Monday, June 30, 2008

Waiting For New President

<Megabubble Waiting For New President In 2009
'Numbers Racket' Exposes Potential Disaster For Economy, Markets

By Paul B. Farrell, Marketwatch | 30 June 2008

ARROYO GRANDE, Calif. (MarketWatch)— Remember that big ah-ha moment in the 1939 classic "The Wizard of Oz?" Dorothy wants to see the Wizard. His voice booms: "Do not arouse the wrath of the Great and Powerful Oz! Come back tomorrow!" Afraid, Lion, Tin Man, Scarecrow shake. Dorothy's dog runs up, tugs on a curtain. She chases Toto, pulls curtain open: "Who are you?" Dr. Marvel stutters: "Well, I— I— I am the Great and Powerful, Wizard of Oz." Dorothy: "You are? I don't believe you!" He replies: "No, it's true. There's no other Wizard except me." Dorothy's miffed: "Oh, you're a very bad man!" Wizard: "Oh, no, my dear. I'm a very good man. I'm just a very bad Wizard."

2009 Sequel: Script Exposes Diabolical Cover-Up Conspiracy

Flash forward: Real life, Washington, new leaders, a new Congress, old wizardry. Be forewarned: No matter who's elected president, America will soon see a massive statistical curtain pulled back, exposing a con game of historic proportions. And when that happens, you and I will suffer another ear-splitting global meltdown, bigger than today's housing-credit crisis, dragging us deep into a recession and bear market for years.

Cast: New 'Leading Man' From Old Nixon Political Machine

Yes, the lead character pulling back the curtain is none other than Kevin Phillips, a former Republican strategist for Nixon, and today America's leading political historian. Phillips just published "Bad Money: Reckless Finance, Failed Politics & the Crisis of American Capitalism," everything you need to know about today's credit meltdown.

Scene 1: Numbers Racket Hiding Behind Washington Curtain

Opening shot: Phillips pulling back the curtain, exposing charlatan Wizards in a brilliant Harper's Magazine article: "Numbers Racket: Why the economy is worse than we know." Far worse. Buy it, read it— this is essential reading if you really want to understand the depth of today's political as well as economic impending meltdown, and the harsh realities facing Washington, Wall Street, Corporate America, and Main Street in 2009 and beyond ... harsh because we cannot cover up the truth much longer.

Scene 2: Statistics, Washington's New Wmds, A Time Bomb

"If Washington's harping on weapons of mass destruction was essential to buoy public support for the invasion of Iraq, the use of deceptive statistics has played its own vital role in convincing many Americans that the U.S. economy is stronger, fairer, more productive, more dominant, and richer with opportunity than it really is. The corruption has tainted the very measures that most shape public perception of the economy," especially three key numbers, CPI, GDP and monthly unemployment statistics.

Scene 3: Backflash, 'It's always the cover-up, stupid!'

As I read further I couldn't help but think about similar traps politicians got themselves (and us) into. Remember nice guys like Scooter Libby and Bill Clinton: The crime wasn't their original stupidity, but their lying during the cover-up. Here, Phillips reviews endless statistical cover-ups since the 1960s and concludes there was no "grand conspiracy, just accumulating opportunisms." I call it plain old greed. And every step of the way the media went along with the con game played by politicians and economists.

Scene 4: Real numbers torture us ... like water-boarding!

How bad is it? "The real numbers ... would be a face full of cold water," says Phillips. "Based on the criteria in place a quarter century ago, today's U.S. unemployment rate is somewhere between 9% and 12%; the inflation rate is as high as 7% or even 10%; economics growth since the recession of 2001 has been mediocre, despite the surge in wealth and incomes of the superrich, and we are falling back into recession."

Scene 5: Most Economists Hushed, Work Inside Conspiracy

Compare that to the phony stats Washington feeds the press and public: Unemployment 5%, inflation 2% and long-term growth at 3%-4% (actually more like 1%). For example, just last week the L.A. Times reported that while "gasoline prices are up more than 20% from a year ago and food prices have risen 5%," Washington says "inflation was fairly mild last month." A Wells Fargo economist shook his head in disbelief: That report isn't "worth the paper it was printed on." Most economists are quiet, working for the conspiracy.

Scene 6: No integrity, they cannot be trusted to tell truth!

The same can be said of any government report, every speech made by today's leaders: All hype, lies and propaganda intended to deceive us. Treasury Secretary Henry Paulson's clearly playing the game: Remember what the former Goldman Sachs CEO told Fortune last July as our credit meltdown was metastasizing into a worldwide contagion: "This is far and away the strongest global economy I've seen in my business lifetime." He has no credibility. He knew the truth. He knew the government's "numbers racket;" after all, he helped create the problems years earlier at Goldman.

Scene 7: There's Enough Kool-Aid For Everyone To Drink

The plot's unraveling: The lies accumulate and compound one on top of the another ... get passed on ... keep mounting ... forcing successive new generations of politicians to drink the same poisonous Kool-Aid ... keep the lies alive ... going strong ... till everyone believes the lies are really "the truth," or at least an inconvenient truth ... as the hoax becomes the conventional wisdom ... not only by Washington, Wall Street, Corporate America and the media, but also 300 million Main Street Americans.

Scene 8: Inflation statistics are America's new 'guillotine'

The biggest of all lies is with inflation. Understating inflation "hangs over our heads like a guillotine," says Phillips. Yet if Washington told us the truth "it would send interest rates climbing and thereby would endanger the viability of the massive buildup of public and private debt (from less than $11 trillion in 1987 to $49 trillion last year) that props up the American Economy." So we keep sipping the Kool-Aid.

Scene 9: Washington and Wall Street delusional in 'Land of Oz'

"Were mainstream interest rates to jump into the 7% to 9% range— which could happen if inflation were to spur new concern— both Washington and Wall Street would be walking on quicksand," warns Phillips. "The make-believe economy of the past two decades, with its asset bubbles, massive borrowing, and rampant data distortion, would be in serious jeopardy."

Scene 10: Cover-Up Failing ... King Really Has No Clothes

Yet everyone still acts paralyzed, unable (or unwilling) to do anything to stop this lethal musical chairs charade ... till it's too late, or a catastrophe wakes us. Meanwhile, we act as if we had no choice but to put up with the crashes of 1987 and 2001 and 2007/8. Just "normal" bull/bear cycles. So, like lemmings driven over a cliff, we'll blindly accept the next crashes, as they increase in frequency and intensity. Next in 2011? As war debt piles? As reforming health care, Social Security and Medicare are delayed? As we deny and deceive ourselves, perpetuating the lie ... except noticing perhaps, out of the corner of our eye, at the edge of the screen, a curtain's being pulled open, slowly, our once-mighty statistical king, the Wizard of Washington, really has no clothes on.

Scene 11: Millions Of Co-Conspirators In Massive Cover-Up

Still, we let ourselves be conned. Why? "The rising cost of pensions, benefits, and interest payments— all indexed or related to inflation— could join the cost of financial bailouts to overwhelm the federal budget," says Phillips. But it's a heads-we-lose-tails-we-can't-win bet. "As inflation and interest rates have been kept artificially suppressed, the United States has been indentured to its volatile financial sector, with its predilection for leverage and risky buccaneering" Yes, Wall Street and the rich love playing this game.

Scene 12: Rich get richer hiding under 'statistical camouflage'

So who really "profits from the low-growth U.S. economy hidden under statistical camouflage?" he asks rhetorically. Certainly not the masses: "Might it be Washington politicos and affluent elite, anxious to mislead voters, coddle the financial markets, and tamp down expensive cost-of-living increases for wages and pensions?" Yes, yes, yes, a voice screams off-camera! Then a gun shot rings out ... dull thud ... silence ... haunting music builds, filling the theater ... signaling the end of this tragi-comedy ... although like Sartre's "No Exit," you know this drama will never end ... until ... the next sequel ...

