Creative Accountants

For years a famous line from Shakespeare's historical play King Henry VI has been usefully been taken out of context. I confess I have enjoyed twisting its original meaning to support an argument. The intent of that line was to state that without guardians of independent thinking chaos would ensue and the speaker, Jack Cade, pretender to the throne would like just that. But, "the first thing we do, let's kill all the lawyers".

Today's reading of the independent review of the Lehman Brothers bankruptcy brought those words to mind with a small twist. "Let's kill all the accountants!" The report on the event and the factors leading up to it does not put their accountants, Ernst and Young in a very favorable light. In fact it seems to me that E&Y is in danger of following Arthur Anderson into the sunset as they did post Enron.

E&Y was culpable of non disclosure of material information about the balance sheet. They were aware of and chose to remain silent on creative accounting by Lehman. If Enron was enough to take AA down, Lehman is much bigger. With E&Y's knowledge Lehman was moving tens of billions of assets off the balance sheet in a overnight cash transaction intended solely to give the appearance of greater liquidity than existed at quarter end. "Repo 105" was intended to do one thing, deceive shareholders and creditors into keeping faith in Lehman's solvency. Ernst and Young signed off on the financials as true and accurate representations of the state of Lehman's financial state. They knew that to be untrue as billions of dollars assets left and billions in cash came in overnight to tart up the books.

From Enron to Parmalat to Lehman it appears when push comes to shove outside accountants provide no value. Management generally dislikes the cost of outside audits running into the millions of dollars and investors receive no value in terms of adequate and honest disclosure of the state of a company. Let the vested interests outside of the company provide the audit function because those on the inside are sitting at the table with the dealer they have chosen. The rest of us? If you can't tell who the sucker is at the table, it's you.

John Barnyak
President

Poof it's gone!

What's in Your Wallet?

Based on surveys by the American Association of Individual Investors (AAII) and the Investment Company Institute (ICI) the answer to the above question is either, still a little, or not much. The AAII surveys individual investors who have been less convinced that the coast is clear or are still licking their wounds from 2008. That group is currently sitting with a liquidity stash that is just about in the middle of the range as far as % allocation to cash. In other words neither dramatically excessively liquid or illiquid. As each uptick pains the remaining cash off the sidelines the upside is limited as is the downside risk at the moment. My concern with the data is that the time frame is again limited to the period beginning only with the 1980's when a new secular bull market was evolving


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On the institutional side of things, as surveyed by the ICI tells a slightly different story, but consistent with the theme of the past year of institutions in the market and individuals out. Portfolio managers have been so worried about missing up moves in the market and thereby lagging their benchmarks they have decreased cash holdings to less than 4% from nearly 6% last year. This is the largest decline in 19 years. It does beg the question of how much the thumb of government was on the scale in 2009. This cash level ties for the lowest level of cash in twenty years, matching the levels of 2007 before the markets turned southward. Conversely corporate bond fund managers are holding cash positions at the high end of the range of the past two decades.



Government liquidity goosed the market last year in 2009. Where will liquidity come from this year as the government faces strong resistance to further deficit spending?

John Barnyak
President

No Harm No Foul...no gain

While the 80's and 90's were "mainlining" stock market investments, the 00's have been mid-lining those indexes. A period of at best, consolidation is in the stars.

John Barnyak
President

Much ado about nothing

If we look back twelve years to the first financial industry bailout, Long Term Capital Management (LTCM), it really is quite like Disney's Magic Mountain. Full of swoops and climbs but getting out pretty much exactly where we started.

Dave Rosenberg of Gluskin Sheff makes the following points with a 30,000 ft perspective on the markets. When we look at the last 12 years, dating back to LTCM and the bailout that ensued, we have endured a 60% rally, followed by a 50% selloff, followed by a 100% rally, followed by a 60% selloff, followed by a 70% rally. Over 12 years the Dow is up about 10 percent, or less than one percent per year. But wasn't it fun to celebrate and commiserate and pontificate for the last decade?

