The Contrarian's View s published 11 times per year on a mostly-irregular schedule, and the views expressed are those of the author and editor, Nick Chase. Because nobody can predict the future, results of past suggestions or recommendations are no guarantee of future results. My own material in this publication may be freely quoted provided proper attribution is given to its source; quotes from other people are subject to fair-use copyright restrictions. Subscription rate: Selections are free on the Internet. Using your favorite Web-browsing program, open URL http://onashi.org. Mailed paper subscriptions are currently not being accepted (current paid subscribers will continue to receive their paper issues). Unsolicited material sent to us by UPS or by courier other than the postal service is refused and returned to sender! ISSN 1536-4429 Phone: (508) 757-2881
Now my knowledge of trusts is limited, and about all I knew about trusts is that they typically would irrevocably assign trust income to a beneficiary (typically, a spouse or a child) with trust termination and distribution of trust assets (principal) to others (typically, children, grandchildren or charities) upon the death of the beneficiary. While many types of trusts are allowed by law, these (I expected) were the most common.
The trustee, I expected, would be bound by the terms of the irrevocable trust, distributing income to the beneficiary and reserving the principal (investments) for distribution on termination; though, of course, the trustee could buy and sell individual assets (such as stocks and bonds) in the trust.
No longer, at least not in Massachusetts. As the newsletter explains:
"Trust administration in Massachusetts has recently undergone substantial change.... the Massachusetts legislature passed the Massachusetts Principal and Income Act.... In brief, the Act gives the trustee the power to adjust between trust income and principal, if the trustee invests and manages assets as a prudent investor, and it is designed to provide a beneficiary with a reasonable return. To assure a reasonable return, the trustee may provide for the current trust beneficiary to receive an increased payout that augments net income with some principal. The Act is particularly relevant in times of historically low yields from interest rates and dividends on investments. [Emphasis is Nick's.]
"The first step towards this approach occurred in Massachusetts in 1999 with the Prudent Investor Rule.... a trust investment portfolio is viewed as a whole, rather than as individual assets. Diversification and the analysis of risk and return are key factors.... making possible a total-return approach to investing (with return coming from both income and principal appreciation).
"....When a trustee weighs the decision to exercise the power to adjust between principal and income, it must consider many factors.... some of these factors include the nature, purpose and expected duration of the trust; the intent of the grantor of the trust; the identity and circumstances of the beneficiary and the needs for liquidity, regularity of income and preservation and appreciation of principal; and the anticipated tax consequences and other economic considerations."
My supposition is that the law was changed to allow trustees to exercise investment strategies which are consistent with modern portfolio theory.... which is to say, earnings-chasing (discussed last month).
Historically, stocks have returned 9% to 11% per year.... let's go with the 11% figure.... of which 4% is dividends, 3% keeps pace with the long-term growth of the US economy, and 4% reflects the efforts of the damnable Federal Reserve to (successfully) slowly render the dollar worthless. So irrevocable trusts created, say, during the Depression or in the 1940s or 50s or 70s or even the early 80s, when dividends from stocks were in line with historical valuations, could be successfully managed according to their terms of creation and still provide a meaningful income to their beneficiaries.
But there is problem with trusts created from the 1990s onward, because of the persistent historical overvaluation of stocks since about 1993. When dividend yields are in the 1% to 2% range.... and bond yields are also abnormally low.... and most of the total return of the past decade and a half has come from the marking-up of assets.... you can see why it seems "prudent" to allow the trustees to cash in some of those capital gains and distribute them to the beneficiaries as income. Even with older trusts, the trustees are hard-pressed to find replacement stocks or bonds with decent dividend yields.
So, never mind what those grantors of trusts a half century ago really intended. The rules have been rewritten to allow trustees to do pretty much whatever they want to do, as long as it is "prudent" .... that is, as long as everybody else is doing more or less the same thing.
Is it accidental that this change in the laws and rules comes only after a quarter-century-long roaring bull market? I think not. I think the law has indeed been bent to the fashion of the moment.
Unfortunately, the new rules flunk both history and basic math. History, because stocks do not remain overvalued forever.... eventually their prices will return to, or below, the long-term value mean, and will generate capital losses (at least, after adjusting for dollar depreciation) in the meantime. And basic math, because if the sum of management fees, payments to the beneficiary and federal and state trust taxes (from portfolio churning) exceeds 7%, the trust is eating its own seed corn. More to the point, if stock prices should return to historical levels at an average real rate of decline of 3% per year for the next decade, then expenses, taxes and distributions should not exceed 1% per year (unlikely!).... and this would not allow for any growth with the economy; just preservation of value.
Ideally, to be fair to both beneficiary and the inheritor of the trust, the trust assets should be allowed to grow in line with the real growth of the economy. This is why the dividend-only distribution model worked so well for many years.
You may think this rather dry dissertation on trusts is of no use to you. Think again. You may not have a rich parent leaving you money in a trust, nor may you have a pile of dough to put in a trust for your children or grandchildren. But many, many people have 401(k)s, 403(b)s or IRAs, which are specialized, tax-favored forms of trusts (complete with "trustees" and "beneficiaries"). Undoubtedly, much of the impetus for managing grantor-type trusts for total return came from investment committees which wanted the efficiencies of scale of managing all piles of money in the same way.
