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To begin with, recession may be an understatement. Jeremy Grantham's GMO firm manages $150 billion. In his midyear report before the credit crisis hit he predicted: "In 5 years I expect that at least one major 'bank' (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private-equity firms in existence today will have simply ceased to exist." He was "watching a very slow motion train wreck." By October, it was accelerating: "Train hits end of track at full speed." Also back in August, The Economist took a hard look at the then emerging subprime/credit crisis: "The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be between a mild recession now, and a nastier one later." However, the publication did admit that "even if a recession were in America's long-term economic interest, it would be political suicide" for Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson to suggest it. Then The Economist posed the big question: Yes, "central banks must stop recessions from turning into deep depressions. But it may be wrong to prevent them altogether." Wrong to prevent a recession? Why? Because recessions are a natural and necessary part of the business cycle. Remember legendary economist Joseph Schumpeter, champion of innovation and entrepreneurship? Economists love Schumpeter's "creative destruction:" Obsolete firms get destroyed and capital released, making way for new technologies, new businesses, like Google. And yet, nobody's willing to apply Schumpeter's theory to the entire economy ... and admit recessions are a natural part of the business cycle. Instead, everyone persists in the childlike fairy tale that "all growth is good" and "all recessions are bad," a bad hangover of the '90s "new economy" ideology. So for the folks at the Fed, Treasury and Wall Street, "eternal growth" is still America's mantra. Unfortunately, the American investors' brain has also developed this blind obsession with "growth-at-all-costs," coupled with a deadly fear of all recessions, as if recessions are a lethal super-bug more powerful than Iran with a bomb. Our values are distorted: It's OK to be greedy and overshoot the market on the upside -- grab too many assets, take on too much debt, make consumer spending a religion, live beyond our means, ignite hyperinflation along the way. Growth is good, even in excess. And yet, recessions are a no-no that drives politicians, economists and investors ballistic. Well, folks, you can block all this from your mind, you can argue that recessions are not a part of Schumpeter's thinking, that they are inconsistent with your political ideology. But the fact is, we let the housing/credit boom become a massive bubble, it popped and a recession is coming. So think positive, consider some of the benefits of a recession: 1. Purge the excesses of the housing boom No, it's not heartless. Not like wartime calculations of "acceptable collateral damage." Yes, The Economist admits "the economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy." But we can't reverse Greenspan's excessive rate cuts that created the housing/credit crisis. It'll be painful for everyone, especially millions of unlucky, mislead homeowners who must bear the brunt of Wall Street's greed and Washington's policy failures. 2. U.S. dollar wake-up call Reverse the dollar's free fall and revive our global credibility. Warnings from China, France, Iran, Venezuela and supermodel Gisele haven't fazed Washington. Recession will. 3. Write-offs Expose Wall Street's shadow-banking system. They're playing with $300 trillion in derivatives and still hiding over $100 billion of toxic off-balance sheet asset-backed securities, plus another $300 billion hidden worldwide. A lack of transparency is killing our international credibility. Write it all off, now! 4. Budgeting Force fiscal restraint back into government. America has been living way beyond its means for years: A recession will cut back revenues at all levels of government and cutbacks will encourage balanced budgeting. 5. Overconfidence A recession will wake up short-term investors playing the market. In bull markets traders ride the rising tide, gaining false confidence that they're financial geniuses. Downturns bruise egos but encourage rational long-term strategies. 6. Ratings Rating agencies have massive conflicts of interest; they aren't doing their job. They're supposed to represent the investors, but favor Corporate America, which pays for the reports. Shake them up. 7. China Trigger an internal recession in China. Make it realize America's not going into debt forever to finance China's domestic growth and military war machine. A recession will also slow recycling their reserves through sovereign funds to our equities. 8. Oil Force the energy and auto industries to get serious about emission standards and reducing oil dependency. 9. Inflation Expose the "core inflation" farce Washington uses to sugarcoat reality. 10. Moral hazard Slow the Fed from cutting interest rates to bail out speculators. 11. War costs Force Washington to get honest about how it's going to pay for our wars, other than supplemental bills that are worse than Enron-style debt financing. 12. CEO pay Further expose CEO compensation that's now about five hundred times the salaries of workers, compared with about 40 times a generation ago. 13. Privatization Stop the privatization of our federal government to no-bid contractors and high-priced mercenary armies fighting our wars. 14. Entitlements Force Congress to get serious about the coming Social Security/Medicare disaster. With boomers now retiring, this problem can only get worse: A recession now could avoid a depression later. 15. Consumers Yes, we're all living way beyond our means, piling up excessive credit-card debt, encouraged by government leaders who tell us "deficits don't matter." Recessions will pressure individuals to reduce spending and increase savings. 16. Regulation Lobbyists have replaced regulation. Extreme theories of unrestrained free trade plus zero regulation just don't work; proven by our credit crisis, hedge funds' nondisclosures, private-equity taxation, rating agencies failures, junk home mortgages, and more. Get real, folks. 17. Sacrifice "We have not seen a nationwide decline in housing like this since the Great Depression, says Wells Fargo CEO John Stumpf. As individuals and as a nation Americans have always performed best in crises, like the Depression or WWII, times when we're all asked to make sacrifices. Pampering us with interest-rate cuts and tax cuts during the Iraq and Afghan wars may have stimulated the economy temporarily, but they delayed the real damage of the '90s stock bubble while setting the stage for this new subprime/credit crisis. Wake up, the train wrecked. Time to think positive, find solutions, demand sacrifices. End of Story.
