WealthTrack: Robert Rodriguez – concerned about the future

Tuesday, December 1st, 2009

This week Consuelo Mack is joined on WealthTrack by Robert Rodriguez of First Pacific Advisors. His 25-year track record of running both a top performing stock and bond fund has earned him the accolade “best fund manager of our time”. The outspoken Rodriguez - who sheltered shareholders from the credit crisis - explains why he is even more worried about the future and how he intends to invest as a result.

Note: The transcript of this interview is below:

CONSUELO MACK: This week on WealthTrack’s “Great Investors” series: he races Porsches for fun and runs top performing stock and bond funds for his profession. What makes First Pacific Advisors’ Robert Rodriguez step on the investment brakes or the accelerator? That’s next on Consuelo Mack WealthTrack.
Hello and welcome to this “Great Investors” edition of WealthTrack. I’m Consuelo Mack. This week our great investor is Robert Rodriguez, a maverick money manager who has accomplished a feat no one else has. For the last 25 years, he has run not one, but two top performing mutual funds, in not one, but two asset classes: a stock fund and a bond fund. As widely followed personal finance columnist Jason Zweig put it, that is the investing equivalent of running two marathons at the same time, which is why Zweig calls him the best fund manager of our time.
Rodriguez is the CEO of Los Angeles-based First Pacific Advisors and co-portfolio manager of FPA Capital, a mid cap value fund, and FPA New Income, his bond fund, which just celebrated its 25th year in positive territory. Last year he and his co-manager Tom Atteberry were named Morningstar’s fixed income managers of the year for their outstanding long-term stewardship. It is an honor Rodriguez has won two other times as well for both the stock and the bond fund, making him only the second fund manager to be honored three times. The first was last week’s great investor, Bill Gross.
Rodriguez, who races Porsches as a hobby, has a high octane personality but a low tolerance for investment pain. He knows what it is like to lose. A first generation American, his paternal grandparents lost everything in the Mexican Civil War of 1910. His grandfather did not survive the war. His grandmother and six children nearly starved to death. It took them almost six years to come to the United States legally, a route his grandmother insisted on taking so her children could walk down the street with their heads held high.
Throughout his 39-year investment career, Rodriguez has taken the high integrity path, sometimes to his business detriment. He was one of the first to rail against the dot-com and credit bubbles, raising large defensive cash positions, early moves that lost him clients. He is an outspoken critic of the U.S. government’s stimulus packages, burgeoning debt levels and business intervention. Four years ago he moved from California to Nevada to protest the golden state’s budget excesses and income taxes, the highest in the nation. And he does not mince words in criticizing Wall Street and the mutual fund industry. In a wide ranging interview, I asked Rodriguez about his exceptional track record which he attributes to discipline and the ability to balance fear and greed.

ROBERT RODRIGUEZ: I think we have a healthy dose here of skepticism about our capabilities. When you’ve had some serious failures, it forces you to look inwardly, and I don’t know of too many organizations where an investment professional puts his worst investment failure on his website. And it just tells you that no matter how skilled you are in this field, there are new ways to snatch defeat from the jaws of victory. So you have to balance these things. And we test ourselves daily on this, whether we’re correct in our assumptions, but we don’t want to let the day-to-day machinations in the marketplace disturb our long-term thinking.

CONSUELO MACK: You had in the Income Fund, you had your 25th straight up year, which is just unheard of. But in the FPA Capital Fund, in the stock fund, you had your worst year ever, down 35%, so what did you learn from last year?

ROBERT RODRIGUEZ: Well, we did as much as we could. I felt that by June of ‘08 there was nothing more we could do.

CONSUELO MACK: You had raised 45% cash?

ROBERT RODRIGUEZ: 45% cash, we’re getting redeemed, you can’t really take it any higher because the more higher you go, the faster the money goes out. So you have to strike a balance. And our largest exposure was to energy. We have a five and ten year horizon on, that we’ve been in the field for ten years after my being out of the sector for nearly 18 years. So there’s the long-term view versus the short-term risk. And we did reduce our exposure in energy, prior to going into it. And we said now it’s up to the gods. They went down with the market very hard and the first phase of an economic or stock market debacle, everything goes down. Then in the second phase they start to separate and in the third phase you start to see what really is going to work. Well, this year I would say what was taken away from us last year has been, a large part, has been given back to us this year for the right reasons. And so I have to think probably look at both years combined to say, all right, how did you go through this cycle, how did the others go through this? And then over the next five years, is your analysis correct? We happen to think it is, and if we are then our shareholders will be rewarded for that.

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CONSUELO MACK: You’ve quoted in one of your speeches and one of your shareholder letters too that legendary economist John Maynard Keynes describing the long-term investor as eccentric, unconventional and rash in the eyes of the average opinion, which fits you to a tee, actually. So where does the eccentric and unconventional side of Bob Rodriguez come from? Where did you get this?

ROBERT RODRIGUEZ: I really don’t like following the norm. If I follow the norm, I would never have been in this business. My last name is not a competitive advantage when I entered the field, and had to knock down a lot of doors, and you had to do things to separate yourself from the crowd, so that all started way back when I was very young. My first time I got anything to do with the investment field was writing a letter to the Federal Reserve chairman when I was ten. It was a school assignment.

CONSUELO MACK: And he wrote you back.

ROBERT RODRIGUEZ: And he wrote me back, and I said gee that’s kind of neat, how many people would do that. What’s the down side? So I started thinking differently about what the norm is, and then how can you turn that to your competitive advantage? So it’s always been that way. I would say when I was in graduate school or just going into graduate school, I discovered Graham and Dodd during the summer before I was coming back to graduate school. And it really struck home, and I had the good fortune of meeting Charlie Munger in our investment course there.

CONSUELO MACK: Warren Buffett’s kind of unknown partner.

ROBERT RODRIGUEZ: As Warren Buffett says, he’s the smart one. And after the class I asked him, I said what can I do to make myself a better investor, beyond just what I’m doing here and researching, et cetera? And he said, read history. Read history. Read history. And if people had read history about the economic crises of before, not only the depression but even before then, they would have said this is an old friend, and so that helped. It’s come from a number of different parts, but I think really not being afraid to fail and be different. That’s what it took in order to differentiate in this business.
I had a friend of mine who was a growth stock manager who got just before the debacle of 2000, we were having lunch together in January of 2000 and he was buying all this dot com, and I said why are you buying this crap? And he says, because you have to, he says yes, if I don’t buy it we won’t be competitive. I said, but don’t you realize, you are at the epicenter of a debacle that’s going to occur? And when you get destroyed, you know, you could either have cash or you can buy these things. If you have cash, you get fired. If you buy the dot-com and it blows up, you get fired. So in both cases you’re fired. What’s the difference? Over here the one with the cash, where you held your investment discipline, you can rebuild your business. Over here, you’ve destroyed your credibility, you can never rebuild.

CONSUELO MACK: Let’s talk about some of your unconventional current calls. You’re describing the current economic state that we’re in as a repression, which it’s not as bad as the Great Depression, but it’s also worse than a recession. Where is this repression taking us? What’s it going to feel like?

ROBERT RODRIGUEZ: Here in the firm, we’re using a new term for the economy. We’re calling it the caterpillar economy. Where it goes up and goes down, goes up and goes down, but it doesn’t move forward very fast, after this waterfall collapse that we had. And this is different from any other kind of economic environment that we’ve been in since the depression. You don’t destroy the consumer’s balance sheet, like what’s gone on. You don’t have the leverage in the system that we have and expect to come out of it the way we’ve come out of other periods. The president, I argue, that I think he’s on the wrong road and when I compare him to let’s say FDR. When he came into power, the debt to GDP was barely 17% when FDR came here, whereas now we’re now at 65% going to 75, going to 90% this year.

CONSUELO MACK: IMF says 100 some odd percent?

ROBERT RODRIGUEZ: Right. And by the way, those numbers when FDR came into power did not include, because we didn’t have any, entitlements. So if you add on the entitlements, it’s even far larger. So as I’ve argued, we do not have the balance sheet flexibility today as we did in FDR’s time. So if they want to go down, they being the Congress and the executive branch et cetera, and they want to build up these larger programs, they’re going to come at a price. And in our opinion that price will be in the debt market, and in the Treasury market longer term. With higher interest rates.

CONSUELO MACK: Bob, you saw the credit crisis coming about five, at least five years ago. And at that time you predicted that there was a new financial system that was going to be created and a new era. So what’s this new financial system that we can look forward to?

ROBERT RODRIGUEZ: I think, first of all, about four years ago we started talking about the breakdown in underwriting standards, et cetera. With the demise of Bear Stearns in March of last year, and what the response was by the federal government and the Fed, that’s when we wrote “Crossing the Rubicon,” that we had crossed over into a new financial era, a new system. And little did we know how far that was going to occur, within six months.
So we’re still in this process of defining what this new system is. As a result, it is very difficult to define what appropriate valuation levels are going to be, because the goal posts keep getting moved. Look at Chrysler- we were extremely vehement against Chrysler and what happened there, where senior secured creditors were treated in such a shabby manner, it really ran over, you know, the sanctity of contract. So we’re in a new system. That means the government is a larger percentage of GDP. The larger the percentage of GDP, the more likely GDP will grow at a substandard rate for an elongated period of time.
We’re in the group, and I’m in the group, where the new world order that you were referring to, that I’ve referred to, is that the U.S. is going to have to change its economic system; that our foreign counterparts that have basically grown on the backs of U.S. consumer have got to turn inwardly for their growth. As a result, as they turn inwardly for their growth, such as China, the U.S. has to expand its exports. I don’t see anything like that coming out of the administration or the incentives or anything else. As a result, the more the government takes a larger share of the economy, the likelihood we will be in a substandard period of growth and profit margins will also be substandard.

CONSUELO MACK: So how do you invest in an environment that is going to be substandard growth, that you don’t know what the rules of the game are because you don’t know what the government is going to do next, what do you do?

ROBERT RODRIGUEZ: It’s going to be very hard. As a result, on the fixed income side, we’re still maintaining our highest levels of quality. We haven’t gone into the lower rungs of the high yield area, even though there’s been big rungs there, because we think this is a head fake of what’s going on in the economy and this rebound, the green shoots that people talk about. So we’re going to stay high quality and let other people destroy themselves.
On the equity side, we think you have to be very focused in terms of the industries you go after. So we have a natural decline rate in, let’s say energy, supplies of energy. So we think longer term- three, five, ten years. Energy prices are going to be considerably elevated from where they are today. So we have a heavy exposure there.

CONSUELO MACK: Heavy, like 55% of the FPA Capital Portfolio, is that right, is in energy?

ROBERT RODRIGUEZ: Well, about 41% of the total portfolio, about 55% of the equity. Okay. So we’re looking for other areas to deploy capital that will both benefit from the international side but also from the commodities side.
So we see, you have to be rifle shooting over the course of the next five years or ten years, and that’s why I gave a speech in Chicago at Morningstar that in my opinion, a highly diversified equity fund in this new order will be at a competitive disadvantage, especially if it carries management fees, et cetera, so you’re going to have to do something different from the rest of the market in order to differentiate again, and that’s what we’re doing.

CONSUELO MACK: So let’s talk about the investment industry, which you have been highly critical of, and the OPM attitude, “other people’s money” attitude that you feel that the industry has been excessively greedy, not really paying attention to shareholders interests.

ROBERT RODRIGUEZ: Let’s say abusive. I mean, how are mutual funds sold? They’re brought out when the particular area is the hottest. So you sell what you can sell, and most of the time that is the absolute wrong time to be marketing that kind of product. So it’s not investment oriented, it’s marketing oriented. It’s a marketing mindset, and as long as we have a marketing mindset in the industry and managers are fearful of under performing their bogey and having what we call tracking error where you deviate too far from your benchmark and god forbid you have too much volatility: all of these things will work to hit the industry. With this collapse, with the technology collapse and now with the credit collapse, the question I’m asking is: if active managers could not identify the two greatest speculative blowoffs in the last 75 years, when will they? And secondly, what are you buying from an active manager if they can’t identify these things? You might as well go to an index.

CONSUELO MACK: Talk to me though about the shakeup that you think is going to happen in the mutual industry. Tell me what kind of a shakeout you expect.

ROBERT RODRIGUEZ: I just think that first of all, we have too many funds. When you sit there with 8,000 funds, and then you have 25 different share classes, it’s quite complicated. And what is the investor getting for all of that? There’s an expense to that, and the higher the expense in a lower return environment means you have less margin of safety for a total return.

CONSUELO MACK: So let’s also talk about the fact that you are a long-term investor, but you told me that you look out– some people say long term like a couple of years, you’re really talking about five to nine years. And you made a decision about six years ago to take a sabbatical next year from your firm in 2010. And one of the reasons that you decided to take a sabbatical as well is because you looked out beyond the current crisis and you see something even bigger and scarier coming?

ROBERT RODRIGUEZ: I see another crisis coming.

CONSUELO MACK: What is that and like when?

ROBERT RODRIGUEZ: It’s the explosion in the treasury debt, and the finances of this country. We still have time. But to, shall we say, become fiscally responsible. Am I optimistic about us doing that? No. You’re residing in the state of California that I left here four years ago, because in my opinion, the system was fundamentally broken and the state was going to experience a devastating recession on the down side.

CONSUELO MACK: Which it is right now.

ROBERT RODRIGUEZ: Which it is right now. I believe the system in
Washington is fundamentally broken. And as a result, the explosion in dealt that I foresee in the next three years and if other programs are added on it will accelerate it, then I think we have a real problem brewing in our finances here. I’m estimating somewhere in the neighborhood of five to seven years from here.

CONSUELO MACK: Do you envision any time in FPA Income basically going out the risk curve a little bit? I mean, is there anything– you’ve got about 90% in triple A rated securities in the portfolio?

ROBERT RODRIGUEZ: We are 22% in cash and we’re barely over a one-year duration. We’ve had as much as 25% of the fund in high yield. We would love to go out on the risk curve. In the last six months, eight months, it’s been highly profitable, just like the stock market has rallied. Is this sustainable? We don’t think so. We think there’s other dominos to fall that can disrupt this. So we don’t like the odds. Plus in New Income, people come into the bond fund in New Income because they can trust it. It’s when they couldn’t trust virtually anything else in this country, other than Treasuries, our bond fund grew in the neighborhood of 60 to 80%. People came in because they could trust it. Well, here we are saying, how do we be good stewards going forward? Do we bet with other people’s money or do we invest as if it’s our money? That’s what we’re doing, we’re waiting for that opportunity.

CONSUELO MACK: Bob, what’s your advice to individual investors who have had severe wealth destruction in their investment portfolios over the last couple of years? How can they rebuild that kind of wealth loss?

