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.

Tags: Agricultural commodities, Agriculture, Aplomb, Asia, asset class, Australia, Automakers, Bail Out, Bailout, Baltic Dry Index, Bank Of Japan, Banking System, Banks, Barack Obama, Barry Ritholtz, Basis Point, Basis Points, Bear Market, Bear Markets, Bear Stearns, Bernanke, Bill King, Bill Rates, Blog, Bloomberg, Bonds, Bottoms, Bps, Br, Brazil, BRIC, Bric Countries, Brokers, Bullion, Canada, CDS, Cement, Central Banks, Chart, China, Cnbc, Cnn, Coal, Collapse, Commodities, Commodity, contango, Corporate Bonds, COT, CPI, Crash, Credit, Credit Cards, Credit Crisis, Credit Default Swap, Credit Market, Credit Markets, Credit Spreads, Currency, Current, Deflation, Diffe, dig, Dollar, Dow, Earnings, Eco, Economic Activity, Economic Indicators, Economic Reports, Economic Stimulus Plan, Economics, Economist, Economists, Economy, eev, Eight Times, Emerging Market, Emerging Markets, energy, Equity Research, Euro, Failure, Fannie Mae, Fed, Federal Reserve, fertilizer, financial stocks, Financial Times, Financials, Financiers, Focus, France, Freddie Mac, FT.com, GDP, GDP Growth, Germany, Global Stock, Global Stock Markets, Gold, Gold Bullion, gold stocks, Government Bonds, government spending, Grain, Health, Hell, high yield, Hong Kong, Housing Market, Img, India, inflation, Information, Infrastructure, Infrastructure Investment, interest rates, International, interview, Investment, Investment Outlook, Investors, Iron Ore, Issuance, Italy, Japan, Jim Rogers, Leading Indicator, Lehman Brothers, Leverage, liquidity, Litany, Loc, Loom, Market Cap, Market Declines, Markets, Measures, Meredith Whitney, Merrill Lynch, Metals, Middle Class, Mining, Monetary Policy, Money, Mortgage, Msci Emerging Markets, Msci Emerging Markets Index, Msci World Index, Natural Gas, Negative Territory, Net Assets, Nick Anderson, Nouriel Roubini, Obama, oil, Oil Prices, Outlook, Outperformance, P500, People, Peter Schiff, Php, Physical Assets, physical gold, PIMCO, Platinum, President Elect, Rally, Raw Material, Recession, REW, RGE Monitor, risk, Rose, Roubini, Russia, S&P 500, S&P500, saa, Sentiment, Setback, Shareholders, Signs, Silver, Slowdown, Societe Generale, South Africa, South Korea, spreads, Squeeze, Stimulus Package, Stock Market, Stock Markets, Stock Prices, Stocks, Switzerland, T Bills, Taiwan, Target, Target Rate, Tarp, The Big Picture, Trading, Treasuries, Treasury Bill, Treasury Bills, Treasury Bonds, Treasury Note, Treasury Securities, Trillion, UK, upw, US Banks, US Dollar, Us Government, Us Senate, Us Treasury, Value, Video, Volatility, Wachovia, Wages, Wall Street, Wall Street Journal, Water, Youtube, Ytd
Posted in Bonds, Commodities, Credit Markets, Economy, Emerging Markets, Gold, India, Markets, Oil and Gas, Outlook, US Stocks | No Comments »

Nassim Taleb on Charlie Rose

Tuesday, December 9th, 2008

Charlie Rose interviews Nassim Taleb, author of The Black Swan, December 4. Taleb’s outlook makes Roubini seem an optimist. The interview is 23 minutes in length. Taleb leads a fascinating discussion with Charlie Rose, rich in analogy, and with a clarity that is brings all that is going on in the financial system into the glare of daylight.

Here is an excerpt:

CHARLIE ROSE: But let me go - you mentioned Nouriel Roubini, who has been here and who has become well-known as someone who has predicted this and saw it coming, and scares the hell out of people when he comes and sits where you do, because he sees it as getting worse, and even suggests sometimes it may mark the decline of America. How bad do you think…

NASSIM NICHOLAS TALEB: I think it is worse than Roubini thinks.

No, I - I had the same story, haven’t changed my story since - and what convinced me of this is that we switched from an environment of inflation, hyperinflation, where people are afraid of commodity prices rising, to a total deflation in no time. Look at inflation bonds…

… I know that we are going have massive deflation. The overhang of debt, massive deflation. Debt needs to be reduced. And I think Paulson seems to be doing a good job, particularly that they were part of the cause of what happened, you know, it is quite commendable.

Tags: Analogy, Black Swan, Blog, Bonds, Br, Charlie Rose, Clarity, Commodity, Commodity Prices, Decline Of America, Deflation, Dow, Eco, Excerpt, Glare, Good Job, Hell, Hyperinflation, inflation, interview, Interviews, James Taylor, Loc, Nouriel Roubini, Optimist, Outlook, Overhang, Paulson, People, Rose, Roubini, Swan, Taleb, Value, Video, Yo Yo Ma
Posted in Bonds, Markets, Outlook | 2 Comments »

James Grant: Return-Free Risk

Sunday, December 7th, 2008

James Grant, founder and editor of Grant’s Interest Rate Observer, and an editor of the newly published sixth edition of “Security Analysis,” by Benjamin Graham and David L. Dodd, has published a column at FT.com and been the subject of a 24-minute Bloomberg audio interview (below) about the new nature of the market and government securities.

Click Play for James Grant’s December 5, 2008 Bloomberg Audio Interview

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Grant very succinctly redefines the bond market as providing Return-Free Risk, rather than the old standby, Risk-Free Return. Here are a few excerpts:

The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price. At the right price, a lowly convertible bond is a safer proposition than an exalted Treasury. Watching the government securities market zoom, many mistake price action for price.

Yes, Treasuries might conceivably redeem the hopes of their besotted admirers. Maybe a deflationary chasm is about to swallow us all. Never before has the US been so leveraged. And-just possibly-never before were lending standards so reckless as the ones that brought joy to so many astonished mortgage applicants in 2005 and 2006.

In their magnum opus Security Analysis Benjamin Graham and David L. Dodd advise that “bonds should be bought on their ability to withstand depression”. They wrote that in 1934. So far is that rule from being honoured by today’s financiers that not a few bonds-and boxcars full of mortgages - could hardly withstand prosperity. Two urgent questions present themselves. One: does something far worse than recession loom? Two: does that certain something definitely spell much lower interest rates?

On non-Treasury and corporate bonds:

The non-Treasury departments of the credit markets have crashed. No surprise then that prices and values are deranged. Market makers have closed up shop for the year, while hedge funds cower in fear of redemptions. You’d suppose that professional investors – doughty seekers of value – would be combing through the debris for bargains. Alas, no. Most seem content to lend money to Henry Paulson (subsequently to Timothy Geithner) at 2 per cent or 3 per cent.

In corporate debt and mortgages, anomalies and non sequiturs abound. They are especially prevalent in convertible bonds. More so than even the average stressed-out fund manager, convertible arbitrageurs have been through the mill. It was they—and almost they alone—who owned convertibles. Now many of these folk must sell them.

Few buyers are presenting themselves, however, though extraordinary bargains keep popping up.

“Risk‐free return” is the standard tag attached to the government’s solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description - “return‐free risk”.

Read the complete article here.

Tags: Admirers, Attribute, Audio Interview, Benjamin Graham, Bloomberg, Bond Market, Bonds, Boxcars, Br, Chasm, Convertible Bond, Corporate Bonds, Crash, Credit, Credit Market, Credit Markets, Deflation, Desc, Dodd, Eco, Economics, Economy, Excerpt, Excerpts, Financiers, Free Risk, FT.com, government securities, Government Securities Market, Hedge Fund, Hedge Funds, Henry Paulson, Img, Interest Rate Observer, interest rates, interview, Investment, Investment Asset, Investors, James Grant, Jim Grant, Leverage, Loc, Loom, Magnum Opus, Markets, Money, Mortgage, Mortgage Applicants, Paulson, Professional Investors, Prosperity, Recession, Redemptions, risk, Security Analysis, Timothy Geithner, Treasuries, Treasury Bonds, Treasury Departments, Urgent Questions, Value
Posted in Bonds, Credit Markets, Economy, Markets | No Comments »

Baltic Dry Index: A Valuable Leading Indicator?

Friday, December 5th, 2008

The Baltic Dry Index is a very important indicator of the health of trade globally, as it measures shipping activity in dry cargo.

Take a look at the chart below: According to the BDI, one of the purest economic indicators, the activity of shipping dry bulk cargo, mainly consisting of commodities such as coal, steel, iron ore, and cement, has almost completely ground to a halt, as indicated by the crash in the index’s value.

The BDI offers a real time glimpse at global raw material and infrastructure demand. Unlike stock and commodities markets, the Baltic Dry Index is totally devoid of speculative players. The trading is limited only to the member companies, and the only relevant parties securing contracts are those who have actual cargo to move and those who have the ships to move it. ^[1]

Another interesting feature of the BDI, is its high correlation to equity markets. Take a look at BDI vs. S&P500 and FXI (China 25 Index iShare), Crude Oil and Copper:

Baltic Dry Index vs. S&P 500

Baltic Dry Index vs. FXI (FTSE Xinhua 25 Index iShare)

Baltic Dry Index vs. Crude Oil

Baltic Dry Index vs. Copper

We’ll keep an eye on credit markets, and the Baltic Dry Index as indicators of the vitality (or lack thereof) of the economy and markets and keep you posted.

As goes the BDI (a leading indicator), so goes the economy, and perhaps equity markets (and commodities, we might add).

At the time of the publishing of this article, the BDI stands at 663 pts.

Tags: Array, Baltic Dry Index, Bdi, Blog, Br, Bulk Cargo, Cargoes, Cement, Chart, China, Coal, Commodities, Commodities Prices, Copper, Correlation, Crash, Credit, Credit Market, Credit Markets, Crude Oil, Debacle, Dow, Dry Cargo, Eco, Economic Indicators, Economy, Equity Market, Failure, FTSE, Ftse Index, Ftse Xinhua, Fxi China, Glimpse, Grains, Health, Img, Infrastructure, Investment, Iron Ore, Ishare, Issuance, Leading Indicator, Lehman Brothers, Loc, Markets, Measures, Member Companies, oil, P500, Php, Precipitate, Raw Material, Relevant Parties, S&P 500, S&P500, Shipping Activity, Time Glimpse, Trading, Value, Vitality
Posted in Commodities, Credit Markets, Economy, Markets, Oil and Gas | No Comments »

Bill Gross, Investment Outlook, December 2008

Wednesday, December 3rd, 2008

In his latest Investment Outlook, Bill Gross, head honcho at PIMCO, discusses the advent of transitioning from the levering world of pre-2008 into the delevering world we now find ourselves in. He points out that in the “new” world we should no longer apply the measures of the past for concluding that stocks are cheap, and that it is a transgenerational idea we need to retool for.

Gross points out the “Q” ratio and Robert Shiller’s 10 year average P/E ratio (above) as evidence that stocks are arguably cheap, but goes on to discredit the reliability of these indicators, saying:

“Professor Shiller may be on to something, although even his 10-year approach may not be enough to adjust for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. Recent Investment Outlooks and indeed, discussions in PIMCO’s Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:

1. Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios - the ability of companies to make money by making paper - are coming down, not going up. In addition, the availability of cheap financing - absent government’s checkbook - will likely not return. Narrow yield spreads and low real corporate interest rates are gone. Last, but not least, the historical declines of corporate tax rates, shown graphically in Chart 3, will not likely continue downward in a Democratically-dominated Washington.
2. Globalization’s salutary growth rate of recent years may now be stunted. While public pronouncements from almost all major economies affirm the necessity for increased trade and policy coordination, and avoiding the destructive tendencies of one-off currency devaluations as a local remedy for global problems, investors should not bank on the free trade mentality of recent years to support historic growth rates. Already we are seeing separate ad hoc policy responses with very little cooperation. Not only does the EU’s approach differ from that of the U.S., but France is in many ways an odd man out within its own community. Asia is legitimately suspicious of any U.S. endorsed approach given the failure of America’s capitalistic model.
3. Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow. Not only have dancers on the financed-based dance floor been shown the exit à la Chuck Prince, but those that remain have been publicly chastened and handcuffed. Golden parachutes, options, executive compensation and bonuses themselves are now at risk. Care to climb to the throne of this new world? Well, yes, egos will always dominate, but the rules will be changed and hormone levels lowered.
4. The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer.

My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to - that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”

In a recent article we noted that the trailing P/E ratio of the S&P500 had ticked up in the year-to-date to November 10, 2008, while the overwhelming majority of global equity markets had experienced substantial P/E compression. This suggested that the E (for earnings) had declined as much as P (for price)in the S&P500. Is the S&P500 due for P/E compression?

You may read the Bill Gross’ Investment Outlook newsletter in its entirety here.

