A very special congratulations to the Seven 0 One team on the opening. Davide's done it again, only this time he's focusing on Peruvian, Japanese and Cuban cuisine. The concept came from Valenti's wife, Juany, who is originally from Peru. To read more about the new bistro and what to expect when you dine there, please follow the link to Quentin Roux's article with the Sun Times.
John Osterweis likes to joke that of the stocks in his portfolio, “some gallop, some trot”. The combination has given the Osterweis Fund an impressive average annual return of 16.2% over the last 10 years. That is 4.7% above the S&P 500 -- a $100,000 investment in Osterweis would have returned $152,000 more than a comparable stake in the index. His key metric when evaluating stocks is free cash flow, or cash flow from operations (the first sum on a company’s flow-of-funds page) minus capital spending (which typically appears just below on that page). The owner of a private company wants free cash even more than he wants net income. Free cash gives him the leeway to plow capital into expansion, pay dividends, buy back stock or whittle down debt. For the shareowner of a public company, free cash has the additional virtue of being less subject to accounting trickery than good old net income. As the saying goes: Earnings are an opinion, cash is a fact.
Performance of the $160 million Osterweis Fund has been equally good in up and down markets, getting a solid B grade from Forbes in both categories and winning the fund a spot on our Honor Roll. The fund boasts a commendable meshing of reasonable expenses (no sales load, $1.36 per $100 of assets in fees) and great risk-adjusted returns. The fund is a fairly concentrated portfolio with only 30 stocks, and it does not turn over much -- 58% annually compared with the average stock fund’s 117%. This minimizes the trading commissions and potential tax burdens to fund shareholders. Size is not a criterion: Companies in the portfolio range in market capitalization from $625 million to $180 billion.
Like other value managers, Osterweis screens for the usual suspects when seeking out beaten-down nuggets: a price low in relation to earnings and/or book value. The prospect of accelerating growth once any problems, perceived or real, are corrected, is a factor. Osterweis’s portfolio averages 15 times trailing free cash flow vs. 38 for the S&P 400. If an outfit is younger, Osterweis will attempt to segregate the capital spending into two parts, one for maintenance, the other for expansion. He subtracts only the maintenance cap-ex in his free cash flow calculation. Thus free cash flows for Laidlaw International, the old-line bus transportation company, and Vodafone, the youngish cellular company, are calculated differently. But their price/free cash multiples are the same at 13. “Vodafone shouldn’t be penalized for putting a higher amount of free cash into the growth of its business than Laidlaw,” reasons Osterweis.
Borrowing short and lending long must be the second most lucrative industry in America, right behind printing currency. A banker borrows short when he issues a 30-day certificate of deposit. He lends long when he writes a multiyear auto loan. Thrifts, mortgage REITs, hedge funds, finance companies and the federally sponsored mortgage behemoths all engage in this ancient gambit. Why wouldn’t they? Short-term interest rates remain well below long-term rates. But the gulf between the two is closing, and therein lies the trouble. A year ago the short-term borrowing rate was 1%, while today it is 2.5%. A year ago the 5-year Treasury yield was 3.12%, and today it is 3.78%. A year ago there were 2.12 percentage points of daylight between the cost of an overnight loan and the yield on a 5-year investment; today there is only 1.28. The less daylight, the less profitable are the banking business and allied financial trades. Following is a speculation on who is at risk, and why.
“Yield curve” is the term to describe the alignment of interest rates over time. The most crowd-pleasing alignment is that of short rates set comfortably below long rates (the curve is “positively sloped”). The least favorite is that of short rates higher than long rates (the curve is “inverted”). Also undesirable: short rates approximating long rates (the curve is “flat”). A flat or inverted curve stymies the business of lending and borrowing. It is ice on the wings of the U.S. financial economy. Today, you would not suppose there is anything wrong -- what is wrong is the direction of change. The Federal Reserve is pushing up the funds rate while the market is pushing down rates on longer-dated fixed-income investments -- treasurys, corporates, and mortgages. Mortgages present a particular problem. When interest rates get low enough, homeowners refinance.
Will the yield curve continue to flatten? The Fed has given no sign it intends to pull back from its campaign to restore the funds rate to something like 3.5% or 4%. And the yield pigs have given no sign that they intend to refrain from gulping down any and every piece of paper on offer. Inflation or credit difficulties -- or both -- should eventually push long-dated yields up. And if they take off sooner rather than later, the curve may regain its former positive slope. “If” is the operative word. We are dealing with probabilities and risks. In an economy as leveraged as this one, the risk of a flat or inverted curve commands our respect. A flat curve would likely flatten, among others, mortgage investors.
George Orwell’s novel about a totalitarian society, 1984, was published 56 years ago but still resonates with anybody familiar with American business today. Maybe we do not have an omnipotent Big Brother and his Thought Police watching our every move. But one of the dictator’s skewed aphorisms sounds familiar: “Ignorance is strength”. In the world of 1984, holding a minority opinion, no matter how sensible, is considered insane and subversive. Individualistic thinking is outlawed. Today groupthink is pervasive in society. Groupthink is also found within the ranks of business itself, where it restricts risk-taking and imagination. Independent thought as a theory is relatively easy to embrace, but practicing it is another matter. Winston Churchill, an Orwell contemporary, once said, “Kites rise highest against the wind, not with it.”
The following companies all embrace original thinking. By no coincidence they each have thoughtful, nonexecutive chairmen who are involved in corporate strategy and are the antithesis of rubber stamps. As a result these gems stand out from the competition and are well-positioned for the future.
Investors know than Russia has an insidious way of creating heady hope followed by letdown, and 2004 did not do much to change their opinions. Between January and April of last year the main exchange, the Russian Trading System, climbed 30%, but has since fallen almost all the way back. It all seems to track the general disappointment with Vladimir Putin’s moves in the Yukos affair -- the Kremlin seized the private oil company’s main production arm in a purported tax collection effort -- and his increasing distance from liberal economic advisers. Depressing.
But the miasma can obscure opportunity. In addition to oil prices there is other good news for Russia, including productivity improvements at large enterprises and a booming construction market. Oil production should continue to grow. At just 7 times estimated 2005 earnings, corporate Russia has one of the lowest stock price multiples in the developing world. How to prosper there? Ask the money men at Prosperity Capital Management in Moscow, a boutique firm with $500 million, mostly in Swedish and U.S. institutional assets. Its flagship Russian Prosperity Fund, now with $220 million under management, was started in 1996 and has 70% in what pass for Russian blue chips.
The chief investment officer, Alexander Branis, 27, and his all-Russian staff use an orthodox value approach and strike an activist attitude toward their investments. Prosperity managers serve on the boards of many of these companies, and when their rights as shareholders are being violated, they have taken oligarch-controlled firms to court. “It’s important to try to sue,” says Branis. The firm’s stance might seem quixotic. Even casual observers have heard tales of assets being stolen outright. Prosperity, though, has had some clear victories. Says Prosperity’s Ivan Mazalov, 32, with some pride, “We’ve been such a nuisance.”
Some economists reckon the simmering debate within the Fed on whether to define, target and publicize a desired range for inflation may be one factor capping long rates over the past six months despite solid growth and several Fed rate rises. Alan Greenspan is a long-time opponent of committing the Fed to an explicit inflation target, favoring greater flexibility and discretion in monetary policy to cope with shocks to the system. So some say it is no surprise he skirted this as a possible factor in the bond puzzle. But with his 18-year tenure the central bank’s helm due to come to a close next year, speculation is bubbling on whether advocates of inflation targets will hold sway when he goes.
Investors believe adopting a target, as several leading central banks around the world have done over the past 10 years, makes long-term debt more attractive by anchoring inflation expectations and reducing the risk premium. Evidence from countries with targets tends to back this up, showing the U.S. pays a price for the existing Fed model in long-term interest rate volatility.
