Monday, April 27, 2009
First let’s look at the domestic demand for dollars. For 5 years, homeowners have used their homes as piggy banks. When they wanted cash to buy something, they just took out a home equity loan. Stocks looked like an attractive investment, so people generally had little desire for money, everyone preferred to own stuff like houses and stocks. Companies held as little cash as possible because cash doesn’t generate the aggressive growth that’s so attractive to investors. As asset prices collapse, every seller demands money. After a foreclosure, banks try to sell the foreclosed home as quickly as possible; during bankruptcy, the court or debtors liquidate the company’s holdings. Any potential buyers of homes or corporate assets need to sell other assets to free up money.
What about the international demand for dollars? Over the last decade, investors and banks rushed to send money to emerging markets for higher rates of return. For example, Eastern Europe had net foreign borrowings of $1.6 trillion at the end of 2008. Any foreign loan or investment requires a purchase of the foreign country’s currency and a sale of your own (there are exceptions, but debt denominated in foreign currencies is relatively insignificant). As the world economy comes under pressure, we’ve had a flight to quality. Investors sought to sell their subprime loans to emerging markets and buy top rated US debt. So investors are selling their zlots and forints and even euros to buy dollar denominated assets.
As asset prices continue falling, inflation concerns wane, general economic conditions deteriorate, people hoard cash. Individuals fear unemployment and increase their savings. Companies find fewer attractive investments and financing costs rise, so they hold more cash. Investors worldwide flee all currencies but the safest. As people hoard cash, the velocity of money drops further and asset prices drop further, deepening the cycle. The fed can mitigate this by printing more money, but just about everyone consistently underestimates the deflationary effects of deleveraging, so the fed is too slow and the dollar shortage deepens. Eventually the cycle ends when there are fewer new foreclosures and new bankruptcies and enough debt is liquidated that companies and individuals start spending more.
Where does the deleveraging end? It’s hard to predict in advance, but we can at least identify when asset prices have further to fall. Real Estate is stagnant in most of the country as sellers remain anchored to old prices and refuse to hit the “too low” bids of the buyers. California is the exception. After a 40% drop in median prices, the real estate market is starting to look healthy with plenty of transactions. Californian real estate may have reached equilibrium while most of the country obviously hasn’t. Prices keep falling until sellers and buyers agree on prices. Another example is mortgage derivatives. With some derivatives, buyers are bidding $0.20 on the dollar while the banks that hold the derivatives are refusing to sell at less than $.80. Without massive subsidies, the result would be that eventually the banks would become realistic and lower their offers or go bankrupt and be forced to sell. The government and the banks are hoping that special programs can subsidize buyers to pay closer to $.80 or that the economy will improve enough for the buyers to pay $.80. History suggests that eventually it is the sellers who must compromise and lower their offers.
Tuesday, April 21, 2009
The recent run-up in the S&P500 and other equities (and the fall of Treasuries as people leave safety) suggests many investors think we have reached and passed the bottom, for these reasons:
-"Green shoots" in the news, and expectations of economic growth have risen. 214 fund managers, ever the optimists, think so, according to a survey of fund managers by Bank of America-Merrill Lynch. The bank’s monthly survey showed the number of respondents expecting the world economy to improve over the next 12 months swung sharply upwards to a net 26 per cent from minus 24 per cent in March – the highest reading since early 2004. The survey, which polls 214 fund managers with a total of $561bn of assets under management, also showed that investor risk appetite had returned to levels last seen before the demise of Lehman Brothers.
-Large positive earnings from money center banks (C, GS, MS, etc.) suggest they are healthy again, and the financial system is recovering.
-The second derivative on growth may be slowing - that is, the rate at which unemployment rises and GDP falls may be slowing. Really, no one has a clue as to Q1 2009 GDP (WSJ economists poll have ranges from -0.7 to -8.0).
-Consumer confidence is up, tech companies are posting decent profits, IPOs are up (3 this quarter, the highest since Q2 2007), and M&A juices have returned.
-Not as many foreclosures as reported, many people are refinancing with low rates.
No bottom yet - we will likely see new S&P500 lows by year end - the only question is at what level - 400, 500, or 650? With lookforward 2010 earnings at 40 to 50 for the index, and a bear multiple of 8x to 12x, the range for the S&P 500 is 320 to 600.
