further state that the ongoing investigation does not affect the rights and obligations of Verenex, and likewise does not affect the plans of the NOC related thereto, and the GPC has not provided its final decision on the NOC's intention to exercise a pre-emptive right.

Verenex considers these allegations to be without merit and vigorously denies them. No specific improprieties or details of the allegations have been provided to Verenex. The Company observes that the allegations are being made more than four years after the award of exploration rights in Area 47 under a transparent bid process and coincident with a request for consent for the sale of the Company.

The market was already accounting for the political risk, and anyone looking at a risk arbitrage position would have as well. It's always hard to peg the political risk involved in these deals. You can also never be sure that the company didn't anything illegal. Many small companies, but at times also large ones, engage in unethical and illegal practices, such as offering bribes, kickbacks, etc. I'm not saying Verenex was engaged in these activities but just saying that it is difficult to say what actually happens in those countries. It's possible that this is an attempt to scare off the Chinese or other potential bidders but one can never be sure.


A look at dividend payouts for the S&P 500

I came across a post by Howard Silverblatt at the Investing Insights blog at BusinessWeek talking about companies that are cutting dividends. Not surprisingly, Howard points out that companies are cutting dividends or cancelling them. He also refers to some interesting data from S&P that I analyze below.

I thought I would take a look at the dividend announcements that are being made; and how the present situation compares to the past. I wish I had access to a longer history but, alas, I have to go with what I can find freely. Unfortunately, the numbers I could find at the S&P site are quite limited and misses the results from the 1974 bear market, which is probably closer to the current bear market in terms of severity (actually, I would like to compare to the 30's but that is too far back and there isn't much (free) information available from that period, let alone anything about dividend announcements.)

I don't generally care about dividends—my ideal company is one that does not pay dividends and, instead, re-invests in high return projects—but dividends do provide powerful signals. For instance, a company will generally avoid cutting its dividend even if it faces financial problems. Some executives and insiders even go so far as to issue debt to pay the dividend rather than cut it. The goal here is to attract passive dividend investors and newbie investors who invest blindly based on dividends. I have cited the crazy example of AIG, which issued shares while increasing its dividend in the first quarer of 2008, all the while the company was just about to implode. A lesser damaging example involves the Canadian banks, who have been issuing a ton of (mostly preferred) shares over the last year rather than cutting their dividend. On top of diluting shareholders, some of the preferred shares seem to pay more than the dividend on the common shares (i.e. cost of financing the common dividend is higher than if it was cut.) However, I will admit that tax treatment may make preferred shares less costly than they seem so the Canadian banks aren't destroying as much shareholder wealth as it seems. So any cuts or cancellations should dividends should be viewed as powerful signals.

For macro investors, dividends are also useful in providing a valuation benchmark. I prefer to use P/E ratios but some like to look at dividend yield as well. High dividend yield implies the market may be cheap while low dividend yield may mean it is expensive. As with any valuation measure, it's not fool-proof and can take years to impact the outcome.

Dividend Announcements

One of the important things I wanted to look at was how present dividend announcements compare to past bear markets and economic recessions. Unfortunately, I couldn't find any data stretching back to prior bear markets. In fact, I couldn't even find data that goes to the 2000 to 2002 bear market :( So, my analysis here is not that satisfying (if someone has a Bloomberg terminal and has the same chart going back many decades, please e-mail it to me so that I can post it.) Anyway, the following chart plots dividend initiations, increases, cuts, and cancellations for S&P 500 companies:

The chart plots the number of announcements so keep in mind that the same company may make multiple announcements. A lot of the negative changes likely come from financial companies. Because the data doesn't go very far back, it's hard to say how the present compares to the past. All we can do is to concentrate on the last two years.

Given how I suggested that dividend cuts or cancellations aren't undertaken lightly by management, we can assume that the huge number of cuts and cancellations in the last year will have long-term consequences. In other words, insiders and management of these companies likely forsee, not just a short-term decline in profits but, some serious problems that may lurk for a long time. They wouldn't cut the dividend just because they faced one or two quarters of weak profits.

Perhaps the most interesting thing to me is how most of the negative changes occurred this year. I had the feeling, and maybe others following the financial crisis too, that serious problems started developing way back in early 2008. It's amazing that companies didn't do much until this year. I'm specifically thinking of financial companies who were facing mounting losses in 2008 and yet probably didn't do much until the first quarter of 2009. A lot of consumer discretionary companies have also been in a bear market for over an year and may not have curbed their dividends (perhaps they were waiting for Christmas to save them?). Of course, commodity businesses only got hit in 4Q07 so I can see them not doing anything on the dividend front until this year.

