A Tale of Sound and Fury

Cartoon courtesy of Salon.com

For now, at least, it appears that a deal has been reached, and the United States will be able to honor its obligations.

I don't know where you stand on recent events in Washington, but I am relieved that we seem to have reached a resolution. However, I must confess that when I read some of the details of the accord I thought: Was this what all the drama was about?

According to Wikipedia, the total size of the federal budget for fiscal 2011 (which ends on September 30) is expected to be $3.8 trillion, and a deficit of $1.3 trillion. The total size of the spending cuts is supposed to be about $913 billion - but spread over the next decade.

In other words, it took the collective wisdom of all of our elected officials in Washington to agree to cut, on average, $91 billion this year - or about 2% of the total budget.

And there's more: Writing in this morning's Washington Post, Ezra Klein notes that most of the expected cuts are due to come from the defense department - Social Security, Medicare and Medicaid are totally off the table, despite the undeniable truth that these three areas are the major causes of the federal budget deficits:

And that gets to the truth of this deal, and perhaps of Washington in this age: it’s all about lowest-common denominator lawmaking. There are no taxes. No entitlement cuts. No stimulus. No infrastructure. Less in actual, specific deficit reduction than there was in the Simpson-Bowles, Ryan, or Obama plans, and even than there was in the Biden/Cantor or Obama/Boehner talks. The two sides didn’t concede more in order to get more. They conceded almost nothing in order to get a trigger and a process, not to mention avoid a financial catastrophe.

http://www.washingtonpost.com/blogs/ezra-klein/post/a-deal-that-found-the-lowest-common-denominator/2011/07/11/gIQAde9TmI_blog.html?hpid=z1

Don't Bank On It

Investment strategist Richard Bernstein had a column in yesterday's Financial Times talking about global bank stocks.

Bank stocks have been poor performers over the last few months, and their valuations would appear to be very enticing. However, it could also be that we are seeing a major shift in the way that multinational financial companies are viewed by regulators, which could lead a significant crimp in earnings.

Here's an excerpt from Mr. Bernstein's column:

Our research suggests that analysts’ earnings projections for the US’s leading financial institutions may be overly optimistic if we are correct in thinking Washington is increasing its vigilance against global risk-taking. The average consensus long-term earnings growth forecast for the US’s global financial firms is 10 per cent. We feel a more realistic long-term growth rate might be about 6-8 per cent a year.

This is significant for valuation, implying that bank stocks should be revalued downward by 10-15 per cent. It is hard to envision the leading financial stocks outperforming for any length of time when secular growth expectations have yet to adjust fully to a post-credit bubble reality.

http://www.ft.com/intl/cms/s/0/9b944e8c-b6e3-11e0-a8b8-00144feabdc0.html#axzz1TPBLn5sW

Then, in this morning's New York Times, Jesse Eisinger writes that it actually make more sense for the big banks to be broken up rather than let them continue to limp along.

He cites Citigroup and Bank of America as being particularly poor performers, and suggests that both companies would probably benefit from simply splitting into different companies.

For example, writing about Bank of America:

Bank of America’s recent quarterly earnings were so weak that investors and commentators wondered whether the bank should sell off Merrill Lynch, the investment bank for which it foolishly overpaid at the height of the crisis. Bank of America trades at half of its book value (the stated value of its assets minus its liabilities), an indication that investors view its asset quality and prospects just a notch below abominable, as Jonathan Weil of Bloomberg News pointed out last week.

And as for Citi, Mr. Eisinger writes that its stock, earnings and revenue growth has lagged for a decade.

http://dealbook.nytimes.com/2011/07/27/once-unthinkable-breakup-of-big-banks-now-seems-feasible/?ref=business

We have not had much bank stock representation in client portfolios for some time now. Our concerns have largely centered on loan growth, which remains anemic for nearly all banks. But the points raised by Messrs. Bernstein and Eisinger makes us even more convinced that largely avoiding bank stocks for the time being is the correct decison.

Don't Believe Everything You Read

Last week the media was full of reports that several large hedge fund managers - including George Soros, one of the most successful hedge fund managers of our generation - were holding large amounts of cash in their portfolios due to the current market environment.

Here was a typical story from Bloomberg, dated July 19, 2011:

Keith Anderson, who runs the $25.5 billion Quantum Endowment Fund for Soros Fund Management LLC, has seen enough of choppy global markets.

In mid-June, Anderson told his portfolio managers to pull back on trades as the hedge fund’s losses hit 6 percent for the year, according to two people familiar with the New York-based firm. As a result, the fund is about 75 percent in cash as it waits for better opportunities, said the people, who asked not to be identified because the firm is private.

http://www.bloomberg.com/news/2011-07-19/soros-quantum-holding-75-cash-leads-hedge-funds-baffled-by-global-crises.html

Well, not so fast. Turns out that Soros is actually closing his fund to anyone other than his family, and so much of the cash could have been raised in anticipation of returning funds to his outside investors, and that Soros is trying to cut back on his investing activities.

Here's an excerpt from yesterday's New York Times:

George Soros, the investor who broke the Bank of England and came to represent the swashbuckling style of hedge fund managers and then their entry into the world of global affairs, has decided to return money to outside investors in his Quantum fund.

Mr. Soros, who will turn 81 next month, is the latest hedge fund magnate to forgo managing the money of outsiders in favor of his own, though his move is more symbolic. Of the roughly $26 billion the fund manages, less than $1 billion belongs to outside investors.

http://dealbook.nytimes.com/2011/07/26/soros-to-close-fund-to-outsiders/?scp=2&sq=george%20soros&st=Search

And, oh, Mr. Anderson is also leaving the Soros company.

