The Quiet Panic

The last time interest rates on U.S. Treasury obligations were as low as they were are today was 1946.

You probably don't remember 1946*:  Harry Truman was President, and the global economies were just beginning to recover from World War II.

Bond yields were low in this country largely because there was very little to either buy or invest in. 

American business was slowly converting back to peacetime production, but there were still widespread shortages of basic consumer goods.

U.S. bond yields had been kept low for a variety of reasons, but the patriotic calls to buy savings bonds to fund our war effort provided a huge reservoir of funding for the government at very low interest rates.

In a society awash in idle cash, banks had little need for funds, as loan demand continued to be sluggish. In 1946, many major banks were actually charging a fee to depositors, i.e. negative interest rates.

And as for stocks:  Scarred by the stock market crash of 1929, and the subsequent horrific decade of the 1930's, the response of most citizens to stocks was: fugetaboutit.

So now, 66 years, U.S. bonds yields are back to incredibly low levels last seen in my parents' generation.  The 10 year Treasury this morning yields 1.6%.

If it is any consolation, our bonds offer a better deal than many other countries.  German government 10 year notes offer a yield of 1.27%, while Japan's 10 year yields 0.8%.

We all know the reasons:  the fate of the euro zone remains in balance while Europe's leaders bicker about solutions.  Yields on government debt may be low, but at least you are assured of getting your principal back at some point.

There's a couple of aspects of the current situation that puzzle me.

First, if the world is really coming to an end, why are gold prices tumbling?

Gold has traditionally been the safe haven of choice throughout history, yet the recent tumble of gold and other commodities would suggest that something else is going on.

According to Reuters, May marks the biggest decline in gold prices in 30 years:

The precious metal is down more than 6 percent so far this month, its biggest May loss since a near 10 percent fall in 1982. The metal is also set to post a fourth consecutive monthly loss for the first time since January 2000.

While the possibility of a fresh round of monetary easing in the United States and demand for alternatives to the beleaguered euro could lift gold, confidence in the metal remains weak.

http://www.reuters.com/article/2012/05/31/us-markets-precious-idUSBRE8390RW20120531


The second paradox is the difference between what the world's bond markets are saying:

"Panic!  Sell Everything! Safety is All!"

and what corporations are actually seeing in their day-to-day business operations:

"Thing Aren't that Bad! Europe is Better than Expected! Earnings Estimates should be increased!"

Yesterday, for example, I went to hear management of Air Products, one of the world's major producers of industrial gases that are used in manufacturing around the world. They too indicated that their businesses are around the world are doing just fine; the only pocket of weakness, interestingly, is in their technology area.

So there's a Quiet Panic going on right now, but it seems to be mostly confined to the credit markets.

*I don't remember 1946 either - I was born 11 years later.

Is Now the Time to Switch from Bonds to Stocks?

Writing in last Saturday's Financial Times, columnist John Authers surveyed the current investment landscape, and discussed a very basic question:


Is now the time to dump bonds in favor of stocks?

His answer, unfortunately, is a definite "maybe".

Here's what Authers wrote:

At present, as I have said before equities look cheaper versus bonds than they have in half a century...

... Equities do look cheap, relative to bonds, because bonds are incredibly expensive.  All else equal, that should mean people start selling bonds - and buy at least some stocks with the money they release.

But talk to fund managers, and it is obvious that they are buying bonds...because regulations force them to do so.  This is financial repression - to deal with the debt they took on to quell the credit crisis, governments are forcing us all to lend to them at ruinously low rates. While artificial incentives to buy bonds stay in force, bonds could stay expensive - and equities could stay relatively cheap.

http://www.ft.com/intl/cms/s/0/7e86e80a-a58e-11e1-a77b-00144feabdc0.html#axzz1wMBzfgUr

In other words, while the data seem to suggest that investors should be running  from the bond market, it could be several years before the switch bears fruit.

We've been through periods like this before.

For example, in December 1996 Federal Reserve Chairman Alan Greenspan publicly questioned whether stock markets were in a state of "irrational exuberance". 

Well, they were, but the S&P doubled in the next four years before finally collapsing.

Further back, in 1979, Warren Buffett wrote an article for Forbes titled "You  Pay A Very High Price for a Cheery Consensus". 

What he wrote more than 30 years ago sounds very similar to the situation today:

Stocks now sell at levels that should produce long-term returns far superior to bonds. Yet pensions managers, usually encouraged by corporate sponsors they must necessarily please ("whose bread I eat, his song I sing"), are pouring funds in record proportions into bonds....

