Thursday, May 27, 2010

"New Jersey - A 'Diogenes' for the Federal Government"

Sydney M. Williams

Thought of the Day
“New Jersey – A ‘Diogenes’ for the Federal Government?”
May 27, 2010

Speaking Tuesday before the Manhattan Institute, Governor Chris Christie of New Jersey spoke of his states’ deficit, at 37% of the budget; he said, “…it’s the worst budget deficit in America – worse than California, worse than New York, worse than Illinois…” What he meant is that it is the worst state deficit. According to the U.S. Office of Budget and Management, the estimated U.S. Federal deficit for 2010 will be $1.556 trillion against a budget of $3.721 trillion – a 42% deficit. And these deficits do not include the losses being rung up by Freddie Mac and Fannie Mae, both of which have been excluded from the demands of the pending finance reform bill.

In many respects it is unfair to compare the situation in New Jersey with that in Washington. Most states are mandated to operate balanced budgets. The Federal government has no such requirement and it has responsibility for defense and most entitlement programs. But it also has no governor on costs, like Governor Christie.

President Obama is not alone in his proclivity to spend. During the eight years of George Bush’s Presidency, Federal outlays increased at a 6% annual rate, roughly double the rate of inflation. Under the new President there is no let up in estimated spending over the next six years, according to the U.S. Office of Budget and Management, and their assumptions about health care entitlement costs are benign relative to the expectations of most experts.

Additionally, the real cost of these enormous budgets has been masked by a period of exceptionally low interest rates, a situation which will not persist. A 100 basis point increase in the cost of our $13 trillion debt will add $130 billion, or about 3.5%, to the current budget, and once interest costs begin to rise they will likely go up a lot more than 1%. In the meantime, the Federal Reserve is incented to keep rates as low as possible.

Uncertainty, as to taxes and regulation, has prevented business from investing in their operations and consumers from investing for their futures. We see their reluctance in the record sums still sitting in money market funds, which serve the government in helping to keep rates low.

Speaking for New Jersey, Governor Christie pointed out that the state “does not have a revenue problem; it has a spending and debt problem.” The same is true for the Federal government. One might make an argument that those who make $50 million a year should not pay the same tax rate as someone making $250 thousand, but the argument should not be confused with the need to increase revenue. Penalizing high earners provides only the perception of equalizing social justice. History has shown time and again that higher tax rates do not produce more revenue. In today’s global world, people and businesses have great mobility. There is always a place in the world that is anxious to attract the most productive members of society. New Jersey, with its high tax rates, has experienced an exodus of high earners.

The tax code can be used to influence behavior. When taxes are too high, people move, or, more commonly, income gets hidden or deferred. When taxes are lowered people become encouraged and incented to become more productive. One can certainly argue that there has been a polarization of incomes in corporate America with CEO pay rising from about 40X average employee pay to around 300X today. On the other hand, anecdotal evidence suggests mobility –the number of high earners that have emerged from low or middle income parents – has never been higher.

Disincenting people to work and to save is not the answer to our financial plight. Low interest costs may help government today, but at the same time penalizes savers. Increased tax rates on investment income will discourage capital formation and make it more difficult for individuals to accumulate the amount of wealth they will need in retirement. Government intrusion generally adds redundancy and inefficiencies. For example, removing the consumer from the equation in terms of how to spend his health care dollars creates less efficiency, not more.

The problem of debt is considerable; not addressing the root cause – spending what we cannot afford on entitlements – is akin to kicking an inflating balloon down the road. It works until it bursts, as Governor Christie realized was about to happen in New Jersey when he took office.

The President, in his campaign, accused lobbyists of spoiling the brew. They, he claimed, have had undue influence on Congress and regulators and have increased costs. He said that, once President, he would put an end to their game. He has not, which is fine and understandable, because he cannot. The problem is not with the lobbyists; it is with those who let themselves be bought, especially elected officials in Congress, which is another compelling argument for term limits. Lobbyists are paid to try to influence decisions. That is their job and it is their right and they correctly target the most powerful, which is why Senator Dodd received special treatment from the folks at Countrywide Credit. Create term limits and you reduce the power of any one man or woman, without reducing the power of the institution.

In New Jersey, Governor Christie is addressing the deficit in a realistic manner – asking teachers to con tribute 1.5% of their income for their health care and limiting property tax increases to 2.5%. President Obama, if he is serious about debt reduction, could take similar steps, but he would have to target entitlement spending, as Medicare, Medicaid, Social Security and now Health Care represent the bulk of the budget. As well, a push to impose term limits on Congress would be welcome.

Arnold Toynbee, the British historian once remarked that “great civilizations die from suicide rather than murder, which is to say that they die when they no longer possess the will to respond confidently and creatively to the very challenges that would otherwise make them stronger and better.” That need not be our fate.

Wednesday, May 26, 2010

"May - Thus Far, Not a Merry Month"

Sydney M. Williams

Thought of the Day
“May – Thus Far, Not a Merry Month”
May 26, 2010

The merry month of May has distinctly gloomy overtones, at least thus far. Unless yesterday’s rally takes traction, it is shaping up to become one of the worst months in the past fifty years. As of yesterday’s close, it is down 9.5%. The five worst months have been: October 1987 (-21.8%); October 2008, (-16.9%); August 1998 (-14.6%); September 1974 (-11.9%), and November 1974 (-11.4%).

With the exception of 1973, in every instance, a year later the market was higher. The record is mixed in terms of the markets’ shorter term performance, though generally it has moved up.

Credit and currency markets have anticipated, and participated with, the sharp decline in stocks over the past several weeks. The yield curve (Ten-Year over Two-Year) has flattened from 282 basis points to 242 basis points. At the end of March the yield on the Ten-Year was 3.83%. Today it is 3.16%. The yield on the Two-Year has declined, in the same period, from 1.01% to 0.74%. The TED spread (LIBOR over Three-Month Treasuries) has widened from 15 basis points to 38 basis points, a significant increase and one worth monitoring, but still below the historically more typical spread of 50 basis points. The spread between Investment Grade Bonds and Ten-Year Treasuries widened as Treasuries rose in price. Reflecting the flight from risk, High Yield Bonds fell in price, as the yield has risen back over 9%. Since the end of the quarter, the Dollar Index has rallied 7.3% since the end of the quarter, 7.9% against the Euro.

Commodities have generally declined as concerns over global growth are fueling whiffs of deflation. The CBOE Index is down 6.3%, principally a function of a 19% decline in oil, offset by a 7% rise in gold. Volatility has returned with a vengeance. The VIX has risen from 17.13 to 34.61 yesterday. And the number of days in May, in which the DJIA has closed +/- 1.5% has been five, the greatest number since last July.

The markets retreat from risk has created an environment which now has an earnings yield for the S&P 500 of 7%, pretty attractive relative to the 4.9% yield for Investment Grade Bonds. And the yield on the 371 dividend-paying stocks in the S&P 500 is 2.5%, which compares favorably with a 3.16% on the Ten-Year.

A market decline that many thought we needed a month ago has, on its arrival, scared the bejesus out of people. The litany of problems is as familiar to investors as the catechism was to parochial school students in my day – uncertainties about the finance reform bill, increased taxes on investments, new regulations, sovereign debt, the balance sheets of FNM and FRE, Greece, California, the oil spill, North Korea, Iran, deflation, inflation, dark pools and high frequency trading.

Investors sense they are being attacked from all sides. What is needed is a re-instillation of confidence – coming from someone in the mold of General Oliver Smith, Commandant of the First Marine Division at the Chosin Reservoir, in northeastern North Korea in late 1950. The Marines were surrounded by Chinese forces, who had crossed the Yalu River, outnumbering them by estimates of up to ten to one. One of his officers radioed him: “Sir, we’re surrounded.” “Excellent,” responded General Smith, “We can attack in any direction.”

Our plight, in capital markets, does not come close to that faced by Marines sixty years ago. But market adjustments, such as we have been experiencing, should be looked upon for the opportunities they offer.

Tuesday, May 25, 2010

"Words - We Should Say What We Mean and Mean What We Say"

Sydney M. Williams

Thought of the Day
“Words – We Should Say What We Mean and Mean What We Say”
May 25, 2010

In our frenetic lives, between disruptive capital markets and discordant Washington, most of us have a tendency to speak first and listen second. We read, watch and listen to those with whom we agree. We hear what we want to hear. We are determined to persuade those who disagree that they are in error. The crescendo is like Humpty Dumpty, speaking to Alice in Through The Looking Glass:

“I said it very loud and clear;
I went and shouted in his ear.”

Thought and reflection have become alien. In capital markets, despite the thirteen month rally, fear has been the dominant emotion since the credit crisis began nearly three years ago. In the immediate aftermath of the Lehman bankruptcy the situation was binary: either the Western, democratic, capitalist system was going to survive or it was not. It did, for reasons we all know.

Examples of reasoned discussion – like interviews conducted by Charlie Rose – seem rare. More common are the shoutings of Rick Santelli, Larry Kudlow, James Cramer or Dylan Ratigan. I sometime agree with their findings, but find it difficult to listen to them. In the arena of politics, the same can be said about Jon Stewart on CNN or Glenn Beck on Fox. It is the absence of those whom Peggy Noonan refers to as the “elders” –reporters and commentators like Irving Kristol, Walter Cronkite, Robert Novak and William Safire – who are missed. Dignified responsibility has been replaced by narcissistic self promotion.