-We are only halfway or so through global deleveraging, per numerous measures (total debt over GDP, household debt over GDP, etc.), and further delevering will be painful. "McKinsey estimates that if the US savings rate had remained steady at the level seen in 1980, a trillion dollars less would have been spent in 2007 alone. Already since its peak in 2007, household net worth has fallen by $13,000bn, almost equivalent to one year of US output. McKinsey reckons that could be worth about $650bn of consumption. Pretty hefty, but it pales next to the risk to spending from household deleveraging. Assuming no income growth, each 5 percentage point fall in the debt-to-income ratio equates to about $500bn less consumption. With debt-to-incomes currently at 130 per cent, even getting back to 100 per cent will be very painful indeed." (FT, below)
-No financial recovery. The bank's are fraudulently making up earnings, with the consent of accountants and US regulators. The idea is to allow them to mark-to-make-believe, book profits, and hope an economic recovery will actually make them solvent (this is the 1990-92 solution when many US money center banks, like C, were insolvent). Abe Lincoln had a saying: "How many legs does a dog have if you count its tail as a leg? Four - because calling a tail a leg doesn't make it one". Unfortunately, the Japanese zombie dead banks of 1990-97 offer another, more likely possibility (banks were only taken over and restructured in 1997, with a semblance of real accounting. Global financial regulators should heed that. Until there are massive restructurings and nationalizations (US govt. takes over C and BAC and other to break them up, same for the UK and its banks and Europe), the financial system will be stuck in rot. From its credit bubble in 1989, the peak to trough drop in Japanese equities was about 80%.
-Housing is still in the dumps. Nationally, prices have only fallen 30%, and Shiller expects the natl. average will be 45% (with 50-60% total drops in some areas). Rogoff's quantitative work suggests it takes 3-5 years for housing to work out. Also, foreclosures were low in Feb./Mar. since many lenders were "waiting and watching" to see what Obama would do. I expect massive foreclosures and corporate defaults in Q2-Q4 2009, higher than anything since 1930. We shall see.
-Massive govt. debt buildup yet to effect markets - at some point, we will see currency devaluations and higher interest rates, which will put more pressure on economic growth - the lesson from 1933 to 1937 was that the best way to reignite growth was to inflate the currency (devalue it), and that fiscal spending and debt had little impact (see Frieden's "Global Capitalism," pp. 187-193 - he asserts that deficit spending did nothing to end the Depression, but it was rather the large monetary increase coupled with bank restructurings - so when FDR pulled back the money supply in 1936, the US returned to a mini-Depression in 1937).
-Unemployment will top 11%, possibly even 12% in 2010. And this is a key economic statistic, because the % of people working clearly affects economic output and growth (CA and 7 other states are already above 10% - compare this to the WSJ consensus of 7.3% to 10.5% for Dec. 2009). While statistically unemployment peaks after growth, I don't see healthy positive GDP growth (above 1%) returning till late 2010 or so.
-Financial losses in the low trillions and a negative wealth effect will keep growth weak or negative well into 2010, according to the IMF's April 2009 Global Financial Stability Report. US consumers are doing what they should, which is saving and investing.
Catalysts: Another run on GE due to the insolvency of GE Capital - further large bankruptcies, done in a disorderly way (GM, Chrysler, MGM, etc.) - monoline blowup (risk or ratings downgrades and cascades still exists) - CA blowup (the state is still insolvent!) - national blowup, such as a run on PIGS' (Portugual-Ireland-Greece-Spain) national bonds as they can't backstop their financial system - Spain is the safest of them, but will have near 20% employment by early 2010.
Alpha's subjective estimate: 80% chance on S&P500 falling further to new lows, 20% that we've hit bottom and will recover. A great time to short into a bear market rally - Spring seems to bring out the foolishness in investors. Personally, I wish this analysis were wrong and that the US will leave this nuclear winter of our own making sooner. But neutrally and rationally, I see more pain ahead.
Tuesday, April 7, 2009
-Seth Klarman, 2005 Baupost Value Partners Letter
"The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market. Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system. And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work."
-Charles T. Munger, A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business, USC Business School, 1994
The following quotations intelligently sum up the conventional wisdom, but are only half true, or perhaps false? Life is full of paradoxes and investing is no different, so I present the proposition that "Investing need not be a zero-sum game."
Strict zero sum games are horse racing and casino games like roulette and blackjack. They are alike in that each have a set amount of money/capital/value being wagered, and a finite amount of players competing for the capital. No amount of game playing will increase the amount of capital in the game or society (social value), though players may glisten and redden with drinks late into the night, tip scantily-clad waitresses, and take in the thrill of gambling (while the hustlers clean up).
Investing is different because capital is being put into productive companies which promise and attempt to create new economic value. Depending on what the company does, that is, what is created, how the plan is executed, how good management is, etc., social value and capital can be created or destroyed. So investing is not a zero sum game. It can in fact be worse, a negative sum game, because if capital is destroyed, all the "players" are worse off than a zero sum game. So investing is like farming - inputs such as seed, fertilizer, water, etc. worth X are put into the ground, and the output is expected to be 2X, unless the farmer screws up and the harvest returns 1/2 X. Luck and uncertainty also matter, since no one knows what the future will bring.
