This article was published at various websites in April 2008, the response and feedback have been overwhelming. I decided to re-post it here at my blog site.
We have all heard about CDOs (collateralized debt obligations) and probably about the insurance of CDOs through CDSs (credit default swaps), which transfer the credit risks of CDOs between two parties (financial institutions).
The CDS is a bet between two parties on whether or not a company or a financial product will default. It is third party speculation on the outcome of the CDO. The CDS provides insurance to cover a fixed income product in case of its default. If a company declares bankruptcy or a debt is downgraded, a claim is triggered.
Currently, the outstanding notional amount of all credit default swaps is about $65 trillion, more than half of the entire asset base of the global banking system. Why are financial institutions are so interested in them? Why have they created so many of them to make this market so big and out of control?
There are many incentives, some of them are larger, and some smaller. I will discuss the three major reasons.
Transference of Risk
First, credit default swaps are not normal insurance policies; each side can trade them to make a quick profit (spread) if there is a willing counterparty. Commonly, after the original CDS contract is engaged, each of the original two parties will try to engage another party to further hedge their risk and earn a small spread. Pretty soon there are layers and layers of counterparties involved, with the total notional amount increasing several fold, until no one knows who they are really dealing with anymore.
You can't monitor this risk since you don't know your counterparty down the CDS chain, and whether they are able to pay in the event of a default. If you throw the counterparty risk out the window, you can always find a sucker to do the trade with you and earn a small spread.
This kind of entanglement has never been seen before in the usually highly-regulated insurance industry. This is why CDSs are traded on OTC (over the counter) derivative markets which bypass all government regulations.
This entanglement creates a chain reaction. If something happens - even a downgrade but not a default - the claim will trigger a domino effect of many claims cascading down through various parties. It will break at the weakest joint (counterparty), probably a highly leveraged hedge fund, and will ripple through all parties involved and likely break the whole chain. It amplifies counterparty risk to the hilt, beyond the default risk of the CDO itself.
Let us use the analogy of new type of car insurance: Car insurance company A trades our car insurance policy costing us $1,000 per year (or $1,000 revenue for them) for another $1,100 similar policy from another company B, and pockets a $100 quick profit. Or we trade our $1,000 policy (company A) with $900 policy from another company C. If we find cheap auto insurance, we just simply cut A out and make a switch to C. Our relationship with the insurance company is always one on one.
However, imagine what happens if both parties trade the policy with a third party. If an accident occurs, company A will not want to pay us, since we engaged company C, and company C will not want to pay either, since it did not issue the original policy. And if company A pays us eventually, they will have to file a claim against company B, who will most likely deny such claim.
This is what happened to the insurance company AON in a story that surfaced last year from a lawsuit. In this real story, Bear Stearns loaned $10M to an entity in Philippines. To hedge this default risk, Bear purchased a protection contract from AON for $0.4M. To hedge this risk, AON purchased protection from Societe Generale for $0.3M. AON thought they were geniuses, offsetting the risk and at the same time earning an easy quick $0.1M profit. Who says there is no free lunch on Wall St.? Think again!
You guessed it - the loan went bust as expected. Bear sued AON for $10M based on the first CDS contract. AON lost the case and paid. Of course, AON sued Societe Generale. Due to some legal technicalities, a different court and judge had a different opinion.
The judgment was that the first and second CDS contracts were two separate contracts. Legally, the resolution of first CDS lawsuit did not automatically grant the similar status to the second CDS. The first judgment can't be referenced in the second lawsuit. As a result, the risk can't automatically be transferred and offset each time.
AON lost the case, and the $0.1M "profit" turned into $10M loss in principal. It was an expensive lunch. This sets an important legal precedent for future CDS lawsuits. A small $10M default in the Philippines impacted three parties. Maybe this is an unexpected downside of globalization?
The market cap of GM is about $11Bn. However, based on estimates in the CDS market, there are about $1 trillion (notional amount) in CDSs betting on GM and their bonds. Any change in GM's situation will create a ripple effect in this $1Tn CDS community of GM.
There are obviously not $1Tn of GM assets to serve as collateral, so you have to trust all parties involved in this wild casino betting that they won't go under water. As a matter of fact, you better pray, because if one goes under, which is a high probability, it will throw a monkey wrench in the whole community, as everyone is trying to unwind and get out at the same time. It becomes a "no way out situation."
Bill Gross at PIMCO did a simple calculation in January in his famous article "Pyramid Crumbling." The total amount of CDS contracts was $45 trillion at that time. The historical default rate is 1.25%, so $500Bn CDS contracts are likely to default. Assuming a recovery rate of 50%, the resulting loss is $250Bn alone.
In the case of CDOs created from sub-prime mortgages, Gross’ assumptions are too optimistic. The assumed default rate is far too low. His recovery rate assumption is probably also too high if you consider the long process of home foreclosure in a deteriorating real estate market with no buyers and legal maneuvers which can be implemented by homeowners (refer to my early articles on foreclosure). I expect to see real losses doubling his estimate, or approximately $500Bn in the sub-prime market.
Using CDS to Smooth Earnings
Second, and more importantly, besides the quick profit earned through a small spread, there is a big incentive to use credit default swaps to smooth earnings from quarter to quarter and to hide losses.
If a CDO is rated AAA by rating agency (almost as good as US Treasuries) why would Wall St. want to buy insurance for protection? At the same time, assume a AAA CDO enjoys a 50 basis point spread above US Treasury rates. It is almost as good as a free lunch. Why would Wall Street firms want to eat into the 50 bp spread (and their profit) to buy CDS insurance?
The answer lies in different accounting treatments. Wall Street firms are not stupid, and they are smart enough to know their CDOs are not US Treasuries, even if their structured product groups and sales people claim they are, with the backing of the rating agencies. It is similar to the promotion of internet stocks in late 1990s, when Wall Street put out a "strong buy" ratings on supposedly great internet companies with unbelievable growth stories, while their internal memos referred to them as "pieces of garbage".
Due to GAAP (generally accepted accounting principles) requirements, investment banks need to mark their CDO products to market if they do not carry CDS insurance. This creates a problem, since both interest rates and credit spreads fluctuate, making it harder to manage earnings. What happens if investors or regulators suddenly realize they are really a piece of garbage? They don't want earnings volatility and surprises, especially at the time when their bonuses are at stake. Banks want to defer paper losses due to write-downs until they actually sell their CDOs, which would mean real bonus reductions for executives and structured finance groups.
By purchasing CDS insurance, according to GAAP regulations, there is no need to mark-to-market, Investment banks need to declare losses only if the CDO is permanently damaged and a claim will have to be paid. No more quarter to quarter fear of marking to market.
This effectively transfers the price risk to a counterparty, who in turn dumps it to another party, and so forth. By the time it comes back full circle, no one needs to worry about marking to market and earning surprises. If a paper loss happens, they can point to the insurance and claim it is only temporary. Financial statements will not be impacted.
CDS provide a vehicle to allow participants to hide any losses to a point where they really can't hide them anymore. They act as an earnings smoother and, worse, they hide the actual risk of investment bank holdings from the public. This is a reason why so many strange things have happened on Wall Street over the last several years.
For example, for a AAA rated CDO with a 50 basis point spread, investment banks would buy insurance from a small second tier bond insurer (such as ACA) whose rating was only single A as a firm (now at junk triple C). If they believed a rating agency with AAA rating on this CDO, why would they want to cover it with a lower rated policy which eating into their profits?
In the example earlier, GM has an $11Bn market cap with $1Tn in CDS outstanding. Use home insurance as an analogy here. If your house is only worth $200k, why would there be policies on your home with a combined notional amount of $20 million?
Using CDS to Accelerate Earnings Recognition
The third and most important use of CDSs concerns the strong incentive to book the next ten years' profit today.
CDSs offer investment banks something called a “negative-basis trade,” which is another accounting loophole like the earnings smoothing discussed above. Using the same example of a CDO with a 50 basis point spread over US Treasures, banks will buy a CDS, costing 20 basis points. By doing so, even though they seem to make less profit (50 vs. 30 basis point spread), banks can book the difference in spread for the whole life of this CDO instantly, through the magic of a negative-basis trade.
If the life of the CDO is ten years, banks can book the whole ten years of phantom profits this year, even if the CDO defaults sometime in the future. This has obvious implications for the bonuses of the structured product groups at Wall Street firms.
Who cares whether this CDO defaults next year? Let’s realize the next ten years’ of bonuses today! There is a common secret at Wall Street - it doesn't matter whether a product is good or bad; the only thing that matters is how you structure it. As former Secretary of the Treasury, John Connally, said to European central bankers in the 1970s' "It might be our currency (the US dollar), but it is your problem." The same thing applies here. If a CDO defaults, investment bankers have already bumped up their stock price, cashed out their stock options and their vested shares, and collected their year end bonuses. Now it is the shareholders’ problem.
This kind of accounting manipulation can fool people for a few years, but not forever, since the well of CDOs gets sucked dry very quickly when every single firm on Wall Street has found out about this and is doing it. A firm owning a mortgage originator has a competitive advantage since it guarantees the source for the well. This is why Stanley O'Neal at Merrill Lynch wanted to buy First Franklin (a mortgage loan originator) so badly, because for every loan First Franklin originates, Merrill Lynch executives and their structured product groups could accelerate ten years of their firm's earnings and future bonuses.
Wall Street wants to package and collateralize everything from residential to commercial mortgages, from credit card to auto loan debt, resulting in a major shift and increase from traditional M&A fees to the so-called trading "profit" in recent years "earned" by investment banks.
How real were the past earnings reported by both Wall Street firms and hedge funds with large CDO profits? If managers can trade a minor reduction in profit (from 50 to 30 basis points) for an immediate bonus of 10 times (by accelerating ten years of earnings to the current year) what would they choose?
If a CDO defaults next year and take a hedge fund under their high water mark, it's no a big deal. The fund already collected a 20% fee from the "profit" the year before. The manager can close the fund and open a new one, raising money probably from the same pool of investors. If you want to see a pyramid scheme, there is none more vivid than this.
How about those unbelievable earnings reported by Wall Street investment banks over the last several years?
Frankly and openly, early this decade, investment banks had repeatedly expressed their dissatisfaction about relying mainly on the traditional banking fees from M&A and IPOs. There was very little room for manipulation since they only got paid when a banking deal or IPO was completed. By discovering the CDO and CDS markets, they suddenly found their Holy Grail, with profit becoming more and more skewed toward the asset "structuring" (or manipulation?) and the trading side now representing the majority of their "earnings."
This kind of accounting abuse is not unusual. It happens in the option ARM (adjustable-rate mortgages) market too. Homeowners (borrowers) for the first year or two pay a teaser rate of 2%. However, in their financial statements, banks (lenders) report the full amount of interest, say 6%, as "profit," while they actually only collect 2%. The net 4% shortfall is added to the borrower's balance. Banks have nothing to lose, but homeowners see their balance increasing and home prices dropping.
