Monday, October 31, 2011

Debt Continues to Haunt Global Economies

Even though there's snow on the ground, and many homes in New England are without power, it's Halloween.

It seems appropriate, then, to on the "debt ghosts" coming back to haunt us in the economy.

If the specter of this past weekend's storm wasn't enough to haunt you (we just got power back this morning), consider this discussion of the global debt burden that arose at a recent conference sponsored by the Economist magazine (I have added areas of emphasis):

Typically, however, the other striking speech came from Kyle Bass, the investor, which illustrated the other side of the problem. He pointed out that total global credit rose from $80 trillion in 2000 to $210 trillion today. In many nations, debt is three to four times GDP. These figures have normally been seen only in the course of major wars (i.e 1914-1918 and 1939-1945) when the result was a complete wipeout for creditors of the losing states.

Mr. Bass's figures include the so-called shadow banking system, which are entities that exist outside the normal banking channels (e.g., money market funds) that also provide credit.

These debt figures are obviously staggering. Now, to be sure, some would argue that they could be overstated, since much of what is considered "debt" are actually credit derivatives that probably will not be exercised.

But still: $130 trillion in a decade?

The Financial Times also picked up on some of the figures that Mr. Bass discussed, noting (again, I have added emphasis):

A study by the Financial Stability Board of the 11 largest economies with significant shadow banking found the sector, which previously peaked at $50,000 bn in 2007, dropped to $47,000 bn in 2008, but is now back up to $51,000 bn. It now constitutes more than a quarter of the financial system and is about half the size of traditional banks....

Regulators fear {non-bank credit} remains a big threat to long-term stability, particularly as more activities move out of the bank sector to escape tighter regulation there.

In short, while we continue to talk about paying off past debts and getting our global economy on a sound footing, the numbers would suggest that in fact we're heading in the opposite direction.

One final thought: Imagine if the shadow banking system was subject to the same capital rules as the banks? It might make the system more stable in the long run, but the shorter term consequences would be very negative.

Friday, October 28, 2011

European Banks

The markets had a huge rally yesterday with the news of the apparent resolution to the Greek debt problems.

European bank share prices soared, led by a rise of more than +20% in French bank stocks.

As I will explain, I can understand why banks are rallying - they're getting bailed out (again).

What I can't figure out is why the solution is anything but very bad news for European economies.

Here's the part that I'm focused on: the plan calls for banks in Europe to raise capital between now and the end of June next year. The figures being thrown around are around 110 billion euros, or about $150 billion.

The idea is laudable: banks need to raise more capital in the event of other sovereign credit problems, especially in countries like Ireland, Spain, Portugal or even (gulp) Italy.

Problem is, most bank stocks in Europe are trading below book value, just like in the U.S.

Issuing equity capital below book value is a sure-fired way to kill your stock value, and it seems logical that most bank managements will be reluctant to do so.

Which then leads to the real heart of the matter. For this, let me show you a very simplified bank balance sheet:


Loans and Investments 100

Total Assets 100

Liabilities & Capital

Deposits, Borrowings* 94

Bank Capital 6

Total Liabilities and Capital : 100

What you can see here is a fairly typical balance sheet which has 6 euros supporting 100 euros of loans and investments. This ratio - 6 euros for 100 euros of assets - is 6%, which is roughly where most of the European banks currently stand. This 6% figure is called the capitalization ratio.

The agreement reached yesterday called for bank capitalization ratios to be raised to 9%. The question is: how can this be done when bank stocks are trading below book value?

Simple algebra will tell you that if you're not going to sell stock, you have to reduce your assets.

If you have 6 euros in capital, and you want the capitalization ratio to go to 9%, you have to shrink the amount of assets to 67 euros, or about one-third less than their current levels.

If this is the case, this will be hugely depressing for Europe. Reducing loan portfolios by 33% between now and next June doubtlessly will entail economic pain. Shrinking the debt markets so quickly means less credit available for all kinds of meaningful economic purposes.

Now, some of the people I have spoken to say I am being too pessimistic.

First, it was announced yesterday that the authorities will be watching the banks very carefully to make sure they don't just shrink their balance sheets in the manner I am suggesting. Honestly, I don't know how effective moral suasion can be in this case, but maybe it will work.

Second, the banks themselves are claiming that they can simply retain more earnings and build capital through business operations. Well, maybe, but these are big numbers, and loan growth in Europe is really slow.

Oh, and the banks might cut their dividend payouts (as French PM Sarkozy suggested yesterday) to retain more earnings. But how does this make bank shares attractive to investors to provide needed capital?

Maybe the banks don't need to shrink their balance sheets: maybe they can just sell off huge chunks of their loan portfolios to other investors, which means that the credit will still remain in the system.

Problem with this happy scenario is that it implies that banks will be able to sell their loan portfolios at attractive prices. We tried this in the U.S. in 2008, and essentially failed - the bids were at huge discounts to book.

If you are a buyer of bank loans, and you knew the banks had to sell, are you really going to make an aggressive bid?

I could go on, but you can see my problem. If the politicians force their solution on the banks, and the "happy" solutions don't pan out, it has the danger of tipping a fragile economic situation into something more serious.

More more ominous note: Almost immediately after the Greek deal was announced yesterday, the Irish Prime Minister was quoted as saying, hey, we would like that deal also - why should we be forced to pay back all of our debt at face value if the Greeks only have to pay 50%?

Look for the rest of Southern Europe to follow Ireland.

Lots to ponder this weekend.

BTW: The funding of the loans is largely done through deposits and borrowing. In the case of the European banks, they make extensive use of the money markets. This makes the Europeans more vulnerable to changes in credit perceptions, since lines can be quickly pulled if any lender becomes nervous.