Lost amid the angst on Wall Street is the fact that the average domestic stock fund — despite real troubles in the credit and housing markets — was still up 2.4 percent this year through Wednesday, according to the latest numbers available from Lipper, the fund tracker. Blue-chip growth funds were doing even better: up 9.1%. For investors who’ve been spoiled by the strong double-digit annual gains of the last two bull markets, these returns may seem modest. But equity investors need to keep in mind that single-digit performance is basically in line with long-term historical norms. And normal could be exactly what investors need right now. “From 1995 to really 2003, you had the extremes on both sides,” Mr. Stovall said. From 1995 to 1999, for example, the S&P 500 index registered gains of more than 20% each year. Then came three consecutive years of losses in the bear market, which were followed by double-digit gains for the S&P500 in 2003 and 2004. To be sure, in 2004, the average blue-chip domestic stock fund posted a total return of 10.6%, which was in line with the 10.4% average annual return for large stocks since 1926. But even in that year, stock investors were being treated to extraordinary returns by a different segment of the market: foreign stocks. Indeed, over the past three years, international equity funds have soared by more than 20% a year, which explains why record amounts of new money have been flowing into such funds. In the first nine months this year, investors plowed $156 billion of net new money into foreign stock funds, according to the Financial Research Corporation. That was three times as much as they invested in domestic equity portfolios. Clearly, investors are interested in quick profits — or at least quicker profits than their domestic portfolios can deliver. But in case you haven’t noticed, international equities are also starting to behave more normally. Blue-chip stocks in the developed markets of Western Europe and Asia are up by a solid 9.9% so far this year, as measured by the Morgan Stanley Capital International EAFE Index — for Europe, Australasia and the Far East. That’s downright pedestrian when compared with the 26% gain that the index registered last year. If the EAFE stalls over the next month, it could turn in its first non-double-digit performance since 2002. Why is it important that both foreign and domestic blue chips appear to be “reverting to the mean?” Because fund investors, despite living through the worst bear market in a generation earlier this decade, may not be convinced that slow-and-steady is the way to go. Since the technology stock bubble burst in 2000, investors have enjoyed a cavalcade of hot asset classes delivering extraordinary returns. First came the rally in precious-metals funds in 2001. That was followed by a surge in small-cap domestic stocks in 2003, which coincided with the boom in energy shares. And throughout all of this, shares of emerging-market stocks have posted dizzying gains that even investors in Internet stocks of the late ’90s would have envied. “Several years ago we tried to lower investor expectations, given an environment of slower profit growth and low interest rates,” said Jack Ablin, chief investment officer at Harris Private Bank. “Yet equities outpaced our capital market expectations like the Jolly Green Giant hurdles a limbo stick.” Now that economic growth “is actually slowing and profit growth is retreating, equity market returns are coming back to earth,” he said. But Christopher Orndorff, head of equity strategy at Payden & Rygel, the asset management firm, said that it might take a bigger slowdown than this to dissuade investors. In part, that is because emerging-market stocks have continued to deliver some eye-popping gains. While foreign equities in the developed markets have started to slow, the average diversified emerging-market fund soared 29.4% this year through Wednesday. That is roughly in line with its three-year annual average gain of more than 33%. “The ’90s were so dangerous because they got investors to think that 18-percent-plus returns were normal,” Mr. Orndorff said. But he stressed that “returns like that are not normal,” whether you were dealing with domestic technology stocks then or are holding emerging-market stocks today. Yet these types of returns continue to draw investors. So far this year, fund investors have invested $1 in an emerging-market portfolio for every $5 they put into a domestic equity fund, according to the Financial Research Corporation. Over the past decade, that ratio has been closer to $1 to $19. Mr. Orndorff says he thinks that emerging-market funds are also likely to revert back to their mean over the next year. But given the run-up that emerging-market stocks have already had, it may take a few years of disappointments to wean investors off of them.
Now, however, as the first baby boomers start to collect Social Security checks, fund sponsors are coming up with a passel of new products catering mainly to those who are knocking at the gates of retirement — or are already inside.“As you enter the phase where you’re going to be receiving income and drawing down assets, you need a different style of investment,” said Keith Hartstein, president of the John Hancock Funds. “You need a targeted distribution fund as opposed to the accumulation type.” At least a half-dozen sponsors, including Fidelity Investments and the Vanguard Group, have either begun marketing retiree-oriented funds or have announced plans to do so. More are undoubtedly on the way, predicted Burton Greenwald, a mutual fund consultant. “It’s a natural evolution,” he said. “All the major fund sponsors will have such products in a short period of time.” Investors can choose among significantly different approaches. Some retirees will expect a specific monthly payout while others will favor a variable amount, based on what the portfolio generates. Some will want a fund whose principal is depleted by a certain year — say, 2028 — while others will want one that leaves assets for their heirs. But while some funds offer annuity-like features, none carry an annuity’s contractual guarantee of specific payouts. One of the first firms off the mark this fall was Fidelity Income Replacement Funds, which comes with a choice of 11 targets, or time horizons, from 2016 to 2036. You specify how big a check you want each month to be paid from the portfolio’s earnings from other Fidelity stock and bond funds, supplemented with as much of your principal as is necessary. If all goes well, your payment will rise each year to keep pace with inflation. The asset allocation of the fund shifts more toward bonds as the years pass. By the horizon date, the fund is liquidated. Vanguard’s Managed Payout Funds is expected to be available in December or January, and is not intended to deplete itself. But whether it can sustain payouts without returning at least some shareholder capital will depend on investment results. Vanguard will set the payout annually, based on fund performance for the three preceding years: The Real Growth fund expects an initial 3% distribution rate, the Moderate Growth fund a 5% rate and the Capital Preservation fund a 7% rate. Lower payouts imply a greater probability of long-term growth and capital appreciation; Vanguard, unlike Fidelity, will invest in a broad spectrum of asset classes to include commodities, real estate and a new market-neutral fund. Diversity of assets, with little performance correlation to one another, can aid capital preservation as well as returns. “The availability of a distribution service in a fund without having to sign up and move assets and try to figure out where to take them from first is an attractive vehicle for people,” said Ellen Rinaldi, a principal in Vanguard’s investment counseling and research unit.Retirees want access to their money, she added, and unlike annuities, which tie up your principal, mutual funds provide it. What distinguishes John Hancock’s proposed Retirement Income Portfolio and Retirement Rising Income Portfolio from the Vanguard funds is that the dividend is fixed in dollars and cents. In the Rising Income portfolio, it climbs by the inflation rate each year. At Charles Schwab's Premier Income fund, with three share classes and a minimum investment of $100, was started at the end of October after raising $116 million during a four-week subscription period. The fund is focused purely on income, not a combination of income and total return, the way some competitors’ offerings are, said Patrick S. Waters, Schwab’s director of retirement investment products. Other new offerings tailored for retirees are three funds from the Russell Investment Group with specific payouts for 10 or 20 years. They are to be available early next year. The Investment Company Act of 1940 bars mutual funds from offering a guaranteed return. But John Hancock has applied for an exemption to the law and believes that if the rules change, future funds of this type will typically carry a guarantee. Indeed, the DWS Scudder unit of Deutsche Bank expects early next year to begin marketing a fund whose 8.25% annual payments over 10 years are to be backed by a warranty from Merrill Lynch. At maturity, the net asset value would be paid to shareholders, or rolled over into another fund. “I think there will be a move to try to guarantee these products” broadly, predicted Andrew G. Arnott, a product development official at Hancock. Although retiree-oriented funds seem to have a bright future, specialists say they should not be bought without considering expenses, taxes and, for those who are at least 70 and a half years old, how they mesh with required annual distributions from Individual Retirement Accounts and 401(k)’s. Some funds are fairly expensive. Shares of Schwab’s Premier Income fund, for example, will cost as much as 0.87% a year, versus 0.34% for the Vanguard Managed Payout funds. And if the funds are held in a tax-deferred account, penalties can apply to withdrawals if investors are under 59 and a half. Bruce Berno, an independent financial planner, advised investors to be mindful of the source of money they will put into new funds. It’s probably better to use “fresh” cash, he said, than proceeds from selling taxable investments that have capital gains. (In I.R.A.’s, however, money can be rolled over between funds without tax consequences.) What’s more, he observed, most investors who keep the funds in retirement accounts will find that their payments are not big enough by themselves to meet requirements, starting at age 70 ½, for annual distributions tied to people’s longevity prospects. That means investors may have to withdraw money from other retirement accounts as well. “They’re designed to deliver income, not to optimize taxes,” said Ms. Rinaldi at Vanguard. Dan Culloton, a senior fund analyst at Morningstar, said that the industry seemed to be meeting a need while avoiding “quick-fix, easy-to-sell” solutions. “The most obvious use for these seems to be for people getting out of their 401(k) plans or people trying to turn their I.R.A.’s into income,” Mr. Culloton said. “They’re designed to help guard against the risk of running out of funds before you run out of days.” But he urged savers to recognize that in some cases, income payments would be coming out of their own capital, and that these funds could decline in value. “Their goal is plausible,” he said, but their usefulness will become clearer as the funds “build a track record and people get a feel for how to use them.”
