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.
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.
The Next Boom Will Come
The global economy is in the doldrums. Collapsing housing prices and ensuing foreclosures have brought both borrowers and lenders to their knees, frozen credit markets, depressed stock prices, softened consumer demand, forced oil, metal (even gold) and other commodity prices lower, and now dragged down the commercial real estate market as well. The Bush and Paulson $700 billion financial rescue plan has morphed from an impracticable illiquid-asset buyback plan to shore up bank balance sheets into an across-the-board equity infusion scheme and sadly, along its porky way, lost focus, impact and credibility. Cynics question what benefit Bernanke's many years of academic study of the Great Depression have brought him, or anyone else, for that matter. Respected business figures (for example, Soros and Dimon) warn of a deepening recession in 2009, possibly even a depression.
Given the dour outlook of economic experts and pervasive pessimism of the investing public, it's hard to be optimistic--but I am. I'm confident that better times and a stronger economy lie ahead of us. Really, a brighter future is all but inevitable. Yes, I repeat, just as day follows night, we will see better times. Let me explain the root of my optimism.
Generally speaking, two basic schools of economic thought have been most influential over the past 75 years--Keynesians (including neo-Keynesians), who advocate fiscal measures such as an increase in government spending to stimulate a sluggish economy, and higher taxes to cool an overheated inflationary economy; and monetarists (led by Friedman's Chicago school), who believe that what's more important is controlling the money supply, primarily through buying and selling government bonds in the open market and raising and lowering the discount rate. Both schools of economic thought unabashedly lay claim to real-world successes of their models--Keynesians take credit for lifting the economy back onto its feet through FDR's New Deal spending following the Great Depression in the 1930s, and monetarists boast of steady and prolonged economic growth in the 1980s (Reagan years) and 1990s--despite the many recessions we have seen, including those in recent decades: 1980 (7 months), 1981-1982 (17 months), 1991-1992 (8 months), 2001-2002 (12 months), and presumably 2008-2009.
While these two mainstream schools of economic thought certainly have their differences, they also share an important commonality--both rely heavily on government intervention to control or at least influence economic growth. President Bush's consumer-targeted economic stimulus package during the early days of the current financial crisis and the new stimulus package that President-elect Obama stressed as a high-priority item in his first press conference a week ago are examples of Keynesian policy in action. The Fed's continual "busy-body" adjustment of the discount rate--Greenspan's lowering of the rate to 1% in 2003 during the last recession precipitated by the dot-com bubble, and raising it back up to the 5% range by the time of his retirement in 2006, and Bernanke's pushing the discount rate all the way back down again to 1% last month, while hinting at more rate cuts to follow--are examples of attempts to steer the economy using monetary policy.
In sharp contrast to these two mainstream schools are those who argue that both the Keynesians and monetarists are wrong-headed. For example, the Austrian school, based on the thinking of Mises and Hayek, explain how government intervention is not the solution. Stating that fiscal and monetary policy fail to produce their intended impact, these economists insist that, instead of smoothing the vagaries of the business cycle, government intervention actually causes the booms and busts, through over-extension and over-contraction of credit at artificial prices via the highly government-regulated fractional-reserve banking system. Quite contrary to active intervention, the Austrian school recommends following a laissez-faire "do nothing" approach, theorizing that this is the only way to cure permanently our economic woes. For a coherent exposition of the Austrian school's position, see Murray Rothbard's 1969 essay, "Economic Depressions: Their Cause and Cure," here.
Which economic school is right? Well, first off, practically speaking, it would be grossly out of character and, in fact, outright political suicide for any president--whether lame-duck Bush, or our country's new icon of hope, "renegade" Obama--to tell us American citizens that, after serious dialog and lengthy reflection, the elected officials and their appointed experts have decided that a "do nothing" policy is best. With home foreclosures at historical highs and rising, and growing worries over burdensome credit card balances, auto loans and other consumer debt, the popular approval ratings of even the most charismatic of political leaders would undoubtedly suffer greatly if all their economic advisory team could come up with is to a "do nothing" strategy for tackling the current economic crisis. No, simply put, Americans are by nature more active doers than thinkers, and doing nothing never has been and probably never will be an acceptable alternative for managing our economy.
So, much to the chagrin of Austrian school economists, we must conclude that government intervention, whether effective or not, will continue when Obama and later presidents take office. Given this inevitability that politicians and their mainstream economic advisers will always be inclined to fiddle with the economy, here's the logic of what to expect:
Suffice it to say, for anyone distraught by the current bust, please have patience: the next boom will come--maybe even sooner than you or anyone now thinks.
