Less Bad = Some Good

Equities are ending the first quarter on a more optimistic note. This pertains not just because stocks are rallying today but to the fact that many investors stared into the abyss of the Great Depression II and came to the conclusion that a couple trillion dollars thrown at the world economy along with an era of better regulatory management and a most appropriate change/modification to mark to market will generate 2008 operating earnings for the S&P 500 at something north of $50.

Moreover, recent economic data suggest that the debt constrained US consumer will find ways to maintain some level of spending while apportioning a larger but not overwhelming portion of earnings to savings. Lastly, emerging economies are well positioned to assist in the global economy averting a worldwide recession, despite the pain emanating out of developed economies.

Perhaps this is the economic justification for the improving technical analysis readings of late.

Investment Strategy Implications

Perception is reality. And the perception that the end of world may not occur this year has led many investors to conclude that an appropriate P/E between 12.5 (bad times) and 15 (average times) applied to a $60 operating earnings number is where equities belong. And that gets to almost exactly where the market is today: P/E of 13.75 (average of 12.5 and 15) times $60 = 825.

Food For Thought

Wrapped around the daily trials and tribulations of the markets and economy, and often lost in the forest for the trees, are three great debates that investors may want to tune their ears to. These debates – the future of Finance, the future Economic model that leads the world economy, and the future Socioeconomic model that drives America – frame the particulars within which economic, political, and investment decisions will be made. I submit them for your consideration.

Future of Finance

The first great debate raging is one between new finance versus the small banking model. Paul Krugman notes this in his current commentary when he states “…it has become increasingly clear over the past few days that top officials in the Obama administration are still in the grip of the market mystique. They still believe in the magic of the financial marketplace and in the prowess of the wizards who perform that magic.”

Krugman’s protestations notwithstanding, if Secretary Geithner has his way the new finance model will ultimately win the day as the dysfunctional components of the new finance model are remedied (via the Risk Czar) and complex financial instruments live another day: this time with better supervision and, hopefully, fewer financial catastrophes.

Interestingly, Mohammed El-Erian apparently supports the Geithner view. As noted in his excellent book “When Markets Collide”, the PIMCO CEO reveals his thinking when he states that the one area in finance that he would recommend his daughter pursue is structured finance. Well, it seems hard to image a bright future for structured finance without a robust financial model. And that is something that you don’t’ get with the small banking model expressed by Meredith Whitney.

Tied to finance is the second great debate area – the future economic model.

Future Economic Model

With the demise of “cowboy capitalism” what will be the reigning economic model? Will it be the European socialist model? Some revised American model? Or will a hybrid model emerge out of the multi polar world, with America, Europe, and China sharing and influencing power? The answer to this question will likely not be clear for several years. Moreover, it will greatly influenced by how the future finance model evolves.

The third great debate is solely a US issue.

Future Socioeconomic Model

This great debate area can be summed up in the following phrase, “Never let a good crisis go to waste”. Here the debate is divided along US political lines with Republicans warning of the third wave expansion of government intrusion while Democrats insist that their hands (and motives) are clean and necessary given the economic mess left by the Republicans. The blame game always rules politics.

Note: I believe there is much to the argument being made by the Republicans. Power is a very strong force and human nature never changes, regardless of campaign rhetoric.

The chronological center point of this debate is the Great Depression. Advocates for greater government spending say the New Deal saved the country while opponents say that is false, that it took World War II, and not the New Deal, to lift the US out of its deep economic funk.* Then there is the subplot to this debate: with greater government intrusion comes greater government power. This is where things like infrastructure spending come into the picture. You don’t stop a road or a bridge in mid construction. Therefore, those that institute the spending will exercise political power for years to come.

Food For Thought

What I have articulated above is meant to be a listing of key issues that investors might want to better acquaint themselves with, and obviously not a comprehensive examination of the subjects noted. A little food for thought.

Have a good weekend.

*In this area, readers may want to acquaint themselves with the writings of Amity Shlaes as one who has been a good source for understanding the Republican argument.

Minyanville posting: The Cyclical Bull within the Secular Bear

excerpt from this week's posting:
"In today’s 2 major financial print-media outlets, Wall Street Journal and Financial Times, you have a remarkable contrast between the academic versus the street-smart way of understanding the current debate over the Geithner banking plan (PPIP) and the core banking issue: liquidity or solvency. In the process of understanding the debate, investors can gain a better understanding of the cyclical bull within the secular bear that we're currently experiencing.