WaMu reported $1.4B profit from this kind of ARM last year, while Countrywide earned approximately $600M from them in 2007. How much of those earnings were real? How much real cash have they actually collected or will collect? They would be lucky to collect one third, and the rest they may never see. ARM default rate jumped from 1.5% from last summer to 5% by end of 2007. There are two big waves of ARM rate resets coming - one this summer and another in October this year. By the end of this year, I forecast ARM default in double digits. The total outstanding ARM loans are estimated to be approximately $4-5 trillion. A 10% default will put $400Bn of loans in default.
There are many other accounting manipulations and abuses in the mortgage market. For example, when MBS (mortgage-backed securities) are sold to investors, banks will record the cash flow from interest and servicing rights over the whole life of this bond up front, as something called a "gain on sale". In another example, since mortgages classified as "loans held for sale" on the balance sheet must be marked to market, banks move them to another category called "loans held for investment," which has no such requirement. Only when banks believe their losses are not temporary, but permanent, must they mark to market. Banks can always argue the current real estate plummet is only temporary, if you think long term.
If you are using the last several years' earnings as a reference point, banks don't look very expensive today (setting aside the risk associated with all the off-balance items in their long footnotes). But do you think those trading profits will return in the future? I really doubt it.
Accounting and legal loopholes will get closed by new regulations, and the CDO market will dry up for the foreseeable future. Banks will not be able to return to their previous earning power without their trading "profit" from accounting loopholes. Even if the economy comes back soon with lots of M&A and IPO deals, which is very unlikely, the good old days of trading "profit" are likely gone forever.
I don't see why all the sovereign wealth funds (SWFs) are rushing to invest in Wall Street banks. There is not much upside - only a lot of downside. It is also very interesting to note the stated investment strategy of many SWFs is to seek a 5% stable annual return in very safe financial products.
SWFs are investing in financial institutions like Blackstone and investment banks which are anything but safe and stable. This totally contradicts their investment strategy. Nothing they have invested in can be regarded as safe and stable, let alone yielding a 5% annual return. Perhaps they will see a 5% fluctuation weekly if not daily.
No SWF has factored in currency risk, which may be 5% in US dollar terms, but could result in a negative 25% return in their own currency (if the US dollar depreciates 30% in the next several years, as I believe is likely). Their investments could not be further from their stated investment strategy, and this raises a credibility issue with regard to everything else SWFs have claimed.
Of the outstanding $45 trillion CDO credit default swaps at the end of last year, JP Morgan owned about $15 trillion, or one third of the whole market. This is may be the reason for the Bear Stearns' acquisition by JPM. Even though Bear Stearns' CDS position was “only” around $2.5 trillion, the default of Bear would bring a shock wave of counterparty risk across the whole CDS market and would inevitably expose JPM, with its huge CDS risk, to the global financial market. Who can afford to pay for this? Who has a large enough capital base to absorb such a loss, especially since these contracts are concentrated in only a few CDS derivative dealers like JPM? No one.
It always comes down to the deep pockets, as in any liability litigation, where litigators will skip all the smaller players but will jump on whoever has the deepest pockets and largest exposure and position. JPM currently seems to fit the picture. When such a time comes, all the other weaker and smaller players will try to dump their risk to JPM to unwind their positions. By buying Bear Stearns, JPM can postpone the CDS debacle for another year, but not forever. I expect JPM will eventually suffer very large losses in this area - bigger than one third of their market share. Bernanke and Paulson better get their helicopter and $500Bn of cash ready for their Wall Street friends.
Early this decade, Warren Buffett publicly turned against derivatives. "When Charlie [Munger] and I finished reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is taking," he told investors. He said "Derivatives are financial weapons of mass destruction [WMD], carrying dangers that, while now latent, are potentially lethal."
I believe what he was referring to at that time were not CDSs, but other derivatives such as interest rate swaps. The day will come when investors become aware of the OTC CDS scheme, which has no footnote in annual reports, no market, is not regulated, leaves no trace whatsoever, has no clearing house, and where everything depends on the credit and liquidity of the weakest player in the CDS chain. If an interest rate swap can be called a WMD by Warren Buffett, I can't come up with a name for the CDS. Just as Paul Volcker said last week, the current crisis is "the mother of all crises." The CDS is the mother of the current credit crisis.
The CDS is a Wall Street vehicle used to manipulate loopholes in accounting and legal regulations in order to move and hide losses, to record future profits today, to manipulate, realize and increase reported earnings in today's financial statements to accelerate bonus payments, all done with the help of willing and eager accomplices, in both bond insurers and rating agencies.
At the same time, it is the same old game of quick profits, phantom earnings, rip-offs, manipulation, distortion and cover-up, played on Wall Street since its inception. Only this time it is greatly exacerbated by the financial deregulations enacted during the Greenspan era.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
Needed: A Large Drop of Helicopter Money
During the past half year, the concerns of the Fed have shifted from worry about commodity-driven inflation (recall $147 oil in July) to its polar opposite--fear about the onset of deflation (coinciding with oil falling below $40 today). With short-term interest rates now lower than the targeted 1% rate, traditional monetary policy measures have become less potent and the U.S. economy is more susceptible to descending into a "liquidity trap." As mentioned by Ben Bernanke in a 2002 speech, one way out of such a predicament is a "helicopter drop"--effectively dropping money from helicopters to consumers and businesses below in order to thwart deflation, stimulate spending and prevent economic stagnation.
Consumer-Based Crisis
The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.
Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.
As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.
Helicopter Money Initiative
As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:
A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.
President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.
Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.
To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:
1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);
2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;
3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;
4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;
5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.
With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.
As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.
Consumer-Based Crisis
The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.
Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.
As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.
Helicopter Money Initiative
As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:
A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.
President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.
Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.
To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:
Beginning during the first half of 2009, write checks to every household filing a tax return, in the amount of, say, $10,000 per dependent (taxpayer, spouse, children, other household members), which is an order of magnitude larger than the consumer stimulus in early 2008.Offhand, it might appear that this type of seemingly frivolous fiscal policy would be a desperate and highly wasteful use of taxpayer money that could spark a new, undesirable bubble. However, given the precarious state of our economy, such a radical measure stands a greater chance of doing more good than harm and has many benefits:
1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);
2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;
3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;
4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;
5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.
With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.
As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.
Needed: A Large Drop of Helicopter Money
During the past half year, the concerns of the Fed have shifted from worry about commodity-driven inflation (recall $147 oil in July) to its polar opposite--fear about the onset of deflation (coinciding with oil falling below $40 today). With short-term interest rates now lower than the targeted 1% rate, traditional monetary policy measures have become less potent and the U.S. economy is more susceptible to descending into a "liquidity trap." As mentioned by Ben Bernanke in a 2002 speech, one way out of such a predicament is a "helicopter drop"--effectively dropping money from helicopters to consumers and businesses below in order to thwart deflation, stimulate spending and prevent economic stagnation.
Consumer-Based Crisis
The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.
Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.
As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.
Helicopter Money Initiative
As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:
A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.
President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.
Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.
To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:
1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);
2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;
3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;
4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;
5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.
With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.
As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.
Consumer-Based Crisis
The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.
Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.
As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.
Helicopter Money Initiative
As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:
A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.
President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.
Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.
To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:
Beginning during the first half of 2009, write checks to every household filing a tax return, in the amount of, say, $10,000 per dependent (taxpayer, spouse, children, other household members), which is an order of magnitude larger than the consumer stimulus in early 2008.Offhand, it might appear that this type of seemingly frivolous fiscal policy would be a desperate and highly wasteful use of taxpayer money that could spark a new, undesirable bubble. However, given the precarious state of our economy, such a radical measure stands a greater chance of doing more good than harm and has many benefits:
1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);
2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;
3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;
4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;
5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.
With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.
As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.
Western Goldfields – Strong Net Cashflow from Operations
Everyone remembers the California gold rush a century ago, but few know a large gold mine is currently under operations in the southeast corner of California near the Arizona and Mexican borders. This is the mining operations known as the Mesquite Mine managed by Western Goldfields (Amex: WGW).
This mine was actually operated from 1985 to 2001 by several mining companies including Newmont, but was suspended in 2001 when gold prices fell to the bottom. However, Western Goldfields acquired the mine in 2003, and production re-started in January of this year, the timing of which couldn’t have been better since the current turmoil in the credit market makes any financing very difficult if not impossible for some other cash stripped mining companies.
Western Goldfields (WGW) is headquartered in Toronto, Ontario. I met their President and CEO Mr. Raymond Threlkeld and Director of IR and Corp Development Mr. Hannes Portmann on November 20 in New York City. They discussed the details of the compelling value and low risk that their Company offered in comparison to their current low stock price.
Their major project, the Mesquite Mine, has 4.3 million resource ounces of gold including 2.8 million ounces in reserves. They are continuing drilling to find additional gold resources that could add 1 to 2 years of additional mine life beyond the current 14 years. Since it is a open pit operation, WGW can produce gold in a relatively cheap cost, with 2008 cost of sales averaging around $500 per oz. With the planned increasing production from 2009 and beyond, the cost of sales is expected to average around $420 per oz for the life of the mine.
This low cost is important during today’s gold correction and high production cost environment, comparing to many other mining companies. It enables WGW to make decent profit and generate substantial cashflow from operations. Even with today’s gold price, and expected 150,000 oz or more of annual production starting 2009, they can generate about $50 to $60 million in cashflow per year from operations. As a matter of fact, their current 3rd quarter 2008 has gold sales of 47K ounces at the cost of $390 only, with cashflow from operating activities at $16.5 million. Their stock price was trading at a ridiculous low level and temporary dipped below $0.50 per share late last month when the whole mining industry got hammered. However, it has since recovered nicely to $1.34 as of last Friday (11/28).
WGW has a very strong cash position of $45 million on hand including $7.5 million of restricted cash due to their loan covenants. At the same time, they are adding cash from their operations each quarter. This is why when their stock price dropped last month, they announced on Nov. 8 that they will buy back their shares up to 12.8 million shares, or 10% of their public float, maximum allowable by TSX. As Raymond said at NYC that in the current environment, cash is king and they definitely have the luxury of their vast cash position to do it. WGW does have $86 million loan outstanding, but since they will be generating strong cash, they are planning to pay it back in about 2 to 2.5 year’s time. By my rough calculation above, with today’s gold price, they should have no problem to pay $30 million toward their debt each year from their operations. Unlike many juniors, they don’t need to do any financing without pursuing any strategic acquisitions. Their management team seems to be very financially conservative in their business operations.
More importantly, if we believe the recent gold price is depressed and not supported by the dire macroeconomic situation and monetary inflation, we should see substantially higher gold price for many years into the future. The operating leverage provided by the Mesquite project will substantially increase the value of Western Goldfields. It won’t surprise me that WGW doubles or even triples from the current $1.34 price level to somewhere in the $3-4 range, which only brings them back to the price level this time of last year.
Disclosure: I don’t own Western Goldfields, but I believe WGW is currently undervalued and provides a good risk/reward opportunity for a diversified mining portfolio for long term capital gain.
