Posted by: Drizzt
on Thursday, July 3rd, 2008
We might see more down side in these few days. I know alot of TA experts seem to be calling for a short term bottom but today’s development should accelerate that.
Perhaps there is more downside to go but now may not be the best time to be cutting your losses.
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Posted by: Drizzt
on Friday, June 27th, 2008
by Joe Ponzio
Phil Fisher laid out fifteen points to look for in a common stock; three of them are directly related to profit margins. Calculated as net income divided by revenue, the profit margin is a quick way to determine which companies in an industry are most efficient (i) relative to the competition, and (ii) as a whole.
Does the company have a worthwhile profit margin?
To hammer the importance of this point home, you need not look further than traditional auto manufacturers.
Does the company have a worthwhile profit margin?
Auto manufacturers have historically low profit margins. MSN Money reports a 5-year industry average of just 3.4% for auto manufacturers versus 11.5% for the S&P 500. That is, for every dollar of sales at the auto manufacturer, just $0.03 ends up in net income. The rest is spent on costs of goods sold, operational expenses, etc.
Take, for example, General Motors. In its fiscal year ended December 31, 2007, General Motors reported $178.2 billion of automotive sales. To make the vehicles sold, GM reported “Automotive Cost of Sales” of $166.3 billion. Simple math would tell you that GM generated about $11.9 billion in revenue, after taking into account the cost of the materials to make the vehicles.
Here’s the problem: In the three years leading up to the end of last year, GM had to spend an average of $13.7 billion on “Selling, General and Administrative” expenses — the costs to keep the lights on, to keep the salespeople motivated, to advertise, etc. $11.9 billion in, $13.7 billion out. Starting to see the problem?
When Margins are Slim
If your company doesn’t have a “worthwhile” profit margin, it has a problem: When tough times surface (as they always do from time to time), weak margin companies will probably start burning cash rather than generating it. When things begin to turn around, your company’s ability to generate cash will be delayed relative to its high profit margin competitors.
As your company begins to use cash rather than generate it, your ownership is in jeopardy. I’m not just talking about negative free cash flow; your company will have to sell assets, fire people, take on debt, and/or sell more stock. The result: Less sales as capacity to fill orders is diminished, lower profit margins and excess cash as interest expenses increase, and dilution of your ownership resulting in less value going forward.
Check out GM’s balance sheet on Morningstar, and specifically look at the changes to shareholder equity. Here’s a company that has spent the last ten years trying to keeps its head above water, struggling to find a balance between too big to be profitable and too small to maintain unit volume. When margins are too thin, the slightest breeze can knock your business around.
The Owner’s Margin
Profit margins are important when looking at the industry and at historical figures for a company; the Owner’s Margin looks forward.
Calculated as owner earnings (or free cash flow) divided by total revenues, the Owner’s Margin can help you judge whether or not your business will be able to sustain prolonged periods of slowed sales or unusually high expenses.
In the case of General Motors, sales slipped and any excess cash they might have been able to eek out when times were good is now a pipe dream. Let’s turn our attention to Pfizer.
Generating about $10.6 billion in owner earnings last year on sales of $48.4 billion, Pfizer’s Owner’s Margin is 22%. That is, for every dollar of sales that Pfizer recorded, it generated about $0.22 in excess cash. Think of it this way: If sales at Pfizer sank 20%, or $9.7 billion, to $38.7 billion, Pfizer would still be able to crank out more than $900 million in owner earnings without firing a single person, selling a single asset, or assuming a dime of additional debt (if it’s business as usual).
A 20% hit to sales, and the company is still generating excess cash without making a single adjustment to its business? Now that’s a worthwhile margin.
Of course, some adjustments would likely be made. At that level, Pfizer would definitely have to kill its $8 billion annual dividend payments (unless management wanted to foolishly assume $8 billion a year in debt to keep the dividend). Furthermore, Pfizer would likely cut staff and take other measures to return to a more worthwhile margin. Still, the company has the operational capacity to sustain a very serious hit to sales without sustaining a commensurate hit to operations or its balance sheet.
When Times Get Tough
Going back to troubled companies. If you are attributing GM’s tough times to tighter consumer spending and higher gas prices, let’s move out of the beaten down auto sector and move to another business — Blockbuster.
For its fiscal year ended December 31, 2006, Blockbuster reported total revenues of $5.5 billion. It generated just $183 million of owner earnings — an Owner’s Margin of 3.3%. For the record, 2006 was a “business as usual” year for BBI.
