5 August 2008 – The Aleph Blog

The Fundamentals of Market Bottoms, Part 2

Posted on 5 August 2008 by David Merkel

Before I get started for the evening, here is a copy of the Fed statements compared in PDF format, in case you couldn’t read it well on RSS.

Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.

		David Merkel
		Housing Bubblettes, Redux
		10/27/2005 4:43 PM EDT

From my piece, “Real Estate’s Top Looms“:

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow’s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

I’m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.

That’s why I think the hot coastal markets are bubblettes. My position hasn’t changed since I wrote my original piece.

Position: none

I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?

The Investor Base Becomes Fundamentally-Driven

1) Now, by fundamentally-driven, I don’t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.

2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.

3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.

4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.

5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.

6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.

7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven’t morphed into permabears.

8) Value managers tend to outperform growth managers at bottoms, though in today’s context, where financials are doing so badly, I would expect growth managers to do better than value managers.

9) On CNBC, and other media outlets, you tend to hear from the “adults” more often.? By adults, I mean those who say “You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.”? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The “chrome dome count” shows more older investors on the tube is another sign of a bottom.

10) High quality companies keep buying back stock, not aggresssively, but persistently.

11) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.

I will try to complete this piece this week.? There should be one more part, and I will publish it all as one unit.

Fed Statements Compared

Posted on 5 August 2008 by David Merkel

Here’s a redacted version of the Fed’s statement today:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Economic~~Recent information indicates that overall economic~~ activity expanded in the second quarter,~~continues to expand,~~ partly reflecting growth~~some firming~~ in consumer~~household~~ spending and exports.. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated~~the rise in~~ energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by ~~The Committee expects inflation to moderate later this year and next year.? However, in light of~~ the earlier~~continued~~ increases in the prices of energy and some other commodities, and ~~the elevated state of~~ some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but~~, uncertainty about~~ the inflation outlook remains highly uncertain.~~high.~~

~~The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time.~~ Although downside risks to growth remain, the~~y appear to have diminished somewhat, and the~~ upside risks to inflation are also of significant concern to the Committee.~~and inflation expectations have increased.~~ The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred an increase in the target for the federal funds rate at this meeting.

Quick Summary

Energy costs receding
Points at past easing indicating future stimulus (don’t expect more soon)
Highlights inflation risks
Many changes, but most of them are language tweaks and a little reorganization
Only one vote against

FOMC: Forking Out More Currency

Posted on 5 August 2008 by David Merkel

Today’s FOMC meeting is largely a done deal.? No moves, but sound hawkish.? Personally, if I were in their shoes, I would move the Fed Funds target to 2.05%, just enough to weird the markets out, but not enough to do any real damage to those who rely on Fed Funds.? Creating uncertainty through breaking the convention on quarter percent moves would be good for the market, because market players have gained a false confidence over what the Fed can and can’t do.

The thing is, the Fed is boxed in, like many other central banks.? A combination of rising consumer prices, rising unemployment, and a weak financial sector will compel them to stay on the sidelines for now.

Now, as for Saturday’s post, I received a number of responses asking me to explain my views.? Here goes:

1) I’m not a gold bug; I have no investments in gold, or metals generally at present.? Any liking that I have for a gold standard is that it gets the government out of the business of manipulating the economy through manipulating the money supply.? Currency boards, pushed by my old professor, Dr. Steven Hanke, are another good idea.

2) Where am I on inflation/deflation?? We are experiencing goods and services price inflation, asset deflation, and a monetary system where the Fed is not increasing the monetary base, but the banks are expanding their liability structures over the last year, but that may have finally peaked.? Consider this graph:

There is a limit to how large the liabilities of the banking system can get relative to the Fed’s stock of high-powered money.? We reached that limit in the first four months of 2008, and now banks seem to be focusing on survival.

It is very hard to reflate bubbles — you can’t build an economy on sectors that are credit impaired, which makes me think that the housing stimulus ideas will likely fail.

3) The Fed is in a box.? They have no good policy options now.? They are stuck between rising (or at least high) inflation, rising unemployment, and the banks are not strong.? Fortunately the US Dollar has been showing a little more strength, but that’s probably anticipating the hawkish tone of today’s announcement.? If the statement is insufficiently hawkish, I would expect the US Dollar to weaken.

4) I expect goods inflation to persist in a moderate way over the intermediate-term, unless the main US Dollar pegs are broken (Gulf States, China).? Presently, we import a little of the inflation that the rest of the world is experiencing mainly through energy, and energy related commodities, like fertilizer.

5) Globalization does restrain wage growth on the low end.? On the high end, it is likely a benefit, and in the middle, probably neutral.? Those who benefit the most are those who are able to use relatively cheap labor for unskilled tasks.? But technological change also affects job prospects in different industries.? My view on steel is that the industry shrank mainly due to technological improvements at the lower cost mini-mills.

6) As for the GSEs, banks, and the investment banks, the Fed would be challenged to raise rates much.? At present, the positively sloped yield curve is allowing some banks to repair by borrowing short and lending long.? That is a good trade for now, but will be prone to trouble if the Fed ever concludes that it has to shift to fighting inflation, and not just put on a rhetorical show.

7) Finally, we have some degree of restiveness among the hawks on the FOMC.? I would expect two (or so) dissents favoring tightening today, but now with the current cast of ten (counting Elizabeth Duke, a banker), but if we get four, which is not impossible, I think it would unnerve the markets.? Mishkin is leaving at the end of August, and the custom is that he attends but does not vote at his last meeting.? (For more on FOMC dissents, I have this article.)

Well, let’s see what the FOMC has to say.? After all, at present, they are all talk.

Discounting Future Prospects

Posted on 5 August 200822 June 2017 by David Merkel

In one sense, among value managers, I’m an agnostic.? I am more than happy to analyze the theories of other value managers, and see how they can help me create an even better method for analyzing stocks.

But in the present environment, many value managers have gotten hit, and hard.? Thus the need for a Value Support Group.? I sympathize with their plight, but value has to be sought considering the likelihood of problems in earnings prospects.

Now, I’m not perfect, and sometimes after underperforming days like today, I wonder if I should be writing at all 🙂 , but part of being a value manager should be looking at the future prospects of the industry one is investing in.? Banks and other credit-sensitive financials are staple investments of value managers, because they are mature businesses, with good returns on equity under normal conditions.? Trouble is, conditions aren’t normal, and I can’t imagine how many times I beat the drum over at RealMoney, explaining from 2004-2007 why financials (away from insurers) would eventually have trouble.

As a value manager, I am doing well this year, because I largely avoided credit-sensitive names, and was more willing to believe that the economy wasn’t doing that badly.? Value investing means looking at both the long and short term prospects for an industry, as well as the valuation.? Industries that have gotten smashed on a price basis, but have reasonable long-term fundamentals can be a fruitful place to invest.? Industries with low P/Es, but have deteriorating fundamentals are usually bad places to invest.? Industries like newspapers, where the long-term fundamentals are bad, are bad places to invest, regardless of valuation, unless there are non-newspaper assets.

Ideally, I invest in industries that have been smashed, but the long term fundamentals are decent; I buy high quality names that can survive.? Less ideally, I buy companies that are relatively cheap, where trends are under-discounted.? This is not a perfect way to invest, but it does tend to yield good results over time, with a decent amount of noise in the results.

In summary, value investors should not be wedded to a few sectors, but should be willing to abandon sectors that were previously regarded as key if the situation is bleak enough, and valuations are too high.