Tags: Advent, Asia, Bill Gross, Blog, Br, capitalism, Cement, Chart, Chuck Prince, compression, Corporate Profits, Credit, Currency, Current, Deflation, Diffe, Dow, Earnings, Eco, Economy, Einstein, Equity Market, Failure, Fed, France, Gearing Ratios, globalization, Gold, Gross Head, Gross Investment, Head Honcho, Img, interest rates, Investment, Investment Committee, Investment Outlook, Investors, Invisible Hand, Leverage, Loc, Markets, Measures, Money, New Universe, Outlook, Outlooks, P/E, P500, People, PIMCO, risk, Robert Shiller, S&P500, spreads, Stock Market, Stock Market Investors, Stock Prices, Stocks, Transitioning, Trumps, Universe, Valuations, Value, Valuing Stocks
Posted in Credit Markets, Economy, Gold, Markets, Outlook | 2 Comments »

Words from the (investment) wise for the week that was (November 24 – 30, 2008)

Sunday, November 30th, 2008

We are very pleased to welcome Dr. Prieur du Plessis as an editorial contributor to GreenLightAdvisor.com. Prieur du Plessis has 25 years’  of global experience in professional investment research and portfolio management. More than 1,000 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns. He has also published a book, Financial Basics: Investment. He also authors a well read blog Investment Postcards from Capetown.

Prieur is chief executive and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and other African countries.

Plexus is the South African partner of John Mauldin, author of the Thoughts from the Frontline e-letter, and also has an exclusive licensing agreement with California-based Research Affiliates for managing and distributing its enhanced Fundamental Index methodology in the Pan-African area.

The holiday-shortened Thanksgiving week brought investors an additional item to be thankful for when stock markets closed higher for five consecutive trading days - a rare winning streak last accomplished in July 2007. The S&P 500 Index gained 19.1% since the start of the rally on November 21 and 12.0% on the week, registering the largest weekly gain since 1974.

Source: Daryl Cagle

Worrisome economic reports were cast aside by equity bulls, arguing that the bad news had already been priced in. However, US Treasury Note yields were less sanguine and fell to its lowest level on record, pointing to deflation concerns and suggesting that investors remained skeptical about the government’s latest moves to help revive the ailing economy. Importantly, US three-month Treasury Bills were trading at a minuscule 0.03%, indicating that liquidity was still being hoarded.

President-elect Obama stressed the need for quick action to expedite an economic recovery and introduced his administration’s economic team, including former Federal Reserve Chairman Paul Volcker as head of a new White House Economic Recovery Advisory Board tasked to revive growth in the US. Involving the 81-year Volcker in this way is a smart move by Obama.

A catalyst for last week’s stock market recovery was the announcement on Monday of the US government’s rescue plan for Citigroup (C), including a direct $20 billion investment and $306 billion in asset guarantees.

With credit markets still not thawing after the introduction of various central bank liquidity facilities and capital injections, the Fed on Tuesday unveiled further steps aimed at lowering borrowing costs for consumers and home buyers. The Fed will buy $100 billion of debt from Fannie Mae (FNM), Freddie Mac (FRE) and the Federal Home Loan Banks, and also purchase up to $500 billion of mortgage paper backed by the agencies. The Fed will furthermore lend $200 million to holders of key asset-backed securities regarding small business and consumer (auto, student, credit card) loans.

Source: The New York Times, November 25, 2008.

Commenting on the US government’s bailout actions and quoting from the Jerusalem Post, Bill King said: “There is one last thing that Hank, Ben and Geithner can do: ‘The country’s chief rabbis are calling for a mass prayer rally on Thursday in the hope that heavenly intervention will stem the global financial crisis.’”

Next, a tag cloud of the text of the dozens of articles I have devoured over the past week. This is a way of visualizing word frequencies at a glance. The usual suspects feature prominently, with “gold” attracting increasing attention.

Has the stock market reached a secular low or is it just bouncing off oversold levels? According to Fox Business Network, legendary investor Jim Rogers said: “We’re ready for a rally. I mean, the market in October and earlier this month has had a huge selling climax. I covered a lot of my shorts. Who knows if I’m right or not. But I expect the market to rally for some time. It may rally into next year. But … this is a false rally. It’s not going to be great. It’s not the end of the problems in America and it’s not the end of the bear market.”

A positive for the bulls is that the period post Thanksgiving through the end of the year has usually been a strong time for stocks. According to Jeffrey Hirsch (Stock Trader’s Almanac), “December is normally a banner month for stocks, ranking second [on the monthly calendar] for the Dow and S&P 500 and third for the Nasdaq.”

Should the bullish seasonal tendencies hold true on this occasion, possible first targets are the November 4 highs of 9,625 for the Dow (current level 8,829) and 1,006 for the S&P 500 (current level 896). This will also result in both indices clearing their 50-day moving averages.

“There is no doubt that time is needed for volatility to settle down before many will have the confidence to return to investing, but if one looks beyond the end of the year, 2009 will almost certainly be a better year for investors than 2008,” said David Fuller (Fullermoney) from London.

Although there is not yet conclusive evidence that we are leaving the corpse of the bear behind (especially with Q4 earnings disasters looming in January), it would appear that the nascent rally could have more steam left. (Also read my recent posts “Is the tide turning for stocks” and “Does the stock market rally have legs?“)

I am about to hit the road again - traveling to New York City - and blog posts will therefore take a back seat for the next week as I explore the Big Apple and meet with friends, blog readers and business associates in the cold weather and depressed economic climate.

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 sentiment is as dark as it has ever been, although the free fall in confidence may be over,” said the latest Survey of Business Confidence of the World conducted by Moody’s Economy.com. “Pessimism is pervasive across the entire globe, with the only distinction being that Asian businesses are somewhat less nervous than elsewhere. Pricing pressures are falling rapidly, although they are not yet consistent with outright deflation.” The global economy is suffering a severe recession according to the results of the business confidence survey.

Economic indicators released in the US during the past week all pointed to a deepening recession. According to Briefing.com, Q3 GDP was revised down to -0.5% from -0.3%, durable orders slumped by 6.2%, existing home sales fell by 3.1%, new home sales dropped by 5.3%, personal spending declined by 1.0%, and weekly initial claims, while improved from the prior week, continued to register a reading above 500,000.

The Chicago Purchasing Managers Index came in at 33.8, the weakest number since the serious recession of 1982. “The national number due next Monday will be just as ugly, as durable goods were down far more than expected, by a negative 6.2%,” added John Mauldin (Thoughts from the Frontline).

Commenting on the outlook for interest rates, Asha Bangalore (Northern Trust) said: “Going forward, real GDP is expected to show a decline that is upward of 4.0% in the fourth quarter of 2008. The Fed is widely expected to lower the Federal funds rate to 0.5% on December 16.” However, the Fed’s quantitative easing approach to monetary policy now seems to be targeting the quantity of money rather than its price.

Elsewhere in the world, the People’s Bank of China (PBoC) slashed its benchmark interest rates by 108 basis points and also lowered the reserve requirement for banks. This move indicates that China will be joining the rest of the world in a marked economic slowdown.

For the upcoming week, the European Central Bank and the Bank of England are expected to reduce interest rates by 50 and 75 basis points respectively in the light of a deteriorating economic outlook.

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

Source: Yahoo Finance, November 28, 2008.

In addition to the Fed releasing its Beige Book (Wednesday) and interest rate decisions by the European Central Bank and the Bank of England (Thursday), next week’s US economic highlights, courtesy of Northern Trust, include the following:

1. ISM Manufacturing Survey (December 1): The consensus for the manufacturing ISM composite index is 38.4 versus 38.9 in October.

2. Employment Situation (December 5): Payroll employment in November is predicted to have dropped by 300,000 after 240,000 jobs were lost in October. The unemployment rate is expected to move up two notches to 6.7%. Consensus: Payrolls: -300,000 versus -240,000 in October, unemployment rate: 6.7% versus 6.5% in October.

3. Other reports: Construction spending (December 1), auto sales (December 2), ISM non-manufacturing, productivity and costs (December 3), and factory orders (December 4).

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, November 28, 2008.

Equities Global stock markets surged during the past week on the back of a combination of bargain hunting and short covering, albeit on light trading volume as a result of the Thanksgiving holiday in the US.

Both mature and emerging markets shared handsomely in the rally that commenced on November 21, as shown by the subsequent gains of the MSCI World Index (+15.7%) and the MSCI Emerging Markets Index (+13.5%). Notwithstanding the improvement, these indices are still down by 43.8% and 57.7% respectively for the year to date.

Click here or on the thumbnail below for a (delightfully 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 US stock markets all rallied sharply over the week as shown by the major index movements: Dow Jones Industrial Index +9.7 (YTD -33.5%), S&P 500 Index +12.0% (YTD -39.0%), Nasdaq Composite Index +10.9% (YTD ‑42.1%) and Russell 2000 Index +16.4% (YTD -38.2%).

The bar chart below, also from Finviz.com, shows the US sector performances over the week, and specifically how strongly financials and materials have recovered.

As far as industry groups are concerned, the automobile manufacturing group (+82%) was the top performer for the week. General Motors Corp (GM) and Ford Motor (F) rose by 71% and 88% respectively on the expectation that auto makers will receive a government bailout.

The homebuilding group (+59%) was the second-best performer on the prospect that the US government’s latest rescue package will result in lower mortgage rates and mortgage credit becoming more readily available.

Seven of the ten underperforming groups were from the three top-performing sectors for the year to date - consumer staples, health care and utilities. These sectors, which typically outperform in a declining market, tend to lag in a rising market such as the one experienced last week.

Interestingly, the percentage of S&P 500 stocks trading above their 50-day moving averages has increased from almost zero in October to 19% on Friday - a promising improvement.

I often get asked by readers about Richard Russell’s (Dow Theory Letters) latest views. This is what the old-timer said on Friday: “The big question now is whether the tide is in the early process of turning bullish. If so, we should be seeing a series of constructive, even bullish days. … I wonder whether my more aggressive subscribers shouldn’t jump the gun and maybe buy the Diamonds (DIA) at the opening on Monday.”

Fixed-interest instruments The ten-year US Treasury Note yield declined to its lowest level since records began in 1958, closing 25 basis points lower on the week at 2.93% after falling as low as 2.82% earlier on Friday.

In addition to economic and deflation worries, Treasuries also benefited from lower mortgage rates as a result of the Fed’s decision to buy GSE-insured mortgage paper. The 30-year fixed mortgage rate dropped by 25 basis points to 5.84%.

“The lower mortgage rates threaten to trigger a wave of mortgage refinancing, the prospect of which has pushed investors to hedge that risk by buying ten-year Treasury debt, a benchmark for mortgage rates,” reported the Financial Times“.

The UK ten-year Gilt yield dropped by 9 basis points to 3.78% and the German ten-year Bund yield fell by 12 basis points to 3.26%. Emerging-market bonds also performed well, with the JPMorgan EMBI Global Index gaining 5.1% during the week.

Although some progress has been made as a result of central banks’ liquidity facilities and capital injections, the credit markets are not yet thawing (see my “Credit Crisis Watch” of November 28). The TED and LIBOR-OIS spreads have tightened since the panic levels of October 10, whereas the CDX and iTraxx indices have also shown some improvement over the past few days. However, US Treasury Bills and high-yield spreads are still at crisis levels.

Currencies Most currencies rebounded against the US dollar during the past week as the greenback came under pressure as a result the Fed’s new measures to unclog the credit markets.

Over the week the US dollar lost ground against the euro (-0.8%), the British pound (-3.1%), the Swiss franc (-0.8%), the Japanese yen (-0.3%), the Canadian dollar (-2.4%), the Australian dollar (-3.7%) and the New Zealand dollar (-4.3).

The US currency also fell against emerging-market currencies such as the Brazilian real (‑7.7%), the Turkish lira (-6.0%) and the South African rand (-4.1%).

Interestingly, the Chinese renminbi (+6.9%) is the only major emerging-market currency that has appreciated against the US dollar over the year to date.

Commodities The Reuters/Jeffries CRB Index (+4.7%) closed higher by the end of the week - only its fifth positive week since commodities peaked early in July. Arguing against a more lasting reversal of fortune for commodities, the Baltic Dry Index - a benchmark for shipping major raw materials, including coal, iron ore and grain, and generally an excellent barometer of economic activity - declined by 14.5% to its lowest level since 1987.

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

Gold bullion (+3.4%) remained in favor with investors as a result of a solid supply/demand situation, store-of-value considerations and a positive-looking chart (see below). A research report from Citigroup, as reported by the Telegraph, said gold could rise above $2,000 within two years. Platinum (+6.9%) and silver (+7.6%) - massive underperformers since March - were also in demand last week.

In the aftermath of Thanksgiving, may I remind you of the following old stock market adage: “The bears have Thanksgiving and the bulls have Christmas.” Let’s hope for an early Christmas! 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.

Hat tip: Mish (via Live Leak)

Big Think: Beyond the crisis - conversation with Larry Summers, George Soros and Robert Merton

Source: Big Think, November 2008.