Here’s where it gets hairy: To generate cash and actually have any sort of value for investors, Blockbuster needs to keep sales extremely high, to keep expenses extremely low, and to operate at perfect efficiency. Any slight change can have a dramatic effect on the business.
Well, it got hairy for Blockbuster. Revenues and most expenses in 2007 were largely unchanged. However, Blockbuster’s costs of sales increased by about 8%, from $2.5 billion to $2.7 billion. Owner’s Margin of 3.3%; cost of sales increase of 8%. Doesn’t look good for this fragile business.
Sure enough, Blockbuster’s operations swung from generating owner earnings of about $183 million to requiring an additional $114 million after all expenses were paid. Its Owner’s Margin dropped to a negative 2%. For every dollar of sales Blockbuster generated, it had to cough up $1.02 to keep the doors open.
In the highly competitive world of movie rentals (think Netflix, Wal-Mart, Apple TV, Comcast On Demand, etc.), a 3% Owner’s Margin is definitely not worthwhile. And Blockbuster shareholders have suffered because of it.
What Is “Worthwhile”?
The term “worthwhile” is relative, and depends on your estimation of how bad things can get at your company. If you are expecting a 50% hit to Pfizer’s total sales or a doubling of expenses at some point in the future, a 22% Owner’s Margin is definitely not worthwhile. If, however, in the ordinary course of business and economic cycles, you would not be surprised by 10% swings in sales, a 13% or 15% Owner’s Margin may very well be worthwhile.
As with everything in investing, look for a margin of safety. The higher the Owner’s Margin, the better.
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Posted by: Drizzt
on Thursday, June 26th, 2008
NEW YORK, June 25 (Reuters) - Warren Buffett, chief executive of Berkshire Hathaway, sees some opportunities for investing in the subprime mortgage business, he told Reuters in an interview on Wednesday.
Buffett said Berkshire Hathaway had already made some subprime investments through its Clayton Homes manufactured housing unit.
“We have bought some subprime paper in the open market, as people have wanted to sell portfolios,” he said of the investments Clayton Homes has made to date.
Other investments are possible, he said.
“We listen to anything we hear about,” said Buffett. “If it is big and unusual, and carries the proper premium, we listen.”
Buffett, who is famous for investing in businesses in beaten-down industries, started up a municipal bond insurer earlier this year.
He said that unit might indirectly invest in some distressed areas, including subprime. “Some of that may be a factor in what we are doing in bond insurance — it is an indirect fall-out from that,” he said.
Buffett said last month that he was generally hoping to make big investment deals, “the bigger the better.” (Reporting by Lilla Zuill and Dan Wilchins; Editing by Maureen Bavdek and Lisa Von Ahn)
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Posted by: Drizzt
on Thursday, June 26th, 2008
I came across this rather interesting app that I will add to the left hand side side panel for the time being
meOwns is a social tool that keeps track of items you own based on your interest. I think fun bloggers as well as finance bloggers would find this social site rather useful.
Add to the fact that there are widgets that enables you to put it up on your blog as well as on Facebook, this makes it good for your friends to see what you own and so they can request it from you.
Do give it a try.
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Posted by: Drizzt
on Wednesday, June 25th, 2008
I was going to host another game of DOTA when i saw something on my thinkOrSwim Prophet. I chided myself for not noticing it but tonight, the S&P 500 is on the weekly 200 day moving average.
Melvin told me there were important news coming up. The FED will decide whether to hike or leave rate unchanged tomorrow. The index started off down, and it looks like the chances of it breaking it this week is rather high. But after my game, it ended up!
I was wondering if its another case of FED making their decision on an important juncture. Talk about a little market manipulation.
Anyway i think i mentioned abit on S&P chart here the past few times. My prediction have not all been entirely right, but then again i didnt make predictions, i merely stated important junctures.
This week it is one as well.
Here is a 10 year weekly S&P 500 chart. Notice the red moving average. That is the 200 day one. We are currently hovering around it.
During the previous down move, the FED actually engineer a news release about saving financial institution on the 200 day moving average. Since then, the index have moved up from there and tried to challenge the pink line, which is the 50 day weekly moving average.
It failed pretty badly and now its moving down. A note on the weekly 50 day moving average. If you look at the 2001 - 2002 correction all the highs in the down leg all didn’t breach this pink line, and for the current case it looks to be doing that as well.
