When's The Recession?

A couple of quarters ago I bet my friend and fellow analyst, B, that we'd have a recession by the second quarter of 2005. Fifty bucks on the line. A recession being defined as a quarter of negative real GDP growth. Right now it looks like I'm going to lose the fifty, which I can ill afford at present but never mind. Certainly B is not a guy to bet against lightly, and it is to his credit that he persuaded me down to fifty from a hundred.

You could see his point. There was no sign of a slowdown in GDP growth at that point, and with both short and longer term rates at historically very low levels it didn't look all that likely: usually it's high short term rates that's responsible for recessions. All the same, my reasoning went, the best time for a recession, from the viewpoint of a political incumbent, is right after the election. Get it out of the way before the mid-terms and try to get the economy roaring again at the four-year mark. Actually it's not as true as it used to be -- recessions have been remarkably scarce in the last 20 years compared to historically. Anyway, I'm pretty cynical, as you may have gathered, about the current incumbents. They'd be the type to play it safe.

It's surely coming at some point. Expectations are continually being revised downward in Europe: France is a little stronger than it has been, though confidence there is at a 15-month low; Italy is looking weak; growth in the UK is pretty minimal and expectations are going more in a southerly direction; and the latest confidence index from Germany, the largest economy in Europe, was unexpectedly low. Japan is flirting with recession once again, and in South Korea factory output recently suffered its worst decline in seven years. (Thanks to the FT's excellent Philip Coggan for some of this info). Latin America is going gangbusters, it's true, as you'd expect from resource-rich regions (ditto, for example, Australia and oil-rich Former Soviet Union countries). Then there's China. Lord knows what's going on in China. Can you really believe the numbers they publish? And, with all the recent news about graft and fraud in the banking industry, not to mention the incredible bad debt levels, can you really expect that economy not to crash at some point? When it comes, it'll be a big one, IMO.

Exports were only 10% of US GDP in 2004, so it's not critical that the rest of the world be thriving, but it certainly helps. Imports (-15% of GDP) are likely to go up, because the dollar is weak. Oil, for instance, is costing a lot more this year. Government spending (about 20% of GDP) is going to stay high, we can pretty much count on that. The biggest factor, of course, is the consumer -- about 70% of GDP in 2004. What will bring him crashing down is a rise in interest rates. That really puts the crimp on big-ticket durable goods spending (cars, large appliances, etc); and these days when so much spending is on the credit card, it's not just big-ticket spending that will get hurt.

Maybe I'm going to be out fifty bucks, but I'm still betting on a recession before the end of 2005. Any takers?

House For Sale

Suddenly there's a flurry of articles on the housing boom. Friday in the NY Times, Saturday in the Washington Post and today in the Financial Times. All with stories of how people are trading houses like they used to trade dotcom stocks in the late 1990s. (See: Extraordinary Popular Delusions And The Madness Of Crowds. By Charles MacKay. 1841. You can get a copy here:

http://www.popula.com/items_fp/item_description.cfm?item_fp_ID=237616 )

There's a theory that goes something like this: LT Capital Management collapsed back around 1998. With that and the related Asian currency crisis, the Fed had to pump a lot of money into the system. The liquidity eventually found its way into dotcom stocks. When that bubble collapsed in 1999, the Fed had to do a whole lot more injecting of money to try and minimize the negative effects on the economy. That easy money policy has been in place pretty much ever since, and its effect has been to support the bond markets, the stock market and, as a kind of side effect, the house market. It's called Pass The Bubble. Where to next?

The thing about "market prices" is that they aren't necessarily representative of the whole market. Prices are made "on the margin" -- there's a whole lot of houses out there, but people determine the value of their houses by referring to a very small number of transactions. It's a very illiquid market, and you really can't value the whole housing stock based on a few trades. (I was reading somewhere the other day about the Japanese property market bubble in the 1990s, when, it was said, the land on the which the Imperial Palace and gardens sit in Tokyo was worth more than the entire state of California. That sort of makes the point. Apparently average prices in Japan have now fallen by about 80%).

Well, prices are certainly getting pretty crazy in my neighborhood. Supposedly my house is now worth over three times what I paid for it about five years ago. So, despite the fact that it would be a royal p.i.t.a. to find somewhere else to live and move all our crap over there, I called in the broker and signed up. If you are one of those speculators who is making such a finel living flipping houses, feel free to drop me a line.

Nationalize Microsoft

No, I'm not a socialist. I wouldn't go around nationalizing everything. But I think exercising a little eminent domain over Microsoft is a great idea, not only for the massive economic benefits but also, as they said when they hanged Admiral Byng, "pour encourager les autres".

Microsoft is still wrangling with the EU as to how to implement the EU antitrust ruling, using the same stalling tactics they've always used to weasel their slimy way to the top.