Jim O’Neill, Chief Global Economist at Goldman Sachs, said he wondered if the recent drop in long rates at least partly reflects a belief the Fed is “close to adopting an inflation target, or at least as close as the Constitution will allow. If so, then it is quite likely the long end will continue to perform. If you look at other nations that introduced inflation targeting, there was a big drop in risk premia.” Paul McCulley, managing director and portfolio manager at the giant bond fund PIMCO, said inflation targeting speculation would not fully explain the bond yield drop, he expects the Fed to adopt a target eventually. “Once Greenspan leaves, I think they’ll move to an inflation objective -- I don’t think they’ll call it a target,” he said. “The only reason that they haven’t done it is because Greenspan hasn’t wanted to do it. For me, the theoretical case is so overwhelming it really doesn’t need any debate now.”
Investors who look overseas to reduce the risks of holding stocks can find support in a new study. Contrary to recent objections that this strategy does not work well, if it works at all, the research has found that global portfolios have been significantly less risky over the long run than ones containing domestic stocks alone. Until the late 1990’s, many people in academia and on Wall Street said international diversification provided a free lunch. In theory, at least, a portfolio holding both domestic and foreign stocks would perform just as well over time as one containing only domestic ones, but with less risk -- when risk is defined as volatility of returns.
The key to this idea was the historically low correlation between domestic and international stocks -- in other words, their tendency not to move in tandem. Thus, a portfolio with both kinds of stocks would be less volatile than one with domestic stocks alone. But in the late 1990’s, a number of researchers found that the correlations were not constant through the market cycle. As a result, they said, the risk-reducing potential of such diversification was exaggerated. The new study, however, says international stocks do a poor job of reducing risk only when an investor focuses on short holding periods. Over the long term, they deliver precisely what theory says they should.
The study’s conclusions do not apply only to American investors. The researchers also studied stock markets in Japan, Germany, France and Britain, again contrasting investors with short- and long-term perspectives. In each case, global diversification provided few short-term benefits for an investor, but big gains over longer periods. The study did not address the argument that international diversification is no longer important because so many companies are multinational. But one of the study authors says this objection is overblown. Even if the free lunch of international diversification may not be as big, he said, “it’s still a free lunch, so why not eat it?”
While short, sharp market plunges are painful, the new study notes that long, drawn-out bear markets are “significantly more damaging” to investor wealth. “Global diversification”, they add, “does an exceptionally good job of protecting investors from these kinds of risks.”
With a slight change in lyrics, the perfect theme song for Baby Boomers -- who have illusions about being able to retire -- could be called Hotel Debt California, with the closing lyrics ... “you can buy any time you like, but you can never own”. In the new “Ownership Society” that our government is marketing, black is called white and freedom is clearly defined as freedom from real choice. Indeed, given the way ownership operates in practice, George Orwell would feel right at home in today’s world. Why have Americans chosen to accumulate so much debt? Why have lenders and the Federal Reserve made it so easy to go into debt?
Consumers are paying so much for real estate these days that the thought of actually paying off their mortgage, and owning the home outright, is almost jokingly surreal. Americans are headed into Debt Slavery, one credit card and one house at a time. To make sure they get there, Congress is rushing though a major reform of the Federal Bankruptcy Law. Since banks have been posting record profits, one must wonder why there is such a rush to prevent the little guy from getting a “clean slate” in Chapter 7. Even though the banks know how to price risk, and charge double-digit interest rates, they are livid when people who fall on hard times can get away with not paying them back with interest.
Congress seems determined to make sure that individuals enter the world of Debt Slavery and want the courts to be the collection agency. Bankruptcy reform means many a poor soul will be hounded for years through a Chapter 13 filing, instead of being given a fresh start in a Chapter 7 filing. Debt Slavery is a cornerstone of the Ownership Society. Why? Because now the bank owns you! Surprisingly, these new bankruptcy laws will still allow corporations to stiff their creditors.
Do not get me wrong. I hate socialism and love freedom. In a socialist country, the government owns everything and everyone is a slave. In our society, you do not have to borrow but we do because it is so easy and seductive. Under capitalism, Debt Slavery is purely voluntary. Our fear is that the average American does not truly understand the extent to which he is in hock, or how much the federal government may need to rely on us in the future for today’s deficits because our country owes so much to foreign creditors.
Stung by two days of defeat for their bids to revise a bill overhauling the bankruptcy laws, Senate Democrats are portraying the measure as making it harder for low-income, elderly and sick people to dissolve their debts while allowing the wealthy to shelter assets. The Democrats maintained a rhetorical accent on what they see as the inequity of the bankruptcy legislation. The Republicans, who hold the majority, maintained tight discipline.
Mostly along party lines, the Senate voted 59-40 to reject a Democratic amendment that would have allowed older people to get special homestead exemptions to keep their homes when they file for bankruptcy. Currently, such exemptions are determined by the states. Also rebuffed, 58-39, were two proposals focused on people whose significant medical expenses for illness force them to file for bankruptcy. By another 59-40 tally, the Senate defeated a Democratic proposal to require that credit card statements show how long it would take the consumer to pay off his or her debt by making only the minimum monthly payment, and what the total interest charges would be.
The bankruptcy overhaul bill would raise the threshold for dissolving credit card and other consumer debts in bankruptcy court. Supporters are predicting a swift victory after nearly eight years of congressional gridlock and feverish lobbying by banks and other credit-card issuers. The new “means” test in the legislation is intended to determine whether those seeking bankruptcy protection must repay their debts or are allowed to have them canceled. Under the current system, bankruptcy judges have the discretion to decide that.
Getting experience seems to be all about learning how to deal with your emotions when trading. Once you get emotional, your objectivity decreases dramatically. If it were not for that impediment, normally intelligent people would make money continually via trading. Obviously, that is not the case. Beating the market requires a transcendence of emotional involvement. That is not to say you must deny your emotions. Quite the opposite. You must yank them out of your unconscious and view them in the cold light of reason. Then you can devise ways to deal with them.
The first step is to try to invert your emotions. Do not use a market rise as a reason to buy and a drop as a reason to sell. Take each move as a potential opportunity to do the opposite. That way, you are more attuned to buying low and selling high, which is the opposite of what everyone else does. Eventually, it will become a habit. While this change will not solve the investment problem, it deters you from making the worst mistakes. Paper trading is useful for testing methodology, but it omits the emotional factor, which is precisely the obstacle that one must overcome to be successful. In fact, it can be detrimental by imbuing the novice with a false sense of security. The best way to develop an optimal state of mind for trading is to fail a few times first and understand why it happened. When you start, you are better off speculating with small amounts of real money.
You need the mental fortitude to accept the fact that losses are part of the game. My observation, after 30 years in the business, is that most people’s biggest obstacle to successful speculation is a failure even to recognize and accept this simple fact. Expecting, or hoping for, perfection is a guarantee of failure. Speculation is akin to developing a batting average in baseball. A player hitting .300 is good. A player hitting .400 is great. But even the great player fails to hit successfully 60% of the time! In the markets, you “merely” have to be better than almost everybody else, and that is hard enough.
The coping part should come before the loss. If you take a position large enough to inflict serious financial damage upon yourself, you are a loser going out of the gate. You should determine an appropriate amount of risk in advance. It is important to be honest with yourself. Most people cope with losses by lying to others and sometimes even to themselves. If you cannot be honest, you are probably not handling losses well. Leverage is also crucial to manage. Most people commit too much each time to futures or options and eventually get killed. After all is said and done, learning to take and handle losses will be your greatest triumph.
Within six months last year, Carlos and Betti Lidsky bought and sold two Florida condominiums. Then they bought and sold two houses. They say they will clear $500,000 in profit, and none of the homes have even been built. Now Mr. Lidsky, a lawyer, and his wife, a charity fund-raiser, have put down a deposit on a fifth property, a $1.3 million condo in a high-rise under construction, and are planning to sell before the deal closes, without even taking out a mortgage. “It is much better than the stock market,” Mr. Lidsky said. “This is an extraordinary, phenomenally good result.”