While the pace of economic recovery has slowed – inventory replacement is largely behind us and the stimulus package has topped out – economic numbers continue positive. The Economic Cycle Research Institute’s (ECRI) leading indicators, among the first gauges to predict the sharp growth in GDP in the 3rd and 4th quarters of 2009, is now pointing to more moderate growth – something less than 3%, but up. The national unemployment rate remains at 9.9%, but 38 states showed job growth in April over March. Bottoms up, operating corporate earnings for the S&P 500 are estimated to be about $75.00 for 2010, putting the market at 14X. Corporate balance sheets are under leveraged. Nevertheless, portfolio managers who only a few weeks ago thought the market needed a ten percent correction, now that it has arrived, have become increasingly fearful, fed by news from Europe and, today, North Korea and Spain. However, the fear has been abetted by a Press, which (to borrow a line from Macbeth) is “full of sound and fury, signifying nothing,” or, at least, signifying less than they would claim.

We have yet to learn the full lessons of that fall of 2008, or of today’s problems in Europe. Fairness and equality do not include promises that cannot be kept, whether it is offering mortgages that depend upon rising asset prices and falling interest rates, or promises to state union workers that prove impossible to honor. We cannot continue to consume more than we produce. Holders of sovereign debt should not assume they will always be protected against default. There is such a thing as personal responsibility; we should be rewarded for our successes and suffer the consequences of our failures. Greek students and government union workers, demonstrating against budget cuts, are only now beginning to grasp that when there is no money, there is no money. The threats of such cuts are already being heard in New Jersey and will be soon heard in California. No favor is conferred when empty promises are made by politicians, who know better, in exchange for votes.

It is politically expedient to cast blame for the financial crisis on Wall Street, and certainly we deserve our share. But Wall Street did not act in a vacuum. Rating agencies eased the way. Regulators failed to regulate. Politicians promised the moon, expecting that when it came time to “pay the piper” they would be safe in a retirement they had guaranteed for themselves. And millions of people acted irresponsibly. The financial crisis, the ensuing recession and the ripple effects of subsequent melt downs have created a lot of stress and heated debates. We see it in demonstrations in Europe and Asia, in the Tea Party and in recent primaries. The situation is combustible and it behooves those with an audience to speak honestly and unapologetically, but calmly and openly, recognizing that for most questions regarding the market and politics there are no concrete answers, only opinions.

Words are important, as is the manner in which they are conveyed. When emotion rules markets, reason should be the response. This morning we hear North Korea President Kim Jong II order his troops to become “combat ready” – an inauspicious remark in a tinder-ready world. Fortunately China seems less inclined to support her neighbor than she might have been five or ten years ago. The government in Spain, also this morning, pressured four banks to merge by June 30. The combined banks would have assets of €135 billion, making it the fifth biggest bank in Spain. This is not dissimilar to action taken by our FDIC when banks are in trouble. In last weekend’s edition of the Wall Street Journal, Jason Zweig interviewed the legendary Seth Klarman who remains concerned: “We didn’t get the value out of this crisis we should have…” It was over too quickly for the lesson of loss to be fully realized. “All of the obvious hedges [including gold] are extremely expensive.” But he added that his own ideas “on bottom-up opportunities in undervalued securities are more likely to be accurate than my top-down on what’s going to happen to the world at large.”

Further on, in Alice’s interview with the singular Humpty Dumpty, she continues:

“The question is,” said Alice, “whether you can make words mean so many different things.”

“The question is,” said Humpty Dumpty, “which is to be master – that’s all.”
“When I make a word do a lot of work like that,” said Humpty Dumpty, “I always pay it extra.”

We should not have to pay the price of misunderstanding the intent of Wall Street, Washington, Brussels or Pyongyang. We are best served by clear and respectful answers to basic questions. But perhaps that is only a “consummation devoutly to be wished.” Nevertheless, words matter.

Monday, May 24, 2010

"To Solve a Problem, First We Must Recognize There is a Problem"

Sydney M. Williams
Thought of the Day
“To Solve a Problem, First We Must Recognize There is a Problem”
May 24, 2010

The social welfare state, which came to epitomize Europe in the post War years, exemplified the positive aspects of life and was a pay-off to the people for years of war and dislocation. It was born at a unique moment – out of the residue of World War II in 1945.

Over the previous thirty-one years Europe had suffered two devastating wars, a rise of militarism in Germany and a global depression. Two generations of young men had been slaughtered; cities had been destroyed and industrial capacity had been drastically reduced. It is unsurprising, given these antecedents, that Europe could be lured, like Ulysses, to the siren call of the welfare state – where hours worked would be minimal, vacations generous, retirement early and personal pleasure would serve as the raison d’ĂȘtre, in a cradle-to-grave state-empowered life. That model, for five and a half decades served the people well. The explosion of births following the War provided the labor to pay for the benefits of the War-diminished generations born during the years 1890-1930.

The longer term weakness of this policy, however, is now widely apparent and is aggravated by declining births and an aging population. In 1950, about seven people were working for every person retired. Today the ratio is 3 to 1. Given current trends – living longer and lower birth rates – the ratio is projected to be 1.3 to 1 by 2050. The problem in Europe is made worse by providing bond holders a sense that default (of state-issued bonds) is not an option. Once the threat of bankruptcy enters the equation, interest rates adjust and a more realistic cost of money will be factored in.

Steven Erlanger, writing in Sunday’s New York Times, exposes the fallacies of the model and why the debt crisis in Greece is but a harbinger of things to come; it should serve as a wake-up call for Americans, as we embark on a trek toward greater government intrusion in business and an increase in entitlements.

What makes a solution to the problem in Europe so elusive is that those who are retired or about to retire make up an increasing percent of voters. Additionally, there is a symbiotic relationship between public unions and politicians. The former fund the latter, and the latter ensure passage of legislation that meets the demand of the former. The bills are paid by private workers. The increase in demonstrations and strikes are a visible manifestation of the Herculean task facing policy makers. The state finds itself between the Charybdis of reducing benefits today and the Scylla of postponing the solution by raising taxes.

While it is easy to dwell on the problems, at least the problems are being addressed and that will, in time, have positive consequences. Resolution is never possible until people acknowledge there is a problem. In Europe, that is beginning to happen, though the depth of the costs and the time it will take are not yet known.

The quick, reactionary answer of most policy makers is to continue entitlement programs (in the U.S., we have expanded social welfare spending through the health care bill) and pay for them by raising taxes on the wealthy. While tempting, such action is short sighted and only postpones the inevitable – reducing benefits and raising the retirement age. Germany has already raised the retirement age to 67, while in France only half the people work past the age of 50.

Once addressed, the problems of the welfare state will begin to diminish and will serve to embolden Europeans. Self reliance will increase, leading to a declining influence of public unions and an increase in productivity. In the United States, we are beginning to see the debt problems of New Jersey, largely a function of unrealistic union demands for health care and retirement, finally being addressed by Governor Christie. It isn’t pretty, but cuts in benefits and pay are needed, as the till is empty. New York, California and our Federal Government have yet to seriously address the problem, choosing instead to continue to kick the bucket down the road.

While Mr. Erlanger’s article is sobering – the chart he displays depicting the number of working-age people (20-64) per person of retirement age (64+) is especially revealing and scary – it is also apparent from his article that among those whom he interviewed and who view the problem with the greatest clarity are the youth. They have little question that current trends are unsustainable. He quotes a 25-year old Athenian economics graduate, as to the current crisis: “It could be a chance to overhaul the whole rancid system and create a state that actually works.”

Historically, the United States has always taken a harsher view toward welfare, relying more on individual initiative and personal responsibility, but we are not immune from the siren calls that tempted Europeans sixty years ago, and we seem to be heeding their call. Many of our states are facing tough choices, and the Federal government is actually expanding entitlements. We have the advantage of positive population growth, but people are living longer. Our tax system encourages consumption and discourages savings and investment. Recognition of the problem is the first step toward salvation. Europe may be on that road. It is unclear that we are. For us, a failure to learn from their example means we are doomed to the plight now encompassing Greece.

Thursday, May 20, 2010

"Lessons for Europe; Lessons from Europe"

Sydney M. Williams

Thought of the Day
“Lessons for Europe; Lessons from Europe”
May 20, 2010

Fear and greed drive markets on a daily basis. Like lemmings, market participants go rushing off, first in one direction then another. Emotions rule behavior, temporarily upsetting performance for investors, but, in reality, providing opportunity for those who utilize “Mr. Market”.

Europe has become the most recent source of concern. Greece has been in the news all year. But virtually coincident with the peak in our market – April 23rd – the Germans began demanding greater austerity on the part of the Greeks; the Greek Ten-Year Bonds spiked to 9.3%. The Euro, however, has been in decline since the beginning of last December.

