Monthly Archives: February 2009

Bigger Guns, More Ammo

Ok, now the “market” has really hit a new low.

I had characterized the November 20th low as the “near collapse of the global financial system” low, and due to the extreme readings of fear and concern at that time (VIX flew to 80, bond spreads widened to historic highs, etc.) I had felt that a retest was unlikely. I was wrong.

This latest new low could be labeled as the “near nationalization of the US banking industry,” but somehow I feel that concern over the banking sector is not the whole story. Even smart people like Barron’s Michael Santoli, who I respect a great deal, find the market’s action so far this year puzzling. In his latest piece he writes, “Rather than a manic and dramatic dive, the drop since early January has been a monotonous and numbing slouch. The selling has been of lower intensity, less inclusiveness, accompanied far less by panic than resignation.” Despite his accurate assessment of the nature of this part of the decline, he fails to discover the root cause for this trip back to the old lows.

Maybe it’s as simple as hedge fund short selling. Short sellers are able to make money as the price of a stock declines. Hedge funds are well-known for their practice of short selling, often as a “hedge” against other assets they own, but in dramatic times like these, where many are fighting for survival, maybe they are simply only investing on the short side. We learned recently that Paulson & Co., a New York City-based hedge fund, made over $200 million from its short position on Royal Bank of Scotland. Multiply this experience by all the bank stocks feeling pressure times all the hedge funds struggling to prosper in these challenging times, and we may find a root cause of the weakness in the market.

I find it somewhat ironic that the heads of US banks receiving government aid can find themselves at the feet of a government panel being berated for alleged mismanagement during the most extraordinary times, while bank stock-shorting hedge funds escape all scrutiny and press coverage. With the traditional buyers of stock (mutual funds, endowments, individual investors) sitting on $9 trillion in money market assets waiting for a “better time” to buy stocks, it is possible that all this short selling is the driving force for the market right now. Consider too the public outrage that might be generated if investors realized that hedge funds were making tons of money as the market declined. And yet, we hear nothing about them…

For all the positive sentiment heroic stories like the Alamo and the Battle for Thermopylae may engender in our hearts, ultimately these brave souls perished because their enemies had bigger guns and more ammo. Maybe “enemy” is too strong a word to characterize the short-selling hedge funds prospering while our portfolios shrink, but it’s easy for me right now to feel more like the Spartans and less like the Persians.

Chant of the Ever Circling Skeletal Family

According to media reports, the economy has been caught in a negative cycle of spending cut backs by consumers (who fear losing their jobs), which leads to fewer sales for companies providing goods and services, who then in turn must layoff workers, which leads to more cutbacks, fewer sales, more layoffs, etc. Down and down this vicious cycle spins (so the story goes) until we are all reduced to bony wraiths, dressed in rags, shuffling our shoeless feet in a bleak David Lynch tableau, muttering in unison “wall street crooks, wall street crooks…” Hence the obtuse reference to the obscure David Bowie song which shares its title with today’s blog.

Apocalyptic? Yes. Entertaining? It must be for some (why else would we hear so much about it in the media?). Reality? Not really.

My reasoning here comes from something I learned back in Econ 101 – the law of diminishing returns. In its most basic form, this concept suggests that, all else being equal, the output for each producing unit (an employee, for example), will decline once a certain number of producing units is realized. In other words, the additional return from adding new production will be in successively smaller increments. For example, if 5 workers can make 100 gizmos in an hour, one might expect that 10 employees could make 200 of them in the same time frame. However, that may not be the case. Why? Production could be dependent on available factory space and machinery, the speed of automated processes and so forth.

So how does this apply to news about consumers cutting back? Think about it. If a working person cuts back spending a bit due to concern over the economy, how much really could that person cut out of the monthly budget? 10%? Whatever the number, let’s assume that that same person (who still has a job) has adjusted spending a bit, but has been watching the TV (or his 401k statement) and thinks that further cuts are needed. How much could this person cut the second time? Unless this person cuts more (in percentage terms) than the first time, the impact on the economy will be less negative than before.

Same thing applies for companies firing workers. The first 10% headcount reduction for any given company would have a bigger impact on the economy than the second 10% would. Even though companies are reacting to fallen demand, they are probably cutting back a bit more than is necessary, just in case things worsen a bit. If this is true, then they are less likely to make additional cuts even if demand slackens a bit more. Perhaps this is why we are not seeing multiple waves of layoffs from any given company, outside of highly distressed industries.

