2007 November « Traderbill's Financial Markets Weblog

Archive for November, 2007

11/30/07…watching and waiting

November 30, 2007 at 5:06 am · Filed under economy, financial, markets ·Tagged ETF's, Fed, Florida government fund, hedge funds, Morgan Stanley, pension funds, Pequod Capital, private equity, SIV's, Treasury Secretary Paulson

TB’s Quote of the Day: ”If it weren’t for sports, I probably would have wound up in prison or worse…who knows, I might be dealing with real guns in real live now it it weren’t for high school sports.” Hint: it wasn’t Johnny Mathis who also attended high school in San Francisco and was a track star. Give up? It was O.J. Simpson in 1991 during filming of Naked Gun II on proposed cuts to school sports programs. Were it not for a runaway jury that let their emotions override facts, an incompetent prosecution and LAPD, he would have been in prison…and now years later will likely wind up there again.

…a lot went on overnight with Fed Chair Bernanke speaking and in sync with Vice Chair Kohn the previous evening. Then Treasury Secretary Paulson who seems unable to mouth “I support a strong dollar,” is calling a confab of BofA, Wells Fargo, and others to do as California is doing and fix subprime loan rates for some period of time. Market is ablaze over these two events…at least so far in Globex, but there are a lot of problems here:

1. The subprime loans that defaulted to date were ones that should never have been made, not due to rising rates. Also there are 1.54 million subprime loans resetting this quarter totaling $331 billion!

2. Wells for example doesn’t own a single subprime loan (but a lot of subprime home equity loans which made up the difference between 80% and 100%…plus some 2% unsecured loans that covered closings.

3. Most of these loans have been sold without recourse to broker/dealers and packaged into CLO’s. Therein lies the problem as you have a contract that cannot be modified without the approval of the holders…that could take months IF they are willing to do it…or…banks could absorb the difference IF they are willing since they are still the servicers.

4. How do you get owners with negative equity in their homes seeing falling prices…you have to see it in San Diego, the outlying SF Bay Area, or Florida or Las Vegas to realize just how bad this is…to stick around when the builders are accepting almost any offer (and including a car with purchase), which further drives down prices of those who are forced to sell for a variety of reasons.

It is the opaqueness of these transactions that is the problem…to provide liquidity markets require transparency and it is sadly lacking at all levels. It is impossible to know who owns what and most of the hedge funds aren’t speaking but we do know they are quietly approaching private equity firms like Black Rock and selling at pennies on the dollar. We also know the $2.5B private equity infusion into Countrywide by a consortium of private equity firms involved buying by buying a large pool of subprime assets at pennies on the dollar and a possible equity stake. CFC is the largest borrower from the Atlanta FHLB at $51 billion…the Fed last night said they adhered to standards…uh huh…also from what TB has heard Washington Mutual is the largest borrower from the SF Home Loan Bank…or at least was a year or so ago and it is hard to imagine that has changed…only the credit has changed.

So let the stock market rally initially on the news…but bear in mind that today is monthend and hedge funds had their cutoff three days ago (T+3 settlement). So the final hour will be the one to watch.

Last night on Kudlow & Company, Sir Lawrence had as guests supply-sider Art Laffer who never met a market he didn’t like, Former Fed Governor Wayne Angell, and Lee Hoskins, former president of the St. Louis Fed, discussing what the Fed should do. All said they should ease but it was Larry who said they should immediately…not wait for the December meeting…cut the Fed Funds rate by 150 basis points…perhaps you now see why TB calls him a political economists as he has changed his view on all this at least three times…calling it his favorite term from the Iraq War “shock and awe.” Even his good buddy Laffer told him to simmer down as did Angell while Hoskins said: how can lower rates solve a credit problem that was caused by the Greenspan Fed keeping rates down far too long? No reply.

This all seems like a sequel to One Flew Over the Cuckoo’s Nest…you can’t tell the inmates from the staff without the uniforms. Anyway, you get the picture and it is why yesterday TB asked: even if they solve the credit crisis…and it is a crisis (despite Fed Funds at 4.5%, 1 mo. Libor in dollars and Euro’s is 5-1/2% up 25 basis points since 10/31…and remember the Fed cut Fed Funds to 4.5% on 10/23 (worse yet is UK Libor which is 7.25% +102%). Wait till we get near year end as banks try to shore up liquidity. Note that asset backed commercial paper has declined by 22% since 12/31/06 but still stands at $236 billion and the Super SIV plan by Paulson is a bad joke and a failure…better luck this time (also note that non-financial CP is up 35% to $51 billion…so corporations are requiring more cash too).

Let the lawsuits begin…and fly they will…everyone suing everyone else for their own greed.

Yesterday, TB asked: where will the replacement revenues come from even after the subprime mess is solved…the Paulson ‘plan’ will only worsen banks condition as they will have to shore up capital and we know how expensive that is. Calls to let FHLMC and FNMA take in more loans are falling on deaf ears as their regulator OFHEO is balking as are most others…neither of these agencies could manage their assets/liabilities before and we want to increase exposure? In the end the government…and you and me, will be the ones to bite the bullet, but talk about a perfect storm…year end just before a Presidential election year! Not only that the rhetoric is flying and they don’t much like one another…still!

The scenarios for pension funds, private equity and hedge funds, mutual funds, and ETF’s are as follows:

Pension funds – some of that unfunded liability will return since actuarially they need 8% to breakeven. But the funds that have put themselves in the best shape did it by investing in private equity and hedge funds.

(also note that state and local government funds will have varying degrees of trouble due to holdings of the questionable paper…Florida’s $12 billion fund had to stop withdrawals, much as San Diego County and San Bernardino County tried to do in the Orange County bankruptcy (OC Cal not OC Fla…another strange coincidence). When one government is in trouble there are always more as they all talk to one another and so several are likely to issue mea culpa’s as soon as they are forced to. Sometimes those T-Bill rates don’t look so bad…at one point in the Depression, T-Bills actually traded ABOVE par!)

Private Equity – after being so hot these funds are now finding lenders either unwilling to lend or reluctant enough to do it that they are exacting big concessions which will undermine the funds profitability and make fewer prospects…and Schwarzman said this would happen if his risk capital didn’t get taxed 15%!

Hedge Funds – lower leverage means lower potential returns. Pequod Capital announce they were shutting down immediately three funds and letting the managers go…expect more of this as assets shrink and fees thus decline…good bye 20% bonus, except for the big ones doing well…and they are not the quant funds or long-short funds. A lot of shingles will come down soon. (Speaking of Pequot, interesting this happened on the same day as its former Chairman John Mack, now at Morgan Stanley, accepted the resignation of President Zoe Cruz, who has decided to retire…she was reportedly doing a good job but someone had to take the fall and it wasn’t going to be Mack…right? Just TB’s opinion, not fact.)

Mutual Funds – expect what you did following the 2000 crash…lower valuations but taxable dividends

due to the sale of lower cost stocks…they always do this…mutual funds hate to take losses!

ETF’s – the three salient points of ETF’s are the ability to track an index or sector, tax efficiency and liquidity. Tracking error is controlled by (at least by iShares) traders replicating indices with a small percentage of stocks, and these traders (about 6 independent dealers), trade to keep tracking error minimal…this works on the way up when markets are liquid, but on the way down the traders (who handle directly large block orders from institutional holders), thus have to adjust positions. Normally this can be done without moving the market but in a bear market liquidity evaporates and as sellers (largely hedge funds trying to lower positions and therefore leverage), sell to them they have to markdown further in order to avoid taking a loss themselves, thus increasing tracking error (if you look at DVY, the Dow Dividend Select Fund, it peaked in June, well ahead of the market and has performed poorly ever since, this TB ascribes to sellers). Tax efficiency is accomplished by ‘harvesting losses’ so not net gain or loss is incurred…but illiquid markets impact this so it is not clear whether there will be gains or losses. So when you remove the liquidity from the equation you might have a problem. (Note that there are now municipal ETF’s -tax-exempt…there are three general market ones from different vendors and iShares has a NY State and California as well…these could be very suitable for individuals in high tax brackets but not buying odd lot bonds and thru retail brokers…check them out.

Everything discussed above emphasizes two key points: transparency and liquidity. Without transparency there is going to be inadequate liquidity. Both are lacking in the current environment and it is wishful thinking to believe the problem will clear up at any time in the near future. Be very careful!

Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries…as he sees it…and in no way reflect the views of anyone other than himself. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. No fee…nothing to sell…merely observations of events in the marketplace offering a non-mainstream viewpoint…sometimes…usually? Hope you find it useful.
Copyright TBD Capital LLC November 29, 2007

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11/29/07…what’s in your wallet?

November 29, 2007 at 5:45 am · Filed under economy, financial, markets ·Tagged Bank of America, Bloomberg, Bridgewater, Citibank, crude oil, Ken Lewis, Kohn, Ray Dalio

…perhaps someone should ask that question of Capital One? While our focus has been on credit we have so far overlooked the impact on federal, state and local government, which could be huge.

