Sunday, February 28, 2010

Its 2010: So What Should Investors And More Importantly What Should Americans Do Now?

Its 2010: So What Should Investors And More Importantly What Should Americans Do Now?

By John Bougearel | 22 February 2010
Author of Riding the Storm Out: What Do Investors Do Now?

Risk is ubiquitous. Markets misbehave. Financial crises are hardy perennials. Wall Street crashed. The private sector blew up. Again! Yet in 2009 U.S. policymakers managed to extinguish the raging fires on Wall Street[[— at least one more time!: normxxx]] By all appearances it would seem that our policymakers have orchestrated a successful rescue of both our stock market and by proxy our economy.

And our policymakers do concur with that view. US Treasury Secretary Timothy Geithner told NPR's Michele Norris in a December 22, 2009 interview that "the policies that the president put in place are helping lay the foundation for growth and job creation" Americans "can be more confident about their financial future, financial security" and promising that "We're not going to have a second wave of financial crisis. That is something that is not acceptable and we will prevent that". Blah, Blah, Blah.

But are the "Nunca Mas" [[Spanish for "Never Again": normxxx]] policies that the administration put in place, really sufficient? Have policymakers really tamed the misbehaving financial markets that hold the private sector of our economy hostage? Have they really brought to heel the marauding Wild West of the OTC Debt and Derivatives markets that drove our economy to the brink of a Great Depression?

In short, can the US Treasury Secretary really claim that 'all is well', and will 'continue to be be well' from now on? Most importantly, can Americans really be confident about their financial futures and secure in their jobs? Or is there yet to be a malevolent and violent second act to the crash of 2007 - 2009 that followed the private sector boom of 2005 - 2007— that culmination to the 'easy' money so liberally dispensed by Alan Greenspan? [[Is the 2009 'boom' the beginning of a 'new' day, or merely the anti-climax to the end of the 'old' order? : normxxx]]

On general principles, history suggests risk has not been eliminated by the policies put in place in 2009. History indicates risk can't be fully decomposed, nor can markets can't be fully tamed. And crises, well, crises, they just happen. Confronted with these realities, portfolio managers devised models long ago to help investors 'decompose' market risks. It's called diversification.

Standard and Poor's analyst Sam Stovall asked a pertinent question in 2009, "Did diversification fail during this bear market?" To answer his own question, Sam created a theoretical model charting the total returns of a weighted portfolio that was 60% SP500 equities and 40% long term US Govt Bonds. In 2008, it shows this diversification model lost -13%. (chart not shown)

Given that a total equity portfolio comprised of the SP500 lost 39% in 2008 (before dividends), it is clear that this particular diversification model may have absorbed some of the shock for investors because the losses in the SP500 had been partially offset by 19% year-end gains (before interest) in the 30 year Gov't bonds. At first blush, Stovall's diversification model appeared to have been a fairly effective if rather blunt tool in 2008.

But is diversification sufficient? Sam's diversification model dating back to 1929 shows a highly erratic model whipsawing in and out of negative territory. What is more, as we shall see, Stovall's diversification model behaved much like a boomerang in 2008-2009.

On balance, if diversification could fully tame market risk, the oscillations shown in this model should have been much smoother. The premise of diversification, then, appears valid, but insufficient to protect investors from excess market volatility. Upon closer examination of Stovall's model, too, it was only by a bizarre sequence of non-recurring events in the final two months of 2008 that even made it at all possible for the long term bonds to offset the steep losses in the stock market.

To wit, most of the 30 year treasury's 19% gains in 2008 occurred after Ben Bernanke's December 1 2008 'quantitative easing' statement and his December 16 2008 race to embrace a zero interest rate policy. Barring these extraordinary policy actions in December 2008, there would have been little to no offset by holding long term government bonds. Moreover, the fixed income holdings of actual balanced portfolios for most investors were not 30 year long term bonds. Hence it is likely that the majority of 'balanced' portfolios did not benefit at all from the special actions of Ben Bernanke in December 2008.

If diversification is not a stand alone tool, what then can investors do to smooth out market risk and volatility inside their balanced portfolios? I submit that investors take a slightly more active risk management approach than simple diversification. Returning to Stovall's theoretical model, we note the bear market of 2008-2009 exposed a boomerang effect in total returns. What goes up largely in one year tends to go down significantly in the next.

Subsequent to years that produce high returns in long term bonds, it would have made sense for investors to reduce their exposure to long term bonds, and conversely. For the 30 year bond in 2008 (up 19% y-o-y before interest), it would have made sense for investors to reduce their exposure in 2009 (when the 30 year lost more than 16% y-o-y of its value). Likewise, during years that produce high stock market returns such as 2009 did (up 23.4% y-o-y), investors should anticipate that subsequent years are apt to reflect substantially lower or negative stock market returns (for example, which could potentially occur in 2010-2012) as valuations and other market considerations might become unsustainable.

Taking an active risk management approach towards diversification for investors entails rebalancing asset allocation mixes to reflect shifts in market risks. Investors can rebalance equity and fixed income weightings upward or downward on an annual basis to achieve the desired mix. For example, in the three years subsequent to 2009's positive equity returns, the proper allocation mix of a diversified portfolio might be 40% equity and 60% fixed income, or less depending on your risk tolerance.

Rebalancing one's asset allocation mix is an underutilized tool. Investors tend to neglect rebalancing their portfolios much because they are generally advised to just overweight equities when they are young and overweight fixed income when they are old. (I suffered from this flawed approach to investing in the 1987 crash.) But overweighting equities does nothing to help a younger investor avoid downside market risks.

To illustrate this simple but very important point, consider the theoretical young investor that made his or her initial equity investment in the SP500 on January 1 2000. Ten years later on January 1 2010 that initial investment would be down 25%. So much for that head start in life!

When the stock market misbehaves erratically, it behooves investors to heed these market signals and rebalance downward to reduce their equity exposures for a spell until the headwinds pass. Once the storm passes, then it is time to consider rebalancing these equity positions upward, or not. While 2009 did generate generous stock market returns for investors, it won't be too long now before the market risks and headwinds we faced in 2007-2008 return.

[[I predict that they already have; the market is once again "fully priced" and, barring some kind of economic miracle, is at best likely to meander sideways for the next several years— and that doesn't take into consideration the very real possibility of a 'relapse' about here; the second dip of a 'double dip' recession.: normxxx]]

The balance of this report will address the potential malevolent and violent backlash American's will face in 2011-2014 from the private sector boom of 2003-2007 that went so dramatically bust in 2007 -2009. Specifically, this report will look at how the follow-on 'restructuring phase' of the debt cycle initiated in the 2004-2007 commercial real estate 'leveraged buyout' (LBO) boom phase will impact the economy and the lives of nearly all Americans in 2011-2014, notwithstanding the Treasury Secretary Geithner's false reassurances. Moreover, readers should pay special heed to the prevalence of "lax underwriting" standards for commercial real estate (CRE) loans and the "covenant-lite" structures of the LBO loans during those boom years. The lack of safe and sound underwriting standards for both CRE and LBO loans during the boom phase of the cycle present substantial downside risks for the debt restructuring scenarios presented below.

Before presenting the details of the imminent restructuring phase, it is worth pausing for a moment to consider the "investment advice" President Obama gave Americans on March 3 2009: "What you're now seeing is— profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal if you've got a long term perspective on it". Unfortunately, President Obama looked right past the heap of trouble the financial markets and U.S. will face in 2011-2014. This will likely prove to be a big mistake, comparable to the mistake Greenspan made in 2004 when he advised folks to secure their homes using ARMs.

Restructuring The Debt Of The 2004-2007 Boom

What most folks are probably unaware of is that the credit that went towards creating that commercial real estate and leveraged buyout boom during 2004-2007 needs to be refinanced between 2011-2014, because these types of loans typically have 5 to 7 year maturations. The risk, simply put, is that the collateral for the bulk of those loans is simply not worth today what it was three to five years ago. Nor will these loans be worth what they were during the boom years when it comes time to refinance the terms of those loans.

The bust at the end of the boom years has created a funding gap between assets and liabilities for both commercial real estate and for LBO loans. In industry parlance, the assets are simply not worth as much as the liability that they assumed during the credit creation boom. That asset/liability mismatch gap will have to close. Call it the Great Convergence Trade, if you like. Whatever you choose to call it, the convergence is going to create quite a bit of unpleasant turbulence over the next three years, and not for just the borrowers of these loans, but for all Americans.

In contrast with the Treasury Secretary's assurances that another financial crisis is unacceptable and would never happen again, the February 2010 Congressional Oversight Panel (COP) forecast $200 to $300 billion in losses coming from the commercial real estate loans, the bulk of which will hit the economy in 2011-2014, peaking in Q2 2012. (chart not shown) Commercial property values, they noted, had fallen more than 40% since the beginning of 2007. They added:
"A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American. Empty office complexes, hotels, retail stores could lead directly to lost jobs. Banks that suffer could grow more reluctant to lend, which could in turn further…accelerate a negative economic cycle….hundreds more community and mid-sized banks could face insolvency…their widespread failure could disrupt local communities…and extend an already painful recession."
This, just months after Americans were promised never again! (See the full COP report on CRE here.)

From the COP:
"Commercial real estate concerns are not new. The nation experienced a major commercial real estate crisis during the 1980s that resulted in the failure of several thousand banks and cost taxpayers $157 billion (nominal dollars). The boom and bust that occurred during the 1980s was characterized by commercial property values that fell between 30 and 50 percent in a two-year period… Between 1986 and 1994, 1,043 thrift institutions and 1,248 banks failed, with total assets of approximately $726 billion (approximately $1.19 trillion in 2009 dollars)

Lax underwriting was also evident in CMBS [Commercial Mortgage-Backed Securities] deals from 2005 to 2007. In the late 1990s, only six to nine percent of the loans in CMBS transactions were interest-only loans, during the term of which the borrower was not responsible for paying down principal. By 2005, that figure had climbed to
48 percent, and by 2006, it was 59 percent.

Current average vacancy rates and rental prices have been buffered by the long-term leases held by many commercial properties (e.g., office and industrial).The combination of negative net absorption rates and additional space that will become available from projects started during the boom years will cause vacancy rates to remain high, and will continue putting downward pressure on rental prices for all major commercial property types. Taken together, this falling demand and already excessive supply of commercial property will cause many projects to be viable no longer, as properties lose, or are unable to obtain, tenants and as cash flows (actual or projected) fall.