This crisis was caused by a big flaw in the structure of our credit markets. The bad structure induced lenders to take imprudent risks and make imprudent loans, which, of course led to losses. What is unique about this crisis compared to others is that the losses are in illiquid, opaque structures scattered around the world. Why should anyone be surprised? We got what we deserved. The big fear that the US Treasury Department is working to avoid is the danger that dozens of huge bank-affiliated funds will be forced to unload billions of dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could force big write-offs by banks, brokerages and hedge funds that own similar investments and would have to mark them down to the new, lower market prices. So the fear is that the new prices are actually disclosed. This is the “don’t ask-don’t tell” method of security valuation. In my view, the credit issues aren’t just about subprime. Subprime is what the media says. Subprime is about them — those people and the people who made foolish loans to them. The word “Subprime” is pejorative. Subprime is not about us, for we are not subprime. How convenient to be able to pass the blame. There has been talk about predatory lending – making loans at high rates to people who couldn’t reasonably be expected to pay them back. That is a bad practice, but that is not what’s shaking the markets. At issue today is that lenders of all sorts have lent too much money and did not demand enough interest to compensate them for the risks they took. There has been a colossal undercharging for credit across the board. I believe the poor lending standards and the low cost of credit in subprime extend throughout the credit markets into all areas of residential real estate, commercial real estate and the corporate lending markets. Let’s start with the U.S. housing market. In addition to under-priced subprime loans, we have home equity loans to prime borrowers. We now see that when house prices fall — and they are falling — from a creditor’s perspective, a second lien is not much better than a credit card receivable, though the interest received is much less. Structures backed by Alt-A loans with no documentation are performing just as poorly as subprime structures, due to the lower amount of over collateralization embedded in those deals. In commercial real estate, we read a few weeks ago about Macklowe, who purchased several buildings from Blackstone with a one-year bridge financing supporting a capital structure that was designed to be negative cash flow for the first five years. Last year Met Life sold Stuyvesant Village to an investor group for about thirty-five times free cash flow. Why were the buyers willing to pay so much? Because lenders were willing to lend over thirty times cash flow at low rates. While this was a large deal, it was by no means exceptional. These are loans based on the borrowers’ ability to refinance rather than the borrowers’ ability to repay. This is no different from 2-year ARMs in the residential market, except we haven’t yet reached the loss period when the music stops. The same has been true in corporate lending. Very low debt spreads and weak lending terms have fueled the leveraged buyout boom. With lower interest rates, a private equity owner can service more debt. More debt means winning more deals at higher prices. Blackstone has said that the benefits of the favorable debt financing have been passed on to the sellers of companies. Many of the loans were “covenant-lite” loans, where practically the only thing that could cause a default would be a missed payment. Some loans were “PIK-toggle” giving lenders the option of deferring payments. Put these together, and it becomes almost impossible to default quickly. The lenders actually convinced themselves this was a good thing — no early defaults mean a good bonus. I believe the “covenant-lite” and “PIK toggle” terms are quite parallel to the now criticized “no-doc” and “pay-option” terms that everyone agrees were ill conceived in the residential market. In all of these areas, lenders have taken on too much risk for too little compensation. There is not enough spread to absorb any material up tick in losses. The only difference between these areas and subprime residential is that we haven’t seen the losses yet. Why have so many borrowers of all sorts been so undercharged for risk? The short answer is “securitization” or more broadly “structured finance.” Advocates of securitization say it disperses risk. However, it does so by separating the loan originator from the eventual outcome of the loan. The originator gets a fee up front. The risk is held somewhere down the line in an alphabet soup of structured vehicles called CDOs, CMBS or CLO — not to mention CDO2, SIVs, SIV-lites et cetera. Why the Market Trusted the Rating Agencies Why would anyone blindly lend to an opaque structure of pools of loans that they didn’t underwrite or even evaluate? Because the structures come with credit ratings from Standard & Poor’s, Moody’s and Fitch. Have the rating agencies developed an expertise in analyzing these structures? Perhaps, but more pertinent, they are the only ones who can evaluate them, because they are the only ones with the detailed information about the structures. The underwriters give the rating agencies much more information than is contained in the prospectus. In their evaluation of corporate credits, rating agencies are exempt from regulation FD. This means that they can receive confidential information not available to other market participants. This is kind of like a confessional where the priest delivers a public opinion on the extent of your virtues or sins — and your spouse has to guess what a AAA or BBB means about your fidelity. In the recent crisis, the rating agencies say they shouldn’t be held accountable for their opinions because they are nothing more than journalists engaged in free speech. What would it be called if you paid a leading publication to do a story on you and you could pull it before press, if it were unflattering. That is not free speech but is ‘for-profit speech.’ According to the rating agency party line, if people disagree, they are free to ignore the ratings. However, a credit rating is not an ordinary opinion. It is a “special” opinion — an insider opinion, because it is based on a different information set. I can’t replicate a rating analysis, because I am not privy to the information. Therefore, I am not on equal footing to be able to decide whether I agree or disagree with a rating agency. Since they know more than I do, the presumption has to be to agree. The rating agencies are structurally set up to have “insider opinions.” They just don’t want legal liability for having issued conflicted and flawed insider opinions. Incidentally, this lack of information has made it harder for the market to find a clearing price for distressed pieces of structured deals. Without enough information in the market — other than a credit rating — it is hard for informed buyers and sellers to know what to do, once the credit rating comes into doubt. One clear improvement to the current structure of the debt markets would be to insist that all information shared with rating agencies be shared with the whole market; the rating agencies should lose their exemption from Regulation FD. When Regulation FD was implemented many worried that if equity analysts didn’t have special access, the stock markets would become less stable. That hasn’t proved out. The credit markets should take the same step. More information broadly disseminated makes for a more efficient market. But All Ratings are not Created Equal If you read Moody’s investor presentation you will see that the reason to buy Moody’s stock is to participate in the growth of structured finance. Moody’s business is to support that growth and Moody’s shareholders depend on this. This conflict has caused a great deal of ratings grade inflation in structured finance. Consider municipal bonds. According to S&P’s long-term data the 10 year default rate on an A rated municipal bond is 1%; while a corporate bond’s default rate is 1.8%; and a CDO’s is 2.7%. An A rated muni has the same chance of default as a AA/AA- rated corporate and a AA+ rated CDO. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporates and CDOs. This isn’t an accident. About a decade ago, Moody’s said, “No matter what types of instruments the ratings apply to, no matter where the issuer resides, and no matter what the currency or market in which the security is issued, Moody’s ratings are intended to have the same relative meanings in terms of expected credit loss.” Without much fanfare the rating agencies abandoned this practice of AAA meaning AAA and BBB meaning BBB. Instead for each type of bond, they use a different rating scale with different so-called “idealized default rates” for each rating. The idealized default rate for a municipal bond at a given rating is less than the idealized default rate for a corporate bond, which is less than the idealized default rate for an asset backed security which is less than the idealized default rate for a CDO. As an example of the lack of soundness in this system, Nomura securities pointed out that hypothetically, if you took a AA+ rated asset backed security and repackaged it all by itself and called the repackaged instrument a CDO, it becomes AAA, because the CDO has a higher idealized default rate than the asset backed security. When a municipal bond is put into a CDO, for modeling purposes the rating agencies ascribe a higher rating to the muni to adjust for the fact that the muni is under-rated in the first place. Maybe everyone knows this, but it was news to me, when I learned it a few weeks ago. I might not be the only one who didn’t know. Is it a coincidence that rating agencies charge more to rate bonds in the more lenient categories? Moody’s recently wrote a report saying that if States were evaluated on the corporate scale, 49 of them would be rated AAA Moody’s noted the 10-year cumulative default rate for all investment grade Moody’s-rated municipal bonds, including bonds one notch above junk, is about half the rate for AAA rated corporate bonds. If municipal bonds are much safer than