Will the real Warren Buffett please stand up?

On Tuesday November 16, 2010 Warren Buffett wrote a New York Times Op-Ed praising government actions in the financial crisis:

When the crisis struck, I felt you would understand the role you had to play. But you’ve never been known for speed, and in a meltdown minutes matter. I worried whether the barrage of shattering surprises would disorient you. You would have to improvise solutions on the run, stretch legal boundaries and avoid slowdowns, like Congressional hearings and studies. You would also need to get turf-conscious departments to work together in mounting your counterattack. The challenge was huge, and many people thought you were not up to it.

Well, Uncle Sam, you delivered. People will second-guess your specific decisions; you can always count on that. But just as there is a fog of war, there is a fog of panic — and, overall, your actions were remarkably effective.

One of the "people" who second guessed Uncle Sam`s decision turned out to be Buffett himself. Contrast Buffett`s latest comments with the Op-Ed he wrote back in August 18, 2009, where he warned about the risks of rising fiscal deficits and "unchecked greenback emissions":

Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Since the 2009 Op-Ed, the current account deficit has widened and the fiscal deficit has taken off like a rocket. We now have unprecedented levels of "greenback emissions" in the form of QE2.

How is the government then doing such a good job?
 
I suppose that the better question might be: "Who are you and what have you done with Warren?"

The Geithner Gang rides again?

In the bad old days when emerging markets were really, really emerging, there were stories out of places like Russia where property rights were blatantly ignored. Share registers were routinely changed, or shareholders would be physically barred from shareholders' meetings by thugs, where existing shareholders' interests were diluted to nothing, sometimes without disclosure or warning.

These bad old days seem to coming to the developed world, where the likes of Tim Geithner et al have decided that it's ok to bail out financial institutions without either bondholders or shareholders taking a hit, as per capitalist principles. The latest rumor comes from Neil Garfield, who comments on the MERS mortgage registration mess (via FT Alphaville):

The legislation is already being drafted under the interstate commerce clause to ratify MERS and everything it did retroactively. It appears that the Obama administration is ready to pardon all the securitization deviants by signing this bill into law.

If this rumor is true, then the Geithner Gang is ready to ride again. Where is the outrage?

China and oil usage

Back on August 23, 2010, the Center for Geoeconomic Studies showed this chart of crude oil usage intensity of China and other countries in a blog posting:

Their comment was that China is rapidly approaching the $15,000 GDP per capita level when oil consumption intensity starts to rise. Given the vastness of Chinese population, this would mean that global oil demand would take off like a rocket [emphasis added]: "Were China’s per capita oil consumption to be brought up to South Korea’s, its share of global consumption would increase from today’s 10% to over 70%."

By implication, such a development would be incredibly bullish for oil and other energy prices.


Does the new five year plan mitigate demand?
Or does it?

In some ways, China's communist based central planning approach gives us a better picture of her intentions. In a recent interview with Caixin, Liu He, a vice minister of the Office of the Central Leading Group on Financial and Economic Affairs, expounded on the Chinese government's latest five-year plan:


In other words, China's aim in the latest five year plan is to move from low value-added production up to higher value added production, both for domestic consumption and export. Romer calls it growth based on creativity, i.e. more design. Michael Porter would call it moving up the value-chain.

In the past, China's insatiable demand for natural resources has been the result in some silly projects, e.g. inefficient steel plants. This mis-allocation of capital has gobbled up a lot of natural resources such as iron, copper, coal, oil, etc. A transformation of the economy that is more oriented to higher value-added and more creative design oriented output is likely to dampen some of the oil and other raw material intensity nature of the Chinese economy.


Long-term bullish or bearish for energy?
Does this mean that crude oil demand intensity is not poised to skyrocket as per the Center for Geoeconomic Study chart above? On the bullish side, we have seen this same level of rising affluence drive up energy demand in other countries. On the bearish side, the Chinese government seems to be at some level working to restrain energy and other natural resource intensity of their economy. Don't forget the transformation in the American economy in the 1980's, when prolonged oil prices resulted in more efficient use of energy, e.g. smaller cars, etc., and oil demand dropped as a result.

I am still leaning bullish on the case for rising oil demand. However, there are risks to this story and the bearish case shouldn't be ignored.


Addendum: Further to my post, I see that the latest IEA report concludes that oil demand would peak in 2020 if CO2 is cut aggressively (also see story here). While it is unlikely that individual countries would adhere to global accords on CO2 emissions, it does show that efforts to cut consumption, such as fossil fuel subsidy reductions, can have a significant impact on demand.

In the past, what was proposed was transforming the economic growth model. Transforming the economic growth model means increasing efficiency, which involves Paul M. Romer’s New Growth theory, which is to improve total factor productivity and the knowledge content of growth. Transforming the economic growth model is really improving the efficiency of supply.

War drums on Remembrance/Veterans' Day?

Yesterday Todd Harrison of Minyanville wrote an article entitled An unfortunate needle points to war, where he expressed his concerns about all the social crankiness that comes with economic stress leading to geopolitical tensions:

I ate dinner with Don Graham of the Washington Post a year or so ago and he asked what worried me most. Before I could self-edit, I said “World War III; global conflicts are usually born from economic hardship and that’s where the needle seems to be pointing.”

He went on:

The signs are pointing towards an unfortunate destination. Earlier this year, we wrote about the percolating cross-border problems, from the Flotilla friction to Iran tensions to saber rattling on the Korean Peninsula to leaks of Afghan war logs, with European social strife on the rise and a global play for crude mixed in for good measure. Sovereign posturing is ever-present and on the rise. Can you feel it?

