Monday, September 29, 2008


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

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

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

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

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
- 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

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."

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

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

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

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.

Monday, September 8, 2008

Drilled Baby, Drilled

A month ago I brought up the issue of Fannie Mae as having once been called the only stock one needs to own. Well that's come full circle now as yesterday the US government stepped in to effectively put Fannie Mae and Freddie Mac into "conservership," the equivalent of chapter 11 bankruptcy. When the first word came out on Friday that there was a bailout in the works I began to consider what the investment themes coming out of the government intervention in the private company that holds or guarantees $5.3 Trillion in mortgages in the United States would be.

By last night when the final announcement was made, I was no nearer to really having my finger on it. Two things were clear from the beginning. Being a huge net debtor to overseas lenders (i.e. China, Japan etc) we were likely not calling the tune. As our nation has gotten into ever deeper debt we can expect the cost exacted in times of crisis will increase. It would not do to bite the hand that feeds us, so Fannie Mae bonds will remain intact. If you happened to own the stock, you've been "drilled baby drilled!"

To let the bond holders go down would have been a global meltdown the likes of which no one has seen in this country perhaps ever. Every bank who writes a mortgage and subsequently sold the mortgage to Fannie Mae in return for a Fannie Mae note would have dissolved in a pool of lost capital. So that was never in the cards. Some institutions do hold FNM equity and they will be punished for their judgement.

Secondly, what about other financial institutions in trouble. Now that the government has established a willingness to bail out troubled institutions what next?
Bear Sterns; Fannie Mae .....obviously if you are among the troubled banks the helping hand will be the kiss of death, at least to owners. However the moral hazard created by government intervention is significant.

Several years ago our hefty labrador retriever discovered an untended sixteen pound Honey Baked spiral cut ham in the kitchen. I found the gold foil on the kitchen floor and Ruth on the basement floor where she stayed for the rest of the day and the better part of the next. The nationalization of Fannie Mae and Freddie Mac is likewise a very big meal to digest and the markets may well have a similar glazed look for sometime to come. If we look at the market response to the action thus far we see the most troubled financial institutions down (fnm -90%, leh -12%, wm -4%) but the beneficiaries of decreasing risk from housing debt up (home depot 5%, citigroup 7%, JP Morgan 5%) I think we will have more trouble digesting this and for a lot longer time than Ruth and her ham and the consequences more far reaching. As the economy continues to weaken, the line of companies, all important to the national health, with their hands out will lengthen. Ford, General Motors, Airlines? No good options exist.

And don't think this budget buster won't have political implications as taxpayers just put up $200 billion into the pot, not to mention another billion to the nation of Georgia to poke Vladimir Putin in the eye. We can't afford WHAT?! Looks to me like we can afford anything!

John Barnyak

Friday, September 5, 2008

The Sky is Falling....

On days like this when the market dives 400 pts and then recovers all of it in a matter of minutes, brewing a cup of herbal tea is as good a response as any. It gives us a calmer set of nerves when they are anything but.

Looking back over the past few months I can say we've been both right and wrong on a few things. Below are excerpts from last quarters letter to clients written at the beginning of July.

The money center banks and investment banks have created their own demise by retaining highly leveraged, illiquid low quality assets from the subprime mortgage market boom. Even worse, these investments are often off balance sheet and provide shareholders very little in the way of visibility regarding their value. As far as I am concerned these assets are marked to myth. In other words the banks are still unwilling write off the assets to the full extent necessary to reflect an accurate market valuation.

This head in the sand approach is understandable. It is likely that if the valuations were accurate, a number of large and important banks could fail. (Indymac following within days)

There are various signs that the stock market is entering a bottoming phase, but how long it will take is anyone's guess. I believe that a 50% retracement of the past five year bull market will be a technical support level worth considering. (that level is about 5% lower than today's low) We are seeing even shares of companies in leading sectors such as steel, coal and materials being sold agressively. (US Steel -40%; Consol coal -46% since July 1) Bear markets begin to find their bottoms when, "they start shooting the generals." The erosion of leading sectors is indicative of market capitulation when nothing is immune to sale. Unfortunately, the fundamental seeds of the next bull market such as seen in July 2002 are not yet apparent.

Having spent nearly twenty years in the commodities markets the current conditions have the scent of a last hurrah. In jargon terms it feels like everyone is, "talking their book." That means all those making their views known have already taken their positions and are now vigorously arguing to support them. Goldman Sachs calling for $200 oil logically means they have made their bets already and hope all the latecomers will help them make their earlier investments profitable. Those calling for higher prices likely long ago made their buys. In my time in commodities I never saw a recession that did not take commodity prices considerably lower. As such I will be reducing commodity allocations in portfolios. It is entirely likely there is still more upside left, but the risk has risen out of balance with the reward. (Crude Oil since early July -28%)

Where have we gone wrong? In mid July we began buying Index Funds which followed with about a 8% bounce, that has now largely been given back. In general our error has been largely one of sentiment as July technical indicators became extremely oversold. I admit to an uncharacteristic burst of optimism in this market which has been whittled away. The primary question now is no longer how bad is it, but rather have the markets priced in the remaining bad news.

One of the caveats I see in my moments of irrational exhuberance is that the market has never performed well during a recession. If indeed we are heading into a recession it seems at best we have priced in the recession but still no recovery in sight on the other side.

The outlook as far as I can see is for continued malaise. The fundamental issues that buoy markets and economies are reeling because of the credit crisis. Digging out of the problems will be neither easy or quick and I expect alternating moments of despair and hope as new shoes drop and new solutions are rolled out. It is not a standard cyclical economy when it looks likely that central banks actions of two decades may well have to be unwound without causing a global meltdown. I have faith that it can be done, but not painlessly.

John Barnyak