Bond Traders vs. the European Central Bank

In January, 1993, President-elect Bill Clinton was discussing fiscal policy with several economic advisors.

The topic was deficit reduction, and his aides were telling the newly elected President that the success or failure of his administration depended on a credible deficit reduction plan. If he failed, the bond market would punish the economy with higher interest rates.

According to Washington Post author Bob Woodward - as detailed in Woodward's book The Agenda - Clinton's face turned red with anger as he said:

"You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of f**king bond traders?"

I was reminded of this anecdote when as I have been reading about the ongoing euro bond debacle.

The success or failure of the euro zone ultimately will not rest on any particular politician or grand strategy. Instead, it will rely on whether the countries most at risk - Greece, Spain, Italy, et. al. - will be able to finance themselves at reasonable levels of interest rates.

So far, the "f**king" bond traders do not seem to be impressed.

Reuters is reporting this morning that the European Central Bank has been intervening heavily in the bond trading of Italy and Spain. Even with the ECB intervention, yields have been soaring for euro bonds from these countries.

Italian euro bonds now yield almost 7%. The contagion is now apparently spreading to other countries, even France. The yield spread between French euro bonds and German bonds is at levels not seen since the early 1970's.

Investing Like Warren

Warren Buffett announced yesterday that he amassed 5.5% of IBM stock over the past few months.

While this is interesting news - Buffett has always said that he doesn't understand technology well enough to invest money in the sector, but apparently IBM is transparent enough - what really caught my eye was the way he went about analyzing the company.

Buffett was interviewed on CNBC yesterday for about 3 hours. The complete transcript of his thoughts can be found on the CNBC website, but several comments stood out to me:

1. He has been reading IBM's annual report for 50 years. I don't think he was just reading the President's letter - I'm sure he has been studying it from cover-to-cover for half a century. But it was only this year that he began buying stock;
2. He never met IBM senior management. In fact, at one point in the interview he mispronounces current CEO Sam Palisano's last name. While this is consistent with Buffett's investment style - focusing on the business, not the management - this too is far different than most investment managers;
3. He was buying IBM stock at near all-time highs, but seemed genuinely unconcerned about the price. Buffett notes in the interview that he bought railroad stocks at their highs also, and has made a bundle;
4. Buffett re-read former CEO Lou Gerstner's book about IBM Who Says You Said Elephants Can't Dance before buying stock. I wrote about this book a few months ago here on Random Glenings, and now you have Warren Buffett's recommendation as well (!);
5. He liked the idea that IBM has dramatically reduced the number of options outstanding from 240 million to 30 million today. This, in Buffett's opinion, is a sign of respect for the shareholder.

I could go on, but I think you get the point. The investment genius of Buffett has been earned by more than 50 years of study, and what often seems effortless is actually the result of countless hours of study and preparation.

Finally, I liked this quote from Buffett about where investors should be putting their money today:

{Buying IBM and other large cap stocks}t also means that some great big strong American companies look very cheap compared to investment alternatives. I mean, in the end, you know, you're sitting with money in your pocket. Do you leave it in your pocket, you get zero on, do you put it in a money market fund, you still get zero on it, do you buy 10-year Treasuries and get 2 percent, or do you buy American businesses that are earning very good money, that have high returns on equity, have high returns on incremental capital, are buying in their stock at a rapid rate so that your ownership in the business increases significantly? I love all those things. Now, you measure one vs. the other. But in the end, you have—you know, you do something. Doing nothing is doing something.

http://www.cnbc.com/id/45290263/

More on Europe

If you think replacing the leaders of Italy and Greece over the weekend gives an "all clear" to the European community, German Chancellor Merkel would suggest otherwise.

Here's an excerpt from a Reuters news piece desribing Merkel's speech this morning in Leipzig:

"Europe is in one of its toughest, perhaps the toughest hour since World War Two," Merkel told her conservative party in Leipzig, saying she feared Europe would fail if the euro failed and vowing to do anything to stop this from happening.

But in a one-hour address to the Christian Democrats (CDU), Merkel offered no new ideas for resolving the crisis that has forced bailouts of Greece, Ireland and Portugal, and has raised fears about the survival of the 17-state currency zone.

"If the euro fails then Europe fails, and we want to prevent and we will prevent this, this is what we are working for, because it is such a huge historical project," Merkel said in the east German city of Leipzig.

http://www.reuters.com/article/2011/11/14/us-eurozone-idUSTRE7AC15K20111114?feedType=RSS&feedName=topNews&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+reuters%2FtopNews+%28News+%2F+US+%2F+Top+News%29&utm_content=Google+Feedfetcher

Then there's the human costs of the euro crisis. Across Europe, ordinary citizens are seeing their standard of living shrink dramatically as governments struggle to comply with the demands of European leaders lead by the French and German governments.