Roll credits: Who was that masked man?

Kudos to the masked curtain-puller. Yes folks, it's the same Kevin Phillips who wrote "American Theocracy, The Peril and Politics of Radical Religion, Oil, and Borrowed Money in the 21st Century;" "The Politics of Rich and Poor: Wealth and Electorate in the Reagan Aftermath;" "American Dynasty: Aristocracy, Fortune, and the Politics of Deceit in the House of Bush" and others. In his "Wealth and Democracy: A Political History of the American Rich," Phillips warned us that "most great nations, at the peak of their economic power, become arrogant and wage great world wars at great cost, wasting vast resources, taking on huge debt, and ultimately burning themselves out." Slowly, fade to black ....



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Sunday, June 29, 2008

The Greater Depression

Casey Files: The Greater Depression
And What You Should Do About It

By Doug Casey, The International Speculator | 29 June 2008

For international investment expert Doug Casey, there's more than a recession on the horizon... he recommends battening down now for the rough seas ahead... with some special information about making sure your investments can weather the coming storms.

I believe in the existence of the business cycle. That's partly because almost everything in life is cyclical, which has been recognized at least since the tale about Joseph and the seven fat years and seven lean years. The Austrian school of economic thinking explains why the business cycle keeps coming around and does so without relying on a soothsayer to interpret your dreams. I urge you to read the appropriate chapters in either Crisis Investing for the Rest of the 90's or Strategic Investing for a full explanation.

But, in a nutshell, government intervention in the economy— through taxes, regulation and, most importantly, currency inflation— causes distortions and misallocations of capital that must eventually be unwound. The distortions degrade the general standard of living, and the economy goes into a recession (call that an incomplete cleansing). Or it goes into a depression— wherein the entire sickly structure comes unglued.

The last real depression took place in the 1930s. The economy very nearly went over the edge again in the early '70s and again in the early '80s. Both times massive re-inflation of the currency papered the problems over (but at a cost). Meanwhile, most importantly, continuing technological innovation and increased savings (motivated by the fear of bad times) led to recovery. Since then we've had 25 years of what Herman Kahn predicted would be "The Long Boom."

Unfortunately, much, much more severe taxes, regulations, and inflation have caused much, much more severe distortions in the economy— especially over the last 15 years. And the boom was financed largely by debt, which made everybody feel and act much wealthier than they really were. It's as though you borrowed a million dollars and spent it all on wine, song and high living.

For a while, you'd have a high standard of living and perhaps have a lot of fun. But eventually, when you either paid the money back with interest or were forced into bankruptcy, your standard of living would take a painful drop. The U.S., in particular, has been living far above its means, burning up its own capital and trillions more borrowed from abroad.

This isn't news to readers of International Speculator or even the intelligent layman who follows the news. Oddly enough, there's one glaringly obvious thing that is not in the news today at all. That's the fact that interest rates— nominal rates too, but especially "real," after-inflation rates— are close to their lowest levels in history. And in today's extraordinarily risky environment, they're artificially low. This, and the reasons for it, should be headlines.

All over the world, but especially in the U.S., currencies are being inflated radically; M3 is rising at about 18% per year. Without exception, interest rates eventually reflect inflation. Therefore interest rates are going to rise radically. Governments are currently suppressing rates by lending money cheaply and promiscuously, to keep both borrowers and commercial lenders from going under.

But rates are soon going to explode -especially long-term rates. My guess is that we'll see at least the levels of the early '80s, which would mean 15%+ for long-term Treasury bonds. And I'll say that's coming within a couple or three years at the outside.

The government wants low rates, obviously, because low rates make it a lot easier for homeowners to pay their mortgages, among other things. But they forget that low rates also discourage saving— which is the one thing that can actually bring down real rates. Officialdom is between a rock and a hard place, and they're choosing to inflate the currency.

Their hoping to stave off an epidemic of bankruptcy among consumers who borrowed and among the financial institutions that did the lending. The effort will fail and both groups will go bankrupt, simply because the whole society has been living above its means. That will result in large-scale commercial bankruptcies and unemployment.

Higher interest rates will absolutely hammer the economy.

It seems to me a near certainty that we're about to enter something I have long called "The Greater Depression." I suspect it will be inflationary (in the direction of what Germany underwent in the early '20s, or Zimbabwe today), rather than what the U.S. had in the '30s. I should somehow trademark the term "Greater Depression," except that I'm sure Boobus americanus would then blame me for it.

Here I'd like to pinpoint my prime candidate for the Decline and Fall of the Roman Empire, since it almost seems America has been reading pages from their playbook since day one. Many reasons have been evoked for the fall: moral turpitude, unrestricted immigration, barbarian invasion, Christianity, lead pipes, etc., etc. My candidate is economic stagnation brought on by taxes, regulation and inflation. I'd love to discuss that assertion in detail, but that's not what this article is about.

What should you do?

Reduce your standard of living NOW (while the situation is still under control), greatly increase your savings (in gold, which is real money) and rig for greatly changed patterns of production, consumption, employment and business for a considerable time. The hurricane that's just starting to hit the economy will both trigger and worsen problems in other areas. Starting with politics, because nearly everyone today believes the ridiculous notion that the government should guide the economy.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Saturday, June 28, 2008

Warren Buffett's Doings

Warren Buffett's Doings

Warren Buffett says he supports InBev's takeover of Anheuser-Busch (BUD). Buffett owns 5.7% of BUD and stands to make $600 million if the deal closes. Buffett is set to meet with BUD chief August Busch IV this week. Maybe the sage will get involved through a financing deal, like he did with Wrigley. However he does it, it's a good bet Buffett wants to be involved. The InBev deal would create the biggest brewer in the world. Buffett likes big competitive advantages, and world-dominating scale is a great one.

The world will continue to drink plenty of beer. (I'm doing my part!) So owning the No. 1 brewer should be a pretty good bet over the long term. I'm still short Lehman Brothers in my monthly Extreme Value letter, but maybe I should reconsider. None other than Hank Greenberg, the man who built the largest company (AIG) in the largest business in the world (insurance), says he's buying "a pretty good sized stake," in Lehman Brothers' equity. Greenberg made the announcement last week, after Lehman announced it would raise new equity capital.

At about the same time Greenberg was revealing his investment plans, AIG, the company he built, was getting a new CEO: its chairman, Robert Willumstad. Willumstad contacted Greenberg immediately. The two are scheduled to meet today. Hank Greenberg is to AIG what Buffett is to Berkshire Hathaway, perhaps more so. Buffett is famously hands-off with the managers of his 70+ subsidiaries, many of whom are independently wealthy and run their businesses because they love it.

The issue of Buffett's succession has been discussed widely in the press, but nobody ever talks about Greenberg's succession. AIG's stock has fallen since his 2005 departure, and with good reason. Greenberg, unlike Buffett, is hands-on. It's harder to imagine AIG without him than Berkshire without Buffett. AIG is worth a look. But it's such an enormously complex beast, I doubt it's possible for a single outsider working alone to really get a handle on it.

BofA/CFC 'Takeover'

Bank Of America / Countrywide Financial 'Takeover'

In case there was any wonder why banks are losing billions on bad loans... Last April, a woman received a credit-card application addressed to her then 5-year-old son. As a test, she had her son fill out the application, absolutely truthfully, and send it in. Young Bennett accurately wrote in his year of birth as 2002, his annual income as $0, and confirmed that he neither owns nor rents a home. He signed his name in a childish scribble. Shortly thereafter, Bank of America granted Bennett a new card with a $600 spending limit.

