By Edward Robinson, Bloomberg.Com | 26 May 2008
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"Cookie anyone?" says Tice, 53, offering peanut butter Girl Scout sandwich cremes to his four-member investment team. Tice, founder of the Prudent Bear Fund, is in his element as short sellers savor a rare advantage in their tug of war with Wall Street's bulls. Tice, an economic history addict who lines his office bookshelves with volumes on the Great Depression, is the most bearish of bears. He's been preaching for almost a decade that runaway mortgage lending would blow up. Tice blames former Federal Reserve Chairman Alan Greenspan, who led the central bank as it ratcheted down the benchmark U.S. interest rate to 1 percent in June 2003 from 5 percent in March 2001 and held it there for a year. Borrowers rushed in and mortgage debt soared to $1.4 trillion in 2006, double the $708 billion in 2001, according to Fed data.
15-Year Bear Market
Now, Tice says the Standard & Poor's 500 Index may tumble 40 percent during the next 12-24 months as the credit crisis undermines the economy, bankrupts households and companies and whacks profits. The drop would be worse than the 37 percent plunge in the index from 2000 through 2002. Tice predicts U.S. equities will enter a bear market that may exceed the 15-year slump from 1965 to 1980.
Moreover, he says if the Fed and Wall Street don't break their addiction to easy credit, the economy will eventually crash in a depression— a condition marked by sharply reduced purchasing power [[via wage cuts/freezes and high inflation: normxxx]], massive unemployment and massive corporate failures. The U.S. can't continue to inflate bubbles in stocks, real estate and other assets without crippling the financial system, Tice says.
`Drunken Sailors'
"We've become a country of drunken sailors" he says, snapping his fingers as he makes his point. "If you spend, spend, spend, there are going to be consequences to that— you can't borrow your way to prosperity." Even so, the turmoil has been good for Prudent Bear. After five years of trailing the S&P 500 with an annualized 0.9 percent loss compared with the index's 11 percent annual gain, the tables have turned for Tice's mutual fund. Prudent Bear, which has $1.1 billion in assets, has returned 9.5 percent from June 30, 2007, to May 20. That's almost 14 percentage points better than the 4.3 percent decline in the S&P 500.
Tice, a short seller who profits when prices fall by borrowing and selling shares and then repaying at a lower price, bet correctly that Citigroup Inc. and Merrill Lynch & Co. would be hammered by mortgage losses. He shorted companies that consumers were likely to avoid in a declining economy, such as Bed Bath & Beyond Inc. and Harley-Davidson Inc., according to Prudent Bear's annual report released on Sept. 30, 2007. Prudent Bear went long on metals with Capstone Mining Corp. and other ore producers. Shares of the Vancouver-based silver, copper and zinc miner jumped 81 percent during the past year through May 20 thanks to the commodities boom and the falling dollar.
Predicting The Credit Bubble
"Tice has been talking about the credit bubble for years," says David Kathman, a mutual fund analyst at Morningstar Inc., the Chicago— based investment research firm. "He may have looked foolish there for a while, but now the chickens are coming home to roost." Tice and fellow bears had better savor their moment because the bulls are poised to take back the market, says Robert Olstein, a money manager in Purchase, New York, who runs the $1.2 billion Olstein All Cap Value Fund. The S&P 500 has rallied 11 percent since Fed Chairman Ben S. Bernanke's unprecedented moves to stabilize the U.S. financial system began in March.
In addition to backing JPMorgan Chase & Co.'s takeover of Bear Stearns, the Fed for the first time since the Great Depression allowed securities firms to borrow cash at the same rate as commercial banks. By March 20, Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc., among others, tapped $28.8 billion in cheap Fed loans, bolstering confidence that Wall Street would overcome the crisis.
`Butt Kicking'
"Don't bet against the Fed," says Olstein, 66, whose fund is down 6 percent this year. "The worst is over, and the market is looking to turn; and when it takes off, the bears are going to be in for a good butt kicking." Richard Yamarone, chief economist at New York-based equity analysis firm Argus Research Co., says the $152 billion package of tax rebates and incentives that lawmakers passed this year will set off a shopping spree.
Another silver lining: Companies in the S&P 500 have almost doubled the average level of cash and equivalents in their coffers since 2001, to $2.05 billion from $1.08 billion, according to data compiled by Bloomberg. After gross domestic product inched ahead 0.6 percent in the first quarter, Yamarone is forecasting the economy will eke out a 1.7 percent increase by year's end.
`Doom and Gloom'
"Depression? C'mon, that's just the doomsayers trying to be funny," Yamarone says. "We're going to be on the rocks during the first half of the year, but the pendulum is swinging too far toward doom and gloom." As he's been doing for two decades, Tice counters that bulls are ignoring the pain ahead. Losses from the U.S. mortgage crisis may reach $945 billion, the International Monetary Fund said in April. That would be a bill six times more costly than the savings and loan debacle of the late 1980s, according to the U.S. Government Accountability Office.