Before you answer that question consider what has happened while everyone breathless gave the play by play on the market yesterday. First, overnight a major oil pipeline fire in Northern Minnesota that transports oil down from Canada…it will take several days to burn itself out meanwhile Crude is up $3.50 overnight offsetting yesterday’s sharp decline…the lord giveth and the lord taketh away? Whatever. Gold too us up over $5 despite dollar doing better. Now the biggie thanks to TB’s friend Mark Gilbert, Bloomberg reporter extraordinaire in London:

“Coordinated Intervention?
   The gap between the Federal Reserve’s key rate and what banks charge each other to borrow dollars for three months has widened to about 58 basis points, the most in 2 1/2 months. The
cost of overnight money is now more than a quarter-point higher than the Fed’s target. There’s a similar picture in borrowing costs for euros and British pounds.
   The European Central Bank said last week there’s a “re-emerging risk of volatility” and that it will supply cash “for as long as it is needed.” This week, the Fed said it would “counter the re-emerging risk of volatility” in money markets and will “provide sufficient reserves to resist upward pressure” on borrowing costs around the turn of the year.
   You know there’s a credit crunch when central banks use identical words to name their pain.
Yielding to the Inevitable
   The 10-year U.S. Treasury yield was whipsawed by 25 basis points in a single 24-hour period this week. “That’s four times the normal daily range over the past decade,” according to Stuart Thomson, who helps oversee $46 billion in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland.
   The two-year yield dived below 3 percent this week, from 5 percent in June. It hasn’t been this far below the 10-year level since January 2005. Jan Hatzius, chief U.S. economist at Goldman
Sachs Group Inc. in New York, this week chopped his mid-2008 Fed rate forecast to 3 percent from 4 percent.
   You know there’s a credit crunch when the bond market is telling you that the Fed will have to slash its key interest rate from 4.5 percent to avert recession.Safety First
   Investors now demand a 4.44 percent yield to own Italian 10-year government debt. That’s 38 basis points more than they charge Germany — the widest spread since March 2001. The 22-
basis-point premium on 10-year Spanish debt versus German bunds is near a six-year high. The story is similar in other European debt markets, including those of France and Greece.
   Even though all the bonds are denominated in euros, investors prefer to park their money in German debt. Those spreads are telling us that there is a flight to quality in Europe as fear trumps greed.
   You know there’s a credit crunch when governments that have done nothing to offend the gods of the capital markets are forced to pay more for their money.

The Incredible Shrinking CP Market
   Investor appetite for commercial paper is withering away. The total U.S. market has shrunk by almost 17 percent since July and is down to $1.8 trillion, the smallest it has been for more
than a year. The amount of asset-backed commercial paper has fallen to $849 billion, the lowest level since January 2006.
   In Europe, the commercial paper market contracted by $23 billion last week and has shriveled by $41 billion in November, according to figures compiled by newsletter Capital Market Daily.
   You know there’s a credit crunch when short-term cash becomes unavailable because investors won’t lend.”

(Complete article at NI Gilbert on Bloomberg…also see NI Charts to see those money rates!)

TB is sorry but if you read that and remain a bull you just don’t get it! Here’s more…according to CNBC, Bridgewater CEO (a guy who puts his money where his mouth is), questions the renewed bullishness in financial stocks as TB did…after all they are paying huge premiums for the money they are getting….Citi paying 11% to Abu Dhabi for convertible debt at a low conversion rate??? Dalio also thinks Citi will need another $25B and who wants it with low margin bank business. (By the way TB heard from a friend that his adjustable rate loan dropped to 4.30%…written as a 5/30 at 5%…where do margins go if losses are up and resets are down due to the flight to quality…you decide). Bet BofA’s Ken Lewis feels sick about his short term ‘victory’ with the Countrywide injection of $8B in 7.25% preferred, also convertible but in just a month it has lost half its value…so what…in the end BofA will own that carcass…TB is betting by yearend…nice job, Ken…will you, like Carly (HP and Compaq) get a bonus for putting it together? Also the Super SIV put together by Citi, BofA, and others is in serious trouble as Blackrock is now shying away…who is going to invest in CP backed by this group to earn 1% over money market rates?…when your exposure is 5%??? Only way it will fly is with govt. backing and that is not on the table…yet! The point is yesterday may have been the best selling opportunity to date.

At the Federal level, expect revenues to decline due to stock market losses and lower interest rates, even as spending increases due to a weakening economy. It would be nice if Fed Vice Chair Kohn spoke sparking the really yesterday…by the way the majority of S&P 500 companies are missing marks.

At the state level, California is the most blatant, the Governator, due to do rising revenues again endorsed the issuance of a record amount of bonds that was approved by voters for infrastructure. Nevermind that he is making the same mistake as his predecessor, Gray Davis, who was recalled. The surge in revenues after a sagging Silicon Valley economy was largely a result of one company: Google! It’s two co-founders, Larry Page and Sergey Brin, along with about 80 employees became billionaires on the IPO and exercising stock options…TB has no problem with this but it is what it is: a one time event (furthermore despite incredible employee perks, TB is told that turnover is high and rising, which isn’t surprising given the run up in price and where options would have to be granted today. So no more hiring at minimum wage plus a pile of options to a chef, a secretary and former masseuse, and others. They have to pay a competitive wage and people will thus move as opportunities arise…in the big years for tech, TB once asked the CFO of a client, Ascend Communications which was later acquired, how they dealt with the declining stock price from the highs. He answered: “Well, you can tell by looking who the ones are with $8 options and the ones with $60 options”…’nuf said).

So the state came to expect these billions of revenues (there is no capital gains rate in California, only ordinary income), and of course the rising real estate market supported the concept. But now with the housing market in disarray and a weakening economy. California just issued $1B of infrastructure bonds (NY State also issued $88 million of variable rate general obligation bonds). Pass the problems on to the next generation, right? So Schwarzeneggers solution may only postpone the inevitable but then, that’s what government does, right? That is also why they cannot correct inequities in the system.

Then there is the issue of property taxes…under the Jarvis-Gann Amendment (Prop. 13) back in 1976, property taxes can only be 1% of the purchase price of the real estate (note real estate, not home, as Howard Jarvis was President of the Bay Area Property Owners Assn in So. Cal., which was apartment house owners…they didn’t pass along the windfall to renters thus causing imposition of rent controls, buildings owned in corporate name did even better since the stock was sold, not the building so no change in taxes…that is the problem with a constitutional amendment…you can’t change it…not easily). In a rising economy that was fine but now when we face a protracted slow housing market. An owner can petition to have taxes reduced due to a market value decline below the level where he purchased the home. In areas where homes are down 25% or more this could be a significant problem for the county and the state…and that doesn’t even address the problem of rising delinquencies.

Last, but not least, is pension funds. Most are now ‘fully funded’ based on 8% constant returns as far as the eye can see thanks mainly to alternative investments (read hedge funds and private equity). We know Florida took a hit but wait till the others have to disclose…TB can hardly wait for San Diego which can find the proverbial pig in a poke! Furthermore, they have just began accounting for health care liabilities and that is huge. Politicians are in deep trouble because state and local employees and retirees are a big percentage of the voting base. It is also that a judge would fail to enforce the terms of retirement benefits. Finally, pension funds are now recognizing three things: the benefits of liability driven investments (LDI), outsourcing the pension fund to a manager who assumes the responsibility for a fee (UK only so far), and now starting to loosen restrictions for conventional money managers allowing qualified firms to SHORT stocks…and perhaps not be fully invested in equity portion of stock portfolio at all times…thank you consultants for screwing up by requiring full investment at all times and negligently rebalancing equity/debt ratios in the period form 1996-2000 allowing levels of 80% stocks and thus causing the huge declines in net asset value and subsequent underfunding of portfolios…and still assuming 8% returns.

Tomorrow: scenarios for private equity, hedge funds, mutual funds, and ETF’s.

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11/28/07…the ‘nut’

November 28, 2007 at 6:00 am · Filed under economy, financial, markets ·Tagged Blackstone, EMC, Federal Reserve, Fortress Group, Goldman Sachs, MErrill, mortgages, VMWare

…hope that upon reading the above slug none of you thought this was an autobiography. In this case, the nut is in a financial sense and is incredibly important to keep in mind right now, since the focus thus far has been on damage control: the subprime and CDS portfolios.

Every person has a ‘nut’, the amount of money you need to earn each month to pay your bills and have enough for living expenses…then comes discretionary income if you have anything left but from the stats it appears most Americans don’t have a sous left…in fact their debt is growing. It is the amount of money left over after meeting the ‘nut’ that makes us feel good about ourselves, especially if the value of our assets are declining…for most of us that means our home value. Still with TB on this?