ROBERT RODRIGUEZ: I wish there was an easy, nice comforting answer to it. Unfortunately, there isn’t. In my opinion it will take probably upwards of eight or ten years for the S&P 500 to get back to where it was in October of ‘07. And thus there has been severe capital destruction, and for some it’s permanent because of where they are in their life cycle. If you’re in your 20s and 30s and 40s, you have the benefit of time. If you’re in your 60s and you’re part of the baby boom generation and you got destroyed, guess what, you better be working. You better find a job. Those things there. You move in, you may become a renter out there.

CONSUELO MACK: If can you sell your house.

ROBERT RODRIGUEZ: Well no, the house gets taken, at least if they would allow it to go. But there is no God given right to an easy retirement. It was a fool’s paradise out there. My parents and grandparents did not have an easy retirement. The world is unsafe and unstable. We had in this country, I believe, a perverse view of what reality truly was, and now that veil is being lifted, and I’m sorry, but it’s going to take a long time and that nice retirement home or continuous vacations may not be there.

CONSUELO MACK: You told me that you see things that other people don’t see.

ROBERT RODRIGUEZ: Sometimes.

CONSUELO MACK: So what are you seeing now that other people aren’t seeing?

ROBERT RODRIGUEZ: I think the difference is many of us see the buildup of federal liabilities. But there’s this feeling, well, it’ll be okay, we’ll get through it. Well, that was the same not too long ago when the house prices were going through and people would raise the question, what happens if housing prices get hit? Don’t worry about it, we’ll get through it. There’s always that element. So I think the question is, as you have to place the odds, what are the odds that we’ll get through this with the least amount of pain? I think that’s where the difference comes.
If you want to be on the optimistic side and say we’ll get through it and you’re wrong, your shareholders pay for it and your clients pay for it. If we’re right and we’ve done our job correctly, we protect capital in the negative side, and if we’re wrong, we just don’t earn as much as our competition. I think that’s a better combination than destroying your clients and saying, well, we’ll go out and get some more new clients out there. I don’t like that one.

CONSUELO MACK: That’s a great way actually to end the interview. So Bob Rodriguez, thank you so much for giving us your time.

ROBERT RODRIGUEZ: Thank you.

CONSUELO MACK: Next week in our “Great Investors” series, we are devoting our program once again to one of the money managers we have identified as the next generation of great investors. AQR Capital Management’s outspoken managing and founding principal, Cliff Asness, will discuss how he is applying his value oriented and computer driven hedge fund strategies to the mutual fund world.
In the meantime, to access the collective wisdom of our other great investors, go to our website, weathtrack.com. Have a great weekend and make the week ahead a profitable and a productive one.

Source: Wealthtrack, November 27, 2009.

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WealthTrack’s Great Investors: A Conversation with Robert Rodriguez

Sunday, July 12th, 2009

This week in WealthTrack’s series on “Great Investors”, Consuelo Mack travels to Los Angeles to interview Robert Rodriguez, CEO of First Pacific Advisors. His 25-year track record of running both a top-performing stock and bond fund has earned him the accolade “best fund manager of our time”.

“The outspoken Rodriguez who sheltered shareholders from the credit crisis explains why he is even more worried now about the future and how he intends to invest as a result.”

Note: The transcript of this interview is not available yet, but will be posted hear as soon as it arrives.

Source: WealthTrack, July 10, 2009.

Tags: Accolade, Bond Fund, Ceo, Credit Crisis, First Pacific Advisors, Invest, Investors, Mack, Robert Rodriguez, Running, Shareholders, Top Performing Stock, Travels, Wealthtrack
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Words from the (investment) wise for the week that was (Dec 8 – 14, 2008)

Sunday, December 14th, 2008

Despite a litany of bleak economic and corporate news confronting investors during the past week, global stock markets digested the bearish fodder with a sense of aplomb. The MSCI World Index and the MSCI Emerging Markets Index gained 4.4% and 10.9% respectively on the week, with other reflation trades such as gold (+9.1%) and oil (+20.4%) also putting in a strong performance.

But investor angst was never completely allayed as seen from the yields on US one- and three-month Treasury Bills briefly trading in negative territory for the first time since 1940, indicating the willingness of risk-averse investors to pay the government for the “privilege” of holding their money. Three-month T-Bills ended the week in positive territory but barely so at a minuscule 0.036% yield, indicating that liquidity was still being hoarded. (Also see my “Credit Crisis Watch“.)

Source: Nick Anderson, Slate

The week kicked off on a positive note after US president-elect Barack Obama had spelled out his plans on Sunday for the biggest infrastructure investment in the US since the 1950s. According to CNN, Obama said: “We understand that we’ve got to provide a blood infusion to the patient right now to make sure that the patient is stabilized. And that means that we can’t worry short term about the deficit [which might surpass $1 trillion before his spending plans are included]. We’ve got to make sure that the economic stimulus plan is large enough to get the economy moving.”

“The resultant infrastructure and physical assets will be far better than endowing busted banks, insurance companies and other financial entities with US taxpayers’ cash, which effectively goes down a black hole,” remarked Bill King (The King Report).

Financial markets reacted negatively to the US Senate’s failure to agree on a $14 billion loan to the troubled automakers. The prospect of the biggest industrial failure in US history caused a sell-off on global stock markets, a widening of credit spreads and an onslaught on the US dollar.

However, the US Treasury was quick to signal its readiness to provide funds to prop up the “Big Three”, as quoted in the Financial Times: “Because Congress failed to act, we will stand ready to prevent an imminent failure until Congress reconvenes and acts to address the long-term viability of the industry.” This indication resulted in an improved tone on financial markets by the close of the week.

Next, a tag cloud from the plethora of articles I have devoured over the past week. This is a way of visualizing word frequencies at a glance. Key words such as “credit”, “debt”, “economy”, “Fed”, “government”, “market”, “rates” and “stock” occur often, but “gold” is also becoming increasingly prominent.

Back to the issue of markets shrugging off bad news for the second week running. Richard Russell (Dow Theory Letters) commented as follows: “On top of everything else, Lowry’s Selling Pressure Index dropped substantially yesterday [Wednesday] and is now in a definite declining trend. At the same time, Lowry’s Buying Power Index is trending higher. Thus, the odds are saying that the trend of the stock market is turning up.

“This is all the more dramatic since this potential upturn has arrived in the face of black-bearish news. Markets bottoming and rising in the face of bearish news are often the most profitable ones. I have never seen a bear market hit its low amid happy news headlines.”

On a fundamental note, 39% of the constituents of the MSCI World Index sell at a discount to shareholders’ equity. “The cash-rich companies allow investors to pay nothing for future earnings streams,” said Jean-Marie Eveillard in an interview with Bloomberg.

A positive for the bulls is that the period post Thanksgiving through the end of the year has usually been a bullish time for stocks, based on studies by Jeffrey Hirsch (Stock Trader’s Almanac). Should the bullish seasonal tendencies provide a tailwind on this occasion, possible first targets are the 50-day moving averages of 8,784 for the Dow Jones Industrial Index (current level 8,630) and 910 for the S&P 500 Index (current level 880).

The last word on equities goes to Hong Kong-based Puru Saxena: “I cannot say with any certainty whether we are already in the early stages of the next cycle. Under my best case scenario, we are in the very early stages of a new multi-year bull market. And under my worst case scenario, we are going to get a very strong rebound (30% move higher in the S&P 500) over a short period of time, which will probably take the markets back to their 200-day moving averages.”

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy
“Global business confidence has been shattered. Sentiment is equally negative in North America, South America and Europe. Asian business confidence is not quite as dark, but it is falling rapidly,” said the latest Survey of Business Confidence of the World conducted by Moody’s Economy.com. “Pricing power is quickly evaporating and approaching that which prevailed in 2003, the last time deflation was a concern.” According to the survey results, the global economy is suffering a severe recession.

Economic indicators released in the US during the past week mostly pointed to a deepening recession.

BCA Research said: “The year-end spending season will be the biggest bust in several decades, as consumers have been hit by a double whammy: a meltdown in financial and residential asset prices; and a sharp rise in layoffs. The government’s failure to deliver a fiscal stimulus plan and unfreeze the credit markets imply that the recession will deepen and any recovery will be pushed farther into the future.

“The contraction in payrolls and economic growth will persist until there are some signs that policy actions are finally becoming effective. The fiscal stimulus plan needed to stabilize the economy will be massive and policy rates will stay near zero for a long time.”

The precarious position of the US consumer is illustrated by a plunge of 21.9 points to 63.7 in the annual average of the University of Michigan Consumer Sentiment Index - the largest annual average decline in the history of the Index which began in 1952, according to Asha Bangalore (Northern Trust).

The Fed fund futures are pricing in a 76% chance of a 75 basis-point cut in rates from 1.0% to 0.25% when the FOMC meets on December 16.

However, Bill King questioned the Fed’s approach: “[Effective] Fed funds traded at zero late last night. We have screamed for months that the official or ‘target’ Fed funds rate was irrelevant because the effective funds rate was much lower, and near zero. Now Fed funds are trading at zero. Yet there will be pundits and experts that will assert that the Fed might cut its target funds rate this week to 0.50% or even 0.25% - even though the cut in the target rate is meaningless. Now that the Fed is paying interest to banks, why did the Fed allow the funds rate to trade at zero? Yep, they are terrified by something.”

Also, the Fed is considering issuing its own debt to further expand money supply without clogging up bank balance sheets and making it harder for the Fed to maintain interest rates at the desired level. RGE Monitor said: “… there are upper limits to Treasury issuance and lower limits to the amount of Treasuries the Fed can sell off from the asset side of its balance sheet. One hurdle to issuing Fed bills: The Federal Reserve Act doesn’t explicitly permit the Fed to issue notes beyond currency.”

Elsewhere in the world, economic reports compounded anxiety about a severe global recession. Specifically, Chinese exports in November declined by 2.2% from a year earlier as a result of a drastic slowdown in demand in many of its main markets. The figures were far below forecasts and the +19% figure for October. “This is the worst collapse in Chinese exports since 1999 and is probably just the beginning of a prolonged export contraction,” said Isaac Meng, economist at BNP Paribas, as reported by the Financial Times.

Week’s economic reports
Click here for the week’s economy in pictures, courtesy of Jake of EconomPic Data.

Source: Yahoo Finance, December 12, 2008.

In addition to interest rate announcements by the FOMC (Tuesday) and the Bank of Japan (Thursday), next week’s US economic highlights, courtesy of Northern Trust, include the following:

1. Industrial Production (December 15): The 1.4% drop in the manufacturing man-hours index in November suggests a 1.0% decline in industrial production. The operating rate is projected to have dropped to 75.7. Consensus: -0.8%; Capacity Utilization: 75.7 versus 76.4 in October.

2. Consumer Price Index (December 16): A 0.7% decline in the CPI is forecast for November versus a 1.0% drop in October, reflecting largely lower energy prices. The core CPI is expected to have moved up by 0.1% after a 0.1% decline in October. Consensus: 1.3%, core CPI +0.1%.

3. Housing Starts (December 16): Permit extensions for new homes fell by 9.2% in October, inclusive of a 12.6% drop in permits issued for single-family homes. These figures suggest a sharp drop in housing starts (730,000). Consensus: 740,000 versus 791,000 in October.

4. Leading Indicators (December 18): Interest-rate spread and money supply are the only two components likely to make a positive contribution in November. Stock prices, initial jobless claims, manufacturing workweek, consumer expectations, vendor deliveries, and building permits are expected to make negative contributions. Forecasts of money supply and orders of consumer durables and non-defense capital goods are used in the initial estimate. The net impact is a 0.5% drop in the leading index during November, assuming building permits fell. Consensus: -0.5 %

5. Other reports: NAHB Survey (December 15), Current Account (Q4) (December 17), Philadelphia Fed Survey (December 18).

Click here for a summary of Wachovia’s weekly economic and financial commentary.

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, December 12, 2008.

Equities
Global stock markets rallied strongly during the past week as bargain-hunters looked past the grim economic and corporate reports. Both mature and emerging markets participated in the rally, as shown by the gains of the MSCI World Index (+4.4%) and the MSCI Emerging Markets Index (+10.9%). Notwithstanding the improvement, these indices were still down by 47.4% and 58.8% respectively since the peaks of October 2007.

Particularly noteworthy, the MSCI Emerging Markets Index has been outperforming the Dow Jones World Index since late October (rising green line), after a period of solid underperformance from May to October (falling line).

The chart below shows the performance of the four BRIC countries since the November 20 lows. Brazil (orange line), India (green) and Russia (red) have all recovered sharply, but China (blue) has underperformed after initial outperformance following the climactic[MR2] November 10 sell-off.

Click here or on the thumbnail below for a (pleasantly green) market map, obtained from Finviz, providing a quick overview of last week’s performances of global stock markets (as reflected by the movements of ADR stocks).

The Dow Jones Industrial Index was one of the few major indices to record a negative return during the past week, with US markets in general lagging other bourses as shown by the major index movements: Dow -0.1% (YTD -34.95), S&P 500 Index +0.4% (YTD -40.1%), Nasdaq Composite Index +2.1% (YTD ‑41.9%) and Russell 2000 Index +1.6% (YTD -38.8%).

The bar chart below shows the US sector performances over the week, and specifically how strongly energy and materials have recovered. Nine of the ten best-performing groups were related to commodities (diversified metals & mining, coal & consumable fuel, aluminum, steel, gold, oil & gas drilling, oil & gas exploration & production, gas utilities[MR3] , and oil & gas equipment & services).

Jamie Dimon, JPMorgan Chase’s (JPM) chief executive, prompted a sharp fall in financial shares with a warning that his bank was having a tough fourth quarter after a “terrible” November and December. Goldman Sachs’ (GS) earnings report on Tuesday is keenly awaited.

Based on the outperformance of emerging-market stocks and the sharp recovery of commodity-related groups, it would appear that investors are becoming less risk averse. Another example is the outperformance of small caps since the November 20 lows. A study published by Bespoke on December 8 highlighted the decile performance of stocks in the S&P 500 Index based on market cap. As shown by the chart below, the two deciles of the largest-cap stocks in the S&P 500 increased by about 17%, while the decile of the smallest-cap stocks was 54% higher.

Fixed-income instruments
The yields on government bonds generally edged up during the past few trading days after a record-breaking plunge since the beginning of November.

The UK ten-year Gilt yield increased by 17 basis points to 3.60% and the German ten-year Bund rose by 26 basis points to 3.30%. Although the US ten-year Treasury Note yield declined by 7 basis points to 2.59% on the week, the yield edged up from an earlier five-decade low of 2.48%.

