Summer Update

These last several months have been full of differing views depending on which media outlets you watch or read. What is most interesting is how most investment professionals lack the quality of being open-minded and believe their opinion to be the only truth. In fact, many follow a herd mentality and anchor on their beliefs to be the only view and will go to any length to prove their point. Recently, I have read some suggestions that our Government along with Wall Street and the Banks have a conspiracy to lie about the state of our economy for their own gain. I would assert that if this conspiracy were to really exist (I doubt that it really does) it is really in the best interest of our people. Many managers have very short memories and tend to forget where we were last October. After the failure of Lehman, AIG and Merrill Lynch were next on the chopping block. If it weren’t for the foresight of Mr. Bernake and Mr. Paulson, we might have had a systematic failure. It is always nice to criticize after that fact but without the intervention, our markets would have failed. There are still many risks that still exist such as the mortgage resets and rising levels of housing inventories. Also, the labor markets are far from being rosy which really impacts the consumer but there is a turn in many leading indicators. The credit markets are the first place to look to see if we are still repairing after the shock we incurred. Spreads continue to narrow in the corporate debt markets and with many securitized products, although some would argue that it is due to the stimulus from our Treasury and Fed. Either way, there is substantial improvement in our credit markets from where we were just a year ago. As the economy improves, so will our stock market and confidence will return to both the consumer and our corporations.

Real Estate Today

Today, many people are talking about the rebound in the Real Estate marketplace that is emerging. I have thought about this and feel that Americans are still very much overextended. Most people have much more debt in the form of mortgages, credit card and auto loans than they do in assets. In Los Angeles, many people I know earn a modest $250,000 and have a house that exceeds $1MM. Their debt level as a function of income is probably around 400-600%. By comparison, we look at the United States with a GDP of $14 Trillion and debt of $11.2 Trillion. That is only 80% of debt to income! This is a great concern because our savings rate is still very small. As the baby boomers get older and need to sell assets to keep up their lifestyle, they will sell their liquid assets and homes. This will keep a long term damper on the prices of homes in the US. We might very well see a stabilization of Real Estate but don't count on a rebound.

Turn of the Millenium

For the last 5 weeks, I have been connecting with something much larger than what our world news agencies have been reporting. Life still goes on and the world still turns. What began in mid-2007 as the beginning of a depression, now looks like it will be a prolonged recession. The economy still looks very bleak although signs of life are springing up in many nooks and crannies. It will most likely be another 6-8 months of labor pains and real estate declines but the stock market has begun what appears to be a turn towards more positivity. It has been noted by many great investors that our markets are Bi-Polar and now we seem to be approaching a more manic stage. The depressive state is subsiding and America is asserting itself as the world leader for the next century. This quarter might mark a return to growth that had fallen off a cliff. We will most likely look back at what Mr. Bernake and Geithner accomplished with much comfort that they staved off a systematic failure. It has been a long time coming with regards to changes in accounting and short selling rules. These changes are necessary for us to move from our current state to a more elastic economy. Using the past to dictate the future is a bad presumption. Learning to live in the present and to stop using models built on past perfomance will no doubt help us out of the mess created by the old guard. With Hedge Funds, Private Equity Funds and Investment Banks all under new regulations, risk taking should take on new dimensions. The next decade will be without a doubt be better than the one we just lived through. Staying positve is the first step.

Bernard Made-Off

All I can say is WOW! For someone to be able to accomplish a fraud like that, many people were well aware of this Ponzi Scheme. What I mean is that there will be a path that unfolds many peculiar aspects of the SEC to the NASDAQ. All money managers of that size are looked at or audited by the SEC and they usually do a very thorough job. Whoever was assigned that task at the SEC was without a doubt in Mr. Maddoff's pocket. My assumption is that almost everyone in the advisory part of this business was well aware of the scheme. I wrote almost two years ago about Hedge Funds and other investment businesses that were taking on too much risk or promised something that was unattainable. Now as the market corrects and deleverages, many strategies have been exposed that they don't work or were fraud. At this point, it becomes very hard to trust anyone with power of the degree of Mr. Maddoff but this should not be the case. Keep in mind there are many people like Warren Buffett to Shelby Davis who are very moral and have a very high degree of integrity. These are the people that we should be listening to and reading about. If you don't take the time to do the homework, you could end up like the investors of Maddoff Securities.