 A simple Pavlovian response may be the major cause of this puzzling behavior. During the last decade, stocks have produced pain--both for corporate sponsors and for the investment managers the sponsors hire. Neither group wishes to return to the scene of the accident. But the pain has not been produced because business has performed badly, but rather because stocks have underperformed business. Such underperformance cannot prevail indefinitely, any more than could the earlier overperformance of stocks versus business that lured pension money into equities at high prices.

http://www.forbes.com/2008/11/08/buffett-forbes-article-markets-cx_pm-1107stocks.html

The S&P 500 has traded at 1550 twice over the past 12 years:  in 2000 and 2007.  These levels are more than 14% higher than the market today.

However, earnings for the companies that constitute the S&P are much higher than in prior periods.

Analysts expect the S&P to earn $102 per share in 2012, which would +15% higher than the S&P earned in 2007 and more than double S&P earnings in 2000.

In other words, to paraphrase Buffett:  stocks have performed poorly over the last decade not because business has performed poorly but rather because stocks have underperformed businesses.

But if you had bought stocks in 1979, you would have lost -5% over the next three years (even more on an inflation-adjusted basis).  It wasn't until 1982 that the Great Bull Market began.

Can Stocks Earn Annual Returns of +10% In the Coming Years?

Sunday's New York Times carried a front page article "above the fold" about the perilous state of our nation's public pension plans.

The article highlighted the fact that the actuarial rate for most pension plans assumes investment returns in the 7% to 8% range.

However, returns for most plans have been well below this range; the pension plan for New York State, for example, earned slightly less than 6% last year.

Corporate pension plans, by comparison, are currently assuming returns less than 5%.

Changing the assumed rate of return on public pension plan to a more realistic figure is not as as simple as it might seem.  The lower the assumed rate, the more taxpayer contributions are required to make up the shortfall, which is obviously not a message that most politicians want to deliver.

Still, at some point a little honesty seems appropriate, as New York City Mayor Bloomberg noted:

“The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” Mr. Bloomberg said during a trip to Albany in late February. “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.” 

http://www.nytimes.com/2012/05/28/nyregion/fragile-calculus-in-plans-to-fix-pension-systems.html?_r=1&src=me&ref=general

Part of the problem for the public plans is asset allocation.

The response of the public pension plans to the financial turmoil of the past few years has been to reduce the risk profile of their investments.

According to Boston College's Center for Retirement Research, the average allocation to fixed income among public plans in the U.S. is almost 30%, while stocks average less than 50% nationally.  Alternative investments - such as private equity and real estate make up the rest.

http://pubplans.bc.edu/pls/apex/f?p=1988:12:1473440180402201:pg_R_420673752751727939:NO&pg_min_row=21&pg_max_rows=20&pg_rows_fetched=20

The average yield to maturity of the Barclays Aggregate Bond Index - which encompasses the entire investment grade corporate bond universe, plus mortgage-backed securities and U.S. Treasury obligations - is 1.74%.

If you have roughly one-third of your porfolio yielding less than 2%, this implies that the remaining two-thirds has to earn nearly 10% in order to come up with a blended rate of 7%.

And while I am generally positive on the outlook for stocks in the coming years, I would note that periods of 10% compound returns from equities are relatively rare.

Investors Flee the Stock Market

In a piece titled "Out of Stock" in yesterday's Financial Times, co-authors John Authers and Kate Burgess wrote the following:

Indeed, equities have not been so cheap relative to bonds since 1956, which turned out to be one of the best moments in history to have bought stocks.

http://www.ft.com/cms/s/0/d754f94c-a4ba-11e1-9908-00144feabdc0.html

By any number of measures, the relative attractiveness of stocks relative to bonds should be evident to most investors.

Interest rates on government bonds in the U.S. and Western Europe are below the rates of inflation. 

Indeed, earlier this week the German government successfully auctioned notes maturing in two years that will pay investors no interest.

The period of "financial repression" that we are experiencing is robbing savers of a reasonable rate of interest. Government policies around the world are all targeting low interest rates, which allows fiscal deficits to move ever higher without a corresponding rise in interest expense.

And why should this change?  Some serious observers of the financial markets suggest that we are actually experiencing a shortage of bonds.  They suggest that low interest rates reflect the huge demand for income and safety from an aging population.

Regardless of why interest rates are low, however, it still is puzzling why bonds continue to be favored over stocks by investors.

Authors Authers and Burgess note fixed income allocations continue to ratchet higher among not only individuals but also managers of pension and endowment funds despite the fact that:

 ...in the long run, equities outperform.  From 1900 to 2010, they beat inflation by 6.3 per cent in the U.S., according to a widely used benchmark maintained by London Business School, compared with only 1.8 per cent for bonds.

And yet:

In the U.S. and U.K., public pension funds had allocations to equities as high as 70 per cent only 10 years ago.  They are now down to 40 per cent in the U.K., and 52 per cent in the U.S.