Personally, I think that Harrison's point about World War III are a little over the top. Nevertheless, his contention is well taken. It seems to be that while there is no immediate threat of war, the current economic conditions represent fertile ground for conflict over the next few years, regardless of whether it's economic or the fix-the-bayonets-and-go-over-the-hill kind.
 
QE2 is proving to be a sore point. The criticism has been coming from virtually everyone, including Federal Reserve presidents. Michael Pettis wrote:

I think there is a very good chance that in retrospect QE2 will be seen as the equivalent of the Plaza Accord. If the US continues to pursue quantitative easing, it could spell the last stage of China’s great growth spurt followed by the beginning of the big adjustment. And like the Plaza Accord it will sow many years of suspicion and conspiracy theories.

In addition, Pettis pointed out some of the misunderstandings surrounding the Chinese and American positions on both sides which are likely to heighten tensions. He pointed to an FT article by Yao Yang, director of Peking University’s CCER, which stated:

China’s leaders believe that, when the political dust of the midterm elections falls to earth, Americans will see they benefit from the cheap goods a weak renminbi provides. They also gain little from an upward valuation. Research suggests that even a 20 per cent appreciation will have minimal impact on the US economy. China, on the other hand, will see employment and GDP drop by over 3 per cent.


No wonder there is a firm belief among China’s elites that rational American policymakers are not serious about appreciation, because it makes no sense for a rational actor to inflict costs on others without gains.

It's these kinds of misunderstandings and miscalculations about the other side's intentions that lead to conflict. Recall April Glaspie's famous statement to Saddam Hussein:

We have no opinion on your Arab-Arab conflicts, such as your dispute with Kuwait. Secretary Baker has directed me to emphasize the instruction, first given to Iraq in the 1960s, that the Kuwait issue is not associated with America.

I agree with Harrison that people are nervous, cranky and jumpy all over. Risks are therefore rising. Personally, I believe that the risks are more tilted towards social and economic risks than a shooting war but the probability of war over the next few years is not zero.

Another way to think about pensions

In May 2009 I wrote that pension fund management needed a new analytical framework and asked for input from my readers. Now I see that the Boston chapter of QWAFAFEW (Quantitative Work Alliance For Applied Finance, Education and Wisdom, otherwise known as quaff-a-few) is hosting a talk entitled "Using Factors to Dynamically Manage Pension Fund Risk" on Tuesday November 16, 2010. Here is the abstract:

Using Factors to Dynamically Manage Pension Fund Risk - Pension Funds are complex systems with many moving parts. A sponsor needs to be concerned about the behavior of the assets, the behavior of the liabilities, and how the two interact. We look at representative Canadian plan and its sensitivities on both the asset and liability side and how they interact and then suggest some asset allocation strategies that can be used to better manage the return dynamics and funding stability of the plan.

If you are around in Boston next Tuesday, you may consider attending. Click on the link above to get all the details.

The neighbors complain about Ben's party

The reaction to the Fed's QE2 program has come hot and fast. Emerging market authorities are complaining loudly about QE2. From Brazil to South Africa, the reaction has been swift and negative. China’s Vice-Foreign Minister Cui Tankai said that the US “owes us some explanation on their decision” and PBoC governor Zhou Xiaochuan complained that QE2 “is not necessarily optimal policy for the world”.  In central banker-speak, that's somewhat akin to Emperor Hirohito's announcement to the Japanese people at the end of WW II "that the war has not necessary unfolded to our advantage.

Beyond the complaints, it will be telling to see how the capital exporters like the OPEC Gulf states and China react. QE2 will export asset inflation to China and push up the prices of real estate and rare antiques.


The critics come out of the woodwork
Beyond other governmental and central bank authorities, the critics have been out in force. Portfolio manager John Hussman was scathing in his criticism. Bernanke, Hussman believes, is blowing another asset bubble and repeating the mistakes that Greenspan made and this will end very badly [emphasis added]:

It is difficult to interpret Bernanke's defense of QE2 as anything else but an attempt to replace the recent bubble with yet another - to drive already overvalued risky assets to further overvaluation in hopes that consumers will view the "wealth" as permanent. The problem here is that unlike housing, which consumers had viewed as immune from major price declines, investors have observed two separate stock market plunges of over 50% each, within the past decade alone. While investors have obviously demonstrated an aptitude for ignoring risk over short periods of time, it is a simple fact that raising the price of a risky asset comes at the sacrifice of lower long-term returns, except when there is a proportional increase in the long-term stream cash flows that can be expected from the security.

As a result of Bernanke's actions, investors now own higher priced securities that can be expected to deliver commensurately lower long-term returns, leaving their lifetime "wealth" unaffected, but exposing them to enormous risk of price declines over the intermediate (2-5 year) horizon. This is not a basis on which consumers are likely to shift their spending patterns. What Bernanke doesn't seem to absorb is that stocks are nothing but a claim on a long-term stream of cash flows that investors expect to be delivered over time. Propping up the price of stocks changes the distribution of long-term investment returns, but it doesn't materially affect the cash flows. This reckless policy has done nothing but to promote further overvaluation of already overvalued assets. The current Shiller P/E above 22 has historically been associated with subsequent total returns in the S&P 500 of less than 5% annually, on average, over every investment horizon shorter than a decade.