The equity market is basically flat for a buy-and-hold investor. The really important lesson though is that this is a great case for active portfolio management, also a lesson that investors will not lose out by going long after a 50% collapse from the high; nor are they likely to feel much pain from selling into a 70% rally from the low. Chasing performance at this juncture is probably unwise.

John Barnyak
President

All the Way Baby!

One of the things I noted early in my career, at the time with a large natural resources company, was that graphs tended to go in one direction. If the market was poor it was forecast to go down continually, if it was good it went to heaven. Being optimists with billion dollar investments, when it was beginning to turn down, it was forecast to bounce back shortly.

Investment professionals are no different. There is a habit of expectations based on the extrapolation of the short term past. The fact that those extrapolations are at odds with historical relationships often is dismissed.

Over the past thirteen years, the S&P 500 has underperformed Treasury bills. "Investors" ignored valuations in the late 90's and let them again rise to unsustainable levels in 2004-2007. Unfortunately we are again at a high valuation.

As the accounting standards has gotten more stringent, we should begin to see with greater clarity the true state of corporate affairs in the banking sector. This greater clarity should make investment decisions more rational.

Stay tuned the next couple months are critical although I expect policymakers to continue to kick the can down the road to avoid dealing with the issues.

John Barnyak

A Sacred Cow

I confess I have been waiting for the first mainstream rumblings to arise about the issue of home ownership in the U.S. Certainly for as long as we can remember the home as castle has permeated the psyche of Americans. I think Professor Shiller's editorial in yesterday's NY Times may be the edge of the wedge for a future national debate. I personally doubt that the mortgage deduction, long taken for granted will survive. The subsidization of home purchases provided through taxes has been a trickle up affair from renters to more affluent homeowners. It should be a long and heated battle.

What say the readers?

John Barnyak
Stonehouse Asset Management

Mom, Apple Pie and Mortgages

By ROBERT J. SHILLER

Published: March 5, 2010

FOR decades, the federal government has subsidized housing — particularly owner-occupied housing. This has been especially true during the continuing financial crisis, with Fannie Mae, Freddie Mac and the Federal Housing Administration propping up the housing market by issuing guarantees for investors on most new mortgages.

But what is the long-term justification for putting taxpayers on the line to subsidize homeownership? Is this nothing more than a sacred cow in American society — a political necessity because so many voters own homes and are mindful of their resale value?

In fact, there is much more to the history of subsidizing housing. While the crisis in the housing market shows that our current approach is far from perfect, there is a certain wisdom behind it, related not only to economic stimulus but also to the preservation of a sense of national identity. It’s important to remember this as we consider re-engineering our institutions as the crisis ebbs.

Federal subsidies for housing essentially began in the Great Depression with, among other things, the creation of the F.H.A. in 1934 and Fannie Mae in 1938. It all started for a simple reason: more than a third of all the unemployed were identified, directly or indirectly, with the building trades. At the time, there seemed to be no way to reduce unemployment without stimulating housing, and much the same is true today.

But consider what will happen once the economy is again operating at full capacity. Basic economics tells us that when Americans, over all, spend more on housing, they must ultimately spend less on something else. Why should housing consumption be better than other consumption, or investments that people might choose?

This time, the best answer isn’t found in traditional economics but rather in American culture: a long-standing feeling that owning homes in healthy communities is connected to individual liberties that embody our national identity. Historically, homeownership has been associated with freedom, while renting — often in tenements or mill villages — has been linked to the oppression of a landlord.

In his classic 1985 book, “Crabgrass Frontier,” Kenneth T. Jackson of Columbia University delineated the complex train of thought that over the last two centuries has produced the American belief that homeownership encourages pride and good citizenship and, ultimately, preservation of liberty. These attitudes are enduring.

Back in 1899, in “The Theory of the Leisure Class,” Thorstein Veblen described homeownership, particularly of large and expensive dwellings, as “conspicuous consumption.” By that, he meant that it was undertaken substantially for the purpose of impressing others by showing the amount of money one can afford to waste on space one doesn’t need.

What is specifically American here — though it’s increasingly seen in other countries, too — may be the modern sense of equal citizenship, engendered by the illusion that we can sustain conspicuous housing consumption even among a majority of the people.