In several metropolitan areas, from Miami to Riverside, California, where the real estate market is white hot, rapidly rising prices are luring a growing number of ordinary people into buying and selling residences they do not intend to occupy, despite warnings from some economists that prices cannot continue to rise as steeply as they have in the last few years. According to LoanPerformance, a mortgage data firm, about 8.5% of mortgages nationwide in the first 11 months of last year were taken out by people who did not plan to live in the houses themselves, up from 5.8% in 2000. In some markets, that proportion is much higher: in Phoenix, more than 12% of mortgages were taken out by investors; in Miami, the figure is 11%. The National Association of Realtors, a trade organization that represents real estate brokers, said that the percentage of homes bought for investment might be as high as one-quarter of the 7.7 million sold last year. “Americans are treating real estate as a viable alternative to stocks and bonds,” said David Lereah, chief economist at the Realtors association. And some are buying at least two properties at a time.
Like the day traders of the 1990’s dot-com boom, people are investing in a market that seems to just go up. Promoters use Web sites to attract investors, promising quick profits. One site, getpreconstructionprofits.com, is run by a pair of investors who offer online training for $197. On their home page, they say people can earn over $100,000 in six months investing in unbuilt real estate. Some economists say the influx of investors into the real estate market could have negative consequences. For now, low interest rates are helping to fuel the frenzy. Sometimes, homeowners borrow equity from their primary residence to finance down payments. These buyers, some of whom lost money when the stock market crashed five years ago, believe real estate is a safer bet.
Taxes can take a sizable part of the profits in these deals. Investors who sell within a year of purchase face federal short-term capital gains taxes of up to 35%, and 15% if they wait a year. Still, investors have been seduced by the steady upward march of house prices over the past few years. Since 2000, the national median price of a house has increased by 33%. Demand for investment properties has risen in markets with the most spectacular price increases, according to brokers. Even in Manhattan, where average sales prices topped $1 million last year, investors are piling into the market, brokers say.
Your editor sojourned to South Beach last week to participate in a private annual meeting of hedge fund managers, most of whom specialize in short-selling. Unfortunately, the host of this select gathering insists that “whatever happens in South Beach, stays in South Beach” ... or something like that. In other words, your editor is not at liberty to discuss any investment ideas from the meeting. But suffice to say that the professional investors in attendance continue to be unnerved by many of the same anxieties that trouble non-professional investors: Will the dollar’s weakness continue? Will higher energy prices begin to squeeze businesses and consumers? Will rising interest rates rattle the housing market? On the final question, fortunately, a South Beach cab driver provided a definitive answer...
“Real estate ALWAYS goes up,” the cabbie explained, without the slightest trace of sarcasm in his voice, “You can’t lose with real estate. It always goes up,” he emphasized a second time. “Ummm ... really? Does it really always go up?” your editor replied politely. “Here in South Beach, yes, you can’t lose,” the cabbie insisted. “Every year it’s up, up, up.”
After arriving at my acquaintance’s condo, 20 floors above the beach below, your editor found himself listening to another disconcerting real estate story. It seems that this particular oceanfront condominium complex includes a handful of deeded beach cabanas, each of which is no bigger than a small walk-in closet. One of these beachfront closets recently changed hands for $850,000. “It’s absolutely amazing,” the source of this anecdote gaped. “Almost a million bucks for a tiny little cabana on the beach. Things are getting pretty crazy down here.” But even while beach cabanas in South Beach are selling swiftly at ever-higher prices, spiffy new houses throughout the rest of the land have begun to sell slowly, at ever-lower prices. ...
Sales of second homes soared last year and accounted for more than a third of all residential sales transactions, according to a study released yesterday. The study, conducted by the National Association of Realtors, showed that nearly one in four U.S. homes bought in 2004 was purchased for investment purposes; 13% were bought as vacation homes. Together, that constituted the surging second-home market, which accounted for 36% of the 7.7 million homes sold in the country last year. Second-home sales were up 16.3% over 2003.
Real estate speculators are buying at a pace that far exceeds previous estimates of their influence on the housing market, according to a first-of-its kind report the National Association of Realtors released this week. Collectively, investors and second-home buyers bought more than one of every three homes sold in last year’s record market, the report said. “I am astonished,” said David Lereah, the association’s chief economist. He said the data suggest a sea change in the role of real estate in the nation’s economy. “What we’re seeing is that real estate is no longer just a place to live. It’s a viable alternative to stocks and bonds,” Lereah said. “Sept. 11 changed real estate forever, the way people look at it. They’re nervous about stocks and bonds and they’re placing money in real estate, which has proven to be a stable and wealth-building asset.”
The report, based on two surveys, found that investors accounted for 23% of the nation’s 2004 home sale transactions and second-home buyers made an additional 13% of all sales transactions. Previous estimates gleaned from other databases had suggested that 8.5% of all 2004 sales transactions were investments. The report said that sales activity surged last year. Investor activity was 14% higher than in 2003, and second-home purchases topped the preceding year by nearly 20%. Federal Reserve officials and other economists have expressed concern that scorching-hot investor activity in certain markets may be inflating home-appreciation rates artificially.
Fiserv CSW, a Cambridge, Mass., firm that tracks price appreciation, calculates that national home values, adjusted for inflation, have appreciated about 40% since 1995, and some metro areas, such as San Diego, are up as much as 160%. “If you go back to the ‘80s, during that cycle, adjusted for inflation, price appreciation was 18%. In the prior boom in the 1970s it was 15%,” explained David Stiff, an analyst for the firm. “It’s kind of alarming,” he said. “I presume investor activity is concentrated in some metropolitan areas, such as southern California, Florida, Las Vegas and Phoenix. But even I am surprised that it’s that high. It’s at the end of a housing cycle that you start to see people investing irrationally.” He singled out increasingly widespread reports about homeowners cashing out equity in their principal residences to invest in properties around the country. “If anything is a sign of a price bubble, that is it.”
Real estate may be Generation X’s pension plan. Nearly one in four home sales last year were to investors, the National Association of Realtors reported this week. Some of these transactions reflect a new breed of buyers -- 20- to 30-somethings seeking their fortunes through smart property investments. While people of all ages see real estate as a solid investment, interest is very intense in the Milwaukee area among younger buyers, many of whom live in the houses they buy as they fix them up for eventual resale.
“To afford the things we want in life, we can’t invest in the stock market, can’t expect our company’s 401(k) will make it for us,” said Brett McPherson, a 30- year-old realty sales associate. “So we’re doing it ourselves.” “Real estate makes sense. You know exactly where your dollars are, and it’s not a matter of fluctuating value,” he added.
Even I did not know HOW crazy things were in the housing market until I looked at the chart which came across my desk. This chart shows a rare but unmistakable pattern in the S&P Homebuilding Index. It is a weekly chart going back more than ten years; this long-term perspective lends that much more credence to what the pattern means. I chose the words “rare and unmistakable” carefully, because this pattern appears in markets where a mania psychology has taken over. It showed up centuries ago in the price charts of the Tulip Mania and the South Sea Bubble. In more recent times it was clearly visible when gold went to $850 in 1979, and in the run-up of the NASDAQ bubble that burst in 2000.
All this and more is true of the housing market in recent months and weeks. Yet I cannot emphasize the “look” of this pattern strongly enough. It puts the housing market in perspective as nothing else can.
Financial markets are abuzz about the possibility of yet another spurt of U.S.-centric global economic growth. Irrespective of the current account deficit and external debt implications of this outcome, America’s growth dynamic is the magic to which the rest of a growth-starved world has become addicted. In the minds of investors and policymakers alike, there’s no breaking this habit for the conceivable future.
Yet history cautions us against taking world economic leadership for granted. Look back no further than the late 1980s: America was widely thought to be “over”, and Japan and Germany -- the two defeated great powers of World War II -- were viewed as on the ascendancy to the pinnacle of global economic leadership. U.S. companies were introducing Japanese-like quality circles into corporate cultures, and Germany’s unique style of worker-owner co-determination (“Mitbestimmung”) was viewed as the new wave of corporate governance practices for the future. Oh, how the once mighty have since fallen.