Andy Xie believes that QE2 won't work to devalue the USD because "most major economies will do something to keep their currencies down":

The world seems full of smoke ahead of a world currency war. The weapon of choice is quantitative easing (QE). If you print a trillion, I'll print a trillion. No change in exchange rate after a trillion? Let's do it again, QE2.

Unintended consequences
Paradoxically, QE2 may have the opposite of depressing the US economy in a couple of ways. If China allows wages to rise and pass the costs along, it would raise the prices of consumer goods in the US. In addition, Andy Xie thinks that the RMB is overvalued:

I think China's currency is overvalued. China's money supply has exploded in the past decade, rising from RMB 12 to 70 trillion. Every currency has experienced depreciation after a pronged bout of money growth. China's industry has risen tremendously to justify part of the growth. However, a massive amount is in the overvalued property market. When it normalizes, the money flows out and the currency depreciation pressure happens. We should see this within two years.

As well, QE2 is pushing up commodity prices, which include food, which is depressing the American consumer's already weakened spending power. (Oh I forgot, central bankers look at inflation ex-food and energy, which is where the inflation is, so therefore there won't be any inflationary effect...)

Michael Panzner posted a graph showing the disconnect between Wall Street and Main Street, in the form of the stock market and US consumer confidence. Notice how they tracked each other until the Lehman Crisis, when the market took off but consumer confidence stayed flat.

QE2 is likely to increase that gap by rewarding the holders of capital by blowing another asset bubble while the suppliers of labor have to suffer the consequences of higher food costs and possibly higher prices of consumer goods made in China.

Recall that even the worse days of the Weimar Republic hyper-inflation, there were clear winners and losers. All that stimulus meant a roaring stock market, which rewarded the holders of capital, while the ordinary working people suffered. We know how that story ended.

It may not come to a repeat of the German experience, but the risks are there. Barry Ritholz points out that already, affluent Americans are more confident now than 2009. I also suggested before that QE2 has the potential to ignite class warfare.

Meanwhile, my inner trader says that the Fed is intent on throwing a party so let's enjoy it and maintain tight trailing stops. Don't worry, be happy!

The Markets have spoken

On Monday I wrote that this would be a momentous week for the financial prices and suggested that it may be time to sell the news. Now that the mid-term elections and the FOMC decision has come and gone, what's the verdict?

In the spirit of elections, where conceding politicians use the words "the People have spoken", I now write "the Markets have spoken."

Fed chairman Ben Bernanke had an important Op-Ed in the Washington Post, in which he admitted that the Fed was targeting stock and other asset prices [emphasis added]:

The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

When the Fed chairman mensions stock prices twice in the same paragraph, it would be foolish not to pay attention. In reaction, commodity prices are skyrocketing and the USD has fallen through an interim support level.

Substantial risks remain
My inner investor tells me that substantial risks remain in the market. First of all, there are the valuation and economic risks of a slowdown or double-dip, as the likes of John Hussman has repeated warned us about. Moreover, political gridlock may not be good for the markets after all. Bernanke concluded his Op-Ed with [emphasis mine]:

The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.

If there is gridlock, then monetary policy will have to do all the heavy lifting. That will lead to a highly risky unbalanced policy by the United States.

More telling is Kid Dynamite's characterization of the comments of Bill Gross, which is "sold to you sucka" as a response to the Fed's QE2 program.


Don't fight the Fed
Does that mean that Bill Gross is fighting the Fed? Let's see what he actually said:

"To your question of selling or buying treasuries - I think for the most part those that should have bought them have bought them already and that would include PIMCO and that we would be looking forward to "handing them off" so to speak as we accelerate towards that outer orbit."

In other words, Gross and others front-ran the Fed in its QE2 program and is now "handing them off" to the Fed. If an institution the size of Pimco wanted to sell, the Fed would be a perfect candidate as a buyer. The rest of us mortals whose portfolios are a fraction the size of Pimco's AUM and the Fed's balance sheet can afford to be more nimble.

My inner trader, who vehemently disagrees with my inner investor, believes that the Fed is intent on blowing another asset bubble. Already, we have commentators like Barry Ritholz and Simon Johnson warning against the likely watering down of the Volcker Rule. Such actions, it is believed, will lead to a repeat of the financial excesses that toppled Bear Stearns and Lehman Brothers.

My inner trader says, "Don't worry, be happy! These policies are bubblicious. They are supportive of the asset bubble that the Fed wants to blow, so relax and go with the flow."

In that case, this will mean a momentum driven market where fundamental don't matter.

Sell the news?

The first week in November will indeed be momentous and full of wild cards. We will see the US mid-term elections, followed by the FOMC meeting in which QE2 is expected to be announced. Right now, the market consensus for both events are both equity bullish. However, it's important to examine the implications of these events to see if they are indeed bullish.


Is deadlock really market bullish?
The Republicans are expected to take back the House, but the Democrats are expected to narrowly retain its Senate majority. The Street consensus has been "deadlocks are bullish for the markets", but is it really in this case?

FT Alphaville highlighted the analysis from the strategy team at RBS. Highlights include (my comments in parentheses):

• Political deadlock means deadlock on fiscal policy. Monetary policy will have to do the heavy lifting (we are back to that QE2 again...)
• It also means regulatory uncertainty. (Do we really want "little" issues like the foreclosure crisis to linger?)

High market expectations for QE2
As for the upcoming FOMC meeting, I wrote about it before here and pointed out the risks that QE2 could spell the end of Bretton Woods 2. The market is pricing in about $1 trillion in QE2, while signals from the Fed is that it will be substantially less, with room for "flexibility" to raise the program if necessary. This, to me, seems to be a recipe for disappointment.
 