The best example of positive sum investing comes from VC firms or IPO investing. If VCs didn't exist, it's possible that large, value-add companies like Google, eBay, Cisco, & Sun would never have been created, and society would be poorer (and so would many investors). Clearly, VC investing is not zero sum because it does not compete for a fixed pie with regular equity and debt investors. Likewise, if the IPO market didn't exist, then it's likely that successful small companies wouldn't grow and expand (or be limited by internal capital constraints), and so couldn't take over their industry. On the flip side, the burning of large amounts of cash/capital from 1999 to 2001 in the bonfires of internet madness was shameful and a loss of social value.
The best example for IPOs is Wal-Mart, whose growth for its first decade was constrained by internal capital and the debt that Sam Walton could personally borrow (his daughter even had nightmares about his guarantees). Once the IPO occurred, which incidentally was one of the 20th century's best to participate in, and whose largest investors were Scottish and not American, the company was free to grow and compete with less efficient retailers. All the while Wal-Mart increased social value. The social loss from K-Mart and Woolworth failing was much less than the gain from Wal-Mart succeeding.
The logic of the proposition applies beyond early-stage companies and IPOs, even to mature companies. For example, if GM, Chrysler, and their financing arms were not given easy/cheap access to capital by incompetent investors, then the reckless consumer car buying boom of 2001 to 2007 would never have occurred. Instead, capital could have gone to more effective uses, like student loans securitized into ABS for high school grads who want to go into trades, nursing, or other socially needed fields. Likewise, if investors hadn't bought a lot of RMBS, which led to houses now sitting empty and rotting, they could have placed that capital with biotech, health/nutrition management, or medical infotech companies deveoping cheap technologies (or processes) for making human beings healthier and more productive.
In sum, investing need not be a zero-sum game because investors can make the pie of total capital larger. However, the down side is that investors can also make the pie smaller, so investing can be positive-sum or negative-sum. With this perspective, the questions of who gets to allocate capital, how to select managers, and how to align incentives, are not just important for pension plans and endowments, but for society as a whole.
There’s a common belief that assets rise when there are more buyers than sellers. The truth is more subtle. Every time a stock (or any other asset) trades, there’s both a buyer and a seller; whenever the market is functioning there must always be an equal number of buyers and sellers. So what makes stocks move in a particular direction? The simple answer from economics is that there were more buyers than sellers at the old price, so the stock price must rise to entice new sellers into the market and dissuade the buyers. This is frequently true, but is far from the whole story. There are many momentum traders who are more likely to buy a stock as it rallies.
As the stock market rallies, the general public becomes more optimistic. More investors believe that stocks are great long-term investments and they allocate a greater portion of their savings to stocks. During big sell offs, many investors swear off stocks forever and even sophisticated investors reduce their exposure. Investors with a historical perspective describe this as the fear-greed cycle. Over periods of 5+ years, investors act exactly opposite the “rational” way economists expect. As valuations climb to the sky there are ever more buyers.
If buying causes more buying, what breaks the cycle? Every asset bubble forms a pyramid. Eventually you reach the top where everyone who might possibly participate in the bubble has already bought in, and there’s no one left to buy. In real estate, this happened when everyone who could possibly be enticed to buy a second home did, and when every bank that would greedily chase the 0-down loans had. Eventually there are no more suckers and the pyramid collapses. A pyramid that was gradually built over a decade can collapse in 6 months. Once you reach the point of no new buyers, the first hint of selling sparks a panic. All the overleveraged speculators were buying because prices seemed like they could only go up; as soon as prices start coming down they all run for the exits.
So how should we think of a rally? Are stocks rising because there are more buyers regardless of price, or are there just more buyers at this price. I think the approach that is most accurate most of the time is this: at any given time there are a lot of players with prices in mind who provide liquidity to the indiscriminate investors. There are price-sensitive investors who think Microsoft is worth $25 and are looking to buy for $20 and sell at $30. There are the price-insensitive passive investors (the vast majority of all investors) who just allocate a portion of their savings to stocks via a 401k, IRA, or pension plan. Finally, there are the price-insensitive active investors who watch CNBC and buy whatever company seems hot without much regard to valuation, or avoid buying stocks when things seem gloomy. When the price-insensitive investors become optimistic and start buying, they drive the prices of most stocks up. Prices stop rising when the optimism fades. The price-sensitive investors drive prices at the margin (causing better companies to outperform over time) or when the price-insensitive investors aren’t pushing things around too much.