Capitulation?

This year has been historic in many ways, but the most important issue seems to be our economic state. Only since 1931 have we seen drops in asset values from Equities to Mortgage related securities all at the same time. Last Thursday seemed to mark an important day as many well known investors finally threw their hands in the air and believed this was truly the end of capitalism as we know it. We have had many jump starts over the last few months but Thursday's volume surge and large drop seemed to mark an important psychological point. Even Friday many were skeptical that we had seen a bottom as fundamentals diverged from market prices to very wide margins. By the end of the day we had recovered and saw a major bounce in the market averages. Corporate America seems to be doing better than most believe although Americans seem to be feeling very depressed. This feeling is very different than what most felt in the 1990's and what I would call bipolar. I have argued for years that Real Estate was very overvalued but I was not aware that we had leveraged ourselves to levels that were unheard of and our Regulators were supposed to be monitoring. Our Government was well aware of this as I recall Alan Greenspan speaking volumes about how great our Hedge Fund industry was and that liquidity was the most important aspect provided to our markets by many crooked billionaires. A consistent framework is very important so you can trust what you are reading, whether it be ratings from S&P or our own FDIC speaking about how our banking system is in great shape (that is from an interview on Kudlow & Company with Sheila Blair of the FDIC in February of this year). It sickens me that we have lost the trust of our people just because of lack of oversight as the world spins into a chaotic economic frenzy. We have seen similar times before but this time, it is my belief that many should be sent to prison for a very long time (I guess Enron taught us nothing). What has been a relief is the American people taking back their own country through an election to change the very problems that have plagued this Nation for more the 35 years. No longer will we be lead to believe that all is well. Businesses are stocks and should be treated as if we are owners, not passive investors with no say in how things are run. If that was the case, we should ban all Public Pension Funds from owning stocks and other risky investments. It is time to take back our future and it looked to me that the free markets did exactly that. I say this only because it is the crooked billionaires who seem to have really lost as their Hedge Funds have blown up, their tax loopholes will be closed and a better society will emerge. With time we will repair the damage done to our economy and the stock market will once again rebound to higher levels. This time, we cannot forget why we are in this position and I hope that people will begin to believe that this is the greatest country in the world with the best principals. It is this thought that makes me believe we have seen the worst in the stock market and better times ahead. That is why I believe we saw real Capitulation last week for the first time in my life.

The Oncoming Corporate Merger Mania

With the market declining over the last two months and all the cash on the sidelines (approx. $2.35 Trillion), it only make sense that corporate mergers, to some degree, will begin. In the late 80's after the 1987 crash, values dropped and money from Japan and Europe made their way into our markets with many acquisitions taking place from foreign companies. Today, we see a similar pattern taking place although the credit crises has made it more difficult for the LBO style takeover. Also, many companies seem "frozen like a deer in the headlight" as to how they should reallocate their resources, while they assess the availability of credit. Those companies who posses a liquid balance sheet may look to enhance their portfolio of business' by using their cash for investment rather than returning it to shareholders in the form of dividends and buybacks. This in turn could help our stock market as the buyouts will be much higher than the stock prices in our current market. Most likely, this will begin in the new year but it could start sooner. I speak of this only in terms of companies who take a long-term view of value and see that many great franchises are selling for pennies on the dollar. If this does take place, it might be the catalyst to move our stock market much higher. This has nothing to do with the recession taking place today, but more to do with CEO's looking to strengthen their position for the future. For a CEO to buy a business growing at 8-10% and most stocks selling at single digit multiples, it sure makes the present value very compelling. I hope the bankers are advising companies during the tumultuous time as first, a business should not be over leveraged, and second, it should posses the right liquidity to take advantage of the fear gripping Wall St. The argument of Decoupling has been answered and put to bed for now so we must look to see what the future holds for our corporations. This brings me to our current recession. Layoffs and resizing a business tends to happen within two quarters or so. Over time, this quick transition leads to V shaped recoveries in Corporate America, although our consumer is still in a very bad spot. I hope our new administration acknowledges the need further stimulus, just not in the form of direct payments to our citizens, but by using the funds to enhance our infrastructure. This would in turn reduce unemployment and bring life back to certain industries that have been crushed. It was a good idea to make sure our system is recapitalized by sending money to our financial companies (although they are still not lending) but we now need to focus our attention on the people. Using Federal Funds to help our country rebuild it's infrastructure will enhance jobs (of all kinds like construction to engineering) but is necessary for our own safety. Change is here and I think the chance to really make the US a great place can happen and will but it takes our corporations and government working together. Placing a greater safety net is not the answer by bailing out everyone. We need to let the weaker players use the bankruptcy courts to workout their situations and concentrate on how to help the larger percentage of our population.