The long history of global economic leadership is replete with countless other examples of the demise of the powerful -- a pattern well documented and analyzed by Yale historian Paul Kennedy (see The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500 to 2000, 1987). Starting 500 years ago with a world dominated by Ming China, the Ottoman Empire, India’s Mogul Empire, Moscovy, Tokugawa Japan, and the great nation-states of western Europe, Kennedy posits a simple but elegant thesis as to why these and the other strains of global leadership that were to follow were destined to fail. In almost all these cases, he argues, the global projection of military power ultimately outstripped the nation’s domestic economic base. Countless other examples in history fit this script to a tee -- from the Hapsburg Empire and Napoleonic France to the Spanish and British Empires and Imperial Prussia-Germany. Remember the Soviet Union?
Kennedy’s book was quite the rage when it was first published in 1987. The U.S. stock market crashed late that year, conjuring up dark memories of the 1930s. Ironically, of course, it was communism that was first to topple -- a power failure right out of the mold of Paul Kennedy. Conceptualists often tend to be early in anticipating actual events. I hear that constantly from my own sympathizers. “Hang in there,” they urge me, “one of these days U.S. deficits and global imbalances will matter.” In retrospect, Kennedy’s timing was terrible: Far from “over”, America was, in fact, entering a new era of supremacy. But was Kennedy simply wrong or just early in applying his historical framework to the US experience?
In my view, the key is the wherewithal of any nation to fund its leadership role. Two factors will ultimately be decisive in that regard: national saving and productivity growth. On both counts, there are grounds for concern -- the U.S. is either in trouble right now (saving) or possibly headed for a rude awakening (productivity).
I strongly suspect that a test is looming for America’s global leadership. On the surface, this leadership seems secure -- especially now, as a lopsided world economy salivates over the possibility of another spurt of U.S.-centric growth. Yet Paul Kennedy’s historical perspective urges caution in presuming that little can disturb Pax Americana. An unprecedented shortfall of national saving is a clear warning of an unsustainable economic leadership model, in my view. As are the responses to this saving shortfall -- freely available foreign funding, artificially depressed real interest rates, and a profusion of asset bubbles that have given rise to asset-dependent saving and consumption behavior.
In the end, globalization is about the diffusion of economic power -- and the technologies, worker skills, and capital that underpin such power. Courtesy of the Internet, that process of diffusion now occurs at hyper-speed. The emergence of the Chinas and Indias of the world, to say nothing of the urgency for the once mighty (i.e., Germany and Japan) to regain their economic prowess, speaks more to global convergence than to hegemonic dominance of one superpower. With U.S. economic leadership on an increasingly shaky foundation, don’t be surprised at yet another swing of the ever-fickle pendulum of global leadership. History teaches us that has long been the rule -- not the exception.
“Below the favorable surface [of the economy], there are as dangerous and intractable circumstances as I can remember. ... Nothing in our experience is comparable ... But no one is willing to understand [this] and do anything about it. ... We are consuming ... about six per cent more than we are producing. What holds the world together is a massive flow of capital from abroad ... it’s what feeds our consumption binge ... the United States economy is growing on the savings of the poor ... A big adjustment will inevitably become necessary, long before the social security surpluses disappear and the deficit explodes. ... We are skating on increasingly thin ice.” ~~ Paul Volcker, Former Federal Reserve Chairman
“Last orders” is the cry one usually hears at closing time in an English pub. The beer spigots are turned off and the party’s over. One had a similar sense of finality for the U.S. dollar last week following the announcement that the Korean central bank, which has some $200 billion in reserves, would “diversify the currencies in which it invests”. The dollar fell sharply and the U.S. market (although subsequently recovering) recorded its largest one-day fall in almost 2 years. No doubt under considerable pressure from Washington, the Bank of Korea’s position was “clarified” within 24 hours. A BOK spokesman iterated that its desire to diversify its foreign exchange reserves was not new and did not mean it would sell the U.S. currency. The ever accommodating Tokyo mandarins were also wheeled in.
But first impressions are often very telling and probably more indicative of the BOK’s true feelings, coming as they did on the heels of warnings by the IMF’s Managing Director, Rodrigo Rato, who urged the U.S. to implement a credible set of policies to reduce its need for external financing before it exhausts the world’s central banks’ willingness to keep adding to their dollar reserves. That the mere threat of an Asian central bank diversifying its reserves out of U.S. dollars temporarily sent both the U.S. currency and stock market tumbling last week is truly indicative of the fragile state of the current financial system.
The Bank of Korea, like every other major Asian central bank, faces the awful dilemma that confronts any large holder of an asset that is declining in value. They would like to diversify their reserves into other assets. To do so they, have to sell dollars and buy, for example, more euros. But if they do that (and telegraph their intentions in advance), they risk pushing the dollar over the cliff, causing a huge loss in value of their remaining dollar reserves. Financial instability would likely ensue, which explains why the Koreans beat a hasty retreat. In spite of the spin doctoring, there is mounting evidence to suggest that the Asian central banks have already begun to lose confidence in the Federal Reserve’s ability to rein in U.S. financial and economic excess and are quietly acting accordingly.
One could make the case that the dire economic circumstances of the Great Depression or the stagflationary 1970s made the exceptional actions taken by FDR or Richard Nixon one-off generational events unlikely to be repeated in more “normalized” times today. But as Paul Volcker recognized, there is nothing normal about the current economic environment, in spite of Mr. Greenspan’s protestations to the contrary. If anything, the problems today may be even more severe.
On current trends, America has embarked on a trend which will exhaust Asia’s central banks’ abilities to hold increasing amounts of U.S. dollars; its recourse to military (as opposed to economic) suasion, may simply make the problems worse. From Asia’s perspective, the Bank of Korea’s threat last week to reduce the share of dollars in its portfolio might simply represent the first of many “cries de coeur” from that part of the world that enough is enough. It may well be the case, therefore, that “last orders” are truly in for the U.S. dollar.
Asia’s economies are rolling the dice with an enterprise that may alter the complexion of the global financial system, affecting powerful central bankers like Alan Greenspan on the other side of the world. It is called “The Asian Bellagio Group”, a name that is borrowed from the European Bellagio Group, a gathering of academics started in the 1960s. Asia’s group includes officials from Japan, China, South Korea and Southeast Asian nations who met in Bangkok last week to discuss the dollar’s slide. The group is a formidable crowd, considering it holds well over $1.1 trillion of U.S. Treasuries.
In fact, if Federal Reserve Chairman Greenspan is wondering why his recent rate increases are not working out as planned, he need only look to the East. Greenspan recently referred to a “conundrum”, whereby U.S. Treasury yields fell in the face of rising official rates. Yet trends here explain why: Asia’s vast purchases of U.S. Treasuries, which reduce U.S. yields, are rendering the mighty Fed impotent in its efforts to cool the economy. These days, markets react more to rumors about Asian central banks selling U.S. debt than what Greenspan says about the economy. One could argue that his comments about low yields were the bond market’s “irrational exuberance” moment. In December 1996, Greenspan’s concerns about overvalued stocks caused shockwaves. Not so when he mentioned low debt yields. Yet when Korea, the world’s 4th-biggest holder of reserves, last week suggested it might diversify into other currencies, markets plunged. When the Bank of Korea said it would hold onto its dollars, markets returned to normal, satisfied that the mighty U.S. had again prevailed over compliant Asian economies.
When the “Asian Monetary Fund” was proposed in 1997, the idea was quickly quashed by the U.S., which feared it would reduce the influence of the International Monetary Fund. Since that would have meant less clout for the U.S. in Asia, then-Treasury Secretaries Robert Rubin and Lawrence Summers would not hear of it. Well, the idea has come full circle. Asia is getting fed up with its reliance on the dollar. Besides, economies here are becoming more and more exposed to Chinese demand, and less so to those of U.S. consumers. Asia’s leaders also have misgivings about their lack of clout in western circles. And so, Asia now seems ready to create such an institution to serve its interests.