their ratings imply, it means that all kinds of states, cities and towns — effectively taxpayers of all sorts — are systemically overcharged for borrowing. The municipal bond market is $2.5 trillion. If the average municipality pays twenty basis points more for its interest because the bonds are under-rated, this scheme is costing taxpayers $5 billion per year. The misrating of municipal bonds directly benefits the banks who underwrite the deals. A lower rating — means bigger underwriting fees. Or alternatively, the excess cost can be shared with the municipal bond insurers who effectively rebate some of the “overcharge” to the municipalities in exchange for a share of the savings through a scheme called “bond insurance.” The municipalities purchase bond insurance to enhance their credits to the AAA level. Of course, since they are in fact, AAA to begin with, the insurance provides no true benefit. I assure you that a quick peek at the balance sheets of any of these so-called AAA rated bond insurers will tell you that they are not likely to be there to pay more than a fraction of the claims they have insured in an environment where there are wide-scale defaults in the municipal bond sector. Is it proper to have the same ratings mean different things in different classes? Probably not. For many bond buyers the statutory requirements are determined by the credit rating. If a bond is rated investment grade, then it is eligible for purchase. No distinction is made for buying the “good” A rated bonds versus the “bad” ones. The bad A- rated bonds don’t come with special warning labels. They tend to find themselves in the portfolios of the least sophisticated ratings-driven portfolios like pension funds. Wall Street has designed a number of lucrative strategies for itself and its clients to take advantage of these discrepancies through so-called “ratings arbitrage.” To take a big problem and make it bigger, the new BASEL II standards for international banks that we are about to implement in the US, tie the regulatory capital requirements to the credit ratings. I don’t believe these standards give distinction to the good A rated paper versus the bad. This should broaden ratings arbitrage opportunities at the potential expense of distorting the regulatory calculations designed to ensure the safety and soundness of our banking system. Coming back to the grade inflation in structured finance — in my opinion, the rating agencies are not in a position to blow the whistle, even if they wanted to, because the conflict of interest is too great. In July, Moody’s publicly complained that by tightening its rating standards it had lost share in CMBS transactions. According to Moody’s managing director Tad Philipp, “It is those deals which we seek to differentiate through higher credit enhancement that we are least likely to be asked to rate.” He explained, “I guess this is sort of like no good deed goes unpunished.” Moody’s stock fell 2% that day. The various entities that enable structured finance direct so much business to the rating agencies that the agencies can’t risk alienating them. If Pocatello, Idaho doesn’t like its rating, it has no leverage with Fitch. Wall Street is a different story. Three Examples of Where the Rating Agencies Have No Control: Bear Strearns, MBIA & Ambac On August 3, Standard & Poor’s revised Bear Stearns’ long-term credit outlook to negative from stable. This made a ton of sense. Three of Bear Stearns best businesses: Mortgages, Hedge Funds and Prime Brokerage have all been severely impacted by the recent crisis. Bear was having trouble funding itself; its clients were fleeing and it was stuck with a highly levered balance sheet full of questionable assets like junior pieces of securitizations and variable interest entities and unsold inventory of mortgages, mortgage backed securities and asset backed securities. Also, it faces litigation over its hedge fund debacle. This very modest action created such a ruckus that Bear Stearns immediately put out a press release and held a conference call. The S&P analyst came out on TV that afternoon to do damage control saying “the market reaction today is overplayed.” Rating agencies say hedge funds cause systemic risk. Funny, I think rating agencies are facilitating an even bigger systemic risk. It can be hard to value certain securities in times of distress. The latest hedge fund getting bad press is Ellington management, a large participant in the mortgage business. A couple of weeks ago, it suspended redemptions from its funds because it could not determine the value of its assets. Apparently they own what I’d call 20/90 bonds. 20-bid and 90-offered. While Ellington made negative headlines for doing the right thing, acknowledging it is unfair to let people in or out in such circumstance, does anyone believe that the large mortgage players like Bear Stearns and Lehman Brothers don’t also have large portfolios of 20/90 bonds? When they reported their quarterly results, investors marveled at their risk controls. However, Lehman moved about $9 billion of mortgage securities into a special classification called Level 3 under FASB 157, which gives them more valuation discretion. Both Lehman and Bear claimed their Level 3 portfolios actually had gains in the quarter, so it looks like they put the 20/90 bonds closer to 90 or perhaps even 95. This appears to be a classic example of a hedge fund being vilified for doing the right thing, while others are cheered for doing the opposite. The rating agencies have lost the ability to impose discipline on the balance sheet of the broker-dealers and the financial guarantee companies — the enablers of structured finance that bring so much business to the rating agencies. This creates an enormous systemic risk, as these entities are able to maintain access to cheap credit while overextending themselves beyond prudence. One day, taxpayers may have to pay, should the government determine than an over-levered leader is too big to fail at the point it reaches the cusp of doing just that. As the rating agencies have lost control, these companies have expanded their on and off balance sheet leverage over time with no apparent negative impact on their ratings. My friend, Bill Ackman, showed me MBIA’s balance sheet from 1990 which actually looked like a AAA balance sheet. Today’s balance sheet looks different from that. Equity was 46% of assets in 1990 compared to only about 16% of assets today. Yet, it is still triple A. The rating agencies offer branded products. Their best brand is AAA. People buy AAA because they don’t want credit risk. There was a big fuss over Enron. Enron was BBB. BBB rated entities default from time to time. AAA ratings don’t — or at least they didn’t. Now, we are set for an unprecedented spate of originally AAA rated bond defaults. In my judgment, the effects of grade inflation will eventually ruin the brand values of the rating agencies. In August, Morgan Stanley wrote a report that estimated Ambac, a bond guarantor, could suffer $5 billion of losses from its subprime exposure in its stressed loss analysis. The report said “if Ambac were to take a $5 billion charge, we do not see how it could possibly raise enough equity to remain a going concern. A loss of this magnitude would erode 75% of its $6.7 billion in qualified statutory capital.” One would think that even the reasonable possibility that Ambac could suffer that fate would be enough for the credit-rating agencies to downgrade Ambac, which currently has a AAA rating. Will the rating agencies at least put Ambac on “credit watch?” I believe the conflicts of interest mean they can’t and they won’t. Morgan Stanley agrees. Its conclusion about Ambac was the cynical, but practical one — it rates Ambac “Overweight.” In early September, a senior Moody’s executive confirmed this suspicion at a small private dinner sponsored by one of the brokerage firms. He said, “Moody’s would never lower the credit ratings of a financial guarantor, because that would put the guarantors out of business.” Two Solutions to Avoid Future Problems It is plain that the States and Cities and Towns in this country are triple A credits without triple A ratings and the financial guarantee companies have triple A ratings without being triple A credits. When ratings agencies are more concerned about the effects of the rating actions than on the accuracy of the ratings, they become part of the Wall Street “confidence” machine and surrender their ability to fulfill their statutory role in objectively analyzing credit. One would think that the lesson here would be to get rid of the bad practices. We should be asking ourselves what role, if any, should there be for credit rating agencies? If there is a role, should the rating agencies lose their exemption to Reg FD so that outsiders can truly do their own credit analyses on equal footing, when they don’t trust the rating agencies? To the extent that we are going to have credit ratings, shouldn’t all credits be evaluated on a single scale? And should ratings agencies be paid by the users of the ratings, rather than by the issuers? Some have questioned whether we would lose the benefit of public ratings and doubted there would be enough business for the rating agencies, if we eliminated the issuer pays system. First, I believe we could mandate the public disclosure of ratings and allow the agencies to profit by selling the more detailed research to subscribers. There are existing firms like Egan-Jones selling credit analysis on this model; however, such a change would likely have an impact on the profitability of the rating agencies. For example, Moody’s has an operating profit of 54% of sales. This ranks it 5th in the entire S&P 500. It is able to have these margins because of the current system. If you change the system, the margins will fall. Certainly, the rating agencies will fight very hard on this issue and try to scare people. However, there is a very big gap between 54% margins and not having rating agencies. If they lost the issuer pays structure, they would hardly say “Oh well, let’s go home, then.” They would have to adapt and they would persist in business. The margins would be less, but the capital markets would be much better served.
