Friday, July 30, 2010

Same Conclusion for Different Reasons

Readers know I have been avoiding financial stocks all year. However, when great portfolio managers, like Bruce Berkowitz of the Fairholme Fund, argue just that financial stocks are great buys, one naturally has to wonder.

The International Monetary just issued a report that our financial system indeed remains very vulnerable to another crisis (1) because our regulatory structure is still too cumbersome, despite the new Financial Regulation bill, and (2) because the commercial real estate exposure of regional banks will be worse than expected.

My argument is that our financial system is vulnerable to another crisis because the explosive nature of derivatives has not been been contained, even by the new FinReg bill, which was a big disappointment.

If I am right, the crisis will produce a short but severe market reaction. If the IMF is right, it will be less severe but longer. But, for the sake of everybody, I hope Bruce Berkowitz is right!

Tuesday, July 20, 2010

The Persistence of Deflation

Tom Brokaw is the famed longtime anchor of NBC News and serious chronicler of generations. His recent study of the Baby Boomers found the belief common to most Boomers was that "things" would always get better, an undying sense of optimism.

As a Boomer myself, I plead guilty!

That's why it is so important to closely examine the bad news. We have seen deflation for the last three months, which is not good. My favorite economic cycle predictor, i.e., ECRI, thinks a serious downturn is coming, perhaps as serious as last year. In other words, they think a "double-dip" is possible. One of my favorite economic indicators is the Baltic Dry Index, which is a rough measure of international trade. It has turned very ugly.

Despite my Boomer optimism, I have to say the evidence is grim. Nonetheless, unless we have a financial "heart attack" which would come through the banking system, I still see the market trading in a relatively wide range of, say, almost a thousand points until later in the year. There is a great sense of unease about the markets today for several good reasons. But, the most important reason is the volatility, which occurs within that thousand point range. Volatility almost always increases when trading volumes are low, and trading volumes are almost always low during the summer time.

Deflation is more problematic. Ben Bernanke is often called "Helicopter Ben", resulting from a speech he gave a few years ago, quiping that deflation could always be cured by taking enough money up in a helicopter and raining dollars onto the economy. The classic Monetarist definition of inflation is too many dollars chasing too few goods. Raining dollars on the economy should cure deflation. That has not happened. Take a look at

If the economy softens this year, I'm not worried, because it will pass. If the market takes a swoon, I'm not particularly worried, because it too will pass. But, if deflation persists, I'll be very concerned . . . unlike a Boomer!

Saturday, July 17, 2010

Business Cycles, News Cycles & Other Knowns

An old Wall Street axiom is that the four most dangerous words are "This Time is Different".

Preceeding the last recession, it was widely believed this time was different because the new risk management techniques provided by derivatives, such as collateralized debt obligations, prevented any financial "blow-out". In fact, some argued that recessions were no longer possible, and that we were entering The Great Moderation instead of The Great Recession.

Prior to that recession, it was widely believed that the tech bubble of the late 1990s was also different because the increased productivity from technology would make everything more profitable, which justified the high share prices, relative to earnings per share.

I just finished reading This Time is Different by Professor Reinhart of the University of Maryland and Professor Rogoff of Harvard. In it, there is almost 800 years of data about financial crises in 66 different countries. It should not be surprising that they found very little is different before any of those crises. This is a great book but not a gentle read for the non-economist.

Frankly, it reminds me of the "Minsky Moment", named after the late Hyman Minsky, which essentially says debt will increase and increase, until it reaches that moment it can no longer increase and then collapses suddenly, causing a financial crises.

The investment implications of this today is to remember tomorrow that the four most dangerous words on Wall Street will always be the same . . . This Time is Different . . .

Thursday, July 15, 2010

Financial Re-Regulation . . . FAQ

Q. Is it over?
A. The bill has passed and will become law. However, any bill this important will require many months and years of regulatory implementation. As always, the “devil will be in the details”.

Q. Is this a disaster for banking U.S. system?
A. No, but it will require some change and increase compliance costs.

Q. Will the costs be passed along to the consumer?
A. Most of it, but probably not all.

Q. Will banks begin charging for checking accounts, etc?
A. Probably, that’s the price to the consumer for reducing the risks of “too big to fail” banks.

Q. Has the problem of “too big to fail” or taxpayer bailouts really been eliminated?
A. No, but it is unlikely any future bailouts will be paid entirely by taxpayers. The regulators will also be able to move faster.

Q. Will it preclude another financial crash?
A. Nothing can guarantee that, but this will provide better tools to deal with it, when it does happen.

Q. Are there any important lessons for bankers?
A. Yes, short term incentive plans have the potential to destroy our economy.

Q. Are you glad it passed?
A. Yes, because we can finally start reducing the uncertainty. Something had to be done soon.

Q. What do you like best about the bill?
A. It creates a new function of examining systemic risk, which has never existed. It will be interesting to see what they do.