Spreading the Wealth

Every day I drive home to hear smear campaigns that have no legitimacy. Ads that ATTACK the American People, that they should fear that their personal wealth is going to being distributed throughout society. Well folks, that has been going on for over 100 years. There are many ways our Government spreads the wealth by taxing corporations and individuals and utilizing the money to employ 35% of the workforce. What about Section 8 housing or even the Public Finance in general. We all work hard to build a nest egg so that one day we can retire, but a portion of that income is taxed and sent to the US Treasury and State Franchise Tax Boards. This money is redistributed to less fortunate people or to build new projects like bridges or schools. In the form of Public Finance, it is your property taxes that pay back the General Obligation Bonds that we all vote on to help improve our society. It seems that personal GREED has taken a very dark turn during this election and the use of FEAR seems very unethical. The average citizen in the US has no idea how our own system works, so hearing adds about your taxes going up and a redistribution of wealth taking place is ludicrous. It was proven just 10 years ago, with the fall of the Soviet Union, that having a society where intellect has no value, fails. From an economic standpoint, we can't raise taxes while in a severe recession, but in the future we need to show some responsibility for the last 25 years of spending. The reason for our recession is multi-dimensional but most importantly caused by the American People using too much credit and not saving. In fact, we have the lowest savings rate in the world. The real FEAR is that if taxes do go up, the ability of greedy Americans to service all the debt they incurred, from credit cards to 100% mortgages, will not be sustainable. Trust your Fed President as he understands these problems and how to tackle them. I only write this as we are being sold a false bill of goods during this election. Let's hope the American People can overcome these personal issues and look at our society as a whole to make our country a better place.

Decoupling

I was wrong back in June about how the market would break. I guess I was too optimistic as we saw the opposite of what I thought would happen, a 25% drop in the S&P. This has actually created many opportunities in both the credit markets and stock markets. It was thought just six months ago that by investing in BRIC countries you would protect yourself from our downturn. In fact, I argued with a PM at WAMCO about decoupling and how we buy the goods from the rest of the world. Meaning, if we go into a recession, theirs will be deeper and longer. This is now the case as everything as correlated. As fear abounds, smart investors are buying great franchises like American Express or Costco at bargain prices. I believe we are nearing the bottom of the margin calls and a turn in the market. Look for great returns over the next 5-15 years.

BofA aquistions of Merrill

The last few months have given us many surprises, one of which is the acquisition of Merrill Lynch by BofA. What I am having a hard grasping is that Countrywide had one of the riskiest mortgage books in America and for some reason BofA bought them at a very hefty premium, given the fact they were facing bankruptcy. As the management team at BofA reflect on how they can fix their financial strength, I laugh. Now they are going to buy Merrill Lynch for $50 Billion? It is my understanding that most of the Private Client groups will move and the Bankers (whom I just had dinner with) are leaving for Goldman Sachs, Morgan Stanley, Lazard and Evercore. What bankers like Ken Lewis don't understand is that their mindset is very different from an Investment Bankers and a very simple strategy of arbitrage from the Fed, borrowing cheap and lending at higher rates to individuals and companies isn't the same as Investment Banks who value Intellectual Capital with an entrepreneurial spirit. These differences make it impossible for BofA to really make something great with Merrill(not to mention Ken Lewis' ego). In the meantime, many firms will benefit from the brain suck that will happen at ML/BofA. I feel sorry that Main Street has got the short end of the stick again.

