When I go to prayer meeting on Thursday evenings, I have recently begun requesting prayer for the economy and policymakers.? Ordinarily, I resist doing that, because it usually doesn’t sound right.? I remember one time two years ago explaining why we should pray about a given economic issue, and my dear wife said, “Let me get this straight.? We’re praying for the World Economy, that we don’t have a disaster?”? But when I was asked to explain my concern recently, I said, “Things are breaking in the financial system that no one a year ago would expect to break, and the costs could be high.? A second Great Depression is not impossible, and a repeat of something similar to the 70’s is more likely, minus the ugly clothes.”? That said, I am satisfied with praying for my daily bread, and the daily bread of others.
I didn’t expect to start the post this way, but that’s what’s on my heart.? Things are breaking that should not break, but what is happening is consistent with what I have been writing about here and at RealMoney for the past four years.? I am not a bear by nature, nor a bull.? I just try to analyze economic situations from a holistic perspective, and what I have seen over the past four years, was a massive increase in leverage that was not sustainable.? This affected the investment banks as well, and in this case, Bear Stearns in particular.
Confidence is tricky.? The investment banks are more highly levered than mortgage REITs, and we have seen the fallout there, even though real estate is more stable than the assets financed by most investment banks.
This is why in investing, I write about having a provision for adverse deviation, or in Ben Graham’s terms, “A margin of safety.”? With leverage, one should always calculate the maximum amount of? leverage consistent with prudence, and then take several steps back from there.? What is permissible in the boom phase has little relevance to the bust phase.
Now, I tell my children, “Don’t blame the Ump.”? In sports, if it is call of an umpire or referee that is the difference between victory and defeat, then you did not deserve to win.? You did not gain a commanding lead in the contest.? In this situation, Bear Stearns played close enough to the edge that rumors could begin to push at their short-term financing base, creating a crisis.? Investment banks must be like Caesar’s wife — there can’t be a hint of impropriety (with respect to financing).
Now, with a downgrade in credit ratings, Bear Stearns will have to find a buyer.? Why?? Major financial companies that lend have to have A-1/P-1 commercial paper ratings in order to make money.? The ability to borrow at cheap rates in the short run is important to profitability.
Naked Capitalism has some good points on this topic.? I would echo on the mortgage exposure.? More important is not being liked.? According to friends of mine, Lehman got rescued privately during the LTCM crisis because they convinced creditors to support them.? Bear walked out on the LTCM bailout, and it still leaves a bad taste in the mouth of Wall Street.? Wall Street does have honor, in a twisted way.? They remember who were their friends during tough times.? Bear was not one of them.
When there is a lot of worry around, it doesn’t take much to kick a marginal firm over the edge.? Bear had ample opportunity to move to lower level of leverage, and did not do it.? Now let’s talk about the rescuer.
The Omnipotent Federal Reserve
The Fed can’t run out of bullets, because it can always print money.? That comes with an inflation price tag attached, though.? In this case, they are providing funds freely to J. P. Morgan to the extent that they lend to Bear Stearns.? Now, I know why the Fed did this.? Bear Stearns my be small in a market capitalization sense, but is large when one considers all of the debts that they have, both in the cash and synthetic markets.? (As an aside, I was analyzing some muni bonds of a major issuer today, and it amazed me that Bear Stearns was their #2 counterparty.)
Now the Fed has Fed funds, the discount window, TAF, TSLF, and more.? I am not here to fault them for lack of creativity.? I am here to fault them for (like Bear Stearns) overtaxing their balance sheet.? There is only so much that the Fed can rescue before it chokes, because they (at that point) have no more safe assets to pledge.
I sold my capital markets exposure earlier this week, and I am glad that I did, late as that was.? The Fed is not big enough to rescue all of the investment banks, nor could they rescue the GSEs, without creating significant price inflation.? What a mess.? Avoid the depositary financials, and those that lend and intermediate aggressively.? This is not a time to be a hero in financials.