Thursday, October 27, 2011

Richard Rosenbloom

One of my favorite clients died earlier this week.

Although Boston Private Bank prides itself on confidentiality, I think I can make an exception in this case, because Dick Rosenbloom was more than a client to me.

I first met Dick in the spring of 2000. He was still teaching at the Harvard Business School, where he was the David Saranoff Professor of Technology. In the summer, Dick and his wife Ruth would head out to the Bay Area, where he was consulting at Hewlett Packard. He was also on the board of Arrow Electronics.

Although I was managing an equity portfolio for Dick, I often felt like I was learning more from him than vice versa. His insights on the world in general, and technology in particular, were incredibly interesting and helpful.

Dick made a terrific market call in August 2000. He had just finished reading Robert Shiller's book Irrational Exuberance, which described the incredible overvaluation of the stock market at that time. Although I was on vacation, Dick called me and told me to sell nearly all of the stocks in his portfolio.

The S&P 500 then started the swoon from which it has yet to recover; the market is off nearly -20% from the time Dick told me to sell.

Dick took the proceeds from his stock sales and moved them into bonds, where he also did very well. Here again his instincts were uncanny: In the midst of the credit crunch in the fall of 2008, for example, he pushed us to invest in bonds issued by banks and brokers, correctly surmising that the government would never let our largest financial institutions fail.

But there was more to Dick than investing - much more. He was totally devoted to his family. He loved talking about his three children, and their activities were always a source of interest. When his wife Ruth became ill, he became a full-time caregiver, and never complained about the burden. Her death left a void in Dick's life, but he continued to live life as best as he could even after the loss of his best friend.

I always enjoyed meeting with Dick to catch up on the markets as well as family. To be sure, Dick could be very challenging, as all good teachers can be to students.

For example, Dick disliked the idea that institutional investors had diversified portfolios, and pushed me to put only my very best ideas into his accounts, regardless of whether it increased volatility. Thanks to his prodding, I must confess that my equity performance numbers in Dick's portfolios were among the best in my client book.

Dick moved to New York City in his last years, and loved the energy and vitality of the City. While I had not seen him as much as I would have liked after he moved, we talked occasionally on the phone, and our conversations were always pleasurable.

Dick will be missed not only by me, but several other members of the Boston Private Bank community who knew him well.

Wednesday, October 26, 2011

More on Bank Stocks

We had a long and heated discussion here at the bank this morning about investing in the financial sector.

The S&P 500 has slightly more than 13% weighting in the financials. Underweight the sector in client portfolios, and financials rocket ahead like they did at the end of 2010, your relative performance suffers.

On the surface, the group looks incredibly cheap. The money center banks in particular are trading at a price/book ratio not seen in 30 years, so it would seem that they are ripe for investment opportunity.

But not to me.

Yes, I recognize that the problems of the financial sector are widely known, and that any "good news" from Europe could cause the group to soar.

Moreover, if the glimmers of economic resurgence continues, financials historically have done very well when economies are healing.

My main problem with the group relates in part to the post from yesterday about Ray Dalio. Dalio's company Bridgewater Associates focuses on what they don't know as much as what they believe, which is an approach I favor as well.

So, what is it that we don't know about the financial sectors health?

Plenty, I would argue.

For example (quoting from Monday's Financial Times Lex Column):

Try this on your credit card company: your creditworthiness has weakened, so you write down the value of what you owe to reflect the greater risk that you will not pay it all back and credit the difference to your personal account. That is exactly what accounting allows; the top five big US banks - Citigroup, Bank of America, JP Morgan, Morgan Stanley and Goldman Sachs - have just reported gains equivalent to more than four-fifths of their quarterly $16bn net profit as a result of falls in the value of their own debt and credit standing. Now European banks are set to report with the same system.

Bank of America reported reasonably good earnings last week - until you stop to consider that it needed 15 separate "one-time" boosts to get to a reasonable earnings number.

This, by the way, was on the heals of the 16 different "one-time" boosts that BofA employed in the second quarter.

So, in fact, we really have no idea what banks are even making.

Then there is the simple problem of low interest rates. Banks typically make a good chunk of their earnings from the spread between short term and long term interest rates. However, with loan demand tepid, and rates on Treasurys at 1% or less on all but the longer maturities, there is no spread available.

This becomes particularly important to banks at the present time, when they are being inundated with deposits. As Monday's New York Times pointed out:

Normally, banks earn healthy profits by taking in deposits and then investing them or lending them out at substantially higher interest rates than what they pay savers. But that traditional banking model has broken down...

Today, banks are paying savers almost nothing for their deposits. As it turns out, the banks are not minting money on those piles of cash. Lending levels have not bounced back from only a few years ago and the loans going out are not keeping pace with the deposits rushing in.

And what do we know about the quality of bank balance sheets? Nothing. Banks have been reluctant to write down non performing loans since they do not want to recognize losses.

In short, we don't know what banks are actually earning, nor do we know anything about credit exposure. With the economy mired in de-leveraging mode, prospects for loan growth do not seem promising.

So what is the catalyst for bank stocks? I'm hard pressed to find one, but I will continue to look.

One final point: one of my fellow managers kept insisting that "everyone" is bearish on the financial sector, and banks in particular. He concludes that the contrarian play, then, is jumping back in the sector.

However, financials still represent the second largest sector weighting in the S&P index, despite massively underperforming the rest of the market this year.

The stock market that by definition has to have a buyer for every seller, there apparently are still lots of folks that believe that the banks are about to turn.