Both articles are critical of PPIP; one makes its case by accepting the market-efficiency argument, while the other provides an inside-game view of how things actually work in the financial markets - the academic versus the street-smart version, if you will.

In the academic corner, we have Professor Jeffrey Sachs..."

To read the full Minyanville commentary, click here
To view all Minayanville postings, click here

Beyond the Sound Bite: An Interview with Bob McTeer

In my interview with the former president of the Federal Reserve Bank of Dallas and Distinguished Fellow at the National Center for Policy Analysis we discussed the economic impacts of mark to market, the Geithner plan, Keynes' paradox of thrift, the Fed's balance sheet, and the necessary deftness to remove monetary stimulus in a timely fashion.

Beyond the Sound Bite postings can be found at beyondthesoundbite.blogspot.com
To listen to this week's podcast interview, click here

Why Paul Krugman is Wrong

Let me start by saying that on many levels, I agree with Paul Krugman. I read his blog regularly and find his work to be of significant value. I also share many of his political views and leanings. But when he makes the market efficiency argument, he has entered a space where he is wholly unqualified to roam. For in several of his recent postings that is, in effect, what he has done. Like other economists that I know, he is attempting to apply his social science skills in economics to the social science skills in investing. In this regard, Krugman is wrong on three levels.

First, to argue against the Geithner plan (accurately portrayed as seeing the problem as one of liquidity and not solvency) is to argue that the markets AT ALL TIMES, IN ALL CONDITIONS know what the fair value of any asset is at any and all times. Yet, everyone acknowledges that the market for the so-called “toxic assets” is dysfunctional. And central to its dysfunctionality is their illiquidity. So, if certain markets for certain instruments are dysfunctional (which includes valuation) due in large part to illiquidity then why isn’t the conclusion that liquidity and not solvency the core of the problem?*

Second, if making the dogmatic argument for market efficiency weren’t enough, Krugman then moves into the math space and applies bizarro logic to the actions professional investors will likely take as they participate in the Geithner PPIP plan: “Let me offer a numerical example. Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100. But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset? The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.”

The logic of this example falls on its face on three levels. First, no professional investor is going to invest in a 50/50 bet (20 points I win, 19.5 points I lose). That ½ point return advantage is all of 38 basis points of upside potential! Does anyone reading this believe that PIMCO, for example, will make such a bet? I don’t. Moreover, since the US government is involved in the process, it is equally hard to imagine that Geithner and Bernanke would allow the US equity stake to engage in boneheaded bid up purchases. Lastly, and most importantly, just what valuation methodology will the PPIP parties engage in? How about one that is rooted in sound economic principles, say, the discounted cash flow method. In the Krugman math example, no such sane and prudent approach will occur.

The third part of Krugman’s argument that is problematic goes right to the heart of his economic skills and the illogic of his thinking when it comes to asset values. Specifically, how will the economic stimuli (monetary and fiscal) that he so strongly advocates in favor of have a positive effect on the economy yet somehow have little to no effect on asset values? Specifically, how do trillions of dollars move the US economy yet asset values for the length of the “toxic assets” remain depressed, if not plunge further? Why wouldn't such assets at least maintain their discounted cash flow values?

You Know You’re In Trouble When Gingrich Agrees With You

Advocate views like Krugman’s make strange bedfellows. So, it is no surprise to see none other than Newt Gingrich sing the praises of Paul’s folly. At least, however, Gingrich’s argument is rooted in the political sphere as he tries to attribute motive to the Obama administration with statements such as “We are currently being run by a left wing machine that want the United States as we have known it to cease to exist”.** Whereas Krugman’s argument is rooted in the dogma of market efficiency.

Liquidity Not Solvency

The central part of the so-called “toxic assets” argument has been liquidity versus solvency. Those with an understanding of how markets work (like Geithner and his predecessor, Hank Paulson) see it principally as a liquidity problem. Those with Nobel prizes living in ivory towers see it otherwise.

I love you, Paul. But on this one, you win the booby prize.

*Of course, other factors such as the economic outlook play a key role in the depressed pricing. However, just as the case with the price of oil last summer, non economic factors play an exacerbating role.

**Setting aside the standard Republican fear mongering playbook, Gingrich’s arguments do offer an alternative methodology, which interestingly contain several very workable elements such as creating an online auction, let the participants decide the value, and cover the losses.