Ponder this for a moment:  a pension fund, by definition, should have a very long term time horizon when it comes to investment policy.  Investing in assets like stocks that have proven over very long periods of time offer superior inflation-adjusted returns should be automatic.

But that's not what is happening.

Some of this behavior is not as irrational as it might seem, by the way.  Government regulations have been enforced on pension plans that make their managers very risk adverse. 

Bonds may offer meager returns today, but their strong relative performance over the past decade relative to bonds makes it easy for plan sponsors to justify high bond allocation.

Yet with interest rates at generational lows - Merrill Lynch writes this morning  that Dutch bond yields are at 500-year lows - it doesn't take much thinking to envision a scenario of interest rates rising and declining bond values.

Before loading up on equities, however, it is worth remembering the words John Maynard Keynes wrote long ago:

Markets can stay irrational longer than you can stay solvent.

Stocks, in my opinion, offer the best opportunity for investors to earn reasonable real returns, yet the ride will not be smooth.

Gatsby: The Movie

The Great Gatsby is probably my favorite book of all time.

I must have read Gatsby at least half-dozen times.  More recently, over the past five years, it has become a summer ritual for me to listen to actor Tim Robbins read Gatsby on my iPod.

(OK, I know that sounds a little weird, but there it is).

I don't know what it is about Gatsby that fascinates me.  The characters are all basically nihilists - no one seems to truly believe in any values or principles beyond basic desires. Gatsby's pursuit of Daisy is obsessive, almost to the point of unbelievability.

Even narrator Nick Caraway - who describes himself as "the most honest person he knows" - seems to have no problem setting up Gatsby's clandestine meetings with Daisy, or having an affair with Jordan Baker while still having a relationship with another woman in the Midwest.

This morning's London Telegraph had a good article written by Guy Stagg about Gatsby. Mr. Stagg may have put his finger on one of the reasons I and many others like reading Gatsby so much:

The Great Gatsby is all about imagination. The characters create enchanted, deluded visions of one another. And so does the reader. F Scott Fitzgerald gives us a few memorable symbols, like the green light at the end of Daisy’s garden, and a few striking personal details, such as Gatsby’s gorgeous smile, and the reader imagines the rest. In our minds the characters become far more vivid than anything on the page.

http://blogs.telegraph.co.uk/culture/guystagg/100063515/despite-the-great-gatsbys-incredible-trailer-baz-luhrmann-is-attempting-the-impossible/

Hollywood has always had a difficult time capturing the magic of F. Scott Fitzgerald's books on the big screen - the 1974 Great Gatsby movie starring Robert Redford and Mia Farrow was a disappointment both to watch and at the box office.

This Christmas there is another, more modern version of Gatsby coming to a theater near year.  The trailer posted above suggests that the story will be told in a much different fashion than either the book or the Redford film.

I am doubtful the new film will be as effective as the book, but I am looking forward to seeing it.

What's Already Priced Into The Markets?

The markets are getting hit hard this morning, as talks in Europe are apparently going badly.

Normura's Michael Kurtz argues that while it is certainly possible that things could get worse before they get better, it could be that the markets have overreacted to the risks of a Greek default/euro exit.

As he writes:

 ..all this market weeping and gnashing of teeth could prove yet another significant buying opportunity: Greece may yet exit the euro after all, but with effective ECB and global policy action its impact could be limited to no more than the rounding error that the Hellenic Republic’s small size and deplorable politics render most fitting.

Read more: http://www.businessinsider.com/nomura-the-selloff-is-overdone-good-time-to-buy-2012-5#ixzz1vh5uCCAI

The chart above would seem to support Mr. Kurtz's view.

The Problem With Low Interest Rates

I've had a column written by Gillian Tett of the Financial Times on my desk for almost two weeks.


Titled " Repression on Bond Sales Heralds an Era of Masochism", Ms. Tett discusses the apparent reality that government policies around the world are deliberately keeping interest rates on their debt artificially low in order to help reduce national deficits.

Just yesterday, for example, Germany sold 2 year notes with a 0% yield.  In other words, the German government will keep your money for two years and return it, with no interest.

True, investors don't have to buy bonds - the stock market is always available - but Ms. Tett points out that many institutions are required to buy bonds, regardless of the prevailing rate of interest.

Regulators in countries like Spain and Ireland are mandating that banks and pension funds to buy government bonds as a  means to financial stability, regardless of the rate of interest.  In addition,  central banks lead by our Federal Reserve are actively intervening in the credit markets to keep interest rates low.

Thus investors and savers are in effect are subsidizing debtors, helped by government policies.

But there's even a more insidious problem that low interest rates create.

If a pension fund has a large chunk of their assets invested in low yielding securities, returns are obviously negatively affected.

While it might seem like basic financial probity to have large investments in government and high quality corporate bonds, if these securities do not return the assumed actuarial rate eventually the funds will need to be bailed out - by the taxpayers, most likely.