Ok, now to corporate land. The same holds true but the stakes are higher since quarterly every shareholder (think creditor in the personal sense), knows how well off they are. Then highly paid (grossly overpaid?) analysts crunch the data and forecast future earnings. But with a corporation, disposable income is actually excess cash…it can be used to pay big bonuses, pay or increase dividends, buy other companies, make capital investments…including R&D, or to make stock buybacks. A few months ago most of you would have argued TB’s point that stock buybacks (especially in the current context where they are not only not retired but used for exercise of stock options), are not the same as dividends and are just one time events…except this time they have been increased over the past five years by record amounts. You now see how that money was frittered away…especially if you own Freddie Mac (-60% over the past 12 months and 9% over the past 3 years…just 2% if you reinvested dividends but not a good investment), or Home Depot (-25% which could soon turn to junk), or Countrywide (-77%…but not for Mozillo). Lately several companies including Freddie and HD financed stock buybacks with debt issuance! All of this is due to the subprime crisis which turned into a collateralized debt crisis and a full blown credit crisis. But the focus has been on write-offs not where the next source of earnings will come from…and that does not make financial stocks especially attractive (overnight Wells Fargo announced another $1.4B increase to loan loss reserves to cover anticipated Q4 losses).

Ask yourself where the nice earnings increases of the past three or more years came from for the financial companies? Mortgage related business…OK, the housing sector. So as one by one they issue their mea culpa’s their stocks and those of their brethren plunge…but the lower earnings forecasts don’t mesh with the amount of revenue generated as it is so enmeshed. If the housing market declines mortgage business slows, but worse credit limits are being lowered and other restrictions added. Look how much of revenues were generated by brokers reselling packaged mortgages (and then buying them in another division without knowing what the other hand is doing), by trades to hedge funds with 10:1 or more leverage that are now reducing the leverage which will result in lower trading margins, get the picture? If you, an individual, take a hit…say the deductible on insurance for an accident, you know that that is a one time event but at least you can count on your income (unless you lose your job…and TB doesn’t even want to go there at this point). So TB fully expects to see lower P/E’s and thus higher dividend yields, lower growth rates of earnings, and therefore slower stock growth…if you were counting on double digit returns or even the 8% consultants use for pension funds…good luck.

We are back to talking about how the Fed will ease…even had a rumor the other day of an emergency Fed meeting and a 100 basis point Fed Funds rate cut…futures market is indicating a cumulative 330%in increase of 25 basis point cuts at each meeting thru April making the rate 3.5/8% at the end. But cuts will be in reaction to the credit crisis…if it happens and may cause the dollar which is now trying to find a footing to fall again. True the economy will be weakening but lower rates will not increase banks willingness to lend or to raise restrictions.

Furthermore we are not concerned about inflation (which is almost entirely food and energy), but is going to rise sharply when we get the Dec. CPI number in January…that is because, thanks to John Mauldin for this, last year CPI jumped in Nov. but then fell back to October levels by Dec. That could be a huge shock to the markets. TB has also commented in the past about how understated inflation is as they took housing out of the computation replacing it with owners equivalent rent…which actually increases as home prices fall, and ‘hedonics’ (not to be confused with ebonics), which discounts technological change. This is most apparent in automobiles and anywhere ‘bundling’ is done…you know all accessories included which is cheaper to produce than adding on each one but did you really want air conditioning, stereo, leather, etc. They also used the substitution effect to lower COLA increases for social security recipients…when meat prices go up substitute chicken or hamburger…eventually dog food?

The point is that any rally will be fleeting and this will take a long time to play out. Let’s take a look at the hottest of the US IPO’s and how they have fared, note that the first is private equity, the second a hedge fund and the last a tech stock:

Blackstone (BX) -33.9% from the IPO pricing and 41% from first day’s close…don’t ask about the high

Fortress Group (FIG) -11% from IPO, 47% from day one close…from 1st day high it is much worse!VMWare (VMW) +146% from IPO pricing but has fallen to up just 40% from IPO while the parent, EMC which still owns 86% of the stock is -8.8% and -5.3% respectively over the same time period. That does not make sense as EMC has so much more to offer than one line…TB owns EMC.

A friend pointed out the retraction by the WSJ of the report that Merrill had illegally ‘parked’ securities. This was what initially started the big downdraft in Merrill and is a very serious charge. WSJ has now retracted the article which came from sources they did not disclose but now appear to be someone who stood to gain from it…a hedge fund? MER rallied 3% off the low which was the prior day, but is still very weak and if their own analysts are correct has much more to write-down. Meanwhile, darling Goldie rallied 2.8% and while the best of the brokers is still straddling the 200 day moving average…weak!

Let TB know if you have a clue where the replacement sources of income for banks, mortgage companies and brokers are to come from…will ya?

Tomorrow we will look at another problem for the economy: federal, state and local budgets.

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11/27/07…hedging your bets

November 27, 2007 at 5:38 am · Filed under economy, financial, markets ·Tagged Citibank, hedge funds, Northern Rock, Virgin

…when is a hedge not a hedge? First, there are no perfect hedges. The original hedge fund concept was to go long say GM and short Ford and if you are correct you make a profit. In this example, since the two companies were in the same industry, the same country, and GM doing better in a weak economy while Ford improved in a good one, it worked quite well with very little risk. Also, not many people or hedge funds were out there to put on the same trade. Commodities are similar when one goes long wheat and short soybeans (not in this environment but when you have a stable dollar, and certainly not with corn…thank you, ethanol). That would be known now as a long/short fund but rather than ‘like’ companies, thanks to the wonder of models and Monte Carlo simulations, it could be any two (or more) ’variables’. The point is that hedge fund has come to mean: do whatever you want to do to generate returns.

For simplification, TB and others, lump hedge funds into one basket when there are any number of strategies: long only, long-short, event driven, bonds…you get the picture. While their fees are staggering, many produce stellar returns but about 25% of them fail over a five year period. But one of the problems with this is ’survival bias’ that makes group performance look better than it actually is. Some studies say this is not true since many funds who close to new money choose not report performance to companies like Hedge Fund Research (HFR). But on the other hand many with poor performance merely return whatever capital is left to investors and morph into a new fund, this too goes unreported. It’s all about fees and if you aren’t going to be able to earn 2% plus 20% (2/20), why stick around?

TB has several readers involved in hedge funds and they object from time to time to his ‘rants’, but if they won’t regulate themselves and fight SEC regulation, they become their own worst enemy. They say they can’t possibly do this with full disclosure of what they are doing. But there are things they could do yet resist doing…in fact, several large funds in London have proposed self-regulation before the game ends. Here are some of the problems:

AUM: Assets Under Management…seems straight forward enough, yet HFR and others have tried to define the size of the industry and there are at least three estimates: $1.25 trillion, $1.5T, $1.75T. When you consider that the difference between each of these is $250,000,000,000, it is astonishing. To a conventional money manager this is straightforward: how much client money does your firm manage?

Yet one well-known fund claimed $1 billion in AUM by counting LEVERAGE! Actual assets were $100 million, with 10x leverage…now that is high-powered money. Consider an investor who wants to have no more invested than 10% of the fund…they could pump in $100 million and own 50%…and of course the fund would then borrow another $900 million! This is not a hypothetical…

Another fund with $3 billion in REAL AUM failed to disclose that $500M came from another fund they control but said they have to count it in order to explain the fees…in other words they are charging the client twice…the spokesman didn’t realize he had effectively said this. This is ‘double dipping’ and prohibited for money managers. If you charge a client a fee to manage their assets you cannot then put some of the money in a money market fund you control and charge a fee on that too.

These two abuses show why they need regulation, perhaps not to the degree of conventional money manager is position secrecy is such an issue, but something has to be done. Even now some pension funds are changing the rules for conventional money managers who can prove they have the expertise to short stocks as well as go long. One state has designated two of its managers in this fashion and with much lower fees could spell trouble for hedge funds…and it will be of their own making.

Conventional money managers are graded on performance using more measures than simple returns. Consultants look at the variance of returns (risk), and performance against the ‘bogey’, but also use a Sharpe or information ratio to find out how much of that performance was due to the market and how much was due to knowledge. TB proposes that hedge funds do similar: report how much of the return is due to leverage…as what goes up must come down…something we now know to be true. Yet, a friend who works for one said not necessary since anyone who really wants to find out can…excuse me, only the largest investors and they don’t know for sure that it is correct. Publish it. Publish or perish.

But like the subprime crisis, the real culprit is the government. Readers know TB’s feeling that capitalism by it’s very nature must be regulated but not controlled…sorry Milton Friedman was wrong…since companies exist to make profits, not to serve mankind (although some do). That theory was based on the premise that companies are managed for the long run and thus would not do anything detrimental to their survival, but sadly, we know that is no longer the case as CEO’s reap the rewards and the expense of investors and rank and file employees. The Greenspan Fed, banking regulators and the SEC are guilty of gross negligence as they allowed greed to replace sound banking and investment principles. Why did Greenspan fail to raise margin requirements and allow all Nasdaq listed stocks to be marginable in an era of day traders and electronic trading firms that made their money of margin, not commissions? Why did the SEC fail to enforce the rule that in order to short a stock you had to borrow it, thus allowing leverage to muscle stocks lower, and worse on July 6 to eliminate the ‘uptick rule’ for shorting stocks, preceding by less than two weeks, not coincidentally in TB’s mind, the first market peak? We have a viable options market if one wants to make a ‘bet’ against a company without gambling with the underlying stock.