John Hussman (Hussman Funds) expressed his concern about the level of Treasuries: “The problem with Treasury yields here is that while there are good economic reasons for the downward yield pressures, the levels are low enough to invite explosive spikes that can easily wipe out a year or more of yield-to-maturity in a few days.”

Emerging-market bonds moved in an opposite direction to mature bonds, with the JPMorgan EMBI Global Index gaining 2.4% during the week.

US mortgage rates were almost unchanged on the week, with the 30-year fixed rate rising by 2 basis points to 5.71% and the 5-year ARM declining by 1 basis point to 5.95%

The CDX and iTraxx credit indices, US Treasury Bills and high-yield spreads are still at distressed levels. Some improvement has been seen as a result of the central banks’ actions, notably the tightening of the TED and LIBOR-OIS spreads, and lower mortgage rates. However, credit spreads need to narrow further to indicate that liquidity is moving freely again and credit markets are starting to thaw. (Also see my “Credit Crisis Watch“.)

Currencies
The US dollar fell sharply as the recent relationship between risk aversion and dollar strength weakened as a result of US-specific factors like the deterioration in the US trade balance and the automaker woes. The greenback plummeted to a 13-year low against the Japanese yen and touched its lowest level against the euro for seven weeks.

As shown by the chart below, the dollar has broken below its 50-day moving average and seems to be topping out. Are foreign investors coming to the conclusion that the US currency, which briefly last week yielded a negative yield, is no longer an attractive option?

Over the week the US dollar lost ground against the euro (-5.0%), the British pound (-1.8%), the Swiss franc (-3.6%), the Japanese yen (-1.8%), the Canadian dollar (-2.0%), the Australian dollar (-3.0%) and the New Zealand dollar (-2.2%). The US currency also fell against emerging-market currencies[MR4] , like the South African rand (-2.0%).

The British pound came under renewed pressure as the worsening economic situation triggered concerns of a currency crisis. Sterling’s trade-weighted index fell to its lowest level since record-keeping began in 1981.

Commodities
The Reuters/Jeffries CRB Index (+8.8%) closed higher by the end of the week - only its sixth positive week since commodities peaked early in July. The Baltic Dry Index - a benchmark for shipping major raw materials including coal, iron ore and grain - bounced by 15.2% from very oversold levels.

The graph below shows the movements of various commodities over the past week, indicating an improvement across the whole complex (with the exception of natural gas) as a weak US dollar pushed prices higher.

The International Energy Agency urged a “substantial” cut in Opec output when the oil cartel meets next week, as global oil demand this year is expected to contract for the first time in 25 years. The price of West Texas Intermediate crude surged by 20.4% in expectation of a cut of at least 1 million to 1.5 million barrels a day.

Gold bullion (+9.1%) remained in favor with investors as a result of a solid supply/demand situation, store-of-value considerations and a weaker US currency. The chart below illustrates the strong inverse relationship between gold (green line) and the dollar (red line). In addition, gold has broken above its 50-day moving average (blue line) and trades at about the same level it started off in January 2008 - quite a feat in these difficult markets. Platinum (+4.9%) and silver (+8.5%) improved in tandem with the yellow metal.

After the storm comes the calm. With only 12 more trading days remaining before we wish the tumultuous 2008 goodbye, let’s hope the calm lies just ahead. And as Richard Russell reminds us: “Calm after a bearish trend is usually bullish.” Meanwhile, the news items and words from the investment wise below will hopefully assist in steering our portfolios on a profitable course.

That’s the way it looks from Cape Town.

Source: Dave Granlund

YouTube: The twelve days of bailouts
A bailout song for the holidays.

Source: YouTube, December 6, 2008.

New York Magazine: Oracles of doom
They always knew the economy would collapse. What do they think will happen next?

FORTUNE TELLER: Gerald Celente
Trends Research Institute founder; owner of collapseof09.com

TRACK RECORD
Predicted 1987 crash, 1997 Asian currency crisis; said in 2007 that US was headed for “economic 9/11″ in 2008.

CURRENT PREDICTION
“Products are going to be cheaper to buy, but guess what? You’re going to need more dollars to buy them because your dollar’s going to be worth less. There is no fiscal or monetary policy that can save this. You cannot save it by printing more money.”

FORTUNE TELLER: Nouriel Roubini
NYU business professor; chairman of RGE Monitor

TRACK RECORD
Predicted this year’s crisis in 2006, pointing to a housing bust, oil shocks, and interest-rate increases.

CURRENT PREDICTION
“It’s becoming a global recession. I expect it to be the worst US recession of the last 50 years. I expect a cumulative fall in output from the peak of 4% and the unemployment rate going all the way to 9%.”

FORTUNE TELLER: Peter Schiff
President of Euro Pacific Capital

TRACK RECORD
Published “Crash Proof: How to Profit From the Coming Economic Collapse in February 2007″; star of YouTube video “Peter Schiff Was Right 2006-2007.”

CURRENT PREDICTION
“I predicted that the economy would collapse. The bigger risk I saw was the government’s attempt to solve the problem by doing exactly what they’re now doing. They’re going to create another Great Depression, but worse, because the cost of living will go through the roof.”

FORTUNE TELLER: Richard Russell
Founder of the Dow Theory Letters

TRACK RECORD
Predicted bottom of 1974 bear market; exited market before crashes in 1987 and 2000.

CURRENT PREDICTION
“As long as we can hold the Dow above 7,470, I think the situation is hopeful. That’s the halfway level from when the bull market started in 1982 and when it ended in 2007. My guess is that it will break that level. Most bear markets have wiped out more than 50% of a bull market.”

FORTUNE TELLER: Barry Ritholtz
CEO and equity research director of Fusion IQ; blogger at The Big Picture

TRACK RECORD
Predicted downturn last year.

CURRENT PREDICTION
“In March, the first-quarter numbers start coming out, and that’s potentially a problem. It’s just going to be an issue of dealing with the market. If earnings continue to drop and you end up with multiple contractions, that basically takes you to a really bad, ugly place, which is an S&P at 400 or 500. I don’t think that’s likely, but it’s certainly possible.”

FORTUNE TELLER: Jeremy Grantham
Co-founder and chairman, GMO LLC

TRACK RECORD
His 1998 ten-year forecast showed severe market declines in 2007 and 2008; warned of global bubble in April 2007.

CURRENT PREDICTION
“I would think, just to guess, that the period of heroic volatility will end pretty soon and will be replaced by a rather 1974-ish environment, where you quietly get bitterly resigned to your steady diet of bad news.”

Source: Jeff VanDam, New York Magazine, December 7, 2008.

CNBC: Merrill Lynch - outlook for 2009
“An economic and investment outlook for 2009, with Merrill Lynch’s Richard Bernstein and Davis Rosenberg.

Source: CNBC, December 11, 2008.

Financial Times: Obama to focus on stimulus not deficit
“Barack Obama on Sunday spelled out his plans for the biggest infrastructure investment in the US for half a century. The president-elect argued that with the economy reeling, his incoming administration could not afford to worry about a spiralling budget deficit.

“Mr Obama’s proposals for government works on roads, bridges, internet broadband and school buildings, together with energy efficiency measures and health spending, are far more detailed than the normal announcements during a time of transition.

“At a time of deepening economic gloom - with half a million jobs lost last month alone - president George W. Bush has been largely absent from the recent economic debate. Mr Obama is highlighting his concern at the depth of the recession he will inherit, while fast-tracking his plans to counter it.

“‘Things are going to get worse before they get better,’ Mr Obama said on Sunday on NBC’s Meet The Press. He emphasised that his plans represented the largest US infrastructure programme since the federal highway system in the 1950s.

“‘The key is making sure we jump-start the economy in a way that doesn’t just deal with the short term, doesn’t just create jobs immediately, but also puts us on a glide path for long-term sustainable economic growth.’

“Noting the US budget deficit might surpass $1,000 billion before his spending plans are factored in, Mr Obama added: ‘We understand that we’ve got to provide a blood infusion to the patient right now to make sure that the patient is stabilised. And that means that we can’t worry short term about the deficit. We’ve got to make sure that the economic stimulus plan is large enough to get the economy moving.’

“He wanted a strong set of financial regulations to make banks, credit ratings agencies, mortgage brokers and others ‘much more accountable and behave much more responsibly’.

“‘I am absolutely confident that if we take the right steps over the coming months that not only can we get the economy back on track but we can emerge leaner, meaner and ultimately more competitive and more prosperous,’ Mr Obama said at a subsequent press conference.”

Source: Daniel Dombey, Financial Times, December 7, 2008.

Bill King (The King Report): Obama Plan one of the better plans
“The Obama Plan to spend massive amounts of money on infrastructure in the US is one of the better plans being proffered to keep the US out of a depression. But it has its drawbacks.

“Other stimulus plans put money or entitlements in US consumers’ pockets. Most of the money ends up in China, Japan or OPEC. Most infrastructure spending will remain in the US. And instead of just passing out checks or larger entitlements, jobs, mostly temps, will be created and permanent assets will result.

“The resultant infrastructure and physical assets will be far better than endowing busted banks, insurance companies and other financial entities with US taxpayers’ cash, which effectively goes down a black hole.

“Obama’s Plan will boost blue collar employment, provided a limited number of illegals are hired. This will produce an income shift to blue collar and lower middle class households. But fired employees of financial, high tech and other high-end jobs are unlikely to participate. So the multiplier effect of increased income will be less on the economy in general.

“The negatives of the plan, besides the massive debt and likely corruption, is that it does not remedy structural problems in the US economy and financial system. There will be few new industries spawned and therefore few permanent well-paying jobs. Nothing addresses the savings and investment problems.

“There is too much capacity in the world. There are hundreds of empty or abandoned factories in China alone. Until excess capacity is scuttled and new industries appear, stable employment is a fantasy.

“The real problem, the one that solons will not address, is the US welfare state is busted. The Keynesian and monetary stimuli that were abused over many decades to paper over welfare state spending are now being escalated to an unsustainable degree in a last grand attempt to salvage the welfare state system.

“Like all state attempts to stave off a debt deflation by running the printing press and nationalization, it will likely result in a massive inflation that destroys the nation’s fabric and the financial assets of the upper middle class and elites. The middle and lesser classes have few financial assets.”

Source: Bill King, The King Report, December 9, 2008.

Financial Times: Treasury signals rescue for carmakers
“The US administration was on Friday scrambling to save Detroit’s troubled car industry, as General Motors said it was closing most of its North American manufacturing plants for the month of January in the wake of the Senate’s failure to agree a $14 billion loan for GM and Chrysler.

“The US Treasury signaled it was ready to step in with funds intended to prop up the financial system to prevent the biggest industrial failure in US history.

“‘Because Congress failed to act, we will stand ready to prevent an imminent failure until Congress reconvenes and acts to address the long-term viability of the industry,’ the Treasury said.

“GM’s bonds fell to a new low of 9-10 cents on the dollar on fears of a bankruptcy by America’s largest domestic carmaker, before recovering to 15 cents on the news that the Bush administration was looking for alternative financing.

“For weeks George W Bush, the US president, has resisted using the $700 billion troubled asset relief program to provide aid to the carmakers, arguing that such an interventionist step would be a misuse of funds.

“However, facing the prospect of the collapse of one or more of the Detroit companies, the White House indicated it had few other options. ‘A precipitous collapse of this industry would have a severe impact on our economy and it would be irresponsible to further weaken and destabilize our economy at this time,’ said Dana Perino, White House spokeswoman, specifically noting the possibility of using Tarp funds.

“A Chapter 11 bankruptcy filing by GM, the world’s biggest carmaker, would mark the biggest industrial failure in US history.”

Source: Daniel Dombey, John Reed and Bernard Simon, Financial Times, December 12, 2008.

Reuters: Fed mulls issuing own debt
“The US Federal Reserve is considering issuing its own debt for the first time, the Wall Street Journal said, citing people familiar with the matter.

“Fed officials have approached Congress about the move, which could include issuing bills or some other form of debt and would provide the central bank with more flexibility to tackle the financial crisis, the Journal said.

“The Fed can already print as much money as it wants, but issuing debt is largely the province of the Treasury Department.

“The Fed stepped in with emergency credit for investment bank Bear Stearns in March and insurer AIG in September, and threw open its direct loan window to Wall Street firms this year in a bid to stabilize financial markets amid a credit freeze.

“But with the credit crisis showing no signs of abating, and the narrow scope for further interest rate cuts from the present levels of 1%, economists expect the Fed to look at new ways to boost the supply and circulation of money to avoid a deflationary slump.”

Source: Reuters, December 10, 2008.

Paul Kasriel (Northern Trust): The credit rating on a benevolent counterfeiter’s debt - infinity A?
“Why would the Fed be contemplating issuing its own debt? To soak up in the future some of the massive credit the Fed has created in the past year or so. Why would the Fed not just sell US Treasury securities from its portfolio in order to soak up this excess Fed credit? Because, as shown in the chart below, the Fed’s outright holdings of US Treasury securities has dropped from a shade under $800 billion to about $475 billion as Fed credit outstanding has risen from a little over $800 billion to about $2.1 trillion. In percentage terms, the Fed’s outright holdings of US Treasury securities has gone from a bit over 90% of reserve bank credit outstanding to about 22-1/2%. The Fed is afraid it might run out of US Treasury securities to sell!

“I can see nothing sinister about all this. It is not a conspiracy to print money. Just the opposite. It is a way to destroy some of the paper the Fed already has ‘printed’.”

Source: Paul Kasriel, Northern Trust - Daily Global Commentary, December 10, 2008.

Bloomberg: Fed refuses to disclose recipients of $2 trillion
“The Federal Reserve refused a request by Bloomberg News to disclose the recipients of more than $2 trillion of emergency loans from US taxpayers and the assets the central bank is accepting as collateral.

“Bloomberg filed suit November 7 under the US Freedom of Information Act requesting details about the terms of 11 Fed lending programs, most created during the deepest financial crisis since the Great Depression.

“The Fed responded December 8, saying it’s allowed to withhold internal memos as well as information about trade secrets and commercial information. The institution confirmed that a records search found 231 pages of documents pertaining to some of the requests.

“If they told us what they held, we would know the potential losses that the government may take and that’s what they don’t want us to know,” said Carlos Mendez, a senior managing director at New York-based ICP Capital, which oversees $22 billion in assets.

“The Fed stepped into a rescue role that was the original purpose of the Treasury’s $700 billion Troubled Asset Relief Program. The central bank loans don’t have the oversight safeguards that Congress imposed upon the TARP.

