Friday, December 19, 2008

A New Bubble

Our economy does not seem to be able to get out of the habit of lurching from one bubble to the next. This, "nothing succeeds like excess," approach makes life difficult in the transitions. We had Technology, Real Estate and now US Government bonds are entering bubblelonia. When a bond fund such as the iShares ETF which tracks the long term bond market moves upward 30% in five weeks, it gets my attention.

How long will investors or even sovereign nations be willing to accept 30 year yields of 2 1/2%? I suspect not very long. Putting money in a mattress is not a long term global strategy if one assumes commerce has a future.

The TIPS market (Treasury Inflation Protected Securities) is discounting five years of deflation. Tax-Free, pre-refunded municipal bonds backed by the US Government are paying returns higher than treasury bonds and without tax. The spread (interest rates over treasuries) on corporate bonds is 3.5 times the average of the past forty years and at the highest levels since the depression.

A little perspective is in order. During the Great Depression, when the United States gross domestic product fell 25%, the default rate on investment grade bonds was 4%. Currently the corporate bond market is discounting (allowing for) a 30% default rate.

The Fed's move to quantitative easing and purchase of debt across the quality spectrum eventually, I believe, will move into corporate debt to unclog the credit markets.

I do not presume to know when this bubble will burst. The government's need to raise $1.5 to $2 trillion in 2009 makes one expect that long dated treasury rates will continue to be under pressure....until they are not. The whisper numbers for fourth quarter GDP are around a negative 6%, so upward pressure on interest rates is not yet in sight.

It seems that fear of yet another shoe to drop is keeping flight to safety the watch word in both equity and fixed income markets. I would put myself in that camp as well. My concerns include disturbingly bad reports to come from financial companies as they incur more balance sheet impairment due to lower values on debt assets on the books. Later in the quarter I expect additional pressure on hedge funds as they open redemptions again and need to raise cash (ala Madoff) and find illiquid asset valuations, previously undisclosed, revealed in the cash raising exercise.

There is, I believe, value to be found in extremes in both bond and stock markets presently, but we should move very carefully since the tide is still going out, and we don't yet know who might still be standing naked, unrevealed, in the water.

John Barnyak
President

Slowly Slowly Catch a Monkey

I admit it, listening to the constant drone of certainty that THIS is the bottom from the media one is tempted to dream. There is an instinctual need to declare an all clear and move to more pleasant times. I THINK we MIGHT be near something approximating a buying opportunity but looking at the market action I just don't see it yet. It feels like short covering rallies followed by lack of buying interest.

The fundamental discomfort with the economy and the serious deflationary data prevents more than a tepid backdrop for buying into equities, or for that matter into automobiles, houses, plasma televisions or just about anything that requires credit or a job.

We've not seen a serious positive move over the 50 day moving average on the Dow since April Fool's Day and for all the drama of the past ninety days, the broad indices are where they were in early October. Irrationality and fear remains firmly in place and dictates caution but long term valuation provides some hopeful optimism.

The market is technically somewhat over bought and I would like to see another test of lows in an oversold condition to put a toe into the market or conversely a reasonable and understandable move above the 50 day moving average.

This weeks immediate positive reaction to the Fed move to our own zero interest rate policy (ZIRP) had me scratching my head. Since much of the demise of the markets has been led by the banks, I was puzzled how structuring interest rates in a way that is negative for banks (a flat yield curve) was cause for euphoria. Fed action created two signals for me. First the usual profitability of a, "borrow short, lend long" policy of banks has become highly compressed. Second, interest rates of essentially zero aren't a very ringing endorsement of the economy's strength.

We're looking across the valley to the next economic cycle, but the reasons to invest are all of the, "it can't get worse" variety. The clues will be in the bond market and will tell us when its safer to come out of the bunker.

John Barnyak
President

Tuesday, December 16, 2008

The Answer is the Problem

In discussions years ago when oil prices "seemed" high, I recall the first time I heard the statement that the "answer to high oil prices is high oil prices." This glib commodity traders' view of the world is the corollary of what we are now seeing, and I would say the answer to low prices will be low prices.

Eventually lower priced assets will attract new capital. The equity market is priced to provide better long term returns than we have seen in many years. Commodities are retracing to levels that have taken much of the speculative fervor out of the price. Distressed debt is priced at levels that predict armagedon in corporations. US Government debt is priced to provide zero profit in return for the security of principal. Tax Free Municipal bonds that are pre-refunded and backed by US government guarantee are yielding significantly more than taxable debt. Such inefficiencies borne of panic are the stuff that market bottoms are made of.


Most fundamentally important is not that production is altered but that behaviour is adapted. Life is a dynamic, not static endeavor whether in governance or economics. In my corporate experience, every meeting to discuss future strategy contained countless graphs and charts and they generally showed continutity, embracing the idea that the same conditions that got us to the moment were the new paradigm. Always a wrong conclusion.

As we watch dramatic policy adaptations unfurl and the markets' pricing process, the volatile but boring market of the past two months gives hope that the worst of this bear market is behind.

John Barnyak
President

Friday, December 12, 2008

Veal Market Ahead

I wouldn't go so far as to call this a bull market except by a purists' definition, but I am hopeful we are within reach of reasonable opportunity for long term gains.

As I have written before, aggregate corporate earnings cannot grow at a rate above that of GDP ad infinitum. There are tangential arguments with this view concerning private companies and their growth, but in a macro view, trees simply do not grow to heaven.

I have been working to test the waters with some reason and looked back to a prior moment to establish a benchmark for growth. I have used the post 1987 meltdown as that base. Taking a economic growth rate about 6% over the 125 years the market is now about fairly valued on a normalized growth rate. If Goldman Sachs new S&P earnings estimate for 2009 of $53 is right there is still the possibility of downdrafts, but investors can begin legging into positions now.

The market response to the automotive bailout refusal by the senate indicates a degree of selling exhaustion and discounting of negative news.

It's not a bull market, but could be a baby bovine.

John Barnyak
President

Slowly Turning the Ship of State (of mind)

This morning we awoke to the news that the U.S. Senate had rejected the automotive industry's pleas for a rescue package. It is difficult to imagine a more definitive and negative headline that is yet to come than "General Motors Files for Bankruptcy." Afterall, what is good for General Bullmoose is good for the USA. I think such a headline must come and should come.

Clearly the failure of the TARP package to banks has colored the attitude of enough senators that carte blanche is not in the cards this time. Who can blame them? The money provided to financial institutions as a quick fix has certainly shored up their balance sheets but as of yet done nothing to goose economic activity. Banks are not lending. Per Federal Reserve data on September 10th, banks held $2 Billion in reserves excess to requirements, essentially nothing. Two months later, November 19th data shows they have $600 Billion in excess reserves. In other words not much is moving. At least one of the two basic conditions of lending is missing apparently.

Banks must feel strong enough to lend, and they must feel their customers are strong enough to pay back the loan. Earlier this week fully one half of the issued debt of U.S. corporations is rated lower than investment grade, junk. It would seem that confidence to let much of that $600 Billion stroll out the door assured that it, plus interest, will come back is lacking still.

I have until this year been in the camp of those who felt money supply was the font of all inflation. Clearly that is only half of the picture and is the combination of money supply AND credit. Currently as money supply soars courtesy of the Fed, destruction of credit is happening even faster. Until credit flows once again we are in a net deflationary environment. The question is for investors, for how long and what do we do in the meantime.

The nation has little option now but to provide, in the public sector, fiscal stimulus. But in a note of optimism, not my generally view, if we as a nation can embrace the idea that it is not a government imposed action, but a public, national call to action we will prevail. The United States has had a history of rising to its greatest challenges. This will be one of them.

A few months ago my son said to me, "its not often I can say I've seen you be too optimistic about the market. This time you weren't pessimistic enough." Ouch! But like the ship of state, I think it is time to begin slowly turning the state of mind.
It won't be easy and the strategies slightly different but we should be looking at beginning to buy into moments of fear.

John Barnyak
President

Wednesday, December 10, 2008

It's No Wonder We Feel Sick

It's not the size of the wave, its the motion of the ocean? In this market we have both.

From 1945 through 2007 there were 49 days when the S&P 500 moved 4% or more, less than once a year on average.

Thus far in 2008, a year not yet finished, we have seen 28 days of more than 4% moves either up or down!

Is it any wonder investors have gone fetal?

John Barnyak
President

Why I Used Charts

Years ago, I was more of a technical trader. "Don't tell me what you think, tell me what you see!" The following make me wonder why I ever started to listen....