Commercial real estate markets currently absorb
$3.4 trillion in debt, which represents 6.5 percent of total outstanding credit market debt. Foresight Analytics, a California-based firm specializing in real estate market research and analysis, calculates banks' exposure to commercial real estate to be even higher than that estimated by the Federal Reserve. Drawing on bank regulatory filings, including call reports and thrift financial reports, Foresight estimates that the total commercial real estate loan exposure of commercial banks is $1.9 trillion compared to the $1.5 trillion Federal Reserve estimate.

The current lack of investor appetite for CMBS greatly constrains the ability of commercial property owners to obtain permanent loans to pay off construction loans or to refinance existing permanent loans. And without the ability to do so, outstanding commercial real estate loans have a reduced chance of repayment, unless the original lender provides funds for refinancing."

Note from the foregoing COP report that the "current" lack of investor appetite for CMBS is largely a reflection of and attributable to the lax underwriting standards that were applied to the original loans when written in 2004-2007. It is not a bold predictive statement to infer that investor appetite for CMBS is probably going to be next to non-existent through 2014 (see Figure 6 in above report). An absence of investor appetite for CMBS presents upside risks to the COP's forecast of $200-$300 billion in losses stemming from commercial real estate loans. And in turn, this would mean even more job losses in the private sector and lost revenues to State and local governments.

At the same time Americans find themselves shell-shocked from the commercial real estate markets, suffering banks are also going to be assaulted by a huge surge of refinancing required by the LBO and M&A loans maturing in the 2011-2014. Unfortunately, like commercial property values that have fallen 40% since the beginning of 2007, the equity valuations of many of these LBO's and M&A's have similarly fallen. Banks won't be in a position to refi the original loan amounts. So, it would not be surprising to see a series of LBO and M&A defaults triggering corporate bankruptcies resulting in the loss of even more American jobs.

According to McDermott Will & Emery's Gary Rosenbaum and Jean Leblanc, "debt issuances for leveraged buyout (LBO) transactions surged from $71 billion in 2003 to $669 billion in 2007. The majority of these LBO's were covenant-lite deals, meaning that the loan documents contained few or no financial covenants." In short, we should expect to find material omissions, similar to the material omissions Greece made with respect to its sovereign debt obligations (with a little help from their friends at Goldman Sachs— must be nice to have such helpful friends in investment banking) in many of the transactions that occurred during the LBO boom. Material omissions in one's financial statements, prospectuses, sales literature, etc. erode ones financial credibility WRT potential lenders, whether you are a sovereign or a corporate entity.

Sure, material omissions may be readily 'overlooked' during a private sector boom. But just try getting away with the discovery of material omissions when it comes time to restructure the loans 5 to 7 years after the private sector boom has gone bust and remains busted. Corporate borrowers may find themselves shunned by the investment community altogether and locked out of any chance of refinancing. While that may be just deserts for private equity and corporate executives, defaults and bankruptcies in the LBO space will create significant collateral damage to their employees who suddenly find themselves out of a private sector job. In turn, this means even more people on the dole requiring extraordinary government (eg, unemployment insurance and medical) services and lost revenues for all levels of governments.

Rosenbaum and Leblanc note that the friendly environment LBO borrowers found themselves in during the boom years has vanished. Those borrowers "will be facing a decidedly different environment as their 2005-2006 vintage credit facilities mature during the next few years. They will find fewer refinancing options" since the number of potential providers of new loans have declined. In fact, many of the loan providers such as Lehman Brothers have "disappeared" in the wake of the last financial crisis. Moreover, many of the remaining LBO 'investors'— such as Citi, Bank of America, Wells Fargo, etc.— are still experiencing financial difficulties of their own.

So many of the investors that are still around and had "previously provided a significant amount of liquidity are no longer actively participating in the lending market". The future outlook for borrowers in the LBO space is about the same as that for commercial real estate borrowers— a decided lack of investor appetite, which can in part be attributed to a few principal reasons.

First, the mismatch between assets and liabilities. That is, the borrowers' assets simply do not any longer cover the amount that they borrowed during the boom years and will want to 'roll-over'. Second, the lax underwriting standards used in many of those 'covenant-lite' deals. In many cases, the underwriting of these loans by the commercial and investment banks is simply not credible. The commercial and investment banks could simply refuse to 'eat their own cooking', ie, refuse to provide new financing terms altogether.

In fact, many of these financial vultures will more than likely be placing 'short' bets against the weaker commercial real estate and LBO borrowers before their loans mature. (GS has already demonstrated a willingness to do so— in many cases betting against the very people— supposedly 'clients' owed some degree of honesty and fair dealing— to whom they 'sold' these loans in the form of CMBS.) Thus, the reckless lending activities of 2004-2007 could have substantial negative feedback consequences for the credit markets in 2011-2014.

To the extent that financial intermediaries are willing to work with LBO borrowers, "lenders are showing extreme caution in refinancing many of these loans, leading to more defaults and bankruptcy filings". Many LBO borrowers "find themselves without any realistic refinancing prospects". Standard and Poor's estimate that corporate loan defaults will skyrocket from 4.5% in 2008 to 14% or higher in 2010. What is worse, the schedule of non-financial corporate borrowers LBO debt maturities will "increase each year until they peak in 2012" concurrent with the schedule of commercial real estate loan maturations peaking in Q2 2012.

Rosenbaum and Leblanc conclude that
"companies with bad business models as well as strong businesses burdened by overlevered balance sheets need to confront the reality of today's frozen credit environment and other recessionary pressures. To adopt a 'wait-and-see' approach is risky; savvy borrowers need to meet the current challenges head on by exploring deleveraging devices and other debt relief options that will be evolving during the remainder of this restructuring phase."
LBO borrowers that fail to meet the current challenges head-on will lead to a whole new wave of corporate bankruptcies and folks entering the unemployment ranks.

The already high unemployment rate is creating a huge burden on most state and local governments throughout the country. And it seems that this will only worsen over the next few years. This view is consistent with the forecasts from the Center on Budget and Policy Priorities' Jan 28 2010 report, which notes that the recession is causing more than 41 States to report budget shortfalls. Budget shortfalls in fourteen States are estimated to exceed 17% of their General Fund Budgets in 2010:

"As we look ahead to 2011 and beyond, States' fiscal prospects remain extremely weak. Indeed, historical experience and current economic projections suggest 2011 will be worse than 2010. Taking all these factors into account, it is reasonable to expect that for 2011, shortfalls are likely to hit $180 billion [and] at least $120 billion in fiscal 2012. This means that after taking into account the federal Recovery Act dollars that are likely to remain available for fiscal year 2011 (approximately $40 billion), States will still have to close shortfalls of some $260 billion for the combined fiscal years of 2011 and 2012. If revenue declines persist as expected in many States, additional spending and service cuts are likely.

Expenditure cuts are problematic policies during an economic downturn because they reduce overall demand and can make the downturn deeper. When States cut spending, they lay off employees, cancel contracts with vendors, eliminate or lower payments to businesses and nonprofit organizations that provide direct services, and cut benefit payments to individuals.

Federal assistance is lessening the extent to which States need to take pro-cyclical actions that further harm the economy. The
American Recovery and Reinvestment Act enacted in February [2009] includes substantial assistance for States. The amount in ARRA to help States maintain current activities is about
$135 billion to $140 billion over a roughly 2½-year period. Most of this money is in the form of increased Medicaid funding and a "State Fiscal Stabilization Fund."

But it now appears likely the federal assistance will end before State budget gaps have abated. The Medicaid funds are scheduled to expire in December 2010, which is just halfway through the 2011 fiscal year in most States. States will have drawn down most of their State Fiscal Stabilization Fund allocations by then as well. So even though the 2011 budget gaps may well be larger than those for 2010, there will be
less federal money available to close them. States are likely to respond with spending cuts and tax increases even larger than those that have already been enacted.

Such measures in most States will take effect with the 2011 fiscal year— that is, in July 2010,
thereby reducing aggregate demand and weakening the economy at a critical moment in its recovery. If States get no further federal assistance, the steps they will have to take to eliminate deficits will likely take a full percentage point off the Gross Domestic Product. That, in turn, could cost the economy
900,000 jobs next year.

A possibility would be for the federal government to reduce State budget gaps— by extending the Medicaid funds over the period during which State fiscal conditions are expected to
[remain] problematic, rather than cutting them off in December 2010. The federal government could also provide additional assistance to States for education through the State Fiscal Stabilization Fund."

Of course, the policy recommendations by the Center for Budget and Policy Priorities for the US government to provide additional fiscal stimulus to state and local governments and what State Governors expect to receive from the federal government may conflict with President Obama's January 2010 announcement "to freeze" government spending for three years beginning in FY 2011 (October 2010). The Center for Budget and Policy Priorities noted in their January 28 2010 press release:

"As States begin preparing for the third year of a fiscal crisis brought on by the recession, governors' new budget proposals contain cuts to core services— like education and health care— and State workforces well beyond those they have already made. The proposals threaten to increase hardship and unemployment.

At least eight governors' State budget proposals assume that Congress will extend the increased federal funding for Medicaid enacted in last year's Recovery Act, the report explains. If Congress doesn't extend it, those States likely will make substantially deeper and broader cuts than their governors are now proposing. Without further federal aid, the actions States will have to take to close their budget gaps could cost the economy 900,000 jobs.

"One of the most effective ways Congress can boost the economy and protect jobs is by making sure that Recovery Act assistance for States' doesn't dry up halfway through the coming year, which would force States into even bigger budget cuts that could stall the fragile economic recovery," Johnson explained.

The Center for Budget and Policy Priorities noted, in their February 18 2010 reports, not surprisingly, that demand for State services actually rise during recessions. They argue that cutting more of these services now will only exacerbate the problem. Yet cutting more services is exactly what State governors are planning to do with their 2011 budgets. [[And, indeed, is the only option realistically open to them.: normxxx]]

"With tax revenue still declining as a result of the recession and budget reserves largely drained, the vast majority of States have already made spending cuts… because revenues sources being used to pay for these services declined due to the recession. At the same time, the need for these services rose as the number of families facing economic difficulties increased… Budget pressures are increasing. Because unemployment rates remain high— and are projected to stay high at least well into next year— revenues are likely to remain at or below their current depressed levels.

Cuts to State services not only harm vulnerable residents but also worsen the recession— and dampen the recovery— by reducing overall economic activity. Over the past two months governors have been submitting their budget proposals for the upcoming 2011 fiscal year (which begins on July 1, 2010 in most States). The majority of governors have now released their budget plans, and these proposals reflect the continued fiscal difficulties that States will face in the next year."