A person who no longer has a job is likely to cut back spending more dramatically than a person who is just worried about that possibility. Even so, the incremental spending cuts (after the first ones) will have a smaller impact on the economy. Look at it this way – if 7% of the workforce is unemployed and each person cuts spending by 50% (for example), a 10% cut by the remaining 93% would actually have a bigger incremental impact on the economy. It’s also important to consider that spending cuts by employed people are largely driven by sentiment – something that could change much faster than changes in the actual economy.

All of these factors are impacted by the law of diminishing returns. Unless each successive wave of spending cuts and layoffs is bigger than the last one, its impact on the economy will be less than the previous one. This suggests that at some not-too-distant point, we could begin to see economic data that, at the margin, is less negative than before. This may be all the stock market needs to begin thinking about a recovery…

The ‘Market’ Hits a New Low

Another headline that misses the point…

The Dow Jones Industrial Average (DJIA) hit a new low yesterday and now is about 47% off its October 2007 high. To many casual observers the DJIA is “the market.” In reality, it is simply an index of 30 stocks considered by the Dow Jones company (publishers of the Wall Street Journal and now a part of News Corp.) to be “blue chips.” It is also a price weighted index which means the stock with the highest absolute price (IBM right now) will have the biggest single impact on the movement of the index. The index now also contains a large number of “fallen” blue chips (General MotorsCitibankBank of AmericaGeneral Electric), which probably would not be selected as members of the index if a vote were taken right now. The index also contains a large number of highly-cyclical industrial stocks (MMMCaterpillarBoeingHome DepotUnited Technologies) whose fortunes are closely linked to the economy.

Most professional investors consider the S&P 500 (which is market cap weighted) to be a better representation of “the market.” Not that it’s much consolation, but the S&P 500 is still 5% above its November 20, 2008 low. Clearly the market (however one defines it) is feeling stress right now. I doubt that this week’s action has much to do with the economy – we have seen little in the way of new economic data that would drive down the market (January retail sales, for example, were actually better than expected). The only new news for the market has been the government’s stimulus plan, the new bank rescue plan and the new plan to help distressed home owners. I’m not suggesting that these items are the reason the market has been down this week, but the correlation is there. Perhaps the market was looking for something different (better?) from the government. Perhaps investors are worried that the plans come with political agendas that may not be totally focused on helping our capitalist economy. Perhaps the Madoff and Stanford scandals have tainted the entire investment industry with a stain that will be hard to remove. Perhaps everyone is just tired.

Regardless of the reasons for this week’s decline, it feels very much like capitulation. I know that I’ve said this many times before, but it’s been true many times before – I have truly felt waves of capitulation over the last six months. The fact that this feeling of capitulation was not the absolute bottom does not change in my mind or the way it felt. There is $9 trillion on the sidelines in money market funds. We are seeing some very early signs of economic improvement (higher shipping rates, a recovery in base metal prices, inflows into the stock and bond mutual funds in January, etc.) and I remain hopeful that the market will soon begin to respond to the expectation that the recession will eventually end. It is starting to feel like the market (and many investors) cannot believe it ever will.

I Have an Idea – Federal Gift Cards

Although I am not an economist or a politician, I think I may have stumbled onto an idea whose time may have come – Federal Gift Cards.

We know that gift cards have become all the rage in the retail business, with consumers spending around $25 billion last year via gift cards. According to the Census Bureau, there were 111 million households in the U.S. in 2007. Assuming that the government and U.S. taxpayers are willing to spend $900 billion to “stimulate” the economy and another $ 1 trillion to help the banks, the costs of these programs works out to be $17,117.12 per household. Why not give this money directly to the households? Critics of the “tax rebate” plan last year argued that it did not stimulate the economy as expected. I would argue that the $1,000 cash rebate failed because 1) it was too small and 2) it could be used to pay down debt. I think $17,000 in gift cards might do the trick.

Also, gift cards are vastly superior to cash because they could be targeted. For example, $2,500 of the total could be Auto Gift cards – used only on new and used cars. If this money were used only on new cars, that would equate to roughly 16 million vehicles, something that resembles a very good year for the US car industry. General Motors (GM) would have to quickly re-hire those 10,000 people it just laid off.