What we notice on the MACD front, is that the highs and lows on a long term chart such as this gave us pretty good intermediate signals. It is going to cut down from there. It would seem that we have abit more correction to go or we are going to go into free fall.
However if you look at just after 2003 on the MACD, there is a similar formation but the trend reverses instead of go down. It could very well happen this time as well.
Finally, the 3 moving average lines, that is, 50,100 and 200 day moving averages are converging and the 50 day seems poised to cut them from top to bottom. Extremely bearish from the long term perspective.
There are no MACD and RSI divergence yet, so to me there isn’t a signal. What i would look for is:
- the volume of the trades and how it does this week and
- next on the 200 day moving average.
- Then if it shows signs of reversing, whether there are renewed strength in the RSI.
- The long term moving averages. See if it continues to narrow and moves down.
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Posted by: Drizzt
on Tuesday, June 24th, 2008
Mish here summarize an article on the cost cutting measures US companies ( and govt!) is undertaking in this bleak economic times. You have to wonder when we will join them (Singapore that is.)
Corporations are slashing jobs. States are in on the act too. Let’s take a look at a few headlines. All are from last weekend.
Citigroup (C) Slashing Investment Banking Jobs
Yahoo Finance is reporting Citigroup to slash investment-banking jobs
Citigroup is preparing fire thousands from its worldwide investment-banking division, The Wall Street Journal reported on Sunday. The Journal, citing people familiar with the matter, said the layoffs are part of a plan to cut about 10 percent of the staff of the 65,000-member investment-banking group.
Miami Teachers Protest Job Cuts
NBC is reporting Teachers Protest Job Cuts.
Teachers in Miami-Dade County are fighting back against the school board’s decision to slash jobs. Several teachers gathered outside the Intercontinental Hotel on Sunday to protest superintendent Rudy Crew’s decision to slash jobs while refusing to cut his own pay. The board approved additional job cuts last week, raising the total number of jobs lost to more than 2,000.
Continental Airlines Slashing Jobs
The Economic Times is reporting Continental Airlines to slash jobs.
Continental Airlines Inc, which is shedding 3,000 jobs in a cost-cutting move, is offering employees a year’s worth of health insurance and travel perks if they leave on their own.
“We are offering all of our work groups voluntary plans to reduce the number of involuntary furloughs and terminations that will be required due to capacity cuts,” said Continental spokeswoman Mary Clark.
Continental has made an umbrella offer to all labor groups that includes the health benefits and free travel privileges for employees and their families until 2023. The offer was extended to employees who have worked at Continental for at least 10 years.
Janesville WI GM Closing To Cost 9,000 Jobs
The Chicago Tribune is reporting Janesville GM closing could result job loss of 9,000
A new analysis shows the closing of General Motors in Janesville could result in the loss of nearly 9,000 jobs and nearly half a billion dollars in labor income. Using software developed by the Minnesota Implan Group, Deller did the analysis assuming that nearly 2,200 of the plant’s 2,667 employees live in Rock County.
It gets to the nearly 9,000 mark — about 10 percent of the county’s resident work force — when jobs are lost through a ripple effect. Every modeling program uses a multiplier, a number that expands the effects.
In this case, the program attached different multipliers to the direct number of GM jobs lost (2,196) and the direct labor income of those GM employees ($188 million).
Pennsylvania Tax Collectors Automated Out Of Jobs
The Evening Sun is reporting Proposal looks to slash local tax collectors’ jobs to streamline process.
Lawmakers are eyeing a bill to drastically change the way wage taxes are collected by slashing the number of tax collectors and creating countywide collection districts. Sen. Jane Earll, of Erie, sponsored the bill, which cleared the Finance Committee on Wednesday by a vote of 25-1 and now heads to the House.
California unemployment hits 6.8%
The Los Angeles Times is reporting California unemployment hits 6.8%.
California’s moribund construction and real estate industries helped push the state unemployment rate to 6.8% in May, its highest level in nearly five years. The state Employment Development Department reported Friday that joblessness in May rose six-tenths of a percentage point from the previous month and was a dramatic 1.5 percentage points higher than in May 2007.
“Although some forecasting groups continue to debate whether or not the economy is heading into a recession, these numbers should make it perfectly clear that the state is already in a recession,” Beacon Economics, a Los Angeles-based research firm, said in an analysis of the jobless data. “The only question now is, how long and how bad will it be?”
Big California Unemployment Jump
Florida Unemployment Rate Highest Since 2003
NBC Is reporting Fla. Unemployment At Highest Rate Since Early ‘03.