Here's what Ms. Tett writes:

Consider what has happened with U.S. pension funds.  Five years ago, these typically had a 60 per cent equity allocation, with 30 per cent in bonds.  But last month, according to the Milliman survey, the top 100 funds placed 41 per cent of their $1,300bn worth of assets in fixed income - topping the equities ratio for the first time.  That shift might have looked rational a few years ago; after all, annualized returns for Treasuries in the past decade have been 6.8 per cent, versus 2.9 per cent for the S&P 500.

However, as I have written on numerous occasions on this blog, shifting to fixed income at the expense of equities makes little investment sense at a time when interest rates are at 60 year lows.

Ms. Tett continues:

But the timing {of the shift to bonds} looks terrible, given that, as David Goerz, chief investment officer of HighMark Capital says, "a 2 per cent Treasury yield is equivalent to a price/earnings ratio of 50x compared to a foward earnings multiple of 13x for the S&P 500 today".  Or to put it another way, it would make more sense, Goerz says, for funds to switch back into equities.

http://www.ft.com/intl/cms/s/0/58078892-9abc-11e1-94d7-00144feabdc0.html#axzz1vbObsYss

Low interest rates and pension fund allocations are hardly the stuff of front page news, but perhaps they should.

European Stocks: A "Scared Witless" Opportunity?

Writing in last Saturday's Financial Times, columnist John Authers writes how difficult it can be to be a contrarian:

And when it comes to buying opportunities, they require you to buy when you are scared witless.

 http://search.ft.com/search?queryText=john+authers

As Mr. Authers writes:

The problem is that history's greatest returns on investments came as reward for taking serious risk.  And that is difficult to do. With hindsight there were great buying opportunities in UK stocks on June 6, 1975 (they doubled in five weeks) and in long-dated US Treasury bonds on 30 September 1982 (they hit a peak yield of almost 16 per cent, and have been gaining in price ever since).

The really big money in investing is usually made when times seem most dire.

While Mr. Authers notes the opportunity in long maturity bonds in the early 1980's, buying U.S. stocks in 1982 was also an unbelievable opportunity:  price/earnings ratios were in single digits and dividend yields were mostly above 5%.

However, as I can personally attest, investor interest in stocks was nonexistent 30 years ago.  After all, stocks had done nothing for investors during the previous 13 years.

Conventional wisdom at the time said that the economic outlook was just too uncertain, and the alternatives were much safer, than investing in common stocks.

Stocks of course then began the biggest bull market in U.S. capital markets, returning 19% per annum for the next 17 years.

The question is: Is Europe now just one of those "scared witless"  opportunities?

Stocks across the euro zone are now selling at single-digit price/earnings multiples, and dividend yields on many high quality European stocks are well north of 4%. And yet there is virtually no interest in moving into the European markets due to the obvious economic turmoil.

As previous posts have indicated, I think we are approaching the time of opportunity for European stocks, even if it is for a short term trade. 

"I'm So Bearish That I'm Bullish"

The title of my post today comes from a comment made yesterday by Michael Hartnett, Chief Global Equity Strategist at Merrill Lynch, who I heard speak at a luncheon meeting.

Most of the discussion, as you might imagine, revolved around Europe.  All agreed that the euro situation is fairly dire, and solutions will not be easy - no surprise there. The overwhelming consensus is that Greece will be leaving the euro block soon, and that European markets and economies are in for a very difficult time.

Michael does not necessarily disagree with the dour assessment of the precarious state of the European community.  However, he does believe that it is the fragile economic conditions are  setting up for a very nice trade in European stocks.

It seems unlikely, in Michael's view, that the leaders of the major European countries are going to simply sit idly by and watch their countries disintegrate into an even deeper economic morass.

The more conditions worsen, and the more civil unrest occurs, the greater the pressure will be on the leaders to inject massive amounts of monetary and fiscal stimulus into the euro block to try to at least ameliorate the situation.

If this occurs, markets should rebound massively.  One only has to consider the large equity rallies that occurred in this country when the Fed intervened twice in the credit markets to see the potential.

The selling in European markets has been broad-based, and markets are priced at historically low valuations.  In Spain and France, for example, bank stocks have actually outperformed traditionally stodgy utility stocks, even though most would probably agree that the financial sector should be more at risk.  Investors just want out.

So here's how it could work out:  faced with a very unhappy populace, European leaders huddle and agree to try stop the economic hemorrhaging through a program of bank recapitalization, fiscal stimulus, and aggressive intervention in the credit markets.  Stock markets soar across Europe, and bond yields plummet, as bearish investors scramble to undo their bearish trades.