You could target another $2,500 for new house purchases. Although, this by itself is not enough for a down payment or even closing costs, I would make the cards tradable. If I needed more money for a new car, and you needed more for a new house, we swap – the barter system could save this economy. Ebay (EBAY) would no doubt be a beneficiary of the plan, as people scrambled to get the kinds of gift cards they really need. This part of the plan would appeal to free market types.

Other gift cards could be targeted for healthcare expenses (get that elective surgery you’ve been putting off), health or other forms of insurance – perhaps we could make these cards exclusive to American International Group (AIG), college tuition, as well as general retailers. People without jobs could eventually end up with $17,000 in cash to meet living expenses. This, coupled with unemployment insurance, could hold them over for a while.

The plan is progressive in that it would provide greater benefit to single member households, both old and young, who may have lower income than the national averages. The plan would also be voluntary. This would allow those who don’t need the money to give it away (imagine Oprah giving a huge bunch of Federal Gift Cards away to her studio audience). I would avoid the temptation to exclude the wealthy or other groups in this plan – everyone gets them. This would allow members of congress to give their cards to needy folks back home in their districts, which is probably better than where some of the pork in the current plan will eventually end up.

States would benefit from all of the sales taxes generated by the purchases.

You could also place an expiration date on the cards – say 6 months. This would assure that all this money gets spent right away, and ultimately exactly where we want it to go. I would have big banks such as JP Morgan, (JPM), Wells Fargo (WFC), Bank of America (BAC) and Citigroup (C) administer the issuance of the cards, allowing them to make a small fee for processing.

All in all, I think this plan would appeal to the greatest number of people and would put in the money immediately to work in the economy. Within this plan are elements of progressive taxation and income redistribution, which will appeal to a portion the political spectrum; it provides assistance to the needy industries currently being helped by the government – banks, insurance, autos and housing; and it has some elements to appeal to free market types and libertarians (spending the money would be voluntary, cards would be fungible, etc.).

Critics of the plan may argue that so much money spent right away may not be a good thing either. To which I would counter, so why do we need to spend this much money anyway? I have yet to hear a convincing argument that $2 trillion is really the “right” number for this plan.

More Bad News on the Employment Front, So Why is Mr. Market Smiling?

Today the US Labor Department reported a job loss of 598,000 for January and an unemployment rate of 7.6%. These figures indicate the current stress on the economy and the distress many households are facing. Much will be said about these numbers, and economists and media people will no doubt crunch their numbers, extrapolate the trends and intone in morgue-serious tones about how these results are the worse since, 1981, 1974, 1933, etc.

Employment, like GDP, is a lagging economic indicator. That is, it is one of the pieces of economic data that shows improvement only after other signs of recovery have emerged. Leading indicators such as building permits, the average workweek, supplier deliveries, etc, are still negative but do not receive as much market or media attention as the monthly employment report.

Despite the unrelenting bad news on the employment front (we hear every day on CNN reports of companies laying off thousands of workers), the stock market is hanging in there. In the chart below we see that the market is well off its Q4 ’08 low and may actually be trying to establish a slight upward bias. In the face of worsening economic news, why is the stock market trading 13% above its lows?

We see three simple reasons for this.
1) Valuation. At some point, a stock will trade at a valuation sufficiently low to attract new money. Despite investor withdrawals over the last few months, mutual fund managers are still in the business of trying to outperform the market. Those following the “value” style of investing are no doubt attracted by the valuations the market is now offering on a large number of stocks. Many value metrics (price-to-book, dividend yield, etc.) are not necessarily tied to the current year’s earning expectations and may not need to decline much further despite a lingering recession.
2) The End of Technical Selling. During the worst days of October and November, it appeared as if the market was not working. The daily action in the market seemed totally unrelated to any fundamentals. The market would violently move up or down regardless of the news items or economic data points of the day. Much of this historic volatility was no doubt due to technical selling by mutual funds, responding to investor withdrawals and hedge funds reducing their leverage. Some time in December, we sensed an easing of this kind of market action. The market is still worried about the economy and volatility remains well above historical norms, but it seems to working “properly” again, that is, stock prices appear to respond to fundamentals as one would expect.
3) Discounting the Future. According to efficient market theories, the market is supposed to discount future events and not just the current situation. Because market prices should already fully discount all available information and investors should be putting capital to risk on the expectation of future developments, we should not be surprised to see the market today respond favorably to the employment report. Why? The market was already expecting bad news on the employment front. It’s not as if investors were waiting for the employment report to sell stocks. No doubt some were waiting for the report to buy stocks (because it was not materially worse than expected).
We have no way of knowing for sure whether we’ve seen the worst in the stock market or not, but we are encouraged by the fact that the market is well off its lows and it seems to be able to absorb waves of bad economic news without falling dramatically.