Bloomberg's investigative journalists Christine Richard and Darrell Preston report that state and local governments struggling to survive the recession are now "seeking concessions from creditors of public projects, including bond insurers". The concessions local governments are seeking pose a new threat to the bond insurers or "monolines" that are currently 'backing' $1.16 trillion of public debt. The monolines were almost bankrupted in 2007-2009 by $11.6 billion of claims on collapsed securities backed by mortgages. [[A mere 1% of their potential liability for public debt.: normxxx]]

"It is a worst-case scenario if the dynamics of the municipal bond market change," said Rob Haines, an analyst who covers the bond insurance business at CreditSights Inc., an independent research firm in New York ."The companies have modeled in virtually no losses."

Last year, 183 tax-exempt issuers defaulted on
$6.35 billion of securities— up from $317 million of tax-exempt defaults in 2007 [[or about 2000% higher: normxxx]], says Miami Lakes, a Distressed Debt Securities Newsletter.

For more than three decades bond insurers paid few claims, allowing them to back bond payments that were
140 times their assets. Insurers described their business as one of "zero-loss underwriting," meaning that each guarantee was expected to result in no claims under the worst probable scenario envisioned by their models.

Rising municipal claims may deplete the remaining regulatory capital of some bond insurers and speed intervention by regulators, said Haines of
CreditSights. Any regulatory takeover may trigger termination payments on billions of dollars of credit default contracts written by the bond insurers, a scenario that forced a government bailout of American International Group Inc. in September 2008."
Americans are going to have to absorb a lot of hits in 2011-2014. Hopefully one of those hits will not be another AIG! To summarize, banks already suffering from bad residential loans [[which show little abatement so far: normxxx]] will find the refinancing required by the previous commercial real estate (CRE) and LBO boom a heavy strain in 2011-2014. The banks that do survive will probably only be able to refi maybe 60 or 70 cents on the dollar to CRE and LBO borrowers. [[So there will be precious few dollars left over to fund any State and local government funding gaps— or defaults!: normxxx]] Worse, the commercial real estate, M&A's, and LBO's that can't withstand 30% to 40% haircuts will probably end in the graveyards, thus incurring another round of substantial job losses in the private sector.

It is little wonder that bank lending has been curtailed and will continue to contract for several more years. It is also little wonder the Basel committee and the FASB granted the banks until 2013 to get their balance sheets in order and meet stricter reserve requirements. That is precisely because the peak of the loan restructuring cycle for CRE and LBO borrowers will be in 2012. I have always feared that the financial 'shock and awe' of the last crisis may just be a prelude to the further financial shocks that are coming due by 2012.

Unfortunately, US Secretary Treasury Geithner cannot promise that America will not shortly face another financial crisis without its having a false ring to it. Not given the way that the banks structured all of these loans from the previous boom that will need to be refinanced during 2011-2014. The CRE and LBO loan maturations peaking in 2012 amount to 'financial weapons of mass destruction' with delayed fuses.

The next seizure in the credit markets will coincide with the peaking of these loan maturations. For the Treasury Secretary to claim there won't be a second wave to this financial crisis, or that 'they' can prevent it— that Americans can be confident about their financial futures and job security— is just so much Blah, Blah, Blah. At the very least, market forces will sorely test Mr. Geithner's hypothesis that all is well and will remain well from now on.

In its totality, the restructuring cycle that lies ahead is largely about funding the debt-to-equity gap between the overvalued commercial real estate and LBOs. Present day cash flows and valuations can not support the enormity of the CRE and LBO debt issuance that occurred during the 2004-2007 credit cycle. Haircuts, defaults, bankruptcies, will have to be taken [[all of which are hugely deflationary: normxxx]]. But the present mismatch between liabilities and assets, the gap, will have to be closed.

The risks and burdens posed by this restructuring phase in the CRE and LBO spaces will be significantly heightened by 'discovery' of fraudulent and quasi-fraudulent material omissions; namely, the widespread prevalence of the lax underwriting standards and 'covenant-lite' loan documentation. As the full force of the 2011-2012 restructuring cycle gets underway, the equity and credit markets will once again founder. Investors may rest assured that credit spreads will widen during this time window. When this happens, balanced portfolios will experience a boomerang effect.

As the equity and corporate debt markets are repriced downward, long term treasuries will provide investors valuable diversification. Until the restructuring cycle in the CRE and LBO space reaches and passes its peak, thereby closing most of the unfunded gap between assets and liabilities, investors that are overexposed to the equity markets will be hurt. Once the Great Convergence between assets and liabilities results in a sounder match-up in the private sector, equities and private debt will outperform and investors overexposed to long-term treasuries will then be hurt.

Hence the principle of the boomerang effect which will recur in balanced portfolios that are structured similarly to the Standard and Poor's 60:40 diversification model above. With all this doom and gloom, however, isn't there any silver lining for investors? Well yes, actually there is! Once the restructuring cycle clears away most of those private sector's unfunded and partially funded liabilities, the private sector of America should be on a much safer and sounder foundation. Then the US Treasury Secretary can say that a foundation for growth and job creation is in place and stand better than a 50-50 chance of being right.

Such news will bode well for both the economy and the stock market. But, in the meantime, prudent investors must hunker down. The next great opportunity for the stock market, and even commercial real estate investors won't arrive until after the peak of the next financial crisis which looks like it is going to hit apocryphally in 2012— and only for those investors prepared with cash. Crises precede opportunity. Opportunity only exists if the crises are successfully resolved— and that opportunity can't happen until we have passed through the peak of the loan restructuring cycle in 2012.

The private sector should be lean and mean and ready to grow substantially by 2013. The only thing left for Americans to worry about once the private sector has been stabilized will then be the funding of the public sectors liabilities; namely the US government's financial and social obligations to medicare and social security. The public sector to be sure, will be forced to undergo a restructuring cycle as well. But this will occur at a later date and so is a story for another day.

[ Normxxx Here:  While we may expect a 'minor' or cyclical bull market circa 2013— mirroring the bull market of 80 years ago (or about 40— actually 38— years ago)— we will yet have many years to go before we again enter into the next secular bull market. Probably not until after 2020.  ]

However, looking past 2014, if the U.S is to remain an operationally viable going concern, "how it goes about it will be crucial to its success" says Richard Duncan.
"The lesson the US must learn from Japan is not to waste money building bridges to nowhere, but instead to use the money wisely to restructure the economy to restore its viability. This global crisis will not end until the United States restructures its economy and restores its long-term viability. Getting the private sector onto a safe and sound foundation by 2013 is merely a prerequisite."

In the meantime, there is one other extremely significant and patriotic thing that would behoove all Americans (us, the little people, the forgotten people) to do between now and the next financial aftershock. And I urge everyone to do it. In the meantime… we can move our money and we can move our credit cards out of the 'bad' banks and into the 'good' banks, [[into banks that are safe and sound and community oriented— rather than motivated solely by greed and the 'fast' buck.: normxxx]] We can start transacting with the good bankers at good banks. This is a feel good opportunity for us all.

As Arianna Huffington and Rob Johnson put it:
"If enough people who have money in one of the Big Six (bad) banks move it into smaller, more local, more traditional community banks, then collectively we, the people, will have taken a big step toward re-rigging the financial system so it one again becomes the productive, stable engine for growth it's meant to be. It's populism at its best."
By far and away, this is the best thing we can do as Americans to keep ourselves and our local communities above water. As Richard Duncan would put it, it's the wisest use we can put our money to in order to restructure our economy and restore its long-term viability.

Leaving our money sitting on the ledgers of the big banks is a waste of our capital resources. In their present weakened financial condition, and until the restructuring phase passes, most such banks can only hoard— not lend. Deposits on the balance sheets of the big banks have the net effect of building bridges to nowhere as far as the eye can see. There is only one hitch, how do we find the George Bailey's in our communities to do our banking business with? Well that matter has been solved for us thanks to the volunteer services of Institutional Risk Analytics (IRA, they're the 'good bank' analysts).

Simply go to Click on the button that says Find A Bank Or Credit Union. Put in your zip code. Get a list of sound community banks near you. The IRA only list banks that get a grade of "B" or better according to its (A+ - F) rating system. That's all folks, be ready to hunker down by 2011, and see you in 2013! Sign up for webinars, free monthly newsletters, etc.



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, February 27, 2010

America The Miserable

America The Miserable

By Patrick Allitt, | 23 February 2010

Patrick Allitt, UK commentator, says that the infuriating but reassuring 'can-do' spirit that once defined the United States is finally dying out. But what will we all do when it's gone?

The first time I went to America, in 1977, I couldn't believe how cheerful, peppy and purposeful everyone was. The late seventies were bad years by American standards, the Jimmy Carter era of stagflation and malaise, but to someone coming out of Jim Callaghan's Britain, the place seemed almost insanely upbeat. Strangers would greet you enthusiastically, with a 'How ya doin?' in New York and a 'Have you taken Jesus as your personal saviour?' in small Oklahoma towns, but always with a radiant goodwill. How to Win Friends and Influence People was still a bestseller and everywhere people worked hard, believed in the future, and talked incessantly about progress.

I felt as though I'd had a transfusion of red blood cells supercharged with espresso, and was fully awake for the first time. The sheer lack of fatalism was exhilarating. In Britain, when something broke in those days of strikes, paralysis and decline, everyone gathered round to take a look and said, 'It's broken. What a pity.' In America everyone gathered around and said, 'It's broken, but we can soon fix that,' and they did.

Where has that America gone? The United States are a little sadder and feel somehow deflated today. The burst of utopianism that greeted Obama in 2008 has disappeared with the return of everyday politics and the slow grind of two unwinnable wars. Now everyone talks about decline, recession and ageing. Admittedly I was a 21-year-old in 1977, eager to look on the bright side, whereas now I'm a 53-year-old who's also declining, receding and ageing, but I think there's more to it than that. The supreme confidence in the future that marked America throughout its first two centuries has begun to disappear.

America was optimistic almost as a matter of official doctrine right from the outset. Anyone setting up a republic in the 1770s had to be aware that nearly every republic in the history of the world had failed, usually under the iron heel of a tyrant or conqueror. No sooner had the American experiment got started than Napoleon repeated the pattern by snuffing out Europe's frail republics.

Yet this one, safeguarded by an ocean, prospered. British visitors in the 19th century, like Frances Trollope and Charles Dickens, found the Americans' self-confidence, national pride and boastfulness almost insufferable, but they had to admit that the Americans got things done. Enterprising chaps like Andrew Carnegie emigrated from gaunt British poverty to amass Wagnerian fortunes on the other side of the Atlantic.