“Congress is demanding more transparency from the Fed and Treasury on bailout, most recently during December 10 hearings by the House Financial Services committee when Representative David Scott, a Georgia Democrat, said Americans had ‘been bamboozled’.

Source: Mark Pittman, Bloomberg, December 12, 2008.

The Wall Street Journal: Mayors get in line for US funds
“Big-city mayors will arrive on Capitol Hill Monday to lobby for more federal spending to be funneled to urban areas that they say drive the country’s economic engine.

“The push comes after a strong Democratic turnout in metropolitan areas helped President-elect Barack Obama - who is set to become America’s first urban president in almost half a century - win by such a decisive margin in November.

“A delegation of mayors, including Michael Bloomberg of New York and Antonio Villaraigosa of Los Angeles, plans to ask the federal government to distribute funds directly to cities instead of going through state governments. The group is set to present a list of more than 4,600 infrastructure projects that they say are ‘ready to go’.

“Tom Cochran, executive director of the US Conference of Mayors, which is organizing Monday’s event, said the next administration has signaled that it will coordinate financing for projects for an entire metropolitan area instead of dealing with cities and suburbs separately.

“‘I am of the opinion, based on our conversations with President-elect Obama, that he gets it,’ said Mr. Cochran. ‘You can’t just have a transportation system that stops at the city line.’

“Mr. Obama’s transition office is drawing up plans to create a White House office on urban policy, which would report directly to the president, to coordinate funding for cities from different federal agencies. Mr. Obama has pledged to provide new funding for job training, education and grants for local governments and organizations.”

Source: T.W. Farnam, The Wall Street Journal, December 8, 2008.

Bloomberg: Interview with Martin Feldstein
“Harvard University professor Feldstein discusses auto bailout, how to fix the housing market as well as Fannie and Freddie, and 3-month T-Bill rates below zero.”

Source: Bloomberg (via YouTube), December 9, 2008.

Ambrose Evans-Pritchard (Telegraph): Deflation virus is moving the policy test beyond the 1930s
“Debt deflation is tightening its grip over the entire global system. Interest rates are creeping towards zero in Japan, America, and now across most of Europe.

“We are beyond the extremes of the 1930s. The frontiers of monetary policy are being pushed to limits that may now test viability of paper currencies and modern central banking.

“You cannot drop below zero. So what next if the credit markets refuse to thaw? Yes, Japan visited and survived this policy hell during its lost decade, but that was a local affair in an otherwise booming global economy. It tells us nothing.

“This time we are all going down together. There is no deus ex machina to lift us out. Certainly not China, which is the most vulnerable of all.

“As the risk grows, officials at the highest level of the British Government have begun to circulate a six-year-old speech by Ben Bernanke - at the time of its writing, a garrulous kid governor at the US Federal Reserve. Entitled ‘Deflation: Making Sure It Doesn’t Happen Here’, it is the manual of guerrilla tactics for defeating slumps by monetary means.

“‘The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost,’ he said.

“His point was that central banks never run out of ammunition. They have an inexhaustible arsenal. The world’s fate now hangs on whether he was right (which is probable), or wrong (which is possible).

“As a scholar of the Great Depression, Bernanke does not think that sliding prices can safely be allowed to run their course. ‘Sustained deflation can be highly destructive to a modern economy,’ he said.

“Bernanke’s central claim is that the big guns of monetary policy were never properly deployed during the Depression, or during the early years of Japan’s bust, so no wonder the slumps dragged on.

“The Fed can create money out of thin air and mop up assets on the open market, like a sovereign sugar daddy. ‘Sufficient injections of money will ultimately always reverse a deflation.’

“Bernanke said the Fed can ‘expand the menu of assets that it buys’. US Treasury bonds top the list, but it can equally purchase mortgage securities from US agencies such as Fannie, Freddie and Ginnie, or company bonds, or commercial paper. Any asset will do.

“The Fed can acquire houses, stocks, or a herd of Texas Longhorn cattle if it wants. It can even scatter $100 bills from helicopters. (Actually, Japan is about to do this with shopping coupons).”

Source: Ambrose Evans-Pritchard, Telegraph, December 9, 2008.

Asha Bangalore (Northern Trust): Household net worth is shrinking rapidly
“Household net worth in the third quarter of 2008 was $56.5 trillion, down 4.7% from the second quarter. This is the largest quarterly decline since the second quarter of 1962 when net worth of households dropped 5.0%.

“Household spending will suffer as setback a household net worth shrinks, which is already visible in consumer spending data, and the proclivity of households to borrow will show a reduction. The chart below indicates that growth of both mortgage and consumer debt have fallen in the third quarter. The sharp drop in mortgage debt (-2.4%) reflects the impact of mortgage foreclosures and a drop in home purchases, while consumer debt grew at a 1.2% pace in the third quarter versus a 7.2% jump a year ago.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, December 11, 2008.

Asha Bangalore (Northern Trust): Weak trajectory for retail sales
“Retail sales fell 1.8% in November, after a 2.9% decline in the prior month. Retail sales have dropped for five straight months, the longest string of declines since record keeping for retail sales began in 1967. The wide swings of gasoline prices influence the headline of retail sales. Excluding gasoline, retail sales dropped 0.2% in November after a 1.6% plunge in the prior month. Retail sales excluding gasoline have recorded six consecutive monthly declines. Unit auto sales have fallen in ten out of eleven months of the year.

“The upshot is that with or without gasoline and autos, retail sales show an extraordinary weakness that is seen the overall consumer spending data and this weak trajectory for retail sales and overall consumer spending is predicted to prevail in the near term.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, December 12, 2008.

Asha Bangalore (Northern Trust): Consumer spending in post-war recessions
“The chart below illustrates the history of consumer spending during recessions. Consumer spending typically declines in recessionary periods with the exception of the 1948 and 2001 recessions.

“Our forecast includes five consecutive quarterly declines in consumer spending, possibly another record for the books if our forecast is accurate. The highly leveraged household balance sheet of households underlies this prediction.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, December 8, 2008.

Bloomberg: Inside look - housing crisis
“From Housing Forum in Washington D.C.: Interview with PIMCO Managing Director Scott Simon.”

Source: Bloomberg (via YouTube), December 8, 2008.

BusinessWeek: Unretired - retirees are back, looking for work
“They saved. They planned. Then housing tanked and the markets melted. Now they need jobs, and there aren’t any.

“Six years ago, Paul Nelson gave up his long career in the defense industry for what he thought would be a peaceful retirement in Tucson. The weather was mild, the neighbors friendly. He had plenty of time to volunteer and garden.

“But retirement hasn’t worked out the way he planned. In 2006 his wife of 46 years died unexpectedly. He tried to swap their house for a smaller one and lost a chunk of his retirement savings in the process. Then this year the stock market cratered, wiping out almost everything he had left. Now the 71-year-old is looking for work at local hardware stores and Home Depot and contemplating filing for personal bankruptcy. ‘I have nothing left,’ says Nelson, a former Raytheon engineer. ‘I am not alone, I think.’

“Far from it. An increasing number of people who retired in recent years, confident they had set aside enough to live on comfortably, are finding themselves strapped. The stock market plunge and the housing downturn have affected many Americans, of course. But retirees have been particularly pinched because their homes and investments are the primary assets they depend on for income. As a result, many of the country’s elderly are finding themselves in Nelson’s situation, low on money and looking for work. ‘Suddenly the rug has been pulled out from under them,’ says Alicia H. Munnell, director of the Center for Retirement Research at Boston College.”

Click here for the full article.

Source: Heather Green, Business Week, December 4, 2008.

Asha Bangalore (Northern Trust): Oil imports lead to wider trade gap in October
“The trade deficit widened to $57.2 billion in October from $56.6 billion in September. During October, exports (-2.2%) and imports (-1.3%) of goods and services fell.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, December 11, 2008.

Reuters: Jim Rogers calls most big US banks “totally bankrupt”
“Jim Rogers, one of the world’s most prominent international investors, on Thursday called most of the largest US banks ‘totally bankrupt’, and said government efforts to fix the sector are wrongheaded.

“Speaking by teleconference at the Reuters Investment Outlook 2009 Summit, the co-founder with George Soros of the Quantum Fund, said the government’s $700 billion rescue package for the sector doesn’t address how banks manage their balance sheets, and instead rewards weaker lenders with new capital.

“Dozens of banks have won infusions from the Troubled Asset Relief Program created in early October, just after the September 15 bankruptcy filing by Lehman Brothers. Some of the funds are being used for acquisitions.

“‘Without giving specific names, most of the significant American banks, the larger banks, are bankrupt, totally bankrupt,’ said Rogers, who is now a private investor.

“‘What is outrageous economically and is outrageous morally is that normally in times like this, people who are competent and who saw it coming and who kept their powder dry go and take over the assets from the incompetent,’ he said. ‘What’s happening this time is that the government is taking the assets from the competent people and giving them to the incompetent people and saying, now you can compete with the competent people. It is horrible economics.’

“Rogers said he shorted shares of Fannie Mae and Freddie Mac before the government nationalized the mortgage financiers in September, a week before Lehman failed.

“Now a specialist in commodities, Rogers said he has used the recent rally in the US dollar as an opportunity to exit dollar-denominated assets.

“While not saying how long the US economic recession will last, he said conditions could ultimately mirror those of Japan in the 1990s. ‘The way things are going, we’re going to have a lost decade too, just like the 1970s,’ he said.

” … Rogers said sound US lenders remain. He said these could include banks that don’t make or hold subprime mortgages, or which have high ratios of deposits to equity, ‘all the classic old ratios that most banks in America forgot or started ignoring because they were too old-fashioned’.

“‘Governments are making mistakes,’ he said. ‘They’re saying to all the banks, you don’t have to tell us your situation. You can continue to use your balance sheet that is phony … All these guys are bankrupt, they’re still worrying about their bonuses, they’re still trying to pay their dividends, and the whole system is weakened.’

“Rogers said he is investing in growth areas in China and Taiwan, in such areas as water treatment and agriculture, and recently bought positions in energy and agriculture indexes.”

Source: Jonathan Stempel, Reuters, December 11, 2008.

CNBC: Meredith Whitney - outlook grim for banks

Source: CNBC, December 7, 2008.

Financial Times: Post-Lehman company defaults to soar
“Default rates for speculative grade companies are forecast to jump threefold next year following the fall of Lehman Brothers, the world’s biggest bankruptcy, according to Moody’s, the US ratings agency.

“The implosion of Lehman on September 15 is widely regarded as a significant milestone, turning the credit crunch into a fully blown economic crisis.

“Jim Reid, credit strategist at Deutsche Bank, said: ‘We are at a turning point for default rates, with much bigger monthly rises from now on.

“‘Two or three months after Lehman’s collapse, we are starting to see the impact on the real economy, particularly for those companies on short-term funding.’

“European companies defaulting on their bonds are also set to outpace those in the US, although analysts suggest this is because the European junk-grade market is smaller, meaning any rise in defaults has a greater impact in percentage terms, rather than pointing to a deeper recession.

“Global default rates are forecast to rise to 10.4% by November 2009 - from 3.1% last month - to levels last seen in 2001 following the dotcom crash. Rates are forecast to jump to 4.2% by the end of this year.

“A year ago, the global rate was 0.9 per cent.

“The ratings agency’s distressed index, which measures the number of companies with bonds trading at more than 1,000 basis points over government paper, rose to 51.8% at the end of last month, up from 48.5% at the end of October, and the highest level since Moody’s launched the index in 1996. This reflects the deepening problems for company funding. Even some investment grade companies are now trading at distressed levels.”

Source: David Oakley and Paul J Davies, Financial Times, December 8, 2008.

Bespoke: 10-Year Treasuries overbought
“It’s an understatement to say that Treasuries are overbought at current levels. We’ve been monitoring the spread between its price and its 50-day moving average, and the 10-year Note has finally gotten to a level that is usually met with selling pressure in the near term. Since 1977, the 10-year has only gotten more than 12% above its 50-day moving average on three different occasions. As shown in the table below, the returns over the next week, month, and 3 months lean to the negative side. The average change of the 10-year over the next three months when getting this overbought has been -3.23%.”

Source: Bespoke, December 9, 2008.

Bespoke: Want to lend money to uncle Sam? It’s going to cost you
“What would your reaction be if you had a friend who had reached the limit on 20 different credit cards and then came to you to borrow $100? Then imagine that you actually said yes, and when you went to give your friend the $100, he or she actually asked for $101 just for the privilege of loaning the money. Well, that is exactly what is happening (to a lesser degree) in the US T-bill market. As just another example of the crazy times we are living in, the yield on 3-month Treasuries went negative today. There was a time when an event such as this was unimaginable. Today it barely gets noticed.”

Source: Bespoke, December 9, 2008.

John Hussman (Hussman Funds): Unusually unfavourabale yield levels for Treasuries
“In bonds, the market climate last week was characterized by unusually unfavorable yield levels and generally favorable yield pressures. As I have frequently noted, yield levels are much more important than market action in driving subsequent total returns in bonds. This is because bonds are less susceptible to ‘bubbles’ as a result of their payment stream being known, so favorable market action can’t be taken as evidence of favorable surprises in those payments.

“The problem with Treasury yields here is that while there are good economic reasons for the downward yield pressures, the levels are low enough to invite explosive spikes that can easily wipe out a year or more of yield-to-maturity in a few days.

“Corporate yields have increased significantly, but default rates tend to pick up in the later stages of recessions, and there isn’t much historical evidence to suggest that corporate bonds reach their lows any earlier than stocks do. For that reason, corporate bonds are essentially equity-equivalents here, and the same considerations about quality apply as well here as they do for stocks. Generally speaking, corporate bonds are currently priced to deliver both lower long-term returns than stocks, but as a group, will probably have lower volatility than stocks as well.”

Source: John Hussman, Hussman Funds, December 8, 2008.

Bloomberg: US Treasury risk surpasses Campbell Soup as debt increases
“The cost to hedge against losses on US Treasuries surpassed the price of default protection on bonds from Campbell Soup and drug-maker Baxter International as government spending on stimulus packages grows.

“Credit-default swaps protecting US government debt in euros for five years are trading at 65 basis points, according to CMA Datavision, meaning costs 65,000 euros ($84,200) to protect 10 million euros of debt. Contracts on Campbell were at 52.5 basis points and Baxter contracts were 57.5 basis points at the close of trading [on Wednesday] in New York.

“The Federal Reserve’s assets have more than doubled from a year ago to $2.14 trillion as the central bank seeks to revive credit markets. Economists including Harvard University professor Kenneth Rogoff and Nobel Prize winner Joseph Stiglitz say President-elect Barack Obama should push for a stimulus package of at least $1 trillion to lift the economy out of a yearlong recession. The US government’s total cost to bail out the economy may exceed $4 trillion, according to strategists including Ira Jersey at Credit Suisse Group AG in New York.