Now, it could very well be that Soros really does have three-quarters of his assets in cash due to market considerations. However, it could also be that the closing of his fund to outsiders may also mean that Soros is really winding down much of his investing activities, so the cash balance is really not a market call at all. Or it could be that the cash positions are collateral for some futures or foreign exchange trades that Soros is doing.

As outsiders, we really don't know, and that's my point.

Hedge fund are notoriously secretive, and to base one's market calls on reported positions is not a particularly good way to develop an investment strategy. George Soros did not become fabulously wealthy by letting others in on his trades, and I doubt he is starting now.

And then there's the Buffett effect. Often a news report that Warren Buffett has taken a position in a particular stock, which inevitably leads to a jump in its share price. Then it later turns out that the rumor is either wrong, or that someone other than Buffett at Berkshire has made the share purchase.

As the old axiom goes, don't believe everything you read.

Monday Night Smackdown

As I talked to clients and colleagues this morning, it appears that I must have been one of the few people to watch President Obama and Speaker Boehner last night blame the other party for the looming debt crisis.

Maybe it's just that I need more hobbies to busy myself at night, or maybe the complacency of my immediate circle of friends is more appropriate.

There is some suggestion that the White House has overplayed its hand on this one. Andrew Ross Sorkin writes in this morning's New York Times that maybe the August 2 deadline isn't so hard-and-fast after all:

The administration may have made a strategic mistake in warning too soon that the market would react negatively. It ultimately undercuts the government’s negotiating position because the doomsday scenario has not played out, even though the deadline is fast approaching.

“They have lost all credibility,” said Neil M. Barofsky, the former special inspector general for the Troubled Asset Relief Program. “It’s so typical of the way Treasury and the Fed treat everything — it is always to warn that Armageddon is coming.”

.. the market seems to believe it was a false deadline. Some economists have said the government would have enough cash on hand to continue making payments for several days at least. The administration could also decide how to prioritize payments. The government, for instance, could opt to pay interest on Treasuries and put off other bills.

http://dealbook.nytimes.com/2011/07/25/debt-drama-blocks-out-big-picture-on-credit/?hp

That seems to be the view of most investors, at least judging from the direction of the Treasury bond market.

As I write this, 10-year Treasury bond yields are down below 3% again. Bonds rallying in the face of financial Armageddon? Something doesn't seem right.

As usual, one of my favorite columnists Ambrose Evans-Pritchard writing in the London Telegraph captures it best. Mr. Evans-Pritchard tells readers to "Calm down: The U.S. will not miss a coupon payment... next Wednesday". He goes on:

..nothing will in fact change when the deadline expires on August 2. The US is the world’s paramount strategic and economic power, with debts in its own sovereign currency. It can do as it pleases.

Yes, the US may be stripped of its AAA by Standard & Poor’s. A nice one-day story, but otherwise irrelevant. Global bond vigilantes are quite able to make their own judgement on the substantive default risk of the US. The rating agencies are out of their league on this one.

(By the way, the serial downgrades of Japan did not stop the yield on 10-year Japanese bonds falling to 0.5pc at one stage. What matters is whether investors really believe that they will be stiffed. In Japan they did not, and still do not.)

http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100011099/the-kabuki-theatre-of-americas-debt-ceiling/

Still, Mr. Evans-Pritchard notes that unless the U.S. does something about the continued rise in health care costs - which is after all the major culprit in the budget deficit battle - the day will come when the world should really worry about the credit standing of the U.S.

But for now I think he's right: August 2 will come and go, and rates will largely remain at today's levels.

Should Investors Be Hiding In Gold?

I have had a number of calls from clients during the last few days asking what steps, if any, they should be taking in anticipation of debt default in Washington.

Frankly, I don't have a lot of answers.

Part of my problem, I guess, is that I have not been able to fathom what rationale any elected official could have to put our country in this predicament. I understand that there are strongly held views on both sides of the aisle, but default?

Ah, some are saying, doesn't today's situation scream out for investments in gold?

Well, maybe, but I don't think so. Still, with gold continuing to reach new highs on a daily basis, it is hard to argue with the gold bugs.

I believe that gold's popularity will be short-lived, and that if common sense prevails, investors will see the investment characteristics of an asset that doesn't generate any earnings, and costs something to store, are limited.

Saturday's New York Times compared the current popularity of gold to 1980, when gold soared to $850 an ounce from $35 in 1971. Then, as now, the papers were full of stories of the investment value of the metal, but if you had bought in 1980 your return for the next 30 years would have been around 2% per annum, assuming you hadn't needed to sell any gold to meet living expenses.

Meanwhile, common stocks over the same time period returned more than 9% per annum.

Then there's this: true, the price of gold over the last few years has moved sharply higher. Not only are investors concerned about the policy decisions of the global central banks, but strong demand from Asia has boosted prices. India, for example, has used some of its new-found wealth to increase gold purchases - but mostly for use in wedding dowries, not as an investment.

Here's an excerpt from the Times article:

While the price fell on signs of progress on these nettlesome issues, gold ended the week at $1,602.60. (That’s well below its 1980 inflation-adjusted peak of $2,516, said Edward Yardeni, an independent economist.) Gold hasn’t been flying this high since the halcyon days of supply-side economics early in the Reagan administration...

Even at central banks, gold’s standing has risen in some respects lately. In June, UBS held a gathering of managers of central bank reserves, multilateral institutions and sovereign wealth funds, and found that a plurality believed gold would be the best-performing asset class through the end of 2011....

In Gold's Popularity, Shades of 1980 - Strategies - NYTimes.com