What does that mean for Greenspan? For now, Asia’s central banks are making the Fed’s life difficult as it tries to slow U.S. growth. Yet there are two ways in which Asia’s efforts at monetary cooperation could complicate things even more for the Fed. One, massive sales by monetary authorities there could cause chaos in the U.S. economy as the dollar plunges and Treasury yields surge. Two, Asian cooperation could keep the current global system in place, hampering the Fed’s efforts to cap U.S. inflation.
It is increasingly dawning on Asian consumers that their governments are funding the U.S.’s way of life. Capital flowing from East to West reduces incentives for the U.S. to tackle its worsening current account and budget deficits. The previously symbiotic relationship between the U.S. and Asia is looking more like unhealthy and unsustainable co-dependence. Asia feeds its addiction to export-led growth by feeding the U.S.’s addiction to importing capital to finance its economy, and vice versa. Now, Asian leaders are concerned they are getting the short end of the arrangement, and they should be. While last week’s meeting of the Asian Bellagio Group did not mark a coordinated effort to abandon the dollar, it may prove to be a watershed event for a region looking to stand alone.
Today was a “three-strike” day for European markets. First, German unemployment hit a new 12.6% high. 5.2 million Germans are now out of work -- the biggest unemployment number in 73 years. “The psychological effect of this unemployment figure is absolutely catastrophic,” said one analyst today (Bloomberg). Strike one. Then a panel of German government economic advisers, known as the “Five Wise Men”, lowered their forecast for Germany, saying that the “the biggest economy in the 12-country eurozone is unlikely to grow by more than 1 percent this year” (Deutsche Welle). Strike two. And then the Brussels-based EU government reported a “significant fall in business and consumer confidence” across the EU in February -- especially in Germany, Spain and Italy. “The gloomy picture is due to the business and consumer pessimism over the present and forthcoming economic situation in Europe.” (Euobserver.com). Strike three.
If someone asked you which way you thought European stocks had moved after hearing this news, what would you say? A logical answer would be, “down”, but you already know the correct answer. This triple-whammy of bad news had the opposite effect. The German DAX dipped at the open, but quickly recovered and ended the day 33 points higher. “Inexplicably”, all other major European bourses closed higher, too. “Inexplicably”, that is, because conventional economic theory has no real explanation for today’s market action.
Pop! That is the sound of the real estate bubble bursting. And it’s a good thing. It is obvious to me that today’s real estate prices are a speculative bubble that is bound to burst. Of course, this has been obvious to me for about three decades and wrong almost all of that time. Nevertheless. One piece of evidence is the Dinner Party Index. The boom is over when more people are bored by real estate anecdotes (“My next-door neighbor got three times her asking price before she even put it on the market, from a professional mind reader who divined that she was thinking about selling. ...”) than have new ones.
Another reason the value of your house is about to plunge is that the Los Angeles Times, the New York Times and The Washington Post all say that it is not. A recent L.A. Times article reported that the median price of a local house had gone up only 17% in the past year. Headline: “L.A. County Home Prices Cool Slightly”. Subhead: “Slowdown may not last”. To describe a 17% annual increase as a “slowdown” assumes that annual gains of 20% or more are the norm. And the evidence for “may not last” is quotes from real estate agents whistling in the dark.
You have got a bubble when today’s prices assume large future increases. If you think prices will be 20% higher in a year, you will be willing to pay 19% more today. But if others share that belief, today’s price will already be 19% higher. Betting on appreciation makes sense only if you are even more optimistic than other buyers. That is hard to be right now. In Washington, where house prices have doubled in five years, The Post says, “Experts Predict Steady Gains in 2005, but More Moderate Than in Past Years”. But whatever “experts” say, it is not the nature of price explosions to segue gracefully into more moderate growth. When today’s run-ups are based on beliefs about tomorrow’s run-ups, the self-feeding frenzy goes into reverse when those assumptions are dashed.
The New York Times also must be talking to experts. “Even the ongoing problem of a lack of houses for sale in Westchester eased somewhat last year,” an article informs us. Like a roller coaster, a financial bubble has a moment of eerie stillness at the top. Buyers have adjusted, sellers have not. So sales dry up. When the Times spins a surplus of unsold houses as a sign that “the ongoing problem of a lack of houses for sale” has been solved, it means that you had better not count on the Times to tell you when it is time to bail.
Let us step back a moment. All the housing in the U.S. is worth about $14 trillion. If the value of existing housing goes up 7% this year -- the recent national average -- homeowners will seem to be about a trillion dollars richer. These are the same houses, in the same place. That trillion dollars comes partly from non-homeowners, who must pay more to buy in. And it is partly illusory. If many current homeowners tried to cash in, the drop in prices would quickly wipe out that trillion.
“It’s totally different in the real estate market than it is in the stock market.” ~~ Thomas Kuntz, CEO, Century 21, February 25, 2005
To the seasoned investor, four of the most dangerous words in the English language are “It’s different this time.’ Five years ago, this country experienced the mania to end all manias for anything tech-related. Today it seems the public has merely shifted to all things credit-related.
Manias share four common characteristics: 1.) A feeding frenzy sends prices parabolic. In March, 2000 the Nasdaq Composite briefly touched 5000, up 44% per year over a 5-year period. Homebuilding stocks today are up 46% annually in five years. The median price of a home is up 8.2% per year over the same period. Adjusted for 5-to-1 leverage on a typical mortgage, the humble abode has appreciated 41% annually. 2.) The public jumps in with both feet. During the late 1990s, stock ownership climbed to roughly 50% of households. Today “home ownership” has passed 70%, a record. 3.) Valuations detach from economic reality. In 2000 many tech stocks traded for over 50 times earnings. Today, in some of the hotter markets such as Southern California, home prices command as much as 50 times their rental incomes. 4.) Rationalizations abound for why valuations are reasonable and the trend will continue. Talk of a “New Economy” has been replaced by the politically-sanctioned euphemism “Ownership Society”. Then, as now, favorable demographics and an accommodative Fed were expected to keep the party going.
Admittedly, there are differences. In 2000 Wall Street underwriters raised equity for marginal businesses; today they raise debt for marginal consumers. Five years ago the federal government enjoyed a surplus; today deficits run as far as the eye can see. In 2000, the dollar was strong, inflation dead, and commodities weak. In the five years since, the U.S. Dollar Index dropped 22%, money supply (M3) grew 44%, and the CRB Index gained 40%.
One question keeps nagging us. Manias are rare occurrences, gracing us with their presence every 30 or 40 years. How can a crowd delude itself twice in just five years? Perhaps at least part of the answer is that there are actually two crowds at work. The tech mania, it seems, was primarily driven by testosterone -- Ferrari driving CEOs of dot-com and Silicon Valley startups, napkin-scribbling venture capitalists, master of the universe investment bankers, and hyperactive day traders. The present day mania appears to have more balance, with women playing a greater role. Men are more prone to think in terms of abstractions and do things like chase technology stocks into the stratosphere, while a house is tangible and appeals to both sexes.
Current federal budget policy is “unsustainable” and Congress must cut the deficit and shore up funding for Social Security and other benefit programs, Federal Reserve Chairman Alan Greenspan said. “I feel that we may have already committed more physical resources to the baby-boom generation in its retirement years than our economy has the capacity to deliver,” Greenspan said in the text of prepared remarks to the House Budget Committee. “If existing promises need to be changed, those changes should be made sooner rather than later.” The Fed chairman made only brief reference to the economy in the text of his remarks, telling committee members the expansion is proceeding at a “reasonably good pace” this year. He did not discuss monetary policy.
The hearing marks Greenspan’s third trip to Capitol Hill in less than three weeks. In his first two appearances, before the Senate Banking and House Financial Services committees, Greenspan urged members of Congress to restore some kind of budget planning and restraint given the costs of promised Social Security and Medicare payments. The government reported a record $412 billion budget deficit in fiscal 2004. The Fed chairman repeated that call. While the expansion should raise tax revenue, helping narrow the budget deficit some, “our budget position is unlikely to improve substantially in the coming years unless major deficit-reducing actions are taken,” he said.