The professors searched for monthly patterns in the performance of all common stocks that traded on the New York Stock Exchange or the American Stock Exchange from 1963 through 2002. They found that some stocks tended to perform particularly well or poorly each January, while others tended to regularly beat or lag the market in February, and so forth for each month of the year. They found that these patterns were remarkably persistent, lasting as long as two decades. Though the professors didn’t measure the precise proportion of stocks that showed the pattern, they do know it is quite widespread. In an interview, Professor Heston said it is a “fairly pervasive effect that exists among both large- and small-cap stocks and across different industries.” How sizable are the monthly patterns? Consider a hypothetical portfolio that each month owned the 10% of stocks that performed the best in the same month a year earlier, and simultaneously sold short the 10% of issues that had the lowest returns a year earlier. Before transaction costs, according to the professors’ calculations, this portfolio would have produced an average annual return of more than 13% a year over the four decades they studied. What’s particularly impressive is that the portfolio was market-neutral: it made no market-timing bet on the direction of the overall market. Why do stocks adhere to monthly rhythms? It is tempting to attribute them to varying cycles of good and bad times that different industries follow during the year. Retailers, for example, tend to shine around the holidays, just as heating oil companies fare best in winter and refineries in summer. But the professors dismissed this possibility after finding that, on average, stocks within an industry showed as wide a variation in monthly patterns as stocks of different industries. Might the patterns be caused by the different months when companies report their earnings? The professors dismissed that idea, too. The monthly patterns they detected were not related to companies’ earnings cycles. The professors came up empty in trying to explain why stocks show these strong monthly patterns. Statisticians might normally view this lack of explanation as a warning flag that the pattern isn’t real. But pointing to its long-term persistence, and its confirmation by various academic referees, Professor Heston says he is “completely confident that the pattern is genuine.” Could a short-term trader beat the market by pursuing a strategy that each month owned the best stocks from that month in previous years, while simultaneously shorting the worst performers? Professor Heston thinks this would be hard to accomplish. He noted that the holding period for this portfolio would be just one month, and that transaction costs for turning over the portfolio 12 times a year would most likely be higher than the 13% annualized return that the portfolio achieved before transaction costs. Professor Heston said traders nevertheless could exploit the results of this research, provided they were about to buy or sell stocks anyway, for other reasons, and would therefore not incur added transaction costs by paying attention to monthly rhythms. Before buying stocks, for example, they should first see how the stocks on their buy lists performed in the same calendar month in previous years. Other things being equal, Professor Heston said, “it would not be a bad idea” for such investors to buy a stock sooner rather than later if it was a particularly good performer in the same calendar months of prior years, while waiting a month if it performed very poorly. The reverse would be the case when selling stocks, he said. Investors would immediately sell particularly bad performers from the same month of previous years, while waiting to sell those that did well. From the study - Other Research on Seasonality Annual cycles can emerge endogenously in economic models and are consistent with rational economic equilibrium (Gur Huberman, Optimality of periodicity, 1988). Seasonal variation in expected return may be a rational equilibrium response to exogenous influences. In this vein Joseph Ogden (The Calendar Structure of Risk and Expected Return on Stocks and Bonds, 2003) has developed a general seasonal model for stocks and bonds. There are also behavioral models that characterize the seasonality of stocks returns in terms of weather and vacation patterns [as found in] Sven Bouman and Ben Jacobsen, The Halloween indicator, ‘Sell in May and go away’ 2002 and Marl Kamstra, Lisa A. Kramer, and Maurice D. Levi, Winter blues: Seasonal affective disorder stock market returns, 2003.
Consider the following key facts: [1] In the long run, stocks outperform bonds; [2] The current expected yield from stocks is significantly higher than the risk-free bond yield; [3] The overall market, and many of the most attractive growth stocks, have now pulled back significantly from recent highs. (We see many attractive stocks.) Paralysis We talk with many individual investors, nearly all of whom have lagged market averages in their own accounts. The biggest single mistake is that they can always find reasons not to invest. One very intelligent person was referred to us in 2004. He was worried about the outcome of the Presidential election. That was about 30% ago in the S&P 500, but he was buying condos instead. He still does not own any stocks. There are always many things to worry about. The leading Internet financial sites emphasize the "wall of worry." Unfortunately, they do not explain it. A market plagued with many concerns, like this one, is actually the best opportunity. When the issues are known, market prices reflect the worries. How NOT to Act Here is what we often see. The market makes new highs. The investor says, "It is is too late. I missed the best time to get in. I can't chase this. I made a mistake earlier, but I cannot buy now." The market pulls back. The investor says, "Wow! I'm glad I did not invest a month ago. There are plenty of problems. Look at the selling. The market is going lower." Notice that the investor cites the direction of the market when it is moving lower, and the level of prices when it has moved higher. Using this approach there will NEVER be a correct time to invest. A Solution The best approach for investors is to have a disciplined method. This can be based upon fundamentals or system. But this is easy to say. We know that the real problem is getting started. So here is our best investment advice as 2007 comes to an end: Do something! Buy a partial position. This is what the pros do when in doubt about timing. Establish a position. If prices go lower, you can buy more. If prices go higher, at least you are participating in the gains. This is much better than following a method that leaves you permanently on the sidelines.
