Insight: Beware the bubble’s distorted allure

By Tim Price
Published: August 25 2009 (Financial Times)

What kind of a financial crisis are you having? If you are a graduating student, good luck with the job hunt. If you are a banker or an economist still in employment, you are probably keeping your head down while you count the bonus that your fellow taxpayers have so generously if involuntarily gifted you. If an otherwise blameless investor, you are probably wondering why you are being penalised with such derisory deposit rates and whether you should be jumping on to the equity market rally instead.

That might be dangerous. Headline equity index returns, year to date, are desperately misleading. There is, in fact, a two-tier market in operation: speculative (or, more politely, “growth”) stocks, which have done fantastically, and everything else. Industrial metals and mining stocks are one of the best-performing sectors internationally – not a little surprising, given that the global recovery has yet to be sustainably confirmed; energy and utilities sector stocks, along with plenty of other classic defensives, have largely been a washout. (They may yet have their day.)

And an analysis of the Altman Z Score, which assesses the likelihood of corporate insolvency by comparing various balance sheet measures, shows that the frankly flakiest companies have seen their shares hugely outperform the rest of the market even as their capital strength deteriorates. In short, this has been a rally driven by junk.

But then what should we expect, when governments and their nominally independent central bank associates have conspired to manipulate prices throughout the capital asset structure, primarily to bail out banks that are conspicuously unfit for purpose? We are now trapped within a global parody of free markets.

Within this parody, governments redirect a waterfall of capital towards the banks. The banks then “invest” this in effect free money in what looks suspiciously like securities speculation and property lending. Meet the new bank: same as the old bank. And while the sums “borrowed” from future taxpayers as economic stimulus have been extraordinary in the west, they are not even the largest. Relative to gross domestic product, as fund managers Eric Sprott and David Franklin point out, China has been busily stimulating its economy more than anyone – injecting the equivalent of fully 64 per cent of its first half 2008 GDP during the first half of 2009. That is the equivalent of buying 122 Ford Class aircraft carriers costing $8.1bn each.

Some questions now deserve to be answered. With credit provision in full-scale withdrawal, does it really make sense to be contemplating bank stocks as investments, not least given the messy governmental scrutiny at work in the sector? And if private sector credit availability is set for broad retreat throughout the Anglo-Saxon economies, how on earth can our nascent economic recovery be described as anything other than pale, sickly and fragile? Equity markets have rallied nicely from their lows, but a degree of realism is surely in order.

The banking sector profits of recent years were never sustainable, inasmuch as they were built on the sandy foundations of leverage. Corporations and households around the world are now urgently paying down debt and rebuilding their balance sheets. They are, in short, battening down the hatches in preparation for a nuclear winter. There is little credit to spare for that diminished crowd with the appetite to take it on. Those are not conditions conducive to a robust recovery, far less to a new boom.

So for those chasing the rally: what, precisely, is your endgame? Perhaps you see extraordinary levels of government indebtedness miraculously evaporating amid new economic expansion, even as taxes rise. Perhaps you see ailing, cash-hoarding banks mysteriously opening the lending taps for the next wave of entrepreneurs. Or perhaps you are looking at the future through the hugely distorting prism of the recent credit bubble. Years of massive misallocation of capital cannot be followed by effortless recovery.

Alternative yardsticks for US earnings tell different stories

Paul Marson is chief investment officer of Lombard Odier. He wrote the following article in today's Financial Times (8/13/2009). It is worth the read because it explains the irrationality behind the financial markets these days. Make no mistake, the upward turn in the market since early March has been propelled by factious perceptions. "Green shoots" are nothing more than code words by politicians and other central economic planners to replace the reality of our situation. The "green shoots" they talk about are merely the consequence of massive fiscal and monetary inflation; they are temporary. In this environment, of course firms are going to report "earnings." Yet, few recognize that these numbers have been massaged and twisted in such a way that value estimates are difficult to ascertain. Against this backdrop, Mr. Marson provides some insigthful comments. Here it is...enjoy.

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The US second-quarter earnings season is now ending, apparently on a good note as nearly three-quarters of US companies have beaten consensus expectations. But a closer look at these earnings shows there is cause to be more cautious about the health of corporate America than the headline numbers would suggest. The cloud of euphoria that followed recent results had more to do with extraordinarily low expectations than to any meaningful and lasting improvement in prospects, which still require a rapid recovery in economic activity. This suggests the recent equity rally off the back of these results is overdone.