In the 20th century, too, a succession of visitors as different as Rudyard Kipling, Winston Churchill, P.G. Wodehouse and Alistair Cooke loved recharging their spiritual batteries with long trips to America. Cooke even made a career out of extolling America's can-do attitude, albeit with an undercurrent of irony at its excesses. What would he make of its current moods and attitudes?

Today, recession-related jitters are widespread. Nearly everyone knows someone who has just lost their job and can't help speculating whether they're going to be next. Entire counties in the Sunbelt are stricken with failed mortgages, evictions and houses worth far less than they cost.

Economic news stories increasingly compare America to China, very much to China's advantage, and predict its increasing dominance. But the decline of American confidence isn't just a temporary blip on the screen brought on by the recession— you could already feel it during the boom days of the mid-zeroes. American gloom comes in highbrow, lowbrow and middlebrow forms. It has become characteristic of the wealthiest and most highly educated Americans to be pessimistic about their country. They fear the erosion of civil liberties at the hands of a metastasising security state, a loss of competitiveness and an inability to produce new generations of elite scientists.

One of their favourite authors is the UCLA professor Jared Diamond, who became famous in 1997 with Guns, Germs and Steel, a lively book about how civilisations get started. But his sequel, Collapse (2005) marks the changing mood. It describes civilisations that went down blind alleys and foundered, ending with the clear implication that America might well be next. His subtitle, 'How Societies Choose to Fail or Succeed', sticks to the traditional American promise of free will, but also implies that those who get to make a choice often choose wrong.

Middlebrow gloom shows up in Hollywood, where recent films tell a similar story. The success of Avatar, for example, is really rather odd. In its lumbering allegorical style it depicts an American way of life that consists in equal parts of cynicism, destruction and a brutal, galaxy-encompassing greed. You might think citizens would object to such demonisation, but they don't. Instead, millions have flocked to it, apparently willing to make an emotional commitment to the crippled marine who symbolically rejects America to become, instead, the local blue people's messiah.

Lowbrow gloom, sometimes veering over into self-contempt, is easy to find just by turning on the TV. Millions watch The Biggest Loser, a show in which hideously overweight citizens cast off their last vestige of dignity as they compete to shed rolls of fat. In Das Kapital Karl Marx made what was probably meant to be a bitingly ironic aside, that the bourgeoisie was becoming so bloated that it would soon be paying to lose weight. The joke's on him; as it turns out, it's the pro-bourgeois American proletariat that is paying millions to slim down, and taking a voyeuristic interest in others on the same quest.

Two further signs that America has lost its old confidence are vitriolic anti-immigrant campaigns and changes in the evangelical idiom. [[Not so; starting in the 19th century, America has suffered through periodic "anti-immigration" spasms, one of the worst occuring after WWI.: normxxx]] An America that once opened its arms to immigrants from all over the world, confident of its ability to transform them into harmonious, egalitarian, democracy-loving citizens, has hunkered down behind the floodlit, gun-swept, fortified wall that now marks the Mexican border. Many evangelical Christian leaders, meanwhile, who once described America as 'God's country', now see it as a land occupied by the Devil and his minions, against whom the dwindling band of true Christians must fight their own Armageddon. These folks don't read Collapse but their version of the same story is Tim LaHaye's Left Behind books, in which Jesus has already whisked the really good people up to Heaven, while the second best have been left behind to fight Satan as best they can, until the apocalypse.

Where will it all end? You can still find vestiges of the old buoyancy, and I dare say the return of good times will give it a bit more lift. Habits as deep as American optimism don't die out easily.

On the other hand, America has experienced a prolonged dose of unpleasant reality since 2001. Its influential and ageing baby boomers feel morose, not having lived up to their own promise, and much of the rest of the world has caught up with America, robbing it of the complacent sense of superiority that it could hardly help feeling 30 or 40 years ago. Ironically, some of America's cheeriest people these days, me very much included, are immigrants who are acutely aware of what a good thing they encountered on crossing the Atlantic.

Patrick Allitt is Goodrich C. White Professor of History at Emory University, Atlanta.



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, February 26, 2010

Greece Economic Crisis Confirmed Worst Fears

Greek PM Says Economic Crisis Confirmed Worst Fears

By Dina Kyriakidou | 26 February 2010

ATHENS (Reuters)— Prime Minister George Papandreou on Friday vowed to ignore the political costs and take drastic measures to pull Greece out of a debt crisis threatening the stability of the euro zone.

Crisis In Credit

Speaking to parliament after a visit by EU economic inspectors, Papandreou said Greece did not want other countries to pay for its debts but expected solidarity from its European peers as it struggled with worse than expected fiscal problems. "Unfortunately, history has fully confirmed our worst fears," he said. "Our duty today is to forget about political costs and only think about the survival of our country. Past policies make it necessary to proceed to brutal changes."

He appeared to be preparing the ground for a fresh set of fiscal measures expected ahead of a mid-March EU deadline to show results in cutting a double-digit deficit. EU Economic Affairs Commissioner Olli Rehn visits Athens next week. "There is only one dilemma: Will we let the country go bankrupt or will we react? Will we let the speculators strangle us, or will we take our fate in our own hands"? Papandreou said.

"We must do whatever we can now to address the immediate dangers today. Tomorrow it will be too late, and the consequences will be much more dire." Greece is also anxious to regain investor confidence by slashing its deficit and restoring the credibility of its statistics as it prepares to sell new bonds in the market with about 20 billion euros due to be repaid in April and May.

EU peers and markets were shocked by the revelation that the previous government had understated its budget deficit by half. Papandreou's socialists disclosed the discrepancy after last October's election. Rating agencies immediately downgraded Greek sovereign debt. Since they started raising concerns in early December, the euro has fallen almost 10 percent against the dollar and Greek stocks are down over 20 percent.

Meanwhile the cost of insuring Greek debt against default fault has more than doubled since early December to nearly 400 basis points. The yield premium for holding 10-year Greek government debt over German government bonds has also soared, but narrowed around 14 basis points to 341 after Papandreou's speech. "We became the weak victim, the guinea pig, we stood unprotected before the markets' wild appetite," Papandreou said.

More Measures

Fellow eurozone members have endorsed Papandreou's pledge to cut a deficit that hit 12.7 percent of GDP in 2009 by 4 percentage points this year. He aims to get the deficit under the eurozone limit of 3 percent of GDP by 2012 with tough public spending cuts, tax increases and pension reforms. Greek government officials say the EU inspectors, visiting Athens with IMF experts, have delivered a grim assessment of the economy. They say further measures worth up to 4.8 billion euros, will be needed to achieve deficit cutting targets.

Despite crippling strikes, opinion polls indicate most Greeks support the government's efforts and are ready to suffer the pain if it is distributed evenly and those responsible for the crisis are punished. "I want to assure the Greek people that its efforts will pay off," Papandreou said. "We must put an end to irresponsibility and cover-ups. If someone has done something wrong, he should be charged, no matter who he is."

EU leaders, grappling with crises at home, have given Greece political support but stopped short of outlining a specific aid roadmap. Polls in countries like Germany showed taxpayers oppose bailing out Greece, fanning tensions between Athens and Berlin. Papandreou said Greece was dealing with its own problems and was expecting not aid but solidarity from its EU partners. "No other country will pay for our debts," he said. "It is a matter of honor and pride for our country to put our own house in order."

Opposition politicians asked Papandreou whether he would renew demands for Germany to pay reparations, stemming from the World War Two occupation of Greece. Germany says it has fulfilled its obligations. Papandreou, who will visit Berlin on March 5 at the invitation of Chancellor Angela Merkel, said the issue of reparations was not settled but he would not bring it up now. "We have never given up on our claims," he said. "But this is not an issue that we will use for our convenience now, when we are in a weak position and called to put our house in order."



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.

Japan Deflation May Trigger More BoJ Action

Grinding Japan Deflation May Trigger More BoJ Action

By Leika Kihara | 26 February 2010

TOKYO (Reuters)— Japan's narrowest measure of consumer inflation matched a record annual fall in January in a sign weak demand will prolong deflation and may prompt the Bank of Japan to expand its supply of funds to the market by mid-year. Analysts say that while the BOJ will want to save its ammunition for when sharp yen rises hurt a fragile economy, it may have to act around June, when government pressure for more steps could escalate ahead of upper house elections expected in July. "The government will continue to pressure the Bank of Japan for action, given that the market is becoming increasingly cautious about each country's fiscal deficit," said Takeshi Minami, chief economist at Norinchukin Research Institute.

"The BOJ may act around June or July, either by expanding its fund-supply operation adopted in December or by increasing its outright government bond buying." The so-called core-core consumer price index, Japan's narrowest measure of price gauge that excludes volatile food and energy costs, fell 1.2 percent from a year earlier, matching a record drop the month before. The indicator, similar to the core index used in the United States, fell for the 13th straight month, in a sign that weak demand was forcing companies to cut prices to lure consumers.

The nationwide core CPI, which excludes volatile food prices but includes energy costs, fell 1.3 percent in the year to the end of January. That was slightly smaller than a median market forecast of 1.4 percent fall but marked the 11th straight month of annual declines. The core CPI index reading of 99.2 was the lowest in 17 years.

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Keeping The Pressure On

The Democratic Party-led government, faced with falling support rates, wants to avoid an economic downturn ahead of the summer upper house elections and has been urging the BOJ to support the economy even as most other major central banks examine rolling back stimulus. Finance Minister Naoto Kan told reporters again after the CPI data was released that he expected the central bank to work toward ending deflation. Many analysts say the BOJ's most likely next step is to expand the fund-supply operation it adopted in December, either by raising the amount from 10 trillion yen ($112.2 billion) or extending the duration of loans from three months.

The BOJ may also opt to increase its long-term government bond buying from the current 21.6 trillion yen per year, a move that would please the government if bond yields shoot up on concern over Japan's fiscal deficit. Assuming the BOJ doesn't change the duration of assets it holds now, a lack of further central bank action would mean a sharp decrease in its balance sheet and therefore liquidity contraction at a time when Japan is still in deflation, said Robert Rennie, chief currency strategist at Westpac in Sydney. "I fully expect additional quantitative easing measures through this year, and one will be an increase in 'rinban' operations" to buy JGBs outright."

The BOJ is forecasting three years of deflation and has said it is committed to keeping interest rates near zero for as long as necessary. But it has offered few clues on what it might do beyond that to beat deflation. Deflation hurts the economy as households put off spending on hopes that prices will fall further, forcing companies to cut prices to lure consumers. The BOJ has caved in to government pressure before, when it introduced the three-month funding operation in December after a barrage of criticism that its economic assessment was too rosy.