Given the dour outlook of economic experts and pervasive pessimism of the investing public, it's hard to be optimistic--but I am. I'm confident that better times and a stronger economy lie ahead of us. Really, a brighter future is all but inevitable. Yes, I repeat, just as day follows night, we will see better times. Let me explain the root of my optimism.
Generally speaking, two basic schools of economic thought have been most influential over the past 75 years--Keynesians (including neo-Keynesians), who advocate fiscal measures such as an increase in government spending to stimulate a sluggish economy, and higher taxes to cool an overheated inflationary economy; and monetarists (led by Friedman's Chicago school), who believe that what's more important is controlling the money supply, primarily through buying and selling government bonds in the open market and raising and lowering the discount rate. Both schools of economic thought unabashedly lay claim to real-world successes of their models--Keynesians take credit for lifting the economy back onto its feet through FDR's New Deal spending following the Great Depression in the 1930s, and monetarists boast of steady and prolonged economic growth in the 1980s (Reagan years) and 1990s--despite the many recessions we have seen, including those in recent decades: 1980 (7 months), 1981-1982 (17 months), 1991-1992 (8 months), 2001-2002 (12 months), and presumably 2008-2009.
While these two mainstream schools of economic thought certainly have their differences, they also share an important commonality--both rely heavily on government intervention to control or at least influence economic growth. President Bush's consumer-targeted economic stimulus package during the early days of the current financial crisis and the new stimulus package that President-elect Obama stressed as a high-priority item in his first press conference a week ago are examples of Keynesian policy in action. The Fed's continual "busy-body" adjustment of the discount rate--Greenspan's lowering of the rate to 1% in 2003 during the last recession precipitated by the dot-com bubble, and raising it back up to the 5% range by the time of his retirement in 2006, and Bernanke's pushing the discount rate all the way back down again to 1% last month, while hinting at more rate cuts to follow--are examples of attempts to steer the economy using monetary policy.
In sharp contrast to these two mainstream schools are those who argue that both the Keynesians and monetarists are wrong-headed. For example, the Austrian school, based on the thinking of Mises and Hayek, explain how government intervention is not the solution. Stating that fiscal and monetary policy fail to produce their intended impact, these economists insist that, instead of smoothing the vagaries of the business cycle, government intervention actually causes the booms and busts, through over-extension and over-contraction of credit at artificial prices via the highly government-regulated fractional-reserve banking system. Quite contrary to active intervention, the Austrian school recommends following a laissez-faire "do nothing" approach, theorizing that this is the only way to cure permanently our economic woes. For a coherent exposition of the Austrian school's position, see Murray Rothbard's 1969 essay, "Economic Depressions: Their Cause and Cure," here.
Which economic school is right? Well, first off, practically speaking, it would be grossly out of character and, in fact, outright political suicide for any president--whether lame-duck Bush, or our country's new icon of hope, "renegade" Obama--to tell us American citizens that, after serious dialog and lengthy reflection, the elected officials and their appointed experts have decided that a "do nothing" policy is best. With home foreclosures at historical highs and rising, and growing worries over burdensome credit card balances, auto loans and other consumer debt, the popular approval ratings of even the most charismatic of political leaders would undoubtedly suffer greatly if all their economic advisory team could come up with is to a "do nothing" strategy for tackling the current economic crisis. No, simply put, Americans are by nature more active doers than thinkers, and doing nothing never has been and probably never will be an acceptable alternative for managing our economy.
So, much to the chagrin of Austrian school economists, we must conclude that government intervention, whether effective or not, will continue when Obama and later presidents take office. Given this inevitability that politicians and their mainstream economic advisers will always be inclined to fiddle with the economy, here's the logic of what to expect:
- If the sketchy long-run track record (performing like a "B" student, with 13 out of the 115 quarters beginning in 1980 showing negative real GDP growth, according to BEA data) of the Keynesians and monetarists is any indication, we should see at least some degree of over-shooting in the future, perhaps this time manifested by a delayed but sudden response of our economy to excessive fiscal stimulus or overly loose monetary policy, resulting in either consumer price inflation or yet another asset bubble. (On the other hand, if by chance (or fluke?) policymakers have learned from the last boom-bust cycle and this time around manage to get the economic fine-tuning exactly right, they will have realized the heroic feat of taming the recalcitrant business cycle, macroeconomic volatility will cease, and we will all live, at least economically, happily ever after. . . . but I would tend to believe other fairy tales before placing undue faith in this one, wouldn't you?)
