Traderbill’s Financial Markets Weblog

 

 

…when TB was in elementary school, May Day was a celebration…girls wearing skirts while the lucky guys got to stand around the May Pole to support it while they danced this in and out pattern that eventually weaved long ribbons into a braided rope…obviously that is a thing of the past. Later, he learned of the political significance of it…especially behind the Iron Curtain…and today it is still a day of protest and a lot of other things in most European countries and Asia. This leaves only the US, UK, and Japanese markets open today…but you can bet that hedge funds globally are not taking time off to celebrate or to protest…business as usual.

 

1. Economic concerns. More importantly the ‘mayday’ situation still applies to the global financial markets and thus has serious economic implications despite the market cheerleaders on CNBC who insist on shouting down anyone who has a different view. It is incredibly unproductive to hear all that shouting and interrupting as it has turned into more of Jerry Springer thing than a market commentary.

 

When one hears ‘mayday’ at sea or when monitoring aviation traffic they become all ears…too bad that doesn’t happen to supposedly educated people who think this is all a game and that the Fed has the power to turn everything back to business as usual. Such is the case yesterday as the Fed eased by another 1/4 point on the Fed Funds rate to 2%, lowest since 2004, as if that will solve the problem… meanwhile bank spreads are becoming compressed and they still don’t want to lend to one another, let alone the public. Yet no mayday’s here…although the Dow was up 178 points just before the announcement and closed down 12. More on that later.

 

So what should the Fed have done? If they cut 50 basis points the stock market would have been shocked thinking things are even worse as they most certainly are; to not cut would have created a state of euphoria that would have provided a continuation for the stock market rally; so rather than too big or too little they did it just right, eh Goldilocks? Furthermore they indicated they were a bit more concerned about the economy and less so about inflation…why not? …they have no control over commodities inflation. Besides the Fed likes round numbers like 2% for rest areas…in 2004 it was 1% and for quite a long time…in fact too long a time but that was a totally different situation caused by the Greenspan Fed not easing soon enough into an economy that weakening, then keeping rates down for too long, and finally raising them again way too late and by not enough…perhaps this time it will be different…perhaps.

 

Milton Friedman, decades ago, proposed abolishing the Fed and letting the money supply grow at the long term growth rate of GDP…no tinkering or knob twisting…no political factors. If more was needed let the government do it through fiscal stimulus rather than have two forces at work with different time lags which in the end creates more volatility. Yesterday, Brian Wesbury, disingenuously stated that he had created this theory and that the Fed Funds rate should be the natural rate, which would eliminate the violent swings caused by Paul Volcker and later by Alan Greenspan. He went on to say that he suggests the natural rate now is ‘north of 5%.’ Of course, he is a Kudlow disciple of goldilocks theory so why not raise it to 5%, since nothing is really wrong here except fear itself.

 

The problem with both of these…especially the latter is that they were designed for a zero sum game, where winners offset losers so all you really have is a redistribution of wealth so don’t mess with it. But the addition of derivatives changes the rules so it is not a zero sum game. According to an article in The Economist, there are $62 trillion of derivatives in the form of Credit Default Swaps (CDS) alone, and while that is the notional value the risk is say 2% of that or $1.2 trillion! Now contrast that with the losses on subprime CDO’s and CLO’s estimated at only $250 billion…of which we have recognized about 60% so far. The best (worst) is yet to come. 

 

Reviewing CDS, this is a form of ‘insurance’ (wasn’t portfolio insurance in 1987 supposed to protect in a similar manner?), whereby investors in all types of bonds could ‘hedge’ their exposure by buying a contract in which a counterparty agreed to take on, for a fee, some amount of risk. TB was on the ground floor of learning of CDS years ago at the International Bond Congress in London. For several years it was a key topic and was growing exponentially, as were hedge funds. In London, the FSA was concerned that it was taking three months or more for the contracts to be fully signed and verified leaving one exposed as they are not valid until all signatories have completed the paperwork. They put pressure on to speed up the process with a goal of 30 days. At Dec. 31, 2007, 13% of newly originated CDS were not finalized…in other words about $7 trillion. If you want to relate, think of buying hurricane insurance which does not cover you for any hurricanes that are forming and have been identified! What are you buying protection for? What are you getting for your money? No problem…if the spread changes favorably, you can sell insurance to someone else thus hedging yourself…or at least so long as no weak link emerges causing the entire house of cards to collapse (wow to metaphors in one sentence).