Tuesday, October 25, 2011

Ray Dalio of Bridgewater

I had the chance to watch Ray Dalio of Bridgewater Associates being interviewed on the PBS talk show Charlie Rose last week.

Ray Dalio is one of the most successful money managers of our generation. Starting in 1975, his firm now manages approximately $125 billion for a wide variety of clients, including some of the largest public pension plans. Last year, Bridgewater was the top performing hedge fund in the United States, proving that size isn't necessary a deterrent to performance.

Unfortunately I was not able to figure out how to imbed the video from Mr. Dalio's appearance. However, if you have 37 minutes at some point, and want to hear from one of the Best, I would encourage you to visit and watch the entire interview.

Bridgewater is a "macro" investor, which means that they place their investment bets based on their work on global economic and market trends.

One of the most interesting parts of the interview, in my opinion, is how much Mr. Dalio says that his firm focuses on what they don't know. Unlike many investors - who make a specific forecast, then invest accordingly - Bridgewater considers a wide range of scenarios, and tries to figure out investments that will do well in a variety of different outcomes.

In this tendency Bridgewater is not alone. It seems to me most of the best investors - including Warren Buffett - spend more time on downside risks than they do opportunities. Despite their enormous success, Dalio and Buffett are humble enough to recognize that events often take place that virtually no can anticipate, and they make their investments accordingly.

Dalio has an editorial in this morning's Financial Times in which he repeats some of the themes that he discusses on the Charlie Rose program.

Dalio believes there are three important trends to consider right now:
  1. We are in the midst of a massive de-leveraging process. Dalio notes that he is not only concerned about the huge government debts around the globe, but also the massive amount of debt that individuals also have amassed. In his opinion, the process of reducing this debt will be a drag on economic growth for years;
  2. Governments are largely out of ammunition. Dalio believes there is are few alternatives left for our elected officials to improve the current economic climate;
  3. We are at each other's throats. The tone of any policy debate has become incredibly nasty and strident, and no one seems to want to try to come up with any workable solutions. This, in Dalio's opinion, is probably the biggest danger to our economies and markets.
Here's the final paragraph of Dalio op-ed piece:

If we calm down and work together to properly manage this difficult situation....we can get through this deleveraging without great pain. If we can't, we may experience an economic, social and political collapse.

Monday, October 24, 2011

Managers, Pigeons, and The Perils of Overconfidence

Let's start the week with a pop quiz.

I am going to sit you down in front of a screen where I will flash two lights: red and green. I will tell you the sequence is completely random, but 80% of the time the light will flash green.

And, oh, by the way: one of my assistants will be doing the exact same experiment in the next room, only she will be having a pigeon doing the guessing.

Who do you think will get more right? You or the pigeon?

Now we'll start our experiment. I will start flashing the light, and I want you tell what color is coming up next.

Here's what you should do: I have already told you that 80% of the time the light will flash green, and that the sequence will be totally random. So, the correct guess will always be "green", so you will be right 80% of the time.

But that's not what most humans do. They tend to look for patterns where none exist. Here's how Jason Zweig described our human tendencies in his book Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich:

Human, however, tend to flunk this kind of experiment. Instead of just picking green all of the time and locking in an 80 percent chance of being right, people will typically pick green four out of five times, quickly getting caught up in the game of trying to call when the next red flash will come up. On average, this misguided confidence leads people to pick the next flash accurately on only 68 percent of their tries. Stranger still, humans will persist in this behavior even when the researchers tell them explicitly...that the flashing of the lights is random.

Meanwhile, the other room, your pigeon competition is guessing correctly 80% of the time, since the bird automatically picks green every time. Mr. Zweig explains:

...birds seem to stick within their limits of their abilities to identify patterns, giving them what amounts to a kind of natural humility in the face of random events. People, however, are a different story.

In short, the pigeon probably wins.


I was reminded of this story yesterday, when I read a piece by Dan Kahneman in yesterday's New York Times about the perils of overconfidence.

Dr. Kahneman was awarded a Nobel Prize in 2002 for his groundbreaking research into behavior finance. He has also written extensively about how one should view any predictions about future events, especially economic or related to the stock market, with a grain of salt.

In my field, you often read predictions about the future course of the stock market, or the direction of interest rates. These pronouncements are usually made with great confidence, yet are often just as likely to be wrong as they are right.

Just as in the behavior experiment, we humans like to look for patterns where none exist. We might know, for example, that investing in stocks will tend to outperform other asset classes, yet we persist in trading in and out of the market based on our belief that we will be able to "time" the market.

Here's Dr. Kahneman's advice:

We often interact with professionals who and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness. ls who exercise their judgment with evident confidence, sometimes priding themselves on the power of their intuition. In a world rife with illusions of validity and skill, can we trust them? .... We can believe an expert who admits uncertainty but cannot take expressions of high confidence at face value. As I first learned on the obstacle field, people come up with coherent stories and confident predictions even when they know little or nothing. Overconfidence arises because people are often blind to their own blindness.

Friday, October 21, 2011

TIPS Are a Crowded Trade

Ned Davis - founder of Ned Davis Research, a market research firm that I highly respect - has three simple rules for investors:
  1. Don't fight the tape (i.e., when the market is trending in one direction, don't try to fight it);
  2. Don't fight the Fed (i.e., when Fed policy is easy, buy stocks, or vice versa);
  3. Be wary of crowds at the extremes (i.e., when sentiment is overwhelmingly skewed in one direction, be careful).
I have often thought of Ned's rules, but I was particularly reminded of rule #3 this morning, when I read this sentence from an email sent by Brad Hintz, Bernstein's financial analyst (TIPS are "Treasury inflation protected securities"):

Yesterday, the U.S. Treasury sold $7 billion of 30-year TIPS at a record low yield of 0.999%. Demand was very strong as the bid-to-cover ratio was 3.06, well above the average of 2.40. Indirect bidders, a class of investors that includes foreign central banks, purchased 43.2% of the securities, above the average of 40.0% for the past four auctions

Think about that: there apparently is a large enough group of investors so convinced that inflation will be roaring back that they are willing to lock in returns of less than 1% for the next 30 years (!).