At this point, however, Michael Hartnett would suggest taking profits, and heading to the sidelines.  He too believes that the ultimate solution to Europe's problems will take years, so that European stocks should be "rented not owned".

Seems like a reasonable strategy.

What If Greece Thrives Outside the Euro Zone?

At virtually every analyst meeting I have attended recently - including the one I just left - it is assumed that Greece will be forced to leave the euro block.

The consensus thinking is that Greece's profligate spending habits, and its reluctance to adopt the austerity measures that the rest of euro countries have tried to force on its citizens, have made it inevitable that Greece will be forced to exit.

But what if Greece actually does better outside the euro?


Tuesday's Financial Times carried an editorial authored by Arvind Subramanian titled "Why Greece's exit could be the eurozone's envy".  Here's an excerpt:

There is an overlooked scenario in which default is not a disaster for Greece.  If this is the case, the real, more existential threat to the eurozone might be a very different one, in which the Greeks have the last laugh. Consider that scenario.

The immediate consequences of Greece leaving or being forced out of the eurozone would certainly be devastating.  Capital flight would intensify, fueling depreciation and inflation.  All existing contracts would need to be redenominated and renegotiated, creating financial chaos....

But this process would also produce a substantially depreciated exchange rate...And that would sent in motion a process of adjustment that would soon reorientate the economy and put it on a path of sustainable growth.  In fact, Greek growth would probably surge, possibly for a prolonged period, if it adopted sensible policies to restore rapidly and sustain macroeconomic stability.

http://www.ft.com/home/us

Mr. Subramanian notes that other countries have gone through similar wrenching economic events, and have come out stronger than before:  South Korea; Russia; and Argentina all were forced by external events to change their economic ways, and their economies recovered nicely..

And this is Germany's problem.

Germany has been a huge beneficiary of the euro idea.  Unemployment is at lows not seen for at least two decades, and corporate profits have soared. 

While the consensus thinks that Germany has the strongest negotiating hand, it could in fact be one of the weaker players, since it needs the euro to survive in order to continue to enjoy strong economic growth.

Think of it this way:  if Greece does better outside the euro block than it had as part of the euro, why would other countries not wish to follow its lead, and leave the euro.

Mr. Subramanian continues:

Suppose that by mid-2013 Greece's economy is recovering, while the rest of the eurozone remains in recession.  The effect on austerity-addled Spain, Portugal and even Italy would be powerful.  Voters there would not fail to notice the improving condition of their hitherto scorned Greek neighbor.  They would start to ask why their own governments should not follow the Greek path and voice a preference for leaving the eurozone.  In other words, the Greek experience could fundamentally alter the incentives for these countries to remain in the eurozone, especially if economic conditions remained grim.

In other words, could a Greek exit from the euro be Germany's nightmare?

European Economies Refuse To Cooperate With Bearish Forecasts

If you were only to read the financial press, and watch the plunging prices on European stock markets, you could easily reach the conclusion that Europe is in the depths of a major economic recession.

But data released yesterday tell a different story.

Helped by a robust German economy - which grew at +0.5% in the first quarter, or 5 times greater than expected - euro zone economic growth in the first quarter was flat overall.

There were some countries that showed significant slowdowns - especially Italy, whose economy contracted by -0.8% during the first quarter - but the yesterday's data surprised pundits and analysts with a resiliency that belied the euro bears.By comparison, the U.S. economy rose by 0.5% in the first quarter.



Now, to be sure, flat economic growth is hardly cause for champagne.  On the other hand, the data suggests that corporate Europe is doing better than expected.

Here's how the New York Times described the results this morning:

Still, along with growth in Germany that was much better than expected, the data provided mild respite from the gloom that has pervaded Europe in recent days. Despite the figures, major stock indexes retreated Tuesday in Europe, and Spanish and Italian bond yields, or interest rates, edged up on news that those two countries’ economies continued to contract. Indexes in the United States, however, were modestly higher in afternoon trading. 

The euro zone, by not slipping into recession in the first quarter of 2012, ran counter to expectations. Growth in the region was zero compared to the previous quarter, according to the figures, from Eurostat, the E.U. statistics agency. 

http://www.nytimes.com/2012/05/16/business/global/euro-zone-economy-skirts-recession.html?_r=1&ref=business 

So here's the continued conundrum that frankly puzzles me.

Yes, the euro has serious structural issues.  And, yes, it is possible that Greece will be forced to leave the euro block (even though the Greek economy grew in the first quarter as well).

But the simple truth for now at least is that European stock markets are trading at valuation levels that are at 10-year lows despite the fact that business in general continues to grow above expectations.

Willem Buiter Talks About Europe

As part of my continuing search for more information about investing opportunities in Europe, I went to hear a lunch speech yesterday given by Willem Buiter.