Here, for example, is an excerpt from last Friday's Financial Times. In a small article titled "Sign this and accept a 25% salary cut", the FT described how highly educated members of the upper middle class in Greece are being forced to take huge pay cuts or else lose their jobs:

...White collar workers such as Constantinos Makris, a stockbroker in Athens, are also feeling the sting. Managers "gave me a call one morning and said 'Would you come downstairs?'...Then they said 'Sign this paper and accept a 25 per cent reduction in your salary'. After threatening to quit, Mr. Makris eventually settled for a smaller cut.

http://www.ft.com/intl/cms/s/0/c6acdf40-0bb0-11e1-9a61-00144feabdc0.html#axzz1dh2kdsTS

The problem is not just belt-tightening; it's a sense that the good times might gone for a generation, thanks to debt obligations incurred by governments who understood that the path to power was to never tell voters "no".

In post-World War II Europe, austerity ruled for years. Rolling Stone guitarist Keith Richard, for example, describes in his autobiography Life that he never tasted sugar for the first nine years of his life after being born in 1946 due to post-war shortages. Everyone understood why basic necessities were rationed, which seemed to make it more bearable.

Today, according to this morning's New York Times, citizens are facing the hard times with more bitterness than a couple of generations before:

In the lands of southern Europe, used to getting by with wile and guile, the prospect of hardship seems all the more bitter, illuminating, as it does, what outsiders cast as an all-too-predictable national failure to live up to the membership rules of the euro club that were devised and watched over by hard-nosed Germany in particular.

Modern austerity could never be described as an ethic; for southern European nations squirming under pressure from the Continent’s wealthier northern lands, it is an affront to come to grips with the legacies of economic ill-discipline. And in the north, it is a high price to pay to rescue the profligate south.

Austerity is a time bomb ticking ever louder.

http://www.nytimes.com/2011/11/14/world/europe/austerity-in-europe-brings-bitterness-unknown-in-postwar-era.html?hpw

Are We Facing A Repeat of 2008?

The crisis in Europe is raising uncomfortable memories among investors.

Several commentators harken back to the latter days of 2007, when it seemed that the subprime mortgage crisis would be limited to just a small segment of the credit markets.

Then, as now, the stock markets kept rallying, eventually reaching new highs in October 2007. At the same time, the credit markets were already showing signs of strains, which eventually manifested itself through the demise of Bear Stearns in early 2008 followed by Lehman Brothers in September 2008.

I don't need to mention that the stock market eventually wound up falling -34% for the calendar year 2008, with most of the decline occurring in the last three months of the year.

I have two thoughts today, one positive and the other negative.

I wish I could be more definitive but I think the situation in Europe is just too fluid - and potentially too catastrophic - to be confident of how this all plays out.

But here's my positive thought: unlike 2008, when the credit markets totally froze, credit today is widely and readily available. Total corporate bond issuance this week, for example, will be well over $30 billion, and most issues have been gobbled up by yield-hungry investors.

Moreover, corporate America is awash in cash. Corporate treasurers have generally positioned their companies' finances to be able to withstand another shutdown of credit availability, at least for a while.

Now for my negative thought: In 2008 and 2009, there was a massive government response in response to the credit crisis. The Fed slashed interest rates, offered guarantees on money market funds, aggressively bought debt in the secondary market - you name, the Fed did it.

The other branch of the federal government did their part also. The Obama administration forced through a fiscal stimulus package of nearly $800 billion. Two years later, it is not clear how much impact this spending actually made on the real economy, but if nothing else it was a huge psychological boost.

I very much doubt this could happen today in the U.S. today, let alone Europe.

Technically the Fed could enact something like QE3 (where it would buy mortgages in the secondary market) but the political reaction would probably be extremely negative. And the talk in Washington is all about cutting spending, not fiscal stimulus.

The most recent proposals from the Europeans basically boil down to cutting spending and tightening credit, which makes no sense to me. When the European Central Bank cut rates earlier this week, they made it clear that they considered it a temporary move. In short, there is almost an Calvinist attitude towards dealing with the debt crisis, which probably means any solutions will not work.

Finally consider this: In 2008, three US government officials - Bernanke, Paulson and Geithner - could sit in a room and come up with solutions. Today, in order to get any resolution in Europe, you essentially have to get 17 different countries to agree,which to date has proven to be nearly impossible.

Several commentators - including one of my favorite columnists Ambrose Evans-Pritchard of the London Telegraph - have suggested that if the US and China joined forces they could end this crisis in the European credit markets*. However, I think this is simply not going to happen.

I am very concerned, to say the least.

*http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100013198/america-and-china-must-crush-germany-into-submission/

Are Bank Stocks A Value Trap?

I got together yesterday afternoon with a pretty savvy client.

The meeting was great - as always, we had a spirited exchange of ideas.My client likes not only to hear some of my recent investment thoughts, but challenge my thinking as well.

We got to talking about the financial sector, and banks in particular. I reiterated my generally bearish views on the financial stocks despite the fact that on a pure valuation they look very attractive.