I know I wrote yesterday that investors should avoid predictions, but here's one that I can safely make: The world will look alot differently in 2041 than it does today.

So does that mean that bonds are overvalued?

Well, maybe, but I think with the Fed keeping short rates at 0% for at least the next couple of years, and deflation, not inflation, a bigger risk, bonds can still play a role in investor portfolios.

But for investing, it still seems to me that dividend-paying, large cap stocks are the way to go. So too does legendary investor Leon Cooperman, who is not a big fan of bonds.

Instead, Mr. Cooperman likes stocks:

“I wouldn’t be caught dead owning a U.S. government bond,” he said today during a presentation at the Value Investing Congress in New York. “Not because I have a problem with the credit. I have a problem with paying 35 percent on the 2 percent to Uncle Sam, and then have a 2 to 3 percent rate of inflation,” he said. “It’s confiscation of my capital. I think I’m too smart to play that game.” ...

Stocks are cheap relative to history, relative to inflation, relative to interest rates,” he said. “The recent facts suggest the economy is accelerating moderately.”

Thursday, October 20, 2011

How Not to Set Investment Strategy

"Prediction is very difficult, especially about the future"

One of the biggest mistakes that investors make, in my opinion, is to try to overlay their views on the economy or interest rates on their investment strategy.

It seems to make logical sense: first you forecast the economy, then the direction of interest rates. Once you've figured this out, you turn your attention to what stocks or bonds will provide the best returns under the scenario that you expect.

Problem is, the accuracy of most forecasts - especially about the economy, interest rates and the stock market - are usually poor at best.

The academic literature is full of examples of how many of the most prominent and learned among us have failed to anticipate changes in the economy. It's not for lack of trying, but rather that it's just too complex.

Take interest rates, for example. Here's a short note written by John Carney the CNBC blog Net, Net:

The latest note from James Bianco points out that Bloomberg’s monthly survey of economists almost always forecasts high rates for 10-year Treasurys in the next six months.

Since 2002, Bloomberg has been asking economists where they think interest rates will be six months into the future. Out of the 104 surveys completed, 100 of them forecast high rates in six months.

Every single survey for 2011, for example, the majority of economists polled forecasted higher rates.

Interestingly, the economists are always right when predicting falling rates—although this has only happened four times so far so the sample may be too small to matter.

Now, with interest rates at 60-year lows, what's the next direction for rates?

Truth is, no one knows for sure.

It seems to me that one should focus their investment attention on sectors that offer the most value under a variety of different scenarios, no matter how far fetched they might appear.

*This quote is usually attributed to Niels Bohr, a prominent Danish physicist, although Bohr himself attributed it to others. Whatever - I like the quote.

Wednesday, October 19, 2011

What to do about Bank Stocks?

I first wrote about this topic last March. Fortunately, I concluded that it was not yet time to dive into the sector, despite the fact that the valuations appeared very attractive.

Here's what I wrote then:

Problem now is that the very same problems that nearly destroyed the system are still very much evident. There still remain thousands, if not millions, of home mortgage loans that are underwater, and the outlook for housing is still very poor, in my opinion. Derivative products tied to mortgage loans also are pervasive in the system.

Then there's the problem of growth. Speaking as someone who works at a bank, we have lots of money to lend, but face a real paucity of credit-worthy borrowers. This is part of the problem the Fed is facing, by the way: the central bank can keep adding money to the system, but it is largely being reinvested in Treasurys, which doesn't do too much to either help the economy (or help bank profits, for that matter).

Lots has happened in the last 6 months, but nothing (in my opinion) has changed in terms of the headwinds facing my industry.

Loan growth remains sluggish. Low interest rates are killing bank net interest markets. Credit metrics for the banks are starting to show deterioration again, after several quarters of improvements.

And recent results from the money center banks appear attractive, yet once you dive into the numbers much of the recent bank profitability has been achieved through "special items".

Consider Bank of America, which posted stronger results than expected, and BAC soared by +10%. However, according to this morning's New York Times:

Still, the story behind {Bank of America's} $6.23 billion profit was mostly a tale of one-time gains from accounting changes and asset sales, including $4.5 billion from positive adjustments to the value of its outstanding debt, a $1.7 billion accounting gain on the perceived riskiness of its debt and a pretax gain of $3.6 billion from the sale of half its stake in China Construction Bank....

Without the special items, Bank of America would have earned about $2.7 billion, which included pulling back $1.7 billion it had set aside, largely for borrowers who fail to pay their consumer and credit card loans.

Jason Goldberg, an analyst with Barclays Capital, counted 15 special items in the quarter, down from 16 in the second quarter but more than the 12 in the first quarter. “It’s a big company undergoing a transformation.”

Now, I am a fan of Jason Goldberg, but is it really a positive that the number of special items in Bank of America's earnings has fallen from 16 "one-off" items to 15?

Then there's this: I asked Rich Sipley, a fellow portfolio manager here at Boston Private Bank (and loyal reader of Random Glenings) a simple question yesterday.

Me: "If bank stocks are so cheap, why are we seeing more acquistions?"

Rich: "No one wants to sell at these prices."

That's why Rich is a good portfolio manager.