Q. What do you like least about the bill?
A. It doesn’t deal with the problem of Fannie & Freddie. Solving that problem would have delayed the rest of the bill, which needed to get done now.

Q. Don’t you think there are already enough regulations?
A. Absolutely, we are already over-regulated but, more importantly, we are very under-punished. Convictions are too rare and way too light to be worrisome to somebody on the verge of making millions.

Pat . . . pat . . . pat . . .

That’s the sound of me patting myself on the back. Tuesday, the Fed changed their position, saying the economy was weaker than they earlier expected and that it could take 5-6 years for the economy to fully recover. Long time readers know I have been expecting a Nike Swoosh type of recovery, not V-shaped, nor W-shaped, but a long, hard slog back to recovery, primarily because it takes a long time to de-leverage. Glad to see the Fed with their acres of economists finally caught up! OK, I apologize and promise not to gloat anymore. But, it did make my whole day . . .

Tuesday, July 13, 2010

Guns versus Butter...Not Really

Recently, there has been considerable debate within the economic community about the cost of the wars in Iraq and Afghanistan. Some argue the cost should only include the money appropriated by Congress, which is a little over $1 trillion. (See

Others argue you should include the continuing cost of veterans’ care over their lifetimes or the wages a fallen soldier would have earned in his lifetime or interest on the money borrowed and other derivative costs. I’ve seen estimates from $3 trillion to $6 trillion. It is interesting to arbitrarily accept the lowest estimate of $3 trillion and compare it to the funds appropriated by Congress for the 2008 TARP ($700 billion) and the 2009 Stimulus Package ($787 billion)

That makes the wars twice as costly as TARP and Stimulus combined. To be fair, there are many other costs associated with the Great Recession, adding trillions to that as well, but I’ve seen no research on that yet. What makes this interesting is these war costs came just before the cost of huge deficit spending required by Keynesian economics to re-start the economy. This will become known as the “Keynesian Endpoint”, which means it doesn’t work past this point. We were already so deep in debt from the wars that the needed deficit spending is more than we can afford.

Sunday, July 11, 2010

The End is Near......Not

Earlier this month, a market analyst named Robert Prechter predicted the Dow would fall about 90% over the next six years, from about 10,000 to only 1,000. He is better known as one of the few surviving apostles of the “Elliott Wave Theory”, first developed by Ralph Nelson Elliott in 1939 but popularized by Prechter in a 1978book titled The Elliott Wave Principle. He’s been writing a monthly newsletter (at $19/month) on this ever since.

Quoting now from the widely respected Dictionary of Finance and Investment Terms, the theory holds that all human activities, including stock market movements, can be predicted by identifying a repetitive pattern of building up and tearing down, represented graphically as eight waves, five in the direction of the main trend, followed by three corrective waves. A 5-3 moves completes a cycle, althought cycles and the underlying waves vary in duration. Some practitioners believe the most recent “supercycle” began in 1932 and ended with Black Monday in 1987, indicating a 55 supercyle.

OK, that’s a mouthful but hold on!

There are numerous other “long-wave theorists”, such as my favorite, Nicholai Kondratieff, a brilliant Russian economist who served as Deputy Minister of Food in the early 1920’s at the tender age of only 25. He also saw a “supercyle” of 48-54 years. He saw this as an advantage for capitalistic systems, since the purging and destruction that occurred during the down-cycle only insured the “surival of the fittest”. Because he believed this made capitalism better in the long run, he was stripped of his office and finally died in a Soviet prison.

And, there are other long-wave theories. But, a few observations are appropriate. First, Elliott Wave theory says “all human activities” are governed by these cycles, even love and marriage. (I struggle with that one.) Second, Prechter’s cycle is out of sync, since it has only been 33 years since the last bottom. Third, some people need to feel a sense of pre-determinism, that all things are foretold, and will find Prechter’s prediction comforting, despite over-whelming evidence of what physicists can “randomness”. Fourth, a University of Michigan study found that 54% of people were more likely to believe an extreme forecast than a moderate one, in the believe the prognosticator wouldn’t make such an outrageous prediction unless it was certain. Lastly, I’m sure Prechter will sell more newsletters (at $19/month) now!

My belief remains that we are in recovery, with predictable hiccups along the way but still in a recovery. It is not a V-shaped recovery, like the stock market made. It is not a W-shaped recovery, because things will not be as bad as last year, either in the economy or in the market. I expect a recovery in the economy to look more like the Nike Swoosh, with a rolling bottom and a long, slow climb back to full recovery. The good news is that, once the economy recovers as much as the market already has, we can expect a return of the bull, a return of positive returns. While nobody knows when that will be, I’m confident it will be.