David,
What haunts me reading this is your observation that things are breaking that should not break. I wonder your thoughts on the lack of rate relief from ECB and BOE. I think a coordinated policy effort from central banks is needed to reduce some of the imbalances and dislocations (say, $USD pressure) from the Fed acting alone.
I apologize for venting in advance – I work in relative isolation and posts in places like David’s excellent blog provide me a much needed source for an intellectual outlet.
I am absolutely sick and tired of people suggesting that there is something the Fed can or should do to address this absolute mess we are in. The Fed is a ridiculously failed institution – just as almost every other institution that has been created out of crisis is or has been. It is laughable that so many are just now coming to this realization due to the current crisis. So many were derided as perma-bears for identifying the massive imbalances that have been building for 20 years.
There is a big difference between identifying a problem and how one executes an investment strategy. Personally, I was a chicken little risk taker up until July of last year even as I had been calling for the financial apocalypse for a few years. The reality is that the WORLD has been in one big credit bubble. This is not just a US problem. Europe is in deep and the emerging markets have been the epicenter of a vendor-financing scheme not all that dis-similar to what pre-empted Cisco’s post-2000 collapse.
Country’s like China have traded the sovereignty of their currencies and monetary policies for political expediency – i.e. trying to employ the billions of entrants into the global labor force. Now, they are dealing with the natural result of price fixing. The inflation problems in the dollar peg nations is causing massive issues that are likely to get worse.
As I wrote on this blog 2 months ago, I targeted the EEV for purchase in the mid $70’s based on my belief that the January/February spike was a bear market rally and that the next phase of the bear market would transition downside leadership to the global growth market segments such as emerging markets that have performed so well over the past 6 years. I believe that the current ruckess over the Bear Stearns and US financial mess is causing people to miss the major shoes to fall next. Europe is likely heading or already in recession and its banking system is not much better than ours – plus they have a fragmented monetary regime. What would happen in the US presently if the Fed was dominated by Texans rather than Californians and there was a vigorous history of centuries of nationalism between the two? Well, the ECB is still dominated by the Bundesbank and Germany hasn’t experienced a housing bubble like Spain has. Will France and Germany bow to the pressures in Spain and Italy? Probably at some point, but it indicates that the Euro zone is also in jeopardy.
While the consumption class in the emerging world is certainly growing at a mighty rate, it remains a rounding error on the global stage. I simply don’t see how people believe that the emerging economies can withstand or even thrive during a Euro/Japan/US recessionary environment. Many point to commodity price strength to justify this belief. ECRI points out that their index of commodities that DO NOT have exchange listed futures contracts are up just 10% yoy versus the 100%+ of those commodities that do. This indicates that there is a massive financial move into commodities that is distorting price discovery…just another misallocation of capital in the long list of central bank induced miallocations. All of that printed money will head somewhere!
As for investing in this environment, I personally have still not heard/read one “value investor” address the issue of valuation in the broad market using normalized profit margins, book value or P/S. Jeremy Grantham stated last quarter that GMO’s long term fair value for the SPX was around 900 and they didn’t pull that number out of thin air.
All historical major economic debacles began with financial crisis that eventually bleed over into the “real” economy. This is a tremendous risk at present in my opinion. Those ignoring this risk are being reckless in my opinion. Certainly, markets are extremely extended on the downside at present, so anything can happen in the short term. However, I believe that anyone not doing some kind of hedging is ignoring the possibility of a “black swan” event. The global economy has reached a critical state and the deer has farted. Whether or not the avalanche turns into the “big one” is unknowable but given the financial sector debacle and global imbalances, the snow levels are at record depths and therefore I would argue that the risks of the “big one” are higher than they have been in decades.