Now the same people who advocated all these things, notably Larry Kudlow, are saying borrowers did it to themselves so let them suffer, that everything is fine (Goldilocks economy), and yet wanted the Fed to cut rates…now that they have cut they don’t want them to do so anymore. They do not look at the consequences of their actions. Meanwhile, ”Caleeforneea” Governor Schwarzenegger and a group of lenders worked out a plan to lock in ‘teaser rates’ for a period of a year but only for owner-occupied residences. This is great but due to massive speculation will mitigate the problem but won’t be enough to stop the housing price slide. This is the most complex financial problem this country has ever faced and we have exported it globally! Nice job USofA!

Morgan Keegan economist Donald Ratajczak on CNBC today, when asked if he thinks we are headed for recession, said “no, but it is very close.” He sees a slowing economy over the next two quarters to 1% growth, then back up to about 2%. The risk he sees is the consumer who he sees as very stretched. That risk would be enough to push us into recession.

Virgin financial subsidiary, Virgin Finance appears to be the winner of bids to take over UK lender Northern Rock. Whether that move is a good one for Northern, Virgin, or the sector is debated in FT’s LEX today. LEX also talks about Sovereign Wealth Funds…overnight Abu Dhabi has pumped in $7.5B for “equity units” in Citigroup…also mulling around Sony Corp. This might be enough to turn the financial sector at least temporarily but remember Saudia Arabia’s Prince Alaweed is Citi’s largest shareholder, so it is like Warren Buffett were to do this but with government jumping in too…although he owns more than one insurer would he buy more than one broker? But markets trade on psychology, not fundamentals in the short run so this might be a good thing…at least temporarily but the jury is still out. Citi in denial in memo’s to employee’s that there will be ‘mass’ layoffs, but come on something has to be done as the organization is FAT! Also, they are saying that WSJ article yesterday on write-offs is not correct…actually implication is that they might have to put these on the companies books. Rumors continue to circulate that company will be broken up. If so, is the sum of the parts greater than the whole?

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11/26/07…the best is yet to come

November 26, 2007 at 6:42 am · Filed under economy, financial, markets ·Tagged , correlation, currencies, dollar, efficient markets hypothesis, freddie mac, hedge funds, monte carlo simulations, random walk, yen/euro cross

…those of you who believe the worst is over…good luck to you. TB spent much of yesterday, while watching football games, reading up on the current financial crisis and it is a crisis. Here we go:

The Dollar: Money manager Ken Fisher wrote a piece in the FT two weeks ago warning to not worry as much about the falling dollar as the rising Yen. TB has alluded to this on several occasions as it is the mother’s milk of the Yen carry trade, which is in turn the mother’s milk of leverage (hedge funds and private equity). Fisher notes that “on days when the Euro rises against the Yen, stocks rise.” This is known as the Yen/Euro cross and if you recall in the overnight global markets section TB has mentioned the “seesaw” effect lately between the Yen and the Euro and Sterling while the dollar just continues to slip. Then there is the same seesaw effect in Globex, overnight US stock futures which has been puzzling.

Fisher points out that there is a year to date correlation of .93 (almost perfect) between the Yen/Euro spread and the MSCI World Index, .89 for the S&P 500, .86 for the FTSE 100, and .87 for the German DAX. In other words if you are a day trader this is like shooting ducks: buy when the Euro is strong relative to the Yen and sell when it is weak…just be sure to close out all positions at end of day.

Correlation: an interesting thing. TB pointed out last week that the Baltic Dry Index (BDIY INDEX on Bloomberg), is now negatively correlated to the dollar by .90. This has not always been the case but this is a record low. This is important as many economists/strategists view the Baltic, which is an index of shipping rates per container over 40 routes around the globe as an indicator of demand…this clearly proves it is not, as the Baltic is coming off a record high with the dollar at a record low. Seven years ago(November 2000), the correlation was positive .65. It declined sharply as US stocks plummeted, stabilized from 2003 and 2006 when the correlation moved back to positive but then has plummeted ever since. TB then checked to see how it fared during our rally from 1996 to 2000…the correlation was incredibly positive as we had a very strong US economy that pulled the rest of the developing nations with it. But what we have now is freight rates quoted in dollars that are being driven higher like all commodities by currency weakness not demand. To prove this TB compared to the Euro: the correlation of the Baltic is .93!…but in 2001 when the Euro was at it’s record low, it was negative .87! TB wonders how many others have taken time to do this exercise rather than just look at the raw numbers. Think about it. Is this the reason we have Crude at record levels and until last week we were constantly being told it will not have a negative impact on consumption?…or the subprime crisis is just that and won’t impact the economy?…or that the wealth gap is at levels unheard of since the late 1800’s, yet Kudlow insists, by looking at the mean rather than the median, that real after tax disposable income is strong? How myopic can you be…but then if the only people you talk to are wealthy like yourself.

It is correlation though, or rather than a perceived absence of it, that produced the crisis we are now experiencing in the financial markets. If you don’t believe it is, you need educating so here goes: some of the best work in correlation related to financial markets was done by Harry Markowitz and William Sharpe on the Random Walk Hypothesis of Efficient Markets. By diversifying a portfolio against the market it is possible to be more or less correlated (Beta), to the index (S&P 500). So a beta of 1 would give an expected return equal to the market…some took that one step further like Wells Fargo at one point who was trying for a zero correlation…meaning that the stocks they picked would have returns based on their own attributes, regardless of the market.

Hopefully you see where this is leading: once the theory was taught at all the ‘B’ schools, and driven into candidates heads by the CFA, we saw more and more closet indexing, where managers attempted to replicate the index with just 20 or so stocks. Then came the Monte Carlo simulations TB has talked about…assuming that you can backtest and find the holy grail. When a handful of hedge funds were doing this they looked like geniuses…remember LTCM? But implicit in all this is standard deviation of returns, with one standard deviation representing about 2/3 of the occurrences and two representing about 95%. This is derived from a plot that creates a bell shaped curve. So a betting man would start gambling at 1 SD and then double or triple down at 2 or more. Think of increasing leverage to achieve this. But you have to constantly bear in mind that all of this assumes randomness.

But what happens when ‘propeller heads’ (as the hedge funds call them) from MIT and India Tech, all take the same classes, all read the same studies, and put them all into risk formulas? Rather than randomness you have correlation from previously uncorrelated events. What started out as useful, and is in things like chemistry and testing of pharmaceuticals, is no longer random because everyone is doing it…and you thought the herd mentality was dead! Furthermore, leverage based on faulty models (if they don’t consider this they must be), amplifies both the returns when you hit it right and when it blows up. Financial engineering has been with us since 1981 when the first collateralized mortgage obligations were created making possible the housing boom we have experienced since then. Instead of a small group of buyers for very long (30 year) mortgages, tranches were created with expected maturities within very short, short, intermediate and long ranges…later interest only and principal only tranches were created which were the riskiest of the bunch if interest rates, and market direction changed, as it always does.

Goldman Sachs in disclosing their Level III assets (those with no liquidity) are just 8% of total assets or $72 billion. But that is 200% of capital and they didn’t take a writedown yet as Merrill and Cit did (although they aren’t sufficient). Who cares about assets in a financial institution…it is CAPITAL that counts, and even if 50% of these assets have to be written off they are out of capital but market mavens know you are out of business long before your capital goes to zero…so you have to raise more. This is the position many companies are in after five years of record stock buybacks which in the case of Freddie Mac have now been frittered away and in some cases replaced by debt (or preferred stock). As Nouriel Roumini wrote: in one year, the market reversed a quarter of a century of gains produced by financial engineering. But Goldman paid record bonuses and is trading just 12.7% below its 10/31 high and is still up 8% over the past year (w/divs reinvested). TB has repeatedly heard they are ‘the smartest guys in the room,’ ad nauseum. We said that about LTCM 9 years ago and they failed, also Enron which also did financial engineering, but it was flawed. Goldman said that this was a “25 standard deviation event”…a 1% probability or 100 year storm…a perfect storm. There are no geniuses when it comes to markets…we are all a flash in the pan. Note: TB believes the real reason for GS strength of late is the hits Merrill, Morgan Stanley, Bear Stearns, Lehman and others have taken…UBS only marked down their positions by 10%…so if you need financial sector representation it looks like the safe place.

Tomorrow, we will look at hedge funds (objectively), and how they fit into this problem. With less leverage, it is unlikely the market can return to new highs anytime in the next few years, and uncertainty implies less leverage…especially with a weakening dollar!