This mine was actually operated from 1985 to 2001 by several mining companies including Newmont, but was suspended in 2001 when gold prices fell to the bottom. However, Western Goldfields acquired the mine in 2003, and production re-started in January of this year, the timing of which couldn’t have been better since the current turmoil in the credit market makes any financing very difficult if not impossible for some other cash stripped mining companies.
Western Goldfields (WGW) is headquartered in Toronto, Ontario. I met their President and CEO Mr. Raymond Threlkeld and Director of IR and Corp Development Mr. Hannes Portmann on November 20 in New York City. They discussed the details of the compelling value and low risk that their Company offered in comparison to their current low stock price.
Their major project, the Mesquite Mine, has 4.3 million resource ounces of gold including 2.8 million ounces in reserves. They are continuing drilling to find additional gold resources that could add 1 to 2 years of additional mine life beyond the current 14 years. Since it is a open pit operation, WGW can produce gold in a relatively cheap cost, with 2008 cost of sales averaging around $500 per oz. With the planned increasing production from 2009 and beyond, the cost of sales is expected to average around $420 per oz for the life of the mine.
This low cost is important during today’s gold correction and high production cost environment, comparing to many other mining companies. It enables WGW to make decent profit and generate substantial cashflow from operations. Even with today’s gold price, and expected 150,000 oz or more of annual production starting 2009, they can generate about $50 to $60 million in cashflow per year from operations. As a matter of fact, their current 3rd quarter 2008 has gold sales of 47K ounces at the cost of $390 only, with cashflow from operating activities at $16.5 million. Their stock price was trading at a ridiculous low level and temporary dipped below $0.50 per share late last month when the whole mining industry got hammered. However, it has since recovered nicely to $1.34 as of last Friday (11/28).
WGW has a very strong cash position of $45 million on hand including $7.5 million of restricted cash due to their loan covenants. At the same time, they are adding cash from their operations each quarter. This is why when their stock price dropped last month, they announced on Nov. 8 that they will buy back their shares up to 12.8 million shares, or 10% of their public float, maximum allowable by TSX. As Raymond said at NYC that in the current environment, cash is king and they definitely have the luxury of their vast cash position to do it. WGW does have $86 million loan outstanding, but since they will be generating strong cash, they are planning to pay it back in about 2 to 2.5 year’s time. By my rough calculation above, with today’s gold price, they should have no problem to pay $30 million toward their debt each year from their operations. Unlike many juniors, they don’t need to do any financing without pursuing any strategic acquisitions. Their management team seems to be very financially conservative in their business operations.
More importantly, if we believe the recent gold price is depressed and not supported by the dire macroeconomic situation and monetary inflation, we should see substantially higher gold price for many years into the future. The operating leverage provided by the Mesquite project will substantially increase the value of Western Goldfields. It won’t surprise me that WGW doubles or even triples from the current $1.34 price level to somewhere in the $3-4 range, which only brings them back to the price level this time of last year.
Disclosure: I don’t own Western Goldfields, but I believe WGW is currently undervalued and provides a good risk/reward opportunity for a diversified mining portfolio for long term capital gain.
My Overview of a Special Year 2008
What a year. It has been 11 months since I put out “My Ten Predictions for 2008”. In general, I think my predictions have luckily turned out to be about right, but I underestimated the severity of both the up and down movement.
Former Goldman Chairman John Whitehead said on Nov 12th that the current crisis is worse than the great depression in 1930s. For the past year, I have been saying all along that this crisis is a repeat of the 1930s and 1970s, but I didn’t expect it would be worse than the 1930s, probably only a repeat of the 1970s. However, like Mr. Whitehead, I am beginning to feel that he may be right. I hope we both are proved wrong, but I will likely take that view into consideration for my upcoming 2009 predictions. Perhaps Mr. Whitehead has been aware of the situation for a long time, but felt he was unable to say it freely to the public due to his position, until now.
Gold, HUI and US Dollar
In my ten predictions from last year, I correctly predicted that gold would hit $1,000, silver would hit $20 in 2008. Also, the US dollar index almost hit my target of 70 (71 to be exact). HUI didn’t hit my target of $600, and only reached around $520 at peak before crashing. I didn’t foresee the severity of the precious metal correction, especially the PM mining industry due to the deleveraging process when commodity hedge funds have been dumping everything for margin calls, for cash, and for redemption. I correctly predicted the volatility of $50 movement in gold which has occurred many times so far this year, including the almost $100 rebound within 24 hours back in September.
During the 1970s, gold underwent 2 years of severe correction, falling 40% between 1974 and 1976. This year, gold has dropped 34% from $1,030 to as low as $680 twice in the last two months. Hopefully, this is the final correction. Even the current correction is more than I originally anticipated, I am still holding my view, as discussed in previous articles, that $700 provides a strong support on a monthly close chart, even on a daily (three times) and weekly (not yet) close chart that gold dipped below this level for a short time. After the current correction, gold should start several years of its inevitable rise, which will lift all other boats such as silver, HUI companies and many financially strong PM mining juniors, just like the 2nd half of 1970s.
Banking Crisis and Citigroup
No one can reasonably discuss 2008 without talking about banks and the banking crisis, so I will spend more time in this area. My best call in this sector was that Citigroup would fall to the teens (below $20). This call was made when Citi was trading at $30 after already falling from $60, and 3 months before Meredith Whitney from Oppenheimer gave her famously bearish view on Citi and her price target of $15 when many people were highly doubtful of her prediction at that time.
Why did I pick Citi out of so many banks in the entire banking industry? My view on the financial industry has been heavily influenced by Jeremy Grantham of GMO when he predicted in the summer of 2007 (not 2008) that a major US bank would fail, and half of the hedge funds and private equity firms would get wiped out by 2010. I was trying to pick a major bank as a candidate of failure to reflect both of our bearish views on Wall St. I didn’t name Bear Stearns or Lehman since they were small, AIG and WaMu were not even real banks, Merrill was a possible candidate, but more of a brokerage house, Wachovia was a bank, but not quite a major one and not on my radar screen.
In order to fulfill Jeremy’s prophecy, the only candidate, a symbol for the US banking industry and financial dominance, a financially weak but a major bank, had to be Citi. In February, when Whitney put out her report after she studied in detail Citi’s balance sheet and especially off-balance sheet (pages of footnotes), I immediately knew that my target was too conservative (too high), I should have said in single digits instead of teens. The timing of 2010 by Jeremy was also too late, it could happen even this year. Usually, analysts from institutions are hesitant to state bearish views on the firms they cover (even for the indomitable Whitney); they would rather stop their coverage than give out potentially financially damaging ratings and targets, such as a share target in single digits. For banks to be in single digits, especially if below $5, it means it can be out of business anytime, when trading partners stop transactions with the bank and customers withdraw their funds. This is what collapsed Bear Stearns.
For many years, since the old Sandy Weill days, I have never thought Citi’s business model would work. Putting all the financial services under one umbrella, the so-called financial power house to leverage the scale and customer base, was only a fantasy even during the good old days. During bad times like now, this model is only leveraging viruses of toxic structured products, contagious OTC derivatives and amplifying losses. In addition, I have always voiced strong disagreement when Citi’s board picked the current CEO. I predicted that he wouldn’t last until the end of 2009, now he will be lucky to survive this year. Asking a salesman selling toxic structured products from Morgan Stanley, and a money losing hedge fund manager, to lead a banking conglomerate is similar to asking a used car salesman to fix all the problems at GM.
At the same time, Citi’s problems have been developing for many years, from his predecessors beginning with Sandy Weill. There has been wide speculation that Mr. Prince was just a scapegoat for someone else still there. Since during his CEO tenure, he was not the one behind the scene to aggressively push Citi into holding huge positions in CDOs, OTC derivatives and off-balance-sheet financing to chase phantom “profit”, which is what has brought down the house. The only solution for shareholders to recoup some value is to break up Citi into 8 to 10 pieces of small financial service firms, with some eventually going out of business. This is still better than the entire firm going out of business.
The 2nd bailout of $20 billion for Citi this week (11/24) came only a month after the 1st one of $25 billion. More importantly, the government will guarantee Citi’s losses up to $306 billion. But Citi is not Lehman which had only $600 billion in assets. How could the government know that the loss on Citi’s $3.3 trillion assets ($2 trillion on its balance sheet and $1.3 trillion on its off-balance sheet), was 5 times bigger than Lehman’s, would maximize at $306 billion? What would happen if the loss turns out to be $600 billion? Will the government put up the difference? Where is the limit? Will government only cover the balance sheet assets, not the more questionable off-balance-sheet ones? How about the estimated $700 billion toxic assets under the $1.3 trillion off-balance sheet, the loss of which can wipe out Citi’s equity not only once but 10 times? What happens to other smaller banks? Should government let them fail like Lehman just because they are small?
There has been four phases of bank rescue by the Fed and the Treasury Dept so far. The 1st one was to let a large bank to rescue a small one, represented by the famous $2 initial offer from JP Morgan to Bear Stearns. Pretty soon, no one wanted to be the white knight or the sucker anymore. Then the 2nd phase was just to let them fail, as in the case of Lehman. It had caused more trouble of leading other investment banks to fail. So that didn’t work. The 3rd phase was to get the $700 billion capital to buy MBS, CDOs and OTC derivatives, except no one knows how to value them and whether they are still worth anything at all. At the same time, it will also force banks to realize and accelerate losses, especially for their off-balance sheet items. So it didn’t work either. Finally, it has entered the 4th phase of injecting capital by buying preferred shares of only the large banks. I think this phase will only buy time for a quarter or two, then another capital injection, then…until the government eventually owns and nationalizes all the major banks in the US, as British government now owns RBS.
The best decision I have seen recently is the $50 billion deal of selling Merrill to BOA. How much was Merrill worth? Maybe at 0.5 of its tangible book value (around $14 billion) based on the share prices of many banks trading these days (PNC bought National City only at 0.3 of its BV), but BOA paid 1.8 of tangible BV. Kudos to Mr. Thain, cash out whenever you still can and if you are lucky, find a sucker to pay a high price. A great deal for Merrill’s shareholders (and bondholders), but really bad news for BOA shareholders. This is actually the 2nd time BOA took the bait and acted as a sucker: the 1st time was with the purchase of Countrywide at an unbelievably over-inflated price, resulting Angelo Mozilo happily cashing out and dumping all his troubles to BOA. Did they forget the “fool me once…and fool me twice….” saying?
Apparently, BOA wants to be another Citigroup by following Citi’s business model, i.e., by becoming another financial power house to offer all kinds of financial services under one roof, only to watch Citi collapse. It didn’t work for Citi, neither will it for BOA. BOA hopes cost cutting will do the trick; just look at how many jobs Citigroup has cut in the last year or so. The more people they cut, the lower their share price. It is inevitable that BOA will follow the same path.