At the risk of sounding like an alarmist at a point when the market is at a multi-year low, I’ll share what I am doing to combat things. I am long the Yen versus the Euro. I am long ag commodities but certainly not the ag stocks. I own some healthcare, which is the one major market sector that is trading around historical norms as far as profit margins go and very reasonably from a P/E and P/S basis. I still own a position in NLY which is certainly at risk but I believe can weather and thrive given the current financial mess. I am short the emerging markets and REIT’s. I’d like to be short the financials but fear that government bailouts could cause excruciating pain as a short seller. I doubt REIT bailouts are on the radar of the Feds at this point and they display many of the same problems as the general financial sector. The precious metals sector has certainly had a run, but it still shows no signs of excessive speculation. The junior minors continue to perform horribly as costs remain a problem. Should the financial buying in broad commodities reverse, gold is sure to be impacted at first, but I suspect the miners to emerge after the initial sell off and be an explosive investment as gold recovers and their energy costs plummet.
I apologize once again for taking up so much space – this is a selfish exercise for me to help clarify my own thinking and I welcome any criticisms/debate. I sincerely wish David and everyone else success in combating this environment.
As I told a 24 year old who works for me on Friday, read everything you can about the current environment, as it has not occurred in this country in almost 80 years and is likely to be a turning point in the history of this once great nation.
James, your erudite comments are always welcome here. If it means anything, I have recommended the yen and swiss franc for the last two years. Jeremy Grantham is a bright guy. He may be right. I am more of a relative value player because I pick stocks and industries well. I need that for the pension plan money with dedicated mandates. I don’t do timing well. I am tilting toward low P/S in my stockpicking.
I don’t think the Fed can right the ship. I don’t think that the Feds can either, without imposing a new type of socialism on us all.
To James Dailey: Thank you for your informative post. I am new to this blog and appreciate your thoughts. That said, could you please elaborate on your views on energy. You state that you “suspect the miners to emerge after the initial sell off and be an explosive investment as gold recovers and their energy costs plummet.” Exactly why will their costs plummet? Thanks in advance.
Hello Andrew,
Many metals mining companies’ cost structures are comprised by 20% or more of energy. Obviously, energy prices have grown at a faster rate over the past several years compared to gold bullion prices. This has resulted in the higher cost producers, often junior miners, continuing to show poor operating results. Historically, major gold bull markets have ended with miners showing excellent operating results (i.e. earnings and free cash flow) and paying substantial dividends. The end stage of a great bull market often results in speculative mining companies that are in the exploratory phase going parabolic as speculators are attracted to good “stories”.
If gold prices begin to increase at a rate more rapid than oil, then the operating results of the miners should improve. Many gold bugs have largely abandoned the miners in favor of the GLD or physical metal because of the frustration of the poor operating results. I think the next phase in the bull market is likely to reverse this trend.
Finally, the sector is quite extended as is bullion. The stocks are quite reasonable compared to the metal, but a 5-10% drop in the metal is sure to drive a correction in the stocks should such a correction emerge. I think it will be interesting to see when/if the stocks can hang in relative to the metal in such a correction. For example, if gold drops 10% and the XAU and HUI “only” drop 10%, then I would take that as a sign that the stocks are so cheap relative to the metal that they will take a leadership role during the next uptrend….assuming there is another uptrend of course!
The basic issue here is leverage. When one is leverage to the hilt and things go wrong then you wind up unwinding. BSC vs Hedgers. The numbers are in and the hedgers won and the shareholder in the bleecher seats lost everything. As was said in the past “Give me a long enough stick and I could move the word”. The is leverage at 1:30 or 1:50. If I could leverage 100 million to 3 billion then make 30% what a great number this would be. But if it fell what a fall it would be. The Fed is more concerned with Pay Out than Bail Out as the amount they payout could be more significant than a bailout. This is why they liquidated the shareholders equity(wealth) to JP Morgan. They blindly announced this Friday with the “Loan” from the NY Fed Reserve to JP Morgan to BSC. All backdoor to me. Maybe musical chairs and BSC lost their seat when the music stopped? Who knows but I do know one ting…there is more to come.