Fed watcher Tim Duy echoed some of the concerns of the RBS team about fiscal policy when he wrote last week [emphasis added]:

The Obama Administration is poised to turn its attention to deficit reduction, seemingly oblivious to the historical errors of Japanese fiscal policy, not to mention the US experience in the Great Depression. For better or worse, that leaves monetary policy to bear the burden. But the Federal Reserve is signaling they are poised to deliver far less than necessary to meet expectations, expectations that already were likely overly optimistic. 

And does the issue of "flexibility" only go one way?

To be sure, Fed policymakers will argue that they are trying to preserve flexibility. Why is it that "flexibility" means the ability to scale up? Why can't "flexibility" mean the ability to scale down? Seriously, it is not as if the Fed is in any danger of hitting either of the objectives in the dual mandate anytime soon. And does Bernanke really believe that it will be any easier to offer a credible commitment to scale up once Dallas Federal Reserve Chairman Richard Fisher is a voting member of the FOMC?

Are the markets getting leery?
While the markets seem to have very high expectations for QE2, early market action is indicating that the tide is turning. The US Dollar, which had been falling on expectations of QE2, seems to be stabilizing:

Interest rates are backing up:

Gold prices have also pulled back:

Bespoke's analysis of the stock market during mid-term elections indicated that equities have an upward bias for election day and for the week. Given the high expectations and the risks to these events, perhaps it's time to "sell the news"?

Signs of the Apocalypse?

As we approach Halloween, here are some signs of the Apocalypse:

• The average American credit score is now 666. Does this mean it's time to watch the Rapture Index more closely?
• The US has slipped to 22nd in the global corruption ranking tables, a historic low. In the Americas, this puts the country behind Canada, Barbados and Chile. Nancy Boswell, the president of Transparency International which conducted the survey, said: "We're not talking about corruption in the sense of breaking the law. We're talking about a sense that the system is corrupted by these practices. There's an integrity deficit."

Do you think that examples such as the banks hiding behind the slogan of "paperwork technical problems" when there was widespread fraud and claiming that no one was thrown out of their home who shouldn't have might have something to do with the "integrity deficit" in America?

How bad are the Financials?

The bad news keeps coming on a daily basis for the Financials:

• FDIC's Bair sounds alarm on foreclosure litigation - Sheila Bair: ""I fear that the litigation generated by this issue could ultimately be very damaging to our housing markets if it ends up unduly prolonging those foreclosures that are necessary and justified. The regrettable truth is that many of the properties currently in the foreclosure process are either vacant or occupied by borrowers who simply cannot make even a significantly reduced payment and have been in arrears for an extended time."
• New York Fed and bond investors gear up for a battle on MBS - Bloomberg has reported that the New York Fed, Blackrock and others has hired Kathy Patrick, a lawyer who has been characterized as a "pit bull on steroids", to take on BoA and others on the mortgage foreclosure litigation.
• Another analyst rhetorically asked the question if student loans are the next bubble [emphasis added]:

According to FinAid.org, student loan debt is now surpassing credit card debt. College graduates no owe $850 billion in student loans versus the $828 billion consumers owe credit card companies. This number is staggering. We’ll have to look it up, but it seems like this is the first time in history, given the short history of student loans, that credit card debt is less than student loan debt in the United States.

Moving forward, we will need to keep our eyes on two key metrics. First, we want to watch the number of defaults on student debt. Student debt is the only debt in our legal system that cannot be ‘forgiven’ during a personal bankruptcy. We could seriously find a generation without a job, without capabilities to pay the debt, and with no choice but to be servants to the banks to some degree. Although a “Lost Generation” is very unlikely, it is still a very small possibility. Secondly, we want to watch the employment rate. If employment does not improve, all of these new graduates will face uncertain futures moving forward. Some schools require students to take out six figures of debt which they could be paying on until the day they die. This grim future could be a reality for many. Could Sallie Mae (SLM) be the new owner of a slave generation induced by student debt?

I suggested a week ago that the relative performance of the Financials to the stock market is one indicator to watch of market health. The chart below shows that the sector has broken down from a relative support level and remains in a relative downtrend.

Is this another Lehman waiting to happen?
I think that everyone needs to take a deep breath. The market is starting to discount the Apocalypse for the sector.

I have heard bandied around is that the banks will have to take losses in the order of $100 billion. While that is a big number, it's not the kind of world ending figure that took down Bear Stearns and Lehman Brothers. $100 billion is roughly the total market capitalization of Citigroup, or about 10% of the BKX.

Yves Smith, who has been all over the foreclosure problems, believes that the magnitude of the problem may be overblown:

We did a quick and dirty analysis last week that showed that even if this effort succeeds, the recovery amount is likely to be far less than is widely anticipated.

In this excellent post on the problem, Smith went on the detail some of the legal and procedural issues surrounding the litigation and concluded:

We are no fans of Countrywide, but that should not stand in the way of recognizing that not every legal case against them is necessarily a slam dunk.

As for the student loan problem, which has a high probability of becoming a drag on economic growth and consumer spending, does not have the size to spark another Lehman-like crisis. (Note that the entire student loan market is $850 billion and not all of them are going to go sour.)


A correction likely, but this is not 2008
Today, investor sentiment is overly bullish, the market is overbought and showing signs of rolling over. These conditions are suggestive of an intermediate term top, followed by a correction with a 10-15% downside risk.