State officials say Florida’s unemployment rate in May was at its highest in more than five years. The jobless rate was 5.5 percent, the same as the national number.
The Agency for Workforce Innovation reported Friday that another 56,000 workers lost jobs last month, bringing the total number of jobless in Florida to more than 500,000.
Dismal Job Reports
Those are dismal job reports. There are hundreds more you can find.
It’s question time.
Which way are foreclosures going to head? Bankruptcies? Credit Card Defaults? Home Equity Defaults? Commercial Real Estate Defaults? Corporate Loan Defaults? Corporate Profits?
The answers: Up, Up, Up, Up, Up, Up, Down.
Unemployment Is Lagging Indicator
Somehow the fact that unemployment is a lagging indicator, is being spun as a positive thing. Unemployment is indeed lagging, but it isn’t positive at all. We have not yet bottomed. When we bottom, unemployment will keep rising for as much as another year.
In normal economic times, with more household savings and less debt, consumers would be better prepared to weather the storm. That is what happened in 2002-2003.
Now, most consumers have virtually no savings to weather the storm. Worse yet, unemployment is likely to rise for at least two more years. I called for 6% in 2008 and 7% or more in 2009. California is nearly there. Michigan is over 8.5% already, perhaps on its way to 10%.
Should Congress act to stem rising unemployment with silly makeshift job programs, the dollar is likely to sink further which will put still more pressure on those with jobs.
Some suggest we are in the eye of a hurricane. However, as I said on Sunday, the reality is there are Many Hurricanes, Many Eyes. Most have not even reached shore yet. Very few people are prepared for the series of storms about to hit. And for those barely hanging on, each storm will be worse than the one before it.
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Posted by: Drizzt
on Tuesday, June 24th, 2008
by Paul McCulley
No, I have not lost my mind. I’m fully aware that inflation is not kind to bonds, so offering a kind word for inflation is de facto offering an unkind word about my own business. Investment managers don’t tend to do that. But facts are facts. And the essential fact right now is that the American economy needs an inflation rate above the Fed’s comfort zone. Needs, you ask?
Yes. Soaring commodity prices, particularly for petroleum and food, and especially in recent months, are an unambiguous negative real terms of trade shock to America. For those not familiar with the term, a nation’s terms of trade is the ratio of what it must give up to get what it imports. The easiest way to understand the concept, at least for me, is to think of the number of hours of work necessary, at the average national hourly pay rate, to buy a barrel of oil – a real variable compared to another real variable. The chart below tells that simple story.
Misery Is as Misery Does
Americans are working more hours for the same barrel of oil. That is a negative real terms of trade shock. Put differently, we are less rich or more poor than we were before oil prices took off. There is no getting ‘round this. In turn, there is no escaping collateral adjustments of temporarily higher inflation and temporarily lower growth and employment. The question of the hour is how this pain should be apportioned. Last week, Fed Vice Chairman Don Kohn provided the right answer, presuming there is a right answer (my emphasis):
“… an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago. Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.“1
Mr. Kohn was preaching the raw, honest truth: a surge in oil prices raises the Misery Index, temporarily lifting both inflation and the unemployment rate. In turn, those outcomes beget lower real wages and, presumably, lower real profits, too. We are less rich or more poor – period. Thus, those who holler and scream at the Fed for letting the inflation genie out of the bottle need to calm down. A negative terms of trade shock is a real shock, so it must be translated into lower real wages and profits. That simple and that painful. Logically, it also must be translated for a time into lower, even negative, real short-term interest rates, the rate of return on money.
Spiral Risk?
But, you retort, if the Fed surrenders to negative real interest rates, it will set off an inflationary spiral, as second and third round effects on prices and wages take hold: capital and labor will extrapolate what should be viewed as a transitorily higher inflation into permanently higher inflation. In a world of perfectly indexed prices and wages, this could well be the case. The 1970s resembled such a world, and nasty oil price shocks that should have been one-off adjustments in the price level via temporarily higher inflation morphed into a price-wage-price inflationary spiral.
In monetary policy terminology, inflation expectations in the 1970s were not firmly anchored at the pre-oil price shock level. This is true, I think, but more elementally, the highly unionized, closed-economy structure of the American economy price and wage setting process was inherently geared to transforming a one-off inflationary shock into an enduring inflationary shock.