However, since you have control over your retirement "trusts", you don't have to buy into the money managers' total-return strategy, with its portfolio churning and corresponding fees, if you don't want to. Since, collectively, money managers can't beat the market because they are the market, you can duplicate their results at lower cost using exchange-traded funds. A good strategy is to buy ETFs in several different sectors (value stocks, growth stocks, energy stocks, foreign markets, minerals and precious metals, bonds, cash) and rebalance them once or twice a year.
If your retirement plan confines you to only mutual funds, well, you are stuck with the damn fees. Hey, those guys gotta eat, too; though they probably eat a lot better than you do. Try to stay in the funds with the lowest fees.
If you are fortunate enough to have enough assets to
place in trust, unfortunately the law is not on your
side. It is written to pretty much let the money
managers do whatever they want (as long as it is
"prudent"). Your best bet is to select a trustee who
thinks the same way you do. That may not work
forever, but it may work long enough to outlast the
current investment-style fads.
Each month, portfolios were formed and then let to run over various time horizons. Of course, this creates problems with overlapping sample periods, but the results don't alter materially if we try to avoid this.
1. those that enjoy a re-rating as the market more generally recognizes a mis-pricing has occurred (type I)
2. those that generate a higher return via dividend yield, but are not immediately re-rated (type II)
3. those that simply don't recover, the value traps. (type III)
So patience really should be a virtue for value managers as long as we are dealing with a type I or type II value stock. The chart below confirms just how strongly this is true. It shows the cumulative returns to an incredibly simple value strategy (buying the lowest 20% of the MSCI Europe ranked by trailing PE). The chart provides very graphic evidence for the rewards to patience.
The strategy tends to generate around 3% outperformance relative to the market in the first 12 months. But if you carry on holding for another year, this rises to 5.7% (a year two return of just over 2%). However, at three-year time horizons and beyond, the excess return pick-up is much sharper, running at the rate of 8-10% p.a. for years 3, 4, and 5!
Also noteworthy, is that the value strategy appears to start working from day one. This surprised me as I expected to see a period of underperformance or non-performance, rather than an immediate return to the value approach.
This finding sits well with the fact that successful value investors seem to display patience. The average holding period for our group of long-term outperforming value managers was 5 years, against the average holding period of just 11 months for stocks listed on the NYSE, and just over 1 year for the average US mutual fund.
A recent paper by Fama and French shines some light on the relative probability of each type of value situation occurring. They examine both the returns and the probabilities of transition amongst US value and growth stocks over the period 1926-2004.
They formed portfolios based around the interaction of price to book and size. In the table below, V = value, G = growth, N = neutral, B = big and S = small. The columns give four possible outcomes; the column labeled 'Same' refers to the group of stocks that one year later are in the same style and size basket as they were in the original sort. The 'Plus' column covers stocks that have moved into a higher price to book category, i.e. value stocks that have moved back towards market average pricing (or been acquired).The 'Minus' column depicts the opposite: here we find stocks that have been growth stocks and are now returning to, say, more normal valuations. The final column heading is 'change in size' and reflects stocks that switch between size groups from t to t+1 - that is small stocks that become big, and big stocks that become small.
So let's take BV (big value) as an example. The upper part of the table shows the average p.a. excess return over the market that such stocks have generated since 1926. So stocks that started in BV and then moved back towards the market average pricing, generate 17.5% outperformance p.a. (type I value stocks from our earlier discussion). However, stocks that start in BV and are still in the BV universe one year later have, on average, generated 3.4% p.a. outperformance (type II stocks). Value traps return an average -34.5% p.a.
Of course, these statistics mean nothing on their own. We need to know the frequency with which they occur, in order to gauge how important they are. A 17.5% p.a. excess return sounds very impressive, but it doesn't mean a lot if there is essentially no chance of it actually occurring. The middle part of the table details the average transition probabilities. For instance, in the BV portfolio, some 75% of stocks remain in the BV portfolio after a year (type II value stocks). Around 23% move to a higher price to book ratio, which moves them out of the BV portfolio (type I value stocks). A mere 2.3% of stocks end up being very serious value traps. (type III stocks)
In fact, Joseph Piotroski has gone even further. He found that a minority of value stocks created the US value premium. Piotroski uncovered the fact that only 42% of value stocks outperform the market on a one-year view. We now know from the Fama and French work that 23% of the value stocks re-rate towards a more normal multiple, and that this generates sizeable returns for the investor. This implies that only around 25% (or one in four) of the type II value stocks generate positive excess returns. This helps to explain why the type II value stocks only generate 3.4% p.a. excess returns: the category of type II value stocks is a broad spectrum that hides a multitude of sins.
In our own work we have found that 50% of the stocks in our simple value screen outperform over a one-year time horizon. This implies that investors who follow such strategies not only need to be patient, but also need to avoid narrow framing. If they look at the portfolio in totality then such investors are likely to be ok, even in the short-term. However, if they frame narrowly and start to look at the individual performance of stocks within the portfolio then problems could arise. With a relatively high percentage of stocks underperforming, the pain of running the strategy would be psychologically hard to bear, and result in the abandonment of the process.
One potential solution is to combine a value selection with a stop-loss system. We leave the investigation of this for another note. But it certainly looks like value investing could be said to be about avoiding losers.
The chart below shows the improvement in the percentage of correct calls as we extend the time horizon. Interestingly, the percentage of stocks outperforming the market rises over time, but not massively. So a 50% hit ratio rises to a 57% hit ratio when a five-year time horizon is used. This improvement presumably stems from a greater proportion of value stocks managing to turn their businesses around as time goes by.