Maybe BofA's credit-card underwriting really is a crackerjack operation. If it is... how would we know? [[Well, after all, this is the bank that's still buying Countrywide Financial for $4 billion— with many, many times that liability in sub-prime mortgages.: normxxx]]

01/11/2008 05:57 PM by Dan Gobis

Do YOU all realize YOU probably helped Fund the Deal with Bank of America and Countryide?

Bank of America is able to use some of Countrywide's losses to offset its own taxable income.

The tax break could total about half a billion dollars over the first five years, according to an estimate by tax guru Robert Willens, who left Lehman Brothers Friday after a 20-year run and will be in business as Robert Willens LLC starting next week.

Bank of America can use a total of $1.35 billion of Countrywide's losses to shelter its income. (That's five years of $270 million annual losses.) If Countrywide's embedded losses when Bank of America buys it exceed $1.35 billion, Willens says, the bank will be able to deduct the rest of the losses, without limit, starting in the sixth year. The losses could be worth considerably more to Bank of America starting in the sixth year, depending on how big Countrywide's losses are when Bank of America formally acquires it.

As part of the deal, the government likely agreed to guarantee BofA against Countrywide-related losses. (There was nothing in the press release about that, so let’s give them the benefit of the doubt and say BofA is shouldering all of the risk and at this price it believes the risk is worth the reward.)

"Catching The Falling Knife"

There has been wide speculation for the last several months that the government is behind the scenes, urging BAC to rescue CFC.
The government would not allow CFC to fail, since it would create a domino effect much worse than the S&L crisis and LTCM. The failure of CFC would have triggered many counterparties conducting OTC derivative trades with CFC to fail, which would have brought the whole OTC derivative market including all large investment banks to their knees, similar to the LTCM situation in 1998. [[The Glass-Steagall act (now defunct) made it quite clear: the government/taxpayers were not going to bail out investment banks! But, I forgot, these days ALL banks are 'investment' banks.: normxxx]]

Countrywide faces numerous borrower lawsuits, and is under investigation by federal and state regulators for alleged lending abuses, issues which are normally assumed by the acquiring company in a takeover [[but, for the most part, issues which can be quietly dropped: normxxx]].

The bulk of the actions against Countrywide are individual claims connected to foreclosure cases across the country, with assertions ranging from violations of federal lending laws during loan origination, to duping elderly borrowers into taking out unnecessary high-interest loans, to mishandling loan payments, according to Ira Rheingold, executive director of the National Association for Consumer Advocates, whose members represent homeowners facing foreclosure lawsuits.

There are a number of other suits that could blossom into costly headaches for the company. In California, shareholders filed six suits this past fall against the company, Chief Executive Officer Angelo Mozilo and other executives in federal court, claiming they issued false and misleading statements about the company's health. The suits have been consolidated, and the company hasn't responded [[However, the Republican-packed court has already demonstrated that it frowns on such shareholder suits.: normxxx]].

Furthermore, the company faces at least 12 class-action suits alleging borrower abuse. BofA must also take care that plaintiffs don't try to empty its deep pockets.

Europe's Terminal Crisis

GEOPOLITICS—EUROPE: Has Europe's Terminal Crisis Begun With A Triple No Vote?

By Ambrose Evans-Pritchard, Telegraph.Co.UK | 26 June 2008

The ultra-Europeans have overplayed their hand. We can now glimpse a chain of events that will halt, and reverse, this extremist push towards an Über-state that almost no one wants. The attempt to override the triple "No" votes of the French, Dutch, and Irish peoples has brought the EU to a systemic crisis of legitimacy. One line too many has been crossed. Any sentient citizen can see that the 'process' has become unhinged.

While "Europe" blunders on as if nothing has happened, it is now an open question whether the Lisbon Treaty— née Constitution— will ever come into force, whether the EU will ever acquire the machinery of an economic, diplomatic, and military power, and whether the euro will ever have a polity to back it up. [[Or, even some Eurobonds.: normxxx]] Henceforth, Brussels will struggle to retain powers already amassed. Functions will flow back to the nation states, the proper venue for authentic democracy.

For three decades— from Rome to the Single European Act in 1986— there were no treaties. Then the pace quickened: Maastricht, Amsterdam, and before the ink had dried on Nice, the ideologues hatched The Constitution. This was the final throw of the Monnet Project: an attempt to lock in the framework of a proto-state [[a United States of Europe: normxxx]], crowned by a supreme court with overweening jurisdiction, before the ex-captive nations of eastern Europe joined and rendered such ambitions impossible. The deadline slipped.

The failure of this gambit became clear this weekend when the Czechs and Poles refused to mug Ireland; or put another way, when they insisted on upholding the Vienna Convention on the Law of Treaties, unlike our own craven government. "The treaty is dead," said Czech president Vaclav Klaus. "To pretend something else is undignified— if we live in a world where one plus one equals two." It is fitting that the central Europeans should emerge as the champions of due process. Their own memories of Soviet methods are fresh.

Radek Sikorski, the Polish foreign minister, cut his teeth as a journalist with Afghan guerrillas fighting Soviet forces in the Hindu Kush. Whatever the Irish decide to do, he said, "we'll respect it". How refreshing. It was France's Nicolas Sarkozy who set off this debacle, sweeping aside the verdict of his own electorate to revive a rejected text. He aimed to score points as Europe's mover and shaker: instead, he charged into the complexities of EU politics with his trademark flippancy.

Louis XIV (1638–1715), by Hyacinthe Rigaud (1701)

Well might Mr Sarkozy rail at the Irish. "Bloody fools. They've been stuffing their faces at Europe's expense for years and now they dump us in the s***," he yelled. Mr Sarkozy still thinks that Ireland can be made to vote again in a few months. Who is the bloody fool? [[He dreams again of a French empire; of a return to the "greatness" that was France under Le Roi Soleil, the "Sun King," Louis XIV: normxxx]] Yes, the Irish voted twice on Nice. That was another world. The Nice "No" came below radar, on a tiny turnout, after scant debate.

This time the contest has been electric. The Irish were warned day after day that rejecting Lisbon would be catastrophic. They rejected it any way, by national instinct, unwilling to sign a blank political cheque. As premier Brian Cowen now admits, Ireland's swing from boom to bust played its part in the vote. "That overall economic landscape is not likely to improve in the short term," he said. Quite.

A property bubble— caused by EMU interest rates of 2% until 2005— has left Ireland with frightening household debt of 176% of gross domestic product. The country now faces a quadruple shock: a credit crunch, rising interest rates in Frankfurt, a plunge in sterling and the dollar versus the euro, and a sharp slowdown in its Anglo-Saxon export markets.

Italy is not happy either, judging by prime minister Silvio Berlusconi's latest tantrum. "The euro is hyper-valued and it is crippling our exports. Europa is culpable for not intervening," he said, launching into a stream of invective against the EU [[and Jean-Claude Trichet, a French civil servant who is the current president of the European Central Bank since 2003: normxxx]]. The fast-moving events of the past two weeks must have market consequences.

Note that German foreign minister Frank Walter Steinmeier said Ireland should "exit" the EU temporarily. Did he forget that Ireland is an integral part of monetary union? His reflex is not only unpleasant, it also reveals that Germany views peripheral members of the eurozone as 'dispensable'. It is an invitation for hedge funds to "short" EMU bonds from the Club Med states. Can one still presume that Germany will do 'whatever it takes' to shore up EMU in a crisis, if only to safeguard its half-century investment in Europe's new order?