You know it will really be time to worry when top regulatory officials start referring to the banks’ problems as “contained.” That was how they described the subprime mortgage mess, remember, even as it became the thing that devoured homeowners in Cleveland, Las Vegas and much of Florida. Here is the problem with the financial sector’s ills: Even though we don’t know what toxicity lurks in these companies’ books, we do know that the sector plays an enormous role in the United States economy. Indeed, because of that growing role, a financial services downturn is likely to have graver economic consequences than ever before. As Paul Kasriel, director of economic research at Northern Trust, noted recently, profits from the financial sector now account for 31% of total United States corporate earnings — up from 20% in 1990 and 8% back in 1950. Profits from this country’s financial engineers now far exceed those generated by mechanical engineers. But we still can’t tally the losses for which these engineering geniuses are responsible. “No one knows how big the challenges in the financial sector are,” Mr. Kasriel said. “What I do know is that we have never had a more highly leveraged economy than we have today. We have never had a more highly leveraged household sector and we have never had a more highly leveraged housing sector than we have today.” While consumer spending has provided a major propellant to the economy in recent years, troubling signs that the consumer may finally be dropping rather than shopping. Chain-store sales have been weak for two months in a row, and shares of major retailers fell on Friday on concerns about weaker consumer spending. The University of Michigan said last week that consumer confidence had fallen to its lowest point in two years. Mr. Kasriel’s point about the economic impact of a damaged financial services sector is this: If you think corporate spending will replace flagging consumer spending as a driver for the economy, think again. Yes, balance sheets throughout most of corporate America are relatively healthy, but company profit growth is slowing. Earnings from the nonfinancial sector, accounting for half of corporate profits, have been contracting, beginning at the end of 2006 and extending through the second quarter this year, the most recent figures available. It appears that overall profits among the companies in the S&P500 index fell in Q3, compared with Q3-06. Soon, profits in the financial arena will come under siege. “Business capital spending was not booming when corporate profit growth and household demand were strong,” Mr. Kasriel said. “So why would it be expected to continue to grow when profit growth and household demand growth are slowing?” Here is another data point to support his view: Corporations still have a good bit of production capacity that they have not tapped. The capacity utilization rate of 82.2% in August is well below the peak of 85% seen in recent booms. It is unlikely that companies will spend capital to increase production capacity if existing facilities are not being fully used. And household spending, Mr. Kasriel points out, is the dominant force behind increases in capital spending. With households possibly retrenching, corporations are not likely to increase their capital expenditures. While the banks are well capitalized because they have made so much money during the lending boom, their profits are vulnerable. One reason for this is that banks are underreserved for losses. To bolster those reserves, managers will have to dip into profits. “A lot of the underlying assets held by financial institutions around the world today are likely to get worse before they get better,” Mr. Kasriel said. “The problem is, this is not going to stay just in housing. There has been a significant amount of noninvestment-grade debt issued during this cycle, and if the general economy slows down or moves into a recession, there are going to be problems in servicing this debt because profits are going to decline.” Is a recession coming? Mr. Kasriel says he has not yet called for one in his economic forecast. But he says an indicator that he finds highly reliable is predicting an economic downturn. His indicator has two elements, and both must be negative for a recession to be in the air. First is the spread between the yield on the 10-year Treasury note and that of the federal funds rate. The second is the change in the monetary base, which is a combination of bank reserves and circulating currency. “Every recession since 1970 has been preceded by this combination,” Mr. Kasriel said. “Over the first three quarters of this year, this combination has existed. At least qualitatively, it is sending a signal that we are on the eve of a recession.”
It’s a fair question. Stocks are supposed to be a predictor of future economic trends. Until last week, the bulls were arguing that because the stock market was still near its all-time highs, the economy could not be in peril. As recently as Tuesday, the S&P500 was less than 3% below its record close of record close of 1,565.15 on Oct. 9. But even back then, the market was signaling that there were problems in the economy — only Wall Street wasn’t paying much attention. For instance, Gordon B. Fowler, chief investment officer at Glenmede Investment Management, said that even though the overall S&P500 was up for the year, “the number of winning stocks has become narrower lately.” This shows that “there are pockets of strength in the market,” he said, “but not as much broad-based strength as there was a few years ago.” From the end of June to the end of October, the average stock in the S&P500 actually fell 1.1%. Yet few people noticed, because the overall index advanced 3.1% during this stretch. How can that be? The index is weighted by market capitalization and the largest stocks in the market have performed best. As a result, the strong showing of the index’s largest stocks has been painting a rosier picture of the economy than the overall market. Which economy is the S&P500 supposed to reflect? “When the S.& P. was devised, it was meant to be a barometer of the domestic stock market,” said Thomas McManus, chief investment strategist at Banc of America Securities. But Mr. McManus argues that “it’s grown beyond that.” For example, 45% of the sales of the companies in the S&P500 are now being generated overseas. Many of the biggest companies in the index — the giant multinationals that have been leading the market — derive an even larger percentage of their business outside the United States. Simply put, “the S&P has become a good indicator of what’s going on globally,” Mr. Fowler said. As for the domestic economy, investors are probably better off looking at the the equal-weighted S&P500, which gives each stock, regardless of size, the same influence on the index. Since August, the equal-weight version — which better reflects the performance of smaller, domestically oriented blue-chip companies — has fallen 1.1%, versus a gain of 1.3% for the index weighted by market cap. Are there any other signs of potential problems for the economy? Investors may want to turn to the corporate profit picture. In recent weeks, analysts’ forecasts for Q3-07 profits have plummeted. As recently as last month, the Wall Street consensus was that Q3 earnings of the S&P500 would jump 3.9% versus Q3-06. But analysts are now bracing for a 2.4% drop, thanks in part to the ripple effects of the credit crisis. If there is a decline, it would be the first quarterly drop in S&P500 earnings since the bear market of 2000. Even more telling is this: Wall Street is bracing for profit contraction in some of the most economically sensitive areas of the market. For example, financial-sector earnings are expected to fall 17% in Q3 versus Q3-06, according to the latest survey by Thomson Financial. To some people, this may not be a big surprise, given the huge write-downs that many financial firms have been reporting lately, resulting from losses on subprime mortgage-related debt. But it’s not just the financials. Thanks to the continuing slowdown in housing, profits in the consumer discretionary sector are expected to tumble 21%. And both the energy and basic-materials sectors are also expected to have a significant profit decline for the quarter, despite rising commodity prices. Mike Thompson, managing director of global research at Thomson Financial, says he believes that the potential slowdown in earnings “reflects a midcycle slowdown.” But he adds that he does not think a recession is on the horizon. He notes that analysts still think corporate earnings growth will reaccelerate in Q4-07 and Q1-08, though many of those estimates have been cut in recent weeks. But even if profits do recover modestly later in the year, a Q3 earnings reversal would be “a sign that the risks to the U.S. economy are much higher than they were six to nine months ago,” said Christopher Orndorff, head of equities for the asset management firm Payden & Rygel. Mr. Orndorff says he still believes that the economy is likely to avoid an official recession — defined as two consecutive quarters of contraction in GDP — in 2008. But he adds that he wouldn’t be surprised if the pending economic slowdown “feels like a recession.” For his part, Mr. Thompson says it’s still too soon for pessimism. The underlying economy isn’t as bad as some investors believe, he says. “We think we’re going to finish the year with something like 2.7%t economic growth,” he added. “That’s not horrible.” Moreover, he said, “unemployment is under 5%, there’s an export boom caused by the weaker dollar, and interest rates are suitably low.” But such positive developments may be cold comfort for investors who’ve been burned in the recent past by assuming that current economic trends are a predictor of future growth. Back in Q2-00, GDP was soaring at an annual rate of 6.4%. That was less than a year before the recession of 2001 struck. And in Q1-90, the economy was expanding at the brisk pace of 4.7%, just months before a recession began that July.