In terms of the percentage of stocks that outperform, the numbers don't make for pretty reading. Only around 38% of the stocks in the growth portfolio have an above-market return. So successful growth investing is all about picking winners, i.e. identifying the stocks that can generate positive returns.
When we extend the time horizon we see the hit ratio decline. That is to say, the longer we wait, fewer and fewer stocks manage to outperform the index. Effectively, the risk of being hit by an earnings torpedo increases as time goes on.
One obvious way in which we might be able to improve on growth portfolios is to introduce a momentum filter. To test this we take the top 20% of stocks by PE and then split the portfolio into three, based around the past 6 months' price momentum lagged by one month.
The impact that this has is dramatic. The chart below shows the high and low momentum portfolios for the growth universe. The benefits of using momentum are massive. The median p.a. performance improvement is over 400 bps.
Of course, the absolute returns are still negative, but the relative gains are massive. Now personally I've never been a great fan of the relative performance game (a future weekly will explore this in more depth), but the potential value added by inclusion of momentum into a growth strategy can't be ignored. Moreover, the best benefits of the momentum input are achieved when the holding period is extended!
In terms of improving the hit rate of the screen, the inclusion of momentum improves the percentage of stocks outperforming from 38% to 41% at the one year time horizon.
Of course, there is an alternative approach which growth investors might consider - use value. The chart below shows the excess 12-month returns to our various quintiles, with each quintile further broken down into three value baskets. It shows that the cheapest of the value stocks achieve relatively little outperformance, with the majority of the value premium being generated by the other two groups.
However, look at the growth stocks. The cheapest of the growth stock significantly outperforms both the growth category generally (by nearly 3% p.a.) and the most expensive of the growth stocks (by nearly 7% p.a.) So growth investors would be wise to remember that value matters - even for growth stocks.
So bizarrely, growth works within the value universe, and value works within the growth universe. Ah, the ironies of investment management.
So if momentum is so useful in a growth context, what is its impact in a value universe? The results are less impressive than their growth cousins. The median value added is 130 bps p.a. Not inconsequential, but not in the same league at the growth results. The chart below shows the cumulative returns for the high and low momentum portfolios within the value universe.
It transpires the improvement in the hit ratio is roughly similar to that seen in the growth arena. The 12-month hit rate rises from 50% to just over 55%.
This finding that momentum works better for growth stocks than for value stocks was first documented by Cliff Asness for US stocks. The chart below, taken from Sebastian's magnum opus on momentum, provides a simple view of the conclusion for European stocks. Here each PE quintile has been split into three, based on price momentum. The difference between high and low momentum stocks in the value universe is around 4% p.a. However, the difference between the high and low momentum stocks in the growth universe is much higher, at around 12% p.a!
The fact that momentum adds relatively little to performance of a value portfolio, but adds major benefits to a growth portfolio, has implications for the portable alpha addicts out there (you know who you are).
If value managers find it hard to beat their benchmark (more on this below) but growth managers can do it far more easily, then a structure which is long value beta and then transports the alpha from a momentum-using growth manager, should be fairly attractive.
Indeed, in a new paper Chan, Dimmock and Lakonishok show that across a wide variety of benchmark measures, growth managers seem to be better able to generate abnormal returns relative to their universe than value managers do. Chan et al found that the average alpha (from 1989-2001) for US growth managers is 2.6% p.a.; the corresponding number for value managers is 1.2% p.a. - entirely consistent with the finding outlined above.
A similar picture is painted by the chart below. Here we have taken data from Houge and Loughran who formed two groups of US fund managers based around their factor loadings on the value premium. Those in the highest loading quartile are value investors, those in the lowest quartile are growth.
The chart compares the returns on the simple stock decile rankings from 1965-2002, against the returns from the two manager groups (net of fees) over the same sample period.
The value universe showed a 16% p.a. return over the period. Value managers (net of fees) showed only 11% p.a. return. The growth universe showed a 10% p.a. return, whilst growth managers showed a 9.9% (net of fees) return. So value managers seem to have trouble actually capturing the value premium.
However, above and beyond all else, we have also shown that patience is certainly a prerequisite for value investors, whilst growth investors would be better off ensuring momentum is one of the factors in their stock selection process and remembering that they shouldn't ignore value.
James Montier is the Director of Global Strategy at
Dresdner Kleinwort Watterstein, a London and
Frankfurt-based investment bank. He is also a prolific
writer and author of the book Behavioral Finance -
Insights into Irrational Minds and Markets.