If dividend announcements are more positive in the future, it may imply that we have hit a bottom. This is something one may want to watch to confirm their bottom thesis. I suspect it will lag reality by many months so one probably can't trade off that but those who aren't traders and not trying to hit the exact bottom can use it to confirm their views.

Dividend Payout

Anyone looking at historical P/Es, especially the 10-year P/E (aka CAPE), can easily see that the late 90's was a huge bull market with valuations hitting the stratosphere. Well, you can also look at dividend yields as another measure of market valuation.

Some argue that dividends may not behave like they did in the past because companies buy back their shares a lot more (share buybacks only took off in the late 1980's). I personally dismiss that view and do not think share buybacks significantly altered the landscape. One can figure out if share buybacks have changed the investing world by looking at the dividend payout ratio now versus, say, the 70's (for those not familiar, the payout ratio is the percent of reported earnings that are actually paid out as dividends.) The following chart plots the dividend payout ratio and the trailing twelve-month (TTM) dividend yield:

As you can see from the chart, the payout ratio hasn't changed much over the last 30 years. It has hovered around 40%, with some spikes during recessions. You get these spikes because earnings drop during recessions but companies, as mentioned before, try their best to maintain their dividend. As mentioned earlier, some companies issue debt to pay dividends—not good for shareholders—and you can see this with payouts above 100% in 1991 and 2003. It should also be noted that a payout over 100% doesn't necessarily mean every single company is paying out more than they are earning. Instead, all it means is that the market as a whole is paying out more than they are earning. If you are a stockpicker then it may not matter much as long the company you own isn't paying out more than it is earning; but if you are a passive investor who buys the whole market index, then it does matter that there is more being paid out as dividends than are being earned.

As for the negative payout ratio in the 1st quarter of 2009 (the last data point), that's because the earnings are negative for the S&P 500. It's really confusing and hard to say if the negative earnings—all of it due to financial companies—are "real" or not. Bulls argue that negative earnings produced from marking assets to market will be reversed in the future. Bears argue that they won't reverse and the losses are real. My feeling is that the marks will reverse but the degree of reversal is hard to ascertain.

The data doesn't go back enough but the market was really overvalued in the late 90's given its dividend yield of around 1.5%. That is extremely low and we know, in hindsight, that the market was wildly overvalued in the late 90's (unfortunately the market is still not cheap right now, even after two major 50%+ crashes.) One should discount for the low bond yield in the late 90's as well but regardless of what you do, the market was overvalued.

The current yield of about 3% is back to the early 90's yield. If interest rates stay really low then stocks don't look that expensive. I think the yields will rise over time (although not any time soon) therefore dividend yields aren't high enough right now. If the dividend yield hits 4% to 5% then stocks are attractive for long-term investors (long-term bond yield averages about 4% so a dividend yield that beats that is generally favourable.) Issues such as political risk, inflation, taxes, and so forth need to be discounted for as well but I'm ignoring them.


Sunday Spectacle XIV

(Illustration by Raffi Anderian for The Toronto Star. "California Nightmare" by David Olive, June 20 2009)

Saturday, June 20, 2009 0 comments ++[ CLICK TO COMMENT ]++

Articles for the third week of June of 2009

Some articles one may find interesting... as usual, not in any order...