- If the Austrian school is correct in their critical analysis of the shortcomings of Keynesian and monetary policy, the current credit-driven bust will inevitably be followed by a boom, and the more our government intervenes to try to fix the problem, the higher the crest and deeper the trough we will see during the next boom-bust cycle.
Suffice it to say, for anyone distraught by the current bust, please have patience: the next boom will come--maybe even sooner than you or anyone now thinks.
The Next Boom Will Come
The global economy is in the doldrums. Collapsing housing prices and ensuing foreclosures have brought both borrowers and lenders to their knees, frozen credit markets, depressed stock prices, softened consumer demand, forced oil, metal (even gold) and other commodity prices lower, and now dragged down the commercial real estate market as well. The Bush and Paulson $700 billion financial rescue plan has morphed from an impracticable illiquid-asset buyback plan to shore up bank balance sheets into an across-the-board equity infusion scheme and sadly, along its porky way, lost focus, impact and credibility. Cynics question what benefit Bernanke's many years of academic study of the Great Depression have brought him, or anyone else, for that matter. Respected business figures (for example, Soros and Dimon) warn of a deepening recession in 2009, possibly even a depression.
Given the dour outlook of economic experts and pervasive pessimism of the investing public, it's hard to be optimistic--but I am. I'm confident that better times and a stronger economy lie ahead of us. Really, a brighter future is all but inevitable. Yes, I repeat, just as day follows night, we will see better times. Let me explain the root of my optimism.
Generally speaking, two basic schools of economic thought have been most influential over the past 75 years--Keynesians (including neo-Keynesians), who advocate fiscal measures such as an increase in government spending to stimulate a sluggish economy, and higher taxes to cool an overheated inflationary economy; and monetarists (led by Friedman's Chicago school), who believe that what's more important is controlling the money supply, primarily through buying and selling government bonds in the open market and raising and lowering the discount rate. Both schools of economic thought unabashedly lay claim to real-world successes of their models--Keynesians take credit for lifting the economy back onto its feet through FDR's New Deal spending following the Great Depression in the 1930s, and monetarists boast of steady and prolonged economic growth in the 1980s (Reagan years) and 1990s--despite the many recessions we have seen, including those in recent decades: 1980 (7 months), 1981-1982 (17 months), 1991-1992 (8 months), 2001-2002 (12 months), and presumably 2008-2009.
While these two mainstream schools of economic thought certainly have their differences, they also share an important commonality--both rely heavily on government intervention to control or at least influence economic growth. President Bush's consumer-targeted economic stimulus package during the early days of the current financial crisis and the new stimulus package that President-elect Obama stressed as a high-priority item in his first press conference a week ago are examples of Keynesian policy in action. The Fed's continual "busy-body" adjustment of the discount rate--Greenspan's lowering of the rate to 1% in 2003 during the last recession precipitated by the dot-com bubble, and raising it back up to the 5% range by the time of his retirement in 2006, and Bernanke's pushing the discount rate all the way back down again to 1% last month, while hinting at more rate cuts to follow--are examples of attempts to steer the economy using monetary policy.
In sharp contrast to these two mainstream schools are those who argue that both the Keynesians and monetarists are wrong-headed. For example, the Austrian school, based on the thinking of Mises and Hayek, explain how government intervention is not the solution. Stating that fiscal and monetary policy fail to produce their intended impact, these economists insist that, instead of smoothing the vagaries of the business cycle, government intervention actually causes the booms and busts, through over-extension and over-contraction of credit at artificial prices via the highly government-regulated fractional-reserve banking system. Quite contrary to active intervention, the Austrian school recommends following a laissez-faire "do nothing" approach, theorizing that this is the only way to cure permanently our economic woes. For a coherent exposition of the Austrian school's position, see Murray Rothbard's 1969 essay, "Economic Depressions: Their Cause and Cure," here.
Which economic school is right? Well, first off, practically speaking, it would be grossly out of character and, in fact, outright political suicide for any president--whether lame-duck Bush, or our country's new icon of hope, "renegade" Obama--to tell us American citizens that, after serious dialog and lengthy reflection, the elected officials and their appointed experts have decided that a "do nothing" policy is best. With home foreclosures at historical highs and rising, and growing worries over burdensome credit card balances, auto loans and other consumer debt, the popular approval ratings of even the most charismatic of political leaders would undoubtedly suffer greatly if all their economic advisory team could come up with is to a "do nothing" strategy for tackling the current economic crisis. No, simply put, Americans are by nature more active doers than thinkers, and doing nothing never has been and probably never will be an acceptable alternative for managing our economy.