OTC Derivatives and GE
My other calls on OTC derivatives (credit default swaps or CDS) being land mines, skyrocketing numbers of lawsuits (among rating agencies, bond insurers, banks, state/local governments and investors), credit card losses, sovereign wealth funds stopping investing in US banks, etc., have unfortunately all turned out to be true. Early this year, I have followed up with another article specifically discussing CDS: “Why Wall St. Needed Credit Default Swaps?”, the main points of which can be summarized as: Wall St. had used CDS for,
1) quick profits;
2) earning manipulation on financial statements; and
3) taking advantage of the accounting loophole “negative basis trading” in order to pay themselves huge bonuses based on phantom earnings.
Let us look at GE. GE had been buying back stocks around $35 for the 1st 9 months of this year, but had to issue new dilutive shares to Warren Buffet and others at much lower prices last month (October), in a unusual buy-high-sell-low act of pure shareholder equity destruction. All their business units are solid and still making money except no one knows what is going on at GE Capital, which is one of the largest OTC derivative dealers and holders of many structured products such as ABS through securitization. GE is never transparent about what is in their portfolio to investors, unlike investment banks, so their stock price has been heavily punished to around $15. Maybe all other GE business units are worth $15, but what happens if GE Capital, like many banks these days is, without a government bailout capital injection, a negative worth of ($5)?
GE has assured public that they only use OTC derivatives for hedging, and are very careful and conservative in their usage (whatever that means). Sure, that is exactly what Lehman said a few days before filing for bankruptcy (Lehman’s derivative positions were all fully hedged), so was AIG. AIG said they had only used CDS very carefully and conservatively, until one day out of blue people suddenly found out that a 300 people small AIG subsidiary in London wiped out the whole firm by selling $450 billion undisclosed “insurance” in the form of CDS? When counterparties are being wiped out one after another, where would GE get their “hedges” from? In addition, when AIG’s rating was downgraded from AAA, the liability of its CDS shot up exponentially, a fate GE will face soon.
Another risk about GE is its dependence on the commercial paper (CP) market to constantly refinance their large $80 billion liquidity needs. The CP market is too big and too complex for the US government to support on a daily basis. The government can save it for a few days, maybe even a few weeks, but not forever. If the CP market freezes up again or worse shuts down eventually, GE immediately faces liquidity problem which can put them out of business. GE has many good and viable industrial operations, and the only solution for them is to shut down GE Capital, even at the price of losing half of their earning power and a vital tool for all their past earning manipulations to deliver quarterly targets that Wall St. had wanted, and to sell assets and business units to raise a lot more cash in order to stop reliance on the CP market.
Commodities and Energy
I was correct about the inflation concern, the booming of agricultural commodities and crude oil, but only for a half year. Inflation expectation has given way suddenly to scary deflation worries and because of that, commodity prices have collapsed in the 2nd half. Is inflation dead? I don’t think so, especially in the eye of recent unprecedented monetary inflation by the Fed. There is usually a lag between monetary inflation and real price (CPI) inflation.
While the US dollar is temporarily experiencing a slight reprieve from its decline in purchasing power, its future, due to the lag time (velocity of circulation) which is somewhat retarded when an economy is in recession, should not be expected to continue in this trend. However, once inflation is out of cage, it is impossible to put it back in. The current debate about deflation vs. inflation could turn out to be both right. In other words, it seems more and more likely that we will face the worst nightmare of inflationary depression. No wonder Mr. Whitehead said this is worse than 1930s.
When I wrote “My Ten Predictions for 2008”, crude oil was traded around $90. I only gave out a target of $100 since oil had been doubled in 2007 from $50 to almost $100 and I expected that there should be a correction in 2008. But oil had a good run in late December and at the 1st trading day of 2008, it already hit $100. I knew then that I set the target too low, and I should’ve predicted $125. Well, even so, it was still too low since oil went all the way to $147.
However, I don’t think the current collapse of crude to $50 has anything to do with demand and supply, nor did the $147 oil. The high was purely greed out of speculation and now the low is purely fear that people will go back and live in caves again to stop using energy. The reality is demand will grow more slowly than previously anticipated, but it will still remain at least flat, if not up, especially with the larger population from emerging market countries demanding more energy. In addition, peak oil is a fact, and it is always a big question whether fast economic growth and higher living standards, especially in emerging market, will be able to accommodate the fast growing population on mother earth.
I also believe that alternative energy: solar, wind, biofuel, etc., is more of a fantasy than reality, more driven by political correctness and sloganeering than by economic sense. Alternative energy, e.g., solar and wind, is too small to make any appreciable difference in the larger energy consumption picture. And if they were economically feasible, people would have used them at large scale centuries ago. Biofuel makes little economic sense without government subsidies. It always takes energy to produce energy. When you see it has to waste 80-90% of one form of energy to make incremental 10-20% of another form of energy, you know something is not right and it is not sustainable. The meltdown in alternative energy stocks such as solar this year has indicated that people are abandoning hype and returning to reality.
Other Markets and GM
My other good call was the October 2007 peak being the peak of the past bull market, from which we entered a long lasting bear market and in which we witnessed many severe corrections. However, I didn’t expect such a washout so quickly. Originally I thought it was more likely in 2009 and 2010 to see a freefall like that of today’s.
My prediction of yield curve getting steep was correct also. However again, I didn’t anticipate the severity and the mess in the fixed income market, and who would’ve expected the short end of the yield curve hitting zero as it did in Japan! The current steep spread between the short and long end is not a good sign. I disagree with some economists who predict a quick economic recovery due to the steep yield curve. Instead, I think the short end shows people dumping anything and everything for cash, and the long end with high yield indicates no confidence in holding US dollars for the long haul. The historical record high spread between corporate bonds, munis and treasuries also indicates big troubles lie ahead. At the same time, I also correctly predicted the double digit fall in the real estate market, as reflected by the national S&P/Case-Schiller Index, which is now common knowledge.
It is hard not to mention GM this year, especially the option of bankruptcy vs. bailout. It is a very tricky and difficult situation for both the government and public. In theory, the auto industry needs to be in bankruptcy before it can rise from the ashes. Auto industry is now paying the price of what they have done in the long past, especially dumping tons of gas-guzzling SUVs onto the public lately--only because they could make 5 times more profit by selling a SUV than a compact car. The environmental damage caused by SUVs will not be reflected in the auto industry’s balance sheet, or even any government statistics, but it is a real liability for the whole of society, and someday it may prove to be catastrophic. Even with the strong SUV sales, they were still only able to break even. Now with SUV sales crashed, how will they be able to sell 5 times the number of compact cars to replace all of the SUVs?
For the three big automakers, bankruptcy is the only way to wipe out all their debts, their pension and healthcare obligations, existing union contracts, their ridiculous large dealer network across the country, and their incompetent management which should have been cleaned up long ago. However, the government’s bailout on the banking industry makes the auto-maker’s bankruptcy option socially dangerous, extremely difficult, ethically wrong, and with many politically incorrect. If the government can spend $5 to 7 trillion to guarantee financially toxic structured loans and products, $300 billion to buy preferred shares of banks which are then used in part to pay bonuses to the already super rich bankers, how can the government not spend what initially appears to be mere pocket change of those sums to rescue the auto industry in order to save millions of jobs and healthcare/pensions for the retirees?
The speculation that bankruptcy in big three could cost 3 million jobs might be a little exaggerated. But we also should realize that the auto industry is not like the airline industry. When all major airlines were in bankruptcy, people still bought tickets for their flight services and there was no competition for domestic routes from foreign airlines, unlikely the auto industry. The consequence of paying bankers while letting even 1 million workers lose jobs and more retirees to lose pensions/healthcare coverage could cause wide-spread social unrest, too much a risk for the government to bear.
At the same time, a “pocket change” of $25 billion doesn’t sound like a lot of money (comparing to the banking bailout). But the three big automakers will burn through that in less than a year, then they will come back next year to ask for more, just like Citigroup getting $25 billion last month then asking for more this month. Pretty soon, the US government will own not only the banking industry, but also the auto industry. To be fair to all, maybe they should own the airlines and any other industry in trouble down the road. How can they favor and save one industry but discriminate and dump the others? Where is the end of this?
Year 2008 will definitely go down in the history book as a very special year. It is a year marking the start of the 3rd depression after the 1930s and 1970s. It is the end of the 20 year Greenspan era of financial manipulation, distortion, rip-off and cover-up by Wall St. This resulted in high profits for the few on Wall St. and a huge burden on the mass of taxpayers from trillions in bailout capital, to destroy the political justification and honorable orientation of our free market society. It is also the beginning of a new, real and honest era for money: the gold era!
Some related stocks and indices: GLD, ^HUI, C, GE, GM, ^GSPC, SPY, USO.
Former Goldman Chairman John Whitehead said on Nov 12th that the current crisis is worse than the great depression in 1930s. For the past year, I have been saying all along that this crisis is a repeat of the 1930s and 1970s, but I didn’t expect it would be worse than the 1930s, probably only a repeat of the 1970s. However, like Mr. Whitehead, I am beginning to feel that he may be right. I hope we both are proved wrong, but I will likely take that view into consideration for my upcoming 2009 predictions. Perhaps Mr. Whitehead has been aware of the situation for a long time, but felt he was unable to say it freely to the public due to his position, until now.
Gold, HUI and US Dollar
In my ten predictions from last year, I correctly predicted that gold would hit $1,000, silver would hit $20 in 2008. Also, the US dollar index almost hit my target of 70 (71 to be exact). HUI didn’t hit my target of $600, and only reached around $520 at peak before crashing. I didn’t foresee the severity of the precious metal correction, especially the PM mining industry due to the deleveraging process when commodity hedge funds have been dumping everything for margin calls, for cash, and for redemption. I correctly predicted the volatility of $50 movement in gold which has occurred many times so far this year, including the almost $100 rebound within 24 hours back in September.
During the 1970s, gold underwent 2 years of severe correction, falling 40% between 1974 and 1976. This year, gold has dropped 34% from $1,030 to as low as $680 twice in the last two months. Hopefully, this is the final correction. Even the current correction is more than I originally anticipated, I am still holding my view, as discussed in previous articles, that $700 provides a strong support on a monthly close chart, even on a daily (three times) and weekly (not yet) close chart that gold dipped below this level for a short time. After the current correction, gold should start several years of its inevitable rise, which will lift all other boats such as silver, HUI companies and many financially strong PM mining juniors, just like the 2nd half of 1970s.
Banking Crisis and Citigroup
No one can reasonably discuss 2008 without talking about banks and the banking crisis, so I will spend more time in this area. My best call in this sector was that Citigroup would fall to the teens (below $20). This call was made when Citi was trading at $30 after already falling from $60, and 3 months before Meredith Whitney from Oppenheimer gave her famously bearish view on Citi and her price target of $15 when many people were highly doubtful of her prediction at that time.
Why did I pick Citi out of so many banks in the entire banking industry? My view on the financial industry has been heavily influenced by Jeremy Grantham of GMO when he predicted in the summer of 2007 (not 2008) that a major US bank would fail, and half of the hedge funds and private equity firms would get wiped out by 2010. I was trying to pick a major bank as a candidate of failure to reflect both of our bearish views on Wall St. I didn’t name Bear Stearns or Lehman since they were small, AIG and WaMu were not even real banks, Merrill was a possible candidate, but more of a brokerage house, Wachovia was a bank, but not quite a major one and not on my radar screen.