 

2. Homeowners Bailout. While TB wants to hold his nose and while Congress debates a bailout package that includes about $6 billion for the homebuilder (recall yesterday’s comments on Eli Broad who thinks this is nowhere near a bottom), a plan was unveiled by the FDIC yesterday that is sparking controversy but needs to be considered. While TB is opposed to bailouts, to do nothing would only make things worse for all homeowners and thus lenders who will become even more timid.

 

The plan, similar to one proposed by Robert Schiller and Martin Feldstein would require mortgage investors to pay costs of the program and agree to concessions on underlying mortgages to achieve an affordable payment. The loans would then be restructured at an affordable rate and treasury would take the 20% of the loan with a rate capped at the Freddie Mac 30 yr fixed rate. A debt to income ratio of less than 35%, verified, would be recalled and mortgage investors would pay the interest on the 20% for the first five years, then the homeowners would have to pay. It would be funded by issuance of $50 billion of debt. The hitch is that we are right back where we started…who owns the debt? Who can decide to accept these conditions? It will be cumbersome but as the housing market continues to deteriorate lenders will eventually come around…or at least one can hope…the alternative is not good. 

 

3. Investing So now we return to the present: is the stock market a good buy? Are bonds overpriced? In investing everything is relative and depends on your objective. If your primary objective is preservation of capital bond prices can never be too high (in 1932 treasury bills traded at a premium), as you are then investing to prevent even more losses in another area, most commonly, stocks. But if your objective is growth, do stocks represent value as we are told daily by the experts being trotted out on CNBC? It is only in the last decade that growth stocks performed well, and then in only two relatively short periods and the total returns over the entire period have been less than stellar, particularly if you bought in too late. Dividends have been replaced with stock buybacks…and look how those have fared? TB listened the other day to a presentation by a consultant on how companies with the most treasury stock are the best performers. Not coincidentally, since these are also the ones with the most stock options and since most buybacks are not retired and thus end up as treasury stock. So we have had five years of record stock buybacks and record earnings…is that a coincidence? Yet the stock prices have faltered badly of late, bringing cries for more stock buybacks since they are more tax efficient. Tax efficiency is the bane of investing. How much money has been lost trying to hold on for a couple more months so as to get a long term capital gain…one situation TB is quite familiar with was an astute investor and friend who bought EF Hutton stock in his own account, as well as his clients, and watched it climb from the low teens to near $50 a share…rather than sell it, since his target was $50 he held on to make it long term…and lost it all when they collapsed. A good lesson: taxes shouldn’t be the foremost consideration and price targeting can be against your best interests.   

 

TB received a call from a friend yesterday who just got a new client…he is a broker with a major firm and a conscientious one, as well as having years of institutional investing experience. The client had a sizable pension portfolio, but one that could be at risk if the company went bankrupt. We discussed, or rather he talked and TB listened, as he said he was concerned about the long-term outlooks for stocks (what if they have low growth for several years), but still felt he should weight the portfolio heavily in common stocks. Back to objectives: the client has a need for capital preservation as well as growth. But are common stocks the answer? Certainly some are, but TB has done a lot of thinking on this and has been approached by several individuals and even some money managers for suggestions.

 

So he devised a “sort of” model that provides both. Through a mix of stocks with dividends of at least 4%, but skipping those with high but vulnerable dividends, and then reinvesting those dividends in the underlying stocks, as well as some fixed income ETF’s and bonds (including zero coupon and TIPs), and some sound preferred stocks with dividends of 6% or more (avoiding trust preferreds of banks like Citi and BofA), it would seem that there would be a stability of principal with perhaps small growth but with reinvestment of the income it should outperform over the long run straight fixed income portfolios.

 

Some other managers that TB knows rely on value stocks and TB lauds that as being another alternative as a slow growth economy will not be good for growth stocks. Look at the consistent winners and what they are trading at? The four horsemen…on the other hand if you view TB’s market summary for stocks you will see that the rest seem to go up and down when they are the market movers with little consistency. The one exception has been energy stocks but as you can see they are starting to falter. Tech continues to be weak as is healthcare…and there are few nuggets out there in finance…a FEW!