Barring some other unforeseen catastrophe, the problems of the Financials do not have the potential to return the major market indices to their 2008-9 lows.

Too much complacency

Just as the SPX sees a golden cross, sentiment measures aren't looking particular positive for equity bulls.

Last week I saw several posts in the blogosphere about stock market technicals breaking down. As well, sentiment measures seem to be indicating excessive complacency - which is contrarian bearish. AAII bullish sentiment is at 50%. Surveys of other measures also show signs of a crowded long in stocks and Mark Hulbert reported that the lastest Vickers report shows that corporate insiders are now selling.

Maybe the best warning for the bulls is when China's 9.6% growth rate is a disappointment, what other possible good news could propel the market higher?

Some perspective on the "Canadian Renaissance"

Sometimes one picture tells a thousand words. Consider the following editorial cartoon that appeared in Canadian newspapers*:

David Hay of Evergreen Capital Management recemtly elaborated on these sentiments by highlighting the "Canadian Renaissance":

As I’ve given various speeches over the last year, it has become clear to me that very few Americans are aware of the extraordinary recovery Canada has achieved since the mid-1990s. When I bring it up, most people seem surprised that Canada could have gone from a laughing stock to the envy of the developed world in just a decade. But, actually, 10 years wasn’t the true recovery period. And that was my big surprise from reading The Canadian Century. The reality is that Canada achieved stunning progress in a mere three years. Further, this time frame was consistent at both the federal and provincial levels.

Hay: "Not all is lost"
His message for Americans is: "Not all is lost, there is hope." If Canada can go from a basket case and enormous deficits in the mid-1990s to the relative fiscal health today, so can the United States. All it takes is a certain amount of willingness to take some fiscal pain.

Having lived in both countries, I feel uniquely qualified to comment on Hay's message. Just as America isn't Japan in the Lost Decade(s) parallels, America isn't Canada either.

While it is true that the Canadian Liberal government, under prime minister Jean Chretien and finance minister Paul Martin Jr. (who later became prime minister), moved from deficit to surplus in the 1990s, it was aided by substantial tailwinds. Don't forget that the US federal budget was in surplus at about the same time during the Clinton years. Much of the US surplus was helped by capital gains during the Tech Bubble of the late 1990s, which is not likely to be repeated.


Fiscal divergence during Bush II era
Hay's essay implies that all it takes is the political will and discipline to take some pain, whether it's in the form of higher taxes and/or reduced government spending, and all will be well. I believe he understates the problem.

Canada and the US diverged substantially during the Bush II years. While Canada maintained its fiscal discipline on a relative basis, the Bush II Administration embarked on two spending initiatives that made the federal budget dive into deep deficit waters. The first was the tax cuts. With another election coming up and contentious debate on both sides of the issue, it would be inappropriate for a Canadian resident to wade in on that debate and I'll leave it up to the American people to decide on whether a continuation of the Bush II tax cuts is a good idea.


Outspending the enemy 10 million to 1
The second, of course, was ramp-up in military spending in the post-9/11 era. Being in government is about making choices. In a democracy, it is up to the people to make choices through their elected representatives. From a strictly fiscal viewpoint, the wild ramp-up in military spending makes no sense. American troops are in Afghanistan, Iraq and the Gulf as a direct result of the 9/11 attacks. The cumulative cost of the Afghan and Iraqi campaigns now exceed $1 trillion.

It makes no fiscal sense to spend $1T in response to the actions of a small group of men, spending roughly $100,000 on a mission that flew civilian airliners into buildings. Nor does it make fiscal sense to propose spending $1.2 billion in aid because one guy tried to get on an airplane with a bomb in his underwear. A strategy of consistently outspending your enemy by 10 million to 1 will make you the loser over the long run. Of course, in a democracy you get to make choices of how to spend money. If a continued military commitment is the choice the citizens of a country chooses to make, then let the People express its will.

Paul Krugman once characterized the federal government as a giant insurance company with an army and I agree. Some really hard decisions have to be made and the choices are stark. In simplistic terms, Americans need to decide between their pension (Social Security) and health care or the essence of their post WW II identity (world prestiage and status) by standing down from their far flung military outposts around the world.

It isn't as simple as firing a few civil servants - Tea Party supporters take note. Also see the New York Times article entitled "As the GOP seeks spending cuts, details are scarce".



* Canadians may be getting overly smug by taking the victory lap and cartoons like this, which reflect popular sentiment, may be the top tick for Canada. Both the Bank of Canada and most recently the Toronto-Dominion Bank are warning about excessive consumer debt - and we know what happened to the American consumer in the last downleg.

Critical technical tests everywhere

Last week I wrote that the relative performance of the Financials was a key to understanding the health of the bull. Given all the news that have tossed the sector around, the relative performance chart of the Financials are at a critical technical testing point:

The chart below shows that the sector had broken down from a key relative resistance level (red line), bounced off a Fibo support level and rallied to test the (red) relative resistance level. Should the sector weaken further on a relative basis, it would be bad news for the bulls.

When I looked at the relative performance of the Materials sector, which is a measure of the reflation trade, the Materials sector approached a relative resistance level and backed off. It's now testing a relative uptrend line. Similar to the Financials relative performance chart, should Materials fail at the relative uptrend, it would be another indication that this bull move is over, at least for the duration.

Instead of analyzing the Materials sector and if we zoomed in on the golds, the relative chart tell a similar story. The group remains in a relative uptrend but it has retreated and is now testing the uptrend line.