Sarbanes-Oxley is complex legislation, containing an assortment of features. One is stiff fines and penalties for reporting misleading financial data; the law requires that a company’s chief executive and chief financial officer personally certify the accuracy of its financial statements. Sarbanes-Oxley also made a number of changes to corporations’ governance structure, like requiring that the board’s audit committee be independent and that the outside auditor have no conflicts of interest. The study, titled “The Impact of the Sarbanes-Oxley Act on Information Quality in Capital Markets,” set out to document some of the law’s effects. Its authors are Joy Begley, an associate professor of accounting at the University of British Columbia in Vancouver; Qiang Cheng, an assistant professor of accounting there; and Yanmin Gao, an assistant professor of accounting at the University of Alberta in Edmonton. A version of their paper, which has been circulating since earlier this year as an academic working paper, is at ssrn.com/abstract=1008986. To measure the quantity and quality of the information available to investors when they’re deciding whether to buy or sell a company’s shares, the professors focused on the accuracy of Wall Street analysts’ earnings forecasts. In an interview, Professor Begley said she and her co-authors reasoned that, if Sarbanes-Oxley had led to more and better information being available, the average analyst’s earnings forecast should have become more accurate after the law took effect. In addition, she said, there should also be less variation among individual analysts’ forecasts. The professors began their investigation by gathering data on all publicly traded companies in the United States that are followed by at least two Wall Street analysts. They focused on analysts’ earnings forecasts for these companies over a four-year period starting in August 2001, one year before the legislation’s enactment. All told, the professors studied 1,807 companies over those four years. The professors found a slight increase in analysts’ forecast accuracy in the first 12 months after Sarbanes-Oxley was signed into law on July 30, 2002, but the improvement was short-lived. Over the next 12 months — from August 2003 through July 2004 — the average earnings forecast was less accurate than it was before the law. And it continued to be less accurate in the 12 months ended in July 2005. But is it possible that this decline had nothing to do with Sarbanes-Oxley? It’s worth asking, because many other changes have been made during this decade that also affect how analysts go about their jobs. For example, Regulation FD (for fair disclosure) took effect in late 2000; that rule prevents companies from conveying materially important information to individual analysts in private conversations, requiring them instead to disclose it publicly. In addition, soon after Sarbanes-Oxley was passed, a number of state attorneys general began to scrutinize potential conflicts of interest under which analysts may operate. Professor Begley acknowledged that while it was “highly likely” that Sarbanes-Oxley contributed to the declining accuracy, it was impossible to know with certainty the relative roles of the law and these other factors. Still, she said, that doesn’t necessarily mean that Sarbanes-Oxley has failed in meeting its objective of increasing the accuracy and reliability of corporate financial disclosures. She and the other researchers felt that they could measure such qualities only indirectly, however, by examining how changes in financial reporting may affect analysts’ ability to forecast earnings. For example, Professor Begley continued, it may well be that while corporate disclosures have become more accurate, the amount of information conveyed in those disclosures has declined sharply. The net effect of such a combination, she said, would be that analysts’ forecasts, on balance, become less reliable. It stands to reason, she said, that Sarbanes-Oxley would have led to a reduction in the total amount of information available to analysts: given the new penalties that the law imposes on misleading disclosures, corporations have an incentive to disclose less information, to avoid the risk associated with disclosing something that might get them into legal trouble. Professor Begley and her co-authors did not take a stand on whether Sarbanes-Oxley’s benefits outweigh the costs identified in their study. It may well be, she said, that a decline in forecast accuracy is an entirely reasonable price to pay for better reliability of corporate disclosures. Nevertheless, she said, that decline should be part of any debate over the law’s effectiveness.
Fast forward to today. The most recent Labor Department inflation report, based on September data, shows the Consumer Price Index climbed 2.8 percent over the past year. Gold prices are now around $780 an ounce. Oil recently hit $90 a barrel for the first time. Yet even against this grimmer backdrop, less than a third of fund managers now think that inflation is a threat. Of course, these fund managers aren’t alone in believing that inflation is either dead, dying or no longer a serious concern. Even the Federal Reserve is talking less about inflation as it focuses on trying to stoke an economy that’s being pressured by ailing credit and housing markets. This week, investors will pay particularly close attention to the Fed to see whether it will cut a key short-term interest rate for the second time in as many months — and to see whether the Fed’s views on inflation continue to evolve. In August, the Fed made clear that it wasn’t convinced of a “sustained moderation in inflation pressures.” But a month later, inflation went from being a front-burner issue to almost an afterthought. After its Sept. 18 meeting, the Fed said it cut rates by half a percentage point to “forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.” And what about inflation? The central bankers indicated that “some inflation risks remain” but also pointed out that “readings on core inflation have improved modestly this year.” This shift in language — and policy — puts the Fed “in a funny corner,” said Jeffrey L. Knight, chief investment officer of the global asset allocation team at Putnam Investments in Boston. Mr. Knight said the Fed clearly believes that it must “liquefy the credit markets” to lend support to an economy that’s slowing. “On the other hand, by doing so, they will be fanning the flames of the very risk that they purportedly were most concerned about two months ago,” he said. To be sure, many investors and economists are convinced that inflation is under control. And a number of government statistics support this. For instance, so-called core inflation readings, which strip out volatile food and energy prices, have been mild for some time. In fact, according to the Labor Department, core consumer prices have been growing at a seasonally adjusted annual rate of just 2.3% for the first nine months this year. That’s down from 2.6% last year. “Inflation, despite some sharp increases in food and energy prices, has really been fairly tame on a year-over-year basis,” said Paul L. Kasriel, director of economic research at Northern Trust in Chicago. But Michael J. Cuggino, manager of the Permanent Portfolio, a mutual fund, says we shouldn’t rely exclusively on core C.P.I. data because “in reality, businesses need energy and people need to eat.” And government data show that the costs of food and energy are going through the roof. For example, in the first nine months this year, food and beverage prices rose at a seasonally adjusted annual rate of 5.7%. Transportation costs jumped at a 6 percent annual clip. For energy, the figure was even higher: nearly 12%. The bottom line is that “inflation is still a risk,” Mr. Cuggino said, especially now that “there’s no longer that same level of diligence there was with respect to keeping inflation down.” In addition to an accommodative Fed, there are a couple of reasons that investors may want to keep an eye on inflation: Rising prices in China In the past few years, the United States economy has essentially been importing deflationary pressures by buying goods from China. And that’s kept overall prices in check. But Thomas H. Atteberry, co-manager of the FPA New Income fund, notes that inflation in China has begun to soar as the economy grows and as millions of new workers a year join China’s burgeoning urban labor market. Indeed, inflation in China was running at 6.2%, year over year, in September, versus 6.5% in August. Both figures were well above the government’s target of a 3 percent rate of inflation for 2007. “Given that we import so much from China,” Mr. Atteberry said, “this certainly doesn’t help.” The Falling Dollar A weakening currency has always been thought to be inflationary, because consumers and businesses require more dollars to buy goods from overseas. Ned Davis Research studied dollar declines back to 1974 and found that when the dollar has dropped more than 4.3% annually against a basket of foreign currencies, the Consumer Price Index has tended to accelerate by half a percentage point more than it would otherwise. Over the last 12 months, the dollar has fallen more than 10% against a basket of foreign currencies. Of course, this relationship isn’t perfect. After all, the dollar has been tumbling for nearly six years, and inflation has been rather benign throughout this decade. But Gordon B. Fowler Jr., chief investment officer at Glenmede Investment Management, an institutional money manager based in Philadelphia, says that “if there’s a run on the dollar, that would be very bad for inflation.” That brings us back to the Fed. Robert D. Arnott, chairman of Research Affiliates, an investment management firm in Pasadena, Calif., says the Fed is “caught between a rock and a hard place.” If the Fed leaves rates alone, he said, it “risks the markets cratering and the economy going from slowdown to possible recession.” But if it lowers rates again, he said, “the dollar would be at further risk.” And that could prompt more inflation, which would be just as bad for the economy. Monthly Employment Stats