“Contracts protecting U.K. government debt for five years were quoted at a mid-price of 114.75 basis points today [Wednesday], according to CMA. Swaps on Italy are at 190, and the Netherlands at 99.5. France was quoted at 58.75 and Germany at 51.5, CMA data show.

“Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to meet its debt obligations. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.”

Source: Shannon D. Harrington, Bloomberg, December 10, 2008.

Jean-Paul Calamaro (Deutsche Bank): Credit markets offer stunning opportunities
“The crisis gripping financial markets has produced some stunning investment opportunities in credit markets. Among the best is the returns available on ‘basis trades’ between corporate bonds and credit default swaps, says Jean-Paul Calamaro, global head of quantitative credit strategy at Deutsche Bank.

“‘Investors buy a corporate bond and also buy default protection on the issuer via a CDS. When the basis is negative [CDS protection costs less than the bond’s spread to swaps] this produces protected cash flows and further profits if the difference between the bond and CDS narrows, or if the issuer defaults. The basis between bonds and CDS has been at historic wides recently, giving significant returns without using leverage,’ he says.

“‘The trade works for many investment grade and high yield issuers in Europe and the US, but high yield trades look most attractive.

“‘This is because investors can earn high returns more quickly when an issuer defaults and at this point in the credit cycle we think defaults are more likely. The trades also work in investment grade, not because we expect defaults but because we expect the basis between bonds and CDS to narrow.

“‘The major cheapening of bonds versus CDS across corporate credit has been due to the heightened funding crisis since the Lehman bankruptcy in mid-September. We believe conditions will start to ease after year end, which makes these types of trades unusually attractive now.’”

Source: Jean-Paul Calamaro, Deutsche Bank (via Financial Times), December , 2008.

Bloomberg: Cheapest stocks since 1995 show cash exceeds market
“Stocks have fallen so far that 2,267 companies around the globe are offering profits to investors for free. That’s eight times as many as at the end of the last bear market, when the shares rose 115% over the next year.

“Bank of New York Mellon in New York, Danieli in Italy and Seoul-based Namyang Dairy Products hold more cash than the value of their stock and debt as the slowing world economy wiped out $32 trillion in capitalization this year. Companies in the MSCI World Index trade for an average $1.17 per dollar of net assets, the lowest since at least 1995, and 39% sell at a discount to shareholder equity, data compiled by Bloomberg show.

“The cash-rich companies allow investors to pay nothing for future earnings streams, providing opportunities to buyers concerned about deflation, according to Jean-Marie Eveillard, whose $16 billion First Eagle Global Fund has beaten 98% of competitors this year. Microsoft and Novo Nordisk, which generate the most money compared with debt, can expand even if lower consumer demand erodes profits.

“‘Cash is king, not necessarily for the investor but for corporations,’ Eveillard said in an interview from New York last week. ‘It’s useful to sit on a ton of cash, No. 1 to survive, as opposed to going bankrupt, and No. 2 to seize opportunities either to make acquisitions cheaply or to squeeze competitors.’”

Source: Michael Tsang and Alexis Xydias, Bloomberg, December 8, 2008.

Richard Russell (Dow Theory Letters): “I’m beginning to like what I see”
“If they create enough of it, will they come and spend it? That’s what Mr. Bernanke is going to find out. The government has created over a trillion dollars of currency. There’s now over $8 trillion on the sidelines in money markets and T-bills - all frozen with fear and waiting for something better and safer to come along. There’s too much money now in relation to the quantity of goods and merchandise available. This is the formula for inflation or even hyper-inflation. What’s holding it all back? Lack of confidence, fear.

“What would change that? The stock market rising steadily would bring back confidence. Which is why I monitor the stock market so closely. Yes, it’s quite a game, and it’s the most important and fascinating game in the world. No wonder I’m in this business. I read the markets, and I’m beginning to like what I see!

“My guess is that the market is establishing a tradeable bottom with a rally that will last into the first quarter of next year. What we’re seeing now might not be the final bottom but it will serve until the real one comes along.”

Source: Richard Russell, Dow Theory Letters, December 8, 2008.

Richard Russell (Dow Theory Letters): Adding some selected stocks
“Up to now, our favored position has been cash and gold (preferably physical gold). Our new position is cash, gold and, for the bolder crowd, a few selected stocks (DIA if you’re a fearless, speculative type).

“Backing off: Subscribers may think Russell’s lost his mind. He’s turning just a bit bullish. The answer is that I’m reporting exactly what I’m seeing. And if what I see doesn’t jibe with what I’m reading in the newspaper and it doesn’t jibe with prevailing sentiment, then I think it’s that much more important. I keep hearing the most horrendous stories about unemployment and companies in trouble, and my thought is always, ‘Has this been discounted by one of the worst bear markets since the ’30s?’ Which is why I report every item that I see, every item that might suggest that the market has already discounted the bad news. The question always is ‘cut through the BS, what is the market saying?’”

Source: Richard Russell, Dow Theory Letters, December 11, 2008.

Puru Saxena: Sowing the seeds
“This nasty bear-market is in its latter stages and I suspect that the bulk of the declines are now behind us. Although it is premature to claim that the bear-market definitely ended on October 10, it does look increasingly likely that the lows recorded on November 21, were in fact a successful ‘test’ of the prior month’s lows.

“History shows that following a major bear-market, it is common for the major indices to retest the lows. In a recent study undertaken to review recovery patterns, JP Morgan examined all the bear-markets going back to 1900 and it came up with a few interesting observations. The study revealed that market bottoms were almost always retested and that such ‘tests’ resulted in a new marginal low about 40% of the time.

“The study also found that 75% of the retesting events occurred within 44 days of a major bottom; so if October 10 marked the bottom of this bear-market, the retest on November 21 was bang on target from a timing perspective.

“At this stage, I am only guessing that October 10 was the pivotal turnaround of this bear-market. It may well be that this market breaks below those lows in the days ahead, however given the favourable technical and sentiment data, at the very least, there is a strong possibility that we will get a multi-month rally from these oversold conditions.

“It is worth noting that new bull-markets are always born amidst abject pessimism; at a time when the majority are convinced that economic activity will never pick up again. Furthermore, it is interesting to note that frightening economic news continues to surface, long after a new bull-market has begun. So, the time to buy is during such scary times. This was also highlighted by Warren Buffet who recently wrote - ‘If you wait for robins, spring will be over’.

“Now, I cannot say with any certainty whether we are already in the early stages of the next cycle. However, the recent rout in the markets has set the stage for above-average long-term returns. Under my best case scenario, we are in the very early stages of a new multi-year bull-market. And under my worst case scenario, we are going to get a very strong rebound (30% move higher in the S&P500) over a short period of time, which will probably take the markets back to their 200-day moving averages.”

Source: Puru Saxena (via Fullermoney), December 10, 2008.

David Fuller (Fullermoney): S&P 500 at extreme divergence from its 200-day moving average
“We first posted this indicator on October 10 when the relevant spreadsheet was created for us by a subscriber. The indicator remains at a historically low level but has risen considerably from its early October nadir. This has been achieved by the relevant indices having gone mostly sideways for the last two months. The moving average is now starting to come down towards the price and while it still has a long way to go, mean reversion is taking place.

“This is not a guarantee that the market will not go lower later but, historically, when the market has diverged from its mean by such a margin, important stock market lows have occurred relatively soon afterwards.”

Source: David Fuller, Fullermoney, December 8, 2008.

Bespoke: Percentage of stocks above 50-day moving averages
“Even though the S&P 500 is in a new bull market, the percentage of stocks in the index trading above their 50-day moving averages is still at oversold levels. As shown in the chart below, at 26%, this indicator has a long way to go before becoming overbought.

“On a sector basis, Telecom, Utilities, and Consumer Discretionary have the highest percentage of stocks above their 50-days, while Energy and Financials have the lowest.”

Source: Bespoke, December 10, 2008.

Bespoke: Third worst bear market on record
“The S&P 500 finally had its first 20%+ rally in 408 days yesterday [Monday], which means we’re currently in a bull market by the standard definition (20% rally preceded by a 20% decline).

“… below we highlight historical bear markets for the S&P 500 since 1927. As shown, the bear market that ran from 10/9/07 to 11/20/08 is the third worst ever with a decline of 51.93%. The bears that ended in June of 1932 (-61.81%) and March of 1938 (-54.47%) are the only two that had bigger declines without a rally of 20%.”

Source: Bespoke, December 9, 2008.

Bespoke: US sector and stock buy ratings
“Below we highlight the average percentage of buy ratings for stocks in each of the ten S&P 500 sectors. As shown, Financial stocks have the lowest percentage of buy ratings of any sector at 35%, while Energy has the highest at 63%. Consumer Discretionary, Materials, and Consumer Staples are the three other sectors (along with Financials) that have below average buy ratings compared to all stocks in the S&P 500.

Source: Bespoke, December 8, 2008.

David Fuller (Fullermoney): Commodities - are they the most promising asset class today?
“I do think commodities have significant recovery potential, despite the global economic slump, deflation threat and depression fears. Moreover, I believe that the fundamentals for commodities have now improved more than for all other asset classes.

“Consider the following bull points:

1. Interest rates have fallen, which is currently better for commodity speculators than commodity producers, because contangos have shrunk considerably, lowering rollover costs.

2. However, the credit crunch means that it is now more difficult for commodity producers to obtain necessary financing. Consequently, miners and oil producers are deferring development projects and laying off workers, while farmers find it more difficult to finance the purchase of fertilizers and equipment. These problems are not fully offset by the lower cost of energy.

3. Prices for all commodities are much lower today than during the first half of 2008, not least because speculators have been shaken out and traders are actually short. This is good news for those who wish to buy oversold commodities. However it is a big disincentive for commodity producers, many of whom are now reducing production.

4. While the global economic slump has reduced demand for commodities somewhat, these are essential resources which the world cannot do without, unlike luxury goods, the latest fashions, lavish holidays or expensive restaurants.

5. The US dollar has peaked and commenced what is likely to be a significant retracement of gains seen since July. This is bullish for commodities because most are priced in US dollars.

“What could significantly delay or even prevent a big rally for commodities? The reflationary efforts could fail, or more likely take many more months before they turn a global economy that is still contracting. If so, there could be some additional downside risk and base formation development would most likely be lengthy. The US Dollar Index could fail to maintain its downward break. Improved weather patterns could lead to increased supplies of agricultural commodities.

“For these reasons, Fullermoney maintains that commodities are best purchased following setbacks. Positions are most safely built incrementally.”

Source: David Fuller, Fullermoney, December 11, 2008.

Financial Times: So long, super-cycle
“The severity of the crisis has surprised natural resources companies’ executives, commodity traders and Wall Street bankers alike. After all, the commodities boom of 2003-08 has been the most notable for a century in its magnitude, duration and the number of commodities whose prices it has lifted. The sudden plunge poses a fundamental question: is this just a temporary blip within an upward trend, with prices likely to rebound in the medium term, or is it the conclusion of another commodities cycle of boom and bust, with a period of relatively stable prices coming ahead?

“The common belief in the industry itself, and among most Wall Street analysts, is that the market is undergoing a correction but that the boom years have not ended. As many point out, the main drivers of what many have come to see as a commodities super-cycle - such as strong pent-up demand in emerging countries and supply constraints caused by a lack of investment over the past 20 years, along with the rise in resource nationalism - are intact. The current drop is, in the words of one senior mining executive, a ‘reset’ of the boom, not the end of it. Prices will rebound, in this view, and continue rising.”

Click here for the full article.

Source: Javier Blas and Krishna Guha, Financial Times, December 9, 2008.

Bespoke: Consensus gold estimates
“Below we provide the consensus price target for gold through 2012. These target prices are based on the median of 21 gold analysts surveyed by Bloomberg. As shown, analysts currently aren’t expecting a big rally or a big decline in gold over the next few years. By mid-year 2009, analysts are expecting gold to be at $825/ounce, which is less than $10 from its current price of $816. At the end of 2011, analysts expect gold to be down to $790, and then down to $762 by the end of 2012.”

Source: Bespoke, December 12, 2008.

Casey’s Charts: Gold stocks - time to bottom feed
“The previous low point for the ratio of the XAU gold stock index to the price of gold was 0.16, when gold was trading around $270 an ounce in October of 2000. Today, the XAU is trading a mere 57% higher than it was in October of 2000, compared to a gold price that has increased by 184%. As a general rule of thumb, anytime the ratio is above the 25-year average is the time to sell, and below its average says gold stocks are cheap. With the ratio bouncing off the lowest level since the inception of the XAU index, it signals a SCREAMING buy for gold stocks!

“Picking the bottom of any market is near impossible, but knowing when something is grossly undervalued can be easy. Gold has long been considered a hedge against inflation, and with trillions of new government bailout dollars ready to circulate into the system, buying precious metal stocks at these distressed prices is the chance of a lifetime.”

Source: Casey’s Charts, December 5, 2008.

Profit NDTV: Asia beats US in gold futures trading
“Asia, which accounts for 60% of the world gold imports, has overtaken the US in gold futures trading, with Mumbai and Shanghai exchanges growing rapidly, leading trade magazine Futures Industry has reported.

“According to the latest edition of the US-based magazine, data from the first eight months of this year show that the combined volumes in gold futures trading at exchanges in Shanghai, Tokyo, Taiwan and Mumbai reached 49.8 million contracts, far ahead of the 34.3 million contracts traded in the US.

“‘From January through August this year, seven of the top 10 gold contracts in the world were Asian,’ it said, adding that much of that growth was in Mumbai and Shanghai.

“‘Some of the boom is undoubtedly driven by the search for a safe haven as the value of stock investments continues to evaporate,’ the magazine said noting that Asian investors may also have a greater cultural predisposition toward gold than Westerners.

“Asia imports 60% of the world’s gold and its exports 40%. India is the largest consumer of physical gold in the world, followed by the US, and then China. And this year, China became the world’s largest gold producer - a title south Africa had held for more than 100 years.”

Source: Profit NDTV, December 9, 2008.

BBC News: UK economic slowdown “worsening”
“The UK economy contracted 1% between September and November, the National Institute of Economic and Social Research (NIESR) has estimated.

“This fall followed after a 0.8% drop in the three months to the end of October, said the think tank. Indicating that the rate of output decline is ‘accelerating’, the NIESR now expects a fall of more than 1% in the last three months of the year.

“Official data showed that the economy shrank 0.5% from July to September. But it will not be until January that the Office for National Statistics reports on the final quarter’s GDP.