PBS News Hour: Taleb, the risk maverick “Interview with Nassim Nicholas Taleb, famous economist and author of ‚The Black Swan’ and Dr. Mandelbrot, professor of Mathematics. Both say that the present economy is more serious than the Great Depression, and the economy during the American Revolution.”

Source: PBS News Hour (via YouTube), October 22, 2008.

IDD magazine: John Bogle - great expectations “John Bogle founded the Vanguard Mutual Fund Group in 1974. He served as its chairman and chief executive until 1996 and remained on as senior chairman until 2000.

“Recently, he wrote ‘Enough: True Measures of Money, Business and Life’, which was published by John Wylie & Sons.

“To call it a business book - a how-to or memoir - would be too simplistic. In fact, it is far from the typical business book because it offers some interesting life lessons on dealing with people, especially clients and customers.

“Bogle spoke with IDD last week, offering his thoughts on long-term investing and how it may come back - as opposed to rapid-fire maneuvers in and out of a company’s shares - and his thoughts on PE fund managers as well as hedge funds. Not surprisingly, they are not positive.

“As Bogle sees it ‘we have made Wall Street too much of a casino. It is totally dominated by speculation … we are engaged in an orgy of speculation the likes of which has never been seen in the history of this country.’

“His rule of thumb for investors: your bond position should equal your age. ‘I’m about 80% bonds. I started 65% about 15 years ago,’ says Bogle.

“Following are excerpts from the interview:

“IDD: How do you think the credit crisis will play out?

“BOGLE: The market can’t bail itself out of this mess. Wall Street has a lot to answer for to Main Street and yet Main Street, which is really where the tax base is, is going to have to bail out Wall Street for Wall Street’s errors. And that is, of course, a tragedy - an economic tragedy. But I am persuaded because I respect people like Larry Summers, I certainly respect Ben Bernanke. I am not so sure about Hank Paulson. I suppose I respect him in a way, but his issue is that he is an investment banker. So it should come as no surprise to anybody that he looks at these things from an investment banker’s perspective. How else can he look at them? It [the bailout] has to happen. I think it is too bad it has to happen, but I think we ought to get ready for building a better financial system, which means building a smaller financial system because what is going on Wall Street is a casino and our croupier has raked too much off of the table before we get paid.

“IDD: When you say our financial system gets smaller, what do you mean by that?

“BOGLE: Revenues will be less for a whole bunch of reasons. First, they are never going to be allowed - with the government being part owners of them - to have 35-to-1 leverage. Number two, we’re going to have better disclosure about what is on that balance sheet. When you think about it, if you are leveraged 35 to 1 and all your assets are Treasury bills I don’t see that as much of a problem. The problem is that none of them are Treasury bills. They are toxic mortgages and we need much better disclosure of that. The third thing is that they are going to have to be content with less revenues.”

Click here for the full article.

Source: Aleksandrs Rozens, IDD magazine, November 17, 2008.

Spiegel Online: George Soros - “The economy fell off the cliff” “George Soros, 78, has made billions as a hedge-fund manager and investor. Spiegel spoke with him about the current financial crisis, how he expects President-elect Barack Obama to respond to the economic disaster and the responsibilities borne by speculators.

“SPIEGEL: Mr. Soros, in spite of massive interventions by governments and federal banks the financial crisis is getting worse. The stock markets are in free fall, millions of people could lose their jobs. More and more companies are in trouble, from General Motors in Detroit to BASF in Ludwigshafen. Have you ever seen anything like it?

“Soros: Never. I find the present situation dramatic and overwhelming. In my latest book ‘The New Paradigm for Financial Markets: The Credit Crisis of 2008′ I predicted the worst financial crisis since the 1930s. But to tell you the truth: I did not actually anticipate that it would get as bad as it did. It has gone beyond my wildest imagination.

“‘I find the present situation dramatic and overwhelming.’

“SPIEGEL: What are your fears for the coming months?

“Soros: I think that the dark comes before dawn. The financial markets are under great pressure because of the lack of leadership during the transition period. In the next two months, the markets will experience maximum pressure. Then we will see some initiatives from the Obama administration. How long the crisis lasts will depend on the success of these measures.

“SPIEGEL: The markets don’t seem to have much confidence in the new president - in stark contrast to the enthusiasm in the population. Since Election Day on November 4, stocks have fallen by almost 20%.

“Soros: I have great hopes for Barack Obama. But at the time of the election the financial community had not yet fully grasped the magnitude of the economic decline. They did not anticipate that the default of Lehman Brothers would cause cardiac arrest in the markets. The economy fell off the cliff, you begin to see mangled bodies lying at the bottom.”

Click here for the full article.

Source: Spiegel Online, November 24, 2008.

The New York Times: Paulson on new moves in rescue plan “CNBC coverage of opening remarks by Treasury Secretary Henry Paulson in a news conference describing new steps to ease credit markets.”

Click here for the article.

Source: The New York Times, November 25, 2008.

Asha Bangalore (Northern Trust): Fed institutes two more programs to support working of financial markets “The Federal Reserve announced the creation of Term Asset-Backed Securities Loan Facility (TALF) in conjunction with the Treasury. The program that will involve the Federal Reserve Bank of New York lending up to $200 billion to holders of AAA-rated asset backed securities ‘backed by newly and recently originated consumer and small business loans’.

“The US Treasury Department, under the Emergency Economic Stabilization Act of 2008, will provide $20 billion of credit protection to the Federal Reserve Bank of New York for these non-recourse loans. The loans will involve a haircut based on the asset class and there is fee for participation.

“This new program is designed to address problems in the auto, student, credit card, and Small Business Administration guaranteed loans. Loans to consumers have become scarce because securitization of consumer loans has come to a standstill. Funding these loans should result in a resumption of the working of these markets. A date and details are being worked out.

“The Fed also announced it will start purchasing Government Sponsored Enterprises (GSE) - Fannie Mae, Freddie Mac, and Federal Home Loan Banks - this week. Spreads of these securities vis-à-vis Treasury securities have widened sharply in recent days. Purchases of $100 billion in GSE direct obligations and $500 of Mortgage Backed Securities will be undertaken under this program. The objective of this action is to increase the availability of credit for purchases of homes.

“These actions will raise reserves in the banking system and increase the size of the Fed’s balance sheet. The sum of today’s action is $800 billion. The Fed’s balance sheet as of November 25, 2008 had ballooned to 2.19 trillion from $995.57 billion as of September 17, 2008.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, November 25, 2008.

Bloomberg: US pledges top $7.7 trillion to ease frozen credit “The US government is prepared to provide more than $7.76 trillion on behalf of American taxpayers after guaranteeing $306 billion of Citigroup debt yesterday. The pledges, amounting to half the value of everything produced in the nation last year, are intended to rescue the financial system after the credit markets seized up 15 months ago.

“The unprecedented pledge of funds includes $3.18 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis.

“When Congress approved the TARP on October 3, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson acknowledged the need for transparency and oversight. Now, as regulators commit far more money while refusing to disclose loan recipients or reveal the collateral they are taking in return, some Congress members are calling for the Fed to be reined in.

“Bloomberg News tabulated data from the Fed, Treasury and Federal Deposit Insurance Corp. and interviewed regulatory officials, economists and academic researchers to gauge the full extent of the government’s rescue effort.

“The bailout includes a Fed program to buy as much as $2.4 trillion in short-term notes, called commercial paper, that companies use to pay bills, begun October 27, and $1.4 trillion from the FDIC to guarantee bank-to-bank loans, started October 14.

“William Poole, former president of the Federal Reserve Bank of St. Louis, said the two programs are unlikely to lose money. The bigger risk comes from rescuing companies perceived as ‘too big to fail’, he said.”

Source: Mark Pittman and Bob Ivry, Bloomberg, November 24, 2008.

Barry Ritholtz (The Big Picture): Big bailouts, bigger bucks “Whenever I discussed the current bailout situation with people, I find they have a hard time comprehending the actual numbers involved. That became a problem while doing the research for the Bailout Nation book. I needed some way to put this into proper historical perspective.

“If we add in the Citi bailout, the total cost now exceeds $4.6165 trillion. People have a hard time conceptualizing very large numbers, so let’s give this some context. The current Credit Crisis bailout is now the largest outlay in American history.

“Jim Bianco of Bianco Research crunched the inflation adjusted numbers. The bailout has cost more than all of these big budget government expenditures combined:

• Marshall Plan: Cost: $12.7 billion, Inflation Adjusted Cost: $115.3 billion • Louisiana Purchase: Cost: $15 million, Inflation Adjusted Cost: $217 billion • Race to the Moon: Cost: $36.4 billion, Inflation Adjusted Cost: $237 billion • S&L Crisis: Cost: $153 billion, Inflation Adjusted Cost: $256 billion • Korean War: Cost: $54 billion, Inflation Adjusted Cost: $454 billion • The New Deal: Cost: $32 billion (Est), Inflation Adjusted Cost: $500 billion (Est) • Invasion of Iraq: Cost: $551b, Inflation Adjusted Cost: $597 billion • Vietnam War: Cost: $111 billion, Inflation Adjusted Cost: $698 billion • NASA: Cost: $416.7 billion, Inflation Adjusted Cost: $851.2 billion

TOTAL: $3.92 trillion

“That is $686 billion less than the cost of the credit crisis thus far. The only single American event in history that even comes close to matching the cost of the credit crisis is World War II: Original Cost: $288 billion, Inflation Adjusted Cost: $3.6 trillion. The $4.6165 trillion dollars committed so far is about a trillion dollars ($979 billion dollars) greater than the entire cost of World War II borne by the United States: $3.6 trillion, adjusted for inflation (original cost was $288 billion).

“I estimate that by the time we get through 2010, the final bill may scale up to as much as $10 trillion dollars …”

Source: Barry Ritholtz, The Big Picture, November 25, 2008.

Casey’s Charts: Budgeting your future “The October statement of the US Treasury Department revealed that the federal deficit has reached the largest level on record. Over the last twelve months, the US government spent $618 billion dollars more than it was able to collect.

“The deficit is already enormous and with all signs pointing towards even greater government spending, the implications are astounding. Casey Research Chief Economist Bud Conrad predicts that next year’s budget deficit will be closer to the tune of $1.5 trillion!”

Source: Casey’s Charts, November 21, 2008.

Breitbart: IMF chief economist - worst of financial crisis yet to come “The IMF’s chief economist has warned that the global financial crisis is set to worsen and that the situation will not improve until 2010, a report said Saturday. Olivier Blanchard also warned that the institution does not have the funds to solve every economic problem.

“‘The worst is yet to come,’ Blanchard said in an interview with the Finanz und Wirtschaft newspaper, adding that ‘a lot of time is needed before the situation becomes normal.’

“He said economic growth would not kick in until 2010 and it will take another year before the global financial situation became normal again.

“The International Monetary Fund on Friday promised to help Latvia deal with its economic crisis after it assisted Iceland, Hungary, Ukraine, Serbia and Pakistan.

“But Blanchard said the IMF was not able to solve all financial issues, in particular problems of liquidity.

“Withdrawals of capital leading to problems of liquidity ‘can be so significant that the IMF alone cannot counter them’, he said, adding that massive withdrawals of investments from emerging countries could represent ‘hundreds of billions of dollars. We do not have this money. We never had it,’ he said.”

Source: Breitbart, November 22, 2008.

The Wall Street Journal: Obama names his economic team “Looking to hit the ground running on January 20 and restore confidence, President-elect Barack Obama seals up his economic appointments.”

Source: The Wall Street Journal, November 24, 2008.

Bloomberg: Obama names Volker to head panel on reviving economy “President-elect Barack Obama named former Federal Reserve Chairman Paul Volcker to head a new White House economic board that will propose ways to revive growth as the US grapples with an ‘economic crisis of historic proportions’.

“‘At this defining moment for our nation, the old ways of thinking and acting just won’t do,’ Obama said at a news conference in Chicago, his third in as many days.

“Volcker, 81, will be chairman of the President’s Economic Recovery Advisory Board. The panel’s top staff official will be Austan Goolsbee, a University of Chicago economist who will also be a member of the president’s Council of Economic Advisers.

“The panel, which will include experts from outside government, will meet about once a month and periodically brief Obama with advice on how to shore up financial markets. Volcker’s position will be part-time.

“‘Sometimes policymaking in Washington can become too insular,’ Obama said. ‘The walls of the echo chamber can sometimes keep out fresh voices and new ways of thinking, and those who serve in Washington don’t always have a ground-level sense of which programs and policies are working.’

“Volcker, who throttled the economy to crush inflation in the 1980s, was an adviser to Obama during the presidential campaign. He was a candidate for Treasury secretary, a job that went to Federal Reserve Bank of New York President Timothy Geithner.

“‘He is one of the most independent-thinking guys you could find and brings massive reputation,’ Ethan Harris, co-head of US economic research at Barclays Capital in New York, said before today’s announcement.”

Source: Kim Chipman and Catherine Dodge, Bloomberg, November 26, 2008.

ABC News: Summers to be top white house economic adviser at NEC “ABC News has learned that President-elect Obama has decided to name former Treasury Secretary Larry Summers the director of the National Economic Council, essentially the president’s senior economic adviser.