In order to fulfill Jeremy’s prophecy, the only candidate, a symbol for the US banking industry and financial dominance, a financially weak but a major bank, had to be Citi. In February, when Whitney put out her report after she studied in detail Citi’s balance sheet and especially off-balance sheet (pages of footnotes), I immediately knew that my target was too conservative (too high), I should have said in single digits instead of teens. The timing of 2010 by Jeremy was also too late, it could happen even this year. Usually, analysts from institutions are hesitant to state bearish views on the firms they cover (even for the indomitable Whitney); they would rather stop their coverage than give out potentially financially damaging ratings and targets, such as a share target in single digits. For banks to be in single digits, especially if below $5, it means it can be out of business anytime, when trading partners stop transactions with the bank and customers withdraw their funds. This is what collapsed Bear Stearns.
For many years, since the old Sandy Weill days, I have never thought Citi’s business model would work. Putting all the financial services under one umbrella, the so-called financial power house to leverage the scale and customer base, was only a fantasy even during the good old days. During bad times like now, this model is only leveraging viruses of toxic structured products, contagious OTC derivatives and amplifying losses. In addition, I have always voiced strong disagreement when Citi’s board picked the current CEO. I predicted that he wouldn’t last until the end of 2009, now he will be lucky to survive this year. Asking a salesman selling toxic structured products from Morgan Stanley, and a money losing hedge fund manager, to lead a banking conglomerate is similar to asking a used car salesman to fix all the problems at GM.
At the same time, Citi’s problems have been developing for many years, from his predecessors beginning with Sandy Weill. There has been wide speculation that Mr. Prince was just a scapegoat for someone else still there. Since during his CEO tenure, he was not the one behind the scene to aggressively push Citi into holding huge positions in CDOs, OTC derivatives and off-balance-sheet financing to chase phantom “profit”, which is what has brought down the house. The only solution for shareholders to recoup some value is to break up Citi into 8 to 10 pieces of small financial service firms, with some eventually going out of business. This is still better than the entire firm going out of business.
The 2nd bailout of $20 billion for Citi this week (11/24) came only a month after the 1st one of $25 billion. More importantly, the government will guarantee Citi’s losses up to $306 billion. But Citi is not Lehman which had only $600 billion in assets. How could the government know that the loss on Citi’s $3.3 trillion assets ($2 trillion on its balance sheet and $1.3 trillion on its off-balance sheet), was 5 times bigger than Lehman’s, would maximize at $306 billion? What would happen if the loss turns out to be $600 billion? Will the government put up the difference? Where is the limit? Will government only cover the balance sheet assets, not the more questionable off-balance-sheet ones? How about the estimated $700 billion toxic assets under the $1.3 trillion off-balance sheet, the loss of which can wipe out Citi’s equity not only once but 10 times? What happens to other smaller banks? Should government let them fail like Lehman just because they are small?
There has been four phases of bank rescue by the Fed and the Treasury Dept so far. The 1st one was to let a large bank to rescue a small one, represented by the famous $2 initial offer from JP Morgan to Bear Stearns. Pretty soon, no one wanted to be the white knight or the sucker anymore. Then the 2nd phase was just to let them fail, as in the case of Lehman. It had caused more trouble of leading other investment banks to fail. So that didn’t work. The 3rd phase was to get the $700 billion capital to buy MBS, CDOs and OTC derivatives, except no one knows how to value them and whether they are still worth anything at all. At the same time, it will also force banks to realize and accelerate losses, especially for their off-balance sheet items. So it didn’t work either. Finally, it has entered the 4th phase of injecting capital by buying preferred shares of only the large banks. I think this phase will only buy time for a quarter or two, then another capital injection, then…until the government eventually owns and nationalizes all the major banks in the US, as British government now owns RBS.
The best decision I have seen recently is the $50 billion deal of selling Merrill to BOA. How much was Merrill worth? Maybe at 0.5 of its tangible book value (around $14 billion) based on the share prices of many banks trading these days (PNC bought National City only at 0.3 of its BV), but BOA paid 1.8 of tangible BV. Kudos to Mr. Thain, cash out whenever you still can and if you are lucky, find a sucker to pay a high price. A great deal for Merrill’s shareholders (and bondholders), but really bad news for BOA shareholders. This is actually the 2nd time BOA took the bait and acted as a sucker: the 1st time was with the purchase of Countrywide at an unbelievably over-inflated price, resulting Angelo Mozilo happily cashing out and dumping all his troubles to BOA. Did they forget the “fool me once…and fool me twice….” saying?
Apparently, BOA wants to be another Citigroup by following Citi’s business model, i.e., by becoming another financial power house to offer all kinds of financial services under one roof, only to watch Citi collapse. It didn’t work for Citi, neither will it for BOA. BOA hopes cost cutting will do the trick; just look at how many jobs Citigroup has cut in the last year or so. The more people they cut, the lower their share price. It is inevitable that BOA will follow the same path.
OTC Derivatives and GE
My other calls on OTC derivatives (credit default swaps or CDS) being land mines, skyrocketing numbers of lawsuits (among rating agencies, bond insurers, banks, state/local governments and investors), credit card losses, sovereign wealth funds stopping investing in US banks, etc., have unfortunately all turned out to be true. Early this year, I have followed up with another article specifically discussing CDS: “Why Wall St. Needed Credit Default Swaps?”, the main points of which can be summarized as: Wall St. had used CDS for,
1) quick profits;
2) earning manipulation on financial statements; and
3) taking advantage of the accounting loophole “negative basis trading” in order to pay themselves huge bonuses based on phantom earnings.
Let us look at GE. GE had been buying back stocks around $35 for the 1st 9 months of this year, but had to issue new dilutive shares to Warren Buffet and others at much lower prices last month (October), in a unusual buy-high-sell-low act of pure shareholder equity destruction. All their business units are solid and still making money except no one knows what is going on at GE Capital, which is one of the largest OTC derivative dealers and holders of many structured products such as ABS through securitization. GE is never transparent about what is in their portfolio to investors, unlike investment banks, so their stock price has been heavily punished to around $15. Maybe all other GE business units are worth $15, but what happens if GE Capital, like many banks these days is, without a government bailout capital injection, a negative worth of ($5)?
GE has assured public that they only use OTC derivatives for hedging, and are very careful and conservative in their usage (whatever that means). Sure, that is exactly what Lehman said a few days before filing for bankruptcy (Lehman’s derivative positions were all fully hedged), so was AIG. AIG said they had only used CDS very carefully and conservatively, until one day out of blue people suddenly found out that a 300 people small AIG subsidiary in London wiped out the whole firm by selling $450 billion undisclosed “insurance” in the form of CDS? When counterparties are being wiped out one after another, where would GE get their “hedges” from? In addition, when AIG’s rating was downgraded from AAA, the liability of its CDS shot up exponentially, a fate GE will face soon.
Another risk about GE is its dependence on the commercial paper (CP) market to constantly refinance their large $80 billion liquidity needs. The CP market is too big and too complex for the US government to support on a daily basis. The government can save it for a few days, maybe even a few weeks, but not forever. If the CP market freezes up again or worse shuts down eventually, GE immediately faces liquidity problem which can put them out of business. GE has many good and viable industrial operations, and the only solution for them is to shut down GE Capital, even at the price of losing half of their earning power and a vital tool for all their past earning manipulations to deliver quarterly targets that Wall St. had wanted, and to sell assets and business units to raise a lot more cash in order to stop reliance on the CP market.
Commodities and Energy
I was correct about the inflation concern, the booming of agricultural commodities and crude oil, but only for a half year. Inflation expectation has given way suddenly to scary deflation worries and because of that, commodity prices have collapsed in the 2nd half. Is inflation dead? I don’t think so, especially in the eye of recent unprecedented monetary inflation by the Fed. There is usually a lag between monetary inflation and real price (CPI) inflation.
While the US dollar is temporarily experiencing a slight reprieve from its decline in purchasing power, its future, due to the lag time (velocity of circulation) which is somewhat retarded when an economy is in recession, should not be expected to continue in this trend. However, once inflation is out of cage, it is impossible to put it back in. The current debate about deflation vs. inflation could turn out to be both right. In other words, it seems more and more likely that we will face the worst nightmare of inflationary depression. No wonder Mr. Whitehead said this is worse than 1930s.
When I wrote “My Ten Predictions for 2008”, crude oil was traded around $90. I only gave out a target of $100 since oil had been doubled in 2007 from $50 to almost $100 and I expected that there should be a correction in 2008. But oil had a good run in late December and at the 1st trading day of 2008, it already hit $100. I knew then that I set the target too low, and I should’ve predicted $125. Well, even so, it was still too low since oil went all the way to $147.
However, I don’t think the current collapse of crude to $50 has anything to do with demand and supply, nor did the $147 oil. The high was purely greed out of speculation and now the low is purely fear that people will go back and live in caves again to stop using energy. The reality is demand will grow more slowly than previously anticipated, but it will still remain at least flat, if not up, especially with the larger population from emerging market countries demanding more energy. In addition, peak oil is a fact, and it is always a big question whether fast economic growth and higher living standards, especially in emerging market, will be able to accommodate the fast growing population on mother earth.
I also believe that alternative energy: solar, wind, biofuel, etc., is more of a fantasy than reality, more driven by political correctness and sloganeering than by economic sense. Alternative energy, e.g., solar and wind, is too small to make any appreciable difference in the larger energy consumption picture. And if they were economically feasible, people would have used them at large scale centuries ago. Biofuel makes little economic sense without government subsidies. It always takes energy to produce energy. When you see it has to waste 80-90% of one form of energy to make incremental 10-20% of another form of energy, you know something is not right and it is not sustainable. The meltdown in alternative energy stocks such as solar this year has indicated that people are abandoning hype and returning to reality.
Other Markets and GM
My other good call was the October 2007 peak being the peak of the past bull market, from which we entered a long lasting bear market and in which we witnessed many severe corrections. However, I didn’t expect such a washout so quickly. Originally I thought it was more likely in 2009 and 2010 to see a freefall like that of today’s.
My prediction of yield curve getting steep was correct also. However again, I didn’t anticipate the severity and the mess in the fixed income market, and who would’ve expected the short end of the yield curve hitting zero as it did in Japan! The current steep spread between the short and long end is not a good sign. I disagree with some economists who predict a quick economic recovery due to the steep yield curve. Instead, I think the short end shows people dumping anything and everything for cash, and the long end with high yield indicates no confidence in holding US dollars for the long haul. The historical record high spread between corporate bonds, munis and treasuries also indicates big troubles lie ahead. At the same time, I also correctly predicted the double digit fall in the real estate market, as reflected by the national S&P/Case-Schiller Index, which is now common knowledge.