July 15th, 2008

This day will go down in history as capitulation was finally reached on the Financial Sector (not in the VIX). It is interesting that David Tice, Portfolio Manager of the Prudent Bear Funds (Short the Market) sold his company to Federated Investors the same day that Tom Brown of Second Curve Capital called a bottom, July 15th. If David really thought the market was going much lower he would have held the company closely while his shorts profited. Instead, he opted for a paycheck and less risk as a manager.

This brings me to commodities and hard assets. Most likely, commodities will come crashing back to earth, but Institutions are waiting to see which way the market breaks. We are at a critical point with $4Trillion in cash and the 10 day moving average just crossed the 30 day on the SPY so we are at a critical spot either up or down 20%. My belief it will be to the upside as all the durable goods orders and ISM numbers have been looking pretty good. Seems to have many similarities to 1974 when the Fed's actions were already helping the economy but not enough for Ford to win the election. By 1975 things were in an upswing but most didn't buy it. Sounds similar to today but staying out of the game does no good but promise you a loss at future buying power.

Naked Shorting

It sure is interesting that our SEC and our largest financial institutions are still under an "Emergency SEC Rule" against naked shorting. This is an illegal activity that has never been enforced though the average investor doesn't have access to this trade. DTC, the 19 Primary Dealers and many others have been engaged in a deceptive practice that is very profitable for them and their Hedge Fund clients. If Adam Smith were to see how we conduct ourselves on Wall Street, he would have flipped! The rich get richer and the poor get poorer.

Go back to July 9th of last year when the SEC did away with the "downtick rule" and think of the increased volatility since. Go to http://glickreport.blogs.foxbusiness.com/2008/07/29/the-sec-and-naked-shorting/ and listen to the CEO of Overstock.com at the bottom. It is understandable to see the declines of our banks given the nuclear waste they created but having two sets of rules in a supposed open market is absolute nonsense. Capitalism in America is not what most think it is. The destruction naked shorting has created is even more than the losses reported by our banks. This needs to be enforced for the whole market and rules need to be adhered to by all participants. A more detailed post is on the way but this has been on my mind for sometime.

Profits from Nowhere

I have discussed the gloom in the credit market for sometime but we can finally see the light. Wall St. is all about guessing too much, and usually they are wrong. For this purposes I introduce financial innovation. Financial Innovation got us to this spot, not to mention the governments prodding of subprime lending, but using our brains is the best way to contain a castasrophy. It seems that today markets are much faster moving and can fix themselves. That brings me to today. It looks like high quality bonds, real estate, and commodities have all run their course. Look for the dollar to increase against the EURO and the Pound and Domestic Stocks to surprise everyone. Stay high quality with good balancesheets and the returns will be great. Also, look that Private Equity stocks have to deleverage. With that, good luck over the next few months.

Government Bailout?

It has been a few months since I last posted anything about the markets. As I have said in the past, government intervention will be the main stimulus that will insulate the markets from major declines. Deleveraging is very painful and we are in the middle of repricing risk. That is why anyone you talk to that in the credit/real estate markets believe that a depression is on the horizon. History does rhyme but it never happens excatley the same. I would note that Wall St. has become to sophisticated for their own good. Structured finance might be the culprit but this was brought on by greed from Brokers, Appraissers and people in general. This will be the largest worldwide bailout in our worlds history.