The behavior of some of these critical sectors and groups in the next couple of days will be important signs for the health of the bull.

The Macquarie solution to Sino-American relations

Michael Pettiis had an interesting, but politically difficult solution to the economic problem of the imbalance between China and the United States (which is why he put as a Modest Proposal in the Swift manner).

Pettis suggests a "New Deal" for both China and America. Instead of the Chinese wildly spending on excessively infrastructure, which is creating an asset bubble in China, why not spend it on American infrastructure? Over time, better American infrastructure will raise productivity and stimulate US consumer spending, which benefits China. It's a win-win.

What Pettis is proposing is the Macquarie solution for America. A number of years ago, Macquarie was known for raising funds and securitizing infrastructure projects, e.g. toll roads, bridges, etc. If the state of Illinois wanted to build a new highway, or if California wanted to upgrade one of its ports, or construct a desalination plant, it could create an authority to build that highway and then collect the tolls. The tolls would then be used to finance the construction. In effect, the Pettis proposal would change Chinese investment in the US from debt (Treasuries) to equity (toll roads, etc.) What's more, a for-profit construction authority would pay more attention to the economics of the project, which would mitigate much of the pork that goes on in many of these endeavors. It would create also American jobs in engineering and construction - another win-win.

It's a very intriguing idea.

Your (un-PC) Friday giggle

In the highly polarized, politicized and politically correct climate that is America, it is difficult to have a rational conversation about some topics, such as how to heal the rift with the Muslim world and community.

Perhaps the first step is to try to relax and laugh about it. Consider these two offerings from America's closest allies, which could never be produced in the United States under the current environment. The first comes from the UK and it's a film called The Infidel, which is about a middle-aged Muslim who discovers that he was adopted and that he is actually Jewish (see the trailer here).

The second, from Canada, is a long running TV series called Little Mosque on the Prairie, about a small group of Muslims who get together and run a mosque in a small prairie town (by renting the hall from the local Anglican parish no less). See the first episode part 1 here, part 2 here and part 3 here.

Go take a look. They are both hilarious.

What QE2 cannot do

The stock and commodity markets have been rallying based on expectations that the Federal Reserve would implement QE2, aka printing money. I have written about the risks to QE2 here and here and I don't want to beat a dead horse.

Despite the general market strength, stocks fell off yesterday based on fears that the mortgage foreclosure mess would seriously impact the financials.


Is this 2008 all over again?
Others have covered the mortgage foreclosure mess much better than I have so I won't repeat the analysis (see Felix Salmon's comments here and Barry Ritholz at The Big Picture here and here). The risk here is that, if all this mortgage paper is shown to be defective, then someone, somewhere, is going to take a big haircut. Most likely, the haircut is going to show up somewhere in the financial system.

I don't want to be overly alarmist because we really don't have a good handle on the magnitude of the problem. I do have a foggy memory that back in 2008, it was the combination of bad paper and excessive leverage caused a financial panic.


The Fed can supply liquidity but not solvency
Panics are the financial equivalent of fires and central bankers act as fire fighters. During these episodes, the central banker can inject liquidity into the financial system. However, if a bank is sunk by bad loans (or bad mortgage paper that it's holding), then its assets are less than its liabilities, or deposits, and it is deemed to be insolvent. Insolvent banks can't be saved by additional liquidity, they need equity injections.

Just remember this: QE2 can only supply more liquidity to the system, not solvency. Should we experience another solvency crisis in the financial system, then no amount of Fed Treasury purchase can save the system. Something else would have to be done, e.g. another TARP.

The market is already starting to price in the solvency risk in the system. A look at the relative performance chart of the Financials against the market shows that, despite the stock market rally, Financials remain in a relative downtrend and continue to underperform the market. In fact, the sector is now testing a relative support zone, with little downside protection should relative support fail.

The behavior of the Financials highlight the risk to the system. This sector bears watching as a barometer of the robustness of continued strength of the market rally.

Will QE lead to class warfare?

Further to my last post about the risks of quantitative easing, I saw a couple of warnings from the IMF that are worrisome. First, they warned that the risks to financial stability remain high. Moreover, they indicated that Basel III won’t ward off another financial crisis.


Policy makers appear to be in my-only-tool-is-a-hammer-so-every-problem-is-a-nail mode. The consensus solution of choice are further quantitative easing, competitive devaluation and trade protectionism (mostly directed at China).

Blowing more asset bubbles
Jeff Rubin, former chief economist at CIBC World Markets, recently wrote that further quantitative easing only benefit the providers of capital, i.e. the wealthy. In other words, QE means more asset bubbles. Rick Bookstaber also commented on the income gap and looked towards a hypothetical 2025:

For those who have the money to burn, demand is moving increasingly toward things that cannot be produced. Land, art, rare wines and Super Bowl tickets are being bid up to unthinkable levels. The major economic pastime that remains to differentiate the rich from the rest of us is picking new stuff to throw into the fray. The latest one is scholar stones from the Sung Dynasty. All that money has to go somewhere. But that only leads to a transfer of income from one well-to-do pocket to another without generating any production. Sadly for those grounded in the middle class, this means more of these things are moving out of reach. But no matter. It all seems silly and abstract to most of us, like the amusing eccentricities of the English upper class a century or two before.