Clearly, the euro break-up risk has been hugely mispriced. The survival of EMU does not depend on Lisbon as such, although the failure of the treaty would make it harder for the EU to orchestrate a covert bail out [[of favored member-states? : normxxx]]. But there is a deeper issue at stake. As the Bundesbank warned long ago, EMU will eventually buckle under strain over time without the cement of political union. This means a de facto EU treasury, a unified wage system, and the plausible prospect of a debt and pensions pool. None of this exists. Nor will it.

The ideologues ignored the warning. Indeed, they saw EMU as the great catalyst, forcing the pace of Europe's integration. This fuite en avant [["headlong rush": normxxx]] has proved a grave miscalculation. It forgot about the voters. The elites will now have to face the great euro storm of 2008 to 2009 with the limited tools they have, bridging the economic chasm between north and south as best they can. Good luck. Viel Glück.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Friday, June 27, 2008

When CB's Clash, Markets Crash

When Central Bankers Clash, Stock Markets Can Crash
Is It To Be Inflation, Stagflation, Or ...

By Gary Dorsch, Editor, Global Money Trends | 27 June 2008

Hyper-inflation in the commodities markets is rivaling the US housing collapse and the global banking crisis, as the biggest threat to the world economy. Finance ministers from the United States, Canada, Japan, France, Germany, Italy, Britain, and Russia, have expressed their alarm over the doubling of agricultural, energy, and key raw material prices from a year ago, which is pushing inflation rates around the world, to their highest in three decades.

Crude oil briefly touched $140 a barrel, and the price of corn, used to make ethanol, hit $8 /bushel. Chinese steelmakers agreed to pay 96% more for Iron ore from Australian miner Rio Tinto, a five-fold increase since 2003. Steel prices have soared almost 50%, this year, as coal and iron ore prices continue to climb and global demand shows little sign of abating. Dow Chemical is raising prices on a wide range of its products by 25%, due to sharply higher energy and raw material costs.

Sharply higher shipping costs, driven by rising oil prices, have increased the cost of transporting a standard 40-foot container from Shanghai to the east coast of the US from $3,000 when oil was priced at $20 per barrel, to $8,000 today, with crude oil around $135 /barrel, according to CIBC World Markets analysts Jeff Rubin and Benjamin Tal. The Baltic Dry Index, which monitors merchant shipping costs on forty major export routes for dry commodities, is 50% higher from a year ago.

South Korea’s President Lee Myung-bak noted on June 16th, that inflation was the biggest challenge the global economy has faced in 30-years. "It’s no overstatement to say that the world is faced with the gravest crisis since the oil shock of the 1970’s, with oil, food and raw materials prices skyrocketing," he said. A week later, Myung-bak switched his government’s top policy goal to fighting inflation, and within hours, the Bank of Korea (BoK) sold US$1 billion from its foreign currency stash to bolster the Korean won against the dollar, to help keep import costs down.

Smaller tier central banks are moving to combat inflation pressures, with tougher monetary policies. The Reserve Bank of India (RBI) raised its key lending rate by a half-point to 8.50%, it’s highest in six years, and increased the ratio of deposits banks keep with it by 50 basis points to 8.75%, to fight inflation, now raging at 11 percent. The Bombay Sensex index fell below 14,000 points for the first time in 10-months, after the RBI tightened it monetary policy. The Indian stock market has lost more than 30% in 2008, one of the worst performing Asian indices this year.

Beijing lifted retail gasoline and diesel prices by 18% last week, the first hike in eight-months and biggest ever one-off rise, which could push the overall inflation rate to 9% next month. A week earlier, the People’s Bank of China (PBoC) hiked the bank reserve ratio by a full-percent to 17.5%, soaking up 422 billion yuan, and knocked the Shanghai stock market 14% lower over the next four-days. "Surely higher energy prices will put some pressure on the CPI, so we may need a stronger policy against inflation," warned PBoC chief Zhou Xiaochuan on June 20th.

Brazil’s central bank hiked its overnight Selic rate by a half-point rate to 12.25% on June 5th, to bring inflation down from a two-year high in Latin America’s commodity powerhouse. The latest half-point rate hike pushes the real interest rate, adjusted for inflation, to 7.25%, the highest among the world’s 52-leading economies. On June 19th, Brazil’s central bank chief Henrique Meirelles signaled a third rate hike, to bring inflation down from a two-year high in Latin America’s largest economy.

Futures contracts in Sao Paulo project a 1% Selic rate hike to 13.25% by year’s end. "It’s necessary to slow domestic demand in order to balance the whole equation and to avoid the pass-through of the wholesale price increases as a result of the raw materials component to retail prices," Meirelles warned. Inflation in Brazil climbed from an eight-year low of 3% in March 2007 to 5.9% in the 12 months to mid-June, and above the bank’s 4.5% upper target for a sixth month.

Brazil’s central bank expects the inflation rate will accelerate further to 6.3% in the third quarter of 2008. The Brazilian real strengthened to 1.591 to the US$, a nine-year high, and is +9% higher this year, the biggest advance among the 16 most-traded currencies against the dollar. The central bank is using a stronger currency to hold down import price inflation, and appears to be adjusting its overnight loan rate in reaction to trends in global commodity markets.

South Africa’s central bank hiked its overnight repo rate by 50 basis points to 12%, to counter surging inflation, extending a tightening cycle that has lifted the lending rate 500 basis points higher since June 2006, to a 5-year high. South Africa’s CPIX inflation hit 10.4% year-on-year in April, and producer prices are 12% higher. Eskom, the electric utility, is raising electricity rates by 27% due to a doubling of coal prices from a year ago. RBSA chief Tito Mboweni is warning the markets of higher interest rates ahead, and "Yes, it will be painful," he said on June 23rd.

ECB And Fed In Game Of High Stakes Poker

Central bankers of fast-growing emerging economies are navigating through the stormy seas of commodity inflation by tightening monetary policies. But the "Group of Seven" central bankers have acted in a different fashion. The British, Canadian, and US central banks are focused on the global banking crisis, and the slide in US home prices, and have lowered their interest rates, while the Bank of Japan has stood motionless. But the European Central Bank was moving in the opposite direction, and guided Euro-zone money market rates to their highest in 7 years.

And when powerful central bankers clash— moving in opposite directions— nasty accidents can happen in the global stock markets. Tighter monetary policies in the emerging economies is an interesting side-show, but what is really rattling the global stock markets these days, is the looming battle of wits between the two most powerful central banks, the Fed and the ECB, which hold diametrically different views over how to cope with the twin-evils of the "Stagflation" trap.

"The world has been staging a run on the greenback, with damaging results if it continues," warned former Fed chief Paul Volcker on April 9th. "Concerns about recession are rife, and the Fed will be tempted to subordinate the fundamental need to maintain a reliable currency, to the impulse to shore up a flagging economy. The danger is that you lose both battles, as in the 1970’s, and wind up with "Stagflation,"— the twin-evil of a stagnating economy plagued by high and rising inflation.

Since the sub-prime mortgage debt crisis erupted into full bloom last summer, the Fed has chosen to counter the "Stag" part of the equation, by slashing the fed funds rate 325 basis points to 2%, and far below the inflation rate. American consumer confidence has plunged to a 16-year low in June, largely due to a 18% erosion in home prices since the middle of 2006, which has slashed $4 trillion in household wealth, or more than $50,000 for each US homeowner.