Every quarter, US companies publish their results under the defined US GAAP accounting rules. These results are labelled "reported earnings". However, the most commonly looked at form of earnings are adjusted "operating earnings" on which companies prefer to focus as they consider these better capture the underlying trend in activity. Adjusted operating earnings exclude non-recurring expenses such as restructuring charges, asset sales gains, major litigation charges, goodwill right downs and other write-offs. While reported earnings are based on strict accounting rules, adjusted operating earnings are at the discretion of companies because there is no defined set of exclusions. Neither measure is perfect but with adjusted operating earnings, exclusions are currently so large that information about the true state of companies (and therefore the market as a whole) is being excluded.

These exclusions have reached the level where the gap between adjusted operating earnings and reported earnings is so wide that they deliver different messages on the state of US corporates.

There is plenty of evidence to show that the exclusions in adjusted operating earnings are not one-off or non-recurring items. Often they contain useful information pointing to weaker cash flows ahead. Messrs Doyle, Lundholm, Soliman, in their "Predictive value of expenses excluded from pro forma earnings" 2003 study found that the three-year return for companies in the top decile of "other exclusions" is 23 per cent lower than for those in the bottom decile for exclusions. One dollar of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.

Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor's is $7.2 per share, down 91 per cent from the 2007 peak. On an adjusted operating basis, earnings are $61.2, down 34 per cent from the 2007 peak. This $54 gap is a record.

How has this come about? Much of the difference between adjusted operating earnings and reported earnings is caused by massive writedowns in the financial sector. However, outside the financial sectors write-offs are also at record highs as corporates are eager to toss out impaired assets during periods of stress.

Furthermore, when looking at adjusted operating earnings, it seems that most US corporates managed to beat their analyst estimates thanks to production and job cuts.

There is no doubt that strong earnings numbers several years ago reflected extraordinarily high, debt-fuelled margins that are difficult to imagine again, particularly in a deleveraging and deflating economy. Investors should not expect a rebound in earnings or profitability and certainly not to previous elevated levels. Why? Because earnings growth must entail some combination of increased profit margins, rising turnover or greater leverage. Increased leverage is currently unacceptable to managements and investors alike. Wider profit margins and higher turnover may be achievable in the short term, but are much less attainable in a deleveraging cycle.

Those assessing the health of corporate America seem to be assuming a substantial, and above normal, recovery in reported earnings, alongside a return to above-trend GDP growth over the next 12 months. They are in danger of looking at the prospects for economic recovery, revising earnings expectations higher, but without considering how this might happen. In the meantime, the elephantine gap between adjusted operating earnings and reported earnings sits quietly in the room.

Read between the lines and know the real facts, or risk being deceived

By Marty Chenard

It is now August. Many are guessing that the 4th. Quarter will see a positive GDP number this year. The market appears to be factoring in that possibility. Will it really be possible to generate a positive GDP?

Second Quarter earnings results can now be given some thought. Here is what happened on the S&P 500:- Almost 61% of the S&P 500 beat their estimates. - 35.5% did better than last year's earnings per share.- Almost 25% had sales ahead of last year's.- 75% reported lower sales.

It is hard to find fault with the improvement in earnings per share ... but the fine print says: "75% had lower sales, but 61% beat their estimates."

So ... 60 out of every 100 companies beat their estimates ... but 75 out of every 100 had lower sales? How does one have lower sales but beat estimates?

You could do it by under estimating future expectations. In this way, what would normally be a bad result, looks good because you did better than the worse result that you reported "could happen".

Okay, so how could you have lower sales, but better earnings? You would have to cut costs ... cut inventories, layoff, reduce expenses, etc. That works the first time around ... the second time around is very difficult to cut as much on a percentage basis. So, the salvation will have to be an increase in sales during the current and future quarters.

That's the rub. The economy needs an increase in spending by consumer and business end users. We are getting some increases due to government stimulus programs. That can't go on forever without the consumer taking back the spending reins ... or our government will go bankrupt, the Dollar will fall, and interest rates will go up.