Markets are feeling better thanks to some reports of Black Friday weekend sales…but what we don’t know is just how profitable they were. TB heard several analysts who think the 4am and even 2am openings on Friday were a sign of fear…have to make sales look hot…for the stock and to attract the buyers. Is this a silly game or what? Consider these stories:*Interviews with shoppers showed them coming in for the bargains and shunning anything that wasn’t deeply discounted

*They didn’t seem joyous about spending, merely the carnival like atmosphere

*A woman shopping at Target said she was handed a $50 gift card as she entered the store…she used it on the way out so her net expenditure was zero! Some marketing strategy…but it boosts ’sales!’

Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries…as he sees it…and in no way reflect the views of anyone other than himself. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. No fee…nothing to sell…merely observations of events in the marketplace offering a non-mainstream viewpoint…sometimes…usually? Hope you find it useful.
Copyright TBD Capital LLC November 26, 2007

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11/23/07…”Bleak” Friday

November 23, 2007 at 6:35 am · Filed under economy, financial, markets ·Tagged dividend yield, dividends, dollar, Dollar Index, stock buybacks

…today is Black Friday…a good thing usually as it is the day when retailers get into the black on earnings – normally. This year might be different unless you have been listening to those ‘eggspurts’ who see no impact from a housing/credit crisis and soaring food and energy costs. If it is a disappointment it will be yet another downdraft for the stock market, and the dollar. Then it would be Black Friday…a bad thing.

After hearing someone on CNBC say that only 5 of the Black Friday’s for stocks over the past 55 years have ended in a down day, TB did a cursory search on Bloomberg and found only two over the past years: 2006 and 1999…note those were both strong rally years too so the important thing here is if you are a bull don’t get sucked into the maelstrom, and if you are a bear this is a good time to sell a rally -it could be just for one day. Not surprising so many of these have been up…you come back to work feeling good after eating all that turkey and then get to go home early too! Also, who in his right mind would short into a market on a day like this? Isn’t there enough bad news out there to worry the markets over the weekend? Also everyone wants to see just how good those weekend receipts are. The bad news is that while you know they spent money and will see what they are buying, so much is deeply discounted that you have no idea how much the stores are really making…nor how sales will go for the rest of the season…the past is no guide in this environment. Don’t forget (as we did when they reported sales last month), WalMart started the big sale earlier than they ever have with some very highly discounted loss leaders. TB thinks we will be disappointed with sales this year…very disappointed.

On Tuesday, TB commented again that a stock buyback is not the same as a dividend. A dividend is a statement of confidence in sustainability of revenues and earnings and has been traditionally the biggest source of stock returns if reinvested in the stock. TB’s favorite example of this is AT&T (T). A company that never impresses but the growth of those dividends is 5.9% over the past five years (the stock now yields 3.79% compare to the S&P 500 at 2%). TB doesn’t own it but was about to do so when the dividend was over 4% earlier this year but here is performance compared to S&P 500:

YTD (11/21/07) Total Return w/Div reinvested

AT&T +4.8% +8.7%

S&P 500 -0.1% +1.6%

12 mos.

AT&T +14.4% +18.6%

S&P 500 +1.0% +2.9%

5 yrs (annualized)

AT&T +6.4% +11.7%

S&P 500 +.8.6% +10.4%

7 yrs (annualized)

AT&T -12.2% -8.1%

S&P 500 +2.3% +4.2%

10 yrs (annualized)

AT&T +2.8% +5.4%

S&P 500 +4.9% +6.5%

Since the 9/27 high AT&T is down 11.8% (7.5% w/div), and month to date the S&P 500 is off 8.6% (8.4%). The point is not whether AT&T is a good company or the S&P 500 is a good measure but the effect of dividends and their impact if reinvested. Consider the record stock buybacks over the past five years and how they have been frittered away. The problem is worse however as they distort S&P earnings and expectations as they are reported on a per share basis. Furthermore as S&P has lamented lately, the stock is not being retired but held in treasury where it can come out again…or be used to offset stock option purchases. So expectations are higher than they should be…and the impact will thus be worse if we really go into a full-blown bear market as TB expects.

To TB, stock buybacks of the type we have seen are contempt of shareholder. They can’t find better investments…or they would be making them rather than buying back the shares…and God forbid they should return the money to shareholders to do what they want with it…or pay the same total dollar amount of dividends rather than per share, which lowers the dividend yield (a key reason for the low S&P 500 dividend yield). Not only do stock buybacks increase CEO bonuses but they keep their key investors…hedge funds happy…they are short term investors who want capital gains, not dividends, for the most part. It is the announcement of stock buybacks that provides the ‘mojo’ to a stock, not the actual transaction. But now as Heard on the Street reported in the WSJ on Wednesday, companies wish they had that money back for operations as the money spent recently has been ‘frittered’ away. In fact as the table above shows all of the stock buybacks over the past 7 years have only mitigated the losses! Furthermore, some companies, notably Kraft (KFT(the Altria spinoff in June 20001) issued 750M corporate bonds in August…for stock buybacks…this for a company with a BBB rating and a P-2 short term rating! The article also points out that Freddie Mac fell 29% because it may have to cut the dividend after buying back $1B of common stock this year and replacing it with preferred. Fannie Mae also raised $1.5B in less than two months by issuing preferred stock. Then there is Countrywide which bought back $2.4B of stock and then had to sell preferred to BofA to keep solvent. Office Depot spent $200 million on stock buybacks at double the price it now trades at. But worse, Home Depot and Citi aren’t able to repurchase shares….note that buybacks occur most frequently when the stock is rallying, not tanking….what a stupid idea…if management has confidence in themselves and the company!

Not even 10 year stock returns are any better than bonds, and while 5 year returns look good what would they be without the enormous leverage that was used by hedge funds (don’t forget that these returns are before taxes and inflation)? If you want to see some interesting charts of returns over any two periods since 1900 (they can be viewed as gross, adjusted for inflation, adjusted for taxes, or both), go to crestmontresearch.com. The charts are beautiful and suitable for printing…download and take to Kinko’s and have them printed on 11×17 paper though! Some strong market we have.

Lastly, consider that over 90% of all financial assets are owned by the top 5% or less of incomes. Most of the others are held in tax deferred accounts such as 401(k)’s, and IRA’s, who do not benefit from the 15% dividend tax and will instead be taxed as ordinary income when withdrawn. TB is in favor of a 15% long term capital gains rate but tax dividends as ordinary income AND abolish the corporate income tax which will offset the differential…corporations don’t pay taxes anyway…not if they can help it!

With a credit crisis, housing crisis, dollar in rapid decline, lack of income growth for the masses, and the leverage that created those stock market returns dropping, do you understand why TB is bearish?

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11/21/07…day of the turkey!

November 21, 2007 at 5:22 am · Filed under economy, financial, markets ·Tagged China, Countrywide, dollar, Dollar Index, ETF, Fed, India, Kudlow

TB’s quote of the day: “It is better to eat a turkey than to be the turkey.” – Trader Bill

From the get-go yesterday everyone was saying the market is oversold and urging everyone to jump in. TB disagreed and still does unless you believe in Goldilocks or the gospel according to Kudlow. We had a relief rally of sorts last week on Tuesday…one day only, but that was for options expiration so no one got in the way and they let it run 320 points, but the next day was a different story. Throughout the afternoon stocks were dumped into an absence of buyers. Since then the market has been week and there has been no capitulation trade…including today. Arguably the rally last week relieved the oversold condition temporarily and it will be four more weeks before the next options expiry…keep your eye on it, 3rd Friday of the month and the commentators are uninformed. Here is why the market looks bad:

See the closing summary below for details on indices and sectors.

The Dow Dividend Select ETF (DVY) which peaked back in May hit another new low…these are the best dividend payers and the biggest holding is Altria (MO) which is at its high and has a 4.1% yield.

GE is supporting on the 200 day moving average while AT&T has closed below it for that last two days. JNJ hit a new high while CAT hit a new low while its high-flying rival Deere (DE) is now finding the 40 day moving average as RESISTANCE (they just reported and had a blowout quarter but lowered the forecast by 1 cent so it will be an important stock to watch today). ADM coming off a record high (thank you ethanol), closed a gap yesterday and almost fell to the intersection of the 40/200 day m/a’s before moving back up to almost unchanged. In Pharma, MRK is above the 200 day while Pfizer which sports a 5.1% dividend is below it and Schering Plough (SDP) is on the 200 day.

High flying AAPL/RIMM/ GOOG and even HP which had great earnings are finding the 90 day as resistance. EMC is just above the 200 day while CSCO is on it and even Whole Foods (WFMI) is below the 200 day. Emerson Electric (EMR) which has been doing well is now supporting at the 200 day. Microsoft is above the 40 day moving average and can’t explain why…not Vista?

Retailing is a jungle but the two that cater to wealthy foreigners especially, Coach and Tiffany are both below their 200 day moving averages.

Saving the best for last are financials: Merrill is near the low while UBS and Wachovia hit new lows. BAC, WFC, TCB, MS, BSC and Citi all made new lows and most new low closes, only USBancorp is below the 200 day but moving sideways. Goldman? In last three sessions, after hitting a new high on Merrill’s bad news broke thru the 40 day and is trying to find support at the 200 day.