In short, this all has a great deal to do with culture, and little to do with financial wisdom. After all, financial theory suggests that people should not own their own homes, at least not in the way that many do today. A cardinal tenet is that people should diversify — meaning they shouldn’t put nearly all of their financial eggs in one basket, which is what homeownership now means for so many people.

American mortgage institutions encourage people to take a leveraged position in the real estate market, which is quite risky because home prices can and do decline, as we have learned so painfully. Leverage a risky investment 10 to 1 and you can expect trouble — and we have plenty of it today. More than 16 million homeowners owe more on their mortgages than their homes are worth, according to Mark Zandi of Economy.com.

If we choose to keep subsidizing individual homeownership, we must also commit to adding safeguards so that homeowners are less financially vulnerable. Of course, that will require some creative finance.

But first, we should rethink the idea of renting, which could be a viable option for many more Americans and needn’t endanger the traditional values of individual liberty and good citizenship.

Switzerland, for example, is a country with strong patriotism, a fighting spirit of national defense, a commitment to freedom and tolerance, and a low crime rate. Yet its homeownership rate is just 34.6 percent, versus 66.2 percent for the United States, according to the two countries’ 2000 censuses.

Swiss national identity doesn’t depend on homeownership. Instead, Riccarda Torriani, a historian at the Swiss Federal Department of Foreign Affairs, links the country’s sense of identity to such things as its system of direct democracy, which enforces popular participation in government; the idea that its citizens are frontier people (living in or near the rugged Alps); and a history of collective courage in defense of freedom, even when outnumbered.

BUT America isn’t Switzerland. Our values and habits of thought are very different. Moreover, our homes are largely scattered in vast suburbs, often with distinct features. If many of these homes needed to be converted to rental units, home prices might well drop.

A stock of apartment buildings in central cities, of course, makes rental management much easier. This is true in Switzerland, as well as in American cities like New York, which aren’t typical of the rest of the United States. We need to consider a gradual transition toward new kinds of housing finance institutions — entities that may lead us to a different kind of housing, yet preserve our core values. Although such innovation isn’t likely to end subsidies, it should refocus them on enhancing the qualities of life that we really value.

We need to invent financial institutions that take into account the kinds of communities we want to build. And we need to base this innovation on an approach to economics that captures the richness of human experience — and not on efficient-market economics, which disregards human psychology and assumes that our basic institutions are already perfect.

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.

From GARP to SIRP

With so much of the economy's health and direction dependent on people actually working, buying and paying taxes, it remains difficult to get too excited about our prospects.

This morning the headline was that layoff data for February reached a four year low. According to the Challenger analysis layoff announcements fell to 42,090 for the month. The ADP report showed job losses of 20,000 but government numbers released on Friday will likely be somewhat worse because of the methodology. ADP counts employees who worked no hours during the survey week as employed while the Bureau of Labor Statistics counts non-working employees as unemployed. The flattening of the slope of decline is certainly encouraging but what awaits across the recessionary valley remains very challenging.

Assuming employment cannot logically go to zero, the stabilizing is a modest light at the end of the tunnel. During the tepid economic recovery we have continued to lose jobs with over 1 million lost during the recovery period. Since the recession began the loss of jobs has reached 8.4 million. The workforce today is the same as in 1999 with both a larger economy and population. Depending on one's perspective, we are either wonderfully productive or woefully underemployed.

Total unemployment and underemployment is close to 17% and 40% of the unemployed have been without work for over six months. These are depression like figures. The U.S. economy is 12 million jobs below full employment. Estimates of time until we reach previous levels of full employment range from 5 to 10 years. Against that backdrop we would continue to expect to see a deflationary investment theme. The threats to that view would be from the public sector debt should policy begin to monetize debt, significantly weaken the dollar and become less attractive to foreign buyers of US treasury debt. All of those are possible.

The investment theme will continue to be safety and income at a reasonable price (SIRP), a far cry from the growth at a reasonable price (GARP) investment tune of not so long ago.

John Barnyak
Stonehouse Asset Management
(412) 849-3723