So, now we need the real thing ... increased spending by the consumer. We need an increase in demand because people can afford it, not because the government gave a consumer a $4,500 credit so he could buy a car. Christmas is not that far away, and the government will not be giving any consumer subsidies out for buying clothes, appliances, pots & pans.

So, as an investor, that's what you want to be watching for: Reports that indicate consumers and businesses are increasing their spending levels. Recent earning estimates are turning up slightly ... that's a good thing. It would be nice if "lots of increased spending" could happen without big increases in debt levels, because all of the excess debt and leverage has not been wrung out of the system yet.

If all goes well, and positive expectations bear fruit, then we will see forward economic progress. But, if GDP remains negative in Q4 along with weak consumer spending appears during the holidays, then the market will have a confidence retraction bringing things back to where the true balance is.

Although some earning estimates have turned slightly up, sales have not moved from declining to "increasing". The progress we are making is one of "getting less worse", and granted ... that has to happen first before we get to where things are "good". For now, don't mix the two ... getting less worse is different than getting better, and less worse is economically a lot different than getting better.

Be open minded and consider the real "comparative conditions" relative to time ... sometimes the media tries to "headline" the news to make things look better than they really are.

Take Financials for example. Some media sources have excitedly reported that " Financials are up 273% from the Second Quarter of 2008". Well, the 2nd. quarter of 2008 was negative, so what did the media really mean? Did that 273% improvement mean that things were in the positive ... or almost positive, or in the negative?

Here is what they could have said, if the media had wanted to use a different time-frame for the same result: They could have said that, "Financials were down 83% from the 2nd. quarter of 2007".

Was it misleading to make things appear as if they were wonderful? Or, was it a good thing to show the optimistic side? Our thinking is that "enough of the numbers should be reported so that someone really understands what is going on". If a person gains 30 pounds, is that good or bad? To answer the question you need to know what their ideal weight should be and how much they weighted before losing 30 pounds. Depending on the answer, they could be grossly over weight, underweight, or just right.

America is for now still blowing bubbles

By Richard Bernstein
Published: July 20 2009 19:30 (Financial Times)


Although many market and economic observers quarrel over whether the Obama administration’s involvement in the private sector upholds the American principals of contract law, private investment and capitalism, this discussion misses the most important point for investors. The question is not whether there is a battle between socialism and capitalism, but whether the US economy is on a path to mimic Japan’s.

Financial history shows that bubbles create capacity, which is no longer needed once they deflate. An inevitable and intense period of consolidation follows. For example, the internet bubble gave rise to hundreds of publicly traded dot-com companies, many of which either merged with other technology companies or went out of business once the bubble deflated. Similarly, the gold rush of the 1800s led to construction of outposts that subsequently became ghost towns after that bubble subsided.

The global economy has experienced during this decade the biggest credit bubble in our lifetimes, and virtually every industry in every country benefited. In fact, all the growth stories of the past decade (such as China, emerging market infrastructure, residential housing, hedge funds, private equity and commodities) are capital intensive investments that benefited from easy access to cheap capital. The global credit bubble seems to have created a global economic bubble.

History would suggest, therefore, that there should now be massive overcapacity in the global economy. That is indeed the case. Global capacity utilisation was recently at generational lows.

Ignoring this history, the goal of Washington’s policies has been to stymie the inevitable consolidation, keeping companies operating – and employing voters – rather than managing the consolidation to maximise the economic benefit. History says that Washington’s is an unwise and ultimately fruitless strategy. Certainly, there may be short-term gains in an economy by keeping a bubble’s unnecessary capacity alive (this may explain the recent improvement in economic statistics), but the continued misallocation of capital significantly hinders longer-term growth.

Washington’s tact has not been unusual. Politicians everywhere are naturally fearful of post-bubble consolidation because it always means higher unemployment and voter distress. As a result, policies in post-bubble environments tend to sustain an economy’s unneeded capacity, with the hope that economic growth will rebound so the economy can eventually grow into and soak up those excesses.

Japan’s post-bubble strategy during the 1990s supported excess capacity and stymied the post-bubble consolidation forces. Companies were deemed “too big to fail”, and excess capacity (particularly in the financial sector) was kept alive. Basic economics states that significant overcapacity leads to lower product prices, and Japan’s policies accordingly resulted in an extended period of deflation. Japan did have some inflation during its “lost decade”, courtesy of China’s boom, which soaked up Japan’s excesses. However, deflation returned to Japan and overcapacity grew once the Chinese economy cooled.