The problems appear to have roots in a profligate, socialist culture in the “Club Med” nations, and in a currency that did not permit default on the part of states. The very existence of debt and deficit limits perversely suggested that politicians would have a hard time resisting bailout pressure. The Euro allowed Greece to borrow at much lower rates than was otherwise possible. German buyers of Greek bonds (and others) were willing to take a moderately higher return, but obviously never anticipated bankruptcy. If, as John Cochrane of the University of Chicago wrote recently in the Wall Street Journal, the founders of the Euro had said to the Greeks, the crisis might never have appeared: “Go ahead, use our currency if you like. Rack up any debts you want. We don’t care, because we are not going to bail you out – we’ve set it up so we can’t bail you out. Bond buyers beware.” The fear of principal loss is what keeps bonds fairly priced.

However, in my opinion, it is too early to count the Euro out. It has only been in existence since January 1, 1999. Europe is a collection of nations, each with a unique culture. Those cultural differences can be a source of discord, as we have seen in recent days, but they also can be a source of strength, as myriad opinions can lead to a broad consensus. While Europe has a history dating back thousands of years, states such as Germany and Italy are younger than the United States, though their city-state predecessors are far older. Our “single currency”, the Dollar, was conceived at the time of George Washington’s first term and whatever currencies existed prior was the province of individual banks or states. At the time, citizens considered their home to be the state in which they lived, which for many dated back 150 years. Virginians were Virginians first and Americans second. Those from Massachusetts considered their state their home. Fifty languages were spoken in Pennsylvania alone at the time of the Revolution; Noah Webster, with his school primers, ensured that English would be the language of the new United States.

Members of the first Congress had difficulty overcoming these regional preferences; and it took years to overcome regional and state biases. Eighty-seven years after the Revolution began, the Civil War was fought to preserve the Union, but regional differences persisted for years. In the scheme of things, twelve years is not a long time to prove the worthiness of a single currency. In 2005, Mark Leonard, Executive Director of the European Council on Foreign Relations and author of Why Europe Will Run the 21st Century, wrote that he sees Europe as a “community of regional entities”. Whether the Euro and/or the European Union survives I cannot predict, but I believe its obituary is premature.

On Tuesday, Angela Merkel, the German Chancellor, imposed bans on the naked short selling of euro-zone bonds, uncovered credit default swaps and 10 financial stocks listed in Germany. Naked short selling implies no need to borrow the assets, so the market can be of unlimited size. Any short, though, has to have someone on the other side of the transaction. Typically, short sellers of equities borrow the stock they intend to short, pay a fee for doing so, are responsible for any dividends and have to put up margin and add to it if the stock moves against them. In the U.S., corporate bonds can be shorted in similar fashion. The creation of synthetic credit default obligations (CDO) and credit default swaps (CDS) permitted markets to become of unlimited size. Again, there has to be an entity – a counter party – on the other side of the transaction. If the buyer of a CDS bets correctly and the underlying bond defaults someone has to pay, as AIG discovered. If the bond does not default, the underwriter collects the premium. In this manner, the CDS market has characteristics similar to the insurance industry, but is unregulated and is of a unknown size, far greater than the underlying issues. A real problem with naked short selling is that it has the ability to “wag the dog.”

Despite this ban, “bond vigilantes” can still do their work, in calling attention to bad credits and bad behavior, without doing damage by accentuating and aggravating the situation. With naked shorts permissible, the very size of these markets can overwhelm the underlying issues they reflect and are real-life manifestations of “reflexivity”, the term George Soros has used: those rare instances where cause and effect create a symbiotic relationship, where cause drives effect and the resulting effect fuels cause. Large deficits cause CDS prices to rise; higher CDS prices raise borrowing costs, which in turn cause deficits to further increase. In the U.S., the naked short selling of stocks is prohibited, though the ban was overlooked by the SEC in the years leading up to 2008. However, the effective naked shorting of debt via the derivatives markets is still permitted, unwisely in my opinion.

Simply banning short selling, as the U.S. did on September 19, 2008 for 799 stocks, was a serious error, as the market fell 25% over four week period until the ban was lifted. But Ms. Merkel’s decision appears to be one on naked shorts.

In the midst of vicious cycles there never seems to be an exit, but there always is – sometimes painful, sometimes not. As to how this particular cycle ends, I do not pretend to know. As investors, the best we can do is look for opportunities and wait for Mr. Market.

Wednesday, May 19, 2010

"Iran, The Deal and New Sanctions - The End Game is in Sight"

Sydney M. Williams

Thought of the Day
“Iran, the Deal and New Sanctions – The End Game is in Sight”
May 19, 2010

Tensions in the Middle East ratcheted up a notch yesterday, as Iran signed a deal to ship half their nuclear fuel – 2,640 pounds of low-enriched uranium – to Turkey where it would be stored for one year. In return Iran has the right to receive about 265 pounds of 20%-enriched uranium from other countries, allegedly for use in a reactor that makes isotopes for treating cancer patients. (Weapons-grade uranium is enriched to 90%.) Brazil negotiated the deal. Of course, the idea to transfer some of their uranium abroad was originally conceived by President Obama last October, when he called for a freeze on Iranian enrichment activity in conjunction with the transfer. The coy Mr. Ahmadinejad refused, but simply bided his time and continued to enrich uranium. The Wall Street Journal reported yesterday: “…in the previous agreement Iran would have halted its efforts to enrich uranium to a level of no more than 3%-4%. The current deal does not call upon Iran to freeze its enrichment program.
While the deal does have to be approved by the International Atomic Energy Agency of the U.N., it is obvious that the Iranian President, with an assist from Turkey and Brazil, has out-foxed his American counterpart. In the wake of Monday’s announcement, the U.S. announced a new level of sanctions with Russia and China (conditionally) on board. A table in today’s Wall Street Journal compares what was sought versus what they got. Compliance has given ground to volunteerism. Additionally, the same article reports: “The resolution avoids measures against Iran’s biggest economic driver, its energy industry.” The Financial Times reported yesterday that the proposed deal “is seen as having dealt a blow to U.S. efforts to get United Nations agreement on further economic sanctions against Tehran over its nuclear programme.” While that forecast appears to have fallen short, the new sanctions are unlikely to “bite”, to quote our Secretary of State. China hailed Iran’s deal with Turkey, as one that would “help promote the peaceful settlement of the Iranian nuclear issue.” David Sanger of the New York Times writes: “Rejecting the new deal, however, could make President Obama appear to be blocking a potential compromise.”

“White House officials,” according to the New York Times, “were clearly angered at the leaders of Turkey and Brazil, whom Mr. Obama had met with personally in Washington at last month’s Nuclear Security Summit…” But the motives of the two countries seem clear – to raise their status and to expand their geo-political influence. Both are significant trading partners, with Turkey sharing an approximate 200 mile border along Iran’s northwest and with Brazil enjoying a $1 billion trade surplus with Iran. The difficulty of getting tough sanctions devolves to economics. Giving up trade, always difficult, is even harder in tough economic times. Like Brazil and Turkey, Russia and China especially are reluctant to sacrifice so much. It reminds one of the inherent truth expressed by Felix, the CIA official, speaking to James Bond in “Quantum of Solace”, “…if we refuse to do business with villains, we’d have almost no one to trade with.”

Interestingly, Israel’s response has been mute. While one official described it as a “trick”, Prime Minister Netanyahu, apparently, instructed his ministers to make no public announcement until they had agreed upon a public response. The silence from Israel is eerily similar to that in the June days of 1981 preceding, and after, the attack on the nuclear reactor at Osirik, 18 miles south of Baghdad, an attack the Prime Minister, Menachem Begin never discussed.

Iran has pledged to “wipe Israel off the map”, and there is little doubt that this deal increases the likelihood that Iran will have the capability to carry out that threat. Like many other problems facing our Country and the world, there are no easy answers. A nuclear-empowered Iran is a risk, not only to Israel, but to the world at large. An airstrike by Israel would be difficult at best, and would likely result in attempts to close the Straits of Hormusz, which separates the Persian Gulf from the Gulf of Oman and the Indian Ocean and through which flows almost all Mid East oil.

It is surprising to me that oil futures appear unconcerned with events in the Middle East. Since May 3, futures are down 21%, now at the same level they were a year ago. Perhaps they are telling us something about the possibility of success of the sanctions, or a possible double-dip in the world economy? I don’t know, but my guess is that oil is oversold. I do believe, however, as for the likelihood of a nuclear-armed Iran, the options for the West are narrowing. Sanctions appear as empty today as they were four years ago and Iran seems as belligerent as ever. If Israel does not succeed militarily, where we appear to have failed diplomatically, the world must learn to live with the consequences of a nuclear-armed Iran…but perhaps that outcome is favorable to the risk of a military strike…either way, a Hobson’s choice.

Tuesday, May 18, 2010

"Mutual Fund Flows - A Contrary Indicator"

Sydney M. Williams

Thought of the Day
“Mutual Fund Flows – A Contrary Indicator”
May 18, 2010

The fright of “Flash Thursday” on May 6, when the market experienced an intraday drop of nearly a thousand points, crushed investor confidence, spawned Congressional investigations, provided grist for the media and sent investors scurrying from U.S. domestic equity funds into cash.