Employment in financial activities was essentially unchanged in October, although the number of jobs in its credit intermediation component (which includes mortgage lending and related activities) continued to trend down. Employment in professional and business services increased by 65,000 in October and has risen by 368,000 over the year. In October, job gains continued in architectural and engineering services (7,000) and in management and technical consulting services (8,000). The number of jobs in the employment services industry rose over the month (34,000), following a large decline in September. Thus far in 2007, the industry has lost 156,000 jobs. Health care employment continued to grow in October (34,000) with job gains in ambulatory health care services and hospitals. Over the year, health care has added 400,000 jobs. Within leisure and hospitality, employment in food services and drinking places continued to trend up in October (37,000). This industry has added 365,000 jobs over the year. Retail trade employment edged down in October. Among the component industries, employment in building material and garden supply stores continued to trend down with a loss of 7,000 over the month. Manufacturing employment continued to trend down over the month (-21,000) with declines in motor vehicles and parts (-6,000), computer and electronic products (-4,000), and chemicals (-4,000). Manufacturing has lost 275,000 jobs since June 2006. Overall, employment in construction was little changed in October. A job gain in nonresidential specialty trade contractors (16,000) was offset by job losses in residential building (-9,000) and in residential specialty trade contractors (-13,000). Since its peak in September 2006, construction employment has declined by 124,000. In October, the average workweek for production and nonsupervisory workers on private nonfarm payrolls was unchanged at 33.8 hours, seasonally adjusted. The manufacturing workweek decreased by 0.1 hour to 41.2 hours, and factory overtime was unchanged at 4.1 hours over the month. Average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls increased by 3 cents, or 0.2%, in October to $17.58, seasonally adjusted. Average weekly earnings also grew by 0.2 percent over the month, to $594.20. Over the year, average hourly earnings rose by 3.8%, and average weekly earnings rose by 3.5%. Quick Facts, Stats & Opinions Get Set for Wave of Debt Downgrades Lucchetti & Ng, WSJ 11-09 In the next few weeks, debt-rating services like Moody's Investors Service, Standard & Poor's and Fitch Ratings look poised to downgrade hundreds of mortgage-related investments worth tens of billions of dollars, creating the potential for more market unrest. Collateralized debt obligations, or CDOs, look primed for more distress. These are investments often backed by portfolios of mortgage-backed securities. They're sold in pieces, or tranches, with varying levels of risk and return. The CDO tranches -- widely held by banks and investors -- haven't been downgraded as quickly as the underlying mortgage securities they hold. In October, when Moody's lowered ratings on thousands of subprime residential mortgage-backed securities, it said it didn't expect another big wave of downgrades on such bonds unless home prices declined by more than 10.4% from their peak in late 2005. That forecast of a fall in home prices was in contrast to the Moody's expectation last year of more-resilient home prices. Home prices were recently down around 4.4% from a year ago, as measured by the S&P/Case-Schiller index. :Figures from the Federal Reserve Board show that the share of subprime mortgages in default is more than 14%. And researchers at the Center for Responsible Lending say that 64% of foreclosures filed during the 12 months ended June 30 involved subprime loans. A September report from Banc of America Securities said that 93% of completed foreclosures this year involved adjustable-rate loans that were made in 2006, pooled and sold to investors. The the percentage of subprime loans that went into foreclosure during the second quarter of 2007 totaled 2.45% while 0.25% of prime loans went into foreclosure. (Gretchen Morgenson, NY Times 11-25) :Within the S&P 500, the average negative surprise in the third quarter was a 13.9% shortfall, the largest negative surprise for one quarter headed back to 1990, according to Merrill Lynch data. Still, Merrill notes that it remains difficult to shake analyst optimism. Fourth-quarter earnings estimates have fallen dramatically during the third quarter, to a growth estimate of 1.3% (from original estimates of 11.3% growth), but 2008 estimates still sit at a lofty 13.8%. (David Gaffen, WSJ 11-21) :Barring mega-record quarters from those S&P 500 names left to report earnings, this will be the first time in more than five years that quarterly profits will have fallen year-over-year. A total of 436, or 87% of S&P 500 names have reported, and the blended growth rate — combining analyst projections and those that released earnings — translates to a 2.5% decline in year-over-year growth. It isn’t just large-cap names that are hurting, either — nearly 3000 companies in the Dow Jones universe have reported, and the result is a 20% decline in net income year-over-year. The worst sector is financials, down 23%, with a 27% decline in net from banks. Fourth-quarter projections, meanwhile, continue to decline: earnings estimates were at 11.5% year-over-year for the fourth quarter at the beginning of this quarter’s earnings season, but that’s fallen to 5.5%. (David Gaffen, WSJ 11-09) How low are consumers feeling right now? By the University of Michigan’s reckoning, consumers are moping around more than they have in two years, and according to John Ryding of Bear Stearns the trend in sentiment “is not untypical of the pattern seen when the economy is entering recession.” Robert Brusca, chief economist at Fact and Opinion Economics, is even more alarmed. “Sentiment readings are now out of the caution area and into the DANGER zone,” he wrote. (David Gaffen, WSJ 11-09) While the S&P 500 is down nearly 8.7% from its intraday high in October, the average stock investor is likely feeling far worse. The average stock in the S&P 1500 is down 24% from its 52-week high. Large cap stocks have held up the best with an average distance of 20.35% below its highs, while small cap stocks have been hardest hit with an average distance of 28.5% below. On a sector basis, utility stocks have held up the best. Currently, the average stock in that sector is trading about 12% from its 52-week high. Even with oil trading near all-time highs, energy stocks haven't fared as well, with the average stock trading nearly 17% from its 52-week high. Not surprisingly, financial and consumer discretionary stocks have been hit the hardest. The average financial stock is currently down 28% from its 52-week high, while consumer discretionary stocks have lost 31.79%. (bespokeinvest.typepad.com, November) Investors would do well to learn from deer hunters and fishermen who know the importance of being there and using patient persistence - so they are there when opportunity knocks. (Charles Ellis, author of Winning the Loser's Game: Timeless Strategies for Successful Investing) What sectors have been the greatest beneficiaries of the Fed’s recent generosity? When the Fed, in mid-August, cut the discount rate at which it lends to banks, the effect was greatest on Latin America. Since the cut, the MSCI Latin America index is up 44% – compared with 37% for emerging markets as a whole. The developed world is up 12%, according to MSCI. (John Authers, Financial Times 10-30) Home Page Previous Factoid Top Sites
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