“Part of the Executive Office of the President, the NEC was created for the purpose of advising the President on matters related to US and global economic policy. The NEC has four functions, by executive order: ensuring that programs and policy decisions are consistent with the President’s economic goals, monitoring the implementation of the President’s economic policy agenda, coordinating policy-making for domestic and international economic issues, and coordinating economic policy advice for the President.

“Summers was the 71st Secretary of the Treasury, serving from July 1999 until the end of the Clinton administration in January 2001, having previously served as undersecretary for international affairs and deputy secretary of the Treasury. He also served as chief economist of the World Bank.

“At the Treasury Department in the 1990s, Summers worked closely with Tim Geithner, the man Obama intends to nominate to be the next Secretary of the Treasury. The two are said to have an excellent working relationship.

“Some Democrats say that Obama and Summers have an understanding that when current Federal Reserve Chairman Ben Bernanke’s term expires in 2010, Obama will name Summers to take his place.”

Source: ABC News, November 22, 2008.

Fox Business: Wilbur Ross on the next Treasury Secretary

Source: Fox Business, November 21, 2008.

Richard Russell (Dow Theory Letters): “Inflate or die, which one will it be?” “Suddenly, the whole investment world believes in deflation. The TIPS (inflation adjusted government bonds) have collapsed, commodities have crashed, gold goes nowhere, bonds remain near their highs, the dollar remains strong.

“Meanwhile, Bernanke and Paulson are battling the forces of deflation with all the ammunition at their command. I believe Fed chief Bernanke will fight deflation with the last dollar available at the Fed. Paulson will give the US Treasury away before he gives in to deflation and economic contraction.

“How will we know whether Bernanke-Paulson are winning their desperate anti-deflation battle? If they are winning, the dollar and bonds will head down and gold will head higher. If they are losing the battle, the Dow will break below 7,470 and the bear market will continue to eat away at US stocks and the US economy.

“What we are witnessing now is the single greatest economic battle of the century. ‘Inflate or die’, which one will it be?

“Remember, Bernanke’s worst nightmare is dealing with out-of-control deflation. The Fed can halt inflation by pushing up interest rates, but in the case of deflation, the Fed can be helpless. And I ask myself, what happens if Bernanke finds that he is losing the battle against deflation? In that case, we are all survivors. I’ve been there before - during the 1930s. I survived then, and I’ll survive now, and so will my subscribers.

“If Bernanke and Paulson are winning the anti-deflation battle, I believe the first ‘signal’ would be rising gold. So far, it appears to me that gold is undecided. Gold corrected down to the 717 area, then rallied above 800, and now appears to be in the process of testing the 800 level. It would be a plus for gold if December gold can hold above 800. Gold has never been a more important barometer for the future.”

Source: Richard Russell, Dow Theory Letters, November 26, 2008.

Asha Bangalore (Northern Trust): Q3 GDP preliminary estimate “Real gross domestic product declined at an annual average rate of 0.5% in the third quarter of 2008, slightly weaker than the advance estimate of a 0.3% drop. Going forward, real GDP is expected to show a decline that is upward of 4.0% in the fourth quarter of 2008. The Fed is widely expected to lower the Federal funds rate to 0.50% on December 16, 2008.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, November 25, 2008.

Barry Ritholtz (The Big Picture): ECRI leading indicators fall to lowest level ever “One of the questions I seem to be getting all the time is ‘when is this recession going to end?’ To answer that, I turned to Lakshman Achuthan of the Economic Cycle Research Institute (ECRI). Their leading versus coincident chart provides insight into that question.

“The cyclical turns in the leading occur before the coincident - they seem to diverge now and then, and that can be telling. The current story they tell is clearly one of a quickly worsening recession with no end in sight.”

Source: Barry Ritholtz, The Big Picture, November 26, 2008.

Wachovia: US economy in recession mode “Economic problems began to show up in our model in the fourth quarter of last year as the recession probability rose sharply to 75%, and since then the probability has remained high. While the official recession call will come from the National Bureau of Economic Research sometime next year, for decision-makers the operational guideline is a recession outlook today.”

Source: Wachovia, November 24, 2008.

Asha Bangalore (Northern Trust): Durable goods orders show widespread weakness “The 6.2% drop in orders of durable goods reflects widespread weakness in bookings of durable factory goods.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, November 26, 2008.

Breitbart: First-ever decline in online retail spending “Online retail spending fell four percent in the first weeks of November from the same period last year, the first ever such decline in e-commerce spending, online researcher comScore reported on Tuesday.

“The Reston, Virginia-based company said 8.2 billion dollars was spent online during the first 23 days of November, four percent less than during the same period last year, when 8.5 billion dollars was spent online.

“ComScore forecast that online retail spending for the November-December holiday period will be flat versus year ago, significantly lower than last year’s growth rate of 19 percent.

“‘With consumer confidence low and disposable income tight, the first weeks of November have been very disappointing, with online retail spending declining versus year ago,’ said comScore chairman Gian Fulgoni.”

Source: Breitbart, November 25, 2008.

Asha Bangalore (Northern Trust): Weakness in consumer spending most likely to persist “Nominal consumer spending fell 1.0% in October, while inflation adjusted consumer spending dropped 0.5%. Inflation adjusted consumer spending has declined for five straight months, the longest string of declines since the 1981-82 recession. Based on October data and conservative assumptions about November and December, consumer spending is most likely to post a 4.0% drop in the fourth quarter after a 3.7% decline in the third quarter.

“The 0.3% increase in personal income during October follows a 0.1% gain in September that was affected by hurricanes. Personal saving as a percent of disposable income was 2.4% in October compared with 1.0% in September. A small upward drift in personal saving is emerging.”

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, November 26, 2008.

Standard & Poor’s: S&P/Case-Shiller - national trend of home price declines continues “Data through September 2008, released today by Standard & Poor’s for its S&P/Case-Shiller Home Price Indices, shows continued broad based declines in the prices of existing single family homes across the United States, a trend that prevailed since 2007.

“The decline in the S&P/Case-Shiller US National Home Price remained in double digits, posting a record 16.6% decline in the third quarter of 2008 versus the third quarter of 2007. This has increased from the annual declines of 15.1% and 14.0%, reported for the 2nd and 1st quarters of the year, respectively.

“‘The turmoil in the financial markets is placing further downward pressure on a housing market already weakened by its own fundamentals,’ says David Blitzer, Chairman of the Index Committee at Standard & Poor’s.”

Source: Standard & Poor’s, November 25, 2008.

The Wall Street Journal: US agrees to rescue struggling Citigroup “The federal government agreed Sunday night to rescue Citigroup by helping to absorb potentially hundreds of billions of dollars in losses on toxic assets on its balance sheet and injecting fresh capital into the troubled financial giant.

“The agreement marks a new phase in government efforts to stabilize US banks and securities firms. After injecting nearly $300 billion of capital into financial institutions, federal officials now appear to be willing to help shoulder bad assets, on a targeted basis, from specific institutions.

“Citigroup is one of the world’s best-known banking brands, with more than 200 million customer accounts in 106 countries. Its plunging stock price threatened to spook customers and imperil the bank.

“If the government’s rescue plan is a success, it could help bring stability to the entire financial system. If it doesn’t, even deeper doubts about the industry’s future could spread.

“Under the plan, Citigroup and the government have identified a pool of about $306 billion in troubled assets. Citigroup will absorb the first $29 billion in losses in that portfolio. After that, three government agencies - the Treasury Department, the Federal Reserve and the Federal Deposit Insurance Corp. - will take on any additional losses, though Citigroup could have to share a small portion of additional losses.

“The plan would essentially put the government in the position of insuring a slice of Citigroup’s balance sheet. That means taxpayers will be on the hook if Citigroup’s massive portfolios of mortgage, credit cards, commercial real-estate and big corporate loans continue to sour.

“In exchange for that protection, Citigroup will give the government warrants to buy shares in the company.

“In addition, the Treasury Department also will inject $20 billion of fresh capital into Citigroup. That comes on top of the $25 billion infusion that Citigroup recently received as part of the broader US banking-industry bailout.”

Source: David Enrich, Carrick Mollenkamp, Matthias Rieker, Damian Paletta and Jon Hilsenrath, The Wall Street Journal, November 24, 2008.

Paul Kedrosky (Infectious Greed): Citigroup - bad bank to create bad bank incubator “I know it isn’t precisely what this headline means - ‘bad bank’ is a euphemism in bailout circles for walling off from one another functional and non-functional parts of banks - but I still like this from the WSJ today.

“To my way of thinking, if we’re interested in creating bad banks, it’s worth knowing that Citi is a veritable ‘bad bank’ incubator.”

Source: Paul Kedrosky, Infectious Greed, November 23, 2008.

CNBC: Mobuis - attraction of Treasurys will wane with lower yields “Despite continued woes in the US economy, the greenback has seen an unexpected surge against currencies around the world. As investors become ever more risk averse, emerging markets are bearing the brunt of a flight to safety.

“But Mark Mobius, executive chairman of Templeton Asset Management, sees a reversal around the corner.

“‘As everyone is rushing into US Treasurys, they need US dollars to do that and have therefore sold everything in sight,’ Mobius told CNBC. ‘This is why emerging markets have gone down, why commodities have gone down as everyone is moving into dollars.’

“But Mobius said that ‘as US Treasury rates go down to 1% or below you will see the attraction of US Treasurys waning’.

“Mobius also believes that emerging markets have learnt a bitter lesson since the Asian Crisis of 1997-1998. ‘One big lesson was ‘don’t borrow in a currency you are not earning in’,’ he said.

“Emerging markets have also curtailed lending and built up foreign reserves, which they can call upon in almost ‘a reversal of 1997 where the emerging markets were debtors, they are now the creditors’, he added.

“But the surge in the greenback has taken a lot of investors by surprise, Mobius said.

“Having learned from the Asian crisis, companies hedged currencies and ‘ironically these hedges have really worked against them in some cases … as they are over-hedged and it went against them as they were expecting the dollar to go weaker and it went the other way,’ he said.”

Source: CNBC, November 20, 2008.

Bespoke: GSE mortgage spreads tighten “The Fed’s actions this morning [Tuesday] have certainly helped to thaw the credit markets so far. As shown below, spreads between 10-year Fannie Mae bonds and the 10-year US Treasury tightened significantly today. While they are certainly moving in the right direction, even after today’s record decline, spreads are still higher today than they were just a little more than two weeks ago.”

Source: Bespoke, November 25, 2008.

Bespoke: 30-Year fixed mortgage rates falling back “Talk of the 30-year fixed mortgage rate falling back below 6% filled the airwaves yesterday [Tuesday], so below we provide a two-year chart of the rate. Even as the Fed funds rate has fallen from 5.5% to 1%, mortgage rates have failed to decline along with it, which hasn’t done much to help the struggling housing market. Economists and investors are hoping that the Fed’s actions yesterday will start pushing mortgage rates lower. This will help ease the credit crisis as banks will become more willing to lend, providing better interest rates for potential homebuyers. 5.81% is better than the 6.4% seen at the start of the month, but the rate could still stand to drop quite a bit.”

Source: Bespoke, November 26, 2008.

Frank Holmes (US Global Investors): Stock market reversal is near “According to research from Thomas Weisel, the S&P 500 has been a ‘Buy’ since that index closed at 800 last Friday, based on its probability models. They say a verification could come in early December, when monthly liquidity figures come out - if there is extreme positive liquidity to accompany the technical ‘Buy’ signal, history shows that on average there’s a six-month price rally of 18.5%.

“Our oscillator tells us that, statistically speaking, the S&P 500 is extremely oversold and thus due for a reversal toward the mean. The chart above shows that the S&P 500 is now down about four standard deviations over 60 trading days, which is a far more dramatic decline than we saw in 1998, when Russia endured a currency crisis and the collapse of the hedge fund Long-Term Capital Management threatened the global financial sector, and in 2001 after the September 11 terror attacks.

“The possible turnaround that we are seeing is not wishful thinking, but it’s not a sure thing, either. Our confidence grows with every positive data point indicating that a reversal is near, and we will continue watching for these indicators …”

Source: Frank Holmes, US Global Investors - Weekly Investor Alert, November 28, 2008.

Eoin Treacy (Fullermoney): Start thinking about stocks to buy “Angst, fear and anxiety are all related emotions which come to the fore when we feel under pressure and begin to doubt our abilities as investors. However, when we see a market fall such as that of the last few months, we have to rein in the temptation to succumb to such emotions. It will prove more profitable over the medium to longer-term, to turn objective about the opportunities we are being presented with sooner rather than later.

“This does not mean one piles into the market with every spare unit of currency right now, but it is a time to begin to think about the shares one wants to own in a recovery environment. From a value perspective there are a number of instruments which have been hit particularly hard and somewhat unjustifiably by the credit / solvency crisis.

“We now need to begin to think more about recovery potential rather than further potential losses. Stocks and corporate bonds are no longer expensive, some are downright cheap. We have not reached the deep value levels seen in the past, but these need not necessarily appear at the numerical low for the market, if they appear at all. However, one looks at the market, given the extent of the fall, this is not a time to become increasingly bearish, but is one in which to make provisions and possible purchases for a recovery scenario.”