However, the ECB wasn’t deterred by a plunging Euro-Stoxx banking sector, and instead, stayed focused on fighting commodity inflation and curbing double-digit money supply growth. The ECB guided the three-month Euro Libor rate to 4.95%, it’s highest in seven-years, and used a stronger Euro to partly shield the Euro zone from the "Commodity Super Cycle," which is wrecking havoc in the US-dollar linked economies from Hong Kong, the Persian Gulf, and to the United States.

Meanwhile, the Fed’s aggressive rate cuts couldn’t stop the bleeding in the US banking sector, nor end the slide in US home prices. The Fed’s "super-easy" money policies are bound to fail, in the opinion of the ECB, since a "sound money" policy is the bedrock for a healthy economy. "Challenging as the present global economy may be, the rules for monetary policy-making are not altered," said ECB chief Jean Claude Trichet on June 3rd. "Inflation is a monetary phenomenon in the long term and price stability is the responsibility of the monetary authorities."

"In demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility, in already highly volatile markets," Trichet said on Jan 23rd. "In this new financial landscape, monetary policy has a stability dimension that central banks simply can no longer ignore," said Bank of Italy chief Mario Draghi on June 11th. "Central banks need to consider persistently rapid growth of money and credit aggregates as early warnings of financial imbalances, and thus to monitor a wider set of indicators, and not just inflation statistics," Draghi declared.

Is the ECB Hijacking Fed policy?

Crude oil prices have multiplied seven-fold since 2001, and surged 40% since January, to now stand above $135 a barrel. Yet the hyper-Inflationists at the Bernanke Fed and US Treasury,— the "Plunge Protection Team," didn’t recognize that their cheap dollar policy was backfiring on the US economy and stock market, until crude oil prices jumped $16 per barrel in two-days, on June 5-6th.

The "crude oil vigilantes" are energized on heavy dosages of steroids, flexing their muscles, and ready to jack-up oil prices, whenever the Bernanke Fed shows a willingness to devalue the US dollar. Recognizing that the devaluation game had run its course, Fed chief Bernanke did a 180-degree turn on June 3rd and vowed to defend the dollar, as Mr Volcker had advised nearly 2-months earlier. [[Like the 'old' Fed, 'too little too late' yields stagflation at best or a double-dip recession at worst.: normxxx]]

"We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations," Bernanke told the International Monetary Conference in Barcelona, Spain. "The Fed’s commitment to price stability and maximum employment will be key factors insuring that the dollar remains a strong and stable currency," he said, signaling an end to the Fed’s rate cutting campaign.

However, the ECB hawks seized upon Bernanke’s vow to defend the US dollar, to telegraph a baby-step 0.25% rate hike to 4.25%. The ECB hawks have been itching for months to lift the repo rate, anxious to combat inflation, which is raging at a +3.7% annual clip in the Euro zone, its fastest in 16-years. "We could decide to move our rates a small amount in our next meeting in order to secure the solid anchoring of inflation expectations," said ECB chief Trichet on June 5th.

"The ECB is not split, we have sent a clear message to the markets about what to expect in the near future, we have to let deeds follow words," said Bundesbank chief Axel Weber on June 5th. The benchmark 2-year German schatz yield soared by 80 basis points to a seven-year high of 4.80%, after Weber’s warning, and snuffed out the German DAX rally at the 7,200-level. The ECB isn’t afraid to pay the price of weaker Euro-zone stock markets, in order to keep inflation under control.

The ECB’s rate hike signal jolted the German 10-year bund market, which plunged into a free-fall to its lowest levels since July 2007, lifting its yield to 4.65%. Given the close synchronization in the G-7 bond markets these days, the tremors erupting in the Frankfurt are also felt in Tokyo and New York, where government bond markets came under attack by the global inflation vigilantes.

The downward spiral in the German bund market widened the Euro’s interest rtate advantage over the US dollar, leaving the greenback on shaky ground and vulnerable to speculative attack. Bernanke would be under heavy pressure to match a second ECB rate hike to 4.50%, to defend the value of the dollar. In essence, the ECB could hijack US monetary policy, and force the Fed to guide the federal funds rate higher, in order to shake-out speculators in the crude oil and commodities markets.

The US Treasury’s "Plunge Protection Team" (aka, 'PPT') has fought a relentless campaign to prevent a bear market from materializing in the Dow Jones Industrials. The PPT’s unleashed its total arsenal— the largest Fed rate cuts in 25-years, negative (real) interest rates, swapping Treasuries for risky mortgages, $165 billion in tax rebates, and intervention in stock index futures. The PPT also convinced the Bank of Canada and England to lower their lending rates, to provide artificial life support for the US dollar against the Loonie and the British pound.

But the PPT’s safety-net for the Dow Jones Industrials was ripped by the ECB hawks, plunging 1,000-points, led lower by the plummeting German bund market. US 2-year T-note yields jumped 65 basis points to 3.05%, the largest weekly increase in 26-years. To put out the fire, the Fed leaked word to syndicated columnist Robert Novak on June 16th that Bernanke wouldn’t be bullied into rate hikes by the ECB. "Speculation that the Fed is about to begin inflation-fighting interest rate increases appears to be dead wrong. Bernanke disagrees more with the European position than is reflected by his public statements," Novak wrote.

Furthermore, the "Fed chairman feels high oil and gasoline prices threaten contraction more than inflation. The depressing impact on the oil-driven American economy is especially menacing in his view," Novak added. Yet sky-high energy prices can inflict more damage to the US economy and the stock market, than a few baby-step Fed rate hikes to stabilize the greenback.

The point of maximum stress could unfold if the ECB carries out a second rate hike to 4.50% in September. That would put enormous pressure on Bernanke to hike US interest rates to defend the dollar. On June 13th, the godfather of the US sub-prime debt crisis, "Easy" Al Greenspan warned, "If you’re going to keep inflation rates down, the Fed is going to have to put increasing pressure on the money supply and reserves, and as a result we’re going to see interest rates rising."

On June 25th, Trichet held his cards close to his vest. "I didn’t say that we envisage a series of rate increases. That being said, of course, we never pre-commit. The observers in the market know that pretty well." However, the central bank chief of the Netherlands, Nout Weilink said tackling inflation must take precedence over slowing growth. "It is way too early to judge on what should happen in the second half of this year. This means all options should be kept open," he said.

Bank of Japan is Inflating the Crude Oil "Bubble"

Venezuela’s energy minister Rafael Ramirez and OPEC chief Abdullah al-Badri agree that oil markets are well-supplied, and that sky-high oil prices have nothing to do with global production levels. "The US economy is in a crisis that is devaluing the dollar and boosting the price of oil and food around the world. Financial speculators are migrating to futures contracts, which are considered safer than other investments," Ramirez explained.

While the weak dollar against the Euro gets most of the blame for the sky-high price of crude oil, the dollar’s strength against the Japanese yen is also elevating the energy markets these days. The Bank of Japan (BoJ) has kept its overnight loan rate pegged at 0.50% for sixteen months, which is nurturing inflation worldwide. Global "carry traders" are borrowing Japanese yen at 1% or less, and converting the yen into US dollars, in order to purchase energy futures in New York.

In his first major blunder, rookie BoJ chief Masaaki Shirakawa scrapped his predecessor’s policy of gradually raising Japan’s borrowing costs, and signaled a green light for "carry traders" to bid oil prices higher. [[They no longer have to worry about BoJ raising their rates unexpectedly.: normxxx]]"The outlook for economic activity and prices is highly uncertain. It is not appropriate to predetermine the direction of future monetary policy. We need to pay utmost attention to the downside risks to the economy," he said on May 12th— switching to a 'neutral' policy.