So, much to the chagrin of Austrian school economists, we must conclude that government intervention, whether effective or not, will continue when Obama and later presidents take office. Given this inevitability that politicians and their mainstream economic advisers will always be inclined to fiddle with the economy, here's the logic of what to expect:
Suffice it to say, for anyone distraught by the current bust, please have patience: the next boom will come--maybe even sooner than you or anyone now thinks.
Given the dour outlook of economic experts and pervasive pessimism of the investing public, it's hard to be optimistic--but I am. I'm confident that better times and a stronger economy lie ahead of us. Really, a brighter future is all but inevitable. Yes, I repeat, just as day follows night, we will see better times. Let me explain the root of my optimism.
Generally speaking, two basic schools of economic thought have been most influential over the past 75 years--Keynesians (including neo-Keynesians), who advocate fiscal measures such as an increase in government spending to stimulate a sluggish economy, and higher taxes to cool an overheated inflationary economy; and monetarists (led by Friedman's Chicago school), who believe that what's more important is controlling the money supply, primarily through buying and selling government bonds in the open market and raising and lowering the discount rate. Both schools of economic thought unabashedly lay claim to real-world successes of their models--Keynesians take credit for lifting the economy back onto its feet through FDR's New Deal spending following the Great Depression in the 1930s, and monetarists boast of steady and prolonged economic growth in the 1980s (Reagan years) and 1990s--despite the many recessions we have seen, including those in recent decades: 1980 (7 months), 1981-1982 (17 months), 1991-1992 (8 months), 2001-2002 (12 months), and presumably 2008-2009.
While these two mainstream schools of economic thought certainly have their differences, they also share an important commonality--both rely heavily on government intervention to control or at least influence economic growth. President Bush's consumer-targeted economic stimulus package during the early days of the current financial crisis and the new stimulus package that President-elect Obama stressed as a high-priority item in his first press conference a week ago are examples of Keynesian policy in action. The Fed's continual "busy-body" adjustment of the discount rate--Greenspan's lowering of the rate to 1% in 2003 during the last recession precipitated by the dot-com bubble, and raising it back up to the 5% range by the time of his retirement in 2006, and Bernanke's pushing the discount rate all the way back down again to 1% last month, while hinting at more rate cuts to follow--are examples of attempts to steer the economy using monetary policy.
In sharp contrast to these two mainstream schools are those who argue that both the Keynesians and monetarists are wrong-headed. For example, the Austrian school, based on the thinking of Mises and Hayek, explain how government intervention is not the solution. Stating that fiscal and monetary policy fail to produce their intended impact, these economists insist that, instead of smoothing the vagaries of the business cycle, government intervention actually causes the booms and busts, through over-extension and over-contraction of credit at artificial prices via the highly government-regulated fractional-reserve banking system. Quite contrary to active intervention, the Austrian school recommends following a laissez-faire "do nothing" approach, theorizing that this is the only way to cure permanently our economic woes. For a coherent exposition of the Austrian school's position, see Murray Rothbard's 1969 essay, "Economic Depressions: Their Cause and Cure," here.
Which economic school is right? Well, first off, practically speaking, it would be grossly out of character and, in fact, outright political suicide for any president--whether lame-duck Bush, or our country's new icon of hope, "renegade" Obama--to tell us American citizens that, after serious dialog and lengthy reflection, the elected officials and their appointed experts have decided that a "do nothing" policy is best. With home foreclosures at historical highs and rising, and growing worries over burdensome credit card balances, auto loans and other consumer debt, the popular approval ratings of even the most charismatic of political leaders would undoubtedly suffer greatly if all their economic advisory team could come up with is to a "do nothing" strategy for tackling the current economic crisis. No, simply put, Americans are by nature more active doers than thinkers, and doing nothing never has been and probably never will be an acceptable alternative for managing our economy.