They no longer serve any useful economic purpose. We don't need any more "upgrades" to our spreadsheet or wordprocessing programs or to our operating system, and it is certainly an economic negative for this company to force us to take them just in order to escape finding really useful ways to make a buck. Nationalizing the company might make others think twice before embarking on such rampant abuse of monopoly power. As for the worldwide economic benefits, just imagine what producticity might be unleashed if nobody had to pay for the operating system and the source code were made freely available. Write to your congressman!

Kids These Days

Tiger Woods gets $50mm to advertise for Nike, or whoever it was. Howard Stern gets $500mm (OK, not all cash) to take his show over to Sirius satellite radio (which, by the way, also agreed to pay $200mm to carry broadcasts of NFL games). By now, we're used to seeing big numbers in sports and entertainment. So yesterday's news that the NBA signed 5-6 yr licensing deals for a reported $400mm sounds pretty ho hum. Wait a minute, though: the deals were with Electronic Arts and four other video game companies. Video games!

Electronic Arts, the world's largest video game company, already has a $500mm 5-yr exclusive deal with the NFL, and Take Two is reported to have signed a $300mm exclusive long-term deal with the baseball guys. By my reckoning, that's about $200mm a year for virtual basketball, football and baseball. Bear in mind, here, that these three are all pretty much North American sports, so we're really not talking about worldwide markets. To the videogame makers, sports games are worth, apparently, about $1.2 billion a year in revenues.

Here's a funny sidelight: part of the revenues are from advertising within the games. They can actually stick ads into the virtual game just like they do in the real ones.

I took a quick look at Electronic Arts's financials (ticker ERTS). They do about $3.2 billion a year in sales and bring $500mm - $600mm to the bottom line. They have a market cap of around $17 billion, no debt and $2.6 billion in cash at 12/31/2004. The stock is trading at about 30x last twelve months' earnings ($55 stock, $1.86 EPS) and, despite all the cash, doesn't pay a dividend. About half their sales are from overseas, mostly Europe.

One of the other companies participating in the (obviously non-exclusive) deal, by the way, is Atari. There was a time when Atari seemed the invincible king of the videogame business, back in the early 1980s when games like PacMan and Space Invaders were the very latest thing. Turned out kids suddenly got bored with videogames and Atari was caught with enormous inventories of unwanted cartridges.

Atari these days (if it's even the same company - ticker ATAR) has a market cap of about $400mm, a tiny fraction of Electronic Arts (which didn't even exist back then) and revenues of around $410mm. There's also Take-Two Interactive Software (TTWO, maker of the very successful and highly criminal Grand Theft Auto series), with a $1.9bn market cap and $1.25bn in revenues, and Midway Games (MWY) with a $900mm market cap and $160mm in revenues. The fifth player is Sony, obviously not a pure play. Other players not in this sports deal are Activision (ATVI) $2.4bn market cap, $1.4bn in sales, and THQ (THQI) $1.1bn market cap, $700mm in sales.

I used to own one called Acclaim Entertainment, which was a fairly decent name in that business in the 1990s. I see they filed bankruptcy back in September. The stock is in the pink sheets at .39 cents a share.

Electronic Arts stock took a pummelling on Monday after it lowered its expectations for sales and earnings for 2005 ($1.62 - $1.64 expected in EPS). Granted it has a very strong balance sheet and can stand, no doubt, several tough years. But, especially give the history of the videogame industry (see above), does it really deserve a forward P/E of over 30x? Not that I really know a lot about this business, but I can't see where the growth is supposed to come from.

For a quick look at the retailing of electronic games, and some light on the hardware side, see this story on GameStop (GME):

http://yahoo.smartmoney.com/onedaywonder/index.cfm?story=20050323&afl=yahoo

This Texas-based (uh oh! red flag!) company has over 1,800 stores around the country and plans to open another 370 - 400 this year, expanding its base by over 20%. Among their competitors are WalMart, Best Buy and, presumably at some point, web-based downloading.

It's a world of bread and circuses. Just seems to me the circus/bread ratio is at an all-time high. If your average joe doesn't have enough bread to pay for a circus ticket, how long can this go on?

Nobel Economist: No Bullshit On Social Security

An editorial in the FT today by Joseph Stiglitz on social security. With the White House Used Car Sales team out there flashing the usual smoke and mirrors it's nice to see some straight talk. It's not really a very complicated subject. Because of a change in the age structure of society (ie a higher ratio of retirees to active workers), the current "pay as you go" system is set to go bust. Not today. Not tomorrow. But, according to the pundits, around 2040. That's 35 years from now, when people who are not even born yet will have been in the workforce for 10 years.