Source: Eoin Treacy, Fullermoney, November 27, 2008.

David Fuller (Fullermoney): Watch developments in US rather than invest there “I believe that America’s problems of debt and deficits are worse than for many other countries. More importantly, I will be guided by price charts, which reflect the collective decisions and views of everyone else. In terms of investment appropriateness, my current view is that I would rather watch developments in the US than invest there.

“The credit / solvency crisis is clearly America’s biggest problem at this time. This is not necessarily true for all other countries, although all are obviously affected to a greater or lesser degree by developments in the USA. I suggest that the West’s credit / solvency crisis was only the second biggest problem for Asia’s developing economies.

“Asia’s biggest recent problem, I maintain, was inflation, not least from previously soaring energy and food prices. That crisis, which in comparison was the USA’s second biggest problem, has largely disappeared today. I suspect commodity inflation will not re-emerge for at least the next year or two, subject to supply, global GDP and the USD.

“Consequently, I believe that developing Asia would be in an excellent position for recovery, were it not for the West’s ongoing credit / solvency crisis. Therefore, the worse the USA’s problems become, the more this will be a drag on Asia’s own recovery. Conversely, if the USA somehow avoids a destructive deflation, Asia should still bounce back more quickly.

“I will invest accordingly.”

Source: David Fuller, Fullermoney, November 26, 2008.

Jeffrey Saut (Raymond James): Geithner gotcha “We still think October 10 represented the capitulation ‘lows’. As Barron’s notes, ‘For a bullish spin, though a weak one, the market has not made a significantly lower low since October 10. The word ’significantly’ is important because some major market indexes, including the Nasdaq, have indeed been setting new lows. But the trend, if we can call it that, has been more sideways than decidedly down.

“A better, but still weak, bullish angle comes from trading volume, or the amount of money committed to either the bull or bear side each day. All of the higher volume days that have occurred since October 10 have come on days when prices rose. Theoretically, when prices are going up and volume increases, it means that investors are chasing the market higher. That’s a sure sign of demand. Subsequent declines occurred with lower volume, so we can conclude that the desire to sell was not quite as strong as it was before October 10.”

Source: Jeffrey Saut, Raymond James, November 24, 2008.

Bespoke: Analysts at their least bullish levels ever “While Wall Street analysts are typically known for being overly optimistic, based on at least one measure, they have never been less bullish. According to Bloomberg statistics that track analyst buy, sell, and hold ratings, only 36% of all ratings are currently buys. As the chart below shows, this is the lowest level since at least 1997, and significantly lower than the 75% level we saw in 1997 and 2000. However, since the Spitzer crackdown on Wall Street research and the bursting of the tech bubble, analysts have grown increasingly shy about putting a buy rating on a stock they cover.”

Source: Bespoke, November 25, 2008.

Bespoke: Q3 and Q4 sector earnings growth “With about 96% of S&P 500 companies having reported third quarter earnings, current EPS growth numbers for the quarter should be very close to what the final tally will read. As shown below, four sectors have had negative year over year growth in the third quarter, while six have had positive growth. Financials and consumer discretionary were once again the sectors that brought down the index as a whole. Financials have seen earnings decline by 129.7% in Q3 ‘08 versus Q3 ‘07. Consumer discretionary has seen earnings decline by 41.4%. Telecom and utilities are the two other sectors with negative Q3 earnings growth, and the S&P 500 as a whole currently stands at -18.4%. The energy sector has had by far the largest earnings growth at 57.4% versus the third quarter of 2007. Consumer staples ranks second behind energy at 10.9%, followed by health care, materials, technology, and industrials.

“So what does the fourth quarter look like? Analysts are expecting the S&P 500 to actually show positive year over year earnings growth in the fourth quarter of 4%. This is because the financial sector is expected to show growth of 64.2% due to the fact that Q4 ‘07 was so bad. Utilities, health care, and consumer staples are the other three sectors expected to see earnings growth, while consumer discretionary, materials, energy, telecom, technology and industrials are expected to see earnings declines.”

Source: Bespoke, November 23, 2008.

Naked Capitalism: Cheery chart - no corporate profits for two years during depression “In case you are starting to look to past crises for clues as to how our financial mess might play out, here is a Great Depression factoid (from Levy Forecast, November 2008):

“Note that the report itself argues that the US will have a ‘contained’ depression, with deep recession conditions for a protracted period and an anemic recovery. It does not believe the zero operating profits pattern of the Great Depression will be repeated.”

Source: Naked Capitalism, November 23, 2008.

Bloomberg: Hambro sees “great entry points” for commodity stocks “Evy Hambro, who manages the world’s largest mining and gold funds at BlackRock, talks with Bloomberg about the outlook for commodities and mining stocks.”

Source: Bloomberg, November 21, 2008.

Bloomberg: Marc Faber says gold is most precious asset

Source: Bloomberg, November 25, 2008.

Ambrose Evans-Pritchard (Telegraph): Citigroup says gold could rise above $2,000 next year “The bank said the damage caused by the financial excesses of the last quarter century was forcing the world’s authorities to take steps that had never been tried before.

“This gamble was likely to end in one of two extreme ways: with either a resurgence of inflation; or a downward spiral into depression, civil disorder, and possibly wars. Both outcomes will cause a rush for gold.

“‘They are throwing the kitchen sink at this,’ said Tom Fitzpatrick, the bank’s chief technical strategist.

“‘The world is not going back to normal after the magnitude of what they have done. When the dust settles this will either work, and the money they have pushed into the system will feed though into an inflation shock.

“‘Or it will not work because too much damage has already been done, and we will see continued financial deterioration, causing further economic deterioration, with the risk of a feedback loop. We don’t think this is the more likely outcome, but as each week and month passes, there is a growing danger of vicious circle as confidence erodes,” he said.

“‘This will lead to political instability. We are already seeing countries on the periphery of Europe under severe stress. Some leaders are now at record levels of unpopularity. There is a risk of domestic unrest, starting with strikes because people are feeling disenfranchised.”

“Gold traders are playing close attention to reports from Beijing that the China is thinking of boosting its gold reserves from 600 tonnes to nearer 4,000 tonnes to diversify away from paper currencies. ‘If true, this is a very material change,’ he said.

“Citigroup said the blast-off was likely to occur within two years, and possibly as soon as 2009. Gold was trading yesterday at $812 an ounce. It is well off its all-time peak of $1,030 in February but has held up much better than other commodities over the last few months - reverting to is historical role as a safe-haven store of value and a de facto currency.”

Source: Ambrose Evans-Pritchard, Telegraph, November 27, 2008.

James Turk (GoldMoney): Scenario for gold is bullish “Gold soared $50 this past Friday. It began the day at $748 and was trading at $800 when the day ended.

“It is rare for gold to achieve such a huge one-day gain. In fact, I checked my records for the past twenty years and found only one other instance when gold climbed $50 or more in a day. Interestingly, the other occurrence was on September 17, 2008, barely two months ago. That rally also took gold back above $800.

“That these two rallies - unique and rare in their magnitude - occurred so near to one another is significant. Is there a message from these two events? Yes, indeed!

“Gold itself is telling us two things. First, there is an enormous short position in gold. Huge rallies occur for a reason, and short covering is always a factor. In order to limit their losses, shorts will bid up the market in a desperate attempt to cover their position. The rule of thumb is straightforward - the bigger the short position, then the bigger the rally.

“Second, and more importantly, these huge rallies are signaling that gold under $800 is too cheap. A higher price is needed to bring supply and demand back into balance.

“There is other, more than ample evidence to support this same conclusion. The demand for physical metal remains strong.

“Friday’s trading action adds to the growing body of evidence that the correction in gold that began after making a new record high in March above $1,020 is ending. The low in gold in all likelihood is probably in place. The $700 level has been tested and re-tested, and the huge rallies launched from prices below $800 mean that other attempts to take gold into the $700s will be met with good demand.

“Gold remains in a bull market, and so does silver. National currencies are in a bear market. Get ready for the next leg in the precious metal’s ongoing bull market.”

Source: James Turk, GoldMoney, November 24, 2008.

The Australian: Perth Mint suspends orders amid rush to buy bullion “Fears of the unknown long-term effects from the global financial crisis have sparked a new gold rush.

“With retail and wholesale clients around the world stocking up on the precious metal, the Perth Mint has been forced to suspend orders.

“As the World Gold Council reported that the dollar demand for gold reached a quarterly record of $US32 billion in the third quarter, industry insiders said the race to secure physical gold had reached an intensity that had never been witnessed before.

“Perth Mint sales and marketing director Ron Currie said the unprecedented demand had forced the Mint to cease orders until January, with staff working seven days a week, 24-hour days, over three shifts to meet orders.

“He said Europe was leading the demand, with Russia, Ukraine, Middle East and US all buying - making up 80% of its sales.

“‘We have never seen this before and are working right at capacity. And we are seeing it from clients in the shop buying one ounce, right up to 30,000 ounces from overseas clients,’ Mr Currie said.”

Source: Sarah-Jane Tasker, The Australian, November 22, 2008.

Mike Wittner (Société Générale): Oil prices susceptible to further deleveraging “Unless oil prices melt down again this week, Opec will not cut production at this weekend’s informal meeting in Cairo and instead will wait until the cartel’s gathering in December to reduce output quotas by 1 million to 1.5 million barrels a day, says Mike Wittner, global head of oil research at Société Générale.

“Mr Wittner says that Opec simply does not have enough information on the effectiveness of the production cuts that it has already made, or sufficient feedback from its customers, to proceed with further reductions in output. ‘We see (a decision to maintain current production quotas) as a 60-40 probability and the outcome of the meeting could easily be affected by price action this week,’ says Mr Wittner, who notes that signals from Opec have been mixed so far.

“Mr Wittner says tanker tracking data suggest there has been a ‘very significant cut’ in Opec’s oil production in November, down 1.2 million barrels a day compared with October.

“But SocGen says fundamentals will be perceived to be weak until the market becomes convinced Opec has cut supplies, given that a tanker requires six weeks to travel from the Persian Gulf to the US. Only then will November’s cuts appear in lower crude imports and stocks, which is what the market wants to see.

“‘Oil prices will remain susceptible to further deleveraging (by hedge funds) and caution remains the order of the day,’ concludes Mr Wittner.”

Source: Mike Wittner, Société Générale (via Financial Times), November 25, 2008.

Financial Times: EU’s stimulus plan met with doubts “The European Union’s proposal on Wednesday for a €200 billion economic stimulus plan for the bloc was met by immediate doubts on whether member states would back the measures aimed at avoiding a deeper recession.

“The proposal envisages that about €170 billion would be contributed by the bloc’s 27 member states through tax and infrastructure plans. The European Commission and the European Investment Bank would provide the remaining €30 billion, partly through the accelerated pay-out of selected spending programmes.

“The package, which is larger than expected, represents about 1.5% of the EU’s gross domestic product. It needs to be reviewed by EU finance ministers next week and by government leaders in mid-December.

“Economists and politicians quickly questioned whether all member states would step up as required or whether individual governments’ responses would diverge from the Commission’s suggested measures.

“Analysts at Capital Economics, the consultants, said: ‘The proposed boost has yet to be agreed by member states and would sadly not do enough to bring European economies out of the gloom for some time anyway.’

“Business Europe, the main business lobby group in Brussels, agreed with the proposals but said a ‘clear commitment from EU member states’ was needed to implement stimulus packages of at least 1.2% of GDP.”

Source: Nikki Tait, Financial Times, November 26, 2008.

BBC News: Boost for Spanish and Italian economies “Spain and Italy have announced plans worth billions of euros to kick-start their economies.

“Italy approved an 80 billion euro emergency package that included tax breaks for poorer families, public works projects and mortgage relief.

“Spain unveiled an 11 billion euro plan aimed at creating 300,000 jobs.

“The announcements are the latest in a series of attempts by EU governments to shore up their economies as the financial crisis bites.

“Italian Prime Minister Silvio Berlusconi called on to Italians to keep on spending. ‘We have helped citizens, the less well off, so that they can continue to consume,’ he said. ‘The intensity and duration of the crisis depends on all of us.’

“Spain’s Prime Minister, Jose Luis Rodriguez Zapatero, said the money will be mainly invested in infrastructure and public works.

“Spain’s unemployment reached 12.8% in October - the highest in the eurozone.”

Source: BBC News, November 28, 2008.

BBC News: German business confidence dives “Business confidence in Germany fell in November to the lowest level since 1993, according to the key Ifo economic climate index. The index, based on a poll of 7,000 companies, has dropped for six consecutive months, the Munich-based Ifo institute said.

“The index stands now at 85.8, down 4.4 points from October.

“‘The downturn has worsened and will now have an impact on the labour market,’ Ifo said in a statement.

“Germany’s exports have been hard hit by falling demand worldwide, with some auto makers seeking state help to maintain production.

“On Friday another key indicator, the Markit purchasing managers’ index, revealed that business activity in the 15 countries sharing the euro had fallen in November to a ten-year low.”