Political “Experts”

“The Federal government will not bail out lenders — because that would only make a recurrence of the problem more likely. And it is not the government’s job to bail out speculators, or those who made the decision to buy a home they knew they could never afford.” (George W. Bush, Sept 2007)

“These institutions [Fannie and Freddie] are fundamentally sound and strong. There is no reason for the kind of [stock market] reaction we’re getting.” (Christopher Dodd, Chair, Senate Banking Committee, Financial Post, July 12, 2008)

“Misery sells newspapers. Thank God the economy is not as bad as you read in the newspaper every day.” (Phil Gramm 7/10/08)

“I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing.” (Barney Frank regarding Fannie & Freddie, 2005)

“I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.” (Barney Frank regarding Fannie & Freddie, 2007)

Financial “Experts”

“Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.” (Alan Greenspan, October 2004)

“There is a chance that housing prices could fall, but its effect on the economy will be limited.” (Alan Greenspan, 2005)

“The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions …. Derivatives have permitted the unbundling of financial risks.” (Alan Greenspan, May 2005)

“I suspect that we are coming to the end of the housing downturn, as applications for new mortgages, the most important series, have flattened out…I think that the worst of this may well be over.” (Alan Greenspan, October 1, 2006)

“The market impact of the U.S. subprime mortgage fallout is largely contained and that the global economy is as strong as it has been in decades.” (Henry Paulson, January 2007)

“All the signs I look at show the housing market is at or near the bottom. The U.S. economy is very healthy and robust.” (Henry Paulson, 4/20/07)

“I’m not interested in bailing out investors, lenders and speculators.” (Henry Paulson, 3/2/08)

“At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” (Ben Bernanke during Congressional Testimony 3/2007)

“We will follow developments in the subprime market closely. However, fundamental factors—including solid growth in incomes and relatively low mortgage rates—should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.” (Ben Bernanke, 6/5/07)

“It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions.” (Ben Bernanke, 10/15/07)

“Changes in financial markets, including those that are the subject of your conference, have improved the efficiency of financial intermediation and improved our confidence in the ability of markets to absorb stress. In financial systems around the world, the capital positions of banks have improved and capital markets are becoming deeper and playing a larger role in financial intermediation. Financial innovation has improved the capacity to measure and manage risk. Risk is spread more broadly across countries and institutions.” (Timothy Geithner, May 15, 2007)

Investment “Experts”

“The worst is over.” (Warren Buffett, on Bloomberg TV, May 3, 2008)

“Sometimes, we drink the kool-aid.”(Moody’s internal email)

“It could be structured by cows and we would rate it.” (S&P internal email)

“Let’s hope we are all wealthy and retired by the time this house of cards falters.” (S&P internal memo)

“Chairman Bernanke has succeeded; the economy has been positioned on a sustainable track for manageable expansion: A Goldilocks scenario that is neither too hot nor too cold.”(MikeThomson, Financial Post, April 25, 2007)

“And I believe there will be NO FALLOUT whatsoever beyond the funds, despite the innate desire by so many people to rumor and panic the marketplace.” (Jim Cramer regarding Bear Stearns, 6/22/07)

“I am indeed sticking my neck out right here, right now… declaring emphatically that I believe the market will not revisit the panicked lows it hit on July 15, and I think anyone out there who’s waiting for that low to be breached is in for a big disappointment and [they’re] missing a great deal of upside. My bottom call isn’t gutsy. I think it’s just a smart call that all the evidence points toward. Bye, bye bear market. Say hello to the bull and don’t let the door hit you on the way out.” (Jim Cramer, August 4, 2008 – market is down 28% since then)

“The stock market is cheap on a price-earnings basis, profits are fabulous, both here and abroad, stocks are a lovely place to be. I have no idea what the S&P will be ten days from now, but I am confident it will be a lot higher ten years from now, and for most Americans, that’s what we need to think about. The subprime and private equity and hedge fund dogs may bark, but the stock market caravan moves on.” (Ben Stein, August 13, 2007 – market down 40% since then)

“The losses in the stock market since the highs of October 2007 are about 14 percent. This predicts — very roughly — a fall in corporate profits of roughly 14 percent. Yet there has never been a decline of quite that size for even one year in the postwar United States, and never more than two years of declining profits before they regained their previous peak.” (Ben Stein, January 27, 2008)

Corporate “Experts”

“We finished the year positioned better than ever to capitalize on the array of opportunities still emerging around the world as a result of what we believe are fundamental and long-term changes in how the global economy and capital markets are developing.” (Stanley O’Neal, former CEO of Merrill Lynch, January 2007)

“We deliberately raised more capital than we lost last year … we believe that will allow us to not have to go back to the equity market in the foreseeable future.” (John Thain, another former CEO of Merrill Lynch, April 8, 2008)

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (Charles Prince, former CEO of Citigroup, July 2007)

But as I do reflect on it, and I do a lot, that nobody saw this coming. S&P and Moody’s didn’t see it coming, but they simply just downgrade bonds, they don’t take hits. Bear Stearns certainly didn’t see it coming. Merrill Lynch didn’t see it coming. Nobody saw this coming. (Angelo Mozilo, former CEO of Countrywide Financial, July 2007 after he sold $138 million of stock)

I’m confident our company is in the right businesses for the long term and that our strategy of being in high growth businesses and markets, our laser focus on customer service, our expense discipline, and our commitment to strong credit risk management, will create value for our shareholders in the future. (KenThompson, former CEO of Wachovia, October 2007

John Barnyak
President
Stonehouse Asset Management

The Big Blunder

One of the smartest guys in the room is David Swensen who runs the Yale endowment and wrote a brilliant book on portfolio management some time ago. The greatest mistake I've made in this past year has been to not heed one of his dictums, or worse half of one of them.

"Bonds exhibit the most extreme misalignment of interests, as most debt issuers benefit by reducing the value of debt obligations, resulting in direct conflict between the goals of borrowers and lenders....

...Investors frequently own more fixed income than necessary to protect against hostile financial environments, leading to behaviour that undermines the fundamental purpose of holding bonds. Confronted with a larger than ideal allocation to fixed income, investment managers often seek to enhance returns by accepting credit, option, and currency risk. Although under normal circumstances, risky bonds might generate superior returns, investors face likely disappointment in times of financial stress."

Mr. Swenson pretty well nailed it in his book published in 2000. I knew that reaching for yield could end in tears and I chose to put clients into a bond fund that has long been among the best multi sector bond investors. I trusted the value of the management of the fixed income portion of porfolios at a time when market stress erupted. The credit debacle decimated the value of the Loomis Bond Fund as every variety of bond other then US Treasury issues plummeted.

The value of struggling to gain the incremental gains in yield in fixed income has been a lesson to many. There are no free lunches.

John Barnyak
President
Stonehouse Asset Management

Better in the Mattress!

Yesterday the world gave a collective vote to its view of the economy. Blah! The United States Treasury had its regular auction to borrow money. We've got lots to pay for and feed the recent largesse so borrow we must. Could it have gone better?!!? We should all be so lucky.

The Three Month T-Bill went to a negative yield. "Investors" actually paid the U.S. Government to take their money. That -0.005% yield is the the lowest since the auctions began in 1929. They actually paid more than they will get back!

It doesn't get more cautious than handing over money JUST to get it back.

If you believe that the massive global fiscal stimulus and monetary easing will fail and deflation will prevail, such such caution is warranted. It won't and irrationality is the place where long term thinking is best used.

Think ahead.

John Barnyak
President

Don't Blink

As of yesterday, we are in a bull market! Before you start throwing shoes, plates anything not nailed down, consider the definition of a bull market. A twenty percent rise, preceded by a twenty percent decline is by definition a bull market. All hail the bull. Over the past 408 trading days, this is the first moment when equity markets have risen twenty percent or more. From 10/9/2007 until 11/20/2008 we have been in a bear market. Yes it IS all a bit of bull but an instructive one nonetheless.

Consider what the market is telling us. Some of the relentless downward pressure seems to have abated. Either long term buyers are beginning to emerge or short traders are beginning to cover their positions and beginning to go to neutral if not bullish postures. Do not be certain that we have passed the bottom of this market though.

During the popping of the dot com bubble, there was a thirty percent rally ending a six month bear market on 9/21/2001. Over the next year, that thirty percent rally was followed by another thirty percent loss to a lower low; which was followed by another twenty percent gain, followed by another twenty percent retracement…..followed by yet another twenty-six percent upswing……and another eighteen percent drop. All of this was within the period from 3/3/2002 to 3/9/2003, twelve months of gut wrenching volatility. Each move would have been a full year’s result in a trending market.

But the process of bottoming is not a trending market. Market bottoms do not occur with an all-clear siren wailing. Rather they emerge, after months or even years of testing and retesting. Unfortunately such volatile swings are the domain of nimble traders, not investors. But the time to panic is past and the time to strategize is now. Investors should be returning to long term strategic allocations. Add to equities slowly aware that the end of this terrible market will be a process, not an event.

John Barnyak
President

Wednesday, November 26, 2008

Please Sir, May I Have Some More??

Much like Oliver Twist with outstretched hands holding his bowl, if there is gruel to be ladled out, there seems there are those asking for more. Give the mouse a cookie and he will ask for milk.

Clearly, in this extreme (although not unprecidented) moment in our economic history policy makers will be listening to dozens if not hundreds of requests for financial gruel. For some, the risks may be worth the reward, for others, they should be shown the door.

One such lobbying effort is coming from the Homebuilders Association. These shameless characters (lobbyists are not paid to have shame) are suggesting that in a market with an oversupply of unsold housing inventory, they should be building *more*, not less. They are asking that the U.S. taxpayer subsidize the building of unneeding housing stock in order to ....in order to what? People who cannot save enough to put a downpayment on a house need a $22,000 tax credit to do so? For those cannot afford the monthly payments, let the taxpayer subsidize interest rates for comforming mortgages lowering rates from 6% to 3%.