I don't know why the Used Car Sales team is deciding to make a big issue of it now. I suppose they've always been opposed to it, and now they're thinking they better get it done before the Sales Director leaves office in 2008, because the chance may not come again. No doubt they have the full backing of Wall St., which stands to make a lot of money in fees and commissions on those pointless private accounts.

"If there is a remarkable achievement of the Bush proposals", Stiglitz concludes, it is that, "they simultaneously undermine the solvency of the Social Security system, worsen the fiscal deficit, diminish the security of the elderly and increase the incidence of poverty". The Bush proposals do nothing to attack the root problem, and it's hard to see how anyone could believe otherwise. Worth a read.

Meanwhile in a related story on the front page, Standard & Poor's has declared that the US, Germany, France and the UK will be junk credits within the next 30 years, for the same basic reasons -- pension and healthcare costs for the growing retiree base swamping the ability of the active workforce to pay.

A lot can happen in 35 years, friends, take it from one who has been around for a while. To assume that society will not find ways to adapt to the changing circumstances is extremely naive. The world population will be around 8.7 billion by 2040 (from around 6 billion now), of which a good 3 billion haven't been born yet. Technology will continue to evolve, and productivity will continue to grow as a result. I'm not saying we shouldn't do something about the theoretical future imbalance in Social Security. But for heaven's sake don't swallow the bullshit being shovelled out of Washington.

Fund Managers Bullish. Ding Ding!

There's an old Wall Street saying: "They don't ring a bell at the top".

Here's a hint, though. Last week Merrill Lynch released its latest survey of fund managers. Merrill has apparently been doing this survey since 1999. It covers 302 managers with almost $1 trillion under management. A record 59% of them are over-weighted in equities. Ding Ding!

Some further points from the survey (http://www.ml.com/?id=7695_7696_8149_46028_46688_47167) : These professionals (often a good contrary indicator because they are the market) are relatively bearish on the US stock markets (and the dollar), which prolly (as my kids say) means they'll outperform the preferred locales, viz. Japan and the so-called "emerging markets". Energy and industrials are the most popular sectors among these cognoscenti.

They're bearish on bonds, though, apparently, with 57% underweighted in fixed-income. I'm pretty bearish myself on this sector, and have been, wrongly, for the last year at least, so maybe I'm going to be wrong again.

I read an interesting paper a couple of days ago about the whole US currency problem. The author is one Nouriel Roubini, of NYU's business school (my alma mater, as it happens). See: www.stern.nyu.edu/globalmacro/ BW2-Unraveling-Roubini-Setser.pdf . This would certainly tend to make you pretty bearish on the US bond market. An interesting sidelight, though, on the Chinese currency peg: one way for the tectonic pressures to be relieved, theoretically, would be for US prices to rise more slowly than Chinese prices. What are the consequences of that for the nominal interest rate differential?

Nerd vs Nerd (vs Us)

The Philadelphia Stock Exchange announced yesterday it will start making a book on "events". Yes, we ordinary citizens will be able to buy/sell the over/under on a number of so-far unspecified events. OK, it's not quite as racy as it sounds -- there are no plans (so far, anyway) to give spreads on football or basketball games. More likely will be bets on economic numbers like non-farm payrolls, crop numbers or individual company earnings reports, or even on events like outbreaks of mad cow disease. Coincidentally, an outfit called HedgeStreet Inc from San Mateo, California, will be offering a similar wagering venue in Q3. This is already done in some places -- notably in the UK where companies like Ladbrokes will make a book on just about anything. The difference is, Ladbrokes is explicitly in the gambling business, with High Street betting shops where people can go and bet on horse races and stuff.

Are we getting too far away from Useful Economic Purpose? Believe it or not, the original futures exchanges did serve a useful economic purpose. A farmer, for instance, who wanted to be sure how much he would make on his wheat, could fix the price today for delivery in three months, hence know that he had enough money to shell out on the new harvester. On the other side of the trade, the flour company would know exactly how much it was going to have to pay for the wheat. In other words, it was all about risk: both sides could reduce their risk.

Maybe not. You can see how the Philadelphia Betting Shop might serve the same function. A hedge fund that was short treasuries, for example, (expecting interest rates to go up, perhaps because it thinks the economy will overheat) might be hurt if the non-farm payroll number came out too low (implying weak economic activity, hence lower interest rates and higher treasury prices). At the right price, it might be worth it to hedge a little just in case they were wrong. Who would take the other side of the trade? I suppose maybe a company that was preparing to issue bonds next month might want to protect itself against rates going up. All sounds pretty reasonable.

But do we really need it? We pretty much already have as many derivatives as we need to do the job of spreading risk in an economically rational way. (See our post from a couple of days ago: $1.9 trillion a day in FX contracts!). Let's not forget that even when the risk-spreading is economically efficient, it's still a zero sum game. You can't help thinking that this is just another way for one set of nerds to pit their computers against another set of nerds. Each side takes its "management fee". Guess who's the loser?