Still, Naoki Minezaki, one of Kan's two deputies, told Reuters in an interview that while some in the government wanted the BOJ to loosen monetary policy, setting a rigid inflation target may not be the way to get the country out of deflation. The finance minister said earlier this month he would favor inflation of around 1 percent, although he did not specifically refer to an inflation target. While that figure roughly matches the BOJ's view, the mere mention of it by Kan was a sign the government was stepping up pressure for more BOJ action.

In a positive sign for the economy, industrial output rose much more than expected in January, as manufacturers ramped up production to meet demand from fast-growing Asia. While market reaction to the CPI and output data were muted, the stronger-than-expected output figure capped gains in Japanese government bond futures.

Click Here, or on the image, to see a larger, undistorted image.



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, February 25, 2010

Euro's Next Battleground: Spain

The Euro's Next Battleground: Spain

By Stephen Fidler | 25 February 2010

MADRID— Greece set off the crisis rattling the euro zone. Spain could determine whether the 16-nation currency stands or falls. The euro zone's No. 4 economy, Spain has an unemployment rate of 19%, a deflating housing bubble, big debts and a gaping budget deficit. Its gross domestic product contracted 3.6% in 2009 and is expected to shrink again this year, leaving Spain in its deepest and longest recession in a half-century.

At the center of the crisis are millions of Spaniards like Olga Espejo. The 41-year-old lost her administrative job at a laboratory in Madrid, then found a temporary post replacing someone on sick leave— until that job was abolished. Her husband and her sister have also been laid off— all among the one in nine working Spaniards who have lost jobs in the past two years. Each gets an unemployment check of at least €1,000 a month, or about $1,350, part of a generous social safety net that Madrid says it won't cut. But Ms. Espejo's benefit runs out in July and her husband's in May.

Click Here, or on the image, to see a slideshow.
Olga Espejo, her partner José Antonio Sacristan and her sister, Marisa Espejo, have all been laid off. They are among the nation's 4.3 million unemployed

"What prospects do any of us have now"? Ms. Espejo asks.

That question haunts Spain and the entire euro zone as the Continent faces its biggest economic crisis since the common currency launched in 1999. Worries over Greece's ability to finance its huge debts have spread to other, weaker members of the euro zone, but these same fears are now nipping at Spain's heels. The problem is that, thanks largely to its membership in the euro, Spain lacks tried-and-true means to heal its economy.

Spain can't devalue its currency to make its exports more attractive and its sunny beach resorts cheaper because the euro's value is driven by Germany's bigger, competitive industrial economy. Madrid can't slash interest rates or print money to spur borrowing and spending, because those decisions are now made in Frankfurt by the European Central Bank.

Spain could still try to stimulate growth through tax cuts and spending increases. But it has already mounted enormous stimulus spending that swelled its budget deficit to 11.4% of GDP last year, and it would need to sell more bonds to raise fresh cash. Buyers of Spanish government bonds, spooked by the prospect of a Greek default, have already demanded higher interest rates from Madrid.

"Spain is the real test case for the euro," says Desmond Lachman of the American Enterprise Institute in Washington. "If Spain is in deep trouble, it will be difficult to hold the euro together… and my own view is that Spain is in deep trouble". But the government rejects talk of crisis.

"The fundamentals of our economy are solid," Elena Salgado, Spain's economy minister, said in an interview. Ms. Salgado said the country's big banks are sound, its economic statistics credible and its companies dynamic enough to maintain their share of export markets. She pointed out that Spain was running budget surpluses until the financial crisis struck, and its government debt has grown from a very low base.

Euro-zone heavyweights Germany and France have pledged to support Greece if necessary. But any bailout for Spain— whose $1.6 trillion economy is nearly double those of troubled euro-zone partners Greece, Portugal and Ireland combined— would be far costlier. A "shock and awe" infusion aimed at renewing faith in Spain's finances, should it be necessary, would take roughly $270 billion, according to an estimate by BNP Paribas.

It estimates similar confidence-restoring moves in Greece, Ireland or Portugal would require $68 billion, $47 billion and $41 billion, respectively. Some observers, to be sure, believe Spain will ride out the troubles. Emilio Ontiveros, president of AFI, a financial analysis firm in Madrid, says recovery is in sight in the second half of the year. "We've had some luck. France and Germany, our biggest markets, are beginning to grow," he said. This should be enough to stop unemployment rising much beyond 20%, a level Spain has coped with as recently as the late 1990s.

Most economists see three options for Spain.

The first is for the government to do nothing, leaving the economy to wallow through years of high unemployment and debt defaults. The second is for the government to take a more active role, slashing its spending while taking unpopular measures to boost the supply side of the economy, including overhauling a rigid labor market. On Tuesday, Spain's top central banker strongly urged this path, calling in a speech for swift government action to reduce the budget deficit and reform the labor market. "If the reforms come late or are insufficient, our future is undoubtedly worrying," Bank of Spain Governor Miguel Angel Fernández Ordoñez said.

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Mr. Lachman of the American Enterprise Institute is among the pessimists who doubt the government will take this course. He thinks Spain's chronic inability to restart growth will lead it to contemplate a third option: splitting the euro zone asunder by withdrawing from the common currency. That would permit a devaluation that would, at a stroke, increase Spain's competitiveness and allow the economy to grow again. A more mainstream view holds that no government, Spain's included, would dare to brave the financial chaos such a move would unleash.

"It's extremely costly to leave the euro," said Jean Pisani-Ferry of Bruegel, a pro-European think tank in Brussels. The moment a government hinted at a possible devaluation, there would be a run on the banks and an effective default on every euro financial contract with that country. "The day you start to admit that you're thinking about it, you're in a financial mess."

The government has announced plans, starting with tax rises and spending cuts this year, to slice the budget deficit to 3% of GDP by 2013, a program financial analysts have described as credible. It forecasts that public debt will crest at around 74% of GDP in 2012, compared with 113% today in Greece and Italy. Still, Socialist Prime Minister José Luis Zapatero has drawn criticism from economists for saying he will deal with the crisis without hurting the country's social programs.

"That's not a plan, but an announcement," said Lorenzo Bernaldo de Quirós, president of Freemarket International Consulting in Madrid. As a result, he said, Spaniards don't yet understand that their comfortable way of life, cushioned by the state, is about to change. Spaniards still "think like Cubans and live like Yankees," he said.

Spain's troubles are a mirror of the boom years after it and 10 other countries entered the monetary union in 1999. The euro was meant to cement a single market across Europe, reducing cross-border costs for trade, investment and travel. In close to a decade of good times, Spaniards overtook the Italians and approached the French in terms of what their salaries could buy. Spanish energy, infrastructure, utility and banking companies spread world-wide.

But seeds of trouble were being planted. Spain's wages grew fast, making its economy less and less competitive. Low [[one-size fits all: normxxx]] euro interest rates, set with the low-inflation, [[semi-stagnant economy of: normxxx]] Germany in mind, began generating a housing bubble.

Spanish house prices more than doubled in real terms in the decade ending in 2008. At the peak, the country of 45 million people was building more houses than Germany, France and Italy— combined population 200 million— put together. Spain's housing market has been slow to adjust, likely delaying recovery. The Bank of Spain estimates prices have fallen 15% from their highs, about half the U.S. peak-to-trough decline. "In the U.S. market, the day of reckoning came quickly. In Spain, it's been postponed," said Mr. Ontiveros of AFI.

Click Here, or on the image, to see a a slideshow.
Europe's Debt Crisis:
Take a look at events that have rattled European governments and global markets.

The housing bust shows how Spain differs from Greece in the current crisis. Economists say Greece's troubles stem from its profligate government. Madrid ran budget surpluses for years— but Spain's private sector went on a debt-fueled spending binge.

Spanish private and public debt rose an average of 14.5% a year from 2000 to 2008, according to McKinsey Global Institute. Total debt peaked at the end of 2008 at $4.9 trillion, or 342% of GDP— a higher percentage than the level in the U.S. and most major economies except Britain and Japan. Six-sevenths of that is owed by the private sector.

McKinsey expects households, indebted companies and real-estate developers to shed debt, a widespread "deleveraging" that is likely to trigger defaults and harm the banking system. Most analysts say Spain's banking problems are concentrated in the country's 45 cajas, regional savings banks usually run by local politicians that often went deep into real-estate lending. Nonperforming loans in Spain's banks and regional savings institutions are now estimated at 5% of the total, up from 3.2% a year ago.

Santiago López Díaz, a bank analyst at Credit Suisse in London, estimates this may underestimate the total by 30% to 40%. Roughly half of Spain's estimated 1.3 million unsold houses are now on the books of cajas and banks, which have been slow to sell them because they don't want to realize losses. Financial institutions "have become the biggest realtors in Spain," said Fernando Encinar, co-founder of, Spain's largest property Web site.

The government has tried to force cajas to merge into stronger institutions, and has set up a fund to encourage them to restructure and bolster capital. Analysts expect cajas to post big losses this year that will likely force the government to raise more money to boost the fund. Massive joblessness could further slow Spain's climb out of debt.

Even in good times, unemployment never got below about 8%. Now the rate is nudging 20% overall— close to 45% among young people— statistics that reveal to economists a deeply flawed employment market. Wages are set through a complicated system of bargaining with trade unions that imposes wage increases on firms even if their business can't afford it.

Because wages are inflexible, Spanish companies can cut labor costs only by firing workers. Yet some workers, hired on so-called 'indefinite' contracts, are deeply entrenched, not least because they are entitled to 45 days' severance pay per year of service. So, when the economy turns down, those on 'temporary' contracts bear the brunt. When prospects brighten, companies think long and hard before inking more indefinite contracts.

That bodes poorly for Eduardo García, 55, who was huddling in line outside a job center recently in Madrid's Santa Eugenia neighborhood. Unemployed for the first time, Mr. García worked for 25 years at a book-and-magazine distributor that closed in November. His wife and 20-year-old daughter are also unemployed. Mr. Garcia said he has had no work offers. "At my age, it will be difficult."

Madrid has vowed to reform the labor market. One proposal would reduce the severance-pay entitlement for new workers by 12 days, to 33 days. Fernando Eguidazu, director-general of the Circulo de Empresarios, a business association, said Madrid has avoided locking horns with labor. Demonstrations against a proposal to raise the retirement age from 65 to 67 took place in several Spanish cities Tuesday and Wednesday.