Credit Crunch Revisited

Today, fear seems to be in abundance in our marketplace. The credit crunch has become increasingly risky to the continued growth of our economy as the Real Estate market continues to decline in value. The danger is that this credit readjustment has an impact on the business environment and that companies start to hold back investment and R&D spending. Also, many families are finding themselves with mortgages that reset from fixed rate to adjustable rate at much higher interest rates. With this backdrop, people have growing concerns about their ability to sustain their current lifestyle. It should be noted that adjustable mortgage resets peak in February 2008 at $52 Billion. With the Fed lowering rates, people are banking that all the adjustable rate loans can be refinanced into fixed rate loans like 2001-2005. Unfortunately, credit has been repriced in the market and spreads have widened to compensate for the risk of the borrower defaulting. This means mortgages are between 6.5%-10% depending on individual credit. The widening of interest rates and credit risk has spread to the banking segment of our economy. There are $750 Billion of M&A loans that need to be securitized along with all the real estate loans that haven't been able to be sold in the marketplace. This backlog needs to be worked off before Wall Street starts to make new loans. Credit problems seem to arise in mid-economic cycles as earnings from companies slow. Most of the problems we are seeing today in our markets are due to the lack of information available to the public from the banks and investment community. With time, this will pass and confidence will return to our financial markets. For the last 30 years, the Central Bank has done whatever it takes to get the markets moving again and this time is no different. It is my belief that the Holiday Season will be much better for retailers than expected and that our exports will help offset the Real Estate decline. This is where I differ greatly from most of Wall Street. Our economy is very resilient as exemplified by post 9-11. In fact, the S&P grew it's earnings by 105% from 2002-2007. Mid-cycle slowdowns are scary but a necessary part of a healthy economy. This slowdown is no different from others we have experiened over the last seventy years.

The Economy and Politics

For the last year we have been concerned about the housing market. Today, the hot word is sub-prime, although this buzzword isn't telling the whole story. It can be seen that new Real Estate projects are taking longer to absorb into the marketplace and new projects are still being built. This happened in the late 80's with the S&L's being the home for all the risky loans and junk bonds packaged by Michael Milken & Co. Today, this same process has taken place with hedge funds and European banks being the home for all our risky loans and junk. The Real Estate market still has a way to go before prices make sense and the impact on the economy might actually be pretty large. We see vacancies in our Malls rising to levels not seen since 1992. The Fed is the key to this dilemma but lower rates will not prop up prices. Our Real Estate problems are just the tip of the iceberg. Politically, we have even bigger issues. Iraq is costing over $1 Billion per month. My concern is that Iraq and other external political problems have taken our focus away from terrorism and corporate responsibility. As we approach the elections next year, we should note that having another Clinton in office would make our country much like a Monarchy. Having the Bush's and Clinton's running this country for 20+ years seems a bit too much. The electoral college must go and the popular vote should be used. These are just a few thoughts about the economy and politics.

Credit Rebound?

I began my blog by describing how our housing and securities markets were interacting with each other in ways that might turn out to be disastrous. It should be noted that adjustable mortgage resets peak in February 2008 at $52 Billion. With the Fed lowering rates, one should hope that the adjustable rate loans can be refinance into fixed rate loans like 2001-2005. Unfortunately, risks have been repriced in the market and spreads have widened to compensate for the credit risk of the borrower. That means mortgages are between 6.5%-10% depending on credit. This widening of interest rates has spread to the banking segment of our economy. There are $750 Billion of M&A loans that need to be securitized along with all the real estate loans that haven't been able to come to market. This backlog needs to be worked off before Wall St. starts to make new loans. These credit problems seem to arise mid-economic cycle as the economy slows down a bit. For the last 30 years, the Central Bank and Fed have done whatever it takes to get the markets moving again and this time is no different. It might take some time and new ideas but we can fix the credit situation. I hope it comes in the form of a coordination among Central Banks but you never know how Geopolitics will play into our economic problem.

Credit Crunch?