Last Saturday night, your editor found himself on the chic side of a velvet rope... Escorted by a well-connected friend, he strolled unmolested past the series of velvet ropes that bars the V.I.P. entrance to “Mansion”, one of the trendiest nightclubs in Miami’s South Beach. As one well-tanned bouncer after another waved us along, we shimmied through a sea of beautiful bodies until we reached a lounge table marked “Reserved”. Here in the eye of “Hurricane Hedonism”, we seated ourselves beside ice buckets full of Dom Perignon and Grey Goose vodka. ... Clearly, we had arrived. The U.S. capital markets used to be almost as fashionable as Mansion, but something has changed. Mansion is still hot; the U.S. capital markets are not.
Reputation and buzz are the lifeblood of chic, whether in finance or in fashion. And hard-won reputations do not die overnight. For decades, foreign investors have been flocking into the U.S. stock and bond markets looking for a good time. Usually their expectations were rewarded. And even on those occasions when returns failed to measure up to expectations, the money continued to saunter in U.S. markets like the cigarette-wielding fashion models into Mansion. But for the past five years, the U.S. stock and bond markets have performed far worse than most of their global peers.
Are foreign investors beginning to tire of the abuse? Perhaps foreign investors have begun to notice what Alan Greenspan, himself, finally noticed: That the record U.S. budget deficit is “unsustainable” and that spending cuts are needed before costs balloon for Social Security and other benefit programs. Or perhaps they are recalling that past investment returns are no guarantee of future results. Or perhaps they have merely tired of gorging themselves on U.S. financial assets.
Like the hottest nightclub in Miami, the U.S. capital markets were once the place to be. Everybody that was anybody wanted to be inside the velvet rope that offered access to the gorgeous returns that seemed to frolic everywhere one looked. But “Alan’s Café Americana” seems to be losing some of its cache, in which case U.S. bond yields will be heading higher, as U.S. share prices drift lower.
For more than a century, successive generations of Wall Street titans have lavished their riches on art, hoping that a Monet or a Cézanne might add a bit of polish to the rough edges of their deal making. Now, young, little-known billionaires who manage hedge funds are roiling the art market, using the vast pools of capital they have accumulated to snatch up some of the world’s most recognizable images. Leading the way has been Steven A. Cohen, a publicity-shy hedge fund magnate living in Greenwich, Connecticut, who took home $350 million in 2003 and even more last year, according to people close to him.
Over the last five years, Mr. Cohen, 48, has spent more than $300 million -- amassing a collection that includes one of Jackson Pollock’s iconic drip paintings, a Manet self-portrait, a Monet waterlilies painting and other trophy works including a Degas sculpture of a young dancer and well-known Pop works like Andy Warhol’s “Superman” and Roy Lichtenstein’s “Popeye”. And most recently, in what may be a wink at his reputation for being one of Wall Street’s predatory traders, he paid $8 million for the British artist Damien Hirst’s 14-foot tiger shark, submerged in a tank of formaldehyde.
Mr. Cohen is not the only young hedge fund investor making a splash in the art market. Kenneth Griffin, 36, the founder of the $8 billion Citadel Investment Group in Chicago, recently bought a Cézanne still life that sold for $60 million at a 1999 auction at Sotheby’s. Also active in the art market are Eric Mindich, 36, a former Goldman, Sachs partner who runs Eton Park Capital, and Daniel C. Benton of Andor Capital, both of whom have recently joined the board of the Whitney Museum of American Art. “These hedge fund guys are having more of an impact on the market than the Saul Steinbergs did,” said Richard Feigen, an art dealer who helped Mr. Steinberg put together his collection of old masters. Mr. Cohen’s case is particularly unusual in that a large stake of the $6 billion in his funds consists of his own money; he has been closed to new investors since 1998.
His prowess as a trader has become the stuff of legend on Wall Street, where his active trading strategy makes him one of the largest generators of commissions. His yearly returns have ranged as high as 60% to a low of 13%, and last year his funds gained 23%. His confidence in his trading abilities is such that SAC takes home up to 50% of the profits that the funds generate each year, an arrangement that far outpaces the standard hedge fund fee of 20%. Part of what makes Mr. Cohen such an accomplished trader is his equanimity. He rarely shouts or yells, just processes information and marshals his order flow to the 70 portfolio managers who work with him. People who have seen him trade say it is impossible to tell whether he is having the best or the worst day of his life at any given moment in the course of a day. “Steve is so good because he does not have his ego tied up in each trade,” said George Fox, a longtime investor in Mr. Cohen’s funds. “He is an anomaly in this business because he hasn’t had three good years, he has had 23 good years.”
What is the difference between a hedge fund and a private-equity fund? Easy. One speculates in bonds, stocks, currencies and commodities, using leverage and derivatives, while the other uses its own capital and borrowed money to buy companies, improve them, and then sell them on. Well, not so fast. The evidence suggests that hedge funds and private-equity funds, the two hottest growth sectors of the financial universe for the past five years, are converging. What seems to be emerging is a new type of alternative investment fund that shrugs aside traditional ideas of risk and seeks the highest returns any way it can.
Last week at a conference in Frankfurt, David Rubenstein, a co-founder of Carlyle Group, the world’s 3rd-biggest buyout firm, said private-equity and hedge funds may eventually converge. “Funds may be created that have the combined characteristics of private equity and hedge funds,” Rubenstein said. Carlyle, based in Washington, estimates that there are 9,000 hedge funds with investments worth about $1 trillion, while 3,000 private-equity funds have $150 billion in assets worldwide. There is certainly no shortage of evidence of the two types of fund treading on each other’s turf.
First, Carlyle itself has just announced plans to launch two hedge funds later this year. And New York-based Blackstone Group LP, which manages the world’s biggest buyout fund, has already set up a hedge-fund unit, which oversees about $9 billion in assets. Meanwhile, Carl Icahn, a legendary Wall Street raider, is launching his own hedge fund. Next, hedge funds are now acting more like buyout firms. For example, Circuit City Stores, the No. 2 electronics retailer, last month received a $3.25 billion takeover offer from Boston-based Highfields Capital Management LP, which manages hedge funds. Likewise, Beverly Enterprises Inc., a nursing-home chain, last month rejected a bid worth $1.41 billion from an investor group that included hedge fund Appaloosa Management LP.
Buying out whole companies because you think they are undervalued? That is the kind of work that used to be done by private-equity firms. So how real is the convergence story? Traditionally, hedge funds and private-equity firms have been seen as deadly rivals. They compete in two main ways. They joust for talent. Any bright 20-something in the financial markets who wants to make a lot of money quickly (and that covers maybe 99% of them) faces a simple choice: work in hedge funds or in private equity. And they compete for money. Most mainstream investors put the bulk of their capital into equities and bonds. They have a small amount allocated to a box marked “alternative investments” for which they are willing to accept higher risk for bigger returns.
Both the hedge-fund and private-equity managers are chasing that same pool of footloose capital. Yet the rivalry is rather like one of those fiercely contested local derbies between football teams from the same town. The competition is intense precisely because they are, in reality, playing on the same turf. The two types of fund are now morphing into one another. Both have always, at root, been about the same thing: using financial engineering intelligently in the hope of generating returns higher than anything available from mainstream investments. Sometimes it works, and sometimes it does not. The plan is much the same.
“Tom, I’m gonna buy some call options on Sketchers,” said a familiar voice on the phone, “and you should too. I was just playing poker in Vegas with a guy who seems to know a lot about the company and he thinks the stock will double by Thanksgiving.”
“Can you buy them for me? I’m already on my way to Panama and I can’t get through to my broker. I want to spend $3000. You want in?” Your editor placed the order as instructed, but politely declined acting on the “hot tip” for his own account.
We had already learned our lesson ... the hard way. Years earlier, we bought stock in a company on the basis of a tip. On that occasion, we were told by a guy who seemed to know something that this particular company’s earnings results -- due out 10 days later -- would be phenomenal. We were so persuaded by the tipster’s strong conviction that, the next day, your editor took a small position in the stock. But things did not go as planned -- and for the next seven or eight trading days, the stock tanked. Come the day of the earning’s announcement, we had lost over 25% of our investment. Then the results came out, and just as our contact had said, they were very good. But not good enough to boost the share price one iota! We gave it a week, and then sold our position at a big loss, swearing never to invest in a hot tip again.