Unions could resist new labor proposals, he said, but it's a needed step: "If they [the government] try to keep being nice to everybody, we are wasting time, and the people and the markets are losing confidence". That sentiment is already apparent in the market for insurance against a Spanish default. The price to insure €10 million in Spanish bonds for five years— just €2,350 three years ago— rose this month to €171,750 before falling to €125,000, said data firm Markit Group Ltd.

Click Here, or on the image, to see a larger, undistorted image and a slideshow.
Growing Apart:
Take a look at the premium in percentage points that selected euro-zone governments must pay on their 10-year bonds.

That translates into increased borrowing costs for Spain, which now pays about 0.8 percentage points more than Germany to borrow money for 10 years. For years to come, Spain will largely be at the mercy of wary bond investors to finance its governments, banks and companies. The national government says it will have to raise €76.8 billion this year and pay back an additional €35 billion of maturing bonds. Amid it all, Mr. Bernaldo de Quirós predicts, investors' worries will ebb and flow over what he calls "a real risk of default" as they await decisive government action. "They more time you lose," he said of the government, "the more devastating the adjustment has to be."



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.

Wednesday, February 24, 2010

Ten Lessons Not Learnt

Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

Lesson 1: Markets Aren't Efficient.
Lesson 2: Relative Performance Is A Dangerous Game.
Lesson 3: The Time Is Never Different.
Lesson 4: Valuation Matters.
Lesson 5: Wait For The Fat Pitch.
Lesson 6: Sentiment Matters.
Lesson 7: Leverage Can't Make A Bad Investment Good, But It Can Make A Good Investment Bad!
Lesson 8: Over-Quantification Hides Real Risk.
Lesson 9: Macro Matters.
Lesson 10: Look For Sources Of Cheap Insurance.

By James Montier | 23 February 2010

It appears as if the market declines of 2008 and early 2009 are being treated as nothing more than a bad dream, as if the investment industry has gone right back to business as usual. This extreme brevity of financial memory is breathtaking. Surely, we should attempt to look back and learn something from the mistakes that gave rise to the worst period in markets since the Great Depression. In an effort to engage in exactly this kind of learning experience, I have put together my list of the top ten lessons we seem to have failed to learn. So let's dive in!

Lesson 1: Markets Aren't Efficient.

As I have observed previously, the Efficient Market Hypothesis (EMH) is the financial equivalent of Monty Python's Dead Parrot.1 No matter how many times you point out that it is dead, believers insist it is just 'resting'. I must admit I really thought we had this one licked (evidence of hubris on my part, for sure). While many practitioners seem willing to reject the EMH, the academics refuse to jettison their treasured theory.

Not only have two economists written a paper arguing that the technology-media-telecoms (TMT) bubble wasn't a bubble, but now several have written papers arguing that not only should the EMH be absolved of playing any role in the most recent crisis [[ie, the "credit" bubble: normxxx]], but that if only we had all understood the EMH better, the crisis wouldn't have happened in the first place! Stephen Brown of NYU (author of one of the aforementioned papers) actually argues, "That it was the failure to believe the EMH that was in fact responsible for the crisis."

His view is that: "It was believed to be rather easy to make money investing …investors borrowed heavily to invest… The resulting increase in leverage and resulting heavy burden taken on by financial institutions was a leading factor in the recent financial crisis". Effectively, Brown believes that if no one had ever tried to generate returns, then this crisis would not have occurred. Of course, this seems to ignore the problem that if no one tried to make returns, either markets would not be efficient, or they would not exist!

The good news is that, as Jeremy [Granthem] pointed out at the GMO client conference last fall, it is now "illegal" to believe in efficient markets at all! The 11th Circuit Court of the United States declared in one of its opinions that "All bubbles eventually burst, as this one did. The bigger the bubble, the bigger the pop. The bigger the pop, the bigger the losses".2 So, I guess it's official now. Personally I'd be delighted to see EMH believers being taken away in handcuffs!

Brown's viewpoint also ignores the role the EMH plays in a long litany of "derivative" ideas, by which I mean the theories that are based upon the flawed assumptions and recommendations of the EMH. This long and dire list includes the Capital Asset Price Model (CAPM), the Black-Scholes option pricing model, modern risk management techniques (which use market inputs as the 'best estimators' of the future as per the EMH), the whole madness of mark-to-market accounting, market cap indexing, the Modigliani and Miller dividend and capital structure irrelevance propositions, the shareholder value concept, and even the Fed, which stood back, [espousing the] thought that 'the market knew best' [[i.e., were rapidly 'self-clearing' and 'self-correcting', precluding exaggerated or extreme behavior— certainly no parabolic spikes upward or crashes!: normxxx]].

Lesson 2: Relative Performance Is A Dangerous Game.

While practitioners are generally happy to reject the false deity of the [hard]? EMH, they are more inclined to continue to worship at the altar of its offspring— the CAPM. This dubious theory is driven by an outstanding number of flawed assumptions (such as investors being able to take any position long or short in any stock without affecting market price, and that all investors view stocks through the prism of mean-variance optimization). It also leads directly to the separation of alpha and beta, upon which investors seem to spend an inordinate amount of time. Sadly, these concepts are nothing more than a distraction from the true aim of investment, which as the late, great Sir John Templeton observed is, "Maximum total real returns after tax."

[ Normxxx Here:  Also, nothing that happened in our several crises of the 21st century has acted in any way to discredit so-called 'soft' EMH, which merely holds, like the Las Vegas casinos, that in the long run, it is impossible to beat the 'house' or the 'market'! And so all bubbles must pop in the end. In fact, the come uppance of the 'quants' was considered ample proof that 'soft' EMH actually will catch up with you, however 'sophisticated' your methods/models.  ]

The alpha/beta framework has given rise to the obsession with benchmarking, and indeed a new species, Homo Ovinus, whose only concern is where to stand relative to the rest of the crowd. They are the living embodiment of Keynes' edict: "That it is better for reputation to fail conventionally, than to succeed unconventionally". The supporters of the EMH love to point out that most active managers fail to outperform a passive index. But if such investors are obsessed with career and business risk, then their failure to outperform is sadly not surprising, and certainly not proof that the market is in any way efficient.

Jonathan Lewellen of Dartmouth College3 has recently looked at the aggregate holdings of US institutional investors over the period 1980 to 2007. As he concludes, "Quite simply, institutions overall seem to do little more than hold the market portfolio … Their aggregate portfolio almost perfectly mimics the value-weighted index … Institutions overall take essentially no bet on any of the most important stock characteristics known to predict returns". Put in our terms, many (if not most) investment managers are more worried about career risk (losing their jobs) or business risk (losing funds under management) than they are about doing the right thing! Further evidence of this pervasive problem comes from a recent paper by Randy Cohen, Chris Polk, and Bernhard Silli.4

They examined the "best ideas" of US fund managers over the period 1991 to 2005. "Best ideas" were measured as the biggest difference between the managers' holdings and the weights of the index. The performance of these best ideas is impressive. Focusing on the top 25% of best ideas across the universe of active managers, Cohen, et al, find the average return is over 19% annually against a market return of 12% annually. That is to say, the stocks in which the managers displayed the most confidence outperformed the market by a significant amount.

The depressing corollary is that the other stocks they hold are dragging down their performance. Hence it appears that the focus on relative performance— and hence the fear of underperformance against an arbitrary benchmark— is a key source of underperformance. As the authors conclude, "The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over-diversify". Thus, as Sir John Templeton said, "It is impossible to produce a superior performance unless you do something different from the majority."

Of course, this begs the question: why are fund managers so wedded to relative performance? The simple, although unpopular, answer is that clients and consultants force them to be. As Goyal and Wahal5 have demonstrated, institutional clients are nearly as bad as retail clients in exhibiting 'return-chasing' behavior. They reviewed nearly 9,000 hiring and firing decisions by institutional pension funds between 1994 and 2003.

The firms that tended to get hired had generated good excess returns (2.9% annually) in the three years before being hired. Sadly, they went on to produce post-hire returns of just 0.03% annually. In contrast, the managers that were fired showed three-year pre-firing excess returns of -1% annually, but post-firing returns of 4.2% annually. Effectively, pension plans had a habit of firing their managers at precisely the worst point in time! [[They should have paid more attention to the probability of mean reversion!: normxxx]]

Lesson 3: The Time Is Never Different.
"Bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy." (Alan Greenspan, June 17, 1999)
"It was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity— the very outcome we would be seeking to avoid. Prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy … we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact … the idea that the collapse of a bubble can be softened by pricking it in advance is almost surely an illusion." (Alan Greenspan, August 30, 2002)
"There is no housing bubble to go bust." (Ben Bernanke, October 27, 2005)
The first Greenspan quotation above has eerily strong parallels with the pronouncements of Joseph Stagg Lawrence (a Princeton economist) who, in the autumn of 1929, opined
"The consensus of judgment of the millions whose valuations function on that admirable market, the Stock Exchange, is that stocks are not at present overvalued … Where is that group of men with the all embracing wisdom which will entitle them to veto the judgment of this intelligent multitude?"
It is also worth remembering that Bernanke is the man who gave us some of the very worst economic doctrines of our times. He espoused the "Global Saving Glut," which effectively argued that it wasn't the US consumer who was consuming too much, it was the rest of the world who were saving too much. He also gave us "The Great Moderation," in which he offered various explanations for the "remarkable decline in the variability of both output and inflation". Although Bernanke allowed for the role of luck, he argued that "improved performance of macroeconomic policies, particularly monetary policy" accounted for the lion's share of the reduced volatility (nothing like a little modesty and humility from your central bankers!).

This viewpoint, of course, completely misses the credit boom, which created surface stability, but was ultimately an edifice built upon dangerous and unstable debt. Bernanke was also a leading proponent of the 'limited contagion' of the subprime problems. "We believe the effect of the troubles in the subprime sector on the broader housing market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system". Not only is Bernanke the originator of these appallingly poor ideas, but to judge from his recent speech, he believes that he has done nothing wrong and has nothing to learn. I guess there are none so blind as those who will not see!

The aforementioned defender of the EMH orthodoxy, Stephen Brown of NYU, in the same paper states that "The irony is that the strong implication of this hypothesis is that nobody, no practitioner, no academic, and no regulator had the ability to foresee the collapse of this most recent bubble" This is utter piffle. Contrary to the protestations of the likes of Greenspan, Bernanke, and Brown, bubbles can be diagnosed before they burst; they are not black swans. The black swan defense is nothing more than an attempt to abdicate responsibility.

A good working knowledge of the history of bubbles can help preserve your capital. Ben Graham argued that an investor should "have an adequate idea of stock market history, in terms, particularly, of the major fluctuations. With this background he may be in a position to form some worthwhile judgment of the attractiveness or dangers of the market". Nowhere is an appreciation of history more important than in the understanding of bubbles.