How Many Americans Collect Dividends?

There's been a flurry of stories lately about how government departments have been turning news releases into propaganda for the incumbent administration. It seems to me that they've always done that, though probably not to the extent we've seen in the last couple of years. Particularly since Goebbels, I suppose, governments have been particularly conscious of the value of propaganda.

Today the US Treasury issued a release (http://www.treas.gov/press/releases/js2326.htm) detailing the numbers of taxpayers benefitting from the two rounds of tax cuts we've seen since the UCS took over the White House. According to this release, over 105mm Americans benefitted in one way or another from the tax cuts. The release didn't break out dollar amounts (ie the extent of the benefit for each group), so there's no direct insight into which income groups benefitted by how much. We can probably assume from this omission that the data aren't particularly favorable to those who voted these cuts in.

Almost 94mm benefitted from the new 10% tax bracket. A little over 25mm benefitted from a reduction in the top tax rates. The number of filers benefitting from the elimination of taxes on dividends and reduction in taxes for capital gains amounted to 22m (or about 10% of the adult population).

These tax cuts, of course, are the major reason for our current humongous budget deficit. The treasury press release ended with an exhortation to make the cuts permanent. Coupled with the explosion of pork barrel spending that's been allowed to pass unvetoed, it's hard to avoid the conclusion that they actually want the government to go bankrupt -- this being the best way, presumably, to force a dismantling of the New Deal state. Remember "Rosy Scenario" and "Deficits as far as the eye can see" ? It feels like Reaganomics all over again.

Metabusiness Is King: But For How Long?

Two very different press releases in the past couple of days. Yesterday, the financial services firm of Lehman Brothers posted very strong results for its first quarter (ending February), way ahead of expectations. It gave the market a bit of a boost early in the day. Today, General Motors, icon of the American manufacturing economy, announced that it would fall below expectations in the first quarter, posting a loss instead of early forecasts of breakeven and reversing its operating cash flow forecast from plus $2 billion to minus $2 billion. GM has been in the news a bit lately because of the possibility that some of its debt will fall below investment grade and into the so-called Junk category -- a development that might well be accelerated by this little piece of news. That, among other things, put Mr Market into a bit of a funk today.

It really puts the US economy into perspective. Lehman made $875mm in the quarter to February on revenues of $3.8 bn, an annualized return on equity of 24.5%. Bond trading generated $2bn in revenues. Investment banking had a record quarter (Lehman advised on four of the top 10 M&A transactions in the quarter; Asia and Europe broke records on the back of strong mortgage and other asset backed securities transactions). Three other publicly traded brokers, or as you might call them, "metabusinesses", Goldman, Morgan and Bear Stearns are all due to report later in the week.

Will someone please explain? I admit I've always had some trouble understanding how Wall St can continue to flourish while Main St seems to spend most of its time under floodwater. I mean, granted there are some relative bright spots in the "real" economy -- we're pretty strong in, for instance, "aerospace" (a bit of a euphemism?), semiconductors, software, and movies to name just three real industries. But Wall Street essentially depends on all these other "real" areas doing well. I mean, they don't actually make anything, do they? They just shift money about. At bottom, they depend for their profits on the profitability of "real" companies. You would think that this situation would be untenable in the long-term. Yet it's been this way for as long as I can remember.

$1.9 Trillion A Day

That's how much is traded, apparently, in foreign exchange markets. Of that, the spot market (ie foreign currencies) account for about $620 billion while the other $1.3 trillion is, presumably, in "derivatives" -- meaning options, futures contracts and whatever other "derived" products there are out there.

Compare that number with the volume of world trade. According to the OECD (www.oecd.org), total world trade amounts to about $2.3 trillion per quarter (close to $10 trillion per year). Or, let's say, $25 billion per day. To put it another way, of the $1.9 trillion in foreign exchange trading that goes on every day, only around 1.3% is necessitated by trade between countries in goods and services.

What the hell is the other 98.7%????

Well, here's a clue: the FT (yes, my main source of news) reports that hedge funds are moving in as market makers. Hedge funds have traded FX for years, of course. (One of the most notorious trades in hedge fund history was in FX, when George Soros made $1.1 billion betting on a fall in sterling back in the early 1990s). But the actual market making has been left mostly to large international banks, which make money on a "spread" (ie they buy at a lower price than they sell, just like a stockbroker) rather than by taking large positions. In recent years, a lot more trading has gone on line, to places like FXAll (you can see them at fxall.com), which sees about $35bn a day in trading (a tiny percentage of the total market, but it's growing pretty fast). I guess the hedge funds have become so comfortable in this market that they're going to have a go at market making (through EBS, a centralized currency trading platform catering directly to banks). So why are they in the market, again? Oh, yeah, not because they need to buy Polish vodka or anything, but because they have a feeling zlotys are headed up.