Sounds like a perfect hangover rememdy recommended to me once by a Russian alcoholic, drink more and more vodka. Any legislator who lets these lobbyists even buy them a lunch should be flogged.

John Barnyak
President

Tuesday, November 25, 2008

Perspective II

Each day we are fed yet another incomprehensible number

If we add in the Citi bailout, the total cost now exceeds $4.6165 trillion dollars. The current Credit Crisis bailout is now the largest outlay In American history.

Jim Bianco of Bianco Research crunched the inflation adjusted numbers. The bailout has cost more than all of these big budget government expenditures – combined:

• Marshall Plan: Cost: $12.7 billion, Inflation Adjusted Cost: $115.3 billion
• Louisiana Purchase: Cost: $15 million, Inflation Adjusted Cost: $217 billion
• Race to the Moon: Cost: $36.4 billion, Inflation Adjusted Cost: $237 billion
• S&L Crisis: Cost: $153 billion, Inflation Adjusted Cost: $256 billion
• Korean War: Cost: $54 billion, Inflation Adjusted Cost: $454 billion
• The New Deal: Cost: $32 billion (Est), Inflation Adjusted Cost: $500 billion (Est)
• Invasion of Iraq: Cost: $551b, Inflation Adjusted Cost: $597 billion
• Vietnam War: Cost: $111 billion, Inflation Adjusted Cost: $698 billion
• NASA: Cost: $416.7 billion, Inflation Adjusted Cost: $851.2 billion

TOTAL: $3.92 trillion

______________________________________________________________________

data courtesy of Bianco Research

That is $686 billion less than the cost of the credit crisis thus far.

The only single American event in history that even comes close to matching the cost of the credit crisis is World War II: Original Cost: $288 billion, Inflation Adjusted Cost: $3.6 trillion.

The credit bubbles created by public policy blunders have created the greatest economic "do-over" in history. Now we must be watchful of the law of unintended consequence as officials try desperately to right the boat. Hopefully without creating the next crisis.

John Barnyak
President

Perspective I

When in the middle of a maelstrom it is hard to catch a glimpse of where one is as the world spins past. The next few entries will try to give some perspective on a few items economic and investment in orientation.

Harvard University is renowned for having the largest endowment in existence. It provides the fuel that keeps the university the envy of the world and the font of great thinking and research by the top minds of the globe. In 1974, Harvard's endowment suffered its worst setback as it saw a 12% decline in the endowment in a very difficult economy and market. The Oil Shock was in full swing and the world saw a global recession of significant proportion.

In 1984, 2001 and 2002 the investments held by Harvard's endowment had "hiccups" as the President termed by with slight negative returns.

In 2008 the Harvard Endowment is projected to decline by 30%.

Nobody is getting out unscathed.

John Barnyak
President

Wednesday, November 19, 2008

Been There Done That

Over the past month as the market roiled and the economy slipped more decisively into recession I have listened as many have used words like, "unprecedented" and "uncharted waters." In fact it is neither. In the last decade investors have been assaulted with pronouncements of how this time it is different and how productivity and technology and countless other items have made history irrelevant. Now that the same people are trotting out the other side of the proverbial cliche' coinage it is time to consider the sources.

We have all from time to time been beguiled by a story which keeps making our own seem out of sync. We only have so much intestinal fortitude when our own theses are being assaulted by daily contradiction.

It is important at a time like this to consider what equity prices are. With so many publications and programs creating a roll the dice mentality, it is easy to forget, or even never consider, what the price of a share represents. It is the claim on a very long term cash flow of the underlying entity. Implicit is the riskless alternative investment, U.S. Government bonds, the expectation of inflation and the risk premium of the equity investment.

Each of these is of course too dynamic to pluck from the headlines as the basis of a long term investment strategy. For a long term strategy long term perspective is needed.

As emotion as well as a dismal reality take hold, it is worth stepping back to the true concept of equity ownership. There is a series of issues worth considering:

1. Equity ownership is the acceptance of risk for the prospect of greater return than in a risk free investment. Currently that risk is the lowest in decades.

2. In the present environment to consider any specific company secure from the real pressures of economic realities is a greater leap of faith than we have seen in many years. General Motors and Merrill Lynch have given a serious dose of harsh reality that is possible.

3. The capitalistic model of commerce and economic growth will endure as it has since the first souk where mercenaries traded plundered wealth for camels.

4. The first order importance is return *of* capital rather than return *on* capital.

5. We should normalize earnings to smooth out the noise of quarterly earning of the market since the focus on momentary earnings will provide a target moving too quickly to be useful. Since market earnings must track closely GDP I use GDP for historical perspective.

1790 to 2007 GDP growth was 5.30 annualized

1885 to 2007 GDP growth 5.98% Dow Industrial Average 5.01%

1932 to 2007 GDP growth 7.55% DJIA 7.38%

1949 to 2007 GDP growth 7.04 DJIA 7.69%

1991 to 2007 GDP growth 5.75 DJIA 9.85%

2003 to 2008 est GDP growth 5.11% DJIA -9.63%

As one can see GDP growth is a relatively steady event. Market performance over time tracks slightly above or below economy performance. In the multibubble era since the early 1990's the stock market delinked from the economy; a logical impossibility in the long run. Now again it has delinked although this time with the market lagging as it has quickly unwound decade long excess.

The credit bubble which began decades ago will not be dismissed easily or quickly. Having said that, the fall in the equity market in the past year have brought the valuation based on normal growth of the economy over the long term more reasonable than seen in many years.

The market action is terrible. Calling the bottom of the market is impossible. However buying a call on the future earnings of the economy at a low price makes far more sense than paying an excessively high price. We will be legging clients back in slowly over the next months and year.

John Barnyak
President

Thursday, October 23, 2008

Closer to the bottom

The most expensive investment that most people will make in their lifetime is comfort. When the herd is confirming that stocks are the way to certain wealth and security we naturally conform to that view. After the bear market of 2002 the explosion in fixed annuity sales is legendary as those burned proceeded to self immolate again with low return "safe" investments.

We are at the inflection point of change. The news media doesn't let us forget for a moment. Stunned investors don't open their statements for fear of what is within.
Even those who can say, "I told you so" are being trotted out ad nauseum into the now believing public eye.

Turn off the television, put down Time magazine and think. What did we do wrong? Why? Were they errors of analysis or errors of trust? We live in a world of never ending information flow and very little wisdom flow. It is simply the nature of our time. One does not think clearly when still gathering information no matter how useless it may be.

I too was caught in the minutae because the minutae moves markets; for a day or a week, perhaps a quarter. It is not how I see the world, but the current is strong when swimming against it and sometimes it wins.

Now to continue the metaphor a bit longer, we've dragged ourselves onto the shore breathless and a bit battered. Now the journey continues.

For all the chaos and panic in both economy and financial markets, this it the time patient investors have been waiting for. But it should be done right and coherently.

I have a friend who through the grace of dumb luck and a job change left her 401-k 100% in the Stable Value Fund offering. While others were losing ten's of thousands, she made $25. Recently she has put 10% into an S&P Index Fund. Even if the market becomes even more apocalyptic I estimate her downside risk is 3% of her portfolio if the market drops another 30%.

Create a structure and then stick to it. Get help if you need it.

John Barnyak
President

Friday, October 17, 2008

Eggheads


Among the last people listened to in the midst of investment happy talk are the academics and economists who look at economies and markets with dispassionate and skeptical eyes. It is not until their always early analysis bears fruit do they become the darlings of the media.

Noriel Roubini, Nassma Taleb, Gary Shilling are all academic economists and financial analysts. The dry arcane analysis got it right long ago. The popular gadabouts trotted out with their selective proof of events will slip beneath the waves as they always do. Jerry Bowyer who appears in the last youtube video with Mr. Shilling is a hack, but its amusing to look back on the certainty that the hack had.

Past these links in your browser to listen to some intriguing takes on the market today. The third, Gary Shilling, from early in the year is particularly prescient.

http://www.charlierose.com/shows/2008/10/14/3/a-conversation-with-nouriel-roubini

www.youtube.com/watch?v=ABXPICWjFIo

www.youtube.com/watch?v=Ewb_hqBwV4k

John Barnyak
President

Wednesday, October 15, 2008

Round 3 of a Heavyweight Fight


Every so often, when the market hits an air pocket, analysts trot out the Nikkei Index of japanese stocks and overlay it on the S&P 500. The point being that the japanese succeeded in turning a market bubble into a two decade zombie market. The reluctance of Japanese banks to write down inflated real estate assets after the 1990 collapse resulted in both a market and an economy that has alternatively sputtered and failed to regain its footing for the better part of two decades. The failure of Japanese policymakers to deal with the banking problems quickly and effectively created a dead man walking market.

Whether we have avoided the same fate is unclear, but thus far the signs are not good. I am in fact confident we will not have the "L" recession of Japan, but rather a protracted "U". Innovative, aggressive and politically unpopular solutions will be needed. Hopefully in times of extrordinary need, extrordinary people will raise to the occasion.