Now the BoJ’s super-low interest rates are boomeranging on the Japanese economy. Wholesale prices for petroleum, coal, and gasoline prices are up +28% from a year earlier. Japan’s oil import bill soared 53% to $12 billion in May, and soaring steel and iron ore prices are hammering Japanese carmakers, such as Honda and Nissan, whose operating profit might drop 32% this year. Japan’s total import bill is up +12% from a year ago, narrowing its trade surplus by 46% to 485 billion yen ($4.7 billion). A half-point BoJ rate hike to 1% is now necessary to shake-out the "yen carry" traders in the energy markets. Don’t count on it anytime soon.

Can the ECB Subdue the Gold market?

On June 25th, Warren Buffett told CNBC television viewers that "inflation in the US is exploding and really picking up. Whether it’s steel or oil, we see it everyplace," he said. A few hours later, the Fed halted its aggressive rate cutting campaign, leaving the fed funds rate unchanged at 2%, but signaled it’s in no hurry to rein-in hyper inflation. "Uncertainty about the inflation outlook remains high." However, "the FOMC expects inflation to moderate later this year and next year."

The Fed is admitting that its hands are tied by the banking crisis and the slide in housing, and is afraid to lift the fed funds rate ahead of the US elections. The Fed thinks the "Commodity Super Cycle" is a speculative bubble ready to burst under its own weight. Therefore, corrective action by the central bank isn’t required. The Fed is letting inflation seep deeper into the economy in order to support Wall Street bankers, and has squandered the last ounce of its anti-inflation credibility.

That’s good news for gold bugs, who put were on the defensive by Bernanke’s bluff about defending the dollar. The Bernanke Fed is holding the fed funds rate far below inflation. In the 1970’s, this condition stoked hyper-inflation, and the Bernanke Fed is repeating the same blunder. Still, a psychological barrier that is blocking a spirited gold rally is the ECB’s move to ratchet German interest rates higher.

The ECB is the solo inflation fighter within the G-7 clique. The ECB has guided the German schatz yield to seven year highs, but so far, has only knocked the European gold market about 8% lower. The ECB’s anti-inflation efforts are thwarted by the "super easy" money policies of the BoJ and the Fed, while the Bank of Canada and England show no inclination to reverse their rate cuts anytime soon. However, the ECB is starting to get some back-up support in the battle against inflation from central banks in the emerging world.

Still, geopolitical events can overtake the ECB’s battle with the simmering gold market. US military chief Admiral Michael Mullen is expected in Israel this week, amid speculation of a possible aerial strike aimed at Tehran’s nuclear weapons program. "Obviously, when Chairman Mullen speaks with the Israelis, they will no doubt discuss the threat posed by Iran," said Pentagon spokesman Geoff Morrell on June 25th. "The US is committed to resolving the nuclear threat posed by Iran through diplomacy and international sanctions, while at the same time holding out the option of a military strike, if necessary," he warned.

Speculation about a possible Israeli strike heated up this week after former UN ambassador John Bolton told London’s Daily Telegraph that Israel could strike Iran’s nuclear sites between the November 4th election and January. "According to Israeli security sources, Iran will have an operable nuclear weapon by 2009. That’s not a very long time," said CBS consultant Michael Oren on June 25.

Gold prices jumped by $30 /oz amid a perfect storm, in early New York trading on June 26th, with investors attracted to the yellow metal’s "safe haven" status. Citigroup shares fell to their lowest level in nearly a decade after Goldman Sachs said the largest US bank might take $8.9 billion of write-downs in the second quarter. OPEC chief Chakib Khelil predicted, "Oil prices will probably be between $150-170 during this summer. The devaluation of the dollar against the Euro will probably generate an $8 rise in the price of oil," he told France 24 television.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Thursday, June 26, 2008

Warren Makes A Bet

Warren Makes A Bet

By John Mauldin | 26 June 2008

The Sage of Omaha made a bet that was written up in a recent Fortune magazine article. Basically, Warren Buffett bet that the S&P 500 would outperform a group of funds of hedge funds over the next ten years. A million dollars to someone's favorite charity is on the line. This week we will analyze the bet, using it as a springboard to learn about valuation and value investing. As we will see, there are times that making a bet on the S&P 500 to outperform hedge funds (or bonds or real estate or whatever asset class) makes sense and times when it doesn't.

Warren Makes A Bet

Buffett is the clear winner in investing, and his wisdom is followed by a large legion of fans, among which I am one. So, let me get myself in trouble and disagree with him on a small matter. Carol Loomis (one of my favorite financial writers) writes in this week's Fortune about a bet that Warren Buffett made with a hedge fund management company. You can read the fascinating story here. Quoting:

"And to that there is a certain history, which began at Berkshire's May 2006 annual meeting. Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking."

A New York firm, Protégé Partners, which manages $3.5 billion in a fund of hedge funds, decided to accept that bet. Basically, Buffet and Protégé each put $320,000 into 10-year zero-coupon Treasury bonds that will be worth $1 million in 10 years. The bet is straightforward. Protégé has chosen five funds of hedge funds, and these funds must return more than the S&P 500 over the 10 years beginning January of 2008. (The list of funds is a secret.) The winner gets the $1 million donated to their favorite charity.

Which way would you bet? If the online response at Fortune is any indication, 90% of you would bet with Warren. As one enthusiastic responder wrote, "How can you bet against Buffett? I'd bet my life savings on it ..." Well, Tom, you might want to hedge your bet. Even Warren said he thinks his odds are only 60%. The basic premise of Buffett's position is that the high fees simply eat up any potential for extra profits, over those of a simple index fund. As Buffett writes:

"A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds."

And he is right about the fees. Hedge funds, and especially funds of funds, must do much better than average to overcome their high fees. Loomis sums it up as follows:

"As for the fees that investors pay in the hedge fund world— and that, of course, is the crux of Buffett's argument— they are both complicated and costly. A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

"So that's
2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones 'bought' by Buffett in the bet.

"On top of the management fee, the hedge funds typically collect
20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the 'helpers' that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

"The summation is pretty obvious. For Protégé to win this bet, the five funds of funds it has picked must do much, much better than the S&P."

True. But the growth of hedge funds and fund of funds suggests that some think there is value there that is worth the fees. But let's set aside that argument for now, and look at the prospects for the bet between Protégé and Buffett.

It's All About Values

As I wrote in Bull's Eye Investing ( and occasionally stress in my writing, the long-term returns you get from index fund investing are very highly correlated with the P/E (price to earnings) ratio at the time you make your initial investment. The P/E is price divided by earnings. If the ratio is 10, then earnings are about 10% of the stock price. If the ratio is 20, they are about 5% of the stock price. The higher the price, the less earnings you get for your invested dollar. However, a rising P/E ratio can be a major boost to stock market returns.

If you make your investment when valuations are low, you return is going to be much higher over time than if you make your investment when valuations are high. Look at this graph from South African partner Prieur du Plessis of Plexus:

Prieur divided the S&P 500 into five groups based on the initial P/E ratio and then calculated what the returns would be for the next 10 years, after inflation. He also used a 10-year average of the P/E ratio, to take out the fluctuations caused by one-off events, recessions, etc. As you can see, and long-time readers should expect, if you invest when stocks are at their cheapest, you can make a remarkable 11% on average for the next 10 years after inflation. As stocks get more expensive in terms of their P/E, returns begin to fall. Real returns for the last group are only 3.2% on average.