We no longer live in such a world. Most importantly, wage inflation is now only loosely connected to price inflation, in the wake of a more globally competitive, less unionized labor force. As Vice Chairman Kohn hinted, the combination of somewhat higher inflation and higher unemployment is a prescription for diminished pricing power by labor, leading to lower real wages (than would be dictated by labor’s productivity growth). Thus, unlike the 1970s, there is little wage fuel to generate over-heating aggregate demand and, thus, a sustained price-wage-price inflationary spiral.
This is good news indeed. Fed officials would make this argument through the lens of well-anchored inflationary expectations, and I have no quarrel with that interpretation, though I think it is but a veil over a more global, more competitive, less oligopolistic price and wage setting structure in the United States. Indeed, I believe the more nasty is the negative terms of trade shock, the fatter is the fat tail of asset price deflation rather than the fat tail of accelerating goods and services inflation.
Avoiding a Modern Day Depression
Deflating asset prices in a highly levered economy are a much more nefarious outcome than temporary increases in inflation in goods and services. This is particularly the case from a starting point of low inflation in goods and services (excluding those involved in the negative terms of trade shock). How so? Simple: a negative terms of trade shock and asset price deflation are a prescription for not just a recession, but a nasty one. More to the point, from a starting point of low goods and services inflation, the Fed is never far from the zero lower limit on nominal short-term interest rates, commonly known as a liquidity trap.
Therefore, the more flexible are wages in the face of a negative terms of trade shock, particularly if it coincides with asset price deflation, the greater is the risk of policy makers losing control of the economy on the downside. In turn, this reality argues for the Fed to tolerate higher headline inflation in the wake of a negative terms of trade shock.
To be sure, the Fed must be aware of the dreaded second and third round effects, constantly checking to make sure that real wages and real profits are being eroded by the aberrantly high headline inflation. But, assuming the evidence supports that thesis, as the following graph displays, it would be an absolute folly for the Fed – or any central bank in similar circumstances – to hike interest rates in an attempt to make the negative terms of trade shock go away. By definition, it can’t. And if it tries, it will create an even bigger mess. In this case, the motto of a central bank should be the same as that of a physician: first, do no harm.
I think the Fed thoroughly understands these exigencies in the wake of a negative terms of trade shock. It doesn’t mean that the Fed won’t or shouldn’t rhetorically sound tough at times, in the name of preventing inflationary expectations from becoming unmoored. But the bottom line is that as long as there is a huge gulf between the negative terms of trade cup and the wage inflation lip, the Fed should talk about the cup and focus on the lip.
Bottom Line
Which means, my friends, that low, even negative real short-term interest rates are here to stay for a considerable period. Yes, I know that many believe that it is somehow sinful or immoral for the Fed to hold nominal short rates so low as to render the real return on cash to be negative. I don’t buy this proposition. Why should it be that those who only have labor to offer to the market should not be made whole for a negative terms of trade shock, while those with cash should be made whole?
In the wake of a negative terms of trade shock, all factors of production should absorb a negative hit to their real returns. If indexing to headline inflation is inappropriate for labor wages and capital’s profits, why should cash yields be indexed by the Fed?
And what if holders of cash don’t like it? Then they can step out on the risk spectrum. After all, a basic of capitalism is no risk, no reward. And temporarily higher inflation in the wake of a negative terms of trade shock is an efficient lubricant for the economy to make the necessary real adjustments.
Paul McCulley
Managing Director
June 16, 2008
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Posted by: Drizzt
on Thursday, June 19th, 2008
June 17, 2008 – June 17 (Bloomberg) — The U.S. economy may be suffering from its first bout of stagflation since the start of this decade, reports on housing prices and manufacturing indicated. Builders broke ground on 975,000 homes at an annual pace in May, the least in 17 years, and construction permits fell, the Commerce Department reported. Meanwhile, the Labor Department said producer prices jumped 1.4 percent, more than economists forecast. A further report from the Federal Reserve showed industrial production unexpectedly dropped 0.2 percent. ……………………………………..
Statistics and more statistics. Meanwhile, we’re searching for a definitive stock market trend, searching for a bottom, searching for anything useful. But you can’t hurry the market, no matter how much you want information, no matter how much you want a resolution, Mr. Market will take his own good time. And if you’re itching to come up with an answer, Mr. Market will be only too happy to drag out the story. And if it seems to take “forever,” so much the better — stew in your impatience, toss in your bed at night, grind your teeth — the market loves it. All your impatience will accomplish is to push you towards making a mistake. It will push you towards doing the wrong thing at the wrong time. Mr. Market loves impatience, he thrives on your impatience.