My client - who used to manage money for a couple of decades - pointed out the some of the historic valuation metrics for banks could be flawed.

He noted that banks used to be like utility stocks are today: boring, slow growth stocks whose main attractions were dividends and stability.

Money center banks today have little resemblance to the large banks of a generation ago. Any restrictions on their activities have largely disappeared. Banking is also much more concentrated in just a few large entities which, as the events of 2008 illustrated, are largely "too big to fail".

I think my client is right: simply saying "oh, look how cheap the price/book ratios are for the money centers" is not necessarily going to be a good guide to profitable investment opportunities.

Even if the crisis in Europe is contained to the European banks - which quite frankly I very much doubt - banks still face the prospect of very slow loan growth in a world focused on de-leveraging.

Moreover, with yields in the bond market so meager, net interest margins are being pressured like never before.

I remain cautious on the group.

Corporate Treasurers Continue to Stockpile Cash

Around the world, corporations are awash in cash.

There is an estimated $1.9 trillion stashed in US corporate coffers, yet the dividend payout ratio for the S&P 500 is a meager 26%.

Numerous companies are sitting on cash stockpiles that are far in excess of any possible corporate use; Apple, for example, will have nearly $80 billion in cash by the middle of next year, yet does not pay a dividend.

So why are corporations continuing to raise cash at record rates?

Nearly $20 billion in new corporate debt issues came to market yesterday, and underwriters are looking to sell an additional $10 billion or more in this holiday-shortened week. Only one company - Amgen - has announced that it will be doing a stock buyback with the proceeds of its $6 billion offering. The rest apparently are just going to hold onto the cash.

According to CNBC:

If the corporate issuance this week surpasses $30 billion, it would be for the fourth time this year. The last was in May, when the week of May 20, issuance reached $35.97 billion. There have been 11 weeks of $30 billion plus issuance since April, 2008.

http://www.cnbc.com/id/45194318

Corporate treasurers are justifiably nervous about the state of the credit markets. They remember all too well the credit crunch of 2008, when borrowing window slammed shut for all but the highest rated borrowers. Better to stash cash in Treasury bills - even at 0% interest rates - than to not be able to fund normal business operations.

And it's not likely that we will see a resurgence in M&A activity, even though it might make sense. Citing a survey from Fidelity International, here's an excerpt from another article on CNBC yesterday:

Companies' cautious outlook has also led firms to avoid growth through acquisitions, the survey said, adding however that conditions were right for a resurgence of M&A activity given strong balance sheets, low interest rates and attractive valuations.

Fidelity analysts said roughly 84 percent of companies they covered had either dismissed M&A entirely to drive growth or were only considering it on a small scale.

"That's because they are generally paralyzed with fear about what's going on in the world, and they don't really want to do anything with the cash," {one Fidelity analyst}said.

"They are worried that they may have to survive a six-month period where global liquidity freezes again."

http://www.cnbc.com/id/45200565

With interest rates so low, huge positions in cash are not especially helpful to shareholders, but it appears that caution is outweighing investment considerations for the time being.

My Education at Parents Weekend

My wife and I traveled to Wesleyan University this past weekend to visit our son Michael, who is a junior at Wes, for Parents Weekend.

We had a great time - the weather was very pleasant for this time of year, with temperatures reaching the mid-50's by mid-afternoon while were in Middletown.

The campus, too, was in surprisingly good shape considering the fact that much of the town was without power for most of last week in the aftermath of the snow storm.

We attended a number of different lectures given by Wesleyan professors, which gave us a glimpse of what a terrific education Michael is getting. We had time to walk around campus, and also attended a football game.

In short, we got the full higher education education experience in just a couple of days.

One of the things that struck me, however, was the dearth of any passionate protest movements on campus. True, there was the usual signs protesting pollution, or conditions in rural India, but most seemed fairly perfunctory. Perhaps this is a good thing, but maybe it also reflects a student body more interested in jobs and the economy than global concerns.

I don't think this is confined to Wesleyan. According to an article in this past weekend's Financial Times titled "Harvard rebels snub Bush aide's economic class", one of the hot protest topics on campus at Harvard revolves around what is being taught in introductory Economics:

On Wednesday, about 70 students walked out of Economics 10, the introductory class Professor {former Bush economic advisor Greg} Mankiw teaches, to protest at what they called a bias towards a destructive brand of free-market economics.

"We found a course that espouses a specific - and limited - view of economics that we believe perpetuates problematic and inefficient systems of economic inequality in our society today, {said the students}. There is no justification for presenting Adam Smith's economic theories as more fundamental or basic than, for example, Keynesian theory."

http://www.ft.com/intl/cms/s/0/5aae33bc-069b-11e1-8a16-00144feabdc0.html#axzz1d24r3L8e

Given my experience as an undergraduate at the University of Michigan - where the hot topics were areas like Vietnam or legalization of marijuana - the "hot buttons" on campus have changed considerably in a generation!