After seemingly bottoming and climbing up from the lows, both Blackstone (BX) and Fortress Group (FIG) set new lows and closes.

Does this sound like a market that is dying to take off? Not to TB. There is a pattern here that is very similar to the 1998-2000 rally. When it was hot the 40 day moving average provided support like clockwork. Then it became resistance. Next the 200 day became support and then resistance. We are now seeing the 40 day provide resistance and the 200 day provide questionable support. The problems here are much worse than we are treating them.

Larry Kudlow started a new tirade to cut Fannie Mae and Freddie Mae loose by removing their federal guarantees…who cares? If you think the housing market is a mess now just wait if these wholesalers of mortgages aren’t propped up. Furthermore it extends to banks, brokers, and monoline insurers (bonds) like AMBAC, MBIA, FGIC, etc. If that happens, you will see financial chaos…unless the government intends to buy up the loans themselves, so why not just leave things as they are. This isn’t about bailing out someone it is about liquidity in the financial markets. Aside from that TB agrees as both have been badly mismanaged but with the same greed that has caused CEO’s to reap the rewards to the detriment of employees and shareholders by focusing on short run results…and when they fail they reap even more rewards thanks to lucrative contracts…this is what will make it so difficult to climb back.

Kudlow, Brian Wesbury and others continue to not get it. They are still in denial over the size and impact of the subprime debacle. They are totally ignorant of the impact of derivatives and the extent of abuses.Countrywide (CFC) hit yet another new low yesterday as they staved off bankruptcy rumors, but the corruption in this country on lending practices is coming to light and it is abominal. Much as American S&L (formerly State S&L) and was the biggest player in the S&L debacle paid higher commissions to salesmen for giving low rates on CD’s, although they had the latitude to pay whatever was required to hold on to the deposits, Countrywide was paying bonuses to salesmen to originate loans at higher rates and since they worked for the company there was no transparency whereas had they been done for a mortgage company they would have had to be disclosed. Some of these salesmen made huge commissions even on loans that never even recieved the first payment. CFC is going down.

Overnight, the Dollar hit another record low against the Euro and all currencies and bonds are rallying hard while Global equity markets are in disarray…including China and India. So much for the ‘a weak dollar is a good thing’ theory. It is not! Not when you aren’t producing anything here except agriculture which is helping the twin deficits but not that much. The global economy cannot carry the US and buy our debt to finance our excesses at the same time…forget what you have been told by the ‘eggspurts’. For six years, from July 1995 to July 2001 the dollar was exploding with the Dollar Index rising by 47% or 6.5% annually without interruption which dramatically lowered our production input costs but now it is playing out in reverse…this also accelerated our move to a service economy since manufacturing abroad became much cheaper…consider now that we are producing everything outside the U.S. that even multinationals aren’t benefiting to the degree expected. It is incredible to TB that economists and others who are supposed to be aware of these things have missed this entirely. TB fears we could be in for a recession and a much longer and deeper one than expected. Worse, it could be of global proportions. If the strong dollar allowed us to grow, and borrow so much, isn’t the opposite true of a dollar at a record low, with no end in sight and everyone, American’s included, with more dollars than they want to own. Sadly, not a pretty story for Thanksgiving.

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11/20/07…an unmitigated disaster

November 20, 2007 at 5:49 am · Filed under Uncategorized

Please note that the blog has been changed so that the market commentaries are now under POSTS so you can comment on them easier and the closing summary and overnight markets are now under PAGES. This should make the site easier to navigate and TB is in the process of providing links to a website that will have all prior commentaries. Thank you for your patience. TB

Bloomberg Quote of the Day: “In three words I can sum up everything I’ve learned about life: it goes on.” – Robert Frost…a wise man indeed!

…the market was down right out of the chute and just kept going down without a meaningful bounce. What we want to see is a capitulation trade like on August 16, where stocks plunge and then reverse and rally to close significantly higher…even in a bear market that can provide a rally that can have staying power and provide an opportunity to sell into it and cut your losses on stocks you don’t want to own. Just too hard to sell into a down market like this.

What TB heard today was most disturbing: from Dow Theory doesn’t matter - who cares about Transportation stocks, even though TB showed you yesterday that they are -4.6% over the past 12 months and 10.1% since 6/30! Then he heard from Goldman’s Abby Joseph Cohen, tech lover that she is that there will be a rally before yearend. Then came Smith Barney’s Tobias Levkovitch go off the wall and say that financial stocks have had an overshoot and buy…TB said and says: Don’t! Unless you want to feel pain. See Overnight Markets comment on Swiss Re losses! It not only isn’t over, it hasn’t yet begun. It was like this all day…and then Bear Stearns said that the Fed would not ease further due to the weak dollar…which TB agrees with…and that stocks will then decline even more…hard to ignore that one. Reread yesterday’s commentary if you don’t understand why!

Now let’s take a look at some financial stocks. Sallie Mae is -20.6% over the past year and still trades at 15.9x earnings…and any possible buyout by private equity is now off the table. See they aren’t stupid, they want value…in fact they need it

FNM is -32% and loan losses would be 0.75% of assets according to Fortune instead of the 0.4% they claim had they not changed the formula and management will not give an explanation why we should trust them on this. P/E is 23x trailing earnings but 12x estimated and PEG is 1.03x…a good value? FRE is -44% and since it has had losses P/E is not meaningful but it is 11x estimated earnings…and PEG is just 0.85x making it deep value…or?

Here is the problem as TB sees it. We have been so busy focusing on credit problems that we have forgotten a key question: once the losses are fully accounted for and the market stabilizes, where will the replacement revenues come from? That, folks, is the big question…and nobody knows or is even making mention of it. This means that the growth rate will likely slow with lower revenues which will translate to lowered stock prices…either that or the P/E has to rise which is a dubious assumption. TB reiterates: this is NOT the time to buy financial stocks!

Also, we keep being told that retail will do fine…why? Because we have been saying debt is too high for years and still consumption hasn’t slowed so it won’t this time. This is simply asinine. It is so reminiscent of The Grasshopper and the Ants…he not preparing for winter while the ants were collecting and storing up food. But for the first time since 1929 home prices have declined nationally, energy prices are to t he moon as are food prices and wage increases are niggardly at best! Add to this a nonexistent savings rate, high debt levels with tightening credit requirements, and a lack of savings for retirement, and you still don’t think they will slow this time around? TB will take that bet if you like. Consider this: even fast food is weak…Starbucks (SBUX) is down 40% over the past 12 months…all those gains based on higher same store sales when they were adding thousands of stores a month is now a drag…not just for them either. The stock is still trading at 22x earnings and long term growth is 21% so the PEG is just 1.06x or almost a value stock…or is it? Not if those growing stores see lower sales and costs are rising.

Forgot to comment on the failed art auctions of the last week…prices came in well below expected levels at both Sotheby’s and Christie’s…they had excuses like a bad day for auction, etc., but the art market is a good indicator of investor sentiment, so caution is advised.

Not trying to scare anyone but being overconfident never served anyone well…ever! Consider your options and move slowly, very slowly. This is not like the selloffs of last February or August!

For months TB has been arguing the virtues of increasing the DIVIDEND not stock BUYBACKS. Several people have said it doesn’t matter…that is akin to the new calculus that brought us the subprime loan crisis. Increasing the dividend is a statement of confidence that earnings are sustainable whereas a stock buyback tells you nothing, especially when management tends to buy the stock when the price is near highs not when it is cheap! Much of the money dumped back into stocks for the benefit of CEO bonuses has now been spent…in fairness they are also pressured by hedge funds who would much rather have buybacks since they, like the CEO’s get immediate gratification. Remember also that the DOLLAR amount of the dividend does not increase with the stock buyback thus the stockholder gets a higher share of the company but gives up some of the income simultaneously…if they are so confident that this is a good thing, why not increase the dividend by the percentage of the buyback? Also, why not retire the stock rather than keep it in treasury where it can be reissued at the whim of management? You would do well to consider this when you evaluate how management has served you.

Similarly, several banks are now issuing preferred stock in order to boost their Tier I capital, due to deterioration from increasing the loan loss reserves. This is not your grandfather’s preferred! Over the past several years banks have begun to issue trust preferred stock. The difference is that the issuer creates a bond and sells it to the trust, usually about $500 million. By doing this the issuer is able to deduct the interest on the preferred stock since it is paid as interest on the bond, which is junior lien subordinated debt. Two years ago bank preferred stock yielded about 5%, then 5.5%, then 6% or so until a month ago. Now, Citibank is issuing 7.25% preferred debt (Wachovia has a7.85% issue too), but TB cautions you to read the prospectus very carefully as the deck appears stacked completely in Citi’s favor. For instance, they can defer interest payments for up to 40 quarters yet you could still have to pay taxes on the interest even though it is deferred. Furthermore, whereas most debt is ranked in order of date of issuance with senior debt followed by junior, Citi’s prospectus states that they may issue other junior lien debt that is senior to the bonds used as collateral for this issue. So much for anyone who might short the common stock and buy the preferred, you might not be any better off and possibly worse. TB would urge you to study carefully any security issued by a financial institution in this environment. Desperate companies do desperate things.