Sources: BBC News, November 24, 2008 and Victoria Marklew, Northern Trust - Daily Global Commentary, November 24, 2008.

Financial Times: Eurozone set for rate cut of at least 50bp “Eurozone official interest rates are almost certain to be slashed again next week by at least half a percentage point after a survey on Thursday showed the region facing its worst downturn since the recession of the early 1990s.

“Economic confidence in the 15-country region crashed this month to its lowest point since August 1993, the European Commission reported. With inflation also falling rapidly, the European Central Bank has not sought to stop financial markets assuming its main interest rate will be cut next Thursday from 3.25% to 2.75% or below.

“Public ECB comments show the bank remains cautious about the pace of cuts, pointing to a half-point reduction next week - the same as in October and this month. But economic news has been consistently gloomier than expected, strengthening the case for a larger cut.”

Source: Ralph Atkins, Financial Times, November 27, 2008.

Financial Times: UK tax hit to fund £20 billion fiscal stimulus “Taxpayers face six years of austerity, paying for the consequences of recession and a £20 billion fiscal stimulus unveiled on Monday by Alistair Darling as he detailed the most dismal Budget outlook seen since 1993.

“National insurance contributions for both employees and employers will rise by 0.5%. Those earning more than £100,000 will pay more income tax - with those on £150,000 facing a new higher tax rate of 45% - and public spending faces its biggest squeeze for 15 years - although all these measures will not kick in until 2011, well after the next election. The tax clawback would leave someone earning £150,000 paying an extra £3,040 in tax.

“Mr Darling detailed the planned tax rises and spending restraint as he sought to show the City and foreign investors that Britain had a clear plan to restore prudence to the public finances after truly shocking forecasts for public borrowing in the next two years.

“Public borrowing will hit a record level of £118 billion in 2009-10 and will fall to a level the government considers prudent only in 2015-16, far later than City forecasts had expected.

“Government debt will blast through the current 40% of national income limit, racing to 57% in 2012-13, when it will top the £1,000 billion mark for the first time.

“Britain’s output will continue to fall until the second half of next year, the chancellor added, as he presented a gloomy forecast with the recession mitigated only in part by the fiscal boost delivered predominantly through a 2.5 percentage point cut in value added tax from next week and lasting until the end of 2009.

“Over the next year, the cut in the VAT rate to 15% will be augmented by £2.5 billion of additional capital expenditure projects brought forward from 2010-11, a £60 payment to every pensioner, an earlier increase in child benefit and a deferral in the planned increases in vehicle excise duties.

“Mr Darling also used the crisis to stage a series of tactical retreats from earlier decisions, announcing a rethink of his plans to reform air passenger taxes and an exemption from tax for the dividends of UK companies’ foreign subsidiaries.

“Together the Treasury assumes the £20 billion package - about 1% of national income for a little over a year - will prevent the economy sinking by a further 0.5%, although Mr Darling’s forecast was for a contraction of 0.75% to 1.25% in 2009.”

Source: Chris Giles and George Parker, Financial Times, November 24, 2008.

James Pressler (Northern Trust): China - getting serious about the slowing economy “The People’s Bank of China (PBoC) slashed its benchmark one-year loan and deposit rates by 108 basis points apiece today [Wednesday], reducing them to 5.58% and 2.52%, respectively. This dramatic move comes well after the industrialized economies coordinated a major monetary easing - most central banks have already turned their attention toward liquidity concerns and an eventual global recession. Only three months ago, Beijing had a proactive mindset, thinking about economic stimulus to compensate for the post-Games lull and a general slowdown in global production. The first question that comes to our mind is why does the government suddenly seem to be lagging in its response?

“One fact worth noting is that the immediate economic impact on the Chinese economy has not been as clear-cut as in the industrialized countries. The Olympic Games threw in plenty of distractions and had widespread effects on economic indicators. Retail sales were positively impacted from the many tourists flooding into the country, but conversely, industrial production fell off as many factories closed in response to temporary anti-pollution measures. The conclusion of numerous infrastructure projects shifted flows of goods and inputs, and plenty of other one-off factors added a lot of noise to China’s economic statistics. Only after the Games passed and some of those factors fell from the calculations did a clearer picture emerge, and the trends are not promising. Industrial production continues to fall, and monthly export growth is showing signs of weakness.

“To be fair, the PBoC issued minor rate cuts over the past three months, and the government did offer a supplementary fiscal stimulus package. Today’s more dramatic move suggests that PBoC officials are now firmly convinced that China will be joining the rest of the world in a significant economic slowdown. Some forecasts recently suggested that after GDP growth of nearly 12% in 2007, the economy could slow to below 10% this year and perhaps 7.5% in 2009. While the growth rate itself is still enviable, officials in Beijing realize all too well that a deceleration of over four percentage points will not go unnoticed, and they will likely be taking more action before the year is up.”

Source: James Pressler, Northern Trust - Daily Global Commentary, November 26, 2008.

Bloomberg: China reserves to pass $2 trillion; Russia’s fall “China’s foreign-exchange reserves may top $2 trillion for the first time by the end of this year, giving the world’s most-populous nation more firepower to stimulate its economy during a global recession.

“China’s holdings increased 25% in the first nine months of the year to stand at $1.906 trillion on September 30. Reserves shrank in Japan and Russia, the nations with the second- and third-largest stockpiles. Russia drained a quarter of its currency and gold assets in less than four months to prop up the ruble, which has dropped 14% since June 30.”

Source: Lee J. Miller and Zhang Dingmin, Bloomberg, November 28, 2008.

Breitbart: Analysts - India economy will be OK despite attacks “The terror attacks that rocked India’s financial capital may depress stocks, dampen tourism and slow new investment, but are unlikely to inflict long-term damage on the nation’s economy, analysts and business people said Thursday.

“‘This is a challenge for the government to maintain law and order in the country,’ said Takahira Ogawa, director of sovereign ratings at Standard & Poor’s in Singapore. ‘At this stage, I don’t think there will be any major impact on the macroeconomic or fiscal position of the government.’

“The attacks, which began Wednesday night when gunmen invaded two posh hotels, a restaurant and several other sites in downtown Mumbai, came as India was struggling to contain fallout from the global financial crisis.

“Foreign investors have already pulled $13.5 billion out of the nation’s stock market this year, driving the benchmark Sensex index down 57% and punishing the rupee. Liquidity has dried up, economic growth is slowing and people are spending less money.

“The attacks are ‘a challenge to the economic resurgence in India’, said Habil Khorakiwala, chairman of Wockhardt, an Indian pharmaceutical company.

“‘The targets identified clearly demonstrate that the intention is to create panic and shatter the confidence in the minds of investors in India and global investors coming to India,’ he said in a statement. ‘This war has to be fought together by all across, to protect the safety of Indian people, for economic resurgence and growth of the Indian nation.’”

Source: Breitbart, November 27, 2008.

BBC News: Saudi Arabia cuts interest rate “Saudi Arabia has cut a key interest rate and taken steps to encourage lending as it faces the slowdown. The central bank reduced the repo interest rate from 4% to 3%, in an attempt to boost liquidity. It also reduced the cash reserve requirements for banks, seen as a way to improve the availability of credit.

“The move came a day after the benchmark Tadawul All Share Index fell to its lowest level in five years, hit by the global slowdown and falling oil prices. The index shed 9.2% on Saturday, the start of its trading week. Since the start of the year the index is down more than 60%.

“The Gulf region has been hard hit by a huge fall in oil prices, a key export. Oil prices are around two thirds lower than they were in July when they hit a record above $147 a barrel.”

Source: BBC News, November 23, 2008.

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Must-Read China Reading: World Bank Quarterly

Thursday, November 27th, 2008

If you read one thing on China this week/month/quarter/season, let it be the new World Bank China Quarterly. Superbly useful stuff.

Get it here.

[via Brad Setser]

“Here are some of Brad Setser’s notes from his CFR blog:

1. China was no workers’ paradise during the boom years.

GDP growth has been quite strong. But wages have fallen from around 50% of China’s GDP at the start of the decade to around 40% of GDP. That – not a high rate of household savings – is the main reason why consumption is a very low share of GDP (See Figure 15 of the World Bank Quarterly). If China’s workers had secured a bigger share of China’s output, they could be better off now even if China had grown somewhat less rapidly. There is good reason to think that a world where China subsidies US borrowing (and consumption) isn’t the best of all possible worlds. The fruits of the recent boom weren’t shared broadly in either the capital-exporting countries or the capital-importing countries.

2. China really is a manufacturing and investment driven economy.

Even when compared to Korea in 1990 or Japan in 1980, China stands out. Investment accounts for a large share of GDP than it ever did for the smaller Asian miracles and manufacturing accounts for a higher share of China’s GDP than it ever did in other Asian manufacturing economies (Figure 14). Given China’s size, it is pretty clear that China cannot continue to grow by investing ever more and manufacturing ever more. China ultimately has to produce for Chinese demand not world demand.

3. China’s current slowdown was made in China, not in the world.

Yes, growth in “light manufacturing” (toys, shoes and textiles) has slowed. But electronics and machinery exports are still doing very well – even if they don’t get the press (Figure 3). Or perhaps I should say were still doing well in the third quarter; must has changed recently. China’ problem this year is simple: labor intensive export sectors have slowed more than capital intensive export sectors. Overall though China’s real exports grew at a 10-15% y/y clip in 08 – far faster than the overall growth in world imports. China’s real export growth is forecast to outpace its real import growth in 2008 – which implies that net exports will still contribute positive to China’s GDP growth. True, the net exports won’t provide as much of a positive contribution as in 07, 06 or 05. But they are still adding to growth not subtracting from it.

Why then is China slowing so sharply? Simple, real estate investment has hit a wall. After growing at 20% y/y for a long time, real estate investment stalled – with a y/y growth rate of around 0% (Figure 5). That means that China is in turn producing more steel and cement than it needs, and producers of steel and cement are cutting back. That in turns hurts iron ore exporters …

This though is very much a result of China’s own policy choices. Rather than allowing the real exchange rate to appreciate back when China was truly booming (05-late 07/ early 08), China’s policy makers opted to rely on administrative curbs on credit growth. That left China more exposed to global slump in demand – as it kept exports up by limiting real appreciation even as it credit curbs limited the amount of froth in the real estate market back when China was booming and real interest rates were negative. China invested a lot in real estate, but it is no Dubai. But China’s policy makers still look to have slammed the brakes on a bit too hard. Rather than slowing gradually, real estate investment fell off a cliff (Figure 5).

4. There is more bad news ahead.

While real exports contributed positive to GDP growth in 2008, they won’t contribute in 09. The World Bank forecasts that for the first time in a long time, 2009 real import growth will exceed real export growth. In 2005, real exports grew about 10% faster than real imports (23.6% v 13.4%). Many economists remain – for reasons that to be honest elude me – reluctant to draw the obvious connection: the most likely explanation for China’s strong real export growth is the large depreciation the RMB in 2003 and 2004. That combined with administrative controls – which limited lending, investment and ultimately imports – to create China’s large current account surplus. Real export growth exceeded real import growth by 5 percentage points in 2006 and 2007 – and by 4 percentage points in 2008.

The positive contribution of net exports to GDP is forecast to end in 2009: real import growth will exceed real export growth by 3 percentage points.

That though doesn’t mean that China’s currency isn’t undervalued. China’s exports are forecast to grow faster than the world’s imports, meaning China’s global market share is still increasing (see Figure 2). And if 2008 and 2009 are taken together, China will still be drawing on the world for its growth: the drag from net exports in 09 will be smaller than the contribution from net exports in 08 (see Table 1)

I fully realize that China is appreciating quite significantly now in real terms – just global demand for China’s goods is falling (Figure 11). The tragedy is that this appreciation is coming now – not two or three years ago when domestic Chinese demand was booming and China didn’t need to draw on the rest of the world to sustain strong growth.

5. The fiscal stimulus is real, but modest. China’s fiscal balance is expected to swing from a 0.7% of GDP surplus in 07 to a 2.6% of GDP deficit in 09. That is a 3.3% of GDP swing. In 2009 alone, China’s deficit is forecast to rise by 2.2% of GDP. See Table 1. That shift is important and will help to support China’s growth– but it will likely lag the swing in the US fiscal deficit. Hopes that surplus countries will end doing more than deficit countries seem unlikely to be ratified.

6. The last thing anyone needs to worry about is fall in Chinese demand for US treasuries.

The Treasury market obviously isn’t worried - not it 10 year Treasury yields are under 3%. And there is little reason for the bond market to be worried if current trends continue.

The World Bank forecasts that China’s current account surplus will RISE not fall in 2009, going from an estimated $385 billion to $425 billion. How is that possible if real imports are forecast to grow faster than real exports? Easy – the terms of trade moved in China’s favor. The price of the raw materials China imports will fall faster than the value of China’s exports. China’s oil and iron bill will fall dramatically.

In macroeconomic terms, China’s fiscal stimulus will offset a fall in domestic investment leaving China’s current account (i.e. savings) surplus unchanged. The 2009 surplus is expected to be roughly the same share of China’s GDP (9%) as the 2008 surplus.