How about hints, are there any hints? Well, consider this — the two biggest problems we are faced with today are the continuing slump in housing and the continuing troubles of the banks and the financials.
OK, if that’s where the trouble is, let’s look at them. The chart below is the ETF, weekly, for the Homebuilders. When is the home-owners mess and the foreclosure disaster going to bottom out and thereby give us a rest? Not quite yet, it seems.
Studying the weekly chart, we note that XHB recorded its low back on January 9. From there it rallied into early-May, only to decline to its current area around 18. On this latest decline RSI has not dropped back to 30, which could actually be a sign of strength. The histograms are negative and as yet shown no sign of contracting toward zero. The full stochastics at the bottom of the chart are oversold, but have not yet turned up. Conclusion — a little bit hopeful, but no clear bullish signs yet.
The other sick but critically important sector is the Financials. Below we see a weekly chart of XLF, the Financial exchange traded fund. XLF is trading below both its 10-week and its 40-week moving averages. Weekly RSI showed oversold in January and again in March.
Today RSI is at 39 and may be turning up. MACD could also be in the process of turning up. The full stochastics are just above 20, and they too could be in the process of turning up. A battered but interesting picture.
All of Wall Street is watching and waiting to see whether the Financials (banks) have discounted the worst. I’d wait a little while longer. A few of the big banks, JP Morgan, Wells Fargo, look attractive (good dividends to boot, check ‘em out on Big Charts).
The third weekly chart for today is the S&P 500, the standard by which most funds judge themselves. The S&P is currently trading below both its 10-week and 40-week moving averages. RSI is at 46 which is just below neutral. The histograms, after being overbought at 20, have just dropped below zero into negative territory. The full stochastics are heading down from the overbought area.
The S&P may be trying to stabilize here, but I don’t trust it enough to buy. I’d like to see the S&Ps drop to full oversold, and at the same time hold above its March low. Lately, the S&Ps have embarked on a sort of halfhearted, low-volume rally.
Richard Russell
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Posted by: Drizzt
on Wednesday, June 18th, 2008
Renowned value investor Jeremy Grantham knows an investment bubble when he sees one coming, and always steers well clear of the risks - sometimes at great initial cost. At the height of the Internet stock bubble in the 1990s, GMO, the Boston-based institutional money manager he founded, lost about 45 per cent of its funds under management when investors sought out firms with sexier strategies. Of course, his sound analysis and risk assessments were vindicated and his clients eventually were rewarded handsomely.
By 2006, Mr. Grantham, whose firm manages about $145-billion (U.S.), including $2.8-billion from Canadian pension funds and other institutions, was warning of the coming implosion of the global credit market. And he has seen nothing since that cataclysmic event last year to convince him the worst might be over.
You draw comparisons between what’s happening today and the start of the Great Depression.
We’re in that 1929-30 window, where we’ve had a shock to the system. But the secondary effects - less consumption, lower profit margins, lower GDP, lower employment, lower global trade - are beginning to work through the system. They’re steadfastly ignored because they’re still quite slight. It takes a year, 18 months [or] even longer for some of these effects to show up.
So no short, shallow downturn, then?
It’s very hard to torture the economics, to think that you can squeeze liquidity, take a hit to your biggest capital asset, housing, mark it down 15 per cent and then maybe another 15 per cent, in an overleveraged society, without having a sustained negative effect that would last two or three years. Which I’m sure it will.
Yet the stock market doesn’t seem to agree. Investors are treating this as a short-term problem that will soon be fixed.
They [equity players] hate anything negative. And that’s grown along with the moral hazard and the credit crisis. They have almost a pathological aversion to honest, negative opinion, which in itself is a sad state of affairs. But what the market never gets are the long lags.
You have said that by pulling out all the stops to prevent a recession, governments actually end up slowing the economy more in the long run.
I think you can argue logically there has to be some movement of assets into weaker hands, and, therefore, some loss of aggregate efficiency vis-à-vis the rest of the world, and, in all probability, a modest loss of growth rate. That certainly tallies with the data.
If the economy limps along, barely above recession levels, don’t people come to expect this condition to last a long time?
Yes. The real divide comes when the recession is sharp enough to wash away the people who were relatively weak at their game or were caught out taking much too much risk and too much leverage. And the next time, there wouldn’t be those weak sisters. It comes back to the health of the financial system. The whole economy becomes a little less vigorous if it’s constantly propped up this way.
And what do you think finally persuades the equity markets?