Several items give me serious pause. The entanglement of the economy and the credit crisis is masking the issues. It is great that the federal government gathered the banking powers that be into a room and acted like it was making fois gras by stuffing money down the throats of the John Mack and others. But stuffing a goose with grain doesn't make instant pate'.

We are clearly entering a significant recession. Today's release of the Empire State Manufacturing Survey shows clearly that more difficult times are ahead. All indicators were negative and the general business condition index dropped to a record low. The allure of thinking that unfreezing credit will avert a recession has been too strong perhaps. Phrases like, "America is on sale," and "buying opportunity of a generation," have been ringing across the airwaves. I doubt it.

The current earnings estimates for companies are already beginning to be lowered. From the current S&P 500 earnings estimate for 2008 is $77.81. As the most recent quarterly earnings come in we are seeing a significant number of companies surpassing expectations, but the same companies voiceing concern that they will be able to meet year end consensus. In other words, the fourth quarter looks like a serious drop.

The current estimate of analysts puts the S&P earnings at $104.16. On the cusp of a recession and estimates of earnings growth in 2009 of 34.2%? I take that with a grain of salt.

Clearly the financial sector will do better next year. The comparisons with bankruptcy should be pretty easy to surpass. But every other sector shows substantial growth as well. My estimate, which I believe to be hopefully conservative is $68. The historic mean P/E for the broad group is 11. In severe recessions it has troughed as low as 7.

At 11 times $68 the S&P would reach 748. At 7x, 476 we would return to the level of the mid 1990's. It sounds preposterous, but the Maestro Greenspan oversaw three successive bubbles as a result of easy monetary policy. It is not impossible the we could see the unwinding of all three. We already reached 844 for the index which is within 12% of a very reasonable long term investment level. Emotionally, the exhaustion of the past 2 weeks has created a pause. Much of the panic is out of the market but there is still plenty of opportunity for "disappointment", when expected bounces fizzle out.

The first round was the subprime mortgage crisis which emerged in all its glory a year ago. It would appear we have an understanding of the issue now, although no adequate solution has yet been provided.

The second round was the resulting credit crisis as the banking system froze and institutions stopped lending to each other. The lubricant of the capitalist system stopped flowing. The injection of capital into the banks and government guarantees of debts on new transactions should allay these fears substantially. I am not confident the capital is sufficient, but the decision was the first right one I believe.

Round three is the recession which was going to arrive in any case, but has been given a massive dose of testosterone by the credit smack down. The prospect of an average recession has receded and one of greater depth and duration looms. Unfortunately the usual remedies for an economic slowdown, i.e. interest rate policy is already exhausted. There are no bullets in that gun.

The next president will have to take a deep breath, show leadership the likes we have not seen in a generation and call upon us to decide who exactly we are as a nation.

John Barnyak
President

Tuesday, October 14, 2008

Portfolio Strategy

I believe the worst of the credit crisis is past. The trillions of dollars of liquidity, equity and loan guarantees past two days from governments around the world should stablize the financial markets.

Yesterdays nearly 1000 point advance was a welcome relief after the relentless recent negative days. Now we have to get back to reality after the very surreal events of the past month. That does NOT mean investors should begin a feeding frenzy based on the media's comments that "America is on sale." It's not.

With the melting of frozen credit facilities we can once more look at the basic issues of valuation, earnings, and longer term market action. The truth is, we were going to get to this level anyway. The credit debacle has brought the market down faster than any previous bear market including the Great Depression. This has truly been a collapse of historic proportions.

There are a number of opportunities within this crisis. Things investors should be doing in a very difficult time. It is not time to abandon long term strategies, but it may be time to clear the decks and mind.

Review portfolios for holdings that no longer make strategic sense. Individual stocks that have lost their purpose and competitive advantages in particular. Indexes and diversified funds will return to positive ground in time. Specific companies many never.

Tax strategies need to be reviewed now for yearend, but this subject is better handled in a single posting because of the many aspects it entails.

After a serious market correction, very often the new leaders in the market are not the same as the past leaders. Remember the Sun Microsystems or Corning, then we had the housing stocks like Toll Brothers, then materials stocks like US Steel, Consol Coal or Alcoa. Don't be afraid to take a very critical eye to holdings because the next winners are very likely not yet in your portfolio.

John Barnyak
President

Monday, October 13, 2008

Karl and Groucho Do Wall Street

It seems ironic that the failure of Marxism has turned in recent days to resemble the, hopefully, temporary failure of free market capitalism. For all the wailing about the impending socialism of effectively nationalizing banks and investment firm with public money if we scratch a bit deeper we find the profession of the free market to be less pure than we ever imagined.

The failure of Marxism was a failure of human character. The mortgage debacle which is at the foundation of the current financial crisis is an agent/principal conflict, a model made for character failure. The risk has been divorced from the risk creator. Even within the investment banks themselves, the complexity of the financial engineering masked risk.




In business transactions there are principals and there are agents. Principals are those who ultimately bear the responsibility as owners for either the loss or the profit. Agents, are like a real estate or stockbroker. Incentivized by the transaction, not the result. Much like the chicken and the pig at breakfast. The chicken is involved, the pig is committed. The current financial collapse was to a large result the result of too many chickens, not enough pigs.

The financial allure of transaction based compensation for so many participants in the real estate bubble created the moral hazard that one's behaviour had no consequence. The mortgage broker needed merely to sign another borrower up and send the mortgage to Countrywide for his commission. The property appraiser needed only to bump up the valuation a little to help grease the skids to move the process along. The easier the valuation, the more business would come from the happy mortgage broker. All along the line, quality was replaced by quantity. Who knew such a simple matter was the seed of such chaos?

An irresponsible freemarket sowed the seed of it's own demise. No is the time for responsible intent to right it again.

John Barnyak

We're Going to Need a Bigger Boat


I admit, I've been a little busy the past two weeks or maybe like the entire investment industry stunned by the speed and violence of the market collapse. Last week as each day brought another stunning loss in the market it reminded me of a shark attack. Shark victims often report feeling nothing but the hit, no pain. The shear historical magnitude of the past month takes on on almost academic amazement to the point you hardly notice you are being devoured.

It became increasingly clear that no one with policy power had any control or any idea of what to do. We watched as credit markets froze. Traders used to making hundreds of billion dollar trades a day reported they had made none in three weeks. Companies limped along with diminished funding options and anecdotal stories of canceled investments and diminishing economic activity spread.

Everyone searched for data that went back one hundred years rather then just twenty. Depression? Japanlike twenty year zombielike economy? I doubt either to be the case, but it takes some nerve to watch markets take entire bear market hits in a week.

Have we seen the bottom? Possibly, but there is a lot of work to do even in a well diversified portfolio. The carefully constructed non-correlated portfolio discovered in a deleveraging world, everything is correlated. Corporate Bonds, Stocks, foreign and domestic, commodities, real estate.

Open the belly of this beast and you'll find it ate just about anything.

John Barnyak
President

Wednesday, October 1, 2008

Skin in the Game



The current crisis is revealing much about the state of our nation and its polarized views of the world. All week we have heard talk of Main Street and Wall Street as if they do not coexist. Until we can address problems such as this from a more unified approach I fear it will not just be credit which is frozen, but much of the hard work of running a nation of the people.

Main Steet and Wall Street are inextricably bound in a gordian knot of shared interests. It is the benefits which have been asymetrical not the interests themselves. The increasing disparity in the benefit of economic growth does not encourage a perception of shared pain nor of shared solution. The public view that the bailout is a socialization of losses by those who would seek to keep capitalism alive only when profitable is arguable, but perception is truth.

Unless our leaders and politicians can craft a financial rescue bill that makes Joe Six Pack feel like he has skin in the game the voters will react with ugliness come November. That we are at the beginning of a lengthy period of pain is not in doubt. But let taxpayers feel like there may be shared gain and I have faith the country can come together. On the otherhand, we have hidden a war from Main Street, why not a financial crisis too?

John Barnyak

Monday, September 29, 2008

Tsunami!



No corner of the world seems safe at the moment. Banks failing in Hong Kong, being nationalized in Europe, Island, Moscow. This market is acting rather abnormally, because it is dealing with a lack of clarity and confidence. Each day there something unexpected arriving on the investors doorstep.

Every headline in the world screamed, Panic! Like a tsunami, there is nowhere to hide and the turbulence is extreme. As with every crisis often the first solutions offered are not solutions at all but rather lifeboats as one hopes to buy time until help arrives. The political crosswinds are dramatic as every solution looks worse than the next. The general population balks at the idea that taxpayer money should prop up the institutions that brought us to this point. Wall Street admits mistakes were made but insists a boat with a hole at one end still sinks at both ends. It needs to be plugged.

The financial rescue package is so flawed the failure to pass in the House was proper, but now we have financial brinksmanship as credit market seize up. The crisis will undoubtedly spread to the economy at large as the oil that lubricates the wheels of commerce, credit, dries up. Already anecdotal stories are coming out of businesses having credit facilities constrained. This will lead to impaired business activity, employment pressure and declining consumer spending. Buckle up for a recession of some depth and length.