In dollar terms, the World Bank forecasts that China will add almost as much to its reserves in 2009 than in 2008. That is a bit misleading: the 2008 reserve growth number leaves out the funds shifted to the CIC (ballpark, $100b in 08) and the rise in the foreign exchange reserve requirement of the state banks (ballpark, another $100b). But it captures a basis truth. Even if a fall in hot money inflows means that China will be adding $500b rather than $700b to its foreign assets, its foreign assets will still be growing incredibly rapidly. China already has – counting its hidden reserves – well over a $2 trillion. It is now rapidly heading for $3 trillion.

In broad terms – if oil stays at its current levels – China will be the only large surplus country in the world, and it will essentially be financing a US deficit of roughly equal magnitude to China’s reserve growth. It makes everything plain to see.

7. The way China manages its reserves matters immensely for the world not just China

China shifted from buying Agencies to buying Treasuries in July. Others did too, but no one has quite the market impact of China. China doesn’t disclose what it is doing with its reserves, but the recent shift in Chinese demand isn’t really in doubt. The market knows it. The TIC data for August showed it. And the latest Fed data strongly suggest large ongoing migration from Agencies to Treasuries.

China now accounts for such a large share of the world’s reserves that it is hard to see how the FRBNY’s custodial data doesn’t reflect, at least in part, a shift in Chinese demand.

A key themes of this blog has been how the internal imbalances of China’s economy are a reflection of its undervalued exchange rate – and that China’s surplus has implications for the world. It has to be balanced by large deficits elsewhere. Another key theme has been that the Fed has been pushed to absorb risks that other central bank reserve managers now shun. Nothing illustrates this more clearly than the Agencies. Foreign central banks are scaling back their Agency holdings. The Fed is gearing up to buy. Big Time.”

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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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Mr President: spend, spend, spend

Wednesday, November 26th, 2008

The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months

John Maynard Keynes

The following is an abridged text of an open letter [PDF] by John Maynard Keynes to the US president.

Dear Mr President,

You have made yourself the trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office. This is a sufficient reason why I should venture to lay my reflections before you, though under the disadvantages of distance and partial knowledge.

At the moment your sympathisers in England are nervous and sometimes despondent. We wonder whether the order of different urgencies is rightly understood, whether there is a confusion of aim, and whether some of the advice you get is not crack-brained and queer. If we are disconcerted when we defend you, this may be partly due to the influence of our environment in London. For almost everyone here has a wildly distorted view of what is happening in the United States. The average City man believes that you are engaged on a hare-brained expedition in face of competent advice, that the best hope lies in your ridding yourself of your present advisers to return to the old ways, and that otherwise the United States is heading for some ghastly breakdown. That is what they say they smell. There is a recrudescence of wise head-waging by those who believe that the nose is a nobler organ than the brain. London is convinced that we only have to sit back and wait, in order to see what we shall see. May I crave your attention, whilst I put my own view?

You are engaged on a double task, recovery and reform - recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range recovery, that you will have the driving force to accomplish long-range reform. On the other hand, even wise and necessary reform may, in some respects, impede and complicate recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place. It may over-task your bureaucratic machine, which the traditional individualism of the United States and the old “spoils system” have left none too strong. And it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once.

My second reflection relates to the technique of recovery itself. The object of recovery is to increase the national output and put more men to work. In the economic system of the modern world, output is primarily produced for sale; and the volume of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, and increase of output depends on the amount of purchasing power, compared with the prime cost of production, which is expected to come on the market. Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out of their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse.

Now there are indications that two technical fallacies may have affected the policy of your administration. The first relates to the part played in recovery by rising prices. Rising prices are to be welcomed because they are usually a symptom of rising output and employment. When more purchasing power is spent, one expects rising output at rising prices. Since there cannot be rising output without rising prices, it is essential to ensure that the recovery shall not be held back by the insufficiency of the supply of money to support the increased monetary turn-over. But there is much less to be said in favour of rising prices, if they are brought about at the expense of rising output. Some debtors may be helped, but the national recovery as a whole will be retarded. Thus rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.

The set-back which American recovery experienced this autumn was the predictable consequence of the failure of your administration to organise any material increase in new loan expenditure during your first six months of office. The position six months hence will entirely depend on whether you have been laying the foundations for larger expenditures in the near future.

I am not surprised that so little has been spent up-to-date. Our own experience has shown how difficult it is to improvise useful loan-expenditures at short notice. There are many obstacle to be patiently overcome, if waste, inefficiency and corruption are to be avoided. There are many factors, which I need not stop to enumerate, which render especially difficult in the United States the rapid improvisation of a vast programme of public works. But the risks of less speed must be weighed against those of more haste.

The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the quantity theory of money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.

It is an even more foolish application of the same ideas to believe that there is a mathematical relation between the price of gold and the prices of other things. It is true that the value of the dollar in terms of foreign currencies will affect the prices of those goods which enter into international trade. In so far as an over-valuation of the dollar was impeding the freedom of domestic price-raising policies or disturbing the balance of payments with foreign countries, it was advisable to depreciate it. But exchange depreciation should follow the success of your domestic price-raising policy as its natural consequence, and should not be allowed to disturb the whole world by preceding its justification at an entirely arbitrary pace. This is another example of trying to put on flesh by letting out the belt.

These criticisms do not mean that I have weakened in my advocacy of a managed currency or in preferring stable prices to stable exchanges. The currency and exchange policy of a country should be entirely subservient to the aim of raising output and employment to the right level. But the recent gyrations of the dollar have looked to me more like a gold standard on the booze than the ideal managed currency of my dreams.

You may be feeling by now, Mr President, that my criticism is more obvious than my sympathy. Yet truly that is not so. You remain for me the ruler whose general outlook and attitude to the tasks of government are the most sympathetic in the world. You are the only one who sees the necessity of a profound change of methods and is attempting it without intolerance, tyranny or destruction. You are feeling your way by trial and error, and are felt to be, as you should be, entirely uncommitted in your own person to the details of a particular technique. In my country, as in your own, your position remains singularly untouched by criticism of this or the other detail. Our hope and our faith are based on broader considerations.

If you were to ask me what I would suggest in concrete terms for the immediate future, I would reply thus.

In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of loan-expenditures under government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months.

I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest. The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term government bonds to 2.5% or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.

With these adaptations or enlargements of your existing policies, I should expect a successful outcome with great confidence. How much that would mean, not only to the material prosperity of the United States and the whole World, but in comfort to men’s minds through a restoration of their faith in the wisdom and the power of government!

With great respect,
Your obedient servant

JM Keynes

Originally published as “An open letter to President Roosevelt” in the New York Times, December 31, 1933.

Tags: Credit, Currency, Desc, Dollar, Fed, Federal Reserve, Gold, Government Bonds, International, New York Times, oil, risk, SRS, UK, Value, wisdom
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McCulley: The Paradox of Deleveraging will be Broken

Monday, November 24th, 2008

Paul McCulley, Managing Director and Portfolio Manager, PIMCO, earlier this year wrote a landmark discussion piece titled, “The Paradox of Deleveraging,” in which he postulated that the deleveraging of the credit market would have a profoundly negative impact that only a government sponsored plan could subdue, as no other party could be big enough to slay the affliction of credit abuse in the housing, investment and banking industries. Here is the follow up:

I’ve only written this essay once since the Kansas City Fed’s annual symposium in late August.1 But it hasn’t been because I’ve been lazy. Rather, I’ve been working virtually around the clock ever since, in my day job as head of PIMCO’s Money Market and Funding Desk. On Wall Street, this desk is frequently viewed as a backwater, a temporary home for new MBAs getting their feet wet before moving on to higher-value-added desks, or a retirement home for those with more senior moments than fresh ideas.

That’s never the case here at PIMCO, even though a number of now PIMCO partners spent their first days trafficking in the money markets and I, of ever-graying hair, still make my home here in the early hours of the day. Money markets frequently are a backwater, except when they are not, in which case they are cascading rapids. Liquidity pressures inevitably are the precursor of solvency and/or going-concern problems. Just ask Wall Street’s independent investment banks.

We here at PIMCO have always known this. Accordingly, we’ve always been conservative beyond conservative in our money market operations, on both sides of the balance sheet - no asset-backed commercial paper (ABCP) for us, and no tri-party repo without regard to collateral types or haircuts either. Meat and potatoes only, no fancy garnishes necessary. But the meat and potatoes must be cooked properly.

Hence, the work load of PIMCO’s money market and funding desk. My new deputy, Jerome Schneider, hit the ground running in early August, a most propitious time, just before the global money markets became not just cascading rapids, but roaring waterfalls. The financial world will never be the same after the U.S. Treasury and Federal Reserve’s fateful decision of the weekend of September 13-14 to stand aside as Lehman Brothers plummeted to death on the rocks below.

Whether that decision was the right one or not, we will never know. Yes, I know that many are quick to take the Treasury and the Federal Reserve to task, maintaining that the on-going global financial crisis - and, thus, growth crisis - would not be nearly so severe if Lehman had been tossed a life line. I simply don’t know. What I do know is that the global financial system was fundamentally broken long before Lehman’s watery death.

Thus, I believe the powerful, systemic policy responses that have unfolded in the post-Lehman world were destined to come about. Lehman was but the unfortunate tipping point. My heart still aches for the pain suffered by my many friends there. Fate is not always fair and at times, is arbitrary and capricious.

But what ailed Lehman was but a manifestation of what ailed, and ails the global financial intermediary system: the presumption that grossly levered positions in illiquid assets can always be funded, because those doing the funding will always assume the borrower is a going concern.

To understand the nature of this systemic malady, we need to return to first principles. Bear with me, please; this is going to be a bit academic. But, I submit, it was the loss of understanding of first principles that lies at the heart of the on-going paradox of deleveraging, which is the proximate cause of the on-going downward spiral of asset and debt deflation.

The Nature of Banking
When I studied the origins of banking in college, we started with the Medici Family of 15th century Italy. I’m quite sure banking existed long before then, just that I haven’t studied it. But regardless of the origins of banking, its founding premise has always been the same: In normal times, the public’s collective, ex ante demand for access to at-par, immediately-available bank money is always greater than the sum of the public’s individual, ex post demand for access to such liquidity.

Thus, the genius of banking, if you want to call it that, is simple: a bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is notionally of finite maturity, as short as one day in the case of demand deposits.

It’s the same alchemy that permits mutual funds to commit to next-day redemption at tonight’s NAV, even though all reasonable people know that a mutual fund - with the possible exception of a money market fund - could not possibly liquidate all assets on the wire tomorrow at tonight’s NAV marks. Systemically, it’s the illusion of liquidity, as so elegantly described by John Maynard Keynes:

“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment.

For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma.

So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organizing markets wherein these assets can be easily realized for money.”2

Yes, liquidity for all at last night’s marks is an illusion. But for banks, unlike mutual funds, it’s not so much an illusion after all, for two simple reasons: banks have access to deposit insurance underwritten by fiscal authorities and to a discount window underwritten by the monetary authority (and one step removed, the fiscal authority). Thus, banks are unique institutions, providing a “public good:”

*
Liquidity on demand at par for their depositors, because of the safety net underwritten by the sovereign, yet
*
The ability to invest in longer-dated, more risky, not-always-at-par loans and securities, because the existence and credibility of the public safety net systemically renders the public’s ex post demand for liquidity at par below the public’s ex ante demand.

Yes, banking with a sovereign safety net against deposit runs is a really cool business. Indeed, the difference between the public’s ex post and ex ante demand for at-par liquidity could be called the banking system’s “float,” similar to that of a Buffet-style insurance company.

But since it’s a really cool business and since the sovereign providing the liquidity safety net is a de facto equity partner in the business, the sovereign quite rationally wants a say in how the business is run - the degree of leverage, corporate governance, risk management controls, etc. Kinda like I do when I pay the insurance premium on my 19-year old son’s car. Jonnie doesn’t like it, and neither do bankers. Or would-be bankers.

Thus, both bankers and would-be bankers have, from time immemorial, sought to get the benefits of the sovereign’s liquidity safety net without shouldering the associated regulator nuisance. And I’m sure that 19-year old sons and daughters, too, have been doing the same for just as long.

Over the last three decades or so, the growth of “banking” outside formal, sovereign-regulated banking, has exploded, in something that I dubbed the Shadow Banking System.3 Loosely defined, a Shadow Bank is a levered-up financial intermediary whose liabilities are broadly perceived as of similar money-goodness and liquidity as conventional bank deposits. These liabilities could be shares of money market mutual funds; or the commercial paper of Finance Companies, Conduits and Structured Investment Vehicles; or the repo borrowings of stand-alone Investment Banks and Hedge Funds; or the senior tranches of Collateralized Debt Obligations; or a host of other similar funding instruments.

The bottom line is simple: Shadow Banks use funding instruments that are not just as good as old-fashioned sovereign-protected deposits. But it was a great gig so long as the public bought the notion that such funding instruments were “just as good” as bank deposits - more leverage, less regulation and more asset freedom were a path to (much) higher returns on equity in Shadow Banks than conventional banks.