Notwithstanding the fact that IMF chief Strauss-Kahn is warning against using currency as a weapon, noted China watcher Michael Pettis wrote that forcing China to revalue the RMB too quickly will also result in further asset bubbles [emphasis added]:

Most probably Beijing will do the same thing Tokyo did after the Plaza Accords and Beijing did after the renminbi began appreciating in 2005. It will lower real interest rates and force credit expansion.

This of course will have the effect of unwinding the impact of the renminbi appreciation. As some Chinese manufacturers (in the tradable goods sector) lose competitiveness because of the rising renminbi, others (in the capital intensive sector) will regain it because of even lower financing costs. Jobs lost in one sector will be balanced with jobs gained in the other.

But there will be a hidden cost to this strategy – perhaps a huge one. The revaluing renminbi will shift income from exporters to households, as it should, but cheaper financing costs will shift income from households (who provide most of the country’s net savings) to the large companies that have access to bank credit. So China won’t really rebalance, because this requires a real and permanent increase in the household share of GDP. Instead what will happen is that it will reduce Chinese overdependence on exports and increase China’s even greater overdependence on investment.

This will not benefit China. It will fuel even more real estate, manufacturing and infrastructure overcapacity without having rebalanced consumption. Expect, for example, even more ships, steel, and chemicals in a world that really does not want any more.

The Federal Reserve is no doubt aware of these risks. Fed Vice Chair Janet Yellen, who is usually perceived as an inflation dove, also weighed in on the bubble risks of excessive easy monetary policy in a speech on October 11, 2010 [emphasis added]:

I noted previously--and it is now commonly accepted--that monetary policy can affect systemic risk through a number of channels.First, monetary policy has a direct effect on asset prices for the obvious reason that interest rates represent the opportunity costs of holding assets. Indeed, an important element of the monetary transmission mechanism works through the asset price channel. In theory, an increase in asset prices induced by a decline in interest rates should not cause asset prices to keep escalating in bubble-like fashion. But if bubbles do develop, perhaps because of an onset of excessive optimism, and especially if the bubble is financed by debt, the result may be a buildup of systemic risk. Second, recent research has identified possible linkages between monetary policy and leverage among financial intermediaries. It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system.

What happens after the next Crash?
We learned the hard way in 2008 and 2000 that asset bubbles end quite badly. If Basel III doesn’t ward off the next Crash, what happens then?

Michael Norton and Dan Ariely wrote a short paper entitled Building a better America, one wealth quintile at a time that surveyed Americans about their perception of wealth distribution and contrasted it with the actual figures.

Not many Americans realize that the 80-20 rule applies here. Roughly 20% of the population have 80% of the wealth, which is not only very different from the estimates, but different from the popular ideal.

No doubt in the next Crash, the bulk of the adjustments will be borne again by the middle class. I hate to keep quoting Simon Johnson but as he says, we seem to keep playing the same song over and over again:

To IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out...

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Depressingly, the developed and emerging markets have switched places today. The most recent IMF economic outlook confirms that:

“The world economic recovery is proceeding,” IMF Chief Economist Olivier Blanchard told a press conference. “But it is an unbalanced recovery, sluggish in advanced countries, much stronger in emerging and developing countries.”

Add to the mix with American net worth is already down 26% and the fact that the rich don’t feel rich anymore.

At what point does that lead to class warfare?

Apocalypse on November 3?

Increasingly, I am reading more and more feelings of unease about the American and global economy. Barry Ritholz's America needs an intervention is a typical sample about how America is living beyond its means:

The United States has been living a lie.

As a nation, we have been kidding ourselves, repeating myths, hoping that if we say something enough times, it will become reality — no matter how untrue. The credit crisis and now foreclosure debacle has revealed to anyone who cares to look what we have sought to ignore: That the past decade has been based on a set of fundamental beliefs that are intrinsically false.

Its time for an intervention. We need someone to force us to stop hitting the bottle, lose the bimbo, skip the dessert cart, visit the gym. Its time to stop bullshitting ourselves about Financial Engineering, and face both the Truth & Consequences of our legacy financial system.

Tim Knight at the Slope of Hope expressed his unease about the current market backdrop in his post The Looming Something:

There will come an event that will - probably very quickly - bring forth the unintended consequences of all this unprecedented action, and the Something will be reviled instead of embraced.

I feel like I am watching a horror movie and the creepy music is starting to build...and it's building to a crescendo. But what will be the trigger for the collapse?


Watch the November 3rd FOMC meeting
One trigger might be the FOMC meeting on November 3, 2010. Already there is global anxiety about currency wars - so much anxiety that the IMF has been asked to intervene and mediate. Tim Duy has indicated that should the Federal Reserve choose to implement another round of quantitative easing on November 3, it would mean the end of Bretton Woods 2:

[T]he Federal Reserve is positioned to declare war on Bretton Woods 2.  November 3, 2010.  Mark it on your calendars...

Consider the enormity of the situation at hand.  The Federal Reserve is poised to crank up the printing press for the sake of satisfying their domestic mandate.  One mechanism, perhaps the only mechanism, by which we can expect meaningful, sustained reversal from the current set of imbalances is via a significant depreciation of the dollar.  The rest of the world appears prepared to fight the Fed because they know no other path. 

Should QE2 mark the end of Bretton Woods 2, it would mark a global regime shift. Global regime shifts are not orderly events. There will be turmoil and volatility. Tim Duy writes:

The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly.

The Buttonwood blog of The Economist also weighed in with similar comments:

Although asset prices may be buoyant at the moment, there are other risks ahead. Competitive devaluation is an inherently unstable system. Someone must lose their share of world trade. And a policy of boosting exports can all too easily turn into a policy of blocking imports.