Maybe I'm missing something here, but... doesn't the other 98.7% sound pretty much like, well, a casino?

US Consumes 22% of World's Food?

In retail value, at least, yes, apparently.

According to a recently released report from IGD, the global retail market for food in 2003 was $3.5 trillion (out of a total global retail market of $8.8 trillion). The US accounted for roughly 22% of this, which would be around $770 bn. (which comes out to about $2,600 per person per year).

So, let's see. Our (US) population is roughly 296mm (see http://www.census.gov/population/www/ ), out of a world population of about 6.4 bn. That's 4.6%. And we're responsible for 22% of the world's retail food purchases. Either we're eating too much, or we get charged too much for food.

BTW, the same report predicts that this world food retail market will grow at 4.8% a year until 2020. You may be relieved to hear that most of the extra calories (OK, dollars, anyway) will be consumed by non-Americans (Indians, Russians and Chinese), so that the US share will decline to "only" 19%.

The 1970s were hellish. Are they coming back?

Markets worrying about inflation again. I suppose there must still be enough of us old timers around for this to scare the living shit out of anyone with an investment portfolio. Back in the late 70s and early 80s it really seemed as if we would never again be able to wring inflation out of the system. It took the enormous resolve of Paul Volcker, plus a deep and abiding recession, to get rid of it. A prime rate that reached, I think, 21%, and the long treasury at 15% in early 1982. You could get a 17% - 18% return just by staying in (the newly invented) money market funds. Milton Friedman was king of economists, and it really looked like controlling money supply was the answer. Thursday after the close the newest money numbers were released, and Friday's market pretty much came or went according to whether people thought they were regaining control.

There were also a lot of commodity shocks -- particularly oil (in 1973 and again with the fall of the Shah in 1979), but also all kinds of other commodities, like sugar, coffee, gold, silver and base metals. There would be periodic consumer scares: suddenly, everyone would be lining up to buy toilet paper because it was rumored to be running out, like gasoline. Once everybody began to expect inflation as a matter of course (and it seemed pretty likely, given that we'd gone for several years without being able to get rid of it), it got sort of built into the system. You expected your pay to go up just so you could stay even with rising prices. They began to put cost of living adjustments into everything, including social security. You'd stay the hell out of bonds, because you were getting paid back with fixed dollars that bought less every month. But even stocks just diddled around, never really going anywhere: most companies had trouble maintaining profit margins, because price increases wouldn't necessarily stick in a stagnating economy even though costs were rising because of wages and raw material prices. It was so bad that you were afraid to invest in companies that didn't use the more conservative LIFO (last in first out) method of accounting for inventories and COGS. Oil and other natural resource stocks did OK, but everything else got left behind. So even though many portfolio managers are too young to remember this horrible time, it's a relief to see they're not totally blind to the threat.

Apparently we're not as vulnerable to raw material costs as we used to be. Apparently, we use about half as much energy per unit of GDP as we used to in 1973 -- a response, obviously, to the 1970s price shocks, but one that took a very long time to come about. (Still, we do import around 10 - 11 million barrels a day of oil, which comes to around $16bn a month with oil at $55. Put that in the context of a trade deficit of $55 - $60bn a month and you can see it's a decent percentage of our total tab. The IEA has just adjusted upward again its estimate of world oil consumption for 1985, to 84.3mm barrels a day.) I suppose we do a lot less manufacturing than we used to; services aren't as badly affected. Still, the Fed noted in their latest beige book out this last week that companies aren't having any difficulty passing along cost increases; so inflation at the wholesale level will, most likely, start finding its way into our pocketbooks.

Speaking of services, a footnote to yesterday's post on hedge funds. CSFB just came out with a study. They say hedge funds now control around $1 trillion of assets. Last year they contributed about $25bn in revenues to broker-dealers worldwide, which would be, therefore, about 0.25% of their asset base. Total revenues to these banks were in the range of $200bn. That's $200bn charged, essentially, for investors to swap assets with one another; $200bn deducted from total returns to savers whose money is being moved around. Some day soon I'll write more about the great savings skim and the economic puzzle of bond salesmen's pay.

A toxic name for Clinton's hedge fund

News today that Bill Clinton will be speaker at the opening for a new hedge fund in New York. It's an Austrian company to be known as Superfund Asset Management, and it aims to put hedge fund investing within the reach of your average investor (minimum holding only $5,000). Apparently the track record is pretty good: two funds started in November 2002 have returned 52% and 82%, and that's after deduction of fees. Superfund, you may remember, was the name given to a large pile of money set aside for cleanup of toxic waste dumps in the 1980s. We're hoping these hedge funds don't become too toxic for their investors.