“If it reports a decline for the three months to December, then the UK will be in officially in recession under the generally accepted definition of two consecutive quarters of decline.

“The NIESR says it has a good track record in forecasting GDP growth in advance of the official figures. The latest data from NIESR is just the latest indication that the UK economy is most probably falling into a recession.”

Source: BBC News, December 10, 2008.

Victoria Marklew (Northern Trust): Swiss rates head toward zero
“The Swiss National Bank (SNB) effectively lopped another 50bps off its main policy rate today, lowering its target band for three-month Swiss franc LIBOR to 0.0-1.0% (down from 0.5-1.5%) and aiming for the mid-point of 0.5%. This brings the easing total to 225bps since October 8.

“The SNB warned that the sharply worsening global climate will push Switzerland into recession next year. Chairman Roth stated that growth is likely to be negative, not just in the first two quarters of 2009 but for the year as a whole. The bank is now forecasting a contraction in real GDP of between 0.5% and 1.0% next year. The inflation forecast was also revised down, with the bank now seeing the annual rate averaging 0.9% next year and 0.5% in 2010.”

Source: Victoria Marklew, Northern Trust - Daily Global Commentary, December 11, 2008.

Financial Times: Japan contracts faster than expected
“Japan’s gross domestic product contracted much more rapidly in the third quarter than previously thought, official data showed on Tuesday, amid new indications of distress in the world’s second-biggest economy.

“The revised GDP data showed a quarter-on-quarter fall of 0.5% for the three months to September, compared with last month’s preliminary estimate of a 0.1% decline.

“The economy contracted at an annualised rate of 1.8% between July and September - a much more precipitous pace than the annualised 0.5% decline suffered in the same quarter by the US, centre of the global financial crisis.

“Analysts said the revision, though bigger than expected, reflected relatively technical factors involving inventories and government spending rather than worrying new information and so would not dramatically change assessments of the economy’s prospects.

“‘The downgrade in headline growth does not look as bad as the headline suggests,’ UBS said in a research note.

“However, the news the recession was deeper than thought came as the Cabinet Office said its latest composite index of business conditions showed the economy ‘worsening’.”

Source: Mure Dickie, Financial Times, December 9, 2008.

Financial Times: China’s export fall worse than predicted
“The impact of the global financial crisis on China became clear on Wednesday when the government revealed that exports fell in November for the first time in almost seven years.

“With demand in many of its main markets slowing sharply, Chinese exports declined 2.2% from a year earlier. Imports also fell 17.9% from a year earlier, according to Chinese customs figures, prompting the government to announce plans to further boost the economy.

“The Chinese data shocked economists. The figures were far below forecasts, even in the light of sharp slumps in exports in November from both Taiwan and South Korea.

“‘This is the worst collapse in Chinese exports since 1999 and is probably just the beginning of a prolonged export contraction,’ said Isaac Meng, economist at BNP Paribas.

“The drop in imports, the biggest since the early 1990s, helped push the monthly trade surplus to a record $40 billion, the fourth month in a row that the surplus has broken records.

“The government pledged on Wednesday to do everything it could to maintain ‘stable, healthy’ growth next year. At the conclusion of the three-day Central Economic Work Conference, an annual meeting of top policy-makers, officials said they would boost public spending in order to promote domestic demand.

“A report on state radio about the meeting said the government had reaffirmed its policy of keeping the exchange rate ‘basically steady’, but would take other measures to deal with falling domestic demand.

“Until last month, China’s exports had held up much better than most observers had expected, increasing by 19% in October compared to the same month last year.”

Source: Geoff Dyer and Jamil Anderlini, Financial Times, December 10, 2008.

Financial Times: China inflation falls as growth slows
“China’s consumer price inflation fell to a 22-month low of 2.4% in November, giving the central bank free rein to cut interest rates further to offset an abrupt slump in the world’s fourth-largest economy.

“Economists had expected inflation to moderate to 3.0% from 4.0
% in the year to October. In the event, the reading was the lowest since January 2007.

“Nie Wen, an analyst with Huabao Trust in Shanghai, said the plunge meant real, inflation-adjusted interest rates in China were now back in positive territory even though the economy had run into fierce headwinds.

“‘The government will become more decisive in cutting rates,’ Nie said.

“Jing Ulrich, head of China equities at J.P. Morgan agreed. ‘We believe there is further scope for the central bank to ease monetary policy in an effort to avoid an excessive slowdown and stave off deflation,’ she said in a note to clients.

“‘Definitely we are going to move into a deflationary environment in China, probably through the first six months of the year,’ said Glenn Maguire, chief Asia-Pacific economist for Societe Generale in Hong Kong.”

Source: Financial Times, December 11, 2008.

Bespoke: Deflation coming in China?
“It wasn’t too long ago that one of the biggest worries facing the global economy was that improved standards of living in China would lead to higher wages for its workers. This, it was feared, would cause the country to begin exporting inflation around the world. As recently as August, PPI data from China showed that inflation was running at a rate of 10.1% year over year (y/y). Since then, however, pricing power in China has collapsed as evidenced by last night’s [Tuesday] release of the November PPI, which showed that prices are now up by just 2.0% y/y. At this rate, it won’t be long before we start seeing minus signs.”

Source: Bespoke, December 10, 2008.

Financial Times: Rouble exodus hits Russia’s credit rating
“Russia on Monday became the first G8 country since the start of the financial crisis to have its credit rating downgraded after Standard and Poor’s took fright at the recent exodus from the rouble and sharp drop in oil prices.

“S&P said it had lowered Russia’s foreign currency credit rating by one notch from BBB+ to BBB because of the ‘rapid depletion’ of the country’s foreign exchange reserves and the ‘difficulty of meeting the country’s external financing needs’. It said the outlook for the rating was negative.

“Russia’s reserves have fallen by $128 billion since August to $455 billion, as the country battles the capital flight that began following the war with Georgia and escalated as the oil price fell and the global crisis worsened.

“S&P said Russia could be forced to spend all $200 billion now parked in its two sovereign wealth funds on recapitalising the banking system and covering fiscal deficits in 2009 and 2010.

“The agency expects Russia to run a current account deficit next year of 2.6% of gross domestic product due to the oil price fall, putting further pressure on the balance of payments.

“‘There are a lot of layers of concern,’ said Frank Gill, primary credit analyst at Standard and Poor’s. ‘There are macroeconomic and political risks … and Russia has not operated a current account deficit since 1997 and that was less than 1% of GDP.’

“The thought of devaluation raises the spectre of the 1998 rouble crash that wiped out Russians’ savings, although economists say any devaluation this time would be far less severe.”

Source: Catherine Belton, Financial Times, December 8, 2008.

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Joe Stiglitz: Bigger is Better

Monday, December 1st, 2008

Joe Stiglitz writes in the New York Times:

Joseph Eugene Stiglitz (born February 9, 1943) is an American economist and a professor at Columbia University. He was chairman of the Council of Economic Advisers from 1995 to 1997 and was awarded the Nobel prize in economics in 2001, and is the author, with Linda J. Bilmes, of “The Three Trillion Dollar War.” He is also the former Senior Vice President and Chief Economist of the World Bank.

A $1 Trillion Answer, by Joseph E. Stiglitz, Commentary, NY Times: What President-elect Barack Obama will need to do is horribly complicated but also very clear.

First, he must stop the economy from going deeper into recession. Then he needs to bring about a robust recovery, preferably in ways that support the long-term needs of the United States: by repairing our neglected public works, invigorating our technological leadership, making our society greener, fixing our health care problems, healing our social and economic divide, and restoring our social compact.

It will not be easy. President Bush’s legacy of debt and the opposition of those who benefit from the status quo present major obstacles. There is an emerging consensus among economists that a big — very big — stimulus is needed, at least 0 billion to trillion over two years. Mr.

Obama’s announced goal of 2.5 million new jobs by 2011 is too modest. In the next two years, almost four million workers will enter the labor force — or would if there were jobs. Combined with the loss of employment this year, that means we should be striving to create more than five million jobs.

A large stimulus package can always be trimmed later if it’s not needed…

Faint measures would be foolhardy. A weaker economy will suffer lower tax revenues, more foreclosures and more bankruptcies. Once a firm is bankrupt, you can’t unbankrupt it by providing a stronger stimulus later on.

… But what you do with the money counts… The money needs to be spent carefully to ensure that every dollar provides as much stimulus now as possible while also contributing to long-term growth.

… Americans are rightly afraid of losing their jobs, and with that, their

health insurance and their homes. We need to provide health insurance to the unemployed and to the uninsured, and we need to do it quickly, possibly through an expanded and more efficient Medicare.

We also need to stem the flood of foreclosures. If we help poorer homeowners, banks will benefit, too… And we need to change the bankruptcy laws to help homeowners.

… Deregulation and the failure to adopt regulations to cover risky new financial products have contributed much to the current mess. So far, we have merely given banks more money to spend recklessly. We have done little to change the banks’ incentives or constraints.

… If the asset program is not changed and if regulations are not imposed to change the behavior of those who got us into this situation — who enriched themselves at the expense of their shareholders — then confidence will not return. Those who got us into this crisis cannot have undue influence in shaping the response.

America has great assets, including a productive labor force and the best universities in the world. None of these assets so far has been impaired by Wall Street’s follies. These strengths, coupled with a sensible and fair economic stimulus package and judicious regulation, will help our economy recover.

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The Road to Depression

Monday, December 1st, 2008

Brad DeLong says two big mistakes made the crisis worse:

James Bradford DeLong (b. June 24, 1960, Boston) commonly known as Brad DeLong, is a professor of economics at the University of California, Berkeley and a former Deputy Assistant Secretary of the United States Department of the Treasury in the Clinton Administration. He is also a research associate of the National Bureau of Economic Research, and is a visiting scholar at the Federal Reserve Bank of San Francisco.

The Road to Depression, by Brad DeLong, Project Syndicate: For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying…,

above all, to avoid a deep depression.

They have also had three subsidiary objectives:

• Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
• Prevent the princes of Wall Street … from profiting from the systemic risk that they created.
• Ensure that homeowners and small investors do not absorb too much loss, for their only “crime” was to accept bad risks, which they would not have done in a world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper - subsidiary - weight, I suspect that we would not now be in this mess…

The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse… The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished…

But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail…

In retrospect, this was a major mistake. … With that guarantee broken by Lehman Brothers’ collapse, every financial institution immediately sought to acquire a much greater capital cushion…,

but found it impossible to do so.

The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Yes, this is what might be called “lemon socialism,” creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.

But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.

Go to Source

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Bill Ackman: Pershing Square Q3 2008 Letter

Thursday, November 27th, 2008

Pershing Square Q3 2008 Investor Letter
by Bill Ackman, November 15, 2008 at 11:44 pm

These are extraordinary times particularly for active participants in the capital markets. While I do not normally choose to write about macro and regulatory events, I thought it would be useful for you to understand how we think about recent events and their impact on our portfolio.

We are currently witnessing the greatest deleveraging event in history. What began as a credit bubble bursting has now spread to the equity markets as banks, investment banks, hedge funds, structured products, mutual funds, pension funds, endowments and other leveraged and unleveraged market participants have been forced to liquidate assets by their counterparties, leverage providers, redeeming clients, and as a result of downgrades, other debts or other commitments that need to be funded.

These actions have led to forced and indiscriminate selling in security markets around the world, which in turn has caused other investors to panic or simply to sell, to get out of the way of other forced sellers.

As a fund which is generally substantially more long than short, we have also suffered large mark-to-market declines in our long investments. Year to date, however, our performance has substantially exceeded that of the broader equity markets, which at this writing have seen a more than 34% decline. Our outperformance is largely due to large gains on our investments in Longs Drugs and Wachovia Corporation as well as profits on our credit default swap and other short exposures. Our market losses have been further mitigated because we operate unleveraged and have substantial cash balances. Currently, we have cash and near-cash (Longs Drugs and Wachovia/Wells Fargo long/short) equal to approximately 39% of our capital.

When, you might ask, will the selling end? While I don’t proclaim to be a market prognosticator, I will make a few observations. Unlike the deleveraging that takes place when banks and other financial institutions sell assets to meet regulatory requirements, which is typically a longer term process, the forced deleveraging that is now taking place in the equity markets is being implemented largely by the prime brokerage firms and margin account managers at broker dealers around the world. Prime brokers are not known to be laggardly in their approach to liquidating an account that no longer meets margin requirements. This is likely to be even more true in the current environment. As such, it may be reasonable to conclude that the forced liquidation that is now taking place may not be a prolonged process.

Security prices around the world have come down tremendously. In the larger capitalization U.S. markets, which are the focus of our strategy, the reductions have been substantial. As of the market close on October 31st, the S&P 500 is down 34.0%, year to date, and down by 37.5% from its high on October 31, 2007; and this is after last week’s rally in which the S&P 500 rose more than 12% from the lows. Unlike the bear market of 1973 and 1974, in which stocks declined by 45% from the highs, this bear market was not preceded by the “Nifty 50″ bubble in which large capitalization growth stocks traded at extraordinary valuations. While valuations were not cheap one year ago, in a long-term historical context, the market as a whole (particularly if one were to exclude financials) was not particularly expensive either.

As such, in today’s market, we are finding extraordinary bargains, the kinds of opportunities that are normally associated with market bottoms. While there are still weak and poorly capitalized businesses that are likely still overvalued, the high quality, well-capitalized, larger capitalization businesses which are the focus of our strategy look very cheap to us.

While this means that now is likely to be a much better time to be a buyer rather than a seller, it does not mean that the market will not continue to decline, even substantially, from current levels, particularly in the short term. In fact, because of tax-loss selling over the next 60 or so days, there will likely be additional selling pressure. At some point, however, the forced selling will come to an end. Large amounts of cash are sitting on the sidelines waiting to be deployed when investors feel the coast is clear. In the event the market were to start to rise again, it would not be a surprise to see institutional, retail, and hedge fund investors rapidly deploy capital so as not to miss a, perhaps, explosive market rally.

What does this all mean for Pershing Square? Despite the fact that we occasionally have an opinion, we spend little time trying to outguess market prognosticators about the short-term future of the markets or the economy for the purpose of deciding whether or not to invest. Since we believe that short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.

Our strategy is to seek to identify businesses and occasionally collections of assets which trade in the public markets for which we can predict with a high degree of confidence their future cash flows - not precisely, but within a reasonable band of outcomes. We seek to identify companies which offer a high degree of predictability in their businesses and are relatively immune to extrinsic factors like fluctuations in commodity prices, interest rates, and the economic cycle. Often, we are not capable of predicting a business’ earnings power over an extended period of time. These investments typically end up in the “Don’t Know” pile.