Quotable Quotes: Hang ‘em High

The lynch mob is out, the US Constitution be damned.

Who isn’t outraged by actions that reward big bonuses to those in failed institutions who caused the failure in the first place? Certainly, the politically tone-deaf selfishness of certain Wall Street types in a time of economic crises warrants a heavy hand. And most likely the political kabuki dance’s end result will be a self imposed clawback and a full recognition that the game has changed. However, all citizens should be concerned when an activist government exacts retroactive penalties targeted toward specific groups. For it's one thing to be responsive to the wants and needs of a constituency, quite another when a politician is willing to sacrifice principles (and potentially constitutional law) for politics. Therefore, a few words on lynching and mobs seem appropriate.

“Those who try to lead the people can only do so by following the mob”
Oscar Wilde

“A democracy is nothing more than mob rule, where fifty-one percent of the people may take away the rights of the other forty-nine.”
Thomas Jefferson

“The nose of a mob is its imagination. By this, at any time, it can be quietly led.”
Edgar Allan Poe

“There can be no such thing, in law or in morality, as actions forbidden to an individual, but permitted to a mob”
Ayn Rand

“I was participating in my own lynching, but the problem was I didn't know what I was being lynched for.”
Gen. William Westmorland

Clint Eastwood (as Jed Cooper): Well, I don't care how you slice it - whether there's nine men out in the plains with a dirty rope or a judge with his robe on in front of the American flag - those boys are going to be just as dead as if they'd been lynched.
Pat Hingle (as Judge Adam Fenton): That's right, Cooper, just as dead - but they won't have been lynched. They would have been judged. And if you can't see the difference, you'd better take off that star right now!

Have a good weekend.

Minyanville posting: Put Some J(u)NK in Your Portfolio's Trunk

excerpt from this week's posting:
"Yesterday, in several accounts I manage, I decided it was time to put some junk in their portfolios. The junk I'm referring to is the high-yield ETF – JNK. The primary reason for adding JNK is the still very wide yield spread over..."

To read the full Minyanville commentary, click here
To view all Minayanville postings, click here

Beyond the Sound Bite: An Interview with Art Hogan

In my second interview with the Director of Global Equity Products for Jefferies & Co. since May of last year, we contrasted the much changed economic and investment landscape. Topics discussed includes the game changer called Lehman, the forces of deleveraging, the impact of ETFs on their underlying holdings, and the sectors and styles in and out of favor.

Beyond the Sound Bite postings can be found at beyondthesoundbite.blogspot.com
To listen to this week's podcast interview, click here

Quotable Quotes: Say Bye Bye to Mark to Market

Poor FASB chairman Bob Herz.

Rarely has one witnessed such an ass whopping the likes of which the House’s special committee gave Mr. Herz yesterday on mark to market. The pounding came from both sides of political aisle as they told story after story of banks and businesses within their districts and how mark to market has wrecked havoc on their ability to do business.

Yet, to my ear nothing captured the mood of the hearing better than the following exchange between Mr. Herz and the Republican congressman from Georgia, Tom Price, regarding the three-week timeframe (which New York Democratic congressman Gary Ackerman exacted from Mr. Herz earlier) in which FASB would provide new mark to market guidelines:

“Congressman Price: Mr. Herz, I understand that you said within three weeks you’ll be able to issue new guidelines. Is that correct?

Bob Herz: That’s what I am going to go back and talk to my board members about. Remember, I have one vote of five. I will clearly take back your very clear message from today. But I cannot do it by myself. I have four other very conscientious board members…

Congressman Price: Do we need to bring the other four in here?”

Note: in a later testimony, upcoming podcast interviewee Bob McTeer (March 25) and former FDIC chairman William Isaac noted that mark to market rules state that banks must write down their losses entirely and immediately BUT can only accrete any mark to market gains they may experience. Yet another reason why you can kiss mark to market as we know it goodbye.* To that I say, Halleluiah!

Have a good weekend.

* This point modifies and clarifies the following segment of my blog posting of February 24th, “The Damage Has Been Done”: “In fact, one could argue that repeal or modification of mark-to-market will actually inhibit, if not outright eliminate, the recognition of the capital appreciation potential in many of the panic driven depressed assets once fear recedes and balanced thinking returns. Under such conditions, one can only conclude that the winners will be those who scoop up the babies thrown out with the bath water. Tragically, those winners are not likely to be the entities who were forced to writedown all the "toxic" assets - the banks.”