Hedge funds, unlike mutual funds, are pretty thinly regulated. That can be good for the participants as long as the management is honest and knows what the hell it's doing. But it also gives them more room for recklessness (they may be called hedge funds, but that no longer means they've hedged their bets) and for fraud. The SEC, which is hampered by a lack of authority over hedge funds, has brought 51 cases in the past 5 years, according to the FT, with investor losses of around $1.1bn. Just last week, a new fraud came to light: some fund in Florida by the name of KL Financial apparently lost $70mm (and maybe as much as $300mm). While they were losing money hand over fist, apparently, they were boasting to their investors of annual returns in the area of 150%.

Hedge funds can put their money pretty much wherever they want, so, unlike mutual funds, they're not bound by particular markets. So their pitch is that they can make money no matter what the stock and bond markets are doing. If stocks look overpriced, they'll do commodities, or currencies, or distressed bank debt, or convertible arbitrage or whatever. I don't know what the numbers are, but they've grown tremendously in the last few years.

I'm certainly not the first one to point out that once everybody's doing it the returns are bound to go down. Worse, the management fees are much higher than you'd generally pay in a mutual fund, so you (as an investor) are starting off at an immediate disadvantage. There are even, now, "Funds of funds", which are hedge funds that invest in other hedge funds -- so the whammy is multiplied. (The last time Funds of Funds were popular, by the way, was in the go-go years of the 1960s, and the most famous Fund of Funds was IOS, the one run by Robert Vesco and Bernie Cornfeld. Bernie went to jail in Switzerland and died a few years ago. Vesco went on the lam, taking a couple hundred million dollars with him (but not before giving $200K to Richard Nixon's reelection campaign). He's in jail in Cuba now, for another fraud he perpetrated there, and due out in 2009 when he'll be almost 80. (You'd think you'd be able to stop once you had the $200 mill, wouldn't you? Check out a short bio at http://slate.msn.com/id/1007117/ ).

The SEC has a paper on hedge funds. If you're thinking about putting money in, you might want to take a quick look: http://www.sec.gov/news/studies/hedgefunds0903.pdf. The old warhorse in charge of the SEC, Bill Donaldson (yes, founder of Donaldson, Lufkin & Jenrette), is trying to get authority to regulate them more, but it's an uphill battle. A goodly portion of brokerage house fees these days apparently come from hedge funds.

Here's a quote of the day, from Anais Faraj of Nomura Securities: "We appear to be repeating the benign 'golden age' cycle that spanned 1955-74". It echoes vaguely that famous quote of Nobel prizewinning economist Irrving Fischer in 1929: "Stock prices have reached what looks like a permanent high plateau..."

Mr Market feeling glum today

Keynes talked about "animal spirits" and Ben Graham apparently liked to talk about a manic-depressive called Mr Market. Some days Mr Market focuses on good news, some days on bad. Today, for instance, he focused on the bad. Today he was worried about an increase in inflation and its corollary, interest rates. He's also concerned that corporate profit growth is slowing down. So he bid the 10-yr Treasury rate up to 4.5%, the highest level it's been for a while, and took the Dow down 100 points or so.

Worry about inflation isn't new. The money supply has been growing at a solid clip (check out the Federal Reserve Board website for the numbers). Interest rates, both short and long, have been on the floor for a long time. Then there's that ever-growing budget deficit. By the old wisdom, these are all likely ultimately to cause inflation. The mystery, really, is why it hasn't reared its ugly head sooner. You can see it in commodity prices all right: oil into the mid 50s, copper at a 16-year high, aluminum at a 10-year high, steel through the roof for quite a while now, just for a couple of examples; but it hasn't really been evident in retail prices. (Not officially, anyway, though you've got to wonder whether they aren't cooking the numbers.)

As for corporate profits, you would certainly expect growth to start slowing there. They're at a pretty high level relative to GDP historically, you wouldn't expect them to continue growing forever. (You can check this out at the Bureau of Economic Analysis website, http://www.bea.gov/). This goes along with the rapid growth of productivity we've seen since the latest recovery: GDP may be up, but job growth lagged way behind, with increased productivity making up the difference.

It all makes a certain amount of sense. A lot of the tax cuts since the UCS took office have gone to the rich. When you give a tax cut to some poor wage slave, he pretty much spends it all, but if you give it to someone who's already consuming everything he wants then it goes into investments. Not surprisingly, you see asset price inflation first -- increased house prices and stock and bond markets. Commodity prices? Well, they've been saying for a while that hedge funds have been wagging the dog at least in the oil markets, why not in other natural resources too? Hedge funds is where, increasingly, these rich guys put their money. On top of that, of course, is the rapid growth of manufacturing in China, whose economic ebullience (so far, anyway) has been widely credited with strength in raw materials markets (China is now the second largest importer of oil, for example, after the US). The asset inflation goes along with a recovery that doesn't make a lot of new jobs: if the tax cuts go to people who don't spend it, you don't get a lot of "demand pull". Ultimately, unfortunately, if the economy doesn't catch up with the markets, asset prices will suffer, at least in real (inflation-adjusted) terms.