Because we cannot predict the economic cycles with precision, we look for businesses which are capitalized to withstand difficult economic times or even the normal ups and downs of any business. If we can find such a business and it trades at a deep discount to our estimate of fair value, we have found a potential investment for the portfolio. Next we look for the factors that have led to the business’ undervaluation, and judge - based on our assessment of the company’s governance structure, management team, ownership, and other factors - whether we can effectuate change in order to unlock value. When the price is right, the business is high quality, the management is excellent, and there are no changes to be made, we are willing to make a passive investment.

Our assessment of the short-term supply and demand for securities plays almost no role in our determining whether to invest capital, long or short. If we believed that it was possible to accurately predict short-term market or individual stock price movements and we had the capability to do so ourselves, we might have a different approach. Below I quote Warren Buffett in his 1994 Letter to shareholders where he perhaps says it best:

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results…

Stock prices will continue to fluctuate - sometimes sharply - and the economy will have its ups and down. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.

I believe we will look at the current U.S. stock market valuations for high quality mid and large capitalization businesses as presenting perhaps the best investment opportunities of our lifetimes.

Portfolio Update

The last quarter and, in particular, the last few weeks have been an extraordinarily busy and productive time for Pershing Square. During this time, we have made considerably more buy and sell decisions than usual, taking advantage of the liquidity of our holdings, the enormous volatility of the market, and new opportunities that have presented themselves in recent weeks.

In the third quarter, we disposed of our investments Cadbury PLC, Canadian Tire, and Austrian Post at prices generally higher than current levels. We also disposed of the substantial majority of our investment in Sears Holdings. We hold a residual interest in Sears (which represents approximately 1.5% of fund capital) as its price declined to a level at which it made no sense to continue to sell. We redeployed the capital from these sales into Wachovia Corporation, which I will discuss further below, as well as a new investment in which we are in the process of accumulating a position.

We sold these positions not because we thought they would be poor investments, but rather because we believed that we could redeploy the capital in investments that offered a more attractive risk-reward profile. As we have often stated, we are always willing to sell an existing holding at a profit or a loss, if we can find a better use for the funds. For our taxable investors, sales at a loss have the additional benefit of offsetting taxable gains.

Our sales were also motivated by the fact that three of the above companies - Sears, Canadian Tire, and Austrian Post - each have a controlling shareholder. Because we believe that one of our important competitive advantages is our ability to effectuate change at companies in our portfolio, other than in special circumstances, we do not expect to make investments in controlled companies in the future.

As a result of recent changes in the portfolio and strategic developments with respect to Longs Drugs and Wachovia Corporation, our long portfolio is now comprised of higher quality, more economically resilient businesses, companies for which we can be a catalyst to create value, and a large amount of cash and soon-to-be cash that we can redeploy in new opportunities.

On the short side of the portfolio, we have been opportunistic in unwinding single-name credit default swaps in cases where spreads have increased significantly, and have covered certain short positions where stocks have declined substantially as a result of company-specific as well as market-related events. We recently repurchased CDS on the investment grade credit index as certain technical factors have made this investment/hedge attractive once again.

Longs Drugs

In last quarter’s letter, I alluded to a new position on which we expected to file a Schedule 13D shortly. That position was Longs Drugs, a West Coast based drugstore retailer. While Longs’ was valued in the market as an underperforming drug store retailer, we valued the business based on its component parts which included: (1) owned and long-term, below-market, leasehold real estate, (2) RxAmerica, a rapidly growing pharmacy benefit manager (”PBM”) which generated more than 20% of the company’s trailing operating income, and (3) an underperforming, low-margin drugstore retailer. At our cost, we believed that Longs real estate value alone more than covered our purchase price and we were getting the PBM and the retailer for less than free. We estimated the fair market value of the company to be $85 to $95 per share assuming each of the company’s assets was sold to the buyer who could pay the highest price.

Unlike many of our previous active investments, we concluded that Longs had reached the end of its strategic life and should be sold to one of its larger competitors, namely CVS or Walgreens. While it has been rare for us to buy a stake in the company with a view that a strategic sale was the right exit opportunity, we have done so in the past. For example, our original investment in Sears Roebuck & Company was predicated on a strategic outcome at the company which was ultimately achieved when it was acquired by Kmart.

In the current weak (to use a euphemism) credit environment, we are particularly wary of investments which are predicated on a sale. However, in this case, we were comforted by the fact that Longs Drugs would be a must-have acquisition for CVS and Walgreens and that both companies, which are many times the size of Longs, could easily finance the acquisition. Even in the event a sale did not go through, we had purchased Longs at an attractive price which offered a substantial margin of safety against a permanent loss of capital.

Within one week of our 13D filing, Longs announced that it had entered into a transaction to be sold to CVS for $71.50 per share in a cash tender offer, an approximately 44% premium to our average cost. While we were happy with the deal, we were somewhat unhappy with the purchase price, particularly when we learned that the company had not run a competitive auction. Thereafter, we hired the Blackstone Group with whom we have worked successfully in past transactions in an attempt to achieve a better outcome for all shareholders.

We and Blackstone were successful in attracting a bid of $75 per share from Walgreens; however, the greater regulatory risk and potential time delay in a transaction with Walgreens led Longs’ board to reject the transaction in favor of the CVS offer. Walgreens subsequently withdrew its offer citing market conditions, and a day later, the CEO of Walgreens stepped down. We anticipate that we will be fully cashed out of our investment in Longs’ by the close of trading today.

Wachovia Corporation

Wachovia is a good example of the types of opportunities that have emerged in the current highly volatile environment. On Monday morning September 29th, Wachovia Corporation announced that it had entered into an agreement in principle to sell its banking subsidiaries to Citigroup. The transaction was structured in an unusual manner. In the deal, Citi was paying $2.1 billion of its own stock to Wachovia Corporation (the publicly traded holding company for the Wachovia banking subsidiaries) and assuming $53 billion of senior and subordinate holding company debt in addition to the debt and other liabilities of the Wachovia banking subsidiaries. The description of the transaction was limited to a several paragraph press release and a conference call presentation by Citigroup that morning. Wachovia stock opened later Monday afternoon at approximately $1.80 per share, down 82% from Friday’s close.

The market’s reaction to the Citi transaction was severe, particularly as the transaction was announced only four days after Washington Mutual’s subsidiary banks were seized by regulators and sold to J.P. Morgan. In that transaction, WaMu’s holding company filed for bankruptcy, wiping out shareholders and materially impairing holding company creditors.

The Wachovia transaction, however, was structured in a materially different manner from the WaMu seizure. It appears that the government, in order to protect bank holding company bondholders from losing their investment and perhaps to avoid triggering a CDS credit event, structured this deal so that Citi would assume the holding company debts. Interestingly, as part of the Citi transaction the government provided an excess-of-loss guarantee on Wachovia mortgages to protect Citi, which the government could likely have avoided if it had not required Citi to assume $53 billion of holding company debt. It appears that the government had concluded that additional bank holding company debt defaults would create systemic risk or reduce the ability for bank holding companies to access this important source of capital, and therefore chose to protect the Wachovia banking subsidiary and the holding company bondholders.

The unusual structure of the transaction created an interesting investment opportunity. By removing the holding company debts, Wachovia Corporation, now orphaned from its bank subsidiaries was left with some very attractive assets. Based on our reading of the public filings, conference call transcripts, and internet research over the course of Monday morning and afternoon, we estimated that Wachovia was left with the following assets: approximately $2 billion or more of cash, $2.1 billion of Citigroup Stock, the Wachovia Securities wealth management operation, A.G. Edwards (which had been purchased one year ago for approximately $7 billion), Evergreen Asset Management (a mutual fund manager with $245 billion in assets under management), Wachovia Insurance Services, and other ancillary assets.

In light of the Citi debt assumption, the only material liability of Wachovia Corporation was $9.8 billion of non-cumulative, perpetual preferred stock. Because this preferred is both non-cumulative and perpetual, Wachovia has no obligation to ever pay a dividend on these securities making these liabilities effectively a free form of equity financing. These types of preferred securities are typically structured to qualify as an attractive form of bank holding company equity which gets favorable regulatory and rating agency treatment. Now that they were orphaned by the transaction, at best these liabilities were worth less than 50 cents on the dollar.

We also determined that the structure of the transaction would create a large tax asset for the holding company. By selling the bank subsidiaries for less than their net tangible asset value, we estimated that a $26 billion tax loss would be created. This tax loss could by carried back two years enabling the holding company to recover approximately $7.5 billion of cash taxes that had previously been paid.

Our conservative estimate of value of New Wachovia was in excess of $8 per share even assuming that the preferred stock was redeemed or valued at par. We began buying the stock shortly after it opened on Monday afternoon. My instructions to our traders Ramy Saad and Erika Kreyssig were to buy every share we possibly could, including pre- and post-market trading. They did a superb job.

Between Monday afternoon and late Thursday we acquired 178 million shares, or approximately 8.3% of the company, at an average price of $3.15. On Friday morning before the open, Wells Fargo announced a definitive agreement to acquire Wachovia for 0.1991 shares of Wells common stock, or more than $7.00 per share based on Friday’s trading price. We began selling our Wachovia stock on Friday. We could not, however, hedge the Wells Fargo stock price because the short selling ban was still in effect.

Citi, which thought it had an exclusive to complete the transaction with Wachovia, brought litigation later that Friday to enjoin the Wells Fargo deal. By late the following week, Citi, likely as a result of pressure from the government, had agreed to allow the Wells transaction to go forward while retaining their lawsuit for damages against Wells Fargo.

As of this date, we have hedged 100% of our exposure to Wells Fargo shares, and have been opportunistic in unwinding a substantial portion of the position. Assuming we waited until transaction closure and taking into consideration Wachovia shares already sold, we have locked in a 67% profit on this $560 million investment.

The government and all of the parties appear to be doing everything they can to consummate the transaction promptly. The transaction received HSR approval in one day and the Treasury and banking authority approvals over the following weekend. Wells has been issued 39% of the voting stock of Wachovia and transaction closure is anticipated by year end. The transaction requires the recently filed form S-4 to be approved by the SEC and the completion of the mechanics of the shareholder meeting in order to be consummated. It is an excellent deal for Wells Fargo and for Pershing Square.

A Mistake

While most of our long investments are comprised of great businesses or assets at fair prices with a catalyst to create value, we occasionally are willing to invest a small amount of fund capital in situations which offer the potential for a many-fold profit at the risk of a large or near-total loss of capital invested. I typically call these investments mispriced options. Our CDS investments fit this profile. While not all mispriced options will be profitable for the funds, I expect our collective experience in these commitments to be quite favorable over time.

We purchased stock in American International Group, Inc. (AIG) after the announcement of the government bailout. In summary, we did so because at the price paid, we purchased AIG at a substantial discount to book value, and we believed that book value was a conservative estimation of the value of AIG’s underlying businesses net of derivative losses. We also believed that there was the potential for a renegotiation of the government’s extremely harsh financing commitment to AIG which provided for 80% dilution, enormous commitment fees, and a high interest rate.

In particular, we believed that if AIG could pay back the government promptly through a combination of asset sales, termination of certain CDS contracts at potentially less than fair market value, and equity investments from existing and potentially other investors, that there was a chance to renegotiate the 80% zero-strike warrant package to the government. If the warrant dilution could be mitigated, it would be possible for AIG shareholders to make a many-fold return on investment. Initially, we believed that the potential for return outweighed the risk of loss. Because of the inherent leverage of AIG, the risk of a permanent loss of capital on this investment was material. As such, we limited the size of our investment to 2.5% of fund capital.

After acquiring our position, we met with other large holders, policymakers and contacted Berkshire Hathaway and other potential investors about a proposed recapitalization of AIG. Unfortunately, the collection of shareholders that were attempting to restructure the government deal was exceedingly disorganized and some large holders were conflicted by a desire to buy certain assets from the company.

We ultimately concluded that the return on invested brain damage from this investment exceeded the probability-weighted opportunity for profit, and we decided to fold the tent. We sold our stock and incurred a modest loss to the funds.

Our Business Model

In order to achieve long-term success, Pershing Square must make good investments and operate with a robust business model. With much media attention focused on hedge fund failures, I thought it would be worthwhile reviewing the characteristics of our business model and explaining why we will withstand industry-specific and overall environmental threats to the investment and hedge fund businesses. The principle factors which contribute to the robustness of our business model are as follows:

* Our portfolio management approach is inherently low risk (where risk is defined as the probability of a permanent loss of capital), particularly when compared with other hedge fund business models. An important distinguishing factor about Pershing Square compared to most other hedge funds is that we do not generally use margin leverage in our investment strategy. The lawyers prefer that I put in the word “generally” to give us the flexibility to use margin to manage short-term capital flows, but, to-date, we have not used any but an immaterial amount of margin, and only for a brief period of time, and we have no intention of changing this approach,
* We generally invest in higher quality businesses with dominant and defensive market positions that generate predictable free cash flow streams and that have modestly or negatively leveraged (cash in excess of debt) balance sheets. We buy these businesses at deep discounts to our estimate of intrinsic value giving us a margin of safety against a permanent impairment of capital. I say “generally” again here because we do make exceptions in certain limited circumstances; that is, we may buy a more leveraged or lower quality business if we believe the price paid sufficiently discounts the risk.
* We often seek investments where we can effectuate positive change to catalyze the realization of value. This serves to accelerate the recognition of value, helps us avoid “dead money” situations, and protects us somewhat from managerial actions which can destroy value.
* We are diversified to an adequate but not excessive extent. This has further benefits for risk and operational management which I will discuss below.
* There is an inherent balance to our long/short investment approach. Historically, when equity or credit markets weaken, our shorts become more valuable, and occasionally materially more valuable, offsetting somewhat the mark-to-market declines in our long portfolio. If we choose to unwind these short positions during market downturns, we can generate capital to invest in a now less expensive market. These short investments generally stand on their own in that they do not typically require a stock market or credit market decline to be successful. That said, they have served as a useful hedging tool during periods of dramatic market declines.
* We have been paranoid about counterparty risk since the inception of the firm. First, we trade with counterparties which we believe to be creditworthy. Second, we have negotiated ISDA agreements which provide us with daily mark-to-market cash and U.S. Treasurys equal to the previous day’s market value of our derivative contracts. In cases where we are required to post initial margin and therefore have some exposure beyond the market value of our derivative contracts, we have typically purchased CDS on our counterparties to further mitigate counterparty risk. While our approach to counterparty risk has protected us from any counterparty losses to date, please be forewarned there is no perfect approach to avoiding counterparty risk.