The fundamental data. It may not be next month, because people systematically make a mistake on how to treat the weak [U.S.] dollar, which affects the 45-per-cent earnings of the S&P [500] that come from overseas.
Can you give us an example of how profits are being misread?
If the dollar goes down 18 per cent against the euro, then all your profits in Germany are marked up by 18 per cent. Bang, simple as that. Let’s say you have 6-per-cent natural growth and an 18-per-cent markup. You have a 24-per-cent earnings increase from your German subsidiary. The next year, the 6 [per cent] may only have gone down to 4, but the dollar has rallied … and your growth has gone to zero.
You have also been extremely critical of America’s love affair with debt.
The [U.S.] debt-to-GDP ratio went sideways for 50 years and the economy was growing handsomely. Then the debt level tripled in 25 years [since 1982] and the growth rate slowed. So this beautiful faith we have that increasing debt will cure all problems is a complete hoax. Growth is about the level of capital spending and saving, education, technology, R&D and all those good things. It’s not about what I owe you and you owe me.
Let’s move on to a favourite Canadian topic: commodities. Are we looking at a bubble that will go the way of credit or U.S. housing or a real sea change?
It’s not a nice simple bubble of the kind that I love and would like to stake a lot on. And the reason is that in the long run, the paradigm has shifted. Raw materials in a world of China and India and so on will never be quite the same tame things that they were from a price point of view for the previous 50 years. Throwing in speculators who like to invest in commodities to get diversification, and two years of almost perfect global economic conditions have set commodity prices on an incredible roll.
It sounds as if a but is coming.
They may be quite vulnerable on a tactical, short-term basis. If I’m right in my general thesis that we’re underestimating the pain, then they will probably take a fairly sharp short-term hit. But they’ll be back, as Schwarzenegger would be saying.
Are there other opportunities for people who want to stay invested?
There isn’t a healthy risk/return ratio around in the equity markets. What I would personally do is look for the greatest vulnerabilities, under anticipated. I’d be looking to make money either by going short or, at the most aggressive, long short. I’d go long emerging [markets] and long high-quality U.S. stocks, and short the U.S. junky [small-cap] stocks. That can do perfectly fine over the next several years.
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Posted by: Drizzt
on Monday, June 16th, 2008
This is not the first time that i posted an essay by Bill Gross. Why do i post so much article on the man? I admire him for his profound commentaries on the market. Sometimes it gets so profound that i need to reread what he wrote a few times just to get what the heck he is trying to say.
At the same time, it is interesting to listen to what the world’s largest bond fund manager have to say about the current investment climate, and in this article it gets really hard hitting. He lambastes Americans’ priorities with entertainment more then the more important things and more importantly, how they interpret data brought in front of them without any questions asked.
More importantly, inflation is understated in the US. Now inflation to bill gross is an important indicator. A wrong view on inflation moving forward can just fuck him up so badly since, as i have said he manages alot alot alot of bonds, and inflation is bonds’ worse enemy.
So what is his advice as a manager?:
- Treasury bonds are obviously not to be favored because of their negative (unreal) real yields.
- U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well.
- On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates.
- These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible.
- Developing, BRIC-like economies are obvious choices for investment dollars.
By Bill Gross
You can fool some of the people all of the time,
and all of the people some of the time,
but you cannot fool all of the people all of the time.
- Abraham Lincoln
What this country needs is either a good 5¢ cigar or the reincarnation of an Illinois “rail-splitter” willing to tell the American people “what up” – “what really up.” We have for so long now been willing to be entertained rather than informed, that we more or less accept majority opinion, perpetually shaped by ratings obsessed media, at face value. After 12 months of an endless primary campaign barrage, for instance, most of us believe that a candidate’s preacher – Democrat or Republican – should be a significant factor in how we vote. We care more about who’s going to be eliminated from this week’s American Idol than the deteriorating quality of our healthcare system. Alternative energy discussion takes a bleacher’s seat to the latest foibles of Lindsay Lohan or Britney Spears and then we wonder why gas is four bucks a gallon. We care as much as we always have – we just care about the wrong things: entertainment, as opposed to informed choices; trivia vs. hardcore ideological debate.