In March, for the first time since the credit crisis burst on the scene, individual investors – a year into the bull market – put $2.7 billion into domestic equity funds. (In February, they had withdrawn $2.9 billion.) March also closed the best first quarter performance for equity funds (+5.67%) since the first quarter of 2006. Over the past few weeks, money market funds, which experienced redemptions of $223.8 billion in February and March, as the market rallied, saw an inflow of $16.6 billion in the second week of May. As the market swooned, in the past couple of weeks, individuals pulled money from equity accounts. In yesterday’s Wall Street Journal, Kelly Evans, wrote that, “…investors took $2.8 billion out of U.S. stock funds in the week through May 12…the most since March 2009” when the rally began A month earlier the Press had been buzzing with the knowledge that individuals were returning to stocks, after a hiatus of well over a year.

The history of money flows into mutual funds proves individuals’ inability to market time. As the stock market peaked in March 2000, flows into equity funds reached record levels. An article in “Investopedia” (A Forbes company), written by Ryan Barnes, stated that mutual fund flows are a contra indicator. He writes that increasing flows into money market funds can be “seen as a sign the market is undervalued, and vice versa.” Anecdotal evidence supports the case.

Jason Zweig, a Wall Street Journal columnist, in the June 2002 issue of Money Magazine, looked at returns of mutual funds versus actual returns for average investors in those funds. He noted that between 1998-2001 (two bull years and two bear years) the average mutual fund reported a CAGR (compounded annual growth rate) of 5.7%, while the average investor earned 1.0%. Dalbar, Inc., a Boston consulting firm, studied twenty years of returns – 1990-2009 – and found that the average investor earned 3.2% on a CAGR basis, while the average mutual fund generated 8.2%. That may not sound like a big difference, but, on a $100,000 investment, at 8.2% over 20 years, the return would have been $484,000 versus $188,000 at 3.2%.

A mythical story has made the rounds about the Magellan Fund under the tutelage of Peter Lynch. During his fourteen-year tenure (1978-1991), the fund accomplished the incredible feat of compounding returns at 29% – enough to convert a $100,000 investment to $3,500,000. The myth suggests that the average investor in the fund during those years did poorly and many investors lost money. True or not, the lesson is that the individual’s ability to time the market tends to be very poor. As the market peaked in early 2000, high growth funds such as the Janus Twenty continued receiving inflows, while value funds, which would do well over the next couple of years, continued getting redemptions.

It is the business of the media to generate profits; however, in doing so they accentuate the daily emotions resulting from Wall Street activity. Drama and entertainment attract viewers and viewers attract advertisers. And advertisers pay the bills. In doing so, though, a disservice is provided individuals who get caught up in the emotions and momentum of the moment.

Successful investors are, as Seth Klarman wrote twenty years ago in Margin of Safety, unemotional. They analyze a security to determine its worth and then patiently wait for “Mr. Market” to provide a pricing opportunity. Unfortunately (but inevitably) mutual fund flows reflect the contra side of true investors. These people respond emotionally, assuming “Mr. Market” knows something. “The reality”, as Mr. Klarman writes, “is that ‘Mr. Market’ knows nothing, being the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.”

Mutual funds manage about $12 trillion, half of which is in equity products. ETFs (exchange traded funds) have begun to take market share and now have close to one trillion dollars. But the same tendencies apply. TrimTabs Research, in a recent study, concluded that there is a strong negative correlation between flows and performance. “Regression analysis,” they write using a double negative, “suggests the probability that equity ETF flows are not a contrary leading indicator is less than 1%.”

Kelly Evans concludes her column in yesterday’s Wall Street Journal: “The long-hoped-for move of individual investors back into stocks was supposed to bring a wave of money off the sidelines. It may take quite awhile before that market prop materializes.” But history suggests, by the time they return, the market will be a lot higher.

Monday, May 17, 2010

"Platitudes and Misinformation are Drowning Out Sensible Finance Reform"

Sydney M. Williams

Thought of the Day
“Platitudes and Misinformation are Drowning Out Sensible Finance Reform”
May 17, 2010

As the Senate debates (or postures on) finance reform, words, written and spoken, swirl through the media, speeches and blogs, generally focusing on the symptoms and obfuscating, or ignoring, the causes.

Two examples, coming from opposite direction, make the point. The President, in his Saturday weekly radio address, urged passage of the Dodd bill. The other example was an op-ed in Friday’s Wall Street Journal. It was entitled “In Defense of Over-the-Counter Derivatives” by Mark C. Brickell, former managing director of Morgan Stanley and former chairman of the International Swaps and Derivatives Association.

The President, in his well articulated but vacuous words: “Wall Street reform will bring greater security to folks on Main Street.” “…it’s to make sure an economic crisis like this one that helped trigger this recession never happens again. That’s what Wall Street reform will do.” Putting aside the obvious error in wording – it was the credit and near-financial collapse, not the economic crisis, that triggered the recession – he, as is so often the case, spoke of no specifics. One gets the sense that either he doesn’t understand the causes, or that he views them as being beyond the comprehension of the average citizen – the latter being the more likely.

Even worse, in my opinion, was the column by Mr. Brickell. After starting out by lauding the growth in derivatives – $2.5 trillion in 1989 to $464 trillion today – he writes of the inherent value of derivatives. Most people understand that derivatives play an important role in reducing risks and lowering costs, for farmers, miners, manufacturers, bankers and consumers. He lays the blame for the credit crisis on a “system-wide misunderstanding of mortgage risk.” Give me a break! It was a result of too much debt, a function of too low interest rates; Washington, especially with its ties to the GSEs; a profligate consumer; bankers with the morals of Billy goats; and a proliferation of trading strategies, which provided no true economic value. Nowhere in his piece does he explain why a $60 trillion dollar global economy needs a derivative market almost eight times as big. Nor does he discuss the fact that speculators took valuable tools, such as credit swaps and mortgage products (CDSs), and perverted them for their own use.

By insuring its bonds, a corporation or a municipality (depending on the price of a hedging strategy) may be able to lower its cost. But permitting speculators to place bets that an entity will default, in an amount that exceeds the size of that entity, serves no economic purpose. It is as though I had a house worth $1,000,000 and that my ten neighbors each took out a fire insurance policy in that amount on my home. Who, in their right mind, would write such policies? Would not the self-interest of my neighbors be to burn my house down? The answer to the first question appears to have been AIG; the answer to the second is yes.

Mr. Brickell crows about the growth of the derivatives market, but doesn’t explain why the product category grew at a compounded rate ten times that of the economy. We all can agree that farmers, steel workers, exporters, bankers all use derivatives to lessen their risk and lower prices to consumers. We applaud the technology that allowed their creation. But we also know they were used for purposes other than that for which they were originally designed. The determining measure for any financial product should be: does it have an economic purpose, beyond enriching a few speculators? Does society benefit? Given the apparent inability of members of Congress to either understand or be able to explain, in sound-bite phrases the proposed bill, risks, to use a tired metaphor, throwing the baby out with the bathwater.

Attempting, as the President desires, to have a bill so comprehensive that what happened in September-October 2008 never happens again will prove an exercise in futility. One will never be able to fully anticipate the creations of every smart, but unethical, soul. What is needed are a few commonsensical, obvious and pragmatic rules that retain what is best about our system, while ridding it of its worst.

We need to restore confidence in our financial markets, a process that will require far greater openness, in everything from where derivatives are traded to corporate balance sheets. We must ensure that every financial product satisfy an economic need. We need to encourage long term investments and discourage short term, disruptive, trading activity. We need to encourage savings and discourage unnecessary borrowing, especially that related to consumption or pure speculation. .

The American people have a remarkable ability to understand commonsensical economics, which is one of the reasons that Tea Parties have proliferated over the last year or so. They recognize the close ties Congress has to Wall Street, despite the denials from the White House and the Hill that it’s “them”, not “us”. (In the past two years, the Democratic Party has taken in more than twice what Republicans have from Wall Street.) Those that are losing confidence in our markets recognize that Fannie Mae and Freddie Mac are nowhere mentioned in the finance reform bill, despite their obvious role in the melt down, and their extremely close ties to representatives like Senator Chris Dodd and Representative Barney Frank. They also know that part of the responsibility lies with regulators who ignored allegations against fraudsters like Bernie Madoff, or who chose not to enforce laws, like naked short selling. These people are disgusted with Washington and see in this proposed legislation a 1400-page populist tome, understood by no one, designed for sound bites, which keeps the current Wall Street-Washington cronyism in place, and that fails to attack the root cause of the problem.

Our capital markets are the essence of our economic well being. They are built on confidence, trust and the extension of credit. Their original purposes were to raise money for businesses and to provide liquidity for those who invested in those businesses. These markets provide investment opportunities for the citizens of this Country, so that retiring seniors may enjoy the fruits of their labor. Our capital markets also assist businesses in offering financial advice, including taking advantage of new tools in financial engineering that technology has permitted. Speculators provide an important role in taking the opposite side in hedging and in keeping corporate managements honest, particularly in their willingness to sell short a company’s stock. But, as our capital markets increasingly act as casinos and overwhelm their primary economic purpose, the risk is that the game ends.