Although the details of bubbles change, the underlying patterns and dynamics are eerily similar. The framework I have long used to think about bubbles has its roots way back in 1867, in a paper written by John Stuart Mill. Mill was a quite extraordinary man: a polymath and a polyglot, a philosopher, a poet, an economist, and a Member of Parliament. He was distinctly enlightened in matters of social justice, penning papers that were anti-slavery and pro-extended suffrage. From our narrow perspective, it is his work on understanding the patterns of bubbles that is most useful. As Mills put it, "The malady of commercial crisis is not, in essence, a matter of the purse but of the mind."

His model has been used time and again, and forms the basis of the bubble framework utilized by such luminaries as Hyman Minsky and Charles Kindleberger. Essentially this model breaks a bubble's rise and fall into five phases as shown below.

  1. Displacement

  2. Credit creation

  3. Euphoria

  4. Critical stage/financial distress

  5. Revulsion

Displacement: The Birth of a Boom. Displacement is generally an exogenous shock that triggers the creation of profit opportunities in some sectors, while closing down profit availability in other sectors. As long as the opportunities created are greater than those that get shut down, investment and production will pick up to exploit these new opportunities. [A net increase in i]nvestment in both financial and physical assets is likely to occur. Effectively we are witnessing the birth of a boom. As Mill puts it, "A new confidence begins to germinate early in this period, but its growth is slow."

Credit creation: The nurturing of a bubble. Just as fire can't grow without oxygen, so a boom needs credit on which to feed. Minsky argued that monetary expansion and credit creation are largely endogenous to the system. That is to say, not only can money be created by existing banks, but also by the formation of new banks, the development of new credit instruments, and the expansion of personal credit outside the banking system. Mill noted that during this phase "The rate of interest [is] almost uniformly low… Credit continues to grow more robust, enterprise to increase, and profits to enlarge."

Euphoria: Everyone starts to buy into the new era. Prices are seen as only capable of ever going up. Traditional valuation standards are abandoned, and new measures are introduced to justify the current price [[as traditional hedges, insurance, and safeguards are abandoned as "too constraining and/or profit limiting": normxxx]]. A wave of overoptimism and overconfidence is unleashed, leading people to overestimate the gains, underestimate the risks, and generally think they can control the situation. The new era dominates discussions, and Sir John Templeton's four most dangerous words in investing, "This time is different," reverberate around the market.

As Mill wrote,
"There is a morbid excess of belief … healthy confidence … has degenerated into the disease of a too facile faith … The crowd of … investors … do not, in their excited mood, think of the pertinent questions, whether their capital will become quickly productive, and whether their commitment is out of proportion to their means … Unfortunately, however, in the absence of adequate foresight and self-control, the tendency is for speculation to attain its most rapid growth exactly when its growth is most dangerous."

Critical stage/financial distress: This leads to the critical stage, which is often characterized by insiders cashing out, and is rapidly followed by financial distress, in which the excess leverage that has been built up during the boom becomes a major problem. Fraud also often emerges during this stage of a bubble's life.

Revulsion: The final stage of a bubble's life cycle is revulsion. Investors are so scarred by the events in which they participated that they can no longer bring themselves to participate in the market at all. This results in bargain basement asset prices. Mill said,
"As a rule, panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works … The failure of great banks … and mercantile firms … are the symptoms incident to the disease, not the disease itself."
He was also aware of the prolonged nature of a recovery in the wake of a bubble. "Economy, enforced on great numbers of people by losses from failures and from depreciated investments restricts their purchasing power Profits are kept down to the stunted proportions of demand Time alone can steady the shattered nerves, and form a healthy cicatrice over wounds so deep". If bubbles follow the same path over and over, it is a reasonable question to ask why people tend not to see the consequences coming. Unfortunately, we have to overcome at least five behavioural impediments. The first is overoptimism. Everyone simply believes that they are less likely than average to have a drinking problem, to get divorced, or to be fired. This tendency to look on the bright side helps to blind us to the dangers posed by [[highly probable and: normxxx]] predictable 'surprises'.

In addition to our overoptimism, we suffer from the illusion of control— the belief that we can influence the outcome of uncontrollable events. This is where we encounter a lot of the pseudoscience of finance, e.g., measures such as Value-At-Risk (VaR). The idea that if we can quantify risk we can control it is one of the great fallacies of modern finance. VaR tells us how much you can expect to lose with a given probability, i.e., the maximum daily loss with a 95% probability. Such risk management techniques are akin to buying a car with an airbag that is guaranteed to work unless you crash! Talk about the illusion of safety.

The third hurdle to spotting predictable surprises is selfserving bias— the innate desire to interpret information and act in ways that are supportive of our own selfinterests. As Warren Buffett puts it, "Never ask a barber if you need a haircut". If you had been a risk manager in 2006 and suggested that some of the collateralized debt obligations (CDOs) that your bank was working on might have been slightly suspect, you would, of course, have been fired and replaced by a risk manager who was happy to approve the transaction. Whenever lots of people are making lots of money, it is unlikely that they will take a step back and point out the obvious flaws in their actions.

The penultimate hurdle is myopia— an overt [and excessive] focus on the short term. All too often we find that consequences occurring at a later date tend to have much less bearing on our choices the further into the future they fall. This can be summed up as, "Let us eat, drink, and be merry, for tomorrow we die". Of course, this ignores the fact that on any given day we are roughly 260,000 times more likely to be wrong than right with respect to making it to tomorrow. Saint Augustine's plea "Lord, make me chaste, but not yet" is pure myopia. One more good year, one more good bonus, and then I promise to go and do something worthwhile with my life, rather than working in finance!

The final barrier to spotting predictable 'surprises' is a form of inattentional blindness. Put bluntly, we simply don't expect to see what we are not looking for. The classic experiment in this field6 shows a short video clip of two teams playing basketball. One team is dressed in white, the other in black. Participants are asked to count how many times the team in white passes the ball between themselves. Now, halfway through this clip, a man in a gorilla suit walks onto the court, beats his chest, and then walks off. At the end of the clip, participants are asked how many passes there were. The normal range of answers is somewhere between 14 and 17. They are then asked if they saw anything unusual.

Nearly 60% fail to spot the gorilla! When the gorilla is mentioned and the tape re-run, most participants say that the clip was switched, and the gorilla wasn't in the first version! People simply get too caught up in the detail of counting the passes. I suspect that something similar happens in finance: investors get caught up in all of the details and the noise, and forget to keep an eye on the big picture [[or the seemingly irrelevent unexpected events: normxxx]].

Lesson 4: Valuation Matters.

At its simplest, value investing tells us to buy when assets are cheap and to avoid purchasing expensive assets. This simple statement seems so self-evident that it is hardly worth saying. Yet repeatedly I've come across investors willing to undergo mental contortions to avoid this valuation reality.

For instance, I often use a Graham and Dodd P/E to assess valuation— a simple measure that takes the current price and divides it by 10-year average earnings. In the past I was informed by investors that this measure was inappropriate as it didn't include any growth (of course, this was during the time when new valuation measures like eyeballs and clicks were in fashion). Conversely, during the [prelude to the latest market surge], investors were making arguments that the Graham and Dodd P/E was overstating the earnings, and thus making the market look artificially cheap.

In both cases, of course, you were best off just following the advice [of buying when stocks were measured as cheap and selling when stocks were measured as dear]. Buying when markets are cheap generates significantly better returns than buying when markets are expensive. Of course, the flip side is that one must be prepared to be [considerably less than] fully invested [or substantially 'insured', ie, hedged] when the returns implied by equity 'pricing' are exceptionally unattractive.

Regrettably, the current juncture doesn't offer many exciting value-based opportunities. Most equity markets look roughly fairly valued, while the US is once again looking expensive. This holds true across many valuation approaches (including the GMO 7-year forecasts as well as the Graham and Dodd P/Es), and also across many different asset classes. All of which leads us nicely on to our next lesson.

Lesson 5: Wait For The Fat Pitch.

According to data from the New York Stock Exchange, the average holding period for a stock listed on its exchange is just 6 months. This seems like the investment equivalent of attention deficit hyperactivity disorder (ADHD). In other words, it appears as if the average investor is simply concerned with the next couple of earnings reports, despite the fact that equities are obviously a long-duration asset. This myopia creates an opportunity for those who are willing or able to hold a longer time horizon.

Warren Buffett often speaks of the importance of waiting for the fat pitch— that perfect moment when patience is rewarded as the ball meets the sweet spot. However, most investors seem unable to wait, forcing themselves into action at every available opportunity, swinging at every pitch, as it were. As tempting as it may be to be a "man of action," it often makes more sense to act only at extremes. But the discipline required to "do nothing" for long periods of time is not often seen. As noted above, overt myopia also contributes to our inability to sit back, trying to understand the overall investment backdrop.

Lesson 6: Sentiment Matters.

Investor returns are not only affected by valuation. Sentiment also plays a part. It is a cliché that markets are driven by fear and greed, but it is also disturbingly close to the truth. Sentiment swings like a pendulum, from irrational exuberance to the depths of despair. As Keynes wrote in February 1931:
"There is a great deal of fear psychology about just now. Prices bear very little relationship to ultimate values … They are determined by indefinite anxieties … Just as many people were quite willing in the boom … to assume that the increase in earnings would continue geometrically."
Using a pure measure of sentiment— with the effect of the economic cycle removed— designed by Baker and Wurgler, a composite measure employing six underlying proxies for sentiment: the closed-end fund discount, NYSE share turnover, the number of and average first-day returns of IPOs, the equity share in new issues, and the dividend premium (the relative price of dividend paying and non-dividend paying stocks), Baker and Wurgler found that certain groups of stocks generated better returns when sentiment was high or low. In general, when sentiment was low, buying young, volatile, unprofitable firms (i.e., 'junk') generated the best returns. Of course, when sentiment was high, buying mature, low volatility, profitable firms (i.e., 'quality') was the best strategy. This is the mean reversion of sentiment in action, and yet further evidence of why it pays to be a contrarian investor.

When sentiment is high: buy mature, low volatility, profitable companies. When sentiment is low: buy young, highly volatile, non-profitable companies.

Percent Bearish

High quality stocks appear to be one of the few fat pitches currently available. As mentioned above, in general markets look essentially close to fair value. However, quality stocks continue to register as distinctly cheap on our metrics. This attractiveness is only enhanced when one considers sentiment. At present, measures such as the Advisors Intelligence Index (a measure of the enthusiasm of investors) show a record low level of bears!