The Plunge Protection Team (PPT) has been confirmed in its existence by US Federal Reserve Chairman Ben Bernanke in testimony before Congress.... One would have to be brain dead, or more naïve than a kindergarten child, or politically corrupted to the core not to observe clear pervasive patterns of PPT effects. Some call it the "10am lift" or "3pm lift" at work. Critical support and stimulation has been delivered routinely to the stock market via S&P futures contracts, major stock index options, USTreasury Bonds, gold, euro currency, yen currency, and probably even crude oil. Of course, they take action with intrepid skill to preserve the American way. You know, life, liberty, and the pursuit of happiness, in addition to basic hedonism. - Jim Willie
The main problem however, is that the real economic damage has already been done, under Clinton with the technology/internet bubble and under Bush with the housing/consumption bubble. As a result, our highly indebted, de-industrialized economy teeters on the brink of collapse, with nothing but the perceived political expediency of foreign central bankers temporarily propping it up. The fact that so many on Wall Street are oblivious to the political storm brewing on the horizon is yet another example of the head-in-the-sand complacency that rules the day. However, based on the seemingly benign current economic statistics, the Republicans should have done much better. Rather than merely attributing the poor showing to Iraq or to personal scandals, perhaps it is evidence that the economy really isn't as good as these phony statistics purport it to be. Of course, it wouldn't actually dawn on anyone on Wall Street to actually connect these dots. - Peter Schiff
So what is the 'reality' of the markets? The reality is that most stocks are very expensive...and that the correction that began in January 2000 was never permitted to become the MAJOR correction that the market needed. The force of a correction is equal and opposite to the deception that preceded it; you've heard us say that before. The whopper market of 1982 to 2000 took prices up 11 times. Our guess is that a huge correction is still waiting to express itself. - Bill Bonner
....the soft-landing bulls are getting it wrong and are altogether confusing cause and effect when they argue that lower oil prices are good news and good signals for future economic activity in the US: oil and commodity prices are exactly falling because we are now experiencing a US and global economic slowdown; so such price action should be interpreted as bad news rather than good news. This is the typical fallacy of non-economists that take a partial equilibrium - rather than a general equilibrium - approach to analyzing data; an economist would ask himself or herself: why are oil and commodity prices falling at the same time? What is the cause of it? There is only one clear and consistent explanation of this generalized price fall: The US is sharply slowing down, dragging with itself the global economy. So, paradoxically, falling oil prices are bad news for the economy: they are the proverbial canary in the mine warning us of the recession risks ahead. Indeed, what both the oil and commodity markets and the bond markets and the housing market are telling us - or screaming at us - is: Slowdown and recession risks ahead! - Nouriel Roubini
I think there's been a curious phenomenon in the equity markets, at least in the last few months: When there is news that the U.S. economy is slowing, the market often gets stronger because investors figure the Fed will stop raising rates, or maybe lower rates -- or maybe they think bond yields will decline. For some reason, they don't seem to say to themselves that earnings may be lower. I think it's very strange. - Robert Rubin
Stocks are making people money - and lots of it. But what the talking heads aren't reporting to you is that the stocks leading the charge are absolute crap. It is not the fundamentally sound companies leading the way in this most recent run-up. Rather, it's the companies with no earnings, no cash and high valuations that people are 'investing' in these days. They are trouncing the fundamentally sound companies with tons of cash, low valuations and strong earning. Anyone holding these 'crap' stocks is going to pay dearly. It's just a matter of time. Since 1947, every rally like this one has ended the same way. Stocks peak...the herd buys...and then they lose their shirts. - James Boric
We know that derivatives are pushing up the demand for equities, as the "new game in town" in New York (center of paper wealth that it is) has discovered the exciting new multi-step game of "hiding bad loans legally." The way this is played is this: Nonperforming loans Are bundled up right at the cusp on nonperformance and as transmuted into "asset backed securities." Normally, if you had a single loan, and couldn't make the payments on your note, your loan would be called "nonperforming" and you'd be sent off to collections, and from there, to foreclosure. But if you have a whole stack of such paper, you simply make arrangements for the mortgage holder to make interest only payments (to prevent default/nonperformance) and then quick-like-a-bunny bundle the paper as a collateralized mortgage obligation with a projected value (and you might reference the underlying Housing Bubble price of the houses in your calculations somewhere) and use the new "securities" as collateral to borrow "clean money" which in turn is invested in the stock markets. Sweet, huh? Except, of course, that I'm hearing rumors out of Asia that we have a few more derivatives players in trouble, but then again, derivatives firms are always in trouble because in my mind, they're sort of like crooks trying to cheat a crooked casino - everyone has dirty hands. Nevertheless, as long as the bubble is going, it's a fine ride for those at the top. - George Ure
The current reasonably accurate inflation number is seven percent. The current estimation of the M-3 money supply is nine percent. The only thing holding back massive price inflation today is the massive over-supply of goods. So today we have the almost unprecedented situation of too much money confronting too many goods. The result is a highly unstable market with accompanying massive speculation and leverage. - Richard Russell
It's one thing to be awash in liquidity generated from capital; it's a completely different matter to be awash in credit-based liquidity. That's why we are now seeing an increasing amount of hedge fund woes. The underlying problem is a hedge-fund return crisis due to excess liquidity and diminishing returns. That's what felled LTCM - they wrecked spreads across almost every market because they had credit liquidity that most others did not. And their continued pursuit of applying increased leverage to capture decreasing returns fostered their implosion. That same self-destructive practice is occurring globally now, but on a scale and magnitude that is multiple of what LTCM practiced. - Marc Faber