Banks alone have reported more than $323 billion in losses or writedowns worldwide since early 2007. U.S. consumer confidence fell to its lowest in 28 years in May as record gasoline prices and the loss of more than a quarter million U.S. jobs this year cut into spending. "The economy is still a wreck," Tice says. "We're not out of the woods."
End Of The Golden Age
The credit meltdown runs so deep that the prosperous years on Wall Street that began in 1982 are probably drawing to a close, says Barton Biggs, 75, managing partner at Traxis Partners LLC, a New York— based hedge fund. "We had a spectacular era of financial success that was extended by the subprime mortgage mania to 2007," says Biggs, who was chief global strategist at Morgan Stanley until 2003. "But I think the golden age of Wall Street is over."
Tice couldn't agree more. For him, the day of reckoning is long overdue. Yet profiting from the upheaval is fraught with peril. The No. 1 danger for bears: No matter how sound their analyses or prescient their predictions, they're often steamrolled by bullish momentum, Morningstar's Kathman says. During the mid-1990s, Tice bet the tech boom was unsustainable. No matter.
Prudent Bear was pounded for four straight years, dropping 58 percent from 1996 to the end of '99 as dot-coms exploded in value. Following the 31 percent drop in the S&P 500 in 2001 and '02, Tice predicted equities had entered a long-term bear market. He was wrong again. The S&P 500 climbed to its all-time peak of 1,565.15 on Oct. 9, 2007.
`Bearish Convictions'
Tice says the market's record-breaking rise has only cemented his view that dangers lie ahead. "He's unshakable in his bearish convictions on the credit bubble and how we're all going to pay for it," says James Chanos, founder and president of Kynikos Associates Ltd., a New York-based hedge fund that, like Prudent Bear, shorts stocks. Chanos says he appreciates Tice's arguments; yet, as a pure stock picker, he doesn't apply macroeconomic analysis in his fund.
Tice, who zips around his Dallas neighborhood on a Vespa scooter and grooves to Led Zeppelin, says dire predictions aside, he's not some dour cynic. He's been enamored with the stock market since his teenage years in Independence, Missouri, in the 1970s. His mother introduced him to investments and analysis by tuning in to "Wall Street Week with Louis Rukeyser," a TV program then broadcast regularly on public television stations. Tice started on his path to becoming a "perma-bear," a market skeptic in good times and bad, after Black Monday, Oct. 19, 1987. That day, the Dow Jones Industrial Average tumbled 508 points, or 23 percent: the worst single-day drop in its history.
Dead Houseplant
Tice, who was studying to pass the chartered financial analyst examinations, was already leery of Wall Street and put off by how investment banks skewed equity research to curry underwriting business. "The banks were just touting the damn things and never had any skepticism," Tice says. "So we would be the devil's advocate." He's still playing that role from a third-floor warren of offices in a 10-story building north of downtown Dallas that he shares with eight members of his investment team.
A couple of these analysts are so contrarian, they delight in rooting against the Dallas Cowboys professional football team, heresy in a town that worships the five-time Super Bowl champs. The offices look like the headquarters that time forgot, with prints of English fox hunts lining the walls and dusty stacks of financial reports in wooden bookcases. A dead houseplant sits on a filing cabinet. Paintings depict lighthouses withstanding the crashing sea, presenting an apt metaphor for how Tice and his colleagues see themselves in relation to the markets.
Biggest Challenge
On this March afternoon, Tice is keeping an eye cocked toward a computer screen that flashes prices of stocks, metals, oil and the dollar. He even plunks his laptop on the table of an upscale Italian restaurant in Dallas during lunch to monitor the action. "There it is; gold just hit $1,000," he says as he tucks into a grilled salmon filet. With many of his predictions about the credit crisis coming true, Tice's biggest challenge may be outfoxing the newly minted short sellers who are rushing to cash in on the economic gloom.
In April, short interest on the New York Stock Exchange reached 4.1 percent of total shares outstanding, the highest level since Bloomberg started tracking the data in 1995. The flood of shorts increases the chances for a market phenomenon that strikes dread in investors such as Tice: the short squeeze.