That 50-year French bond is being quickly followed by a 50-year Italian job. This time, though, it's a corporate, from Telecom Italia, a 500mm Euro issue rated at the low end of investment grade (BBB average of the three agencies). According to the FT, demand for these really long-dated issues is due to "ageing populations, asset-liability mismatches at pension funds and insurance companies, and regulatory changes in several EU countries". Sounds a bit thin to me. (50-year liabilities? Are there suddenly many more 20-year olds buying life insurance policies?).

Venezuela came with a 1bn-Euro deal maturing in 10-years priced at 350 over the US treasury (ie 7.1%). It's rated an average of B by the three rating agencies. The spread is roughly comparable to that of single-B US junk bonds. Venezuela. Isn't that where that guy Chavez is in charge?

In Europe they issued a CDO called Leopard III. Yes. The spread on the AAA piece was 25 over Euribor (I suppose that's roughly like LIBOR) -- the tightest ever for a CDO and, for the first time, below the spread on a US CDO. I like name. Hope it doesn't come back to bite them.

What is a CDO, anyway? Well, it's just another form of the securitized loan I talked about a couple of days ago, where they essentially borrow at a low rate to buy loans that pay a higher rate. They're getting pretty damned complicated these days. They now have what are called CDO-squared (CDOs whose assets are CDOs) and even CDO-cubed. What does it all mean? As our friend Warren B noted, probably nobody really knows. But the essential point, as far as I can see, is leverage: using small amounts of equity to control large amounts of assets. Works great when the asset goes up, not so great on the way down. It's the same thing that caused the great market crash of 1929 and the 10-year depression that followed.

The new McKinsey quarterly is out. There's an interesting piece purporting to debunk the idea that the weak job growth of the last few years (actually they're talking about 2000-3) was due to foreign competition. Rather, they say, it's because of high productivity growth (you need less labor to get the same output), weak domestic demand and the strength of the dollar. Sounds about right to me, though I think you do have to be skeptical of these ivory-tower studies, which rely heavily on assumptions and reasoning that is not necessarily made clear in the published report. ("We estimate that... " "Our research shows that..." and so on). They conclude that protectionism isn't the answer. Rather, focus on stimulating domestic demand and encouraging exchange rates (especially the dollar-pegged Chinese rate, I'm guessing) to reach their natural level.

Warren Buffett's annual letter

Can a nice guy get rich? It's hard to read Warren Buffett's annual letter to shareholders without thinking that, yeah, against all reason, it really is possible for a nice guy to get rich. (You can download the letter at berkshirehathaway.com. There's always a few good one-liners in there and it's generally very educational besides. And I don't mean educational like your math teacher's lectures on calculus: he actually has a talent for making economics and accounting comprehensible, even to people like us.) Of course, he may just have really good PR, and there are, no doubt, one or two skeletons lurking somewhere in his apparently pristine closet, but this is a man you can't help liking. (Of course, his friend Bill Gates is an entirely different kettle of fish; and they do say you can tell a man by the company he keeps...)

This year, Father Warren's lecture is on the trade deficit. No doubt you've seen the headlines about America becoming a "sharecropper society" as we struggle to pay the interest on all the money we've borrowed from foreigners to finance our spending. He's forecasting a decline in the dollar as a result. No big surprise there. Every day, we spend $1.8 billion more on foreign goods than they buy from us. That's basically how much our debt to them goes up every day. Mounts up after a while.

A couple of years ago, he sounded the alarm on "derivatives" as a financial weapon of mass destruction that was liable to blow up at some point. We still haven't seen that prediction come true, but then he does tend to be early on these things -- remember how everyone thought he'd lost his touch when he refused to join in on the dotcom frenzy? The derivatives market has done nothing but grow ever since. (See, eg, the post on securitizations. There's also been pretty impressive growth in so-called Credit Default Swaps, of which more, perhaps, anon). Meanwhile, the General Re subsidiary is still, after three years, busy unwinding its derivative positions in what is supposed to be a highly liquid market. If this is liquid, Buffett implies, what kind of a meltdown can we expect when everyone wants to unwind at once? Scary thought. An interesting question to ponder: how would you play this one if you thought it was coming tomorrow?