I never met a man who got rich buying hedge funds. I've met several who got rich operating them. - Felix Dennis
There are so many hedge funds; their overall, net rate of return is bound to regress to the level of the general market - minus their high fees. But it doesn't make sense for investors to put their money in hedge funds if they only get the same thing they'd get from the market itself. So, the hedge fund manager has to increase his rate of return or he will lose his customers. What does he do? He uses more leverage and takes riskier bets. He knows that many of them will go bad...and his customers will lose money. But if he doesn't take the chance he'll lose his customers anyway! Expect more spectacular losses in the hedge fund industry. - Bill Bonner
Enquiring minds might be wondering how it is remotely possible for a government bond fund to be up only 2.16-2.5% so far this year. After all, anyone parked in three-six-month Treasuries would be up 5% annualized or so. Anyone playing longer durations that caught the market bottom in May would be up substantially more than that. Something is seriously wrong with this kind of performance when someone can do much better by buying Treasuries and holding them, or simply by parking money in CDs. Short-term government backed CDs are yielding 5.5% at some banks. Could the answer be expenses and management fees? If so, exactly what performance are investors paying for? What are investors getting in return? If one is going to pay a management fee, one might expect better management. Perhaps the problem is the nature of the funds themselves. There are short-term funds, intermediate-term funds, and long-term funds. Exactly what is there to manage in those funds that remotely merits fees approaching 1% or even higher? After all, the investor is supposed to pick the duration correctly himself, then, within a limited range, the fund manager takes as much as 25% off the top for "managing" that decision. Give me a break. How about a "managed Treasury fund" that allows management discretion to do the task at hand: manage money. Is that too tough to ask? If there were such a fund and IF the manager did the task at hand very well, perhaps that person/management team would be worth 1%. The reality of the picture is that close to 25% of the gains in these bond funds go up in smoke in management fees, with enquiring minds asking, "For what?" - Mike Shedlock
There was once a time when stocks were valued based on their ability to produce earnings and dividends (e.g. free cash) to owners. But lately, ownership of stocks has changed fundamentally. Stocks in some ways act like real estate insofar as you're not buying a dividend stream, you're buying a "property" and with that you're buying "market position" and "niche." Further, a stock - even a declining one - has securitization value - so you can roll more layers of debt into play. Just as domestic inflation in moderation can drive up the price of an asset like an apartment building, so too can inflation (masquerading as the declining value of the dollar) drive up the price of stocks because they are now more valued as assets than free cash flow generators.... In the Weimar experience, the price of everyday goods and services went up. In the present Global Blow Off, fueled by derivatives and debt-piled-on debt, the financial markets where layers of paper feed more layers of paper, we might see a hyperinflation scenario where the bulk of inflation is contained within financial market, debt instruments, and the like. Oh, by the way, if you or the folks managing your money get this wrong, your life savings could disappear. Stuff happens though, right? - George Ure
A humorous Hallmark card reflects my sentiments about the Federal Reserve. It reads "I must admit, you brought religion into my life. I never believed in hell until I met you." - Richard Daughty
Central banks may have dumped far more gold on the markets over the last three weeks than officially reported, accounting for the sudden plunge in prices that has stunned investors. Barclays Capital said Europe's banks had sold an extra 100 tonnes from reserves in a rush to meet a quota deadline on Sept 26, but had done so by selling through forward contracts that disguised the effect. The huge sales would help explain gold's brutal fall from $640 an ounce in early September to $559 an ounce this week, an effect compounded in recent days by hedge fund liquidation. - Ambrose Evans-Pritchard
"Gold goes up and down, just like other kinds of money," say economists. Which is true. "You can protect yourself from inflation in other ways," say the speculators. True again. "Gold pays no dividends or interest," say the investors. True. Nor will gold cure baldness or add inches to your most private part. Even as money, gold may not be perfect. But it is better money than anything else. Gold was around millions of years before the U.S. dollar was invented. It will probably be around a billion years after. This longevity is not in itself a great recommendation. It is like buying a suit that will last longer than you do; there is no point to it. But the reason for gold's longevity is also the reason for its great virtue as money: It is inert; it yields neither to technology nor to vanity. - Bill Bonner and Addison Wiggin
For the consensus, the U.S. economy's shallow recession in 2001 is the most splendid justification of Mr. Greenspan's repeatedly expressed idea that it is better to fight the bubble's aftermath with easy money than to prick it in its prime. This is plainly a gross misjudgment, because America's shallowest recession was followed by five years of the shallowest economic recovery, with unprecedented large and lasting shortfalls in employment, income growth and business fixed investment. Actually, there have been major changes in the U.S. economy's pattern of employment and resource allocation, but altogether changes for the worse, not for the better. These structural changes are bound to depress U.S. economic growth in the long run. - Kurt Richebächer
I believe the Fed is more likely to either keep rates the same or raise them to outpace the anticipated increases in Europe and Asia. The reason for this is simple: it presently takes nearly $2.5 billion per day to maintain our current account deficit. To continue to attract foreign capital, US Treasuries must offer a higher rate of return than their foreign competitors. Now that the economies in Europe and Asia are growing, their interest rates are going up accordingly (to slow inflation). That means that the only way that America can continue to expand its debt, through the exchange of fiat currency for resources and manufactured goods, is by raising the return on Treasuries. And, that is probably what Bernanke will do, even though it will skewer the struggling American worker and the US economy at the same time. - Mike Whitney
If I am right and we are going into a recession or serious slowdown next year, if the market did not have a serious problem, it would be the first time in history. I don't like betting on "It's different this time." So far this year, I have been wrong; but I don't think the game is over. The fat lady hasn't sung. - John Mauldin