Our simple approach to investing also allows us to avoid complicated approaches to risk management. Our investment strategy does not require us to open offices all over the globe. As such, we don’t need traders working around the clock. We can go to sleep at night and sleep. Our weekends are largely our own (Ok. I admit it. I am writing this letter in the office on Sunday.) Our risk management approach is to: (1) put our eggs in a few very sturdy baskets, (2) store those baskets in very safe places where they cannot be taken away from us and sold at precisely the wrong time due to margin calls, and (3) to know and track those baskets and their contents very carefully. We call this approach the sleep-at-night approach to risk management. If I can’t, we won’t.

I am extremely skeptical of more automated, algorithmic, Value at Risk, and other business school sanctioned approaches to risk management. None of these approaches saved Lehman, Bear Stearns, Fannie, Freddie, AIG, WaMu, Wachovia or any of the other institutions that used these and other ostensibly more sophisticated risk management strategies.

Our investment strategy and approach to counterparty risk serves to limit the risks inherent in our individual investment selections, our counterparty risk, and the portfolio as a whole. There are, however, other important risks to our business, principally operational, reputational, and regulatory risk.

Operational Risk

Our investment approach is largely straightforward and relatively simple. This, coupled with the concentrated nature of the portfolio, allows us to run our business with a limited number of personnel. We have five senior investment professionals including myself. Shane Dinneen, still officially a junior investment professional, is fast earning his stripes as an eventual senior member of the team.

We could manage our portfolio with less human talent than we have. For members of the investment team reading this letter, don’t be concerned because I have no intention of shrinking the team, but I make the point nonetheless. Simplicity in our investment approach allows for a simpler back office and a smaller overall staff. We have 31 people total at Pershing Square. It could be fewer, but one of Tim Barefield’s (our COO) important risk management principles provides for back-up talent for every role in the firm.

Our Noah’s Ark approach to personnel duplication makes for a good analogy for the ship we have designed. We have worked hard to build a business that can withstand the Great Deluge, and this goes beyond counterparty risk. For example, it is not yet clear this year whether there will be any incentive allocation to be shared at the firm. That said, whether or not the funds’ finish the year in the black, it will be extremely unlikely that a member of our team leaves by choice, and I have no intentions of letting anyone go. This is due to several factors:

* Pershing Square’s large amount of assets under management per investment principal and per overall employee are important ratios to consider when evaluating the sustainability of Pershing Square or any hedge fund for that matter. The economics of a high Asset per Employee ratio attract and allow for the retention of top talent. Our team can be compensated appropriately even in times of short-term underperformance. Hedge funds which barely (or don’t even) cover their costs with management fees are inherently unstable enterprises because in an unprofitable year they cannot pay their people and are likely to lose their most talented professionals to other firms.
* Pershing Square is a nice place to work. While this sounds like an obvious approach to retaining talent, many and perhaps most hedge funds don’t fit this description. We are big believers in taking care of our team not just financially and with attractive benefits, and we have those in spades. We consider every employee at the firm a member of our extended family, and we treat and care for them appropriately. We do this not for business reasons, but it has important long-term business benefits.
* Pershing Square is an extremely exciting place to work. We believe our work creates value beyond the profits we historically have generated for our investors. Our approach to value creation at businesses has created enormous value for investors who happened to own companies to which we contributed to the creation of value. Similarly, investors and counterparties who listened to our views on the bond insurers, Fannie Mae and Freddie Mac, etc. saved themselves from large losses or perhaps profited by short sales. The fact that our work creates value for the markets as a whole provides additional motivation to the team.

Bottom line, we are built to last, and we will continue to work hard to deserve your continued support.

Reputational and Regulatory Risk

Reputational risk is one of the key risk factors for a business that is subject to a high degree of regulatory scrutiny in an industry that seems to generate considerable public scorn. Our approach to assessing reputational risk is to apply the New York Times test. We ask ourselves whether we would be comfortable having our family and friends read a front page New York Times story about actions taken by Pershing Square written by a knowledgeable and intelligent reporter who has access to all of the facts. If we are comfortable with such an article being read by our close friends, our families, and the public at large, our action passes the test. If not, we reconsider our potential action.

More recently, I have decided to participate in the public dialogue about hedge funds, agreeing to occasional appearances on television or otherwise talking to the press, speaking at industry events, meeting with Congressman, Senators, and other officials. I do so not for any desire for public recognition, but rather because I believe that it is important for the hedge fund industry to come out of the shadows and defend the importance of our work. If we and others (that includes hedge fund investors in addition to the managers) don’t do so, the industry, in my view, is at even greater risk of further regulatory, tax, and other legal changes that will materially harm our business models and industry.

One does not need to look further than the recent short selling ban which was an extremely ill-advised regulatory change that contributed to market turmoil and the recent market decline. By imposing a ban on an investment approach that has been legal for generations with no warning or opportunity for public debate, the SEC caused a short squeeze and subsequent market disarray that wiped out large amounts of hedge fund capital, caused forced selling as long/short, market neutral, quantitative, and other managers had to sell long positions to rebalance their books. More significantly, it cost the U.S. capital markets its highly respected position as an exemplar free marketplace where the rule of law prevailed. It also contributed to hedge fund underperformance, thereby leading to investor redemptions, further reducing industry capital.

I believe the short selling ban also contributed to continued market declines since the ban was put into place. In that hedge funds are among the most opportunistic investors in the world, destroying large amounts of hedge fund capital likely contributed to market declines because of a dearth of opportunistic hedge fund buyers who would normally step in and purchase the compelling values created by falling markets.

Even though the restriction on short selling has been eliminated, the longer-term consequences of populist regulatory actions will continue to be felt by the markets and its participants until such time as our securities regulator makes clear that the U.S. will never again change the rules of the game mid play.

Specifically, the short selling ban was harmful to Pershing Square because we lost the opportunity to lock in even greater gains on our Wachovia investment by not initially being able to hedge our Wells Fargo exposure. I estimate this loss at approximately 3% to 4% of fund performance. This loss was somewhat offset by our ability to sell certain investments into the short squeeze at higher than anticipated prices. We were otherwise not materially affected because short selling equities has not been a material part of our investment program, although we did cover one large equity short at a loss which is now trading at a more than 40% lower price, another 4% to 5% potential loss of profit assuming we had not covered at higher prices.

Hedge fund investors - the pension funds, state plans, charitable, healthcare and other institutions and the individuals who invest in hedge funds - are a much more appealing constituency to defend the industry than the managers themselves. I encourage you to consider becoming part of the public debate on the industry. We collectively need one another’s support.

Investor Risk

The stability of a hedge fund’s capital base is critical to its long-term success. We have endeavored to attract high quality investors who have a deep understanding of our investment approach. We do our best to continually inform you of the progress of our holdings and business, and remind you of the inherently volatile nature of our concentrated strategy. Our investment strategy is also transparent. The nature of our approach requires most of our holdings to eventually be disclosed publicly. As such, it is easier for you to understand how we have made and lost money over the years, and to assess our ability to replicate our historic strategy and performance.

Over the last nearly five years, we have delivered very little of the volatility that investors are concerned about, that is, downward volatility. As such and with strong historical performance, we have not “tested” our investor base. We hope never to “test” our investor base.

While we have considered a longer-term lock-up structure, we chose not to modify our existing liquidity terms because we did not want our terms to be overly burdensome to investors and to present a hurdle to the reinvestment of capital, particularly during a period of temporary underperformance. Year to date, we have had minimal redemptions. New commitments have exceeded our redemption requests by approximately 3 to 1. We have a pipeline of new prospects that are in the process of completing their due diligence. That said, the continuity of our investor base is a long-term success factor for the funds and for this we are relying on you.

Is Now a Good Time to Invest in Pershing Square?

I have never before suggested that one time or another would be a better time to invest in Pershing Square. I am going to take the risk of doing so now. At the risk of sounding promotional, I believe that now is perhaps the best time in our history to increase your investment in Pershing Square. A few thoughts to consider:

When one invests in Pershing Square today, with respect to our current portfolio and potential opportunities in the market, the spread between price and value is the widest it has been since the inception of Pershing Square and likely over the last 30 or more years in our opinion. Investments like Target Corporation which we purchased initially in the mid to high $50s per share now sell at approximately $40 per share and there has been no meaningful diminution in the per-share value of Target since our initial purchase 18 months ago. In fact, the probability of Target and other Pershing Square holdings implementing a value-creating transaction are higher today than before because of management and shareholder frustration with current share price levels. Consider that Target management options are nearly all out of the money, and a meaningful number of vested options will soon likely expire worthless if there is no change in the status quo.

An additional investment in Pershing Square today also purchases a pro rata interest in our cash and near-cash investments. While purchasing cash indirectly is not an inherently attractive proposition, we are currently analyzing a number of long and short investments that appear extremely interesting, and subject to completion of our due diligence, may become large new commitments. While for the first nearly five years of our business, we found only a limited number of interesting opportunities, albeit a sufficient number to generate attractive returns, we are now presented with tens of intriguing situations that are worthy of careful review. One could reasonably conclude that the greater spread between price and value and a wider selection of attractively priced opportunities will lead to higher rates of return on these commitments than during previous periods of greater market efficiency which characterized the first four years of the funds’ existence.

While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility. We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital. As market values have declined substantially, this risk has actually diminished rather than increased. Risk is high now for the leveraged short-term investor, but actually much lower for the unleveraged, long-term investor in high quality, mid and large capitalization, modestly leveraged businesses.

Unlike levered hedge funds whose risk increases as NAV declines, Pershing Square’s risk has declined with the recent decline in the value of our portfolio. Why? This is due to the fact that a leveraged manager’s probability of being sold out by its prime broker increases as its portfolio’s equity declines. Many hedge fund strategies are confidence and credit sensitive because they require continued access to low-cost financing. Recent declines may also require leveraged hedge funds to post additional collateral on trades which did not require an initial down payment. Because our investment strategy does not require leverage to operate, recent increases in financing costs and reductions in leverage afforded to hedge funds have no impact on our current or future prospects. In our case, the margin of safety of our investments actually increases, the greater the decline in our holdings’ share prices. We, of course, also have no margin leverage creating the risk of a forced sale. So yes, I believe now is a good time.

Pershing Square Advisory Board Addition

Matt Paull joined the Pershing Square Advisory Board on September 1st. For some of you, Matt’s name may be familiar for he was formerly the CFO of McDonald’s Corporation before his retirement earlier this year. I have known Matt for about 10 years, and interacted with him intensively in mid to late 2005 and in early 2006 when Pershing was advocating for change at McDonald’s.

As CFO of McDonald’s, Matt was one of the most highly regarded public company CFOs in the country. Shareholders were the beneficiaries of superb capital allocation and strong share price appreciation during his tenure as CFO. I consider it one of Pershing Square’s greatest accomplishments that we were able to garner Matt’s respect and friendship even though there were occasionally contentious moments during our engagement with McDonald’s.

Matt has already proved enormously helpful in our interactions with Target Corporation. As a former CFO, particularly one that has been on the other side of one of Pershing Square’s most significant engagements, Matt brings a uniquely valuable perspective to the firm and to the management teams of our portfolio companies.

In addition to his Pershing Square advisory role, Matt is currently serving on the business school faculty of University of San Diego.

Organizational Update

We completed our move to the 42nd floor of 888 Seventh Avenue in August. The second time round, we really got it right. The space is beautiful, promotes communication, and is extraordinarily well organized and efficient.

After the move, we made several additions to the team. Courtney Leonardo and David Robinson joined the IR team in administrative roles, roles which had previously been filled by temporary employees. Alex Song joined us from Goldman Sachs as the newest junior member of the investment team. Amy Stern joined the Finance and Accounting team from Tiger Global, and will focus her efforts on management company accounting. Amy is also attending the NYU Stern School of Business where she is working on a business school degree. Jill Skousen replaced Whitney Stodtmeister as the administrative assistant for the investment team after Whitney moved to Santa Barbara. Helena Tunner joined us to work with Dianna Baitinger at front desk reception.

On other news, Alex Kaufmann of our IR team will be attending Columbia University’s Executive MBA program on Fridays and weekends. We are big believers in continuing education for our personnel.

As always, we are extremely appreciative of your support, particularly during uncertain times. If there are any questions I have failed to answer above, please call Doreen, Alex, Ashley or myself.

Sincerely,
William A. Ackman

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Few Gain, Many Lose from Frannie Bailout

Monday, September 8th, 2008

UK bank shares are having a huge day (above are the 9:20 a.m. (Eastern Time) prices of UK bank stocks, September 8, 2008), following this weekends Frannie bailout announcement.

It appears that the short squeeze in bank stocks is in this morning’s trading.

Here are some excerpts from the saavy folks at DealBook.

Over the years, Fannie Mae and Freddie Mac showered riches on many winners: their executives, Wall Street bankers and Washington lobbyists. Now the foundering mortgage giants are leaving some losers in their wake, notably their shareholders, rank-and-file employees and, in the worst case, American taxpayers.

Golden Parachutes all around:

Daniel H. Mudd, the departing head of Fannie Mae, stands to collect $9.3 million in severance pay…

Richard F. Syron, the departing chief executive of Freddie Mac, could receive an exit package of at least $14.1 million

Its not clear that these former Frannie executives will actually get compensated.

But worst of all, long investors in either are getting killed:

The shareholders of Fannie Mae and Freddie Mac, including many employees, will not be so lucky. The companies’ share prices have plunged about 90 percent this year, wiping out about $70 billion of shareholder value. The shares are likely to be worth little or nothing under the government’s rescue plan.

As a result, Wall Street money managers and everyday investors alike stand to lose big. Bill Miller, the star mutual fund manager at Legg Mason, increased his bet on Freddie Mac even as the company’s shares plummeted this year. Last week, when Freddie Mac stock was trading at about $5, Legg Mason disclosed that it had bought an additional 30 million shares. Other value-oriented investors, including Rich Pzena, David Dreman and Martin Whitman, also placed big bets that the mortgage companies would recover. None of these money managers returned calls for comment.

“I am just shocked how they missed this, and why, when it became completely clear that the problem was snowballing, guys like Bill Miller doubled down,” Douglas A. Kass, head of Seabreeze Partners and an outspoken short-seller, told The Times.

And the few investors that gain:

Among the most vocal short-sellers betting against the companies is William A. Ackman, who runs a hedge fund called Pershing Square Capital. Mr. Ackman was among the earliest to warn of the credit crisis, and he is believed to have landed a windfall after shorting both companies, according to The Times, which cited a person with direct knowledge of a recent investment letter.

In the end, American taxpayers have been handed the bill, helping the rest of us around the world sleep a little better at night, now that a great deal of credit risk has been been mitigated.

Thank you Secretary Paulson.

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