I remain against the Paulsen plan but accept that intervention is required. Purchasing the toxic debt at opaque prices with taxpayer money will not solve the problems. The current state of insecurity in the banking system has created a situation of banks unwilling to lend to other banks as no one knows who is solvent and who is not.

The solution requires capital, but not to buy illiquid debts. That ship has sailed. The government (taxpayer) should step forward to buy preferred stock in the troubled banks, injecting the needed capital to assure solvency and transparency. It should not be business as usual as banks would need to match the capital call with private equity while cancelling dividend payments to common stock holders. This would provide the taxpayer with some benefit for our dollars in the form of a call on the equity of the institution. Restoring confidence in the solvency of banking partners MUST be paramount.

The underlying problem which started the house of cards, real estate, must then be addressed. Whether by cancelling debt of some homeowners through a forgiveness or other procedures needed to keep home value and debt in step. The current situation of value below debt level provides incentive to walk away, foreclose and create additional downward pressure on the housing market. The housing market needs to stablize.

It is unfortunate that the urgency and panicked solution offered is such a poor one. But clearly time is of the essence.

I am confident a solution will be found and that rush to judgement never provides good outcomes. The term that comes to mind it triage. One third cannot be helped and should not use limited resources when the negative outcome is already known. One third can walk an need no attention. It is the other third, the injured but survivable that needs focus.

Friday, September 26, 2008

Mushroom Hunting

Some years ago a friend of mine, feeling both pioneer spirit and the paternalistic imperative to teach his son went into survivor mode on a weekend camping trip. That included cooking up some delicious mushrooms to add to the ambience. A short while later, cell phone in hand (not THAT pioneerish) he called another friend who knows a good fungus from a bad. The conversation went something like this. "We're both sick. I think it might have been some mushrooms. What? Do they glow in the dark??? Hang on....uh, yeah they do. Hmmm...oh. Damn. Won't die, just feel like it? Oh. Gotta go....RIGHT NOW." Click

Congress for fear of the proverbial mushroom cloud being threatened (once again)by the administration is instead about to pick a toxic mushroom of its own. Barely an economist outside the investment banking world favors the bail out. Even Richard Fisher one of the Federal Reserve Bank governors has broken ranks with Ben Bernanke, his own chairman. In his words, "These are grand ideas that cannot be executed."
Paul O'Neill, Bush's former Treasury Secretary declared our president and nation's leaders, "in a panic." When asked the specific problems with the bill he replied, "Everything."

Last night the largest Savings and Loan in the country was taken over by federal regulators and within hours the FDIC had auctioned it off to J.P. Morgan which has sufficient capital to operate the bank, business as usual and did not run itself aground.
To put it in perspective, the previous largest bank failure in U.S. history was Continental Illinois in 1984 which had $40 billion in assets. WaMu had $310 billion.
The largest savings and loan in the country just quietly slipped beneath the waves. Its owners and bond owners have taken it on the chin. But it cost the taxpayers is close to zero and its depositors have been protected. True the FDIC may exhaust its insurance coffers as banks fail and the government will have to step in to top up the fund, and raise insurance premiums to banks, but its not a trillion dollars on a silver platter.

There is even suspicion in some serious circles that lending markets are freezing up as part of strategic behavior of large financial institutions about to benefit from the biggest gift in history. The stakes are huge. There will be winners and losers. Congress is about to choose for us.

Financial darwinism? Creative destruction? Call it what you will. There are enough managements who exercised proper risk management to survive and now are reaping the benefits. Warren Buffet, Bank of America, J.P. Morgan, PNC? or Washington Mutual, National City, AIG, Lehman? Who should get your money and your support?


John Barnyak
President

Thursday, September 25, 2008

Kaopectate for Cholora

Treating symptoms does not cure illness even if it feels better. Fear. Fear and Greed. It is merely a pendulum that swings from one sentiment to another. Currently fear is in charge and those who can keep their heads will pick the pockets of those who haven't. The derivative markets had provided substantial obscurity to the value of assets and congress is being asked to provide systemic salvation with information provided by Wall St. Permitting congress or conversely the Treasury Department to determine the price of these assets is fraught with combination of temptation for abuse in the investment sector and a fear of blame in Congress. Can there be a more toxic combination? It remains to be seen what the final package will look like.

There is no shortage of capital in the world. There is a shortage of capital in the risk taking banking system. Risk was mispriced substantially because of the volume incentives in banks creating the mortgage backed securities. The request of the Treasury now,is to transfer capital from taxpayers to those banks. Those who took the most risk and made the largest mistakes are about to reap the greatest benefit. Having been for a number of years sadly sceptical of the correct functioning of a perverted capitalist model we now have an opportunity to snatch back the goodness of the free market from hands of those who abused it. What are we doing instead? Fighting back with a socialization of the losses of the profligate money changers. It is bad economics and bad public policy.

Lehman Brothers declared bankruptcy last week. There was fallout certainly. I know of an innocent investor who has seen his Lehman money market funds at his brokerage account frozen. He can't withdraw it or use it for investment. If this relatively uncommon event were to multiply across the market it would have a devastating effect. This is the type of outcome that has congress white with fear.

But the Lehman Brothers bankruptcy resulted in the company being bought as a going concern by Nomura in Japan and Barclay's in Europe and the U.S. That transaction resulted in a price whereas the bailout further obscures value and forces the taxpayer to pay more than the market and be the least senior creditor. Unless the final bill includes both protection for the taxpayer as well as participation on the upside it should not be passed.

The ensuing problems to the economy will be with us for some years but I believe the solutions should be more focused rather than random and wholesale. Let me believe in the capitalist model again, balanced to prevent abuse while allowing entrepreneurial incentives to succeed as they once did. This is the opportunity to clear out the excesses of a perverted system without the clumsy hand of government intervention. It is regulation which is needed, not distortion.

John Barnyak

Wednesday, September 24, 2008

And the Winner Is....?

This morning the media gushed with the news that Warren Buffet has bought a sizable portion of Goldman Sachs. The man with the golden touch sent a sigh of reassurance through some circles. In other circles it sent calculators clicking as we all tried to figure out just what the Oracle of Omaha had actually done. It's not a bad thing that a slow, patient, important investor has thrown in with GS, but rest assured that Warren struck a hard bargain with a weak negotiating partner.

In Buffet's words "Five" billion is "a bet on brains," but his boot is firmly on the throat. First Goldman will pay a 10% dividend, or $500 million per year from after tax earnings. Nice little cash flow for WB.

Next, he has "given" Goldman the right to call (buy back) the preferred stock at a premium of 10%. So, 10% yearly dividend and 10% more if they decide things are going well enough to buy back the shares.

Finally Mr. Buffett gets warrents giving him the right to buy 44 million shares of Goldman at $115. It is now trading at 128. The value in the option market of that right is $1.5 Billion. So he really is paying $3.5 Billion and has an effective dividend rate of 14%. Sweet. What an extrordinarily generous man to say he was, "betting on brains." Over the summer Goldman Sachs bought back 1.5 million shares at $180/share. He never did say whose brains he was betting on.

John Barnyak
President

Monday, September 22, 2008

Hitting the Mule

How do you get a mule to turn at the end of a row? Simple, you shout in one ear, kick it in the leg, pull on the other ear and hit it with a 2x4. Now that you've got its attention....

Now that I've had a weekend to consider the trillion dollar 2x4 I think the so called bailout may be, as the germans say, an ungeborenes kind, an unborn child.
I also think it should be.

Disrupting the credit availability of a system run amok on credit is not something to be taken lightly. But neither is the bill for the taxpayer of astronomical proportions with nothing in return.

The Fed over the past few years has micromanaged the interest rates, investment banks have borrowed with extremely high leverage and inadequate capital and the easy mark for incrementally higher returns was the mortgage market.

Investment and pension funds desperate to increase returns above the risk free treasury note bought into belief that real estate values only go one way, up. The rewards for bundling mortgages into marketable securities became so profitable, every investment bank sought to obtain more and more of this debt. Underwriting standards evaporated.Investors worldwide clamored for the mortgage debt considered safe and many cases with the implied blessing and backing of the U.S. government.


Housing prices soared above normal ratios of equity or income to debt. The end was predictable if not in the midst of the maelstrom. Income had to catch up with debt or debt with income. We are now in the midst of debt catching up with income. Debt is being destroyed at an ever accelerating pace and this bailout is seeking to transfer the debt being destroyed to the taxpayer. Not very sporting of the AIG's and Morgan Stanley's of the world.

So now we have debtors in unaffordable homes, which are still above the long term housing equilibrium price. We have investment banks with inadequate capital and non-performing assets on the books. The government solution is to murmur the recent mantra, "mistakes were made." Responsibility without consequence just doesn't cut it.

The homeowners lulled into believing that a home is a giant atm machine refilling with cash each time the value went up, and the value never falls, are not without blame. But we live in a society of relentless marketing and what investment types call "asymetrical knowledge." Knowledge is not equal. The mortgage broker lists the reasons to borrow and the homeowner shrugs and says, "sounds good, I trust you."

And how will the government price this toxic debt it is intending to buy? If it offers the bank below market rate, there is no incentive for the bank to sell it. If offered at more than market, the taxpayer eats the difference and hopes that the value will increase enough over time to dig out of the hole.