Lesson 7: Leverage Can't Make A Bad Investment Good, But It Can Make A Good Investment Bad!

Leverage is a dangerous beast. It can't ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn't transform it into a good idea. Leverage has a darker side from a value perspective as well: it has the potential to turn a good investment into a bad one! Leverage can limit your staying power, and transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital. Mill was aware of the dangers that the use of leverage posed and how it could easily result in asset fire sales.

"The … trader who employs, in addition to his own means, a proportion of borrowed Capital … has found, in the moment of crisis, the conjuring power of his name utterly vanished, and has been compelled to provide for inexorably maturing obligations by the forced sales of goods or produce at such prices as would tempt forth reluctant capital." Keynes too opined, "An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money."

While on the subject of leverage, I should note the way in which so called 'financial innovation' is more often than not just thinly veiled leverage. As J.K. Galbraith put it, "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version". Anyone with familiarity of the junk bond debacle of the late 80s/early 90s couldn't have helped but see the striking parallels with the mortgage alchemy of recent years!

Lesson 8: Over-Quantification Hides Real Risk.

Finance has turned the art of transforming the simple into the perplexing into an industry. Nowhere (at least outside of academia) is overly complex structure and elegant (but not robust) mathematics so beloved. The reason for this obsession with needless complexity is clear: it is far easier to charge higher fees for things that sound complex. Two of my investing heroes were cognizant of the dangers posed by elegant mathematics.

Ben Graham wrote: Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom Whenever calculus is brought in, or higher algebra, you could take it as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.

I can't imagine a better description of recent times: the rise of the Gaussian copula [[aka, "bell shaped" curve: normxxx]], which "enabled" the pricing of such delights as CDOs, correlation trading, etc. Keynes was also mindful of the potential pitfalls involved in over-quantification. He argued
"With a free hand to choose co-efficients and time lag, one can, with enough industry, always cook a formula to fit moderately well a limited range of past facts … I think it all hocus— but everyone else is greatly impressed, it seems, by such a mess of unintelligible figures."

In general, critical thinking is an underappreciated asset in the world of investment. As George Santayana observed, "Scepticism is the chastity of the intellect, and it is shameful to surrender it too soon or to the first comer: there is nobility in preserving it coolly and proudly". Scepticism is one of the key traits that many of the best investors seem to share.

They [stop to] ask themselves, "Why should I own this investment"? This is a different default from the average Homo Ovinus, who asks, "Why shouldn't I own this investment"? In effect, investors should consider themselves to be in the rejection game. Investment ideas shouldn't be accepted automatically, but rather we should seek to pull them apart. In effect, investors would be well-served if they lived by the Royal Society's motto: Nullius in Verba (for which a loose modern translation would be, "Take no one's word for it").

One prime area for scepticism (subjected to repeated attack in this note) is risk. Hand in hand with the march toward over-quantification goes the obsession with a very narrow definition of risk. In a depressing parody of the "build it and they will come" mentality, the risk management industry seems to believe "measure it, and it must be useful". In investing, all too often risk is equated with volatility. This is nonsense. Risk isn't volatility, it is the permanent loss of capital. Volatility creates opportunity. As Keynes noted, "It is largely fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them."

We would be far better off if we abandoned our obsession with measurement in favor of understanding a trinity of risks. From an investment point of view, there are three main paths to the permanent loss of capital: valuation risk (buying an overvalued asset), business risk (fundamental problems), and financing risk (leverage). By understanding these three elements, we should get a much better understanding of the true nature of risk.

Lesson 9: Macro Matters.

In his book on value investing, Marty Whitman says, "Graham and Dodd view macrofactors as crucial to the analysis of a corporate security. Value investors, however, believe that such macrofactors are irrelevant". If this is the case, then I am very happy to say that I am a Graham and Dodd investor.

Ignoring the top-down can be extraordinarily expensive. The credit bust has been a perfect example of why understanding the top-down can benefit and inform the bottom-up. The last 12 months have been unusual for value investors as two clear camps emerged from their normally more homogenous whole.

A schism over financials has split value investors into two diametrically opposed groups. The optimistic/bottom up view was typified by Richard Pzena. In his Q1 2008 quarterly report he wrote: A new fear has permeated conventional investment thinking: the massive leveraging-up of the recent past has gone too far and its unwinding will permanently hobble the global financial system.

This view sees Bear Stearns as just one casualty in a gathering wave that has already claimed many U.S. subprime mortgage originators along with several non-U.S. financial institutions and will cause countless others [still] to fail. It sees the earnings power of those that survive as being permanently impaired. The obvious question then is, which scenario is more logical: the extreme outlook described above, given the long period of easy credit extended to unqualified individuals?

Or, the scenario of a typical credit cycle that will work its way out as other post-excess crises have, and without impairing the long-term ROEs of the survivors? We believe this latter.

The alternative view (pessimistic, top-down informed) is well summed up by Steven Romick of First Pacific Advisors in a recent interview in Value Investor Insight:

VII: Has your negative general view on the prospects for financial services stocks changed at all?

SR: We believe in reversion to the mean, so it can make a lot of sense to invest in a distressed sector when you find good businesses whose public shares trade inexpensively relative to their earnings in a more normal environment. But that strategy lately has helped lead many excellent investors to put capital to work too early in financials. Our basic feeling is that margins and returns on capital generated by financial institutions in the decade through 2006 were unrealistically high.

"Normal" profitability and valuation multiples are not going to be what they were during that time, given more regulatory oversight, less leverage (and thus capital to lend), higher funding costs, stricter underwriting standards, less demand, and less esoteric and excessively profitable products.

Essentially, the difference between these two camps comes down to an appreciation of the importance of the bursting of the credit bubble. Those who understood the impact of the bursting of such a bubble didn't go near financials. Those who focused more (and in some cases exclusively) on the "bottom-up" just saw 'cheapness', but missed the value trap arising from [such] a bursting credit bubble.

It often pays to remember the wise words of Jean-Marie Eveillard. "Sometimes, what matters is not so much how low the odds are that circumstances would turn quite negative, what matters more is what the consequences would be if that happens". In terms of finance jargon, expected payoff has two components: expected return and [its] probability [of occurrence]. While the probability may be small, a truly appalling expected return can still result in a [substantial] negative 'payoff'.

The bottom-up can also inform the top-down. As Ben Graham pointed out,
"True bargain issues have repeatedly become scarce in bull markets … Perhaps one could even have determined whether the market level was getting too high or too low by counting the number of issues selling below working capital value. When such opportunities have virtually disappeared, past experience indicates that investors should have taken themselves out of the stock market and plunged up to their necks in US Treasury bills."

Another example of the complementary nature of topdown and bottom-up viewpoints is offered by Seth Klarman. In his insightful book, Margin of Safety, Klarman points out that the inflationary environment can have dramatic consequences for value investors: Trends in inflation or deflation also cause business values to fluctuate. That said, value investing can work very well in an inflationary environment. If for 50 cents you buy a dollar of value in the form of an asset, such as natural resource properties or real estate, which increases in value with inflation, a 50-cent investment today can result in the realisation of value appreciably greater than $1.

In an inflationary environment, however, investors may become somewhat careless. As long as assets are rising in value, it would appear attractive to relax one's standards and purchase $1 of assets, not for 50 cents, but for 70 or 80 cents (or perhaps even $1.10). Such laxity could prove costly, however, in the event that inflation comes to be anticipated by most investors, who respond by bidding up security prices. A subsequent slowdown in the rate of inflation could cause a price decline.

Conversely, In a deflationary environment assets tend to decline in value. Buying a dollar's worth of assets for 50 cents may not be a bargain if the asset value is dropping The possibility of sustained decreases in business value is a dagger at the heart of value investing (and is not a barrel of laughs for other investment approaches either). Neither top-down nor bottom-up has a monopoly on insight. We should learn to integrate their dual perspectives.

Lesson 10: Look For Sources Of Cheap Insurance.

The final lesson that we should take from the 2008-09 experience is that 'insurance' [[aka, hedging: normxxx]] is often a neglected asset when it comes to investing. The cash flows associated with insurance often seem unappealing in a world when many seem to prefer "blow up" (small gain, small gain big loss) to "bleed out" (small loss, small loss big gain). Insurance by its very nature means that you are paying out a premium, so in the short term you are pretty much guaranteed to suffer small losses. Of course, if the [normally improbable] event occurs, then you receive a significant payout.

It is the short-term losses [[and the prospect of a 'lifetime' of such payouts: normxxx]] that make insurance seem unattractive to many investors. However, this disliked feature often results in insurance being cheap. One should always avoid buying expensive insurance. The general masses will tend to want insurance after the event— for instance, when I lived in Japan, the price of earthquake insurance always went up after a tremor! So, as is so often the case, it pays to be a contrarian when it comes to purchasing insurance.

However, insurance serves a very useful function within a portfolio. If we accept that we have only a very limited ability to divine the future, then cheap insurance [[eg, 'out-of-the-money' puts?: normxxx]]can help us protect ourselves from the known unknowns [[and even a few unknown unknowns: normxxx]]. Among the many imponderables facing us at the moment are the possible return of inflation, the 'moral hazard' issues from extended 'easy' monetary policy, and what happens if/when the authorities decide to end 'Quantitative Easing'. Hunting for cheap insurance that protects investors against these conundrums would seem to be worthwhile.

Will We Learn?

Sadly the evidence from both history and psychology is not encouraging when it comes to supporting the idea that we might learn from our mistakes. There is a whole gamut of behavioral biases that prevent us from learning from mistakes. However, just this once I really hope this time is different!

Disclaimer: The views expressed herein are those of James Montier [bio] and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Mr. Montier is a member of GMO's asset allocation team. He is the author of several books including Behavioural Investing: A Practitioner's Guide to Applying Behavioural Finance; Value Investing: Tools and Techniques for Intelligent Investment; and The Little Book of Behavioural Investing.

1 See Chapter 1 of Value Investing (2009) Montier, J.
2 See Stein vs Paradigm Mirasol, The United States Court of Appeals for the Eleventh Circuit, No. 08-10983
3 Lewellen, J. (2009) Institutional Investors and the Limits to Arbitrage, working paper.
4 Cohen, R., Polk, C., and Silli, B. (2009) Best Ideas, working paper.
5 Goyal, A. and Wahal, S. (2008) The Selection and Termination of Investment Management Firms by Plan Sponsors, Journal of Finance.
6 Simons, D. J., & Chabris, C. F. (1999). Gorillas in our Midst: Sustained Inattentional Blindness for Dynamic Events. Perception, 28, 1059-1074.



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