The roots of the problem, not the symptoms, must be addressed. Mostly, it is simple common sense that is needed. It is these simple, sensible points that should be kept in mind as Congress debates, and the President preaches, finance reform.

Friday, May 14, 2010

"The Market - A Longer View"

Sydney M. Williams

Thought of the Day
“The Market – A Longer View”
May 14, 2010

While I am no student of long-wave theories, such as Robert Prechter’s Elliott Wave or the Kondratieff Wave Cycle, simple observation suggests there is some truth to the theory that there are cycles to markets. Since entering the brokerage business in 1967, I can identify three distinct periods. The DJIA first breached the 1000 mark on February 9, 1966, closing that day at 995.14. On August 12, 1982, the Dow Jones closed at 776.92 – a negative return of 21.9% after almost sixteen years. The second period began that same August day. Almost eighteen years later, on January 13, 2000, the same index closed at 11,582.43 – a 1390.8% positive return. The third phase, which we are now in, began in early 2000. (Both the S&P 500 and the NASDAQ peaked in March of that year.)

Long cycle bear markets do not go straight down. During the 1970s the market actually peaked in January 1973, at a time of the “nifty fifty” and during the 2000s the markets exceeded their 2000 highs by nominal amounts in October 2007, but the game, in both cases, had changed by the earlier date.

A characterization common to all three periods is that the psychology of investors is slow to adopt, and when it does the ground is already beginning to shift in the opposite direction. People remain too bearish as markets exhibit positive signs and they remain too bullish as markets turn negative. Much fund flows are the most visible example of this tendency. The simplest explanation is the fact we extrapolate our most recent experience. For example, despite the wiping out of about $6 trillion in equity value during the three year period ending March 2003, consumers continued to leverage their houses – the most significant asset for most people. Debt did not deter them, as the 1980s and 1990s had shown positive economic growth and declining interest rates. As George Soros so famously said in May 2000, “the music had stopped, but people were still dancing.”

It is unsurprising, but as bull periods persist, people, the media, and even professional investors become increasingly bullish. The train may be leaving the station, but they race down the track to jump on board. The same is true, in reverse, during bear markets.

Today, ten years into a bear period, the gloom is deepening; in part it is justified, as innovative investment bankers and traders created products, purportedly to serve society, but in reality to enhance their pocket books, and which eventually resulted in the mother of all credit collapses. Additionally, the situation in Greece and California are now visible manifestations of the dangers of unfunded entitlements. The obviousness of those problems, however, did not deter Congress from passing what will certainly prove to be the most expensive entitlement yet – the health care bill. It is characteristic of times such as these that negative news will dominate. It is the markets one must watch for clues as to where we stand.

During the 1970s the actual low point was reached in December 1974; so that one could divide those sixteen years (1966-1982). During the first half, bullishness persisted, capped with the above mentioned “nifty fifty” peaking in early January 1973. Regardless, the markets declined during those eight years. The second half – marked by final extrication from a seemingly endless war in Vietnam, gas lines, rising inflation, hostages in Iran and a general malaise – saw stock prices gradually rise. Five years into the “Great Bull Market” the market crashed in October 1987, and market Cassandras’ felt justified in their bearishness. Nevertheless, the economy persisted on its upward slope and within two years the market was at new highs. Twelve years later it was 400% higher. In the final few years of the ‘90s exuberance became truly irrational.

Markets are never predictable and the future is always opaque. But one must be careful to not get too caught up in hype of the moment. The media, which should largely be ignored by long term investors, is (naturally) principally interested in attracting viewers, so as to increase their revenues; thus their focus on the negative, the scary, the sensational.

A lesson, for me, is that during the second half of the 1970s, as news worsened, stocks became differentiated and gradually began to rise. For sixteen years the market traded within a range, but in the second half the lows were less low. It is too early to know what the future holds, but a guess would be that the March 2009 lows will prove to be the low and that the market will trade within a range over the next several years until a time comes that marks another sea change.

The market today is lower than it was eleven years ago – a time frame far more similar to that of the 1970s than that of the ‘80s or ‘90s. This period, too, shall, end. It is impossible to know when or the catalyst; it is more important to keep your wits, not lose faith in the long term future of the Country and to keep an eye on value.

Thursday, May 13, 2010

"Gold - The 'Canary in the Coal Mine' for Paper Currencies"

Sydney M. Williams

Thought of the Day
“Gold – The ‘Canary in the Coal Mine’ for Paper Currencies”
May 13, 2010

The most impressive thing about the New York Stock Exchange (at least in my opinion) is that millions of dollars of securities change hands without the presence of lawyers and without the signing of documents. Over the phone, or through e-mail, or IM, or via the internet, one can place an order to buy 50,000 shares of Microsoft and the order gets executed at a price in line with the client’s wishes and a report, within seconds or minutes, is sent via the same medium in which the order was received – a $1,500,000 transaction, without a lawyer! It is always been so, and has become so commonplace that we take these transactions for granted. But a $200,000 house or a $25,000 car cannot be purchased without papers being signed and, in the case of a house, a lawyer present. What permits such trust and ease of transaction is confidence in the financial system and trust in the exchanges and counter parties.

Today, as debt-financed government spending is increasingly critical to western economies, such transactions reflect an inherent trust in currencies. Recently, there has been a growing confusion (either intentional or not) on the part of many policy leaders implying solvency crises are nothing more than liquidity crises. A liquidity crisis can be resolved with injections of capital. The cash will serve to tide the company, or country, over until the natural forces of an improving economy allows the debt to be re-paid. A solvency crisis also demands a cash infusion, but also suggests the company, or country, is bankrupt and is in need of restructuring – a reduction of costs and elimination, in whole or in part, of their debt obligations. In the United States, the most obvious current examples are Freddie Mac and Fannie Mae. California may be another. A number of the Mediterranean European nations would also qualify.

The problem with the state throwing money at bankrupt entities is that ultimately the currency is debased; so that a difficult, but manageable, problem becomes far more severe.

Watching the price of gold on Monday was instructional. On Sunday evening the European Union finance ministers announced €750 billion in loans and guarantees, as a measure of their will to defend the Euro. Markets on Monday, as expected, responded positively. The DJIA was up 404 points, or 3.9%, the biggest point rally since March 23, 2009. In sympathy, the yield on the Ten-Year Treasury rose by 11 basis points. Yet gold, which early in the day had been down $22.00, rallied in the afternoon and closed down only $10.00, at $1200, suggesting the markets fear of paper currencies.

There is little doubt that Washington had to inject funds into the system a year and a half ago. The risk was real that the financial system could have melted down. It also appears that something similar may have been happening in Europe, though credit markets had not seized up to the extent they had in the fall of 2008. However, LIBOR, over last week has risen by 40% to 42 basis points, a substantial increase, but far below the 465 basis point level it traded at in September-October 2008. Even so, it is now at the highest level it has been since last August. So liquidity was necessary and was provided, but the problems are structural – Greece, for all intents, is bankrupt. Without serious cutbacks in entitlement expenses, it is hard to conceive that normal economic growth will be adequate to pay back what they owe. In the United States, one could make the same argument regarding Fannie Mae, Freddie Mac and, in fact, California. These entities are not having liquidity problems; they are insolvent. Both FNM and FRE are necessary to the housing industry, as they now account for about 90% of the mortgage origination market. But they are requiring enormous continued infusions of money, and their operations demand increasing oversight and regulation. The existing system has manifested the worst consequences of cronyism, which explains Senator Dodd’s decision to exclude them from his pending financial reform bill. In their current form, they continue to ask for only minimal down payments making them a sequestered entitlement. Their balance sheets should either be incorporated fully into the Federal Government’s budget, or they should be spun off as private, regulated businesses – a doubtful possibility in today’s market.

The risk policy makers run, as they pump billions of Dollars/Euros into failing enterprises – treating the symptom, not the cause – will be a debasement of the currency, which will cause investors and consumers to lose confidence, thereby threatening capital markets. An honest acknowledgement of insolvent institutions is the first step toward redemption.

While capital markets have been exposed as having cracks and no one doubts the need to repair those problems, on balance they have served us well – Main Street as well as Wall Street. What does work, though, should be left alone. We, in the West, have been the fortunate beneficiaries of a capital markets system that, at its heart, is based upon confidence and trust. Anything that engenders that confidence must be viewed skeptically, and that includes the risk of expanding paper currencies (sanitized, or not) at unmanageable rates. The penalty is exorbitant inflation. The price of gold is “the canary in the coal mine”; its rise needs to be taken seriously.

Wednesday, May 12, 2010

"The Supreme Court; And By Focusing on Achieving, Are Our CHildren Learning Less?"

Sydney M. Williams

Thought of the Day
“The Supreme Court; And By Focusing on Achieving, Are Our Children Learning Less?”
May 12, 2010

David Brooks had an op-ed in yesterday’s New York Times, entitled “What It Takes”, which will certainly raise eyebrows. The purpose of the piece was to raise doubt about President Obama’s selection of Elena Kagan to serve on the Supreme Court, but the implications of his essay have far broader implications. Mr. Brooks’ point, at its essence, is that too many children are being raised to succeed by “going along”, not challenging authority – suppressing their opinions for the sake of their career. A Professor is looked upon as a boss who must be pleased.