Let them fail. Let the market buy the assets at the market price and the owners of the bank absorb the loss. It is the invisible hand of creative destruction. The market cleans itself out by taking resources away from the losers, so it creatively destroys the losing companies and reallocates resources to the winning companies. How to manage the bankruptcy of an entire system is the question.

Surely a trillion dollars can be used more effectively to bridge the abyss of personal pain. If the government must be involved a more proactive fiscal approach would surely be preferable to one that rewards the profligate risk taker. We have infrastructure needs left wanting for years. Bridges, water systems, schools. Find a way to build a trillion dollar bridge connecting national need with citizen pain. If we have to give up a trillion dollars let's find a way to give it to ourselves. Privatizing profit and nationalizing losses is a perversion of capitalism.

John Barnyak
President

Friday, September 19, 2008

Big Picture Backdrop and a Surprise

With the market getting a much needed pause from despair I am concerned as to when we get the next reality check. Hopefully this bounce will provide room for portfolio adjustment as a bear market relief rally. You only find out who's been swimming naked when the tide goes out. Today the tide came in, but the analogy is apt since it will be going out again soon enough.

There is already evidence that the economy is retrenching as the credit bubble deflated. Household debt growth fell to 1.4% in August, the lowest on record. The next step will likely be a debt decline as the U.S. consumer retools to begin a rebuilding of national savings.

Federal nondefense, noninterst spending soared to a record 14.7% of the economy and the foreign holdings of U.S. debt exceeded 15% of total debt for the first time. Fundamentally sound? I bet Senator McCain would like that sound bite back.

A view I have held for a long time and over the years repeatedly been proven wrong is that the only way out of the debt will be inflationary. Perhaps this time I'll get it right with the U.S. government (taxpayer) on the hook for possibly over one trillion dollars.

The government needs to buy time to avoid a financial and credit freeze. Its move to consider establishing a fund to buy up to $800 Billion in "failed assets" on top of $400 Billion to prop up money market funds is serious stuff. Given time it is possible that a significant portion of these assets will be disposable at a level even profitable to the US taxpayer. That remains to be seen. There were rumors that Goldman Sachs tried unsuccessfully to find raise sufficient cash to buy such assets before the government moved in. Perhaps like the private purchase of Longterm Capital assets, this could actually provide some profit. More likely this will be a deal of less than the worst fears but still substantial cost to the taxpayer.

It will be necessary for the real estate market to stabilize and begin recovery to have any hope of these bail outs being less than disasterous.

Looking past the dark abyss, opportunities will likely lie in inflation sensitive asset classes and investors may want to take a deep breath and add a child's portion real estate back into the portfolio if no longer there. If it is in the governments interest to stop the collapse of real estate you can bet they will be making a mighty effort to do so. As Collin Powell once said, "you break it, you bought it."
Come January a new administration will get a chance to see if they are any better at fixing broken things.

John Barnyak
President

Economics takes a Holiday

As we approach the election for the next president of the United States I urge all readers to consider carefully the path forward as we witness, through the financial markets, something quite remarkable. The demise of conservativism. What should now be paramount to all of us is avoiding the demise of something more basic and fundamental. Exercise your right both to speak up and to vote. Never has there been in my lifetime a more crucial moment when civil discourse and dialogue is needed amongst the citizenry. Speak up, but also listen.

Some years ago I came across a quotation from a scottish academic musing on the birth of the United States as a democracy. Alexander Tyler observed in 1787 the stages of democracy and opined that it would last about two hundred years as it progressed from stage to stage.

There are eight stages of democracy he observed:

From bondage to spiritual faith;

From spiritual faith to great courage;

From courage to liberty;

From liberty to abundance;

From abundance to complacency;

From complacency to apathy;

From apathy to dependence;

From dependence back into bondage.


Tyler and others also felt that when the majority voted themselves the power of the purse, democracy was passing its potential for greatness.

The events of this past week and the political reaction to the age of conservativism by the very powers that professed it is certainly interesting. Below are the reactions of conservatives to the results of deregulation. Massive transferrance of wealth not to the society at large, but to those who enjoyed the benefit of deregulation until it turned and collapsed beneath its own weight.

- Bear Stearns
- Economic Stimulus progam
- Housing Bailout Program
- Fannie & Freddie
- AIG
- No Short selling rules
- Fed liquidity programs (Term Lending facility, Term Auction facility)
- Money Market fund insurance program
- New RTC type program

Another observer of the events of this week sees it like this;

"If you are a fan of irony, consider this: The conservative movement has utterly hated FDR, and his New Deal programs like Medicaid, Social Security, FDIC, Fannie Mae (1938), and the SEC for nearly 80 years. And for the past 8 years, a conservative was in the White House, with a very conservative agenda. For something like 16 of the past 18 years, the conservative dominated GOP has controlled Congress. Those are the facts.

We now see that the grand experiment of deregulation has ended, and ended badly. The deregulation movement is now an historical footnote, just another interest group, and once in power they turned into socialists."

This election should not be about conservatives and liberals. It should be about a nation and its electorate projecting and protecting what we believe to be good and right about this country.

John Barnyak
President

Max Pain

The properly famous Sir John Templeton who died recently said the time to buy is at the moment of maximum pain. When is that? He never said, but I think we have been close this week. I actually put a toe in yesterday and rented some equity positions.
I say rented because I think that while the panic and chaos of this week is behind us, economic realities are still very much not about to let loose a rousing verse of "Happy Days are Here Again."

The government's decision to create JBOA (Junk Bank of America) should ease concerns that each day will bring another investment bank failure. Its regulatory prohibition on "naked short sales" in the financial sector should also create buying pressure of financial stocks.

Naked shorting is the act of selling a stock one does not own and has not borrowed. It is the flip side of buying a stock for which you have no money nor any idea of where you will get any. There are rumors that the massive short selling of financial stocks began on 9/11 in London and Dubai? Financial terrorism or just a clever trading strategy, I don't know. But when you have a house of cards, one swift kick to the foundation can have devastating effect.

The relieving the pressure of uncertainty should move the market up slightly, until the the next concern takes hold. That will, in my opinion, be driven by rising unemployment, declining consumer spending. With consumer spending at over 70% of GDP rather than the historical high 60%'s, burdensome consumer debt and tightening credit that driver of economic growth will be taking a breather for some time.

From the investment perspective, opportunities and risk will alternate in the coming years so that gauging cyclical moves correctly will be the only way to succeed in the market and remain ahead of inflation. The days of secular bull, buy and forget will be for the next generation. My father had the 50/60's, we had the 80/90's, our children will get their chance in the teen/20's.

John Barnyak

Thursday, September 18, 2008

Sifting for Positives

Just about the time an investor feels exhausted by negative market news, everyone else is too. As humans we are wired to look at our past for guidance while the market is looking toward the future. That is why fixed annuity sales soar near a market bottom and investors borrow to buy equities near the top.

Make no mistake, there are very deep concerns in the financial systems and as we head deeper into recession I doubt the market has found its point of reversal. But whether looking looking for better entry or exit points, market sentiment measurements can help keep calm frazzled nerves or nudge us into action when otherwise paralyzed.

Two of the indicators most useful are the VIX index which I have written of before and is one measure of either complacency or fear and the PUT/CALL ratio. The latter shows when, in the option trading market, everyone has gone to one side of the boat or the other.

Today the VIX hit a level approaching the levels of 9/11, during the Long Term Capital crisis and the Russian and Mexican debt meltdowns. It seems to have reversed from the earlier highs of the day and changed a 140 point Dow decline into a 410 point advance.




The PUT/CALL ratio indicator is over two standard deviations above its normal level. If the past is prologue this is not a time to panic, but rather take measured and patient action. It might be a reasonable time to take a deep breath and relax.

We are still in a decidedly downward sloping trend, with underlying problems that are moving from the financial markets to the economy of main street. I suspect the current buying will be a trading buy and also there will be better exit points for rebalancing portfolios.




Wednesday, September 17, 2008

China Syndrome

In October of 1987 I was in Guangzhou China for the once famous Canton Trade Fair. It was my first visit to China, I was on my own and the only contact I had with home was the regular sound of faxes being slipped under my hotel door throughout the night.

Early one morning I noticed seemingly everyone was agitatedly speaking on a mobile phone, still a rather rare occurance those days. Next I heard rumors that amounted to the end of the financial system as I knew it. London was plummeting, then New York, then Tokyo. Hundreds of points. I honestly wondered if anything would be left when I touched down in New York days later.

But there was.

This is a very difficult environment for investing and the I hear over and over we've never seen anything like this. What I've heard before. There is no question but that I overestimated ability of regulatory agencies and the markets to keep the genie in the bottle. The frozen credit markets are grinding the financial machinery to a halt in some cases. Additionally the value of assets on the books of various financial institutions is largely unknown. With Lehman assets bought by Barclays and AIG assets bought by the US government it is likely that the non transparent assets will be sold offered at any price until a market begins to function once more.

When this ends if an impossible question to answer.

It's Not Easy Being Green.....