It’s Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headed for modern day Rome – better educated, harder working, and willing to sacrifice today for a better tomorrow. Can it be any wonder that an estimated 1% of America’s wealth migrates into foreign hands every year? We, as a people, are overweight, poorly educated, overindulged, and imbued with such a sense of self importance on a geopolitical scale, that our allies are dropping like flies. “Yes we can?” Well, if so, then the “we” is the critical element, not the leader that will be chosen in November. Let’s get off the couch and shape up – physically, intellectually, and institutionally – and begin to make some informed choices about our future. Lincoln didn’t say it, but might have agreed, that the worst part about being fooled is fooling yourself, and as a nation, we’ve been doing a pretty good job of that for a long time now.
I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control. I laid out the case three years ago in an Investment Outlook titled, “Haute Con Job.” I wasn’t an inflationary Paul Revere or anything, but I joined others in arguing that our CPI numbers were not reflecting reality at the checkout counter. In the ensuing four years, the debate has been joined by the press and astute authors such as Kevin Phillips whose recent Bad Money is as good a summer read detailing the state of the economy and how we got here as an “informed” American could make.
Let me reacquaint you with the debate about the authenticity of U.S. inflation calculations by presenting two ten-year graphs – one showing the ups and downs of year-over-year price changes for 24 representative foreign countries, and the other, the same time period for the U.S. An observer’s immediate take is that there are glaring differences, first in terms of trend and second in the actual mean or average of the 2 calculations. These representative countries, chosen and graphed by Ed Hyman and ISI, have averaged nearly 7% inflation for the past decade, while the U.S. has measured 2.6%. The most recent 12 months produces that same 7% number for the world but a closer 4% in the U.S.
This, dear reader, looks a mite suspicious. Sure, inflation was legitimately much higher in selected hot spots such as Brazil and Vietnam in the late 90s and the U.S. productivity “miracle” may have helped reduce ours a touch compared to some of the rest, but the U.S. dollar over the same period has declined by 30% against a currency basket of its major competitors which should have had an opposite effect, everything else being equal. I ask you: does it make sense that we have a 3% – 4% lower rate of inflation than the rest of the world? Can economists really explain this with their contorted Phillips curve, output gap, multifactor productivity theorizing in an increasingly globalized “one price fits all” commodity driven global economy? I suspect not. Somebody’s been foolin’, perhaps foolin’ themselves – I don’t know. This isn’t a conspiracy blog and there are too many statisticians and analysts at the Bureau of Labor Statistics (BLS) and Treasury with rapid turnover to even think of it. I’m just concerned that some of the people are being fooled all of the time and that as an investor, an accurate measure of inflation makes a huge difference.
The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.
In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.
In 2004, I claimed that these revised methodologies were understating CPI by perhaps 1% annually and therefore overstating real GDP growth by close to the same amount. Others have actually tracked the CPI that “would have been” based on the good old fashioned way of calculation. The results are not pretty, but are undisclosed here because I cannot verify them. Still, the differences in my 10-year history of global CPI charts are startling, aren’t they? This in spite of a decade of financed-based, securitized, reflationary policies in the U.S. led by the public and private sector and a declining dollar. Hmmmmm?
In addition, Fed policy has for years focused on “core” as opposed to “headline” inflation, a concept actually initiated during the Nixon Administration to offset the sudden impact of OPEC and $12 a barrel oil prices! For a few decades the logic of inflation’s mean reversion drew a fairly tight fit between the two measures, but now in a chart shared frequently with PIMCO’s Investment Committee by Mohamed El-Erian, the divergence is beginning to raise questions as to whether “headline” will ever drop below “core” for a sufficiently long period of time to rebalance the two. Global commodity depletion and a tightening of excess labor as argued in El-Erian’s recent Secular Outlook summary suggest otherwise.
The correct measure of inflation matters in a number of areas, not the least of which are social security payments and wage bargaining adjustments. There is no doubt that an artificially low number favors government and corporations as opposed to ordinary citizens. But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation. And although the Gordon model for the valuation of stocks and real estate would stress “real” as opposed to nominal inflation additive yields, today’s acceptance of an artificially low CPI in the calculation of nominal bond yields in effect means that real yields – including TIPS – are 1% lower than believed. If real yields move higher to compensate, with a constant equity risk premium, then U.S. P/E ratios would move lower. A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.
A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate repricing or the BLS was ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of the world during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to be “entertained” with the notion of artificially low inflation than to be seriously “informed.” But just as many in the global economy are refusing to mimic the American-style fixation with superficialities in favor of hard work and legitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact is closer to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets are increasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?
What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.
Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today’s world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable. Join me in lobbying for change in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook) the market’s assumption of low relative U.S. inflation in comparison to our global competitors.
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