Minyanville posting: Why Divergences Work

excerpt from this week's posting:
"Tuesday’s big up-market demonstrated a tried-and-true investment axiom: When market conditions are ready, a catalyst is all that's needed to get the show on the road. The show, in this case, is a cyclical bull rally. And the catalyst was the Citigroup's (C) earnings statement. Here are some of the particulars.

Over the past 2 months, several bank executives stated..."

To read the full Minyanville commentary, click here

To view all Minayanville postings, click here

Beyond the Sound Bite: An Interview with Axel Merk

In my wide-ranging interview with the President and Chief Investment Officer of Merk Investments we discussed depression investing, mark-to-market, Europe, Eastern Europe, and unique economic situation in Norway, capitulation and investor psychology.

Beyond the Sound Bite postings can be found at beyondthesoundbite.blogspot.com
To listen to this week's podcast interview, click here

Street Scan

Billionaires are now Slumdog Millionaires because:



A. The credit markets remain frozen
B. The US economy is falling off the cliff
C. Corporate earnings are headed substantially lower (<$50 S&P 500 operating earnings)
D. The socialist programs of the Obama administration threaten capitalism as we know it
E. All of the above, and then some
***
from International Monetary Fund “Global Financial Stability Report (GFSR) Market Update”
January 28, 2009

“Until now banks have managed to obtain sufficient capital to offset existing writedowns, but that is mainly due to the massive public sector injections of capital in the fourth quarter. The worsening credit conditions affecting a broader range of markets have raised our estimate of the potential deterioration in U.S.-originated credit assets held by banks and others from $1.4 trillion in the October 2008 GFSR to $2.2 trillion. Much of this deterioration has occurred in the mark-to-market portion of our estimates (mostly securities)*, especially in corporate and commercial real estate securities, but degradation is also occurring in the loan books of banks, reflecting the weakening outlook for the economy.”
***
Aggregate assets in money market funds (institutional and retail): $4 trillion (approx.)
Total market capitalization of the S&P 500 as of March 9, 2009: $5.9 trillion
***
from Dave Rosenberg, North American Economist, Merrill Lynch
March 9, 2009

"Beige Book mentions nine positive areas
Even if we still do not see a bottom in sight just yet for the economy or the equity market, there are sectors that at least from a macro standpoint have a relatively firm underpinning even in the midst of this unbelievably severe recession and bear market phase. We have said it once and we will say it again, the Fed's Beige Book offers up the most timely and detailed information on sectors. The most recent report that was issued last week contained positive mentions on these nine areas of the economy:
􀂄 Food production
􀂄 Pharmaceuticals
􀂄 Apparel retailing
􀂄 IT services
􀂄 Biotech
􀂄 Aircraft manufacturing
􀂄 Fast food restaurants
􀂄 Discount stores
􀂄 Environmental services

Positives outperformed the market by 800 basis points
While these sectors, on average, were down 8% between the most recent Beige Book and the one that preceded it in early January, they collectively outperformed the market by 800 basis points.

21 negative sectors mentioned
At the same time, there were 21 sectors that received negative mentions in last week's Beige Book. They are listed below:
􀂄 Travel/tourism
􀂄 Education services
􀂄 Luxury goods (jewelry)
􀂄 Agri-business
􀂄 Banks
􀂄 Homebuilding
􀂄 Electronic equipment
􀂄 Computers
􀂄 Motor vehicles
􀂄 Staffing services
􀂄 Commercial real estate
􀂄 Rails/Trucking
􀂄 Furniture/Appliances
􀂄 Health care services (elective)
􀂄 Oil drilling
􀂄 Metals and mining
􀂄 Wood products
􀂄 Media services
􀂄 Petrochemicals
􀂄 Construction equipment
􀂄 Semiconductors

So, for every positive mention, there were more than two negatives. The S&P 500 sector equivalents, on average, declined 26% between the last two Beige Books, and underperformed as a group by 1,000 basis points."
***
email sent last night to "Kudlow Report" producer Donna Vislocky in response to Larry’s plea for bullish commentators:

“On tonight's program, Larry said his producers were having a hard time booking those who were bullish. Well, here I am.