That said, there is more feelings that the longer term outlook is for a large increase in bank merger activity, simply because the costs of banking in this country are rising significantly at a time when revenue growth has been nonexistent.

This morning's Financial Times carried a piece this morning discussing the need for the banking sector to shrink in the U.S.

According to the article, a recent report by turnaround specialists Alvarez & Maral suggests that large U.S. regional banks will "need to cut expenses by up to 40% to cope with slower economic growth, increasing pressure to cut staff or merge with rivals".

Here's the problem:

Companies such as Regions Financials - which is trading at about a third of its book value - and Sun-Trust banks - trading at about half of its book value - will be among those facing pressure either to pare back their operations significantly or merge with competitors. Many already have announced cost-cutting measures to placate investors.

From 2002 to 2006, banks' ROE was about twice as high as their cost of equity capital, according to Alvarez & Marsal. Since 2008, the cost has exceeded the return, a trend that is forecast to continue until 2013.

So for now I remain very defensive in my bank positions in portfolios.

Tuesday, October 18, 2011

Market Volatility

The blog Zero Hedge posted an excerpt this morning from Michael Higley's weekly "By the Number$" newsletter:

During the first 4 months of the year through 4/29/11, the S&P gained +9.1% (total return). From 4/29/11 to 10/03/11 (i.e. approximately the 5 months that ended just 2 weeks ago), the S&P 500 lost 18.6%. But in the last 9 trading days through last Friday (10/14/11), the stock index gained +11.5%. The net YTD result: down 1.1% as of 10/14/11.

Put another way, net-net, stocks have gone nowhere this year, but its been a helluva ride.

To me, this year's volatility illustrates the futility of trying to time the market. Others, however, continue to try to trade the market, despite the overwhelming evidence that most trading makes money for the broker, not the investor.

I continue to think that dividend-paying, large cap stocks are the only game in town for most investors who can take a longer term time horizon. I don't know what the market will do next week, or next month, but I find it hard to believe that over the next three to five years stocks will not be the superior asset class.

One of the more bullish market analysts this year has been Lazio Birinyi, but he wrote a piece in this morning's Financial Times modestly changing his tune.

Mr. Birinyi now describes himself now as being only moderately bullish. He is concerned about data showing an economy that is decelerating, and the possibility that the European and Asian markets will also drag on the US stock market.

That said, Mr. Birinyi would not abandon the market, noting that some of the bearish arguments that are currently making the rounds have been made for years. Abandoning the market based on current sentiment, as Mr. Birinyi notes:

I don't know how and when this will end. One clue might be to look for negative reports. On March 9, 2009, at the bottom, the Wall Street Journal's Money section headlined "Dow 5,000? A bearish possibility."

And one of the longest market stories in last year's New York Times - again at the bottom for markets that year - was subtitled "Wall Street tallies new losses with a bear market in mind."

Monday, October 17, 2011

Investing in Farmland

In the early 1980's, when I was just getting started in the investment business, there was widespread consensus about where all "smart" investors should have funds: gold and oil.

Gold hit a high of $850 in 1980, while oil had reached $39 a barrel in the same year. The thinking among most institutions was that commodities in general, and gold and oil, in particular, were only destined to move higher in price, especially since they had outperformed all other asset classes in the prior decades.

Then reality hit. Gold prices started to fall, and by the year 2000 gold was priced at $250 an ounce, or nearly -70% lower than two decades earlier.

While gold prices have recovered recently, investing in gold in 1980 would have yielded a return of less than 1% per annum for the past 30 years, far below traditional investments in either stocks or bonds.

Oil prices, too, had peaked in 1980, even though it was not apparent to anyone at the time. Oil prices fell by more than -75% by 1986 to less than $10 a barrel, as oil supplies far outstripped demand.

Like gold, oil prices eventually recovered, but here again the returns from investing in oil have been barely higher than 2% per annum over the last 30 years.

Which brings me to farmland investments.

The current investment du jour is farmland, according to Gillian Tett of the Financial Times. In her piece last Saturday, Ms. Tett notes that TIAA-CREF, the huge pension fund targeted largely to educational and non-profit institutions, is now apparently the largest owner of U.S. farmland today.

Other large institutional investors have joined TIAA-CREF in their appetite for farmland. According to an OECD report, notes Ms. Tett, 54 investment funds now have $7.44 billion of agricultural investments around the world, and this is "expected to double or triple in the near to long term".

The logic of investing in farmland is to me eerily reminiscent of the same reasoning that lead investors to pile into oil and gold investments a generation ago: the world is changing, the amount of farmland is finite, etc.

Oh, and the historic returns from investing in farmland have to date been far better than investing in stocks or bonds.

Now, it could be that I am too cynical, but after growing up in the Midwest I can tell you that farmers tend to be pretty good judges of the value of their land.

And if farmers are selling to the "shrewd" money managers from New York, I would be more than a little cautious.

Past performance, as people in my industry constantly remind us, is no guarantee of future results. I would be willing to bet that returns from indiscriminate farmland investments will be poor indeed relative to other alternatives in the years to come.

Friday, October 14, 2011

Investment Choices in a Low Return World

It has been said that democracy is the worst form of government except all the others that have been tried.
-Winston Churchill

When I look at the asset markets today, I am reminded of Churchill's quote.

Investors and savers face a fairly unappetizing menu of investment choices these days.
  • Stay in cash and earn nothing for the next two years?
  • Buy high quality bonds with yields at 60-year lows?
  • Buy stocks whose returns over the last decade or so can best be charitably described as mediocre?

You already know where I stand on this: I think that dividend-paying, larger cap stocks offer the best combination of income and capital appreciation potential.