First, this should be taken as a personal explanation for the financial problems that have engulfed our credit markets since last February. It began with the risky lenders going bankrupt in February (although the underlying bonds representing their loans were never priced appropriately). This was caused when Bankers\Hedge Fund Managers and Portfolio Managers stretched for return and had no bearing of risk over the last few years when volatility was low. Over the last three months, most short term leverage (i.e. commercial paper and medium term notes) have been called by Banks/Wall Street Brokers and investors (or never rolled). This caused massive selling on the parts of leveraged Hedge Funds/CDO and CLV's. One positive note is that most of the assets that had been liquidated are high in quality due to the lack of bid for esoteric derivatives and mark to model non-rated debt held by these entities. This means that the Hedge Funds had to sell their stock positions and Treasuries to raise capital for margin calls and redemption's. In due time, the credit markets will begin to measure risk in in a prudent manner and the young managers will loose their jobs just like previous credit crunches. Times seem to repeat themselves. This time the global economy is in full swing and corporate profits look healthy. During this fallout, an overweight in high quality equities (especially International) as well as some corporate/AAA Mortgage Debt that has dropped in price during the credit crunch should be tactical. In the coming weeks, more news might hit like Countrywide or some small regional banks like Vineyard Bank might have further short term cash needs. This will cause more panic but these are just short term movements. Just remember that in 2002 many un-failable companies declared bankruptcy. This is not the end of the world. Just unraveling of a bubble. The market still looks poised to rebound this small correction and continue higher by year end. Again, 14,000 has been already crossed over. Remember, stay away from leverage a major correction in Residential Real Estate seems to be setting in.

Dow 14,000?

Even with the Subprime mess, companies are continuing to surprise the street with exceptional earnings. Most likely the Fed will keep interest rates steady even though most strategists think they will lower. Inflation is still a persistent problem even though China and other up and coming countries are making the world more competitive. One important aspect that most people don't pay attention to is the "pipeline" of M&A activity. That means the Investment Banks will have a windfall of profits this year. Couple that with a wide "crack" between crude oil and unleaded gas and you can see how profitable the energy companies will be again this year. Both those industries will surprise everyone. That is why they are all trading close to 10 times earnings. Another sector ripe for great gains is Technology. As people upgrade to Windows Vista (only 15% of computers are upgradable today), this will cause another spending boom that is long due. The last cycle was in 98' to 99'. These are important undercurrents that will help the market reach new highs. The S&P is fairly valued at 1700 and I see the Dow crossing the 14,000 mark by year end. Of course these are just predictions but let's see if I am right.

International

Given the decline in the dollar over the last year, it is a great idea to keep between 15-40% of your portfolio in overseas companies. One might also include Mulit-national corporations like GE or Coke because they derive over 50% of their revenues from countries other than the US. This should help balance the value of your dollar denominated assets with other assets that generate the revenues in other currencies like the Euro. For many, one idea is a Global Fund that allows the manager to decide where to invest. Emerging markets should only be a small percentage of the International allocation due to the risk inherent with their economies. Just remember what happened to Brazil and Russia in the 90's. There are many ways to make money investing and having a portion overseas will help with diversification.

Investment Market Outlook

The last few weeks have finally shown the world that volatility still exists and will suprise even the most sophisticated Hedge Fund Managers. What most people don't understand, is that the market looks forward about 6-8 months. This initital decline over the last few weeks is most likely an indication of things to come (mainly that China is overvalued and will not continue to grow it's GDP the way it has). I also believe that people are worried about our low savings rate, high debt, unbalance budget and that a decline in Housing Values will crimp the consumer. That means less electronics and clothing that is imported from overseas thus slowing the world economy. What has interested me for the last four months is the spike in premiums with the credit default swaps. Investors now believe the probability of a major financial institution collapse has grown. I think we have had 6 Subprime Lender bankruptcies in the last two months. It always begins in a far flug market, the subprime mortgage market this time and Malaysia in 97. Like Mr. Buffett says, expect what is unexpected and you shouldn't loose you shorts. Perception is the key to the market (albeit the manipulation being done by the large players of moving prices to make a quick buck) that will drive the price of all free markets. Riskier Assets will now be out of vogue as people shift to higher quality assets and Indexing becomes less advantages. I am not a dume and gloom investor but rather pointing out the negatives.

On the other hand, corporate profits are at new records and productivity seems to defy odds. The S&P's P/E is still trading under 20 and cashflow is at an all time high. I think stock picking is very important at this time and Munipal Bonds offer the greatest value for the yield. For the most part, our economy is in a great position but risks still might arise. In fact, there might even be some investment value's in the Real Estate sector when this all unfolds.