No, but it's a lot easier than being red, relentlessly, repeatedly, red. In the interest of making the complex easier to understand, I found this small explanation of what is happening with the take overs or bankruptcies of three of the biggest firms on Wall Street.

• Lehman Brothers was like the little kid pulling the tail of a dog. You know the kid is going to get hurt eventually, and so no one is surprised when the dog turns around and bites the kid. But the kid only hurts himself, so no one really cares that much.

• Bear Stearns is the little pyro -- the kid who was always playing with matches. He could harm not only himself, but burns his own house down, and indeed, he could have burnt down the entire neighborhood. The Fed stepped in not to protect him, but the rest of the block.

• AIG is the kid who accidentally stumbled into a bio-tech warfare lab . . . finds all these unlabeled vials, and heads out to the playground with a handful of them jammed into his pockets.

John Barnyak

Moral Hazard and the Senator

It seems ironic to me that Senator McCain has discovered the concept of moral hazard in financial markets rather late in the game. The senator announced yesterday in a political stump speech that AIG should not be saved because of the moral hazard engendered. In a system broken by its own market forces and complexities, to wait until financial Armageddon to politically discover the dangers of moral hazard is insulting.

It is fitting that the issue should arise to the level of popular political speech writing with regard to AIG, the world largest insurance company. Insurance by definition confronts moral hazard everyday. Compensating for loss by circumstance and by extension through behavior is what insurance is about. The writing of insurance is "regulated" by a company's underwriting procedures. It is usually quite clear, or at least written, what losses will be covered and which will not be covered. In our current regulatory environment, to allow an opaque and essentially invisible financial structure to grow to the extent that failure will create catastrophe is too great a risk to accept.

The current financial crisis is significantly the result of bad information and bad incentive. The derivative market which has dwarfed the financial system's ability to absorb it has benefited from standards which permitted information to be hidden either by shear complexity or by "off balance sheet" accounting. Such arcane financial engineering as Credit Default Swaps are in danger of taking both Wall Street and Main Street to its knees.

The compensation structure of the industry is focused on short term result and performance metrics based on short term measurement. When behaviour has no need to address long term costs it creates a "take the money and run" environment.

The establishment of standards which will enhance clarity and disincentivize gambling in lieu of investment behavior is not an act of anti-capitalism. It is the stuff of preserving social and financial infrastructure for the nation and citizens for years and generations to come.

As I mentioned earlier this week AIG would not be allowed to fail. It could not be allowed to fail. It was a teetering domino in a line of far too many dominos covering the globe. So now the taxpayers own it. It should have never had to happen.

John Barnyak

A Trillion Here a Trillion There

Everett Dirkson, the powerful Illinois senator of the fifties and sixties is credited with the quote, "a billion here, a billion there and pretty soon you're talking about real money." Times change, or at least the numbers get bigger.

The loss of value over the past year in the financial sector of the US economy has now passed the trillion dollar mark, real money for shareholders and the nation. The link below to this week's New York Times article has a great interactive visual of how much and from where the losses have occurred.


www.nytimes.com/interactive/2008/09/15/business/20080916-treemap-graphic.html"

Citibank has been surpassed by Bank of America as the largest financial institution in the country. Household names have disappeared and it's going to be a long road back. When a problem isn't understood, it is difficult to solve, and derivatives have made this problem too complex for even experts to understand.

John Barnyak

Tuesday, September 16, 2008

When will it stop?

Back in 2000 the chief strategist for one of the now last remaining major investment firms stated we were entering a long term flat equity market. He was one of the few who pleaded with the brokers to get their clients out of technology investments in 2000 and was always measured, rational and pragmatic in his advice. That advice has kept me fairly ambivilent to the market for the past eight years.

At the moment the investment markets are the only news and presidential candidates are working hard to appear knowledgable while media pundits put on brave but excited faces. I don't like excitement in investing. It clouds judgement. In the interest of stepping back, let's examine the longer term markets of the past one hundred years. That should be enough to flatten out the specific market moving events and focus on longer term.

I've used the Dow Industrials average as the benchmark because the S&P did not exist back far enough. The readers can reach their own conclusions as far as appropriate strategies if history is any guide.

In the past century there have been three complete bear markets and three secular bull markets. Market cycles are like bubbles, you don't know you are in one until it is over often. Secular Markets are the result of longer term underlying economic conditions unlike cyclical markets which are of shorter duration and occur within the longer term theme.



Secular Bear Markets vs Secular Bull Markets and Dow Performance

Secular Bear_____ Duration_____ Avg Yearly
Markets_______ (Years)_____ Return
1906-1921_____ 16 ________ 1.58%
1929-1949_____ 21 ________ 1.69%
1966-1982_____ 17 ________ 1.59%
2000-2008???____ 9 ________ <0.6%>

Secular Bull Markets
1922-1928______________7 year_____ 17.20
1950-1965_____________16 year_____10.60%
1983-1999__________ 17 year_______ 15.30%

Were the equity markets to begin a new long term bull market it would mark the shortest secular bear market in a century. With interest rate declines the single most important impetus for for market valuation, the current low level of interest rates do not provide a catalyst in the immediate future.


Low levels of savings, asset devaluation and financial under capitalization issues also do not indicate the factors to fuel a longer bull market are in place. Individuals are going to have to be more flexible in investing and more diligent in savings to attain the future goals that investment and real estate markets once passively and effortlessly provided.

John Barnyak

Imelda Marcos Market

Years ago the philippine president's wife Imelda Marcos was known for her ostentatious extensive shoe collection, one thousand-sixty pair by her admission. How many shoes are there to drop before we reach the capitulation point?

Some of the moments when we heard the worst is behind us are distant memories. The large write downs of Citibank and Merrill Lynch were the bottom. Then the demise of the largest mortgage broker, Countrywide, was the moment we hit bottom. No, wait, Bear Sterns imploded and had a shotgun wedding with Chase. All clear? Not quite.

IndyMac, the second largest savings and loan expired under the weight of its agressive mortgage business in July.

The stock that Money Magazine touted a few years ago as the "only stock you need to own" was taken into conservership by the US government. Fannie Mae and Freddie Mac, the cornerstones of the mortgage market collapses. Lest our international lenders lose hundreds of billions of dollars and close their lending facilities to the United States, they were bailed out at taxpayer expense.

Lehman Brothers, the 158 year old investment bank having read one of those bottoms as the all clear bought heavily in the mortgage market to make anticipated profits on the rebound. Lehman acting like a retail investor tried to call the bottom. It went elephant hunting and got crushed for the effort. Having weathered wars and depressions for a century and a half, it couldn't handle today's pummelling.

Merrill Lynch prempted its own demise by throwing itself into the arms of Bank of America and got married faster than a pregnant Alaskan seventeen year old.

AIG, the world's largest insurer has tin cup in hand and looking for $70 Billion by tomorrow. I believe AIG will not be allowed to fail. The derivative exposure across the world with entities such as PIMCO ($760 million) and AXA would have a knock on effect due to debt guarantees

The largest Saving and Loan, Washington Mutual, looks to be next unless a suitor steps up. IndyMac was the largest bank failure since the savings and loan crisis of the seventies. WaMu is ten times larger.

I am watching for signs of selling exhaustion as markets are getting a little punch drunk.

John Barnyak

Monday, September 15, 2008

Shooting Bears

Turning on CNBC last night was inadvertant. I was looking for the football game, unaware that my dear mother's clock is forty-minutes fast. Clicking through the channels, I heard the words, "Merrill Lynch gone. That was unexpected." Whoa! Across the bottom, "Lehman brothers discussion fail. Bankruptcy filing expected tomorrow" Whoa! The Steelers game would wait.

Since then I have been seeking to turn the "whoa" into something more dispassionate than throwing dice. Obviously these are remarkable changes. One hundred-fifty year old institutions don't disappear everyday. A brokerage house that holds $1.6 Trillion in client assets doesn't simply go away without a pretty good (or bad) reason. It is very easy to panic. But what has been the market reaction to this as per the broad S&P 500 index?

Over the past week, the index is down less than 2%, and is dead even from a month ago. Obviously accumulating equities against the trend is not a profitable endeavor, but it does show there are still long side trading opportunities for the nimble. In our management of investments rather than trading this is a call for patience until the market shows us the way up and a more ambitious strategy is called for.

The chart below shows the S&P 500 on the bottom half, and the VIX index on the top half. Whenever the VIX spiked above 30, there was a tradable bounce, although not an investable buy, yet. I will be looking for a break out of the downtrend before making additional long investments and using the using the lower VIX readings to pull pull back on long positions if still in the downtrend.

Storm Before the Calm?

As I sit and watch the markets in Tokyo, London, Frankfurt slipping lower in response to the extrordinary events of yesterday I admit it's going to take a while to digest. Merrill-Lynch? gone Lehman Brothers, gone. AIG teetering. Washington Mutual likely to disappear. The Fed taking unprecedented actions that are by its founding mandate, illegal.

The only person I know of who understands all of it is the fellow I overheard last Friday night at an art gallery opening. He was apparently a banker from some comments I heard. "This mortgage crisis is all hype from the news media. It's not that bad."
My wife was showing her paintings in the gallery so I stifled my, "are you out of your fricken mind?!", and said, "nice color in this one don't you think?"

