Traderbill’s Financial Markets Weblog

…TB must have slept thru his finance courses when they explained modern financial theory…or perhaps it just didn’t exist then…even when he was working on his Master’s. It seems to him that revenues are crucial and then by controlling expenses a profit margin is achieved. That produces earnings that after dividends (you do remember what those are, don’t you?), become retained earnings and boost capital and are available for research, development, and other capital expenditures including acquisitions. But that is really accounting and other than for tax planning purposes, and thus backward looking. To better measure operating performance there is a category for nonrecurring expenses or one time charges. TB recall’s AT&T CEO Bob Allen who managed to make a series of one time charges so steady that they could almost be categorized as recurring (how about the number of reorganizations of Citibank this year alone!).

Then along came Steven Ross an advocate of cash flow accounting. This self-serving ‘guru’ and former operator of funeral homes, convinced the street that Warner Communications was a strong company even though it was making money…he did this with cash flow analysis. He parlayed this into a merger with profitable Time Inc. His employment contracts, including making his widow a consultant to the company for $5 million a year, were the beginning of the great CEO rip-off. Apparently the company so believed in his methods of accounting that they bought AOL right at the peak…so much for cash flow, as it can turn negative too. But why do we do these things over and over…the conglomerates of the 60’s, and resurrected in the ’90’s? Because of the greed in our financial sector…”greed is good,” Ivan Boesky.

TB heard a smart investor say that normally the financial sector is about 25% of the S&P 500. So to make money you buy it when it is on it’s knees…20%. But it got to 30% quickly this year and is now at best fairly valued…TB thinks that is a stretch. The reason it got that big is first, the abolishment of Glass-Steagal which allowed banks to expand into all sorts of activities and government’s failure to enforce the Sherman Anti-Trust Act, and secondly, the advent of financial derivatives beginning with the inauspicious introduction of treasury bill futures and then collateralized mortgage products and interest rate swaps.

Now we are at the crux of the problem…the explosion of derivatives and derivatives on derivatives: futures, options, options on futures, and finally collateralized subprime mortgages into tranches that the rating agencies based on historical default rates of mortgages (in an era where there was such a thing as a downpayment), made the whole sounder than the sum of its parts. But even that wouldn’t have gotten us to where we are today without everyone being on the take or blind: the Fed, the bank regulators, the SEC, the realtors, mortgage brokers, banks, Broker/Dealers, appraisers…you name it they were all involved. Then the Structured Investment Vehicle (SIV) was created so that banks could hold these assets but off balance sheet as they were investments they couldn’t hold. They did this by setting up a subsidiary that issued commercial paper backed by the assets but when the subprime crisis evolved they were suddenly back on balance sheet…and it isn’t pretty! 

So the question is: even if we had full transparency now, where is the replacement revenue going to come from? Subprime was a major part of the income of brokers and commercial banks, let alone mortgage companies which have failed in droves. Even seemingly immune companies and governments have been sucked in…H&R Block, Florida, Orange County.

Then comes the latest craze: injections of capital from foreign countries. Why were we so concerned about Dubai Ports managing our shipping ports yet the same opponents greet sovereign equity funds with open arms as they take control of our financial companies? Even Swiss-owned UBS who will show a loss for the quarter and likely for the year and has converted the dividends to PIK’s (payments in kind), meaning stock, like Citi got foreign investors on expensive and favorable terms to the investors at the expense of the shareholders…there has been no talk of dilution! Perhaps because it is replacing retained earnings that have been squandered. This is the more immediate threat: dilution of equity. Yet, no one is talking of it…in fact UBS rallied…the stock market rallied…even as Washington Mutual is now joining Countrywide in drowning in bad loans…and raise $2.5B in additional capital.AND cut the dividend (due to drop in price dividend yield was up to 11.2%…but since that would be excessive (right?) they cut it to 3%! Whatever happened to the Markowitz Dividend Growth Model? It died with stock buybacks.

Now we are at the last point as to why the bulls are wrong: we have had four straight years of record stock buybacks…since S&P earnings are measured on a per share basis they too have soared. Meanwhile, despite the buybacks, the dividend per share was not increased at the same scale and as TB has pointed out numerous times, the stock isn’t retired but merely held in treasury! This week’s Barron’s, in an article entitled “Buybacks That Bite Back,” two S&P equity analysts (too bad they weren’t the ones evaluating subprime loans), did a study that showed that of the 20 billion shares that were retired in 2006 and 2007, the shares of the repurchases fell by only 4.4 billion or 22%. Furthermore these purchases were made at or near historic highs. Furthermore many financed these repurchases with debt! TB will forward the article to anyone interested or you can find it by title at www.barrons.com.

TB wished he had remained awake during those classes so he could understand the stock market…or not!     

Now on to a last point since today is Fed day and full of hype and other forms of detritus:

There is far too much emphasis on whether the Fed will cut rates by 25 or 50 basis points today and not enough on why they are doing it. First, they are ignoring inflationary aspects of the economy, while ignoring the fact that the economy isn’t that bad (the bulls keep saying it is doing just fine but how about cutting rates by 50bp’s so the market can continue to rally?), and second they ignore the fact that this is a subprime lending crisis, turned into a credit crisis, and morphing into a financial crisis of global proportions. It is so large that even a small town in Norway has had their cash wiped out by investing in paper of SIV’s…who would have thought? Yet for days now, CNBC has trotted out one expert after another to give you insight (?) into just what the Fed will do and what that means for markets. This morning they went so far as to say: why not just go 50 basis points…what harm can that do? The answer is a lot, and other than TB and a few other brave souls like investment advisor Doug Cass, everyone is drinking the Kool-Aid!

Cutting Fed Funds will harm, not help, the dollar. So far, after years of being pretty much coordinated, at least in appearance, the central bankers of the world have been concerned with inflation, yet following the lead of the Fed, the Bank of Canada has now cut their lending rate (TB believes the real reason for this was the Canadian dollar trading above parity with the U.S.), and last week the Bank of England also cut, while the more austere ECB held the line still expressing fears of inflation…that they would do this is telling since more damage was suffered by the banking system there than in the U.S. At any rate, TB expects a 25 basis point rate cut today and more importantly a 50 basis point cut in the Discount Rate that banks and other financial institutions pay to borrow from the Fed. But as one article TB read points out: borrowing from the Fed is a stigma…due to the Fed’s image as lender of last resort…in other words it is there in case of emergency but you better not use it or investors/depositors will panic and pull out their money. That is why Citi, UBS, and a whole raft of others are getting injections of capital from private equity and sovereign equity funds rather than borrow from the Fed at a far cheaper rate.

The bull’s case favors a weak dollar as it will boost exports…on paper, yes, but tell TB just what we really produce here in quantity for export?…agriculture exempted and that is gaining from commodities being denominated in dollars (at least for now). A knowledgeable friend pointed out to TB that the cost of producing abroad vs. here is down to just a 15% cost savings, so he thinks that might lead to less outsourcing of production facilities…it might, since there are so many people working part or full time at Wal-Mart or other retailers, who would jump at the opportunity of a manufacturing job and with changes in the pension structure it could well happen as a win-win…although our manufacturing workers have lost with no union advocacy. In fact there is no advocate for the worker…only the CEO has an advocate: the board of directors, no matter how poor a job he is doing.

The bulls also say that even if the U.S. economy slows the rest of the world can carry it along just fine. They are wrong…we are the greatest market in the world with the most powerful consumers…or were. They also point to year after year of record earnings and that the P/E multiples are attractive.

 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 December 11, 2007