Short Squeeze
That's when a stock that's being sold short experiences a sudden upturn. Bears, fearful that shares are moving against them, rush in to buy the stock— to "cover" in trading parlance. That buying spurs prices ever higher [[and, in a thinly traded stock, no stock may be available for purchase at any price! (Old Wall Street adage: "He who sells what isn't his'n, must buy it back or go to pris'n."): normxxx]]. Tice says he and Noland defend against squeezes by maintaining short positions in 75 different stocks: none of them exceeding 1.25 percent of the portfolio. That way Prudent Bear can quickly unload any shares that start to climb. As of March 31, Tice was shorting organic grocer Whole Foods Market Inc. and credit card provider Capital One Financial Corp. He expects both to suffer if there's a recession as consumers cut back.
Noland and Prudent Bear analyst Ryan Bend feared a short squeeze on CarMax Inc., the national auto retailer based in Richmond, Virginia. In April 2007, Tice bet the worsening economy would wallop CarMax with falling sales and rising auto loan delinquencies. So Prudent Bear started shorting it at $24.78. By Feb. 29, other bears had sniffed out the opportunity and laid siege to the stock: CarMax's short interest climbed to 17 percent of its daily trading volume from 9.8 percent on Dec. 31, according to Bloomberg data.
`Candy Bars'
Worried any scrap of good news might send shares higher and trigger a squeeze, Noland trimmed CarMax to 0.5 percent from 0.85 percent of the fund in the first quarter. "We have to cut back on the candy bars to rein in risk," says Bend, 32, using lingo for a tasty short candidate. On April 18, with short interest at 23 percent, Bend closed the position. Based on the stock's drop from $24.78 in April 2007 to $17.50 in January, Tice's target price, the trade delivered a 29 percent return. Tice and Noland also have to be careful not to fall so in love with their own analysis that they overstay their short positions.
Homebuilders have been so-called candy bars amid the real estate crash. As of September, Prudent Bear was shorting 75,000 shares of Los Angeles-based KB Home, which dropped 58 percent last year. The fund was also short 90,000 shares of Toll Brothers Inc., based in Horsham, Pennsylvania, which fell 38 percent. The two hit bottom in January. KB Home returned 9 percent and Toll Brothers rose 15 percent this year through May 20. Prudent Bear closed its short positions in the companies in the first quarter even though Tice expects little immediate improvement in homebuilders' fortunes.
Pulling Weeds
"You have to pull the weeds," he says, referring to closing out losing positions. Tice forged his bearish views in Texas's investing scene during the 1980s, the era of the TV drama Dallas. He earned a bachelor's degree in accounting from Texas Christian University in Fort Worth in 1976 and a Master of Business Administration from the same school the following year. He spent the next eight years toiling as an internal auditor and acquisition planning executive in the Texas operations of oil giant Atlantic Richfield Co. and Enserch Corp., a Houston-based oil and natural gas firm.
Tice witnessed firsthand the perils of rampant speculation as the oil boom turned to bust. Then came the S&L debacle, when more than 740 lending institutions failed in a wave of corruption. By Black Monday 1987, Tice identified with the skeptics, not the market boosters. And he opted against looking for a job on Wall Street, which he considered a haven for Ivy Leaguers.
Investing Career
"I had a little chip on my shoulder," says Tice, leaning back behind a wooden desk in his office. Eager to start an investing career, Tice read a book by Thornton O'glove called "Quality of Earnings" (Free Press, 1998). O'glove, who co-wrote a newsletter by the same name with money manager Olstein, showed that financial statements could reveal how companies used legerdemain to boost income and downplay expenses.
As a CPA, Tice loved the notion of becoming a financial detective. He also recognized that there was money to be made when stocks tumbled. Tice started his own newsletter called "Behind the Numbers." It dissected financial statements and issued sell recommendations. He tapped $10,000 in savings and worked out of a spare bedroom in the Dallas home he shared with his wife and infant daughter. Soon enough, he started signing clients who saw his research as a way to cross-check Wall Street analysis.
`Cracks in the Financials'
"We didn't always agree with him," says Luther King, a fellow TCU grad and founder of Luther King Capital Management in Fort Worth, a money management firm with $7.7 billion in long-only funds. "But he was an independent voice, and I knew by his nature he was looking for cracks in the financials." In the mid-90s, Tice was charging $10,000 a year for his reports. He counted hedge fund managers George Soros, Michael Steinhardt and Chanos as clients. CEOs often recoiled at his research.
In October 1999, Tice issued a sell on Tyco International Ltd. Chief Executive Officer Dennis Kozlowski expressed outrage after Tice raised concern that the Bermuda-based conglomerate was generating quarterly increases in income partly by disguising routine operating expenses as one-time charges for acquisitions. Analysts at Credit Suisse First Boston Inc., Bear Stearns and JPMorgan reiterated bullish recommendations on Tyco. "Kozlowski was ripping us, and Wall Street was attacking, but we felt strongly that we were right," Tice says. In December 2002, an internal review found Tyco had used "aggressive accounting" to bolster results.