Investors should be prepared for this possibility. Don't say that this is another black swan event and no one foresaw this. You have been warned.

A political Rorschach test

I read an interesting article last week in the New York Times entitled Scientists and Soldiers Solve a Bee Mystery. The article detailed how some scientific researchers collaborated with Army researchers to solve the mystery of what was killing off honey bees. It turns out that the combination of a fungus and virus is proving fatal to the honey bee population.


Why is the government doing bee research?
While the article was interesting, it occurred to me that the story could be viewed through some very different political lenses, depending on where you sit in the increasingly polarized political spectrum. Deficit hawk could ask the question: "In an era of fiscal austerity, why is the government spending money on something as esoteric as bee research? If we wanted the government to stop wasting money, this is a perfect example of activity that government shouldn't be in."


Does the Pentagon get a free pass?
On the other hand, this isn't just the federal government doing esoteric research, it's a special branch of the government, i.e. the Pentagon. For some conservatives, the military gets a special pass for their activities. Is bee research one of them?


Or has the military gone too far?

Or has the military gone too far to intrude into ordinary life? Consider the development of the publication of a controversial article by Andrew Milburn (Lieutenant Colonel, USMC) in the Joint Forces Quarterly entitled Breaking Ranks: Dissent and the military professional. Key quote here [emphasis added]:

There are circumstances under which a military officer is not only justified but also obligated to disobey a legal order. In supporting this assertion, I discuss where the tipping point lies between the military officer’s customary obligation to obey and his moral obligation to dissent. This topic defies black-and-white specificity but is nevertheless fundamental to an understanding of the military professional’s role in the execution of policy. It involves complex issues—among them, the question of balance between strategy and policy, and between military leaders and their civilian masters.

One more step towards Argentina?
Lt. Col. Milburn's comments are reminiscent of comments from the colonels of the Latin American juntas of a bygone era. At what point does the military stop getting a free pass on policy?

Allowing the Army to reach into parts of civilian life where it doesn't have a traditional role, e.g. bee research, echoes the reach of the Army in other emerging market countries of today, e.g. Asia where the Army can be found in industries such as banking and real estate.

Is this another step in America going south towards Argentina?

This is a political Rorschach test: Your answer depends on where you are in the (increasingly polarized) political spectrum.


Disclaimer: The purpose of this post is to raise questions so that you can examine your own biases. I actually don't have a strong opinion on this issue. Good investors are politically neutral and agnostic. They watch, react and capitalize on the political, economic and financial climate.

Equity analysis: Beyond corporate stenography

I normally don't write very much about company analysis, because I have spent most of my professional life as a quant. Nevertheless, I was fortunate to have been a small cap/special situations analyst early in my career. That experience from the school of hard knocks taught me that, indeed, different industries have very different value-drivers and therefore different valuation metrics, which was a invaluable lesson for me later in my life as an equity quantitative analyst.

Two recent events prompt me to write this post. Firstly, I volunteered to be a team mentor in the CFA Institutes' Global IRC Challenge, where teams from universities around the world compete by performing investment analysis. As well, I was asked to give advice to a junior company seeking a stock exchange listing on the issues of raising capital and investor relations.

I therefore write this post with those two groups in mind.


The basics of company analysis
The basics of company analysis depend on how an investor answers the following two questions:

1. What is the company's competitive "moat"? Why does it exist in the first place? For example, a corner grocery store's competitive position is likely it's location - convenience is probably the main factor here. On the other hand, a company like Apple depends mainly on its technology, design and "coolness" factor - which is why customers line up overnight for new releases of iPhones.
2. How do you value the company? Answering this question depends on how you answered the first question. What kinds of margins are sustainable in that business? If the "competitive moat" is large enough, then the company can extract above average margins and returns on capital for a long time. On the other hand, a corner grocery store in a commoditized business can only earn market rates of return, barring other competitive advantages.

Don't just focus on valuation
IMHO, way too much of the focus in business schools is on valuation. No doubt, corporate valuation modeling is a skill that need to be learned. Once learned, however, it's a highly commoditized skill and offers the analyst little or no competitive advantage over his peers. Analysts who mainly focus on building company financial models often wind up just becoming a stenographer for the company and add little new investment insight.


Adding independent investment insight
I have found that the analysts that really stand out from the crowd are the ones who have effectively mastered the principles in Michael Porter's books Competitive Advantage and Competitive Strategy.

It doesn't mean, however, that the analyst needs to do a 50 page Porter analysis of a company's competitive position, i.e. threats from suppliers, customers, existing competitors and new entrants, etc. It does mean that the analyst should be aware of these issues and flag the positives (competitive advantage) and negatives (risks) faced by the company.

To give an anecdotal example, I recall researching Nokia, a darling stock during the days of the Tech Bubble. It was the American based analysts who were very good at understanding the Nokia competitive position at a top down level. The story at the time, was that Nokia had a leading market share in handsets and a valuable brand. It could therefore use its volume muscle to drive down margins for its competitors and remain dominant.

On the other hand, the European based analysts who knew where all the figurative bodies were buried. They were much better at the bottom-up analysis and the channel checks. I depended on the European analysts for alerts about problems in the telecom business, e.g. relationships with major customers, production lines going down and their possible implications, etc.

Both are forms of competitive analysis. One is strategic in nature and the other tactical. Both are valuable. Without both, financial modeling becomes a GIGO (garbage-in-garbage-out) exercise in fundamental analysis.