I don't see how anyone with a modest amount of intelligence or knowledge of history can conclude that this is not one of the more dangerous times our economy has seen. - Bill Fleckenstein
I can almost feel the coming cataclysm, and pity those who have not moved their money into silver, gold and other commodities, especially oil, or have otherwise bet against the dollar and the preposterous U.S. economy. But they will soon learn a valuable lesson, as have all stupid people who have foolishly entrusted a government to issue fiat money, and as have all stupid people who have foolishly allowed the banks to engage in such preposterous amounts of fractional-reserve banking, and as have all stupid people who have foolishly allowed their governments to grow so large as to actually become their economy. And it is a cruel lesson that their children will learn first-hand, too, and their children's children will learn second-hand. So there is, I suppose, an upside to it all, if increasing national smarts can be counted as increasing national wealth. Cold comfort, perhaps, but maybe better than nothing, which is what they deserve, and will get. - Richard Daughty
In today's marketplace, even some of the dead people who voted for the late John Kennedy can get mortgages. - Mychal Massie
Recent archaeological evidence suggests there was actually a time when people needed something called a "down payment" in order to buy a home. The size of this down payment was apparently between 10% and 20% of the purchase price. I figure that these prehistoric folk either emptied out their savings, or earned and saved until they had a lump sum big enough to fork over. Only then did they become homeowners. In these enlightened times, of course, we realize it's not even normal to build equity in your home. It's much more fashionable to cash it all out, and then some. Saving -- as in, "for a rainy day" -- well, really, it's such a quaint notion. - Robert Folsom
A lot of people are going to lose their homes. It's a family tragedy. It's not an economic - or macroeconomic - tragedy. - Alan Greenspan
How long will it take this time for house prices to nosedive? There are no historical cases of a national housing bubble collapse since adequate data became available in recent decades. What we can glean from regional cycles, however, suggests a two-year lag between the peak in house sales and the beginning of price collapse. But given the huge amount of speculation this time, the gap may be shorter, 1.5 years in our judgment. Since sales peaked in mid-2005, the big slide in prices might well commence roughly at the end of this year. - Gary Shilling
Some of our clients who work in the distressed arena and buy crappy mortgages have reviewed large nationwide portfolios of existing homes that are up for sale because of mortgage default. Their findings indicate that prices are already down 8 20 percent on average across the country! Remember, based on actual history of past real estate bubbles, the housing price drop is almost certain to take 2 to 3 years before it hits bottom. The primary reasons why home prices are so vulnerable are: Home values have bubbled up almost 80 percent in just a few short years; Speculators and flippers bought a few million homes they now can't sell; $1 trillion of adjustable-rate mortgages are scheduled to adjust upward in 2007; Lenders permitted sub-prime borrowers to buy homes with no credit and no real money down. - Richard Benson
The Street is scared -- scared to death that we are in for a housing crash that will rock our economy to its knees.... How can you evaluate a market like this from the comfort of a cushy Manhattan office? No way. No how. So let me tell you, simplistically, what we see and hear on the front lines. On the street we are dealing with builders and sellers every single day. And both groups are trying to leap-frog the other on the way down. That means lower margins or no margins for the builders. And that means the banks that have financed the millions of homes flippers bought, as well as the ATM cash drawn down with ARMs, will wind up owning a lot of property they cannot sell. Sure, most banks sell their paper. OK, so the guys like Fannie Mae will own hundreds of thousands of homes they can't sell. The result is the same. Massive amounts of inventory flooding the market at foreclosure sales. And prices drop further. On the other end, here's what I am hearing from the desperate builders. "Mike -- we've got to unload inventory. Bring me offers. Please, Mike, we'll look at anything." And from the big money that have financed many of these builders? They want to know how bad it is... and how bad it is going to get. These guys are truly on the razor's edge. - Mike Morgan [Morgan Florida]
Eventually, lenders are going to be forced to tighten standards, which will only intensify problems in the housing market, increase the drag on consumer spending, and worsen household debt loads. That, I'm afraid, will amount to a vicious cycle, leading to a recession and prolonged credit crunch. - David Levy
This massive tidal wave will effect all aspects of our economy. Some banks will fail. Other banks will suffer the worst liquidity crisis since the Depression. And there is no way to stop this wave. This wave not only affects current mortgage holders who can no longer afford to live in their homes, but it devastates the new home market. Buyers with contracts are finding it tougher to qualify for mortgages. We can't forget that rates are also up about 18% from a year ago, so buyers cannot afford the same home they could have a year ago. - Mike Shedlock
I live at ground zero of the real estate bust. It's unfolding before my eyes every day.... I know you hear a lot of talk that the housing market has hit bottom ... that it's all blue skies from here ... that we're getting a soft landing..... Now Greenspan says it's all over, and we're supposed to believe him? No way! All around me, I still see desperate flippers stuck with homes and mortgages they can't afford ... I still hear everyday homeowners grumbling about how unaffordable their loans, taxes, and insurance bills have become ... And I see "for sale" ads morphing into "for sale or rent" ads. That tells me that homeowners are stuck with two or more loans, and they're trying to generate at least some income from properties they can't sell. I read in the local newspaper that home auctions can't even get the lowest prices sellers are willing to accept. One example: A property that listed for as much as $725,000 couldn't garner a $500,000 bid! This is the legacy of the housing bubble. This is what the Fed's reckless monetary policy has wrought. This is what happens when your economy becomes utterly dependent on asset booms. Am I angry? Darn right I am! Houses never would have gotten so ridiculously unaffordable if Fed policymakers had raised rates sooner to curtail rampant speculation. Mortgage standards never would have gotten so ridiculously loose if regulators hadn't twiddled their thumbs while lenders threw long-standing practices out the window. Loan fraud, appraisal inflation, and other shady practices wouldn't have skyrocketed to the unbelievable levels we're seeing now if more resources had been dedicated to ferreting them out months or years ago. Now there's no telling how many people's lives will be ruined by delinquencies and foreclosures. I wish the worst was over in housing. I really do. But I don't think it's here yet, nor do I expect it anytime soon. - Mike Larson