It is hard not to mention GM this year, especially the option of bankruptcy vs. bailout. It is a very tricky and difficult situation for both the government and public. In theory, the auto industry needs to be in bankruptcy before it can rise from the ashes. Auto industry is now paying the price of what they have done in the long past, especially dumping tons of gas-guzzling SUVs onto the public lately--only because they could make 5 times more profit by selling a SUV than a compact car. The environmental damage caused by SUVs will not be reflected in the auto industry’s balance sheet, or even any government statistics, but it is a real liability for the whole of society, and someday it may prove to be catastrophic. Even with the strong SUV sales, they were still only able to break even. Now with SUV sales crashed, how will they be able to sell 5 times the number of compact cars to replace all of the SUVs?
For the three big automakers, bankruptcy is the only way to wipe out all their debts, their pension and healthcare obligations, existing union contracts, their ridiculous large dealer network across the country, and their incompetent management which should have been cleaned up long ago. However, the government’s bailout on the banking industry makes the auto-maker’s bankruptcy option socially dangerous, extremely difficult, ethically wrong, and with many politically incorrect. If the government can spend $5 to 7 trillion to guarantee financially toxic structured loans and products, $300 billion to buy preferred shares of banks which are then used in part to pay bonuses to the already super rich bankers, how can the government not spend what initially appears to be mere pocket change of those sums to rescue the auto industry in order to save millions of jobs and healthcare/pensions for the retirees?
The speculation that bankruptcy in big three could cost 3 million jobs might be a little exaggerated. But we also should realize that the auto industry is not like the airline industry. When all major airlines were in bankruptcy, people still bought tickets for their flight services and there was no competition for domestic routes from foreign airlines, unlikely the auto industry. The consequence of paying bankers while letting even 1 million workers lose jobs and more retirees to lose pensions/healthcare coverage could cause wide-spread social unrest, too much a risk for the government to bear.
At the same time, a “pocket change” of $25 billion doesn’t sound like a lot of money (comparing to the banking bailout). But the three big automakers will burn through that in less than a year, then they will come back next year to ask for more, just like Citigroup getting $25 billion last month then asking for more this month. Pretty soon, the US government will own not only the banking industry, but also the auto industry. To be fair to all, maybe they should own the airlines and any other industry in trouble down the road. How can they favor and save one industry but discriminate and dump the others? Where is the end of this?
Year 2008 will definitely go down in the history book as a very special year. It is a year marking the start of the 3rd depression after the 1930s and 1970s. It is the end of the 20 year Greenspan era of financial manipulation, distortion, rip-off and cover-up by Wall St. This resulted in high profits for the few on Wall St. and a huge burden on the mass of taxpayers from trillions in bailout capital, to destroy the political justification and honorable orientation of our free market society. It is also the beginning of a new, real and honest era for money: the gold era!
Some related stocks and indices: GLD, ^HUI, C, GE, GM, ^GSPC, SPY, USO.
Hedging Is Simple, But Market Timing Is Not
What follows is some perspective on the buzz we're hearing about portfolio and fund manager performance in this horrendously painful bear-market year, which most investors would love to forget about--if only they could.
While Miller Missteps (Again) . . .
Recall that around this time in 2005, Bill Miller was being hailed as the most successful fund manager of all time, with his Legg Mason Value Trust Fund outperforming the S&P 500 for a record-breaking 15th straight year. Then, in 2006, Value Trust underperformed for the first time since 1990, returning just 6% versus the S&P 500's double-digit 16%. Last year, in 2007, Miller again underperformed, this time -7% (i.e., a loss) for Value Trust versus a 5% gain for the S&P 500. In 2008, as of last Friday, Nov. 14, Value Trust is down a whopping 50%, versus a 40% decline for the S&P 500, making it quite likely that Miller will underperform once again--for the third straight year.
In his third-quarter commentary published last week (Nov. 12), Miller discusses flaws in the government's delayed ("too late") response to the financial crisis, while also admitting,
. . . Hussman Hedges
While most equity fund managers, like Miller, are suffering complete and unforgiving drubbings this year, one fund manager is making news due to his notable outperformance in this year's most disastrous market in decades. John Hussman's Strategic Growth Fund (HSGFX) is running only slightly negative year-to-date through Oct. 31, which sure beats the 40% or larger decline most fund managers are experiencing. Of course, Hussman's stand-alone performance begs the question, what's his secret formula?
Though academic credentials do not necessarily or even typically help one become a better investor, perhaps at least it is no detriment to his performance that Hussman holds a Stanford economics Ph.D. and is a former finance professor at the University of Michigan. His investment strategy, as described on his website and in his fund's prospectus, seems to be a rational approach firmly grounded in interpreting historical data, utilizing "observable evidence" (sounds scientific . . .) in an attempt to distinguish between favorable and unfavorable "market climates" (weather forecasting analogy?), taking into account both "market action" (an allusion to physics or sports?) and valuation (yeah, he has a value-investing approach, similar in some respects to Buffett and Grantham).
To date, Hussman's differentiator has been his hedging. What really distinguishes his investment style from that other fund managers is his ongoing implementation of partial or full hedging of his underlying long-equity portfolio, even though he could potentially become fully invested or even leverage up beyond full exposure if market conditions ever call for it:
Because Hussman varies the amount of his protection (or exposure) to market moves in accordance with market conditions, he is, in my opinion, attempting at least partially to "time" the market, even though he insists that he is not pursuing "market timing" in the usual sense of the term. In his own words from a recent weekly commentary:
To understand the impact of hedging on Hussman's longer-term performance, we can look at his fund's returns, which he conveniently discloses both before and after hedging.
Since its inception in 2000, Hussman's Strategic Growth Fund has carved out a winning track record, as evidenced by the stellar performance chart displayed prominently on Hussman's website. For the eight-year period, while the S&P 500 has lost 1.04% annually, Hussman's unhedged portfolio has gained 6.37% annually, and his Strategic Growth Fund has returned 10.76% annually. These results indicate that Hussman's stock-picking ability (or is it luck?--more on this topic below) has boosted his annual return to some 741 b.p. above the S&P 500, while his hedging has apparently added another 439 b.p. to his annual performance. This is a very solid track record over the past eight years, particularly in light of the two bear markets fund managers have had to endure, both in 2000-2002 and beginning from the last quarter of 2007.
Before jumping to conclusions about Hussman's apparent analytical genius or market clairvoyance in largely avoiding both bear markets, let's take a closer look at the data--his data--posted here on his website for the casual (or better, not so casual) perusal by anyone interested. Taking the 33 quarters of data from the third quarter of 2000 through the third quarter of 2008, we can make a scatter plot of his unhedged and realized fund performance versus the S&P 500, as shown in the chart below.
If Hussman's realized fund performance points (in pink) on the chart seem to sketch out a typical, albeit somewhat noisy, hockey-stick-shaped option payoff diagram, this graphical result should come as no surprise, since, after all, the basic purpose of Hussman's hedging is to protect his portfolio against market declines, while allowing participation in market upside potential.
Let's take our analysis of Hussman's performance a step further. In the chart above, observe that the pink points sit above the blue points on the left half, while the reverse is true--pink below blue--on the right half. To understand this behavior, we need to distinguish between hedging and market timing:
What this all indicates is that Hussman's performance is basically consistent with that of someone who makes a practice of always hedging with put options, regardless of market conditions. By and large, it is not what we should expect to see from a portfolio manager implementing a market timing strategy, even though Hussman does at least occasionally remove some portion of his hedge to reduce cost when he believes that risk is low and the chance of a market rise is high.
Skill Versus Luck
The above classification of Hussman as a hedger and not a market timer is in agreement with the often-stated warning to investors and traders that market timing is difficult, if not impossible, and should be attempted only with extreme caution by anyone with risk aversion. In a Tech Ticker interview last week on the topic of skill versus luck in stock-picking and market timing, Professor Kenneth French (whose name figures prominently alongside Fama's in finance theory) states:
What this means is that we, the investing public, should not read too much into the performance of successful fund managers, however superb their performance may have been (in Miller's case) or appear to be (in Hussman's case). Both Hussman and Miller have certainly assembled relatively long track records as ostensibly excellent stock-pickers, but, as history has shown, anything is possible. If Miller's 15-year winning streak can suddenly undergo a complete metamorphosis into a 3-year (or longer?) losing streak, and if Hussman's track record is solid but exhibits inherent underperformance in rising markets as consistently as it displays outperformance in falling markets, we can only suspect that unquestionable evidence of skill, as opposed to luck, in investing has become that much harder to find.
Although anyone actively managing a stock portfolio may hate to admit it, Professor French is most likely right--unfortunately, in the world of investing, we will probably never really be able to tell if our own or anyone else's performance stems primarily from luck or, as many may want to believe, from having a discernible edge over other investors who are only almost-as-skilled as ourselves.
While Miller Missteps (Again) . . .
Recall that around this time in 2005, Bill Miller was being hailed as the most successful fund manager of all time, with his Legg Mason Value Trust Fund outperforming the S&P 500 for a record-breaking 15th straight year. Then, in 2006, Value Trust underperformed for the first time since 1990, returning just 6% versus the S&P 500's double-digit 16%. Last year, in 2007, Miller again underperformed, this time -7% (i.e., a loss) for Value Trust versus a 5% gain for the S&P 500. In 2008, as of last Friday, Nov. 14, Value Trust is down a whopping 50%, versus a 40% decline for the S&P 500, making it quite likely that Miller will underperform once again--for the third straight year.
In his third-quarter commentary published last week (Nov. 12), Miller discusses flaws in the government's delayed ("too late") response to the financial crisis, while also admitting,
"I have made enough mistakes in this market of my own, chief among them was recognizing how disastrous [government] policies being followed were, yet not taking maximum defensive measures [italics mine], believing that the policies would be reversed or at least followed by sensible ones before things got completely out of control."Miller is alluding here to his failure to implement an appropriate hedging strategy to protect his fund against the precipitous collapse of the market during the past couple of months. With 20/20 hindsight, of course, it is easy to say that he (or anyone long the market) should have either sold their equity holdings, shorted S&P 500 futures, or bought puts to protect the downside.
. . . Hussman Hedges
While most equity fund managers, like Miller, are suffering complete and unforgiving drubbings this year, one fund manager is making news due to his notable outperformance in this year's most disastrous market in decades. John Hussman's Strategic Growth Fund (HSGFX) is running only slightly negative year-to-date through Oct. 31, which sure beats the 40% or larger decline most fund managers are experiencing. Of course, Hussman's stand-alone performance begs the question, what's his secret formula?
Though academic credentials do not necessarily or even typically help one become a better investor, perhaps at least it is no detriment to his performance that Hussman holds a Stanford economics Ph.D. and is a former finance professor at the University of Michigan. His investment strategy, as described on his website and in his fund's prospectus, seems to be a rational approach firmly grounded in interpreting historical data, utilizing "observable evidence" (sounds scientific . . .) in an attempt to distinguish between favorable and unfavorable "market climates" (weather forecasting analogy?), taking into account both "market action" (an allusion to physics or sports?) and valuation (yeah, he has a value-investing approach, similar in some respects to Buffett and Grantham).