Mr. Buiter has long been involved in European economics.  In the past he has served as an external member of the Bank of England's Monetary Policy Committee as well as chief economist for the European Bank for Reconstruction and Development.

He is now a professor at the London School of Economics, and is the chief global economist for Citigroup.

There was a pretty big audience yesterday. European politics are driving much of the activity in the financial markets, and every day it seems there is a new development that needs to be studied and understood.

Mr. Buiter spoke for almost 90 minutes, so I will not attempt to capture all of his comments here.  However, although he also talked briefly about China (it will be OK, according to Buiter), here are some of the highlights from his talk specially focused on Europe:

• Europe faces three issues: insolvent sovereigns; insolvent banks; and near-insolvent sovereigns.  However, all three issues can be addressed by aggressive intervention by the European Central Bank (ECB).  The euro will survive;
• The fiscal shape of the combined countries of the euro zone is actually better than the United States.  However, with 17 different member countries - rather than 50 states - fiscal solutions are much more difficult;
• The near-term problems in the euro zone are largely related to its banking system.  The total size of the European banking system is 330% of euro GDP, while in the U.S. it is less than 100%, making the problems of the European banks that much more important;
• Greece will probably leave the euro zone, but the departure is not as easy as some would think.  In particular, leaving the euro block would be devastating to the Greek economy  - who would want a separate new Greek currency knowing that it was kicked out of the euro block?  Buiter thinks hyperinflation in Greece will inevitably follow any departure, accompanied by a severe economic recession.  Greece's leader obviously understand this;
• The ECB is the only institution capable of keeping the euro going.  Buiter estimates that it could pump 2.9 trillion euro (!) into the system without creating any inflationary pressures.  In addition, the ECB has 500 billion euro in gold reserves that could be used to help the banks;
• Buiter thinks that ultimately bank shareholders will be wiped out in many countries as part of the recapitalization efforts;
• Germany does not have as much influence as many believe.  Its financial institutions hold huge amount of euro debt, and a collapse of the euro would be devastating.  Leaving the euro zone would hurt Germany tremendously.  Moreover, the euro has been a boom for German companies;
• France has "so much fat" - public sector spending accounts for 58% of GDP.  President Hollande will probably try to enact some of changes he discussed during the recent campaign, but Buiter doubts these will amount to very much. In particular, Buiter joked that if Hollande raises the maximum tax rate to 75% (as he proposed during the election), 50,000 Frenchmen will simply move to London, and help the British real estate market;
• Much of the euro zone is actually doing better than commonly believed.  Spain, for example, is showing export of growth of +13% yoy, and is actually taking market share from other European economies.  If the financial system can be stabilized, growth can resume, and some of the severe unemployment issues can be addressed.

I would only quibble with Mr. Buiter on his thoughts on the banks.

I don't think that the European authorities will nationalize the banks. While this move might have some emotional appeal, the simple truth is that running a large multinational bank is very difficult (just ask Jamie Dimon of JP Morgan!), and no government wants to get involved.

When France nationalized its banks in the early 1980's, it was a disaster.  Lending collapsed, and the economy suffered.  Hollande well remembers this - he was serving President Mitterand at the time - and would rather simply use the banks as convenient scapegoats rather than take them over.

Bottom line:  The euro survives, and baring any major financial policy blunders, business should continue to muddle along.

Bargain Hunting In Europe

I wrote a piece last Friday noting the incredible values now to be found in the European stock markets.

Quoting global strategist Michael Hartnett of Merrill Lynch in a piece from last Friday:

European equities as cheap versus German bonds in almost 90 years. The spread between European equity dividend (4.29%) and German 10-year government bond yield (1.52%) was 277 basis points.  This yield spread has been surpassed only once (303 bps in Feb '09) since 1925.

This morning, with European markets once again in turmoil, 10 year German bunds now offer 1.45%, making the relative attraction of European equities even more startling.

Saturday's Financial Times had a long story about Carlos Slim, the Mexican multi-billionaire.

Mr. Slim has made most of his reported $69 billion net worth through investing in markets that others have fled, yet still offer compelling fundamental value.

In an article entitled "Mexico's meticulous mogul with an eye for a bargain", here's what Mr. Slim is up to these days (emphasis mine):

In 1982, as Mexico lurched towards a financial crisis so brutal it triggered the Latin American debt crisis, Mexican and international investors stampeded for the exit. Except for one:  Carlos Slim.

That was the year Mr. Slim, now the richest man in the world...set out on a shopping spree to Mexican companies at fire-sale prices across industries as diverse as aluminum, tobacco, insurance and rubber...