Still, there is no question that stocks will continue to show more volatility than most would prefer as the world struggles with the mountain of debt we accumulated over the past decade.

The Economist has written in this week's issue about the difficult choices facing investors these days.

For example, the article cites a Deutsche Bank study on bonds:

Deutsche Bank’s study suggests that, if yields revert to the mean, investors in 30-year Treasury bonds will suffer an annualised loss of 3.3% over the next five years and 1.3% over the next ten; investors in ten-year bonds will suffer annualised losses of 4.3% and 2% respectively.

And what about commodities? Here's The Economist's view:

The problem with gold, and other commodities, is that with no yield or earnings they are hard to value. Demand from Asian countries has certainly pushed up prices; non-oil commodities have trebled over the past decade. But if the economy does start to slip into recession, commodity prices could fall very sharply; they almost halved between March and December 2008. This year they have dropped by around a fifth since February.

I could go on, but you get the idea: there are very few safe havens in today's world.

Still, as both The Economist and other analysts have suggested, buying higher yielding equities trading at reasonable valuations offer the best potential returns from a relatively meager list of alternatives.

The key, in my opinion, will be to focus on companies whose dividend is not only attractive today, but has the potential for growing along with inflation in the years to come.

Fortunately, there are numerous companies that fit the bill. Corporate America flush with cash, and margins are at record levels. Payout ratios for most companies is at historically low levels, which gives the chance for dividends to grow.

Thursday, October 13, 2011

Stocks Do A Three Year Round Trip

Last week, on October 3, the S&P 500 closed at exactly the same level that it closed on October 3 three years ago: 1099.23.

As John Authers noted in his column in the Financial Times last weekend:

"Buy and hold" investors in US stocks had spent three of the most exciting years in financial history getting back to exactly where they started...

Stocks have endured a lost decade. And looking just at the past three years, all the gyrations since then have left us exactly where we were only three weeks after the fall of Lehman Brothers.

No wonder investors are discouraged.

The question is whether the period going forward will be any different than the fall of 2008, when stocks started the swan dive that did not end until March 2009.

I think it will be, although there is still the possibility of a negative political "surprise" from either Europe or Washington.

Unlike the fall of 2008, when the credit markets were virtually shut, corporate America is flush with cash, and credit is widely available for most credit-worthy borrowers. In addition, most corporations report that business trends remain favorable, although corporate CEO's have been very careful in their expansion plans.

Economic data also suggests an economy that is expanding, albeit at a tepid pace. Last Friday's non-farm payroll report, for example, indicated an economy that was adding jobs at a rate faster than most economists had predicted.

Still, stocks are searching for the catalyst that will restore a sustainable rally, and that seems to be lacking at this point.

Wednesday, October 12, 2011

Are ETF's To Blame for Stock Market Volatility?

I am a big fan of exchange-traded funds (ETFs).

Following in the footsteps of index funds, ETF's became popular about a decade ago.

As originally conceived, the ETF concept is simple: offer investors a low cost, tax-efficient way to gain access to a particular market segment without taking the risk of a single security.

There are more than $1 trillion of ETF's now outstanding, so I am not alone in my enthusiasm for the product. Indeed, ETF's and low-cost Vanguard index funds are really the only segments of the financial products markets that have shown significant growth this year.

However, as with any good idea, the ETF concept has been morphing into different product types that tend to be more complex and, of course, more profitable to the provider. There are more ETF's outstanding today than actual stocks, and the number of new ETF introductions keeps growing.

You can now put your hard-earned savings into an ETF that can offer leveraged bets on any or all parts of the markets, for example.

Andrew Ross Sorkin wrote a piece for the New York Times yesterday quoting investment guru Doug Kass as indicating that these leveraged ETF's are partially to blame for the wide swings in stocks prices that we often see at the end of the trading day:

{Kass} says he knows the culprit behind the late-day market swings: leveraged exchange-traded funds or E.T.F.’s....

To Mr. Kass, these E.T.F.’s are the “new weapons of mass destruction.” (His description is an homage to Warren Buffett’s widely quoted line that derivatives are “weapons of mass destruction.”)

“They’ve have turned the market into a casino on steroids,” Mr. Kass said. “They accentuate the moves in every direction — the upside and the downside.”

Mr. Kass... may be right: at the end of every day, leveraged E.T.F.’s have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted. If the E.T.F. made money that day, to remain balanced it has to reinvest the proceeds and leverage them again. In many cases, leveraged E.T.F.’s use options, swaps and index futures to keep themselves in balance.

You might consider the E.T.F. the new derivative.

Columnist Herb Greenberg also wrote about ETF's and market volatility in a piece published on CNBC:

ETFs, or exchange-traded funds, which started as a sound idea but, with Wall Street being Wall Street, have all but turned into a monster... even the biggest operator of ETFs, BlackRock, is concerned about the direction some ETFs have taken—becoming too complex and confusing, with so-called double- and triple-leveraged ETFs leading the charge...

With most ETFs mindlessly mirroring various indexes of everything from the S&P 500 to the illiquid stocks of makers of lithium batteries, THEY have become the market. (Stats showing that the market has never been more correlated to itself—another way of saying everybody is trading in and out of the same things at the same time—have never been higher.)

I don't have enough data on the impact of ETF's, or leveraged ETF's, on the market, but it would be interesting to see the numbers.

What I really worry about, though, is an ETF provider that lacks the sophisticated management tools of, say, Blackrock, State Street or Vanguard.

Packaging and managing an ETF is more difficult than it might appear at first glance, particularly in volatile markets.