Some economists follow the Baltic Dry Index (formerly the Baltic Freight Index) closely. It is an index of container freight shipped over 40 freight routes. The assumption is that if freight rates are rising then trade must be rising and therefore economic growth is sound. But after TB’s study of the dollars decline since July 2001 and impact on the stock market, commodities market and bond market that was published in yesterday’s column, he decided to see how the Baltic is doing. It is at a peak going back to July 2001. In spite of the weak economy in 2001 and 2002, it gradually rose as the dollar declined and then in 2004 and 2005 as the dollar stabilized it paced the dollar in a more or less steady fashion even as the global economy was growing rapidly. Then, starting in mid-2006 as the dollar resumed its decline it began to rise sharply so it is no coincidence that it has peaked just at the dollar has reached a low. From 1987 to 2001 while the dollar was strong it gained and was positively correlated with the dollar by about .65. But since 2001 the correlation has become negative and is now at a record correlation of -.95…almost perfectly negatively correlated! Thus the strength in the economy that some observers see from the Baltic is false: it is strictly due to the declining purchasing power of the dollar…remember most shipping companies are foreign!

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11/19/07…color TB disgusted

November 20, 2007 at 5:23 am · Filed under Uncategorized

TB’s Quote of the Day: “When I look at a coin I can’t resist turning it over to look at the other side.” Peter Jennings, late journalist. This is what Trader Bill is all about, examining the other side of the argument, then you decide. A long-time reader wrote Friday to thank TB for making him challenge conventional wisdom. He also added that he does not always agree with TB but since he has doing this he has improved his business. Someone out there gets it…and thanks! TB

TB is disgusted at the media for not making clear exactly what happened last week: options expiration! Whenever it was mentioned other than in this column, it was uttered under the breath, especially on the day of that low volume 320 point rally on Tuesday when those in trouble on the options after the steep market plunge that took us to an 10 week low, covered, and there was a total absence of sellers. So despite closing +134 points on the week it was still the second lowest weekly close in 10 weeks. The best performing Nasdaq 100 had the second lowest weekly close in 9 weeks and was up just 14 points from last week, had the second worst close in 9 weeks too, while the larger Composite gained just 9 points for the second lowest close in 9 weeks. The S&P 500 gained 5 points, also for the second lowest weekly close in 11 weeks. Note that these didn’t even qualify as bounces as a percent from last week!

But of even more concern were the Dow Transports which lost 40 points or 9% on the week and closed at the low of the year and just 3 points above the 12/29 close which is a 52 week low and in fact the lowest weekly close since 10/6/06! Of similar concern is the once high-flying Russell 2000 Small Cap Index which closed down 3 on the week and a 15 week low and the second worst weekly close since 11/10/06. Despite this damning evidence the bulls are still out in force telling you to buy financial sector stocks, tech, even retail stocks! This despite the first time since 1929 that home prices have declined on a nationwide basis, and a growing credit crunch with many more devaluation’s of asset-backed securities to follow over at least the next four months, and banks bidding up short term rates due to a perceived shortage of liquidity over the turn (yearend). Their only hope hangs on continued easing by the Fed.

Since 2002 as the US economy slowed and stocks plunged TB has heard the economists panel at the Euromoney International Bond Congress each year in February, rail at the worsening trade deficit and balance of payments. They have repeatedly warned that if the dollar plunges and the US economy weakens at the same time that the Fed will have no choice but to tighten…not ease…in order to raise US bond yields so that our deficit can be financed and not result in further disintermediation from the dollar. Look what has happened to the US Dollar over this period of time:

Dollar Index: This basket of six major currencies has declined in value by 42%, which might not be so bad if only we were still a manufacturing economy rather than a service economy and global commodities weren’t denominated in dollars, making them cheaper for other nations at the same time as they become more expensive for us. Once again the term stagflation is rearing its ugly head, but should the Fed worry about inflation when the core rate of inflation is only 2.2%? After all, it is only food and energy that is the problem since the average worker is worse off than a year ago or more and has had his available credit yanked out from under him…yet the “eggspurts” continue to see no impact on spending.

Let’s look at the problem by first examining the currencies since the dollar’s decline began in July 2001. Then we will examine the effect on select commodities prices over that period of time, and lastly stock market performance to see if there is any indication of what is to come.

Since July 2001, the Dollar Index has declined from 119.90 to 75.83 (as of Friday’s close and in every case cited below the currencies are off their recent highs but not by much), a decline of 42%! Look:

Yen: 111.08 vs 134.71 a gain of 21%…and this is truly important due to the Yen carry trade!

Euro: $1.466 vs $84.95 +73%!…the Euro’s low from inception 1/99 coincides with dollar decline!

Sterling: $2.055 vs $1.3674 (high was $2.1162 on 11/9, a 26 year high), a gain of 49%!

Canadian Loonie: $1.03 vs $.65 for a gain of 58% from our largest supplier of natural resources!

Australian Dollar: $.893 vs $.485 or a gain of 84%…incredible low also coincided with $ high

Swiss Franc: $.90 vs $.55, a gain of 64%…this, not the dollar, is the safest currency in the world.

Now compare commodities prices (due to changes in composition cannot provide data on CRB or GS Commodity Index), and think how much cheaper goods are to the above countries than to us. The only beneficiaries here being multinational corporations due to currency translation. If we were still a manufacturing nation our exports would increase and imports decline even more, but we are a service economy and the only gains we are seeing are in agriculture, which does little. The manufacturing companies that remain are shells of what they once were, importing most of the parts from other companies or producing them there.

Crude has gone from $18 to $93 and a high of $96 for a gain of 516%!

Unleaded Gasoline futures +360% (reformulated gasoline has only been around for a couple of years)

Corn is +203% despite the largest planting since 1945 due to conversion to ethanol

Feed Cattle are up 18% due to corn and will rise more as their life cycle is longer than say chickens

Gold is at $787 and off a high of $848 highest in 26 years and as of Friday is up 305%

Now consider 10 year US Government Note yields. Currently it yields 4.15% vs UK Gilts at 4.63%, and an average for the rest of Europe of about 4.25%…why would a foreigner want to buy them with a following dollar? Yet we have to sell them in order to finance our deficit…there is no alternative. So the only benefit of further easing would be to borrowers with adjustable rate loans but of little value to prospective borrowers. By the way, had you bought a 10 yr t-note (5% due 2/10/04) on 6/29/01 your return would have been 5.40% thru Friday’s close. Here is the total return for bonds assuming you rolled them at each treasury auction, thus creating a constant maturity (source Merrill Lynch):

2 yr note: 28.6%, 4.10% annualized

5 yr note: 38.3%, 5.21% annualized

10yr note: 42.6%, 5.72% annualized

30yr bond 58.9%, 7.53% annualized

So what, stocks have done better over the same time period? …or have they? The S&P 500 is up 32.1% or 4.7% with dividends reinvested in the index. The ‘hot’ Russell 2000 is up 55.56% or 8.79% but is much more volatile than the S&P 500. Makes those bonds look pretty good. Lastly, let’s look at the key indices over the past 12 months, year to date, and since June 30…note the changes:

Dow Industrials: +9.5%; +7.9%; -0.8% – this despite multinationals and large caps being the picks!

Dow Trans: -4.6%; +1.1%; -10.1% - to a Dow Theorist this speaks volumes! Hello fuel costs!

S&P 500: +6.1%; +4.6%; -2.2% – risk adjusted bonds look much better

AMEX Comp: +22.9%; +19.7%; +7.9% - due to ETF’s especially emerging markets

Nasdaq Comp: +8.3%; +9.9%; +1.6% – remember most of increases were due to a few stocks

Nasdaq 100: +14.1%; +17.0%; +6.1% - both Nasdaq markets had been strong but slipping of late Russell 2000: -1.5%; -1.3%; -7.3% – watch out small caps were the hottest of the hot!

NYSE Energy: +27.6%; +23.0%; +5.2% – also decelerating…this with energy prices near highs

Philly Semi: -12.5%; -8.1%; -14.6% – note acceleration of deterioration

Just because an index looks better currently doesn’t imply you should be buying it….the point is that this is a market in transition! Also, stocks like Goldman, Sachs are being bought because they appear safe. It is possible that they and UBS and MS will have the biggest writedown’s to come…stay tuned.

So TB is in the camp that says the Fed should ease based on a slowing economy but to ease on credit conditions will serve no one well and in fact drive the dollar lower and food and energy prices higher. This is cost push inflation at its worse, not the evil demand pull, and even as the economy slows. Thus the cries of ’stagflation’. So if they are to ease, and even Kudlow now agrees that this would be foolish, it will merely make a bad situation worse. Low interest rates and easy credit created this speculative bubble so how can easing solve it…especially when the banks who have been burned badly…will not open the spigots accordingly.