“A man must believe in himself and his judgment if he expects to make a living at this game,” said celebrated stock operator, Jesse Livermore. “That is why I don’t believe in tips. If I buy stock on Smith’s tip, then I must sell those same stocks on Smith’s tip. I am depending on him.”
We did not want any part of this Sketchers trade ... but we told the voice on the phone we would be happy to put the trade on for him. We bought 25 contracts of the January 2005 $15 call option at $1.20 a piece. At that time, the stock was trading at around $13. The stock made a run at the strike price, and after a couple of weeks, the options moved into profit. He should have sold then, but did not; the options soon fell away, expiring worthless. “Nevermind,” he said to us recently, “I took at least five grand off that guy in the poker game. And besides, we were in Vegas. He was probably just some gambler trying to ramp up a stock position...”
If Wall Street and many stock investors have been acting as if there never was a three-year bear market (2000-2002), today’s bond investors act though there never was a 1998. When 1998 began, bond investors were -- shall we say -- complacent about risk. The first two months of that year saw record junk bond sales of some $34 billion. But in the spring came renewed financial troubles in Asia; in the summer a full-blown crisis began to erupt in Russia. The Long-Term Capital Management hedge fund collapsed in the fall and nearly took the world financial system with it. Russia’s default on its debt produced huge credit “spreads” and turmoil in global bond markets.
Junk bond prices began a slide that lasted until 2002. In October 2003 the spread (difference in yield) between high-risk junk bonds and ultra-safe U.S. Treasuries was more than 10%. Yet the collective memory of 1998 began to fade from bond investors’ minds in 2003. On January 23, 2004, junk bond yields fell to an all-time low of 6.94%. Junk bonds default all the time, yet investors accept this risk for just a few percent points over virtually no-risk Treasuries. Junk bond sales in the first two months of 2004 were nearly $28 billion, the fastest start to a year since -- you guessed it -- 1998. By December 2004, the spread between junk bonds and Treasuries was 263 basis points, the narrowest spread in at least 14 years.
When I was one of the lone voices talking up commodities and China heading into the new millennium, I ran into much skepticism among the press. The writers, reporters, and anchors around the world, the so-called business media who ought to have known better, were more likely to raise an eyebrow or even turn hostile when I wanted to talk about oil, lead, and sugar more than about the “next big thing” in stocks.
I told a skeptical French business writer one day that the price of sugar that day was 5.5 cents per pound, so cheap that no one in the world was even paying attention to the sugar business. I reminded her that when sugar prices last made their all-time record run-soaring more than 45 times, from 1.4 cents in 1966 to 66.5 cents in 1974-her countrymen were planting sugar all over France. She nodded -- “Supply and demand”, she said.
Sugar prices were so low for so long that it was the last business enterprising souls around the world would be likely to enter in the 1990s and early 2000s. Sugar has had its boom times in the past - that 1974 record, and another spike in 1981 during the last bull market in commodities. And if I am right and we are in another long-term bull market in commodities, we are likely to see another sugar high. With world sugar prices at 85% or so below their all-time high, the chances of moving higher are strong. To those of us who have been here before, it is promising to note that similar supply and demand imbalances are shaping up that could push sugar prices upward over the next decade.
Commodities and natural resources used to be the butt of jokes and misconceptions. Now they are finally getting the respect they deserve. Traditional investors and advisors are rushing into commodities, hoping to find the high growth that traditional equities no longer deliver. But even with the commodities turnaround, there is still one sector of the real asset market that is still taboo to many mainstream investors -- the commodity futures markets. Resource stocks and stock options are fine for most investors. But they still think that trading in the futures markets is nothing more than gambling, and that is a real mistake. The fact is, traders need to diversify. And if the next several years are as bumpy for stocks and bonds as some analysts expect, commodity futures and options might provide the kind of returns investors need.
Yes, commodities carry risk ... but they are not intrinsically risky. What makes them risky is the same thing that makes them attractive -- LEVERAGE. You can trade futures on very, very low margin. So the question becomes, exactly how risky are futures? The truth may surprise you. Gary Gorton of the University of Pennsylvania and K. Geert Rouwenhorst of Yale researched commodity futures contracts between 1959 to March 2004. Their first major finding commodities are negatively correlated with stocks. That is, they often move one way when stocks are moving another, and vice versa. So diversifying a stock portfolio into commodities can significantly reduce your risk. That is something we have been saying all along, but there were some surprises in the professors’ findings.
Previous studies have shows that commodities are able to match equities’ returns. But the index model they constructed showed commodities were about 19% less risky than the S&P 500 -- on a risk-adjusted basis, they outperform stocks by a significant margin. Very interestingly, it turns out that a disproportionate amount of stocks’ volatility came from months in which they lost significantly, while an outsized portion of commodities’ volatility came from months in which they scored big gains. In other words, stocks have greater risk on the downside than commodities do.
Those are some pretty strong arguments for considering commodity futures and options for your portfolio. But can you get the same results just holding resource stocks? Not quite. According to Gorton and Rouwenhorst, over the last 40 years, the commodity futures index more than tripled the cumulative performance of average resource stocks involved in the production of those commodities. They conclude: “An investment in commodity company stocks has not been a close substitute for an investment in commodity futures.”
In his talks to Congress at the end of February, Chairman Greenspan dropped in these words, which did not make the highlight reels, but nonetheless should be listened to: “People experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency.” America’s record imbalances are inherently unstable. They are the proverbial unsustainable trend. Yet things seem to be rocking along just fine. One of America’s finest theoretical economists, Hyman Minsky, gave us this great quote, “Stability is unstable”. What he meant by that is that the longer things remain the same, the more we expect them to remain the same and the more complacent we get. Thus, when things actually do change, the shock is much greater. Few have “remained vigilant”. The long-term stability of trends is the seedbed for asset and credit bubbles of all types.
While the game can go on for much longer than reason would dictate, there will be an end to it. Will it be the soft landing with nations agreeing to work together to find a sort of stable equilibrium; or, the hard landing where the “vacuous rhetoric of globalization” masks the reality of each nation going its own way, in a kind of “devil take the hindmost” world?
The U.S. is living, many say, on the kindness of strangers. If it were not for the willingness of Chinese and Japanese central banks, along with their smaller Asian counterparts, to finance our trade deficit, we would be in perilous circumstances. If Asian currencies saw the dollar fall by 33%, they stand to lose over $600 billion in buying power due to their massive $1.8 trillion U.S. dollar reserves. That is a massive amount of confidence. Yet it works both ways. Exports to the U.S. alone accounted for about 12% of China’s GDP, and that was up from 9% in 2000. At current growth rates, U.S. imports could be responsible for 20% of China’s GDP by 2008. It may be that China is depending upon the kindness of strangers, in this case U.S. consumers.
The elephant in the world economic room is the now $660 billion U.S. current account deficit. At least $465 billion of that comes from foreign central banks. They take our paper, which they know will one day be worth less than it is today, in order to be able to sell us products that keep factories growing. How long can the game continue? It is not a matter of things staying the same. The system itself is inherently unstable, as we will see.
The essential message Federal Reserve Chairman Alan Greenspan is trying to pound into the heads of members of Congress in his recent testimony is that the federal budget process is so broken that it has become a danger to the nation’s long-term economic health. One can only hope he is also pounding privately on President George W. Bush, his White House aides and his secretary of the Treasury. The fundamental problem is a lack of restraint at the White House and on Capitol Hill in spending money and cutting taxes. Both are politically popular, of course, and with interest rates and inflation low and the economy moving forward nicely, what the heck.