That {value-investing} approach drew him into the now-booming Brazilian telecoms market in 2002, when fears of a socialist government under then newly elected Luiz Inacio Lula da Silva were crushing prices.  It also led him into Argentina when it was still in disarray after financial collapse in 2001.  Now a similarly distressed situation has led him to the eurozone:  shares in KPN {a Dutch telecoms company}, which has operations in Germany, Belgium and Spain, had fallen 30 percent this year before Mr. Slim made his move.

http://www.ft.com/home/us

Now, to be sure, the problems facing the euro zone are very real, and very serious.  Investing in Europe these days will require patience, and a recognition that while the eventual returns could be substantial the ride will be a bumpy one, to say the least.

However, it seems to me that if you are looking for markets that are trading on emotion rather than fundamentals, Europe is your first and only stop.

In Search of a One-Handed Market

Former U.S. President Harry Truman famously used to say that he wished he could find a one-handed economist.

Truman was frustrated by the fact that he never seemed to be able to get a definite answer on the issues of the day from his economics team.

Whenever he would ask for an opinion, Truman related, he would inevitably get a response that started with "Well, on one hand" but then shortly followed with a completely different opinion that started with "Of course, on the other hand".

Hence Truman's desire for a one-handed economist.

If Harry Truman was investing into today's economic climate, he too might be frustrated by the lack of a cohesive economic pattern.

For example, government bond yields in "safe haven" countries like the U.S., Germany and the U.K. are approaching record lows. 

So investors are worried, right?

Well, maybe, but why are corporate bond yields also approaching record lows.  Investors are not only gobbling up bonds from high grade issuers like IBM but also riskier credits as well.  Ford, for example, was able to borrow 3-year money at 3% earlier this week, despite the fact that its credit rating remains below investment grade.

Then there's more:  earnings estimates for companies are gradually being moved higher after first quarter results for not only U.S. companies but European corporations as well.

Yet global analyst Michael Hartnett at Merrill Lynch wrote this morning that (I have added the emphasis):

European equities as cheap versus German bonds in almost 90 years.  The spread between European equity dividend yield (4.29%) and German 10-year government bond yield (1.52%) was 277 basis points.  This yield spread has been surpassed only once (303 bps in February 2009) since 1925.

German bond yields are at lower levels today than during the depression of the 1930's. Indicates Europe very oversold. As does the price relative between European and U.S. equities, which is trading 3 standard deviations below norm.

Finally, consider the price of gold.

Gold prices have plunged by -15% since reaching a peak last September, and now stand at roughly the same level as a year ago.  Someone who had heeded the advice of the gloom-and-doom crowd last fall and bought gold rather than stocks would have suffered a relative return shortfall of nearly -30%.

So if we are approaching financial Armageddon - as many pundits are suggesting - why is gold (the ultimate safe haven) losing value?

Hal Prince on Broadway

My wife and I headed over to the Museum of Fine Arts (MFA) last night to hear Broadway producer Hal Prince give a talk.

Hal Prince has produced some of the most memorable musicals on Broadway over the past half century.  Shows like West Side Story; Fiddler on the Roof; Cabaret; Evita; and The Phantom of the Opera were all produced in whole or in part by Mr. Prince.  Not surprisingly, he has won the most Tony awards (21) of anyone ever involved in theater.

Last night's talk was hosted by Stephen Terrell from Emerson College. There were also two separate musical interludes featuring students from Emerson performing some of memorable music from Mr. Prince's shows.

I always come away from these talks learning so much about what goes on "behind the scenes" in music and the arts, and last night was no exception.

Many of the musicals that Hal Prince produced have, of course, become American icons, yet at the time they were first introduced critical reaction was often less than favorable.

West Side Story, for example, features a story and music that is some of the most memorable in our culture. However, when the show was first performed in 1957 the reviews were largely negative, according to Mr. Prince. Audiences found it difficult to relate to a love story set in the Puerto Rican community in New York City, and the music written by Leonard Bernstein was too different than what audiences were used to hearing.

Mr. Prince related how he became involved in West Side Story.  The show's rehearsals had not gone well, and it lost its original backers.  Desperate for money, Bernstein and lyricist Stephen Sondheim called Prince and his partner Hal Wallis in Boston to come to New York.

It was the last chance for West Side Story.  Its unconventional story - for the late 1950's - was falling on deaf ears in the Broadway community, and had Prince and Wallis decided to not take a chance the show probably would have never seen the inside of a theater.

But as Mr. Prince related last night, he immediately loved both the music and story, and the rest is history.

This was a pattern repeated in many of Prince's shows, and moderator Terrell asked him why he seemed comfortable to challenge the conventional wisdom.

Prince said that it had always been his opinion that Broadway producers should produce what they considered quality work, and not base their decisions on what they think the public might like.

Ironically, he said that he personally did not like musicals when he was growing up.  While the music was often memorable, the stories were banal and formulaic, and as a young boy he was often bored at the theater.

So when he decided to get involved in producing Broadway shows, he was determined to make the kind of shows that he found interesting, and hope that the audiences would follow.