  • Business of movies (The Globe & Mail): A note about the present state of movies...also has an interesting note about movieds financed about private equity and hedge funds (I wonder if they are actually making money.)
  • An opinion on why USA remains the leader (The Globe & Mail): Historian Freedman says, the reason USA hasn't faltered while many others have come down to "...two features which distinguish it from the dominant great powers of the past. American power is based on alliances rather than colonies. And it is associated with an ideology that is flexible, potentially universal and inherently subversive of alternative ideologies." The author, interpreting Freedman's views, says "Democracy itself is the first explanation for American flexibility. Capitalism is the second. Liberal democracies make for flexibility by allowing discontent to be expressed, channelled and absorbed. Capitalism makes for flexibility by demonstrating that it can survive recession and depression without long-term damage to a country's global position. Democracy and capitalism can bring down governments - but won't bring down the state. " I concur with this view and think it captures why democracies and capitalism can out-last other econopolitical systems.
  • How Chicago-based Aon became the sponsor of Manchester United (The Atlantic): The last sponsor was AIG so let's hope the same fate doesn't befall on reinsurer Aon.
  • (Recommended) Recap of Warren Buffett's past shareholder letters (Wide Moat Investing): Wide Moat Investing has been going through Buffett's shareholder letters, starting in 1977. It's a good read for those who haven't read the letters, which shamefully includes me :)
  • David Swensen's Yale investment techniques very different from suggestions in his book or public comments (Investing Insights at BusinessWeek): I'm not a passive investor so I don't follow Swensen but the referenced blog entry points out how the strategies used by at Yale are different from the simple methods he has suggested. The author is also skeptical that the suggested asset allocation can avoid big losses. I have a feeling that a lot of passive investors blindly assume that their strategies involve less risk than active investing, and that their returns are going to be quite good (I also have a similar feeling with dividend-oriented investors who tend to imply that their portfolios are safer.)
  • The inflation case (Fortune): I'm not in the inflation camp but it's always worth hearing why some think that high inflation will be inevitable.
  • The anti-inflation case (BusinessWeek): Why high inflation may not materialize. For what it's worth, I think we will only get high inflation if government purposely pursue it. A lot of people who keep referring to countries with high inflation generally ignore the fact that those governments purposely pursued such policies. To pick an extreme example, the hyperinflation in Zimbabwe in the last decade was done on purpose and anyone living in Zimbabwe would have known that this was an "official" policy. Coming to America or Canada, past actions do not lead me to believe that high inflation is likely or will be pursued by anyone. However, an exception needs to be made for war. Governments almost always recklessly print money during wars—makes sense since lives and their existence are under threat—and my opinion is that the high inflation in the 70's was mainly due to the Vietnam War. Inflation in the 70's wouldn't have been so bad if it weren't for the heavy military spending in the 60's to the mid-70's. Barring a major war—Iraqi war is not major even though Americans are spending a lot of money—inflation seems unlikely. The important point is not the amount being spent per se. Rather, it is why it is being done. With war, high govt spending will be inflationary but the same amount spent to couteract destruction of capital (say real estate) won't have the same effect. (IANAE and these are just newbie opinion.)
  • Distillates weak in the US (MarketWatch): Demand for diesel, which is an oil distillate, looks really weak in the US. Diesel prices have declined below gasoline prices and this is supposedly uncommon. Refiners, who have had a few terrible years, might be hit really hard again this year.
  • Another black eye for Russia (New York Times): This NYT story covers the judgement by a Russian court against a Norwegian company, ordering it to pay a massive fine (for lost potential profits), and then seizing its Russian investment when it refused. I don't know who is at fault here but the court seems quite shady. Russia is basically becoming uninvestable (not sure if that's a word :)). I have never invested in any Russian company but did take a cursory look at several companies in the past. It's getting to the point where I may have to completely cross off the country from my investment list.
  • The charade that is known as annual shareholder meetings (The Economist): The biggest long-term problem—one without any obvious solution—is the poor corporate governance structures. I have ranted in the past against the nature of board of directors and how corporations are run. The Economist questions why institutional investors don't challenge executives or even show up in person for annual meetings.
  • Allen Stanford charged with $7 billion ponzi scheme (The Globe & Mail): Brings to close the mystery over the story that emerged earlier this year. Interestingly, a former Antigua regulator is also charged. If it weren't for Madoff, this would probably be the biggest scam (in nominal terms) in decades.
  • Investment spending in China not as bad as it seems (The Economist): The Economist has a bullish article on China, suggesting that capital investments by the government may not be as bad as some fear. I'm still cautious about China's economy but if they are indeed directing their investments towards the rural west or towards railroads, rather than in steel, real estate, manufacturing, and so on, it is a very good thing. This is an unfolding situation and it's too complex to see what the ultimate impact of any of this will be.
  • (non-investing) Some downbeat tunes capturing the economy (Financial Post): Recessions always leave a lasting impact on culture. The linked article mentions a slight shift towards gloomy tunes from established musicians. It remains to be seen what happens to the younger crowd.
  • (non-investing) Recession filtering into pop culture (Financial Post): As a film fan, the most interesting one for me will be Money Never Sleeps, aka Wall Street 2, but it is slated for a 2010 release. The script was probably written before 2008 (not sure) but it'll still be interesting to see the direction Oliver Stone takes this.

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