The Fed has made some unprecedented moves that would only be made if they have looked into a very dark abyss and are urgently trying to figure out how to cross it. Much like the Long Term Capital crisis in 1998, a group of banks have put up $70 Billion of liquidity for a borrowing fund for brokerages to tap. The Fed has said it will accept equity collateral for direct loans to investment banks. (Illegal, but they can sort that out later.) Commercial banks can now extend liquid funds to their brokerage affiliates, contrary to the Federal Reserve Act of 1933.

It now appears that the entire broker-dealer model is broken. The ability of brokerage subsidiaries to acquire federally funded liquidity from their commericial bank parent companies puts the last to remaining serious brokers at a disadvantage. I expect Morgan Stanley and Goldman Sachs are in serious discussions to merge into a major banking entity.

In moments of uncertainty there is always turmoil and error, just as in moments of certainty there is turmoil and error. On this most confused day keeping a steady hand on the tiller is crucial and look rather than think.

John Barnyak
President

Thursday, September 11, 2008

Secular, cyclical or just a throw rug?



If a small strange woman with a Fargo twang can deal with a bear, so can calm investors.

Yesterday as I wrote about the disconnect between the market and the economy in the short term I recalled one the the most interesting articles I've read some years ago which put that fact into perspective. Despite the idea that hatched in the 1990's and seemed to find its way back to popular conventional wisdom, the stock market is not a steady climb to heaven. In fact the alternating longer term (secular) bull and bear cycles tend to be the better part of a generation long. I believe we are midway into one of those long hiatuses.

The animal spirits that can hardly be held back during the times of investment plenty can bearly be roused in the times of dormancy. Interestingly enough there is little direct correlation between the nations economic growth and the market's performance.

If one looks closely at the period from the end of 1964 until the end of 1981, the Dow Industrial Index in that seventeen year period gained the princely sum of less than one single point, exactly 1/10th of 1%. Try retiring on that growth or putting a child through college without saving. During that time, the United States Gross Domestic Product (GDP) grew 373%.

Fast forward to the next seventeen year period, from the end of 1981 to the end of 1998. During that span the Dow Average advanced 8306 points, 949%, while the economy grew half as fast, 177%. Everyone's retirement and college educations looked pretty secure for those who hadn't gone into hibernation earlier.

The nearly ten years beginning at the end of 1998 haven't been quite as bad, with a gain of 24% or 2.4% per year, although all of the gain actually came in the first year of the period.

There will be periods that present opportunities for investment gains but it is going to take a little work. Neither throwing darts nor throwing one's hands in the air will help.



What We See Technically

Since I've railed against being blindsided by fundamentals let's have a look at the visual aids of the markets.

Recently I have bought exchange traded funds (ETF) tracking broad equity indexes particularly the Nasdaq. In the spirit of the political season, I have to say, I was up before I was down. Below is the chart of the Nasdaq Composite index.

As you can see, we are clinging to the long term uptrend, but clearly in an intermediate downtrend. When indicators of market sentiment became historically extreme in July we bought entry positions in the index. Additionally the mysterious Fibonacci 38.2% retracement support is near at hand. Three times the Nasdaq has touched this level and held. Because technology stocks are at relatively attractive valuations we have chosen to put a toe in the water here.

Looking at the upper limits of the recent market cycles, one can see the high points have been lower with each cycle. Technically speaking this is not a good pattern and although we bought on the support we will not be adding to positions without more positive market action.



The yellow line represents the bull market which ran from 2002 until 2007 and took the Nasdaq higher by 158%. The green horizontal line is the 38% Fibbonacci retracement level at which I believe there is a reasonable strategic purchase. The average bear market runs about 10 months and with an average 25% loss. We are now at 10 months and 25% on the Nasdaq. Until earnings start to show improvement this could be a longer bear market but during 2009 I expect the market to begin looking across the abyss.

John Barnyak
President

Is It Any Wonder?!

I have no illusions that "guessing" the next market move is easy. Lord knows, I've been wrong often enough to have earned the gray hair. But sometimes I wonder what the collective geniuses on Wall Street are thinking. In my time at one of the major investment houses I saw some things that made me furious. Analysts going silent when clearly a sell recommendation was in order, the trading desk working the other side of a recommended BUY. I shall remember forever the words of the New York exec who told me, "we wear a lot of hats," when I asked why the company was going massively short a stock the retail side was recommending highly to clients.

Yesterday Argus Research downgraded Lehman Brothers to "HOLD" after elevating it to "BUY" on March 27, 2008. It was a buy at $40/share. It is now a "HOLD" at 9. (I give them some credit as it now trades at $4/sh since the downgrade yesterday.)

The past years are littered with BUY recommendations on Worldcom, Tyco, Countrywide, Lehman Bros and many others. The point is much like I wrote a couple weeks ago, "don't tell me what you think, tell me what you see". The analysts who make these recommendations are among the brightest people in the land and frankly often don't have a clue. So diversify, diversify, diversify. If you got Microsoft right one day years ago, or made a fortune in Pfizer once upon a time, get over it. There is another Freemarkets with your name on it out there.

Try to watch the interest rate developments and diversify across low correlation assets classes and leave the individual stock picking to other geniuses unless, you just love to roll the dice. And don't forget, if you got it wrong, don't average down. You're probably didn't get smarter and you're probably still wrong. Even the Morgan Stanley analyst who said, "I liked it at 50, I really liked it at 30 and you have to love it at 20" needs a dope slap sometimes. He gave up at about $2/sh on a stock now in the bin of history.

John Barnyak
President

Wednesday, September 10, 2008

Its only partly the economy stupid

Each day we get a steady diet of disembodied economic data. Inflation is up, unemployment is up, GDP is up. From this constant drone of economic news scrolling across the bottom of the television screen many of us try to intrepret all this information into an investment theme. Depending on our emotional constitution that might be, "it can't go lower," "it's hopeless, get out," or "to the moon alice!"

In fact that economic news is only half the story. Valuation is the other half. The global economy will always grow. Sometimes fast, sometimes slow, but world economic growth only very rarely grinds to a halt, and then for a very short time.

When determining an investment strategy don't look for the answer in the economic data alone. Consider how much the market is charging for future earnings and be dispassionate.

Below are two charts to exhibit the fact that the market and the economy don't always move in lockstep.

The first is the annual growth of China's GDP from 2003 - 2008. The second is the Shanghai Stock Exchange index from 2006 to 2008. As the economy in China continues to grow strongly, the market "slipped" 60%.



Painted Into A Corner

The Fannie Mae and Freddie Mac debacle is alternatively hailed as a masterful financial operation, a gun held to the head of the american taxpayer, the result of government intervention in the first place, or the advent of pure american socialism. There is something for everyone in the analyses being offered. To me the issues cut very deeply into the heart of this country's self perception and we best listen carefully to the messages.

The Government Sponsored Enterprises (GSE's) were put in place to enhance the flow of credit to targeted sectors of the economy. Housing, Agriculture and Education were the three areas originally focused on, but education was removed in 1995. In my opinion the one most forward looking for the nation was relinquished. Housing is by far the largest of the GSE's through Fannie Mae, Freddie Mac and the Twelve Federal Home Loan Banks.

In past years we have heard much of the "ownership society." With the encouragement of sloppy central bank policy it became the debt society as individuals acted rationally and borrowed, leveraged, speculated, and lied their way into what they were told time again was the American Dream. Throw in some extra institutional greed as the profits offered by securitizing the billions and billions of mortgage debt and we're ripe.

Every civilized society has concepts of ownership, but also that ownership is earned in some way, not stolen and free market forces should eliminate the "free lunch." The credit bubble that has ensued over the past decade made the lunch look free. Borrowing at 5% with 10%+ annual appreciation in value, make the gain tax free, give a tax deduction for the interest paid and welcome to America's 21st century version of tulip mania. Add a profit motive to coerce and cajol even the least credit worthy into the game, package the loan as a U.S. Government sponsored bond paying better interest rates and every yield hungry pension fund, hedgefund and sovereign wealth fund on the planet lined up at the buffet table. If you had any cajones at all you leveraged it 30:1 and cracked a bottle of Dom Perignon regularly. That is until the law of ever rising residential real estate values was repealed.

The discussion of whether the government should or should not have stepped in with what will end up being over $100 Billion in taxpayer cash is moot. They did. They had to. As the greatest debtor nation in the world, with an insatiable appetite for consumption and no national savings, we live by the willingness of others around the world to trade their savings for our investment paper. After years of at least giving the impression that Fannie Mae paper was "nearly" as good as Treasury bonds to let the institutions fail and take the sizable investments of our creditors like China, Japan, Singapore, Germany and so on fall into a worthless abyss would have taken our word as our bond right with it. When you are an addict, you need that fix.

During the recent political conventions I heard the phrase "addicted to oil," repeatedly and wondered why no one mentioned that oil is small potatoes compared to our addiction to spending beyond our national means. A trillion here, a trillion there, pretty soon it adds up to real money. Given the pervasive problems facing the financial system it is likely there are more shoes to drop and doubtful the political will to offer much more taxpayer money into the hopper.