BTW, M. Buffett puts in a plug for The Financial Times as good reading material for those who are interested in these things. Me too. And it's not just financial news. There are a couple of very entertaining columnists, among them Lucy Kellaway and Peter Apsden. The weekend section is great. The crossword, for those who like the English-style cryptic, is a relatively easy one and fun to do (we especially enjoy compiler Cinephile, an 80+ year old retired vicar). Best of all, perhaps, is the Martin Lukes column on Thursdays (it's kind of a Dilbert thing, only told in e-mails rather than pictures, and makes you squirm almost as much as watching that other Brit feature, The Office TV series).

ESPN has launched a free online poker game, and got more than 30,000 people to sign up in the first couple of days. Course, it's not a real-money game. For that you have to go to partypoker.com. Which, incidentally, is rumored to be getting ready for an IPO, most likely in Europe. (Best thing about this one are its founders' names: Ruth Parasol and Anurag Dikshit. I kid you not). What is it with the sudden reawakening of poker? I thought it had gone out of style in the 50s. (By the way, as I recall, Warren Buffett boasts of having put himself through school partly on poker proceeds. "In every poker game", he says, "there's a patsy. And if you can't figure out who the patsy is, then you're the patsy").

Yield crazy

The bond market is still red hot, pretty much in all sectors and practically around the world. The French government just sold a 50-year bond to yield 4.21%. The deal was so hot it had to be upsized to 6bn Euros ($7.9bn). For those of us who remember the 15% treasury (with inflation running well into double digits), it seems a bit weird. Why would anyone go for a deal like that?

Meanwhile another record was broken in the securitized market, where homebuilder Centex sold a $1bn deal at 7bps over 1-month LIBOR for the top tier (1-yr paper). The 3-yr tranche was at 17bps. In other words, the market is looking at them as being just about as safe as treasuries. Asset-backed securitization deals in 2004 amounted to a record level of almost $900bn (vs $585bn in 2003), and so far this year is ahead of last. The assets in "asset-backed" are mostly houses, cars and other unspecified loans. (Some of them were a little more unusual -- like, for example, the David Bowie, James Brown and Isley Brothers music-royalty deals -- shades of Hollywood Stock Exchange here).

What are securitized loans? OK, say you want to buy $100mm of mortgages yielding $6mm a year in interest. You issue $90mm of 1-year "asset backed" paper yielding LIBOR + 20 or 3.1% right now. The rate is nice and low because the paper is "overcollateralized" ($100mm of assets covering $90mm of paper) and there's a lot of buyers. Then you put in $10mm of your own cash to fund the rest. So you pay out roughly $2.8mm in interest to the asset-backed guys and get to keep the $3.2mm balance. So you're earning 32% on your $10mm of equity. Pretty nice, ey?

But what happens, I hear you asking, when you have to refinance the 1-year paper, short-term rates have shot up and house prices have collapsed? Yeah, well, that's leverage for you, gotta take the rough with the smooth.

It's the same story all over the fixed income market. Spreads are way down in emerging market (3rd world) debt and in junk corporates (which had a record year for issuance, at $140bn, last year and is still pretty hot, even though, according to the rating agencies, the proportion of "triple-hook" (CCC) debt has been steadily rising). Everyone's looking for yield.

What's driving all this? Our friend the Span, of course, and his liquidity-crazed cronies at other central banks around the world. They've been pumping money into the system with what you might call "irrational exuberance". If you can get money so cheap, why wouldn't you go out looking to play the spread (between what the money costs you and what you can lend it out at)? No wonder there's a new hedge fund every two minutes.

March 4th, 2005

Greenspan voices support for consumption tax (in testimony to a Bush tax panel yesterday). The Span has really turned into a sandwich-board for the Used Car Salesmen in the White House. I don't know why. He never seemed so far-right ideologically. I guess he just doesn't have the balls of his plutonium-orbed predecessor, Paul Volcker.

The consumption tax is another step in the UCS dismantling of our democracy. It's non-progressive, of course -- ie hits lower-income people hardest and, like the two tax-cuts-for-the-rich, doesn't foster demand, hence is pretty non-stimulative. I guess they must want to live in the third world.

Speaking of which...

HSBC will be hiring analysts in Bangalore. They changing the way they do research, to long-term, big-picture. (Actually, there's a carve out for "trading ideas", which sounds pretty much like research-as-usual to my mind). They're doubling their analyst staff in Hong Kong, New York and wherever the hell else they have offices, and also intending, apparently, to hire about 100 "junior analysts" in Bangalore. First it was call centers, then accountants and draughtsmen. Get the trend here? As education improves in countries like India, so outsourcing will more higher up the scale. Production = Capital + Labor. Capital is global, and in time so will be labor, I suppose.

Productivity numbers for Q4 2004 were revised upward, to a growth rate of 2.1%. If it gets high enough we'll evnetually be able to do without Labor altogether. At least a few of us, anyway.