As someone who is now 100% invested, I am at the opposite end of when I last appeared on your program in early 2007 when I was highly cautious. Today, however, the picture is swung completely to the other side of the pendulum.

Here are a few bullish reasons that I am more than willing to debate a bear:

1 - Investor psychology is so thick you could cut it with a knife. Too bearish now, just like they were too bullish two years ago.
2 - A mountain of cash sits in money market funds - nearly $4 trillion. The stock market value for the S&P 500 stands today at $5.9 trillion.
3 - Valuation levels in many areas are very attractive and any upside earnings surprise would drive stocks higher.
4 - Technical analysis has recently begun to generate some positive divergences - downward momentum pressures have diminished, divergences (emerging markets, for example) have, uh, emerged.

Moreover, as someone who has criticized mark-to-market since March of last year, I am in complete alignment with one of tonight's guests, Steve Forbes.”

*emphasis added

Quotable Quotes: Zombies

With all the talk of zombie banks, how about a few words (and sounds) about zombies.

“And what about Zombies? You never hear from Zombies! That's the trouble with Zombies, they're unreliable! I say if you're going to go for the Angel bullshit you might as well go for the Zombie package as well.”
George Carlin

“The good, say the mystics of spirit, is God, a being whose only definition is that he is beyond man's power to conceive - a definition that invalidates man's consciousness and nullifies his concepts of existence. The good, say the mystics of muscle, is Society - a thing which they define as an organism that possesses no physical form, a super-being embodied in no one in particular and everyone in general except yourself.... The purpose of man's life, say both, is to become an abject zombie who serves a purpose he does not know, for reasons he is not to question.”
Ayn Rand

“Yeah, I know I'm ugly... I said to a bartender, 'Make me a zombie.' He said 'God beat me to it.'”
Rodney Dangerfield

Bush versus Zombies
click here

The Zombies (with the lead singer moving at the speed of a zombie)
click here

Have a good weekend.

Minyanville posting: Bears Out of Momentum

"A few weeks ago, the bears fired a warning shot at the equity markets: Should the S&P 500 break its intraday low of 741, the next stopping point would be 600. The fundamental justification for 600 is fairly straightforward - $50 operating earnings times a 12 P/E gets you to 600. $50 is the mid point between the top-down super bears calling for a mid-$40 number, and the more conventional top-down prognosticators with their mid-$50s number..."

To read the full Minyanville commentary, click here

To view all Minayanville postings, click here

Beyond the Sound Bite: An Interview with Marc Siegel

In my comprehensive interview with the FASB member of the board we began with the ever contentious issue of fair value, FAS 157, and mark-to-market, and related issues such as the loan component of bank obligations, the distinction between regulatory capital and GAAP, and dynamic provisioning. We then went on to discuss two other important topics: the progress re US and international accounting rules and the progress re evolving financial statements' look and feel.

Beyond the Sound Bite postings can be found at beyondthesoundbite.blogspot.com
To listen to this week's podcast interview, click here

Wanted: Gene Krantz

There’s this one moment in the movie Apollo 13 when mission control manager Gene (failure-is-not-an-option) Krantz, frustrated by the steady stream of bad news, asks his colleagues to identify what is working on the crippled spaceship. From that starting point, from that solutions oriented point of view the process of rescue begins for the mission and crew. Which brings us to the current economic malaise.

In the current climate of all misery and all doom, in a world where nothing seems to work and crooks and incompetents emerge daily, perhaps someone should take the lead and begin to ask the same type of questions and, with the same determination that Mr. Krantz had, apply it to the US and global economy and thereby begin the transformation process from what is wrong to what is right, what is working, and with something that resembles a failure-is-not-an-option attitude.

Frankly, I am sick of listening to the Dr. Doom’s of the world prescribe their vision that the only medicine the world economy needs is an even more bitter elixir. What happened to the can-do spirit of America? What happened to focusing on what is working? Where is that solutions oriented process that includes some out of the box thinking? Too much myopic, woe is us, bureaucratic thinking and not enough innovation, what’s working, and let’s fix and not fiddle around the edges.

This is not to say that problems should be ignored. Nor am I suggesting that the problems are easy to solve. But, give me a break, for as complex as CDS and CDOs might be, they can’t be more complex than the human genome. And they certainly cannot be more pressure cooked than saving three lives in a crippled spaceship.

Where’s Gene Krantz when you need him?