We are currently in the range of the highest valuations. If you make the generous assumption that inflation will be 3% over the next decade, you are talking about a 6% total return, based on historical averages. Not bad, but not what a lot of investors are hoping for. Remember that 6% number, as we will revisit it in a moment.

One of my basic premises is that we need to look at markets in terms of valuation and not just price. Markets go from high valuations to low valuations and back to high. The round trip can take the better part of 30-40 years. These are long-term secular markets, and they are mean-reverting. By that I mean that markets will go both well above and well below the long-term mean average over time.

To see how well correlated long-term returns and P/E ratios are, you can go to and click on the link where it says "get the stock market graphs here" on the upper right-hand side. You can see what your returns would have been in any period of time since 1900. Then check at the top to see what the P/E ratio was at that time. If the return numbers are white, then P/E ratios were falling and returns were either negative or low. When the numbers are black, that means P/E ratios were rising, and returns are also likely to be good.

Look at the following charts from Vitaliy Katsenelson (author of the most excellent book Active Value Investing, and one I recommend to anyone interested in value investing.) Again, these are 10-year trailing P/E ratios. Notice how the P/Es always go back below the average? And we are a long way from the average now. There are two ways that we can get back to low P/Es. Either the stock market can go down or earnings can go up faster than prices (or some combination thereof). The stock market bottomed in 1974 in terms of price, but in terms of valuation the market took another eight years to get to its low. Then in 1982, with valuations below 10, the stock market was a coiled spring ready to explode.

Let's look at one more chart from Vitaliy. This chart shows the one-year trailing P/Es. Today, if you go to the S&P 500 tables at Standard and Poor's, you find the current P/E ratio is a heady 22, with the long-term one-year average being 15.2. There is a long way to go before we get to anything we can call mean reversion.

Hedging Your Bet

Now, let's look at how Warren's bet would have done in the bull market years of 1990-99. We will compare how a fund of hedge funds index from did between 1990 and 1999, to the S&P 500.

(Note: these hedge fund indexes are representative of funds of funds in general, but you cannot invest in them. They have problems like survivor bias; they don't have all the fund of funds, just the ones that report, etc. Past performance is not indicative of future results. Further, the hedge fund climate is much different today than in 1990. But the indexes are the best proxy we can find if we want to do a comparison.)

The S&P 500 rather handily beat the hedge funds. The S&P 500 went from 353 to 1469 in those 10 years, for an average total return (including dividends) of 433%, or an average 18.2% a year. The hedge fund index returned 14% a year for a total return of 271%, net of fees. The standard deviation for the S&P 500 was 13.38% and for the hedge funds was a lower 7.87%, so the hedge funds were a lot less volatile. Still, buy-and-hold index investors were rewarded for the risk. The chart below shows how $1,000 invested might have grown over the 10 years.

Now, let's look at the last 10 years, from May 1998 to May 2008. Here we use a fund of funds index from Now, we find a different story. The market returned 4.21% on average, or a total of 51%, with a standard deviation of 14.7%. The hedge fund index returned 7.7%, with a standard deviation of 5.1%. So, you got a lot less return with a lot more volatility, if you stayed with the S&P 500.

Of course, there was a nasty bear market in 2000-2002, and a roaring bull market in the 1990s. But let me make one observation. In 1990 the P/E ratio was 15 and had been below 12 just a few quarters earlier. In 1998 the P/E ratio was 27.8, almost double what it was eight years earlier. A lot of the difference came from the starting point of stock market valuations.

Where are we today? The P/E ratio is 23.2. Earnings are dropping as we work our way through a very tough economy. As I have written elsewhere, I think the recovery, such as it is, will take at least two years before we can get back to 3% growth, because the twin bubbles of the housing market and the credit crisis will take at least two years to work themselves out. 1-2% growth in GDP for the next two years is not an environment for significant earnings growth. It is also not an environment in which stock markets are likely to thrive.

Roughly 20% of the S&P is financial stocks. Do you think they are likely as a group to start reporting robust earnings growth over the next two years? They are deleveraging, which will not help earnings growth. There are more write-offs to come. A significant portion of the S&P is tied to US consumers, who are pulling back. On the other hand, there are some very large multinational corporations that are benefitting from a weak dollar, as both their exports rise and their foreign subsidiaries profit.

But the climate is not favorable to robust earnings growth for the next few years. That will make it tougher for the stock market to keep up with the funds of hedge funds.

Mean Reversion Of National Wealth

One more thought pointed out to me by Woody Brock: National wealth is a mean-reversion machine. That is a fundamental basic truth in economics. Over very long periods of time (multiple decades), growth in national wealth will equal growth in nominal GDP. And by national wealth, I am referring to our homes, stocks, bonds, real estate, etc.

Now, nominal GDP has been running about 5.5% for a long time. But between 1981 and 2006, US national wealth grew at an astounding 7.2%, from $10 trillion to $57 trillion. Mean reversion, or getting back to the average, means that national wealth must dip below 5.5% for an extended period of time. Woody thinks that from 2009 to the end of the next decade, we could see national wealth grow between 2.5-3%, well below our recent experience.

National wealth is likely to fall this year and maybe next as housing values drop. This drop in wealth and slower growth means that consumers are not likely to return to their previous "shop till we drop" mode. And that is a serious pressure on earnings. Graham taught us that in the short run the stock market is a voting machine, but in the long run it is a weighing machine. And what it weighs are earnings.

I have little doubt that earnings will rise at 6-8% on average over the next 10 years. The 1990s saw earnings more than double over 10 years, and the back of my napkin says that is around 8% annualized growth, although earnings dropped by 50% over the next three years. Over the very long run, earnings are going to grow at the level of nominal GDP, or around 5.5-6%. For the stock market to do more than 6%, P/E levels would have to rise to even loftier levels than at present. Can it happen? Sure, it did in the late '90s; but we saw how that ended.

Let's go back to the graphs from Katsenelson. If P/E ratios continue the process of mean reversion and continue to fall, that will be a serious headwind for stock market growth. And we have no example in history where valuations did not revert to the mean. That doesn't mean that this time it couldn't be different. But that is not usually the way to bet. If it was 1990 and a lower P/E, or 2002 and low P/Es (on a normalized basis), when the stock market outperformed the hedge funds, then I would not want to bet against Warren.

But with today's valuations, a Muddle Through Economy staring us in the face for the next two years, a potential and serious tax increase in 2010 that would prolong any recovery and be even more problematical for earnings and stocks, I think the absolute-return funds will win this time. In the end, it will depend on how good the funds of funds are that Protégé picked, but these are savvy managers. They want to win, and I bet they picked the best they could find. We will find out each year at the annual Berkshire meeting how the bet is coming along. Right now, the market is down 10% and the hedge funds are down about 2%, but this is a long race. The first five months mean very little. But the real winners will be the charities they have picked. And that is a good thing, no matter who wins the bet.

Now, if Buffett had bet that Berkshire would do better than the funds of funds, I would not take that bet. But that is another story.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Poor Augery For Unemployment Rate

June Conference Board Data Augurs Poorly For The Unemployment Rate

By Paul Kasriel | 26 June 2008

T.S. Eliot might have been off by a couple of months. It looks as though June might turn out to be the cruelest month instead of April. Earlier this month, the Buffalo Fed branch and the Philly Fed reported that manufacturing activity had deteriorated in their regions. Today the Richmond Fed corroborated the message from its regional brethren with a report showing that its composite manufacturing survey index dropped to minus 12 in June from minus 3 in May. At the same time that Richmond was reporting, the Conference Board released its June consumer confidence, or lack thereof, report.