To date, Hussman's differentiator has been his hedging. What really distinguishes his investment style from that other fund managers is his ongoing implementation of partial or full hedging of his underlying long-equity portfolio, even though he could potentially become fully invested or even leverage up beyond full exposure if market conditions ever call for it:
"In conditions which the investment manager identifies as involving high risk and low expected return, the Fund's portfolio will be hedged by using stock index futures, options on stock indices or options on individual securities. . . . The Fund will typically be fully invested or leveraged when the investment manager identifies conditions in which stocks have historically been rewarding investments."In Hussman's framework, although market action remains unfavorable, the market's recent decline has shifted valuation from unfavorable to more favorable, leading him to begin transitioning his portfolio from being fully hedged (underlying stock positions essentially 100% protected by put-call combinations as of a few months ago) to taking on moderate market exposure (now 70% to 80% protected). Currently, Hussman views any near-term market declines as opportunities to strip away a few more layers of protection and increase market exposure, since stocks have become "both undervalued and oversold."
Because Hussman varies the amount of his protection (or exposure) to market moves in accordance with market conditions, he is, in my opinion, attempting at least partially to "time" the market, even though he insists that he is not pursuing "market timing" in the usual sense of the term. In his own words from a recent weekly commentary:
"The Strategic Growth Fund is not a 'market timing' fund. Nor is it a 'bear' fund or a 'market neutral' fund. Strategic Growth is a risk-managed growth fund that is intended to accept exposure to U.S. stocks over the full market cycle, but with smaller periodic losses than a passive buy-and-hold approach. We gradually scale our investment exposure in proportion to the average return/risk profile that stocks have provided under similar conditions (primarily defined by valuation and market action). We make no attempt to track short-term market fluctuations. We leave 'buy signals' and attempts to forecast short-term market direction to other investors, preferring to align our investment positions with the prevailing evidence about the Market Climate."Hedging Versus Market Timing
To understand the impact of hedging on Hussman's longer-term performance, we can look at his fund's returns, which he conveniently discloses both before and after hedging.
Since its inception in 2000, Hussman's Strategic Growth Fund has carved out a winning track record, as evidenced by the stellar performance chart displayed prominently on Hussman's website. For the eight-year period, while the S&P 500 has lost 1.04% annually, Hussman's unhedged portfolio has gained 6.37% annually, and his Strategic Growth Fund has returned 10.76% annually. These results indicate that Hussman's stock-picking ability (or is it luck?--more on this topic below) has boosted his annual return to some 741 b.p. above the S&P 500, while his hedging has apparently added another 439 b.p. to his annual performance. This is a very solid track record over the past eight years, particularly in light of the two bear markets fund managers have had to endure, both in 2000-2002 and beginning from the last quarter of 2007.
Before jumping to conclusions about Hussman's apparent analytical genius or market clairvoyance in largely avoiding both bear markets, let's take a closer look at the data--his data--posted here on his website for the casual (or better, not so casual) perusal by anyone interested. Taking the 33 quarters of data from the third quarter of 2000 through the third quarter of 2008, we can make a scatter plot of his unhedged and realized fund performance versus the S&P 500, as shown in the chart below.
If Hussman's realized fund performance points (in pink) on the chart seem to sketch out a typical, albeit somewhat noisy, hockey-stick-shaped option payoff diagram, this graphical result should come as no surprise, since, after all, the basic purpose of Hussman's hedging is to protect his portfolio against market declines, while allowing participation in market upside potential. Let's take our analysis of Hussman's performance a step further. In the chart above, observe that the pink points sit above the blue points on the left half, while the reverse is true--pink below blue--on the right half. To understand this behavior, we need to distinguish between hedging and market timing:
- Hedging: The underlying unhedged position is Hussman's long-equity exposure to his chosen portfolio of stocks. If he were always (i.e., without attempting to time the market) simply to buy put options with at-the-money or slightly out-of-the-money strikes to protect his portfolio against market downside, the puts would show a profit when the market declines but would expire worthless when the market rises. The result would be an insurance-like payoff pattern from the hedge--protection against loss in a declining market, but with a cost relative to the unhedged position particularly evident when the market rises.
- Market Timing: On the other hand, if Hussman were attempting to time the market and successful in doing so, presumably by selectively hedging to protect against downside under risky market conditions but operating without a hedge when prevailing conditions are less risky, the data ought to show not only realized fund performance above the unhedged case (pink above blue in the chart) when the market declines, but also at least an occasional occurrence of this type of outperformance of his fund over the unhedged case when the market rises.
What this all indicates is that Hussman's performance is basically consistent with that of someone who makes a practice of always hedging with put options, regardless of market conditions. By and large, it is not what we should expect to see from a portfolio manager implementing a market timing strategy, even though Hussman does at least occasionally remove some portion of his hedge to reduce cost when he believes that risk is low and the chance of a market rise is high.
Skill Versus Luck
The above classification of Hussman as a hedger and not a market timer is in agreement with the often-stated warning to investors and traders that market timing is difficult, if not impossible, and should be attempted only with extreme caution by anyone with risk aversion. In a Tech Ticker interview last week on the topic of skill versus luck in stock-picking and market timing, Professor Kenneth French (whose name figures prominently alongside Fama's in finance theory) states:
"There this a whole academic literature trying to figure out who won because of luck and who won because they truly had skill. We don't know how to do it. I mean there's a little bit of evidence that we can distinguish luck from skill, but, in essence, it's absolutely futile.Surely, coming from an accomplished expert in finance, this type of statement is enough to throw into question anyone's claim of having ability to pick stocks and time the market to achieve excess returns in a consistent fashion.
"So, when I have a mediocre M.B.A. student who spent the weekend studying Morningstar and is convinced he knows how to pick the winning fund, what I challenge him with is sort of, 'Geez, you know, it's good that you didn't even need to bother to get a Ph.D. and spend the last 30 years of your life solving this problem. You know, those of us who did that, we don't know how to do it. But, congratulations. That was a really productive weekend!'
". . . To basically try to distinguish skill from luck . . . [is] almost impossible. . . . What I'm saying is, I can't tell . . . one from the other. . . . If I can't tell good from bad, why play the game?"
What this means is that we, the investing public, should not read too much into the performance of successful fund managers, however superb their performance may have been (in Miller's case) or appear to be (in Hussman's case). Both Hussman and Miller have certainly assembled relatively long track records as ostensibly excellent stock-pickers, but, as history has shown, anything is possible. If Miller's 15-year winning streak can suddenly undergo a complete metamorphosis into a 3-year (or longer?) losing streak, and if Hussman's track record is solid but exhibits inherent underperformance in rising markets as consistently as it displays outperformance in falling markets, we can only suspect that unquestionable evidence of skill, as opposed to luck, in investing has become that much harder to find.
Although anyone actively managing a stock portfolio may hate to admit it, Professor French is most likely right--unfortunately, in the world of investing, we will probably never really be able to tell if our own or anyone else's performance stems primarily from luck or, as many may want to believe, from having a discernible edge over other investors who are only almost-as-skilled as ourselves.
Hedging Is Simple, But Market Timing Is Not
What follows is some perspective on the buzz we're hearing about portfolio and fund manager performance in this horrendously painful bear-market year, which most investors would love to forget about--if only they could.
While Miller Missteps (Again) . . .
Recall that around this time in 2005, Bill Miller was being hailed as the most successful fund manager of all time, with his Legg Mason Value Trust Fund outperforming the S&P 500 for a record-breaking 15th straight year. Then, in 2006, Value Trust underperformed for the first time since 1990, returning just 6% versus the S&P 500's double-digit 16%. Last year, in 2007, Miller again underperformed, this time -7% (i.e., a loss) for Value Trust versus a 5% gain for the S&P 500. In 2008, as of last Friday, Nov. 14, Value Trust is down a whopping 50%, versus a 40% decline for the S&P 500, making it quite likely that Miller will underperform once again--for the third straight year.
In his third-quarter commentary published last week (Nov. 12), Miller discusses flaws in the government's delayed ("too late") response to the financial crisis, while also admitting,
. . . Hussman Hedges
While most equity fund managers, like Miller, are suffering complete and unforgiving drubbings this year, one fund manager is making news due to his notable outperformance in this year's most disastrous market in decades. John Hussman's Strategic Growth Fund (HSGFX) is running only slightly negative year-to-date through Oct. 31, which sure beats the 40% or larger decline most fund managers are experiencing. Of course, Hussman's stand-alone performance begs the question, what's his secret formula?
Though academic credentials do not necessarily or even typically help one become a better investor, perhaps at least it is no detriment to his performance that Hussman holds a Stanford economics Ph.D. and is a former finance professor at the University of Michigan. His investment strategy, as described on his website and in his fund's prospectus, seems to be a rational approach firmly grounded in interpreting historical data, utilizing "observable evidence" (sounds scientific . . .) in an attempt to distinguish between favorable and unfavorable "market climates" (weather forecasting analogy?), taking into account both "market action" (an allusion to physics or sports?) and valuation (yeah, he has a value-investing approach, similar in some respects to Buffett and Grantham).
To date, Hussman's differentiator has been his hedging. What really distinguishes his investment style from that other fund managers is his ongoing implementation of partial or full hedging of his underlying long-equity portfolio, even though he could potentially become fully invested or even leverage up beyond full exposure if market conditions ever call for it:
Because Hussman varies the amount of his protection (or exposure) to market moves in accordance with market conditions, he is, in my opinion, attempting at least partially to "time" the market, even though he insists that he is not pursuing "market timing" in the usual sense of the term. In his own words from a recent weekly commentary:
To understand the impact of hedging on Hussman's longer-term performance, we can look at his fund's returns, which he conveniently discloses both before and after hedging.
Since its inception in 2000, Hussman's Strategic Growth Fund has carved out a winning track record, as evidenced by the stellar performance chart displayed prominently on Hussman's website. For the eight-year period, while the S&P 500 has lost 1.04% annually, Hussman's unhedged portfolio has gained 6.37% annually, and his Strategic Growth Fund has returned 10.76% annually. These results indicate that Hussman's stock-picking ability (or is it luck?--more on this topic below) has boosted his annual return to some 741 b.p. above the S&P 500, while his hedging has apparently added another 439 b.p. to his annual performance. This is a very solid track record over the past eight years, particularly in light of the two bear markets fund managers have had to endure, both in 2000-2002 and beginning from the last quarter of 2007.
Before jumping to conclusions about Hussman's apparent analytical genius or market clairvoyance in largely avoiding both bear markets, let's take a closer look at the data--his data--posted here on his website for the casual (or better, not so casual) perusal by anyone interested. Taking the 33 quarters of data from the third quarter of 2000 through the third quarter of 2008, we can make a scatter plot of his unhedged and realized fund performance versus the S&P 500, as shown in the chart below.
If Hussman's realized fund performance points (in pink) on the chart seem to sketch out a typical, albeit somewhat noisy, hockey-stick-shaped option payoff diagram, this graphical result should come as no surprise, since, after all, the basic purpose of Hussman's hedging is to protect his portfolio against market declines, while allowing participation in market upside potential.