My knowledge of Ms. Kagan is insufficient to draw an opinion as to her qualifications, but I suspect there is truth in what he says – not about the Solicitor General, but about the tendency of couples to encourage their young to succeed without rocking the boat. Very likely my own children feel they were raised with similar goals and limitations.

Nevertheless, there is something disturbing if we conclude that our most successful young students are reluctant to challenge their teachers. Have not the world’s greatest scientists and philosophers discovered new concepts and uncovered new natural laws because of their refusal to conform to accepted principals and ideas?

In discussing Ms. Kagan, David Brooks writes: “Yet she also is apparently prudential, deliberate and cautious. She does not seem to be one who leaps into a fray when the consequences might be unpredictable.” For a Justice, those characteristics sound appropriate, but in most jobs we need people who are willing to take chances. However, the Constitution does have plenty of grey area and is subject to interpretation. A four thousand word document that governs tens of thousands of laws represented in millions of pages is, at best, a guide. Interpretation is the reason we have courts in the first place.

It is unimportant that Court decisions be decided 9-0. (In fact they rarely are.) What is important is that whatever the decision, it reflects the opinionated interpretation of the nine Justices. The ultimate decision is not arrived at consensually, but is determined by vote, which is why dissenting opinions are published simultaneously with opinions.

Of the three branches of government, the Supreme Court most closely resembles the institution created 235 years ago. Since the assassination of President Kennedy in 1963, the Presidency, understandably, has become increasingly isolated from the people and, in doing so, more imperial. Congress, likewise, has become a separate island distanced from the people she supposedly represents. Nepotism has become more commonplace. Nancy Pelosi, the Speaker of the House, travels back and forth to California on a C-32, a military version of a 757-200, provided by the Pentagon and paid for by the people. Congress often exempts itself from the laws they create, the most infamous being the recent passage of the Health Care Bill, a bill which, in time, will ration health care and will, ultimately, result in a single payer. The Supreme Court, alone, remains as it was envisioned. Attempts to politicize the Court, as Roosevelt discovered in 1937 when he attempted to limit the age of Justices, so he could pack it with new appointees and as President Obama has hopefully learned when, in his State of the Union, he publically dissed the Justices for their decision not to place a ban on corporate spending in elections, have not been well received by the people.)

But, to return to Mr. Brooks’ column; without actually saying so, he suggests a student can achieve good grades and receive great recommendations without really learning. Learning takes time and it often involves challenging one’s teachers, not to be rude, but to deepen one’s knowledge. Socratic teaching focuses on asking students questions, not providing answers. It results in self-discovery, not the provision of rote answers.

We live in a world in which time moves swiftly – we are an attention deficit disordered society. We want our child to be the best student, the best athlete, the best dancer, the best debater. We program their lives from an early age for achievement, but we risk suppressing their naturally inquisitive minds, minds that should be nurtured, so they can discover new horizons – go places where no man has gone before. These children, as David Brooks writes, are not “intellectual risk takers”; they are prudent rather than poetic. To the extent that is true, it is unfortunate.

Tuesday, May 11, 2010

"Greece, California, etc. - There is No Easy Answer"

Sydney M. Williams

Thought of the Day
“Greece, California, etc – There is No Easy Answer”
May 11, 2010

A news item not widely reported over the weekend, but pointed out to me by an alert portfolio manager and good friend, was that California’s expected revenue from income taxes for April (the largest month for collections) fell $3 billion short at $7.4 billion – a better than 30% miss.

While Europe went into heart failure over Greece’s 14% budget deficit, California’s 20% budget deficit has not elicited the same kind of response. Perhaps it should not. Greece is a sovereign country. California is a state. But California, with $1.8 trillion in GDP, is the seventh largest economy in the world and almost six times that of Greece. Both have the same basic problem – too much debt resulting from promises by the state that cannot be honored. In Greece, public employees can retire at the age of 53. In California, 80% of the budget goes to education and health services. The next highest item, prisons, consumes another 8%. And California’s budget deficits do not include unfunded pension and health care benefits, a subject we wrote about on February 19 and March 11. Using a reasonable discount rate of 5%, the unfunded liability for California’s three largest public unions – CalPERS, CalSTRS, and the University of California Retirement System – exceeds $500 billion, a big number even for a $1.8 trillion economy.

The decision Sunday to provide €750 billion ($960 billon) by European finance ministers to stabilize nations in the Eurozone served to restore investor confidence, but it remains to be seen whether it will address the roots of the problem – public sectors that are too large and too expensive to maintain. Allegedly, any funds the finance ministers provide will require adherence to strict austerity measures, but it was the possibility of such bounds that caused workers in Greece last week to strike so violently, riots that led to the weekend’s decision. Ironically, the cure may aggravate the problem. Just as low interest rates made it easier for consumers to pile on leverage as housing bubbled, the knowledge that a safety net exists may increase the adamancy of public union workers.

The solution for California, as it is for Greece, is simple, but painful to implement. Costs must be cut and revenues must increase. Cost cutting is easy to formulate, but difficult and painful to implement. Revenues can increase in two ways. The fastest way to increase revenues, but the least reliable on a long term basis, is simply to raise rates or levy new taxes. A far better and longer term more certain way is to allow the economy to blossom, which will require cutting taxes. Over the longer term, higher taxes impair economic growth, thereby limiting tax revenues.

Those in policy positions in Europe and the United States are faced with a Hobson’s choice. The problems they face are daunting. On the one hand, the nations of the West, virtually without exception, spend more on entitlements than they can afford, solutions to which will require draconian measures. Most of these countries have flat or declining populations. As the world flattens, they face increasing competition from emerging nations with significantly lower labor costs. On the other hand, long term solutions, such as investing in education and increasing savings, demand short term sacrifices, politically difficult to accomplish during a time when people demand immediate gratification.

Mr. Micawber, a Dickens character not known his financial acumen, however once offered sensible advice to David Copperfield, advice that western nations should heed: “Annual income twenty pounds, annual expenditure nineteen nine and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” The problem of excessive spending is deeply ingrained in nations where entitlements exceed the ability to pay. It is a deeply rooted problem that €750 billion Euros alone will not solve.

As costs are being gutted and debt reduced, confidence in capital markets must be maintained. It is a necessary ingredient to the success of any economy. When confidence fails, as it did in the U.S. in the fall of 2008 and in Athens last week, chaos ensues.

The trick for policy makers will be to adhere to this narrow, ridge-line trail of reducing costs, lowering debt, increasing revenues and encouraging growth, without falling into the abyss.

Monday, May 10, 2010

"Computers - Have Their Power Exceeded Man's Abilities to Control Them?"

Sydney M. Williams

Thought of the Day
“Computers – Have Their Powers Exceeded Man’s Abilities to Control Them?”
May 10, 2010

Helplessness, rather than panic or fear, was the emotion I experienced at 2:45PM on Thursday afternoon, as the market evaporated, dropping 600 points in a matter of minutes. The world just doesn’t change that quickly. However, after a few moments a fatalistic calm reassured me that more tranquil voices would prevail.

The crack in the market Thursday exposed a fundamental flaw – machines have advanced faster than man’s ability to control them, or for regulators to understand them. The actual cause – a “fat finger”, an algorithmic trade gone astray, an errant high-frequency trading program, or a rogue quant – is less important than the culture that has not only permitted, but encouraged, such activity. In our capital markets, speed has overtaken deliberation; thinking has been supplanted by doing; irrationality has swamped reason. The focus on computer trading, which can take advantage of minute mis-pricings (multiplied millions of times per minute) and other automated strategies, have diverted attention from long term, fundamental investing.

To dismiss Thursday’s market collapse as nothing more than a computer glitch could have far reaching negative consequences, not just for Wall Street, but for Main Street. A few quants have found quick means of making exorbitant trading profits, by converting our capital markets into a casino; in doing so they risk millions of small investors losing confidence in those markets. Should that happen we all become losers – businesses will find it difficult and more expensive to raise capital; jobs will be lost; retirees and shareholders will see their savings dwindle. Changing the culture of a society is not easy, but the government must focus on encouraging long term investment (at the very least, capital gains should be indexed to inflation); an uncompetitive corporate tax rate should be reduced; dependency on the largesse of government, as we have seen in Greece, does not work; the concept of personal responsibility should be reasserted; punitive taxes should be levied on very short term trading profits to discourage rampant speculation.

According to a piece in Saturday’s New York Times, non registered exchanges account for more than a third of all trading. We know that on Thursday two NYSE-listed stocks (there were more, but these two stand out) – Proctor & Gamble and Accenture PLC – had dramatic declines (and recoveries) in a matter of minutes, declines that could not have reflected fundamental changes. The price of P&G fell from 61 to 39 in a couple of minutes, while, according to the Times, Accenture fell from $32.62 at 2:47:46 to $0.01 at 2:47:53! The NYSE had halted trading in both stocks, but computer driven programs automatically diverted orders to platforms where there still was a bid – platforms not subject to the rules of the NYSE. Within minutes both stocks recovered most of the ground lost, but the die had been cast.