Wow! Gasoline at 4 bucks a gallon really knocks the wind out of consumers' sails, to mix transportation metaphors. Chart 1 shows that the June reading on the present-conditions component of consumer confidence dropped to its lowest level since September 2003. But Chart 1 also shows that, in June, the expectations component of consumer confidence fell to its lowest level in the history of the series. Folks are so bummed out that they don't even want to take a vacation (see Chart 2), much less buy a house or a car.

Chart 1

Chart 2

Not only are high gasoline prices getting people down, but the job market also apparently is a downer. The spread between the percentages of respondents saying that jobs are hard to get minus the percentage saying that jobs are plentiful hit its highest level since December 2003. Chart 3 shows that there is a high correlation, 0.87, between this spread and the level of the unemployment rate. So, you might want to prepare for some pyrotechnics on Thursday morning, July 3.

Chart 3

Case-Shiller House Price Index Declines— Light at the End of the Tunnel?

The Case-Shiller Composite 20 house price index dropped at an annual rate of 18.5% seasonally adjusted (by me) in April compared with March. This was a relatively sharp slowdown in the rate of descent as the March month-to-month annualized decline was 24.2%. On a year-over-year basis, this house price index descended at its fastest rate to date, 15.3% vs. 14.3% in March (see Chart 4). If, in fact, the slowdown in the rate of price decreases on a month-to-month basis is signal, not noise, then perhaps we are nearing an inflection point in house prices.

That is, the trend in house prices will still be down for months to come, but the rate at which these prices are declining might be moderating. This would be "less bad" news for households and for holders of home-mortgage-related debt. But before these mortgage holders pop the champagne corks, keep in mind that the Case-Shiller home price index screens out foreclosure auction sales (hat tip on this point to Eugene Xu of Deutsche Bank Securities via Michael Nicoletti, an independent housing market analyst). Also keep in mind, as can be seen in Chart 4, that the month-to-month changes in the price index are "noisy."

Chart 4

Paul L. Kasriel, Director Of Economic Research
The Northern Trust Company
Economic Research Department



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Priced For Poor Returns

Us Stock Market Priced For Poor Returns
Click here for a link to complete article:

By Rich Toscano and John Simon | 26 June 2008

In early 2007 we wrote an article summarizing the risks in the U.S. stock market. The article cited a study by legendary value investor Jeremy Grantham in which it was shown that, on average, long term stock market returns have corresponded quite well with valuations at the time of investment. Here we reproduce Grantham's study with updated data and a variation or two, followed by some thoughts about where we are now in the markets and what to do about it.

Valuations And Long-Term Returns

The idea behind the study is fairly simple. We took 100 years' worth of monthly data on the S&P 500 stock market index. For each month, we calculated two figures: the market's average valuation during the month, and the 10 year total returns on the market dating from that month. Here is a little more detail on the calculations, for those interested. (If you are not interested, feel free to skip the next two paragraphs).

The market valuation is a modified price-to-earnings ratio based not on the past year's earnings, as are typically used, but on the past 10 years' worth of earnings. This technique is recommended by Yale professor Robert Shiller (who also provided most of the data for this study) in order to smooth out the shorter-term ups and downs in market earnings that result from the booms and busts of the business cycle. Earnings are also adjusted for inflation to provide an even comparison between periods with different levels of inflation.

We think that this method of valuation makes a lot of sense for long term investors because it smooths out earnings spikes and troughs and provides an indication of how expensive stocks are compared to a sustainable level of earnings. The 10-year future return for each month includes both stock price appreciation and dividends. Returns are also adjusted for inflation.

Once we had each month's valuation and return, we separated all the months out into five quintiles based on valuation (i.e., cheapest through most expensive) and determined the average annualized 10-year return for each quintile. The chart below shows the results.

Clearly, starting valuation has been quite predictive of average long-term returns. People who bought in the cheapest 20% of months enjoyed an amazing average 10-year return of 15.7% per year after inflation. Their counterparts who bought during the most expensive 20% of months averaged just 3.4% per year. And at every quintile in between, higher valuations led to lower average returns.

As one might expect given the above results, people who bought at high valuations were also a lot more likely to lose money even after 10 years. A full 33.3% of the time periods in the highest valuation quintile led to real 10-year returns that were negative, while the lowest valution quintile didn't contain a single period of negative real returns. As a matter of fact, the very worst annualized return for the lowest valuation quintile was 4.9%. It is typical to believe that higher rewards go hand in hand with taking more risk, but this study indicates that investors who heed the message of valuations can enjoy higher returns with lower risk.

Incidentally, valuations predict average returns on shorter timeframes than 10 years. For instance, the 7-year return results looked very similar to the above with a 17.3% return for the cheapest quintile and a 3.9% return for the most expensive quintile. Averages are similar even for shorter timeframes. The problem is that the variation among the numbers comprising those averages gets higher and higher as the timeframe gets shorter, rendering the predictions less and less useful.

This makes sense— a market that's overvalued or undervalued may stay that way for years, but as time goes on the market is more and more likely to have reverted to a more normal valuation (with a commensurate impact on returns). In case anyone thinks that 100 years ago is ancient and irrelevant history, we also ran the study for the past 50 years and achieved very similar results, with the cheapest quintile sporting an average real return of 15.0 percent versus just 3.1 percent for the most expensive quintile.

Where Are We Now, And What To Do

With the S&P 500 at 1,377.20 as of this writing, we fall comfortably within the most expensive 20% of time periods as measured by the price to 10-year real earnings ratio. As a matter of fact, we fall comfortably within the most expensive 10% of time periods. This means that we are in a situation that has, on average, led to very poor long-term returns for buyers of the S&P 500.

So what does one do?

We'll start by talking about what not to do.

Conventional wisdom has it that the stock market returns 10% per year over the long term, so at any given time you should just close your eyes, go all in to a stock market index fund, and forget about it. Hopefully the above study sheds some light on why this is a poor approach. As the chart shows, that 10%-per-year figure includes lengthy periods of widely disparate returns. And starting valuations provide a pretty good idea of the kinds of risks and returns that can be expected in the future.

All in all, the strategy of buying the entire market regardless of prevailing valuation just doesn't make sense to us.

Granted, people who go all in to the U.S. stock market right now may end up getting decent long-term returns. It has happened, even at these valuation levels, and even over 10-year time frames. But it's been fairly rare, and unless "this time is different," history suggests that the stock market is likely to provide poor long-term returns and a higher risk of loss from this level of valuation.

At the same time, staying out of the market entirely entails its own risks. With short-term interest rates below the rate of inflation, cash is a sure loser for all but the shortest time periods. For this reason, as we warned in our inaugural article appearing on this website, cash is anything but a safe haven. Bonds are even worse, generally speaking, because we feel that they are seriously underpricing long-term inflation risk.

The solution, we think, is to stay invested, but to carefully choose your investments rather than indiscriminately buying the entire stock market. The above study treats the entire stock market as a single unit— this is useful to get an idea of overall valuation, but it's certainly not a limitation that we suffer as investors. The ability to invest in individual sectors, in other countries, and in alternative asset classes is important to investors trying to navigate high-risk, high-valuation markets like this one.

We firmly believe that there are great profit opportunities in any market, and this one is no different. But when markets are broadly overvalued, it is that much more important to choose your investments carefully. It is crucial to stay cautious, skeptical, and patient; to diligently seek out good values and avoid the risks that are being underestimated by others; and to analyze the economic and monetary trends and understand their likely effects on the markets and the world.

Such analysis is exactly what we do here at Pacific Capital Associates. Feel free to visit our commentary archive if you're interested in our thoughts on the risks and rewards to be found in today's markets.

  M O R E. . .


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