This, in his opinion, is no longer the case on Broadway, which is part of the problem in theater today.  Audiences are surveyed as to what they might like to see, and shows are produced accordingly.  However, using public opinion polls to make artistic decisions inevitably leads to watered-down productions.

That said, Prince said several times that finances play a critical role on Broadway.

He noted, for example, that a typical Broadway show now costs 40x what a show would cost when he first started in the business.  With so much money at stake - shows often have to run for at least a year before they become profitable for their backers - it is hard to take a chance on unconventional performances.

Naturally, because of what I do for a living, I was reminded of a paragraph written by legendary investor Benjamin Graham in his book The Intelligent Investor.

Although Graham was speaking about buying stocks - and not producing Broadway shows - it is clear to me that both Prince and Graham looked at their work in the same fashion.

Here's what Graham wrote:

If you have formed a conclusion from the facts and if you know your judgement to be sound, act on it - even though other may hesitate or differ. (You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right).

My Two Cents on Facebook

It has been a long time since an IPO has been as eagerly anticipated as the Facebook offering that is scheduled to be priced next week.

Facebook management was in town yesterday to pitch the deal. Here's how the Boston Globe reported it this morning:

The excitement surrounding Facebook Inc.’s forthcoming Wall Street debut arrived in Boston Tuesday as the company’s top executives pitched the massive social media company to hundreds of potential investors, and Mark Zuckerberg, its 27-year-old celebrity chief executive officer, met privately with some of the city’s premier money managers.

It was the second stop in a nationwide “roadshow’’ ahead of the social network’s initial public offering, when it will sell shares on public markets for the first time. The company could begin trading as early as May 18, and is expected to raise up to $11 billion in the biggest-ever stock launch for a technology company. Last week, it set a $28-to-$35 price range for its shares.

http://www.boston.com/business/markets/articles/2012/05/09/facebook_pitches_boston_investors_on_coming_ipo/

Facebook has also prepared a 30 minute video for potential investors:

http://facebook.retailroadshow.com/show/retail.html?m&u=6642#

In my experience, it is difficult for investors to make money in an IPO.  By definition, companies sell shares to the public at the highest possible price, and at a time that is most advantageous to itself, and not to the investor.

I remember when Apple came public in 1980.  The hype was similar to Facebook, and for a while Apple's stock soared.

But then reality set in. Steve Jobs was fired, and Apple nearly went out of business.  Apple of course has since rebounded in a spectacular fashion, but it took many years.

I suspect that Facebook shares will enjoy a strong start when they are priced next week, but then the real work begins:  justifying its lofty valuation.  This will take time, and I also expect that Facebook investors will experience some pretty volatile times.

We have seen numerous IPO's of internet properties over the past year - Groupon, Zynga, Pandora Media and LinkedIn - and all wound up trading below the IPO price within months of the offering (although LinkedIn has since rebounded).

I am not as skeptical as some about the valuation of Facebook.  True, the projected offering price is 99x last year's earnings, and 50x revenues, but Facebook's potential growth could be phenomenal.

I am probably not buy Facebook shares for clients at the initial offering, but I am also going to keep a very close eye on the company.  If they can figure out a way to direct advertising to their 900 million users, it may very well be that we'll look back 5 years from now and wonder why we weren't buyers.


Although I did not attend yesterday's event, my colleague Rich Sipley did, and here's a small excerpt from an email that he wrote to all of us when he returned (thanks Rich!):

 

-        Mark Zuckerberg and his black hooded sweatshirt did not make it.  COO Sheryl Sandberg and CFO David Ebersman led the discussion.  Both were well dressed.

-        Investors were asked to be at the hotel at 7:15.  

    A few got there as early as 6:30 (not me!).  Rather than casually filing into the meeting room, we were kept in the lobby as a security detail kept people from going up the stairs.  Around 7:30, they started letting people go through 25 at a time.  I’m guessing there were 250 people or so.  The meeting didn’t really get started until 8:05.

-        Ebersman made a few initial comments, mostly revolving around the concept of the company – the words “social”, “connected” and “experience” were seemingly in each sentence in one form or another.  They then threw it open to Q&A.

-        The questions were fairly powder-puff and revolved mostly around ads on Facebook and how they provide a different experience to marketers in the way they can target their message.  

    The sense is that they will introduce more ads and charge more for each ad going forward.  Sandberg stressed points that from a marketing client perspective, ad dollars spent on Facebook have the highest ROIC and that marketers need to rethink how they market on Facebook (they will get more bang if they target their ads rather than take their print message, which isn’t all that targeted, and just port it to Facebook).  She told stories of Ford’s introduction of the new Mustang and Pepsi’s involvement in the Indian Cricket championship as success stories.