According to the L.A. Times, Wells Fargo is no longer going to allow ’stated income’ home equity loans to be made for loans originated thru mortgage brokers. This is because loan losses increased by 35% in Q3, largely because of these. Furthermore, they see higher loan losses in Q4 and to “remain elevated” throughout 2008. Now here is the most important point that those who are recommending financial stocks, especially brokers, need to ask: how can the p/e ratios of the affected stocks not fall since there is no replacement for the lost revenues. In Wells Fargo’s case mortgage brokers provided 17% of the $148 billion in loans in the first half of 2007…so without replacing them revenues will be down 17% and loan losses will continue to rise. Still, the Minneapolis Star sees WFC, USBancorp, and Minneapolis TCF Financial (TCB) as the best values in banking with Wells sporting a near 4% dividend and the other two at 5%. TCB has lowered growth forecasts and increased loan loss reserves and relies heavily on mortgage and home equity lending. The riskiest to TB from a return standpoint are BofA, Citi, JPMorganChase, and others with dealer operations, as well as even well run small banks due to their valuations being excessively high. TB was considering buying Westamerica Bancorp (WABC) a regional bank in northern California with a very clean loan portfolio and no dealer operation. He was, that is until he looked it up: the dividend is 3.05%, with an 8.6% growth rate of dividends over the past five years, but the p/e ration is nearly 14x and with the long term growth rate of earnings of just 4.5% that puts the PEG rate at 3.33x…or extremely overvalued…this was due to buyout anticipation by speculators. Still, he will follow the stock because this is the kind of bank you want to own…at a price.

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11/16/07…games people play

November 20, 2007 at 5:21 am · Filed under Uncategorized

…we are a nation of investment fools. It is the opposite of sex whereAmericans are obsessed with it but don’t want to talk about it. With investments everyone wants to talk about it but nobody knows anything about it. Whereas sex is like riding a bicycle: once you learn you never forget how, investments too are like a bike: once you fall off you never forget how!

CNBC has turned Wall Street into a gigantic carnival. Larry Kudlow who is always right…politically too, Jim Cramer who makes P.T. Barnum look like an amateur, Maria Barteromo with her breathless inane comments and “coming up a panel of experts to tell you exactly what to do.” Never mind that they are all screaming at one another and have no idea of what they are saying.

TB used to say the difference between a bond geek and an equity geek is that bondos are paid to be bearish while stock jocks are paid to be bullish. But there is a corollary: all money managers, even if they are bearish tell you not to sell. Why? Because if they say that on CNBC and don’t sell your stocks they are in deep trouble, so they love to tell you what they have been buying…past tense. Some are open thinkers but most see everything coming up roses…even after a week of no matter what happens (Tuesday excepted), taking it down in the afternoon. TB repeats: TODAY IS OPTIONS EXPIRY!

But it is the overconfidence and audacity of people like Larry Kudlow who spew their wisdom on CNBC backing it up with facts…but only those that support their case. TB attempts to offer his views but to merely suggest alternative scenarios so you can make up your own mind.

Here is an example of Kudlow. This morning on CNBC he continued his Goldilocks philosophy by saying that the economy is strong as “the best indicator of well being is Real Disposable After Tax Income” is up 4% over the past year. This is exactly what got TB on his case and why he is dangerous. Look, all economic data is an average, but there are three averages: mean, median, and weighted. All headline economic data is mean which was fine until we got the widest wealth gap since the nineteenth century. You have heard all about the top 2%, 1%, 1/2% but nobody lays it out for you so you can see the flaws…well TB has but it isn’t getting through. But recently TB has been emailed columns from Nouriel Roubini, who also has a blog and TB recommends you check it out. It is: http://www.rgemonitor.com/index.php

He has done some great research on FASB157 and lets see what he pointed out that blows Mr. Kudlow’s claim out of the water. According to IRS data for 2005, the latest available, but we all know how the wealth gap has widened in 2006 and 2007 on low wage increases and a hot economy and housing market (until August), the top 1% (ONE PERCENT) of incomes rose 21.2% in 2005 while the bottom 50% (FIFTY PERCENT) declined by 12.8%. Also, the ratio of wages to income is the lowest since 1929. Chalk this up to a lack of wage increases for workers and a 15% and capital gains and dividend tax rate which Warren Buffet has labeled as obscene since his secretary pays a higher tax rate and she works for it while his is investment income. The low dividend tax rate has got to be raised as it doesn’t affect anybody but the wealthiest taxpayers as virtually all other income is in tax deferred accounts which will be taxed as ordinary income when paid out.

The GOP has made a crusade of not raising taxes, implementing deductions that apply to only the top 2% of households, and attempting to abolish the estate tax on the grounds that taxes have already been paid on it and it would force estates with small businesses to divest. Really? With a $3 million exemption it is hard to see how many ’small businesses’ fall into this category. Furthermore, if there is a spouse the basis is stepped up on homes and investments, so it is understandable why the estate tax only affects the same 2% of taxpayers. Warren Buffett has been taken to task on this that it will destroy the economy much as taxing private equity and hedge fund partners at more than 15% on their ‘risk income.’ False! Lest you think TB feels the Dems will do any better, remember that this country is driven by special interests and they have strong lobbyists who pump billions into the coffers of elected officials. But the GOP who labels them as ‘tax and spend’ needs to review what happened on their watch. Also, Bush rants about them but where was his veto pen for seven years? Not once during that time but twice since the Dems took over. Add to this the failure of Congress to work together on anything.

These are the same people who tell us that free market capitalism is the best form of economy. Yet they have no problem with an alternative minimum tax that is not indexed and if a ‘patch’ isn’t put on it will sweep in 20 million households this year, out of 150 million total and many are dual incomes that are penalized even worse? So should people earning $150k be taxed at 25% and not be allowed to deduct state and local taxes paid? The estate tax produces $25 billion of revenue each year. So should it be abolished so that the Helmsely estate (“only the poor pay taxes”) is tax exempt and yet a worker gets hit with the AMT? Don’t forget the inequality by state either as $150k in Arkansas is a fortune while in California or NYC, it is minimal given the cost of living and high state taxes!

Why is the recision of a tax cut that was implemented to stimulate the economy, and like most tax cuts came as the economy was already out of the brief recession, a tax increase? At this rate we would soon be a zero with no money for government services or to fight wars in Iraq and Afghanistan. Remember we are not talking about raising rates on EARNED income, but investment income which is passive. Similarly, why are workers penalized on social security payments if under 65 and making over $12k a year while one can have $1 million of investment income and still collect full social security benefits?

Kudlow has made another inane statement that is very important and brings up something TB has meant to bring up all week. He says we are overstating the impact of the subprime meltdown. Of course he has done this for month saying it is an infinitesimally small portion of the overall mortgage market – wrong! Not in the flow of dollars for interest payments! He goes on to say that the estimated subprime losses is $350 billion while total income of financial companies is $550 billion. This shows a total lack of understanding of markets…especially the stock market which values a company at a multiple of earnings. In other word if you cut corporate earning for the financial sector by 60%, shouldn’t it be accompanied by a commensurate (or larger), decline in stock price? But here is the big point: where are the revenues that made up those earnings going to come from? In other words, if future earnings are going to be lower shouldn’t the equilibrium P/E ratio decline? Sounds like common sense to me as expected earnings drive the P/E ratio. Also, P/e divided by the growth rate of earnings determines whether a company is fairly valued.

Despite the problems this is supposed to be the second best earnings year for Wall Street, but you have to realize how many derivative products are now toast. Where will the replacement revenues come from? Furthermore the effects of FASB157 have not been felt yet. As Roubini points out they cannot arbitrarily classify securities as Level III and thus eligible for mark to model accounting. He points out that while Merrill appears to be the worst, they have actually marked down way more than UBS, Morgan Stanley or even the venerable Goldman Sachs…wait till 157 kicks in and Goldman may not wind up as ‘the smartest guys in the room.’

Speaking of which: financial engineering makes everyone look smart until it doesn’t.

1987: program trading resulted in the Oct. ‘97 crash.

1998: Long Term Capital Market…right theory but highly leveraged with other people’s money

2000: a stock bubble built on margin borrowing…a problem that is about to hit electronic trading once again

2007: the culmination of two huge bubbles…derivatives and housing…financed by low rates, high leverage, and easy credit which reduced risk premiums to meaningless levels.

Think it over…then you decide, don’t take TB’s word for it!

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Older Posts »

	Russell on 11/4/09…Buffetted
	Gerry Roberts on 10/2/09…as predicte…
	traderbill on 9/23/09…you know it…
	mkoleary on 9/23/09…you know it…
	traderbill on 09/09/09…three nine…

Traderbill's Financial Markets Weblog

Archive for November, 2007

11/30/07…watching and waiting

11/29/07…what’s in your wallet?

11/28/07…the ‘nut’

11/27/07…hedging your bets

11/26/07…the best is yet to come

11/23/07…”Bleak” Friday

11/21/07…day of the turkey!

11/20/07…an unmitigated disaster

11/19/07…color TB disgusted

11/16/07…games people play

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