A contractor who does some work for me is selling his house. He told me six months ago that it was on the market. I asked him if he had any bites. He said he had one, but was offered $5,000 less than his asking price. He would wait it out. I mentioned politely that he should call the potential buyer back and offer to sell it to him at the lower price. He, of course declined. The house is still on the market today and will likely be on the market this time next year as well. In the meantime the owner will have spent at least $20,000 in mortgage interest, maintenance, insurance and property taxes. Multiply that by several thousand and you see what the future of real estate in the US looks like a few months down the line. - Karim Rahemtulla
The tax change regards a new plan to tax Canada's income trusts. Not only does it come out of the blue, it breaks a pledge made by Canada's Conservative government not to change the trust taxation rules. Canada's rationale for doing this is that they are missing out on too much revenue as the income trust sector expands. But this rationale is self-defeating; because of the message Canada's government sends with the arbitrary change: If you do business in Canada, you are liable to confiscatory changes in tax policy at government whim -- even if we promise no such changes beforehand. - Justice Litle
Why did Flaherty propose the shocking tax change? Because a couple of large Canadian telecoms were planning to convert into investment trusts, thereby dodging the taxes they would otherwise owe... Understandably, Flaherty had grown tired of watching one Canadian company after another convert itself into a tax-free entity. Less understandable is why he did not merely end the policy instead of proposing major retroactive changes to the tax laws. If he had merely ended the investment trust mechanism, he could have halted the erosion of the Canadian tax base without also destroying $25 billion of shareholder wealth in a single day, shutting down the existing investment trust apparatus, violating the trust of every investor in Canadian assets, imperiling future investment in the country, eroding the Canadian government's credibility, undermining the Canadian dollar and looking like an incompetent buffoon. If enacted, this proposal will not merely bite the hands that feed the Canadian economy, it will amputate them. Flaherty's proposed retroactive tax reneges on longstanding agreements between investors and the Canadian tax authorities. As such, it is just as much an appropriation of capital as anything conceived by Venezuelan President, Hugo Chavez. - Eric J. Fry
We have not won the war in Iraq because of something completely unforeseeable: widespread massacres of Iraqi civilians by other Iraqis and Muslims. We have never seen mass murder of fellow citizens in order to remove an outside occupier. No Japanese blew up Japanese temples to rid Japan of the American occupier. No Germans mass murdered German schoolchildren and teachers to rid Germany of the American, British, French and Soviet occupiers. The level of cruelty and evil exhibited by those America is fighting in Iraq is new. Had Iraq followed any precedent in all the annals of resistance to occupation, America would likely have been victorious in Iraq. It may just be impossible, if one is morally bound not to kill large numbers of civilians, to fight those who target their own civilians and hide among them. But George W. Bush had no way to foresee such systematic cruelty. - Dennis Prager
Since 2001, the US has been edging toward bankruptcy defending against all manner of possibilities and carrying out a hugely expensive war - and all the while all our enemies have been doing is waiting for our spending to slow, then they'll almost certainly hit us again, and lacking a better response, we will resume our lurching toward bankruptcy. Asymmetric warfare, no? - George Ure
....the situation has become crude and binary: Either the U.S. government deploys force to prevent Tehran from acquiring nukes, or Tehran acquires them. This key decision war or acquiescence will take place in Washington, not in New York, Vienna, or Tehran. (Or Tel Aviv.) The critical moment will arrive when the president of the United States confronts the choice whether or not to permit the Islamic Republic of Iran to acquire the Bomb. The timetable of the Iranian nuclear program being murky, that might be either George W. Bush or his successor. It will be a remarkable moment. The United States glories in the full flower of public opinion with regard to taxes, schools, and property zoning. Activists organize voluntary associations, citizens turn up at town hall meetings, associations lobby elected representatives. But when it comes to the fateful decision of going to war, the American apparatus of participation fades away, leaving the president on his own to make this difficult call, driven by his temperament, inspired by his vision, surrounded only by a close circle of advisors, insulated from the vicissitudes of politics. His decision will be so intensely personal, which way he will go depends mostly on his character and psychology. Should he allow a malevolently mystical leadership to build a doomsday weapon that it might well deploy? Or should he take out Iran's nuclear infrastructure, despite the resulting economic, military, and diplomatic costs? Until the U.S. president decides, everything amounts to a mere re-arranging of deck chairs on the Titanic, acts of futility and of little relevance. - Daniel Pipes
We are turning Gaza into south Lebanon.... We are importing rockets and the knowledge to launch them and
we are also making many plans for battle.... We have warm relations with Hezbollah, which helps with some
of the training programs. We don't have anything to be ashamed of - that we are dealing with Hezbollah and
that we are receiving training and information from them.... Our preparations include the building of special
bunkers.... It is only a matter of a small period before Gaza is ready for war. - Abu Ahmed [northern Gaza
leader for the Al Aqsa Martyrs Brigades]
Even if the bear market does not return before the end of 2006, it is highly unlikely to be deferred beyond January 2007. Historically, more bear markets start or return in January than any other month, and this is especially true in a post-election year when the economic excesses need to be defused in order to goose up the economy again in time for the 2008 elections.