Dive When You See Only Rocks

The young man stands perfectly still contemplating the near future. In less than three seconds, if all goes well, he will be floating in the warm water that stretches to the horizon in three directions. All that separates him from the comfortable swim awaiting him is 136 feet of pure Acapulco air. Despite the height, the jagged rock cliffs flanking either side of his narrow aerial pathway, and the unpromising physics of flesh and bone piercing the churning waters below, he feels oddly calm. He has done this many times and knows that those who came before him, those who taught him to perform this rare feat, have been doing this for over 50 years. In a flash, he jumps and during his few seconds of human flight his emotions fluctuate wildly between mortal fear and otherworldly excitement. Then, in an intense adrenaline rush, he hits the water at nearly 50 mph. Although the 9 ½ feet of water seems too small to be an adequate landing pad, it embraces him, safely and perfectly. Relief now overwhelms him and he briefly basks in the satisfaction of yet again having performed well the task he has chosen as his vocation.

We recently heard stories of the cliff divers of La Quebrada and had to marvel at their courage and skill. As with many things, the devil is in the details. We learned that the most difficult part of this extreme sport is timing the tide. The depth of the water in the narrow inlet, into which the divers dive, at some times during the day, varies greatly with the tide. According to the accounts we heard, to assure the maximum depth of water at impact, the diver must jump off when he sees only rocks below. To jump when the water appears to be at it deepest and safest, will lead to an unfortunate outcome.

As we reflected on the experience of the cliff divers, we began thinking about the perceived perils of investing in the equity market. While not a life or death exercise, equity investing to some must feel now like an endeavor with only unfortunate outcomes. Regardless of the causes, a great deal of investor wealth has been damaged over the last four months, and concern about the future remains high. Although we have seen some improvement in many of the quantitative measures the capital markets use to measure fear and risk (VIX, LIBOR, Corporate bond spreads, interest rates, etc.), fear on Main Street has yet to abate. It’s as if investors can only see rocks and do not expect the water to ever refill the inlet.

There is a palpable feeling that somehow, things will never get better; that somehow everything is broken beyond repair and that all avenues to grow assets have been blocked off permanently. This feeling is hard to shake when nothing but bad news assails the senses daily on TV and in the newspapers. Corporate losses, layoffs, reduced expectations about future earnings, cancelled orders, bankruptcies, foreclosures and scandals have become commonplace, and there seems to be no end in sight.

Yet we, like the cliff divers, have been taught by our elders to know when to dive and to know that there will always be water there when we land. History has shown us that EVERY recession since 1929 has ended (the average length after the 1930s has been 10 months) and that the stock market ALWAYS begins to recover long before the recession ends. There are two reasons why we think this recession may not last as long as the consensus expects: 1) High Cash Levels and 2) the Government’s Response.

Many have concluded that cash is the only “safe” investment out there. Money market assets have ballooned to over $9 trillion, the highest level on record (and more than the entire S&P 500 market capitalization). Granted, cash can’t lose its value, but it doesn’t grow value either. We would argue that cash is the riskiest investment possible right now for investors looking to grow assets over time. Historically, high cash levels ALWAYS precede big market rallies. We wonder why this time could be any different.

One could debate for hours whether the government’s response is the “right” one, but at least it’s doing something. It has so far avoided the huge missteps that exacerbated the Great Depression (do nothing for a long time, then pass protectionist measures and raise taxes). Easy monetary policy is a huge boon. Supporting the commercial paper market has been a critical and positive move. Even the stimulus package might help.

All in all, we see only rocks right now and think this is a great time to dive into the equity market. Some stocks such as Leucadia National (LUK), Cemex (CX), Whirlpool (WHR), Western Union (WU) and Veolia Environnement (VE) appear to be discounting worst-case scenarios and could offer better-than-market returns over the next few years.