So, much to the chagrin of Austrian school economists, we must conclude that government intervention, whether effective or not, will continue when Obama and later presidents take office. Given this inevitability that politicians and their mainstream economic advisers will always be inclined to fiddle with the economy, here's the logic of what to expect:
- If the sketchy long-run track record (performing like a "B" student, with 13 out of the 115 quarters beginning in 1980 showing negative real GDP growth, according to BEA data) of the Keynesians and monetarists is any indication, we should see at least some degree of over-shooting in the future, perhaps this time manifested by a delayed but sudden response of our economy to excessive fiscal stimulus or overly loose monetary policy, resulting in either consumer price inflation or yet another asset bubble. (On the other hand, if by chance (or fluke?) policymakers have learned from the last boom-bust cycle and this time around manage to get the economic fine-tuning exactly right, they will have realized the heroic feat of taming the recalcitrant business cycle, macroeconomic volatility will cease, and we will all live, at least economically, happily ever after. . . . but I would tend to believe other fairy tales before placing undue faith in this one, wouldn't you?)
- If the Austrian school is correct in their critical analysis of the shortcomings of Keynesian and monetary policy, the current credit-driven bust will inevitably be followed by a boom, and the more our government intervenes to try to fix the problem, the higher the crest and deeper the trough we will see during the next boom-bust cycle.
Suffice it to say, for anyone distraught by the current bust, please have patience: the next boom will come--maybe even sooner than you or anyone now thinks.
Augusta – Focus on Advancing Copper Rich Deposit in Arizona
Augusta Resources (AZC) is primarily focused on the Rosemont Copper deposit near Tucson, Arizona, one of the largest copper mines currently in development in the North America. Augusta is headquartered in Denver, Colorado, and their Rosemont property is 50 km southeast of Tucson, conveniently located for mining operations via highway, a network of unpaved roads, and proximity from major transmission line and main rail lines to key ports. Their President & CEO, Mr. Gil Clausen, was in New York City on October 29th to discuss their strategy and growth potential of their resources.
In the past week or so, Augusta has two important announcements. They first announced on October 31st that a silver off-take financing arrangement with Silver Wheaton is to be re-structured upon completion of the Updated bankable feasibility study which is expected to be complete by yearend. My expectation is that the term will be likely more favorable than the previous agreement elected back in April, 2008, due to higher resource estimates and thus better economic value. Then this Monday (Nov 3rd), they announced that they have received significant strategic interest regarding their 100% owned Rosemont Copper/Moly project.
The Rosemont Copper project for Augusta is a very large low cost open-pit copper deposit. The total resources (M&I and Inferred) are estimated to be 7.7 billion lbs of copper, 190 million lbs of moly and 80 million ounces of silver, which turns into about 11 billion lbs of copper equivalent. The cost estimate is expected to be in the neighborhood of $0.5 per lb of copper, net of by-product credits (the net by-product credit is calculated based on very conservative long term $12 moly and $8 silver). Even without including the by-product credit, the cash cost is still only $0.9 per lb of copper. With today’s depressed commodity prices across the board, there is still a good profit margin due to its high grade and low cost. This puts Augusta well below other median and marginal cost producers and give them a large competitive advantage. Strategically, the major U.S. copper producer Freeport-McMoRan is also operating near Augusta’s property, and this location, the low-risk jurisdiction and its copper/moly rich mines make Augusta well situated for future options.
The production is expected to start in the 2nd half of 2011, assuming permitting and construction on schedule, with average annual planned production of about 230 million lbs of copper, 5 million lbs of moly and over 3 million ounces of silver which ties to the silver-backed financing deal with Silver Wheaton mentioned above. This level of output will account for 10% of US copper output once in production, and propel Augusta to become a solid mid-tier copper producer, probably the 3rd largest in the US.
The capital expenditure of their Rosemont project costs about $800 million total, with 40% of the capital committed under fixed price contracts. According to the last bankable feasibility study (BFS) back in 2007, which will be updated by yearend, with conservative assumptions on commodity prices for the whole life of this mine: $1.5 for copper, $15 for moly, and $10 for silver, and with a discount rate at 10%, the net present value (NPV) is still around $460 million, more than 4 times higher than the current Augusta’s market cap of $96 million. The payback period is also impressive with less than 3 years. The upcoming BFS is likely to be more favorable due to increased level of resources.
Even with the recent reduced forecast of copper demand, the copper mine supply still falls short for foreseeable future years. No doubt that the current slump in commodities has depressed the stock prices of many developmental mining firms like Augusta. But financially Augusta is strong, and had $15 million cash at the last Q2 report. The previous April Silver Wheaton deal has satisfied about 20% of total capital requirements for the Rosemont project by only sacrificing 2% of the total future project revenue. Then on June 17 this year, Augusta has secured another $40 million loan with Sumitomo. Both deals have minimized equity dilution for existing shareholders. What might happen in the near future, maybe Q1 next year when an updated BFS is available, it is very typical for a junior to sell partial interest in its project to a major in exchange for financing to continue the construction of their mining operations. The latest press release indicates the possibility of such joint venture potential.