A failure to address the root causes of a problem is akin to kicking the ball down the road, as the Europeans seem to have done late last night. In Europe, the problem is debt and a dependency on government. In the U.S., it is also debt and a focus on the very near term. The root causes of problems must be addressed which necessitates pain, or they will reappear.

In a pragmatically sensible weekend editorial, entitled “Volatility You Shouldn’t Believe In”, Investor’s Business Daily stated: “We all understand that electronic markets are here to stay. What we need, however, is an electronic market, not markets – a market that features a system of price discovery that has one set of rules for all platforms and exchanges, is transparent rather than secretive, is consistent not fractured, and is fair not privileged.”

One bright spot about Thursday’s market’s crash is that it may serve as a call to fix the regulatory lapses that allowed such behavior, and to galvanize Washington into focusing on the need to make investing (as opposed to trading) an integral part of reform. An interview by John Fund with Mark Bloomfield, CEO of American Council for Capital Formation, in Saturday’s Wall Street Journal, was informative and encouraging on this subject. It is worth reading. As we have written many times in the past, Washington should use behavioral studies to encourage savings and discourage consumption, for we are facing an onslaught of retiring baby boomers, and there is not enough money in the till. Compounding the problem, events such as what happened on Thursday cause confidence, a necessary ingredient in capital markets, to wane.

In terms of the economy, things are getting better, not quickly perhaps, but they are improving. Employment data for April (and upward revisions for February and March) were encouraging. The ECRI Index rebounded last week from a 38-week low. A widened TED spread (from 19 basis points on Monday to 32 on Friday) was noted, but remains below the pre-crisis norm of 50 basis points. S&P 500 earnings are forecast to be $76 to $80, providing – before dividends – an earnings yield of 7%, which compares favorably to a current yield on Investment Grade Corporates of less than 5%. Preliminary earnings estimates for 2011 are for a gain of 10%-15%, suggesting an 8 1/2% to 10% earnings yield. The economy is not out of the woods, and stocks over the short term always move in mysterious ways. But things are improving. Volatility is likely to remain elevated as we go through a detoxification process, but it seems a mistake to remain too bearish when the environment is depicted so negatively and chaotic. Keep in mind Laszlo Birinyi’s Cyrano principle, “If the concerns of the markets are as obvious as the nose on your face, the market and policy makers will have an amazing ability to adapt and adjust.”

In October 1938, as clouds of war were spreading across Europe, E. B. White wrote an essay, “Clear Days”. He was repairing the roof of his Maine barn and thinking of Chamberlain’s infamous September 29th signing of the Munich Pact with Hitler. Mr. White was dismayed by the Treaty. “There is a certain clarity on a high roof…One’s perspective, at that altitude, is unusually good. Who has the longer view of things anyway, a prime minister in a closet or a man on a barn roof?”

If one substituted prime ministers for quant-driven high frequency traders and Mr. White for long term investors, mightn’t that be an applicable analogy?

Thursday, May 6, 2010

"A Day to Remember!"

Sydney M. Williams

Thought of the Day (2)
“A Day to Remember!”
May 6, 2010

Evoking grisly memories of the fall of 2008, the Dow Jones Industrial Averages, at 2:47PM, was down 981.6 points. Like an over-stretched rubber band the Index snapped back 593.2 points in eleven minutes. Weak all day, the sharp decline in the averages appears to have been triggered by the sale of 1,900,000 shares of Proctor & Gamble, which took the stock from 61.73 to 39.37 and back to 61.36 in a matter of six minutes. For someone (or some computer) to decide that a company the size of P&G was worth a third less in a matter of minutes – and then to decide that perhaps they were wrong – smells of panic, not rational thinking.

Additionally, the scare in the market around 2:45PM reminded those of us who are a little older of October 1987 when “portfolio insurance”, a newly created product at the time, proved there was no insurance against such declines; in fact they magnified the fall.

Action in the Treasury market was largely coincident with that in the stock market; the yield on the Ten-Year fell from 3.8% to 3.3% and back to 3.8% during a period of fourteen minutes, as investors dove for safety.

While no one knows what tomorrow will bring, panicking this afternoon did not pay. Those who sold stocks at 2:47PM are out 5% on their stock sales and out something less on their Treasury purchases. But no matter how one colors it, the day was not pretty. The DJIA closed down 348.6 points (3.2%), the biggest point decline since February 10, 2009. Rather, today’s market showed the wisdom of maintaining some liquidity.

It is also worth noting that Bloomberg, earlier this afternoon, determined that the riots in Athens were more news worthy than events in this Country – speaking of taking one’s eye off the ball! The situation in Greece is certainly dire, but we should remember that Greece represents about 2% of the European Union’s GDP – not exactly an elephant.

E.B. White, fifty-five years ago, wrote in the New Yorker about the stock market: “It sometimes sows the hurricane, instead of reporting the breeze.” His wisdom is as relevant today, as when he penned the words.

Enjoy the weekend and remember Sunday is Mother’s Day!

"Yield Spreads + Dividends + Nervous Markets = An OK Period for Stocks"

Sydney M. Williams

Thought of the Day
“Yield Spreads + Dividends + Nervous Markets = An OK Period for Stocks”
May 6, 2010

With the Yield Curve as steep as it is – the Ten-Year Treasury is 267 basis points above the Two-Year – it is hard to recall that a mere three years ago, concern was of an inverted yield curve. Despite the implications that an inverted yield curve suggested banks were having trouble making money in their loan portfolios – borrowing short and lending long is their business – their stocks were riding high. Citigroup, for example, was selling at 55.

Of course, as we now know, loans were only incidental to the business of many banks; as well, they hedge out differences between short rates and long rates. Nevertheless, an inverted yield curve has historically spelt trouble for banks, and the economy. Now, with a steeply sloped curve and assuming a financial reform bill does pass, lending is likely to become a bigger percentage of banks earnings, but now (admittedly with billions more shares outstanding) Citigroup is selling at less than one tenth of the price it sold at three years ago. This is not a recommendation of Citigroup, for I am far from qualified to do so; it is more of an indictment of the lack of common sense that too often courses through our markets. A yield curve as steep as this one acts as a free pass for banks. The question is how long will it persist and what will cause the slope to moderate.

Richard Shaw, the managing principal of QVM Group LLC, wrote a piece for Seeking Alpha in January 2007 pointing out that in 72 of the last 82 years the Yield Curve has been upward sloping. There were eight years in which the average weekly slope was inverted – 1927-1930, 1966, 1969, 1980-1981. Most of those years were associated with tough economic times. Mr. Shaw wrote, “It is generally held that a prolonged inverted yield curve produces a subsequent recession.” As we now know, 2007 became a ninth, and 2008 proved a doozy.

Yesterday Paul Hackett of Sidus Funds sent me a study he had done looking at spreads between Ten-Year Treasuries and One-Year Treasuries. There have been, according to his work, only three other times since 1976 when spreads exceeded 300 basis points – January 24, 1992 to January 29, 1993; July 25, 2003 to January 9, 2004 and May 29, 2009 through the present. As Mr. Hackett points out, “Up” markets persist even after super-steepness ends. Since the credit crisis, banks have been reluctant to lend to small businesses, despite the fact that large ones have meaningfully increased their liquidity. In the investment business, there are no infallible formulas, but when banks get paid to lend, without having to resort to the swaps market, it is difficult to imagine credit getting worse. Of course any financial reform bill will (or should) require reduced bank leverage, but leverage has already been reduced over the past year and a half, so further restrictions may prove not that onerous.

Credit markets, as we have mentioned on numerous occasions, rallied toward the end of 2008, with the TED spread (Three Month LIBOR less the Three-Month Treasury and a measure of liquidity) narrowing from over 450 basis points in September-October of that year to 131 basis points by year-end 2008. Today the spread is 21 basis points.

Bears (as do Bulls) always look to rationalize their opinions. Contagion has become the new watchword for bears. The Greek crisis, they tell us, will spread to Portugal, Spain and Italy and ultimately to the U.K. and America. Perhaps it will. I certainly worry about our deficits and the propensity we have to spend, not save. But when words like “contagion” become part of everyday speech, it suggests markets are at least prepared. Laszlo Birinyi had a piece yesterday portraying an historic perspective, providing charts on nine previous crises ranging from 1970 to the present, and covering such events as Penn Central to Orange County to Long Term Capital, and the conclusion is that they have all provided good ‘buy’ points.

Despite the rally we have had since the depths of March, 2009, and supporting the case for stocks, dividends have been rising. A year ago, when the yield on the S&P 500 exceeded that of the Ten-Year it was the first such instance in forty years. Since then bonds have fallen (yields have risen) and stocks have rallied (dividend yields have fallen). Even so, today the yield on dividend bearing stocks in the S&P 500, at 2.29%, almost exactly matches that of the Five-Year Treasury, at 2.31%. Over time, dividends tend to be increased. A Morgan Stanley study issued in April, suggested that 52.7% of total return to stocks over the past seventy years have come from dividends. Further, the study showed that the decade of the 2000s was the only one in the past seven to provide a negative total return, marking that period a “Black Swan” event. The 1930s was the last decade to show negative returns; according to the Morgan Stanley study, the 1940s were positive by 143.1%.