Tuesday, October 11, 2011

Steve Jobs's"Amazing" Estate Plan

I have no way of checking this story - only Steve Jobs's family and estate attorneys know the facts for sure - but it seems reasonable to assume that the authors have done some pretty thorough research.

Steve Jobs, of course, died a very wealthy man. Most estimate put the wealth of one of Apple's founders in the neighborhood of $6 billion or so.

However, it appears that his estate tax bill will be essentially nothing.

According to this article which appeared on The Trust Advisor Blog, after Jobs had his first brush with death in 2003 he put the vast majority of his assets in trusts.

Most of Jobs wealth was in the form of three huge stock positions: Disney (he was a 7% owner); Pixar; and, of course, Apple. Since these assets were moved into trusts, so none of them would be part of his estate.

His house would have naturally gone to his wife Laurene (as the surviving spouse) but apparently he put this in trust also.

Jobs was famous for not taking a salary from Apple in recent years, which meant that he probably had little in the way of assets other than his stock holdings.

His estate plan would also explain why Jobs did little in the way of large philanthropic gifts like his fellow billionaires Warren Buffett and Bill Gates. Since most of his assets were in trusts, and he didn't have any salary from Apple, he might simply not have had the money.

Here's an excerpt from the blog:

Given his efforts to keep his personal life private, we won’t ever know exactly how his estate plan allocates his wealth — unless, of course, he wanted the world to know.

We do know that it involved a network of at least two trusts. California records show that he and his wife, Laurene, moved their Palo Alto house and other real estate into two trusts when his liver was failing in early 2009...

Completely under the radar, SEC filings reveal that Jobs was also busy moving the rest of his material wealth — 5.5 million shares of Apple stock and 138 million Disney shares, a memento of his other baby, the animation company Pixar — out of his estate and into a trust.

Since he basically earned nothing from either Apple or Disney since then, it’s possible that he died with no real assets in his name...

Given the elegance of the products he designed, it is not surprising, I suppose, that his estate plan was so clean and effective.

Or, as he might have said, it's "amazing".

Monday, October 10, 2011

Finally! Regulators Take on the Computers

It appears that even regulators are getting tired of high frequency trading.

As I written earlier, many people - including myself - regard computer-driven trading (most of which is no more than front-running) would like to see high frequency stock trading curbed, if not eliminated.

So I was pleased to pick up the New York Times yesterday morning and see on the front page ("above the fold", no less) a story entitled "Clamping Down on Rapid Trades in Stock Market". Here's an excerpt:

Regulators in the United States and overseas are cracking down on computerized high-speed trading that crowds today’s stock exchanges, worried that as it spreads around the globe it is making market swings worse.

The cost of these high-frequency traders, critics say, is the confidence of ordinary investors in the markets, and ultimately their belief in the fairness of the financial system....

I think we'll expect the usual push-back from Wall Street, but I think that anything that help restore confidence in equity investors will go a long way to helping the individual investor.

Friday, October 7, 2011

Saving the Euro

The fate of the euro will be decided over the next few weeks.

The key player in the drama - Germany - is conflicted over its desire to save the euro and its anger and irritation at having to bail out its more profligate neighbors.

Meanwhile, austerity measure proposed in Greece, Italy and other countries are drawing nationwide protests.

There have been any number of proposals on how the euro can be saved. I don't know which will be adopted - if any - but they all have one thing in common: they're going to require huge sums of money.

However, an article yesterday in the New York Times suggests that vast sums of money alone may not be enough.

Written by Peter Boone and Simon Johnson, the piece discusses one current proposal which suggests that a mere 4 trillion (!) euro bailout package should do the trick.

This is a mind-boggling number: the authors note that the GDP of Germany is around 2.5 trillion euro, so the bailout would involve either direct funds or guarantees totaling 50% more than the yearly economic of the largest economy in Europe.

Yet they also suggest that a massive bailout package may not save the day. Moreover, if additional funds were to be needed after the initial financial infusion, there is the real question as to when donor fatigue would set in, i.e. when would the German citizenry say, enough is enough:

Lech Walesa famously remarked that it was easier to make fish soup from fish than to do the reverse. So it is with fiscal crises — once fear prevails and markets start to think hard about the stress scenario, it is hard to solve the problem simply with reassuring words or financial support that never needs to be used....

Putting in place a huge financial package is not enough. Policies have to adjust across the troubled euro-zone countries so that nations stop accumulating debt, and the periphery moves rapidly from being among the least competitive nations in the euro area to the most competitive — and this includes lower real wages, even if debts are restructured appropriately.

The European leadership is a long way from even recognizing this reality, let alone talking about it in public.

In other words, even if a massive bailout package is announced tomorrow, it is not clear that the eurozone will be saved unless fundamental changes are enacted.

Interesting thoughts going into a long weekend.

Thursday, October 6, 2011

Steve Jobs, and Tobin Taxes

I'm not going to write about Steve Jobs this morning - the papers and media are full of great memories - but I wanted to mention again how much I found his 2005 Stanford commencement talk inspirational.

The full text can be found at the link below, but here's an excerpt from his talk:

Your time is limited, so don't waste it living someone else's life. Don't be trapped by dogma — which is living with the results of other people's thinking. Don't let the noise of others' opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary.

Back to the markets:

This past Tuesday afternoon, at about 3:30, I was in the midst of a conference call with an investment committee of an important client.

I have two screens on my desk, so while one screen had my PowerPoint presentation, the other had stock markets updates flashing.

When we started our call, the screen was mostly red: stocks were largely down for the day.

Then, about 15 minutes into our call, a funny thing happened: the stock market turned around, and suddenly my screen turned from mostly red to mostly green, as stocks suddenly moved sharply higher.