More importantly, if we believe the recent copper price was oversold and has reached the bottom, and will stay above $2 on average for many years into the future, the operating leverage provided by Augusta will substantially increase the value of its Rosemont project. It won’t surprise me that Augusta would triple or even quadruple from the current $1 price level to somewhere in the $3-4 range, which only brings them back to the price level this time last year.
Disclosure: I don’t own Augusta Resources, but I believe AZC is currently undervalued and provides a good opportunity for a diversified mining portfolio for long term capital gain.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.
In the past week or so, Augusta has two important announcements. They first announced on October 31st that a silver off-take financing arrangement with Silver Wheaton is to be re-structured upon completion of the Updated bankable feasibility study which is expected to be complete by yearend. My expectation is that the term will be likely more favorable than the previous agreement elected back in April, 2008, due to higher resource estimates and thus better economic value. Then this Monday (Nov 3rd), they announced that they have received significant strategic interest regarding their 100% owned Rosemont Copper/Moly project.
The Rosemont Copper project for Augusta is a very large low cost open-pit copper deposit. The total resources (M&I and Inferred) are estimated to be 7.7 billion lbs of copper, 190 million lbs of moly and 80 million ounces of silver, which turns into about 11 billion lbs of copper equivalent. The cost estimate is expected to be in the neighborhood of $0.5 per lb of copper, net of by-product credits (the net by-product credit is calculated based on very conservative long term $12 moly and $8 silver). Even without including the by-product credit, the cash cost is still only $0.9 per lb of copper. With today’s depressed commodity prices across the board, there is still a good profit margin due to its high grade and low cost. This puts Augusta well below other median and marginal cost producers and give them a large competitive advantage. Strategically, the major U.S. copper producer Freeport-McMoRan is also operating near Augusta’s property, and this location, the low-risk jurisdiction and its copper/moly rich mines make Augusta well situated for future options.
The production is expected to start in the 2nd half of 2011, assuming permitting and construction on schedule, with average annual planned production of about 230 million lbs of copper, 5 million lbs of moly and over 3 million ounces of silver which ties to the silver-backed financing deal with Silver Wheaton mentioned above. This level of output will account for 10% of US copper output once in production, and propel Augusta to become a solid mid-tier copper producer, probably the 3rd largest in the US.
The capital expenditure of their Rosemont project costs about $800 million total, with 40% of the capital committed under fixed price contracts. According to the last bankable feasibility study (BFS) back in 2007, which will be updated by yearend, with conservative assumptions on commodity prices for the whole life of this mine: $1.5 for copper, $15 for moly, and $10 for silver, and with a discount rate at 10%, the net present value (NPV) is still around $460 million, more than 4 times higher than the current Augusta’s market cap of $96 million. The payback period is also impressive with less than 3 years. The upcoming BFS is likely to be more favorable due to increased level of resources.
Even with the recent reduced forecast of copper demand, the copper mine supply still falls short for foreseeable future years. No doubt that the current slump in commodities has depressed the stock prices of many developmental mining firms like Augusta. But financially Augusta is strong, and had $15 million cash at the last Q2 report. The previous April Silver Wheaton deal has satisfied about 20% of total capital requirements for the Rosemont project by only sacrificing 2% of the total future project revenue. Then on June 17 this year, Augusta has secured another $40 million loan with Sumitomo. Both deals have minimized equity dilution for existing shareholders. What might happen in the near future, maybe Q1 next year when an updated BFS is available, it is very typical for a junior to sell partial interest in its project to a major in exchange for financing to continue the construction of their mining operations. The latest press release indicates the possibility of such joint venture potential.
More importantly, if we believe the recent copper price was oversold and has reached the bottom, and will stay above $2 on average for many years into the future, the operating leverage provided by Augusta will substantially increase the value of its Rosemont project. It won’t surprise me that Augusta would triple or even quadruple from the current $1 price level to somewhere in the $3-4 range, which only brings them back to the price level this time last year.
Disclosure: I don’t own Augusta Resources, but I believe AZC is currently undervalued and provides a good opportunity for a diversified mining portfolio for long term capital gain.
Thomas Tan, CFA, MBA
Thomast2@optonline.net
Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.
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