Also, in 2008 we hit the "demographic wall", when the baby-boomers start to retire in large numbers, and since they can't eat stocks, they will be selling assets to raise cash for living expenses. It is reasonable to expect the market to start discounting this massive asset sale in 2007.
In case I have not made myself clear, let me say it again: The return of the bear market is long overdue.
The "window" for a systemic failure is closing now
that the holiday season is nearly upon us. Currently,
the odds for a systemic failure are only about 20%,
and a stock-market crash before January is unlikely.
I'm going to wait a bit to see how things develop
before I assess the odds for a systemic failure in the
new year.
A. "Inheritance" - real (normalized) "dividend and interest distribution" portfolio:
SUMMARY - "Inheritance":
Original cost: $100,000.00 (normalized)
Present value: $109,037.58 (see below)
Increase: $9,037.58 [+9.04%]
COMMENT on "Inheritance": Peoples Energy is (was) up about 18% from where I bought it so, given the current high level of systemic risk, I decided to reclaim most of my original investment and let the profit ride.... as what will be 15 shares of Integris after the merger of PGL with Wisconsin Public Service is completed early next year. Also, FPL - after a proposed merger was dropped - had risen more than 25% on strong earnings from electricity wholesaling, so I recaptured approximately my stepmother's original investment by selling 30 shares and am letting the remaining "profit" of 10 shares ride. FPL now yields less than 3%, not currently competitive with T-bills at 5-plus percent. (This was the last of the money manager's positions in which I was fully invested. Now I'm on my own, I guess.)
More interesting is what happened to PrimeWest, and the Canadian investment trusts generally. Reneging on a commitment made last year about this time, on November 1 the Canadian Minister of Finance proposed that beginning in 2007 (2011 for already-established investment trusts) regular corporate income taxes of about 31% would be imposed on the trusts, a move which effectively screws non-Canadian owners by cutting their after tax income by about a fourth, and which screws everybody (Canadian and non-Canadian alike) who holds trust units in a tax-deferred retirement plan. The amount of taxes the Canadian governments are likely to receive if this new tax is implemented as proposed is not likely to change greatly; it is just collected at a different stage in the "pipeline". Actually, tax revenues are likely to decline (if oil prices remain stable), as typically happens when an activity (in this case, oil/gas extraction) is hit with a stiff new tax.
The world needs new sources of energy, and Canada has them, and the Canadians could use foreign capital to help develop them. So what do they do? Slap energy development with a new tax. Yeah, that should help produce lots of energy. (Would you believe, hot air?)
Let's see, tax revenues don't change much, but everybody who owns trust units is suddenly made 25% poorer on paper due to the instant markdown of their units to reflect the reduced after-tax yield. Dumb.... really dumb. Oh well, par for the course for politicians. (Remember this incident when the time approaches for you to collect on your Social Security promise.) The politicians giveth, and the politicians taketh away; but mostly they taketh away.
Anyway, the panic and gyrations in prices that ensue when an investment is hit with an unexpected "external" shock such as this (as opposed to problems within a company becoming known) typically last about three days, with the best buying point (lowest prices) typically in the middle of the second day.
I took a re-examining look at the trusts. Same solid businesses. Same potential appreciation in the price of energy. Lots of confusion due to the proposed changes in taxation. At their markdown prices, PrimeWest (and Penn West in my Roth IRA) would, in the four years before the new tax cuts in, return about half the cost of the units in dividends alone (if the distributions remain the same). So, I decided to "double up" on my holdings, buying as close to the middle of the second day (November 2) as my schedule would allow. On November 10, with PWI stlll in shock, I added another 60 units using most of the proceeds from the FPL sale.
The portfolio cost (normalized) is $108,800.96 with $83,756.71 currently in cash or near-cash.
B. "Professors' Investment Group (PIG)" - investment club portfolio.
SUMMARY - "PIG":
Original cost: $10,699.00
Present value: $20,167.65
Increase: $9,468.65 [+88.50%]
COMMENT on "PIG": I continue to "roll over" 3-month T-bills, one per month.
C. Roth IRAs - real portfolio:
SUMMARY - Roth IRAs:
Original cost: $28,776.19
Present value: $34,836.20
Increase: $ 6,060.01 [+21.06%]
COMMENT on Roth IRAs: For comments on Penn West, see the discussion under "Inheritance".
D. TIAA/CREF 403(b) and (non-Roth) IRA retirement plans: My TIAA-CREF and Fidelity retirement investments, both the part from which I am making monthly withdrawals and the parts that are "resting", are invested as follows: TIAA traditional, 59.00%; T-bills and money-markets, 37.93%; CREF inflation-indexed bonds, 0%; TIAA real estate, 3.05%; TIAA-CREF High-Yield II, 0.02%
TIAA-CREF values, 14Nov2006: stock, 236.22; equity-index, 93.45; MM, 23.58; bond, 79.41; inflation-indexed bond, 47.23; real estate, 270.37; TIAA current yield in SRA, about 4.82%. COMMENT on NYSE "Timer's Trend": We are currently on a BUY signal of July 25, 2006.
COMMENT on NASDAQ "Timer's Trend": We're on a BUY signal given November 6, 2006.
NEXT ISSUE - will appear in December 2006 (or possibly in early January 2007).