Let's take our analysis of Hussman's performance a step further. In the chart above, observe that the pink points sit above the blue points on the left half, while the reverse is true--pink below blue--on the right half. To understand this behavior, we need to distinguish between hedging and market timing:
What this all indicates is that Hussman's performance is basically consistent with that of someone who makes a practice of always hedging with put options, regardless of market conditions. By and large, it is not what we should expect to see from a portfolio manager implementing a market timing strategy, even though Hussman does at least occasionally remove some portion of his hedge to reduce cost when he believes that risk is low and the chance of a market rise is high.
Skill Versus Luck
The above classification of Hussman as a hedger and not a market timer is in agreement with the often-stated warning to investors and traders that market timing is difficult, if not impossible, and should be attempted only with extreme caution by anyone with risk aversion. In a Tech Ticker interview last week on the topic of skill versus luck in stock-picking and market timing, Professor Kenneth French (whose name figures prominently alongside Fama's in finance theory) states:
What this means is that we, the investing public, should not read too much into the performance of successful fund managers, however superb their performance may have been (in Miller's case) or appear to be (in Hussman's case). Both Hussman and Miller have certainly assembled relatively long track records as ostensibly excellent stock-pickers, but, as history has shown, anything is possible. If Miller's 15-year winning streak can suddenly undergo a complete metamorphosis into a 3-year (or longer?) losing streak, and if Hussman's track record is solid but exhibits inherent underperformance in rising markets as consistently as it displays outperformance in falling markets, we can only suspect that unquestionable evidence of skill, as opposed to luck, in investing has become that much harder to find.
Although anyone actively managing a stock portfolio may hate to admit it, Professor French is most likely right--unfortunately, in the world of investing, we will probably never really be able to tell if our own or anyone else's performance stems primarily from luck or, as many may want to believe, from having a discernible edge over other investors who are only almost-as-skilled as ourselves.
While Miller Missteps (Again) . . .
Recall that around this time in 2005, Bill Miller was being hailed as the most successful fund manager of all time, with his Legg Mason Value Trust Fund outperforming the S&P 500 for a record-breaking 15th straight year. Then, in 2006, Value Trust underperformed for the first time since 1990, returning just 6% versus the S&P 500's double-digit 16%. Last year, in 2007, Miller again underperformed, this time -7% (i.e., a loss) for Value Trust versus a 5% gain for the S&P 500. In 2008, as of last Friday, Nov. 14, Value Trust is down a whopping 50%, versus a 40% decline for the S&P 500, making it quite likely that Miller will underperform once again--for the third straight year.
In his third-quarter commentary published last week (Nov. 12), Miller discusses flaws in the government's delayed ("too late") response to the financial crisis, while also admitting,
"I have made enough mistakes in this market of my own, chief among them was recognizing how disastrous [government] policies being followed were, yet not taking maximum defensive measures [italics mine], believing that the policies would be reversed or at least followed by sensible ones before things got completely out of control."Miller is alluding here to his failure to implement an appropriate hedging strategy to protect his fund against the precipitous collapse of the market during the past couple of months. With 20/20 hindsight, of course, it is easy to say that he (or anyone long the market) should have either sold their equity holdings, shorted S&P 500 futures, or bought puts to protect the downside.
. . . Hussman Hedges
While most equity fund managers, like Miller, are suffering complete and unforgiving drubbings this year, one fund manager is making news due to his notable outperformance in this year's most disastrous market in decades. John Hussman's Strategic Growth Fund (HSGFX) is running only slightly negative year-to-date through Oct. 31, which sure beats the 40% or larger decline most fund managers are experiencing. Of course, Hussman's stand-alone performance begs the question, what's his secret formula?
Though academic credentials do not necessarily or even typically help one become a better investor, perhaps at least it is no detriment to his performance that Hussman holds a Stanford economics Ph.D. and is a former finance professor at the University of Michigan. His investment strategy, as described on his website and in his fund's prospectus, seems to be a rational approach firmly grounded in interpreting historical data, utilizing "observable evidence" (sounds scientific . . .) in an attempt to distinguish between favorable and unfavorable "market climates" (weather forecasting analogy?), taking into account both "market action" (an allusion to physics or sports?) and valuation (yeah, he has a value-investing approach, similar in some respects to Buffett and Grantham).
To date, Hussman's differentiator has been his hedging. What really distinguishes his investment style from that other fund managers is his ongoing implementation of partial or full hedging of his underlying long-equity portfolio, even though he could potentially become fully invested or even leverage up beyond full exposure if market conditions ever call for it:
"In conditions which the investment manager identifies as involving high risk and low expected return, the Fund's portfolio will be hedged by using stock index futures, options on stock indices or options on individual securities. . . . The Fund will typically be fully invested or leveraged when the investment manager identifies conditions in which stocks have historically been rewarding investments."In Hussman's framework, although market action remains unfavorable, the market's recent decline has shifted valuation from unfavorable to more favorable, leading him to begin transitioning his portfolio from being fully hedged (underlying stock positions essentially 100% protected by put-call combinations as of a few months ago) to taking on moderate market exposure (now 70% to 80% protected). Currently, Hussman views any near-term market declines as opportunities to strip away a few more layers of protection and increase market exposure, since stocks have become "both undervalued and oversold."
Because Hussman varies the amount of his protection (or exposure) to market moves in accordance with market conditions, he is, in my opinion, attempting at least partially to "time" the market, even though he insists that he is not pursuing "market timing" in the usual sense of the term. In his own words from a recent weekly commentary:
"The Strategic Growth Fund is not a 'market timing' fund. Nor is it a 'bear' fund or a 'market neutral' fund. Strategic Growth is a risk-managed growth fund that is intended to accept exposure to U.S. stocks over the full market cycle, but with smaller periodic losses than a passive buy-and-hold approach. We gradually scale our investment exposure in proportion to the average return/risk profile that stocks have provided under similar conditions (primarily defined by valuation and market action). We make no attempt to track short-term market fluctuations. We leave 'buy signals' and attempts to forecast short-term market direction to other investors, preferring to align our investment positions with the prevailing evidence about the Market Climate."Hedging Versus Market Timing
To understand the impact of hedging on Hussman's longer-term performance, we can look at his fund's returns, which he conveniently discloses both before and after hedging.
Since its inception in 2000, Hussman's Strategic Growth Fund has carved out a winning track record, as evidenced by the stellar performance chart displayed prominently on Hussman's website. For the eight-year period, while the S&P 500 has lost 1.04% annually, Hussman's unhedged portfolio has gained 6.37% annually, and his Strategic Growth Fund has returned 10.76% annually. These results indicate that Hussman's stock-picking ability (or is it luck?--more on this topic below) has boosted his annual return to some 741 b.p. above the S&P 500, while his hedging has apparently added another 439 b.p. to his annual performance. This is a very solid track record over the past eight years, particularly in light of the two bear markets fund managers have had to endure, both in 2000-2002 and beginning from the last quarter of 2007.
Before jumping to conclusions about Hussman's apparent analytical genius or market clairvoyance in largely avoiding both bear markets, let's take a closer look at the data--his data--posted here on his website for the casual (or better, not so casual) perusal by anyone interested. Taking the 33 quarters of data from the third quarter of 2000 through the third quarter of 2008, we can make a scatter plot of his unhedged and realized fund performance versus the S&P 500, as shown in the chart below.
If Hussman's realized fund performance points (in pink) on the chart seem to sketch out a typical, albeit somewhat noisy, hockey-stick-shaped option payoff diagram, this graphical result should come as no surprise, since, after all, the basic purpose of Hussman's hedging is to protect his portfolio against market declines, while allowing participation in market upside potential. Let's take our analysis of Hussman's performance a step further. In the chart above, observe that the pink points sit above the blue points on the left half, while the reverse is true--pink below blue--on the right half. To understand this behavior, we need to distinguish between hedging and market timing:
- Hedging: The underlying unhedged position is Hussman's long-equity exposure to his chosen portfolio of stocks. If he were always (i.e., without attempting to time the market) simply to buy put options with at-the-money or slightly out-of-the-money strikes to protect his portfolio against market downside, the puts would show a profit when the market declines but would expire worthless when the market rises. The result would be an insurance-like payoff pattern from the hedge--protection against loss in a declining market, but with a cost relative to the unhedged position particularly evident when the market rises.
- Market Timing: On the other hand, if Hussman were attempting to time the market and successful in doing so, presumably by selectively hedging to protect against downside under risky market conditions but operating without a hedge when prevailing conditions are less risky, the data ought to show not only realized fund performance above the unhedged case (pink above blue in the chart) when the market declines, but also at least an occasional occurrence of this type of outperformance of his fund over the unhedged case when the market rises.
What this all indicates is that Hussman's performance is basically consistent with that of someone who makes a practice of always hedging with put options, regardless of market conditions. By and large, it is not what we should expect to see from a portfolio manager implementing a market timing strategy, even though Hussman does at least occasionally remove some portion of his hedge to reduce cost when he believes that risk is low and the chance of a market rise is high.
Skill Versus Luck
The above classification of Hussman as a hedger and not a market timer is in agreement with the often-stated warning to investors and traders that market timing is difficult, if not impossible, and should be attempted only with extreme caution by anyone with risk aversion. In a Tech Ticker interview last week on the topic of skill versus luck in stock-picking and market timing, Professor Kenneth French (whose name figures prominently alongside Fama's in finance theory) states:
"There this a whole academic literature trying to figure out who won because of luck and who won because they truly had skill. We don't know how to do it. I mean there's a little bit of evidence that we can distinguish luck from skill, but, in essence, it's absolutely futile.Surely, coming from an accomplished expert in finance, this type of statement is enough to throw into question anyone's claim of having ability to pick stocks and time the market to achieve excess returns in a consistent fashion.
"So, when I have a mediocre M.B.A. student who spent the weekend studying Morningstar and is convinced he knows how to pick the winning fund, what I challenge him with is sort of, 'Geez, you know, it's good that you didn't even need to bother to get a Ph.D. and spend the last 30 years of your life solving this problem. You know, those of us who did that, we don't know how to do it. But, congratulations. That was a really productive weekend!'
". . . To basically try to distinguish skill from luck . . . [is] almost impossible. . . . What I'm saying is, I can't tell . . . one from the other. . . . If I can't tell good from bad, why play the game?"
What this means is that we, the investing public, should not read too much into the performance of successful fund managers, however superb their performance may have been (in Miller's case) or appear to be (in Hussman's case). Both Hussman and Miller have certainly assembled relatively long track records as ostensibly excellent stock-pickers, but, as history has shown, anything is possible. If Miller's 15-year winning streak can suddenly undergo a complete metamorphosis into a 3-year (or longer?) losing streak, and if Hussman's track record is solid but exhibits inherent underperformance in rising markets as consistently as it displays outperformance in falling markets, we can only suspect that unquestionable evidence of skill, as opposed to luck, in investing has become that much harder to find.
Although anyone actively managing a stock portfolio may hate to admit it, Professor French is most likely right--unfortunately, in the world of investing, we will probably never really be able to tell if our own or anyone else's performance stems primarily from luck or, as many may want to believe, from having a discernible edge over other investors who are only almost-as-skilled as ourselves.
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