US policymakers made a clear choice to follow a Japanese-like route when they declared that a select group of financial institutions were too big to fail, and devised the troubled asset relief programme (Tarp), term asset-backed securities loan facility, and public-private investment programme. The bankruptcies of General Motors and Chrysler may seem to run counter to this contention, because the government took swift action to reduce unnecessary productive capacity, but it will be interesting to see how the government deals with the resulting consolidation within the industries that supply carmakers.

Recent private sector support for CIT Group – which saved the lender from failure – may be a good deal for investors who bought CIT’s debt at a discount, but it is clear that lending capacity will not be reduced as much as it would under a full CIT bankruptcy. If CIT had failed, some rightly feared that lending to smaller companies might have been constrained. However, the government could have encouraged other Tarp-funded institutions to lend to small businesses rather than continuing to allow bailed-out institutions to make outsized trading profits. If public policies insist on maintaining excess financial sector capacity, then at least utilise that excess capacity productively for the economy.

Many observers claim that comparisons between the US and Japanese economies are inaccurate because the US economy is more “dynamic” and less “rigid”. There are, of course, differences between the two economies, but it seems increasingly clear that both the US public sector and, with CIT, now the private sector too are working against post-bubble consolidation, slowing the economy’s dynamism and increasing rigidity.

A California roll is an American version of a maki, a type of sushi. It is based on Japanese tradition, but has a decided American flavour. Similarly, the actions of the US’s public and private sectors seem to mimic Japan’s. Although the markets’ short-term reactions might correctly be positive, investors should be wary that the US will be an American version of Japan’s moribund economy.

The writer is CEO of Richard Bernstein Capital Management and a former chief investment strategist at Merrill Lynch

“The Invisible Hand, Trumped by Darwin?” - My Critique

This is my response to an article written by Robert H. Frank, an economist at Cornell University, titled “The Invisible Hand, Trumped by Darwin?”

Given the times we are living, I am not surprise that such nonsense by Mr. Frank is camouflaged as scholarly. First, Adam Smith never attached “greed” to his “invisible hand” statement. This was done by free-market haters to further their flawed economics. They, like Mr. Frank, conveniently disregard Smith’s Theory of Moral Sentiments written in 1759, which buttresses any legitimacy of equating “invisible hand” with “greed.

Second, the basic premise of Darwin’s theory provides the foundation to socialism/communism/totalitarianism. This is why Karl Marx said it was the “most important and suits my purpose in that it provides a basis in natural science for the historical class struggle.”

Third, although never explicitly stated by economic Darwinist but certainly inferred, implementing their theory means a few (e.g. a committee or an elite group) coordinate the most efficient allocation of capital in a society. In other words, a few control the many. Any which way one looks at it, Mr. Frank’s philosophy is anti-free market to the core.

Why hopes of a fast recovery have been much exaggerated

By Eric Uhlfelder
Published: June 28 2009 (Financial Times)

When he was made chief economist at the International Monetary Fund in March 2007, Simon Johnson was deeply concerned about the state of finance across the world’s major developed markets.

But under secretaries of Treasuries, deputy ministers and deputy central bank governors of G7 nations reassured the IMF that in spite of some rumblings all was well.

While he was amazed by how unprepared these leaders were for dealing with the worst economic meltdown seen since the depression, Mr Johnson acknowledges that everyone, including himself, “bought too much into the idea that the financial industry, particularly big banks, had a complete grip on what we thought was risk and how it was being managed”.

But a year after the initial market hit in August 2007, Mr Johnson felt much of the developed world was still in denial about what needed to be done to address the crisis. So he left the IMF and became an academic at Massachusetts Institute of Technology. He is now professor of entrepreneurship, global economics and management at the MIT Sloan School of Management.

“I was trying to speak out while I was at the IMF,” he recalls, “but certain constraints come with position, and I found it was time to speak more bluntly than I could as an official.”

And blunt he was in a recent article in The Atlantic entitled, The Quiet Coup, in which he noted a disturbing similarity between emerging market failures and the US. “Elite business interests – financiers in the case of the US – have played a central role in creating the crisis,” wrote Mr Johnson, “making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse.”