And why did the public buy such instruments as though they were “just as good” as bank deposits? There are a host of reasons, not the least of which was lust for yield. But most fundamentally, Keynes again gives us the systemic answer (his italics, not mine):

“In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention - though it does not, of course, work out quite so simply - lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.

The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities.

We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuations which are in no way relevant to the prospective yield. Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.

For if there exist organized investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence.

Thus investment becomes reasonably “safe” for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are “fixed” for the community are thus made “liquid” for the individual.

It has been, I am sure, on the basis of some such procedure as this that our leading investment markets have been developed. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment.”4

And so, Keynes provides the essential - and existential - answer as to why the Shadow Banking System became so large, the unraveling of which lies at the root of the current global financial system crisis. It was a belief in a convention, undergirded by the length of time it held: Shadow Bank liabilities were viewed as “just as good” as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by both the sovereign and the sovereign-blessed rating agencies.

Until, of course, convention was turned on its head, starting with a run on the ABCP market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization of Fannie and Freddie in July, and the actual death of Lehman Brothers in September 2008. Maybe, just maybe, there was and is something special about a real bank, as opposed to a Shadow Bank!

And indeed that is unambiguously the case, as evidenced by the on-going partial re-intermediation of the Shadow Banking System back into the sovereign-supported conventional banking system, as well as the mad scramble by remaining Shadow Banks to convert themselves into conventional banks, so as to eat at the same sovereign-subsidized capital and liquidity cafeteria as their former stodgy brethren.

The new conventional wisdom: levered capitalism is good, and made even better with a bit of socialism to protect the downside.

Well Maybe
I’m quite sure that last sentence is not going to sit well with some of you. It’s not supposed to sit well. It doesn’t sit well with me, I must acknowledge, nay confess. Like most of us, I’ve always had a separation in my mind between strictly capitalist activities and strictly public activities. Not that the demarcation is always clean. But it’s a useful way of thinking.

As far as I know, the place where I buy my fishing tackle is a capitalist outfit. If we customers don’t buy enough rods and reels, the owner will go broke; his operation is simply not systemically important enough to be bailed out by the taxpayers, including my neighbors who don’t fish. In contrast, the local Department of Motor Vehicles, sometimes called the DMV, is unambiguously not a capitalist outfit, but a public outfit. It cannot go broke, as evidenced by our tolerance of its fluctuating service level, because it provides a public service that the private sector can’t provide. To be sure, AAA can get you new plates for your car, but you can’t renew your driver’s license at the AAA; for that, you have got to go to the monopoly called the DMV.

Well actually, that’s not entirely true, either. The DMV is actually an oligopoly, with offices in many surrounding neighborhoods. And rumor has it here that the service is a lot quicker at the San Clemente office than the Costa Mesa office, which serves Newport Beach. So the consumer does have the choice of driving to San Clemente, a form of time arbitrage versus going to the Costa Mesa office. However, rumor also has it that this rumored better service in San Clemente is so widespread that, as Yogi Berra might say, the San Clemente office has become so popular nobody goes there anymore.

But you get the point: there is private enterprise and there is public enterprise. And then there is banking, a hybrid of the two. There is no way ‘round this, for good or bad, because fractional reserve banking depends upon the sovereign’s safety net against liability runs, a safety net that the private sector definitionally can’t universally supply. In this sense, the safety net is like national defense: we all need it, but since nobody individually has the incentive to pay for it, we collectively tax ourselves to pay for it.

Yes, sometimes we collectively end up paying $800 for military toilet seats, as was the case about 25 years ago. But that doesn’t change the proposition that public goods do exist, and a stable system of intermediation of private savings into private investment is indeed a public good. The maturity transformation power of a fractional reserve banking system provides an unambiguous benefit to society and as such, must be underwritten by society.

Bottom Line
I could regale you yet again about the power of the analytical thinking of Hyman Minsky, complete with his Forward Journey turning into his Moment, followed by his Reverse Journey.5 But I don’t need to do that any more: we’ve collectively lived it and are now caught in the debt-deflationary pathologies of “the paradox of deleveraging.”6 Not everybody in the private sector can delever at the same time without creating a depression. Accordingly, the sovereign must go the other way, levering up the public balance sheet. And Washington has finally started to do so with appropriate vigor and enthusiasm.

It’s not a pretty picture. In fact, it’s repugnant, giving proof to the proposition that breaking the paradox of deleveraging does involve socializing the downside of previously profitable private sector activities. In a recent speech, I called it “creeping socialism” and was interrupted by an irate, older man in the back of the room bellowing, “It ain’t creeping socialism, it’s galloping socialism!” I really didn’t have a soothing come back, noting that many things are what they are only in the eye of the beholder. But his point wasn’t lost on me or anybody else in the room.

And it is not lost on Washington, DC either, I can assure you. If the sovereign must backstop a private sector activity that produces a public good, then the sovereign will, at least in a democracy, rightfully demand both bottom-up and macro-prudential rules to harness the greed that lubricates the invisible hand of capitalism. Yes, the visible fist of government and the invisible hand are presently engaged in a massive arm wrestling contest in the provision of financial services. And the fist is winning.

At least for now. Capitalism, and especially financial market capitalism, brought this outcome upon itself through greed and hubris. Capitalism is now re-grouping and learning how to play by new rules, which are still being written. And ultimately, I’m sure, capitalistic bankers will once again bend those rules in the pursuit of higher profitability. And that’s okay, I think. In the end, we really don’t want to turn our banking system into the DMV. At the same time, we also don’t want our banking system to be nothing more than a betting parlor.

Or, in the famous words of Keynes again:

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

Paul A. McCulley
Managing Director
November 13, 2008

You can download a complete PDF here.

Tags: Banking System, Banks, Bear Stearns, Blog, BRIC, capitalism, Credit, Credit Market, Desc, Fed, Federal Reserve, Focus, Hedge Fund, Hedge Funds, Investment Banks, Italy, Journey, Lehman Brothers, liquidity, Market Cap, Markets, Mutual Funds, oil, Paul McCulley, PIMCO, risk, Valuations, Value, Wall Street, Water, wisdom
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Jeremy Grantham: Alan Greenspan is My Nemesis, and More

Monday, November 24th, 2008

Here is the first at-length TV interview we have ever seen GMO’s Jeremy Grantham do. We could not figure out how to embed it, so here’s the link.

The co-founder and chairman of global investment management firm, GMO, Grantham oversees investment strategies for the firm’s more than one hundred billion dollars in assets for mostly institutional investors. The Economist recently described Grantham as a Cassandra of the investment community for his bearish and accurate ten year forecasts. The British born investor writes a widely read quarterly letter but until now has avoided television.

Definitely a must see interview. Click for the video:

Here is a very small excerpt of this provocative interview.

CONSUELO MACK: So let me ask you about that, you call it the curse of the value manager, that you could be quite early.

JEREMY GRANTHAM: Could be, almost invariably are, if you are a value manager. Because a value manager could be described that we are paid to buy cheap assets, we are paid to get out of expensive assets; but if you are paid to buy cheap assets when they are very cheap indeed, typically you have owned them for quite a while and are regretting it. And simultaneously on the other side you have paid to get out of expensive assets and when they’ve become gloriously overpriced like 2000, we are long gone and looking like idiots.

CONSUELO MACK: Now, let me ask you because one of your themes of the last past three years, up until recently, was avoid risk, avoid risk, avoid risk. Do you have a mantra now? 

JEREMY GRANTHAM: Not as clear-cut as that. We were blessed with a great opportunity there, to be nearly certain that we were right. Now it’s much more one of creative tension. Regret minimization. I’ve had lots of regrets, and I’m the czar of regret minimizing at GMO. Which means, for example, if we buy too soon now, and the market goes down- as I really think it will, two to one, it will be down quite a lot next year- and we put the clients’ money to work, they’re going to say, “Jeremy, you of all people, why did you put our money in when you thought the market was going down?”  And we’ll have bitter regret and we’ll be very unhappy. 
If, on the other hand, we recognize the market is cheap and in some parts of the world very cheap, and we don’t buy, and the market goes, as it might, screaming up, barely pausing for breath, we have terrible regrets, the clients are thoroughly upset and they say, “Jeremy, you told us they were cheap and you didn’t put our money in, what were you thinking about?” And of those two, I think that is the shooting effect. As I like to say, you not only look like an idiot, you really are an idiot if you do that. And our decision is to step our way as best we can, balancing the two regrets. And how we do that is starting four weeks ago, we started to put money back fairly quickly, but only into the very cheapest areas of the market- very high quality U.S. blue-chips and emerging markets, and perhaps Japan. And then having done that and closed the gap towards neutral weight, then moving very slowly indeed into the more diversified areas that are merely cheap, not spectacularly cheap. So we’re taking some risk the market will run away. I don’t think we’ll hit neutral against our benchmark and positions in equities until the middle of next year.

Read the complete transcript here.

Hat Tip: Infectious Greed, Paul Kedrosky

Tags: Alan Greenspan, CPI, Desc, Dollar, Emerging Market, Emerging Markets, interview, Investment Management, Japan, Markets, Php, risk, Value, Video
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Hendry: Going long on government bonds

Monday, November 24th, 2008

By Hugh Hendry

Published: November 19 2008 16:03

Someone once said there are certain things that cannot be adequately explained to a virgin, either by words or pictures. It is therefore with some trepidation that I attempt to outline our investment policy. We are bullish on agriculture and bearish on the financial community. For 10 years we have contended that equity markets can, and do, stagnate for periods as long as a quarter of a century. Accordingly, we have refused to follow the market, choosing instead to invest in unleveraged sectors which have endured long bear markets.

However, there are complicating cycle considerations. A process of debt liquidation is under way that resembles a turning point heralding weaker global growth. This undermines almost all risk taking, including agriculture, and for this reason we presently favour only government bonds.

According to Prada: “There is a rejection of fakeness - the fake avant-garde.” And the inflation scare that took the price of oil to almost $150 per barrel, and created a hawkish central banking community, was perhaps the biggest head-fake of all. Certainly, the market for 10-year government bonds is beginning to think so. It is trading near a record high.

And today, even those regional Fed governors and hawkish European central bankers seem to see it as well. As I say, this is the time to own government bonds. But we are aware of just how out of sync we are with our heroes. Can the combined intellectual weight of Mark Faber, George Soros and James Grant all be wrong? Why do they insist on shorting Treasuries during the worst financial crisis since the Depression? I blame the Romans.

Monty Python’s Life of Brian famously asked, “What have the Romans ever done for us?” In a similar vein, one might enquire: “What did the central banks do to contain inflation in the 1970s?” As in most things, fate and chance play an important part. Let’s consider the facts. The Fed reacted to the first oil shock 36 years ago by driving its rate up from 3.5 per cent in February 1972 to 13 per cent in the second quarter of 1974. Such high nominal rates were unheard of and at the time ranked as the highest in American economic history. The average US stock lost 74 per cent of its value from its 1968 high. The real economy went into reverse and contracted in both 1974 and 1975.

Perversely, I would attribute the decade’s inflation to the lack of leverage in the economy. The bankruptcy of so many banks during the 1930s encouraged the politicians to de-risk the sector. For more than 40 years, the banking sector grew modestly, attracted modest people and produced modest returns. The emergence of today’s cadre of cavalier banker was only detected by Soros, Rogers et al in their 1972 report, The Case for Growth Banks, some 43 years after the stock market peak in 1929.

If a tree falls in a forest and no one is round to hear it, does it make a sound? Likewise, if house prices fall but mortgage debt is low, does it really matter? This was the case in the mid 1970s and, in the absence of today’s unprecedented leverage, house prices did not falter, repossessions never soared and there was no major bank insolvency. I would contend therefore that it was the phenomena of low asset prices and a conservative banking sector that ensured that the Fed’s monetary policy response failed to tame inflation.

Contrast with today and the prospect of containing inflation should be high. Thirty years of unfettered monetary expansion has left the banking sector fully leveraged and vulnerable to insolvency. For instance, the mere act of holding UK interest rates at 5 per cent from April through to October of this year has guaranteed a sharp contraction in the economy which has the Bank of England reaching for the “D” word.

Don’t get me wrong, I think Soros, Faber and Grant are right to fear the inflationary consequences of our present breed of central banker. But my paradoxical recommendation is to buy bonds. Many scoffed, but this policy is working. A paradox, remember, is a self- contradictory statement based on a valid deduction from acceptable premises. Here is another: the smartest investor in London is short bonds. I’m long bonds, yet we share the same vision of the future. I’ll let you decide.

The writer is chief investment officer and founding partner of Eclectica Asset Management

Source: FT Alphaville

Tags: Agriculture, Banks, Bear Market, Bear Markets, Central Banks, Eclectica, Eclectica Asset Management, Economy, Euro, Faber, Fed, FT.com, Government Bonds, Hugh Hendry, inflation, interest rates, Markets, Monetary Policy, Mortgage, oil, REW, risk, Trading, UK, Value
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