The Dean of Dracut
James, thanks for the response. I have two quick follow up questions. First, do you believe there will be a lot of consolidation in the sector? I thought that a lot of the explorers would have been or be in the process of being acquired with gold where it is, but apparently I was wrong. Second, would you mind sharing a few names (or do you just use the indexes)? The ones I own have been dead since 2006. Many thanks.
Andrew,
I actually posted a response yesterday that appears to have been eaten by the web gremlins. I am not comfortable offering advice – simply not appropriate on David’s blog. I own some mutual funds and one junior miner.
I believe that consolidation will emerge once operating results improve. Notice that the bloodletting today in the sector has the metal down more than the major sector stock indexes. This is VERY positive in my opinion. The correction could surely last for a while and be quite deep, but I think the miners emerge as a great place to be if this is the beginning of the unwind of the global growth trade – i.e. commodities and emerging markets.
Thanks once again for your response. REreading your original post, I was wondering if you couold clarify one point though. You have postioned yourself long agricultural commodities and are bullish on gold, but bearish on oil (via the prediction that the miners energy costs will decline). Perhaps all this requires is a yes or no, but do you believe that the price of oil over the intermediate to long term will depend on global growth (which I assume means growth in the developed world). Do you believe that the demand from China and India for agricultural products will be sufficient (with our insame ethanol policies) to drive the prices of soft commodities higher, but won’t prevent a collapse in oil prices? Thanks in advance for any clarification.
Personally, I believe that commodities as an asset class are in a secular bull market that began when the global economy emerged from the 1998/1999 recession. My view on oil is a cyclical one. However, in all great commodity bull markets specific commodities have had their day in the sun for periods. For example, I believe soybeans made their 1970’s peak in the middle of the decade while gold peaked in the early 1980’s.
Even great secular bull markets involve crashes and violent price moves down. The crash of 1987 occurred within one of the greatest financial asset bull markets in history. Gold suffered a horrible cyclical bear market in 1973/1974 in its epic run from $35 to $800.
I think that there is a tremendous amount of financially driven money influencing commodity markets at present. ECRI tracks two commodity indexes – one of those that have exchange listed futures and another that do not. Those that have futures trading are up 100% as a basket year over year. Those that do not have futures trading are up just 10%.
This is reflective of the emergence of what I would call the “dumb” smart money flowing in to the “asset class” in the last 3 years. Many pension funds and endowments are now trying to replicate what Yale was doing 5-10 years ago – obviously very late to the game. They have been buying commodity index products to gain exposure. These indexes are dominated by energy – crude oil being the largest component by far.
The ag commodities and precious metals are much smaller portions of these indexes. I would expect them to get caught up as they were today in the initial stages of a commodities crash/cyclical correction, but eventually they should diverge.
I believe the long term fundamentals for ag commodities are excellent. The demographic forces in Asia and other emerging markets are powerful as their increased standards of living bring with them higher demand for protein in their diets. Stupid policies like ethanol just add gasoline to the fire. There is surely some financial buying/exposure in the space, but ag commodities are infamous for purging hot money in spectacular fashion and I suspect this period will be the same. Sugar is still at a very low inflation adjusted level…..and is down 20% in 11 days!
So in summary, I think today ushered in the beginning of what may be a vicious unwind of the “global growth” trade. Ag and gold is likely to suffer in the short/intermediate term but I believe they will diverge (particularly gold stocks) at some point. I/we have a significant position in the EEV to hedge our exposure in gold and ag which we reduced to what we’d call “core” positions last week due to our fear that they could get caught up in an unwind. Personally, I think the emerging markets are likely to lead the next downturn in the bear market – assuming that is what we are in of course.
Thank you once again for posting. Is there another blog on which you post or which you find to be particularly educational. Believe it or not, I found your posts among the more incisive I have seen in the last few months.