Bloodied And Unbowed
Separately, Kozlowski and Chief Financial Officer Mark Swartz were charged in New York state court with looting $137 million from Tyco. Convicted in June 2005, they're serving 8- to 25-year prison sentences. Tice sold "Behind the Numbers" for an undisclosed sum to his former analysts last year. By the time Tice had made the Tyco call, he'd expanded into managing money himself by opening Prudent Bear in 1995. He chose the name to reflect his investing approach: He shuns using leverage to boost returns and doesn't hesitate to close out positions to rein in risk.
Still, Tice's wager that the technology-led boom was headed for the rocks was four years too early. Crushed by dot-com mania, the fund suffered a 34 percent drop in 1998. Tice refused to become a bull. "I was bloodied, but I couldn't waver," he says. "We were a [reverse] hedge; that was our mandate, and I couldn't just tell clients, 'Well, I'm just going to be bullish for three months."'
Finding Footing
Prudent Bear found its footing in 2000. Betting that Wall Street would suffer from a decline in underwriting securities offerings and weak earnings amid the economic slump, Tice shorted shares of Goldman Sachs, Lehman Brothers and Morgan Stanley in 2002. They each fell more than 20 percent that year, contributing to Tice's best performance ever: a 63 percent return. Tice became intrigued by forces such as credit. As early as 2001, he cautioned that the Fed, by lowering interest rates, was rescuing the economy from one bubble by inflating a new one.
"We do not believe it is advisable to stimulate a burst of unprecedented mortgage credit creation," he wrote in Prudent Bear's annual report in September 2001. Tice also decried Wall Street's use of derivatives to transform toxic subprime mortgages into investment-grade securities. Derivatives are financial contracts whose value is based on, and determined by, another security or benchmark. He says banks pumped the credit bubble by manufacturing collateralized debt obligations and mortgage-backed securities.
Mining Fed Data
Ultimately, many of these instruments couldn't justify their value. Net issuance of asset-backed securities skyrocketed to a seasonally adjusted annualized rate of $906.8 billion in the fourth quarter of 2006, three and a half times the $255.6 billion in 2001, Fed data show. Last year, issuance plunged to $177.4 billion. Noland, whom Tice had met in 1997, was a kindred spirit when it came to the credit bubble. The Indiana University MBA holder had turned bearish working for short seller GW Ringoen & Co. in San Francisco before joining Tice in 1999.
An intense man who utters complex sentences in a husky voice, Noland, 45, revels in mining arcane Fed data. Setting down a document that's 2 inches (5 centimeters) thick called "Flow of Funds Accounts of the United States," Noland says, "The whole story is right here." Noland points to tables showing how total borrowing in the credit markets climbed to a seasonally adjusted annual rate of $4.96 trillion in the third quarter of last year, a 148 percent jump from 2001. The increase occurred even as U.S. home prices fell for the 14th straight month and foreclosures spiked.
Five-Alarm Fire
For Noland, this was a five-alarm fire: Wall Street was cranking out more high-risk debt securities in the face of deteriorating credit quality. "Unlike the tech bubble, which was isolated, the mortgage finance burst is causing huge distortions in the entire economy," Noland says. Tice and Noland anticipated the pummeling Wall Street would take and bet against securities firms. Prudent Bear was short 65,000 shares of Citigroup as of Sept. 30. The bank wrote down $18.1 billion on subprime losses in the fourth quarter.
Tice also sold short 21,000 shares of Merrill Lynch, which lost a record $9.8 billion in the same period. Both stocks dropped more than 40 percent last year. Last May, Tice started shorting about 351,000 shares of Starbucks Corp. at $28.46 in a bet that stretched consumers would balk at $4 coffee drinks. Yesterday, the gourmet coffee maker closed at $16.83, meaning Prudent Bear would have reaped at least a 41 percent return if Tice covered that day.
Resilient Market
Now the challenge dogging Tice and Noland is that the markets may once again prove as resilient as they have in the past. Since March 10, bullish investors have driven the Dow up more than 350 points on three occasions, including a 420.4 point surge on March 18— five days after Tice was proffering cookies amid Bear Stearns's meltdown. "The bears won for a while, but winter will turn to spring, trees will bloom and market psychology will shift," says Neil Hennessy, CEO of Novato, California-based investment firm Hennessy Advisors Inc.
For Tice, who has long been dismissed by bulls as a Cassandra warning of doom that would never come, the credit implosion has at least for now validated his pessimism. "I do feel intellectually vindicated," he says. Vindication may be cold comfort. In April, the S&P 500 rallied 4.8 percent, its biggest monthly rise in more than four years. If the bulls continue their stampede, Tice may find that even after being right about the credit crisis, he may be wrong about how long the bears will reign.
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Normxxx
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