Nothing in the world of finance is writ in stone. However, despite the obvious problems we face, many of which we have discussed in previous pieces, it is difficult to imagine, with a steeply sloped yield curve, dividends being raised and
skeptics apparent in persistent low rates, that the next ten years will be as bad as the last.


On Friday I will be out at yet another Grandparent’s Day, this time with two grandsons at Rye Country Day School. A blessing not an obligation, Grandparent’ Day is a wonderful way to spend quality time with special people.

Wednesday, May 5, 2010

"The Corporate Elite versus the Wealth of Nations"

Sydney M. Williams

Thought of the Day
“The Corporate Elite versus the Wealth of Nations”
May 5, 2010

George Friedman, with dialectic persuasiveness, argues in a recent essay, “The Global Crisis of Legitimacy”, that it is the political system, which over time has reallocated risk away from those managing businesses that led to the credit crisis. He argues that the “political elite” enabled the “economic elite” to enrich themselves at the expense of the wealth of the nation.

Mr. Friedman, a Hungarian born U.S. political scientist with a PhD in government from Cornell, is the CEO of Stratfor, a private firm that gathers and disseminates global geopolitical intelligence.

In the essay he writes, “The precise distribution of risk within an economic system is a political matter expressed through law…The state defines the structure of risk and liabilities and ensures that the laws are enforced…The entire scheme is designed to increase, in Adam Smith’s words, the ‘Wealth of Nations’ by limiting liability, increasing the willingness to take risk and imposing penalties for poor judgment and rewards for wise judgment.” The success of the system was not determined by whether individuals benefitted, but whether the wealth of the nation was enhanced.

The financial crisis occurred when “the corporate elite used the law’s allocation of risk to enrich themselves in ways that undermined the wealth of the nation.” They enriched themselves through systematic imprudent behavior, “while those engaged in prudent behavior were harmed.” In the Lehman bankruptcy, long term shareholders were devastated, yet former CEO Richard Fuld walked away with hundreds of millions of dollars.

The conclusion Mr. Friedman reaches is that the crisis was political in nature, as the modern corporation with limited liability is a political creation. “The public”, he writes, “is cynical about such things [and] expects elites to work to benefit themselves. But at the same time, there are limits to the behavior the public will tolerate. That limit might be defined, with Adam Smith in mind, as the point when the wealth of the nation is endangered.” This argument explains why the Obama administration must go after Goldman Sachs and others who benefitted at the expense of the nation and those more prudent – savers, in particular. It also explains, in my opinion, why Lloyd Blankfein will likely resign – not because he did anything wrong – but because Goldman Sachs is bigger than the man; the nation, as well as shareholders, are better off with the firm continuing and the man gone – a sacrifice, but seemingly necessary.

A new Presidency always represents on-the-job-training. George Bush was confronted with 9/11. Barack Obama has had to deal with the aftermath of a credit crisis that has challenged conventional economic responses. As George Friedman writes, nations consist of three basic systems: political, economic and military. All three systems have their elites. It is the interaction of the people within these systems that bear watching; success will be determined by the balance found.

Tuesday, May 4, 2010

"Future Inflation - Not 'If', but 'When'"

Sydney M. Williams

Thought of the Day
“Future Inflation – Not ‘If’, but ‘When’”
May 4, 2010

Complacency is largely absent from the behavior of equity investors and, in fact one might argue – given the low level of money flowing into domestic equity funds – that fear still grips many individual investors. Nevertheless I feel somewhat squeamish about the persistent low cost of money and the impact of these negligible costs on assets, and would suggest that complacency is surviving (if not thriving) in the realm of cheap money.

Asset inflation, in the form of home prices, played a critical role in bringing down the house of cards that served as our financial system in 2007-2008 and it seems to be playing an important role in driving the rush into Treasuries and other fixed income securities. Is 3.7% adequate compensation over ten years for a currency that is likely to be debased by inflation, as our national debt expands? The yield on Investment Grade Corporates is lower than the earnings yields on stocks, and is 50 basis points lower than it was in March 2007, at a time when we were cocooned from the tumult going on around us.

Bond market gurus tell me that the yield on High Yield Corporates still look attractive, but it seems to me that a yield decline on the FINRA-Bloomberg Index from more than 25%, at the end of November 2008, to 8.25% is indicative of a pretty good ride. In this environment, stocks look relatively attractive. The margin requirement on stocks is less than that on bonds (2X leveraged versus 4X leveraged for corporate bonds and 20X leveraged for Treasuries.) The fact that stocks have been in a bear market for ten years suggests one should not become overly bearish. Despite the fourteen month rally, stocks have benefitted less than bonds from this period of loose money, though valuations indicate they are not exactly undiscovered.

It is perhaps premature to conclude, but this concern of future inflation seems reflected among consumers in an attitude of “live well today for tomorrow we die.” The Advanced First Quarter GDP numbers suggest that consumers resumed their propensity to spend and reluctance to save, as consumption increased 3.6% and savings declined 2.7%.

While Congress and the Administration seem intent on ramming through social legislation, they appear to have little appetite, despite hundreds of televised hearings, to confront the root causes of the credit crisis, in part, I am sure, because it would implicate members of Congress and their co-conspirators, the Regulators. The Federal Reserve, which failed to see the asset bubble developing in securities and home prices, under the Dodd Bill, gets increased powers over consumer matters. Fannie Mae and Freddie Mac, which largely created and packaged mortgages, appear exempt from reform under any of the Bills in Congress. It is still unclear what will happen to derivatives, such as CDSs and CDOs, in spite of the obvious problem of insurance (CDSs) being written against assets in which buyers often have no economic interest. At the very least, all derivatives should be subjected to what Justice Lewis Brandeis termed sunshine being “the greatest disinfectant”. Existent regulatory bodies, especially the SEC, do not appear to have been scrutinized for failure to enforce existing laws, such as naked short selling so prevalent during the fall of 2008.

There is little question in my mind that inflation will be the ultimate result of the enormous deficits we are currently creating by ramming through social programs and the failure to account for the unfunded portions of Social Security and Medicare. As one wag recently put it, the analogy of Congress spending money like a drunken sailor would be appropriate, except that it insults sailors. Forthcoming inflation is no longer a question of “if”; it is a question of “when.”

Regarding Fannie Mae and Freddie Mac, I would urge everybody to read an op-ed on the two GSEs in today’s Wall Street Journal by Robert Wilmers. His piece is fact-filled and chilling in its depiction of the crony capitalism that exists between Congress and these two government agencies. Bob, who I knew forty-odd years ago when he was married to a friend of my wife’s, is the chairman and CEO of M&T Bank Corp. in Buffalo. The link is below.

Monday, May 3, 2010

"Rating Agencies - Do We Need Them?"

Sydney M. Williams

Thought of the Day
“Rating Agencies – Do We Need Them?”
May 3, 2010

The Financial Reform Bill, so highly touted by President Obama (to such an extent that he has suggested that whomever is against it must be in the pay of Wall Street fat cats!), leaves unmolested such root causes of the credit crisis as Fannie Mae and Freddie Mac, along with their incestuous relationship with Congress. The Bill also largely excuses the rating agencies from regulation, despite the role they played in being so quick to accord AAA ratings to thousands of structured mortgage products, many of which sank beneath the waves.

One of the more fascinating factors of the financial wonderland in which we live and work is that investing in equities (the riskier of the two asset classes – bonds being the other) has long relied on independent research. Bond investors, on the other hand, have largely depended upon the ratings from services such as Moody’s, Standard & Poor’s and Fitch. Since the rating agencies are paid for by the businesses, or governments, which they rate, they could be viewed as nothing more than glorified, over-priced financial public relation companies, masquerading as independent research firms. That’s probably too harsh, but you get my point. While most companies have investor relations departments, or hire financial public relation firms to promote their stocks, most investors – both retail and institutional – rely on independent analysis by firms such as ours, or on their own analysts.

It is true that many “buy-side” firms employ credit analysts and that a number of brokerage firms do as well, but they are frequently tucked away receiving little of the glory (or the notoriety) that frequently descends upon equity analysts.

Individual investors are the ones most reliant on the rating agencies; so were the ones who suffered most grievously, in part, due to the lack of honest diligence and disclosure on the part of the rating agencies.

In an editorial on Sunday, the New York Times, stated that “reform bills before Congress have only vague proposals to fix the rating agencies…” The Times, not surprisingly, urged that the agencies “should be financed like a public good, with a tax or other levy, and paid by the government.” But after watching what government did to the two GSEs, Fannie Mae and Freddie Mac, it is difficult to imagine that government is the best arbiter as to what constitutes risk and what does not. The better solution, what the Times refers to as a “drastic step”, would be to simply let them disappear. The result would be an increase in independent fixed income research and more open, honest and efficient pricing of bonds and other fixed income instruments.

So, my answer, despite the defense of Moody’s by Warren Buffett over the weekend (Mr. Buffett, an owner, has been selling the stock recently), to the question in the header is “no”. The void created by their demise would be filled by creative, entrepreneurial firms specializing in credit research and whose clients would be investors, not issuers. Those firms, either old or new, would then become the equivalent in fixed income research to what firms like Sanford Bernstein or Monness, Crespi, Hardt & Co. are to equity research.