What he finds even more unnerving is that these special interests “are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.”

This is not to say Mr Johnson thinks administration policy is way off mark. He likes the mixed-bag approach. “It makes sense that if you’re not sure what will work, you try a bit of everything: fiscal stimulus, housing support, and recapitalising the banks.”

While he thinks Barack Obama has been a little overweight on the fiscal stimulus, he says the president “bent over backwards not to really annoy the banks or to do anything harmful to their interests”. And to Mr Johnson, this could be Mr Obama’s Achilles heel. He thinks the so-called bank stress tests underestimated the worst-case scenarios by as much as a factor of two.

So, then, is the market rally for real?

Mr Johnson thinks it is mostly a response to the end of the panic phase of the crisis and calm returning to financial markets.

But he does not think those two features alone can carry stocks very far. “We’ll need to see a turnaround in the real economy before investors believe the current rally is sustainable.”

He fears that hopes of an immediate recovery have been greatly exaggerated, and thinks there is still a lot of nastiness that has to work its way through the system.

Asked about a model portfolio, Mr Johnson thinks in terms of US securities as he believes America has the greatest capacity to regenerate through the creation of new technologies and innovation.

Seeing a lack of creative policy response across the eurozone, he is sceptical about western European prospects. He anticipates anaemic growth for some time to come due to the European Central Bank’s refusal to sufficiently lower interest rates and embrace quantitative easing [where Treasuries purchase securities to pump capital into markets].

He is much more keen about certain emerging markets that have already weathered their own crises over the past 10 to 15 years. “I like Brazil, Mexico, India, and South Korea,” says Mr Johnson, “countries that have made systemic changes, which have helped them to hold up much better than most people anticipated.” With an eye on good management, he would have between 20 to 30 per cent of a model portfolio in such places.

However, he would be underweight equities in general. “I can’t imagine a return to the kind of equity growth we had seen over the past two decades, but I can imagine a 10-15 year period where stocks go nowhere.”

He admits his own retirement account is too equity heavy and should include more bonds. He also feels this crisis has taught many investors they have been holding too much stock, and that lots more volatility comes with such exposure. He thinks the recent market collapse proves the need for investment horizons of at least 20 years when investing in stock.

Since he believes quantitative tightening will be no easy feat to ensure impending inflation is contained, Mr Johnson agrees with many financial advisers that commodities will likely prove an effective hedge to future rising prices. But he cautions investors about the likely reinflating of commodity bubbles.

For the same reason, he also likes inflation-linked government bonds.

Overall, he thinks we are still in very uncertain times and believes the average investor would be well served by sticking with safe investments, such as US government debt. But he cautions “that even ostensibly safe sovereigns may not be for the faint of heart”.

Causes of Recessions

There is a perception that the current economic crisis stemmed from appropriate regulatory oversight, compounded by the creation of opaque financial instruments. None of these issues by themselves adequately explain the dire circumstance we are presently experiencing. In fact, considering the first part of the alleged reason leaves a lot to be desired. The fault lies in Central Bank policy.

The creation of money out of thin air by Central Bankers all over the world gave financial institutions perverse incentives to undertake unprofitable business. The financial instruments created during the bubble period could not have happened if money were not so easily available. Indeed, any financial firm (just like any other business) that desires to expand needs capital, which comes from saving not by resorting to the printing press. Printing money is not capital. Ask yourself this question, why is that a large number of businesses, which its owners are risking their capital in this endeavor and receive profits by adequately forecasting future demand, suddenly and in unison fail in their function? In other words, why business owners experience a “cluster of errors”? The answer lies in that Central Bank policy (i.e. printing money) fools them.

The severity of an economic crisis is directly related to the level of interference preceding it. The U.S. Central Bank, for example, lowered interest rates to historically low levels in 2003-2004 (1%). The easy money fed through the financial system and to the housing market. When the Central Bank reversed the easy money policy in 2006, the bust phase was inevitable. The economy began to crack in mid-2007 and busted in 2008. “Austrian” Theory says that we are not out of the woods yet; but rather a bigger bust is ahead, given the unprecedented level of market interference that has occurred thus far.