What the heck was going on?

The official explanation was that there was a story written by the Financial Times that suggested that European governments were close to some sort of rescue package for Greece.

(This report, by the way, turned out to be false.)

What really seems to be going on is a market increasingly divorced from fundamentals. Instead, the direction of the market is being set by high frequency, computer-driven trading and leveraged hedge funds. These investors care little about fundamentals or economics; instead, they are looking to hop on stocks if they are going higher, or short them if they are going lower, with a time horizon of five minutes or less.

Here's what Reuters wrote yesterday:

In less than one hour on Tuesday, the U.S. stock market surged by 4 percent -- for no apparent reason.

The last hour of trading was the most volatile final hour in two months -- and it occurred at a speed that frightens many, from experienced hedge-fund managers to mom-and-pop investors.

The late-day "melt-up" that pushed the S&P 500 index .SPX out of bear-market territory might be construed as good news. But it brings back echoes of the "flash crash" that saw markets dive by several hundred points in a matter of minutes, and it's a big reason many are staying away from the market.

"Everyone is scared in both ways -- the shorts are scared, the longs are scared, everyone is scared. The high-net-worth investor is very, very scared," said Stephen Solaka, managing partner at Belmont Capital Group in Los Angeles, which manages money for independent wealth advisers and family offices.

Tuesday's move was the latest example of an erratic, high-octane stock market increasingly driven by levered exchange traded funds and complicated hedging and options strategies that unwind with dizzying speed.

It's a far cry from when the U.S. stock market was viewed as a place for capital-raising by businesses seeking to expand and a place for investors looking to put their savings to work.

There has been a lot of talk recently about instituting a small transaction tax on every stock or bond trade. Originally called the "Tobin tax" after the economist who first mentioned the concept back in the early 1970's, the idea would be to try to encourage longer-term thinking in the investment community by taxing trading.

Wall Street, of course, hates the idea, and mentions all sorts of reasons why such a tax will either not work or will penalize pension funds.

But the real reason the Street hates such a tax is that it would make high frequency trading considerably less profitable, and reduce trading volumes in general.

If a transaction tax were to be enacted in all of the world's major markets - so that traders couldn't avoid the tax by simply moving their activities to another market - I think it might go a long way to making stocks more palatable to individual investors. Yes, the markets would continue to move up and down, as they always have, but at least the direction would be determined by reality, and not cyberspace.

I think a Tobin tax is worth a serious look.

Wednesday, October 5, 2011

Investment Lessons from Andrew Carnegie

A little more than a century ago, in 1901, Andrew Carnegie sold his family's interests in its steel enterprises to a group led by J.P. Morgan and Charles Schwab (no relation to the brokerage).

The consortium - which was retitled the United States Steel Company - immediately became the largest corporation in the world, with a market capitalization of over $1 billion.

The sales price was 12x annual earnings (interestingly, about where the S&P 500 is trading today). The total value of the transaction was $480 million, or about $13.7 billion in today's dollars (according to Wikipedia, by way of Gale Virtual Reference Library).

Carnegie's personal share of the transaction was slightly more than $225 million, which was paid to Carnegie in the form of 5%, 50-year gold bonds. According to Wikipedia:

The bonds were to be delivered within two weeks to the Hudson Trust Company of Hoboken, New Jersey, in trust to Robert A. Franks, Carnegie's business secretary. There, a special vault was built to house the physical bulk of nearly $230,000,000 worth of bonds. It was said that "...Carnegie never wanted to see or touch these bonds that represented the fruition of his business career. It was as if he feared that if he looked upon them they might vanish like the gossamer gold of the leprechaun. Let them lie safe in a vault in New Jersey, safe from the New York tax assessors, until he was ready to dispose of them..."

What made me think about Carnegie's transaction was how, in some ways, the world is still struggling to find the right combination of safety and yield.

In Carnegie's day, there was no Federal Reserve (which was actually started in 1912). Deposit insurance was unheard of, and bank failures were not uncommon. Government bonds were relatively scarce, and even if they were, the creditworthiness of the United States was not perceived as strong as other countries like Britain or Germany.

So it would make sense for someone looking to preserve great wealth to look for two key characteristics: first, it had to offer an attractive yield (5% sounds pretty good today!); and, second, it had to be absolutely secure (hence the gold backing).

Unfortunately there are no 5% gold-backed bonds available today. Moreover, the only place that investors can find any sort of relatively safe yield is in dividend-paying common stocks.

Bloomberg had an interesting article this morning noting that while dividend yields are attractive, there is plenty of reason to believe that corporate America can raise payouts significantly in the coming years, especially if stock market returns remain subdued:

Pressure is building for higher dividends as U.S. companies from Google Inc. (GOOG) to Valero Energy Corp. (VLO) sit on record cash stockpiles and payouts remain at three- year lows.

Standard & Poor’s 500 Index companies paid 27 percent of earnings in dividends in the second quarter, down from 30 percent in 2008 and below a 30-year average of 41 percent, according to Wells Fargo & Co. Company cash, equivalents and short-term marketable securities jumped 63 percent to $2.77 trillion in the same period, according to Bloomberg data.

The article goes on to quote several investment professionals noting the extremely high cash levels that many corporations have stockpiled for fear of a repeat of the credit crisis of 2008.

Put another way, stock buybacks and hoarding cash are in some ways a bull market strategy. Investors have no problem not receiving cash directly from their investments so long as their stock investments are rising in value.

However, with the S&P down more than -17% over the past 5 years, and the papers full of recession talk, it seems logical to expect more pressure on company managements to return more cash to shareholders.

Unless we can convince someone to issue 5% 50 year gold backed bonds.