The cost of the wars and reconstruction in Afghanistan and Iraq have not been nearly as important to the budget and the economy as was Vietnam. Nevertheless, administration officials have downplayed them at every turn and this year again refused to include them in the fiscal 2006 budget sent to Congress. Meanwhile, there has been a new set of tax cuts or extensions proposed each year, and the hugely expensive Medicare drug benefit has been passed at the urging of the president. And the long-term impact of all this has been obscured, quite deliberately, by administration changes in budget documents. For instance, it switched from a 10-year budget window to a 5-year window.
In addition, exactly the sort of long-term fiscal analysis Greenspan says is so crucial in making budget choices, which used to appear each year in a budget document entitled “Analytical Perspectives”, is no longer included. These attempts to hide the real impact of tax and spending proposals have been possible only because most members of Congress have gone along with the fictions. After all, in 2001, Congress played numerous games with the revenue loss associated with that year’s big tax cut, including repealing its provisions in year 10. In that case, the fiction was there for all to see. Still, it allowed everyone favoring the tax cut provisions to understate the revenue loss with a straight face. And those were the numbers in the news story headlines. There is a level of dishonesty in all of this that is appalling, and no one much seems to care. The alternative, after all, might be to make some of those “difficult choices among budget priorities”.
When oil charged through $55, your editor almost lost an eye. He was standing so close to the crude oil trading pit -- on the floor of the New York Mercantile Exchange -- that an airborne “Buy” ticket nearly grazed his cornea. The near-miss left your editor with two good eyes, both of which locked onto the tick-by-tick price action of crude oil, as displayed on the massive electronic price board above the pit. In the span of a few minutes, the April contract jumped more than $1.00 to $55.20 a barrel. Was this stunning advance the start of an even bigger move, or the beginning of the end of oil’s recent rally?
The NYMEX is one of the few “open outcry” trading floors in the U.S. In other words, it is one of the stereotypical commodity trading floors where arm-waving brokers in jackets of various colors scream orders out across a trading pit, while also gesturing incomprehensible (to regular folks) hand-signals to one another. The antiquity of the trading process does not seem to present any impediment to rising prices. Whether “price discovery” -- as market gyrations are euphemistically called -- relies upon screaming traders or ticker tapes or carrier pigeons, the collective opinion of investors ALWAYS finds expression in the financial markets ... eventually. And the collective opinion of energy investors is that oil deserves to command a price that is higher than what it used to command a couple of years ago.
“It’s the Iraq War that’s causing this,” one veteran commodity trader informed your editor. “Really? The War?”, he replied incredulously, “Aren’t simple supply/demand dynamics a more reasonable explanation?” “Yeah, that too,” the trader admitted. Another shell-shocked trader told the Associated Press, “About the only way to explain this rally in the market is fund buying. They’re pushing the market higher while producing nations are sitting on their hands and smiling ear to ear. This is incredible.”
Admittedly, ones day’s trading action does not possess a great deal of significance. But crude oil has been rallying for more than one day. Indeed, it has been rallying for more than one year ... or three years. We call this a bull market. And bull markets generally occur for legitimate reasons, at least in their infancies. We have no idea, of course, where the oil price might be heading tomorrow. But we may easily observe that demand for the stuff shows little sign of ebbing, especially in the country whose energy demands are growing fastest. $55 oil may seem like an “obvious” short sale to a world accustomed to $35 oil. But what if $55 oil is actually a counter-intuitive “long” to a world that might have to adapt to $75 oil?
You may have noticed that supply and demand data do not always affect prices as you were taught they should. Crude oil prices punched through the April contract highs on Thursday (Mar. 3) to briefly flirt with October’s all-time nominal record. But as one mainstream financial newspaper observed that day, at least one oft-hyped fundamental is at odds with the surge: “Even as crude and gasoline inventories rose to well above their five-year averages in inventory data released [Wednesday], analysts said concerns about a tight supply-and-demand balance in the global oil market continued to support towering prices.” We have no doubt that higher oil prices reflect the emotional and psychological “concerns” of analysts and other market participants, not the latest facts about the “supply-and-demand balance”.
Traditional economic ideas about supply and demand work well when you are talking about shoes or bread. People buy more of these things when prices are low. Yet objective data consistently reveals that participants in financial markets -- such as crude oil -- act as if they are saying, “The higher the price, the more I will buy.” In other words, most individual oil market participants fail to exhibit the rational behavior assumed by traditional economics. The Wave Principle governs these financial market trends in a way that the Efficient Market Hypothesis of economics cannot. Elliott wave analysis observes the price patterns that emerge from the shared mood of investors acting as a herd.
One of the best reasons to use Elliott wave analysis -- or any non-fundamental analysis -- is that it reminds you to question consensus opinions and conventional wisdom. In the case of surveys of economists, we have learned that survey results often serve as contrary indicators. That is, if a bunch of economists say something is going to happen, usually the opposite actually happens. We are not the only ones who take these pronouncements with a grain of salt. Recently, as reported in a Wall Street Journal column called Ahead of the Tape (February 24), a strategist at Dresdner Kleinwort Wasserstein did some checking on yield predictions by economists. DKW’s James Montier studied the quarterly forecasts of economists compiled by the Philadelphia Fed, and he found that, “over the past dozen years, whenever economists have predicted that 10-year yields would rise in the following 12 months, they have ended up being right only 45% of the time.”
With this in mind, now consider the results of the recent WSJ survey. In February, 52 of the 56 economists the newspaper surveyed called for a consensus 5% yield on Treasury notes at year’s end, well above the current 4.27% rate. Will these economists contribute to or defy their dismal track record?
Though, in truth, there are more important things to worry about than the meanderings of Alan Greenspan’s dilettantism, or the back flips which his political trimming produce, there were one or two notable exchanges in last week’s testimony to Congress which bear inspection. In the first, Greenspan actually had the scales fall from his eyes regarding the money illusion which so afflicts us all. Replying to a question about funding Social Security Senator Jack Reed (D–R.I.), Greenspan put the fundamental problem of the inflationary welfare state in a nutshell, saying: “We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power.” In other words, money can always be created -- there is just no guarantee it will buy anything once it has been.
Secondly, our Oracle did show that he has some grasp of the basic raw materials which fuel the process of material advancement -- the need to add to the useful capital stock via savings made out of current income (not by exercising partial restraint in drawing “equity” out of notional paper gains in inflated asset prices): “If we are going to create the ... standard of living that we need in the future ... we’re going to need to build the capital stock, plant and equipment...”
Finally, it was wryly amusing to see him wriggle when the redoubtable Ron Paul twitted him over his oft-quoted, 1960’s Randian plea for a return to the gold standard: “... I think, in an effort to discipline the Congress, that the Federal Reserve would have a role to play as well, because ... the Federal Reserve accommodates the spending. ... When you buy our debt that we create, you do it with credit out of thin air. ... Do you think that the gold standard would limit spending, here in the Congress?” OUCH! With the fish having been forced to swallow the bait of his own words, Greenspan was left to wriggle, guppy-like, on the hook. But: “... Since [1979] I think we have been remarkably successful, in my judgment ... [in] mimicking much of what the gold standard does. ... I think in that context so far we have maintained a stable monetary system. I do not think that you could claim that the central bank is facilitating the expansion of expenditures in this country [SIC!]”
So, after two brief flashes of economic clarity, the real Alan Greenspan at last regained the upper hand in all his self-congratulatory, equivocating and -- let’s face it -- delusional glory. The Fed Chairman thus stoutly refuted the claim that he has had in any part to play in helping Federal debt grow, of late, at a rate of $1.7 billion a day -- which torrid gain has meant it has risen by over a third in less than three years. He further denied any complicity in helping money supply swell by a third since late 2000. He swore that he certainly never encouraged personal indebtedness to grow the $3.1 trillion it has in the past four years -- an average of $25,000 or so per household; a pace twice as fast as income has gained over the period; and an increment equal to a little more than the total of all the debt accumulated in all the years leading up to Greenspan’s appointment to the Fed Chairmanship, back in 1987. Well, thank goodness for that! Just think what might have happened if the Fed had been deliberately “facilitating the expansion of expenditures in the country”!
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