January 2008 Archives

Economist and money advisor Ed Yardeni has a nice table in his latest newsletter on the buying spree by the sovereign wealth funds. This is only the beginning.

1) CIC made a $5 billion investment in Morgan Stanley.

2) Merrill Lynch received a $5 billion cash infusion from Singapore's state-owned Temasek Holdings.

3) ADIA bought a $7.5 billion stake in Citigroup.

4) China's government-controlled Citic Securities paid $1 billion for 6% of Bear Stearns, which invested the same amount in the Chinese investment bank.

5) UBS boosted its capital base by $11.5 billion from Government of Singapore Investment Corp. and an unidentified Middle Eastern investor by selling them bonds that will convert into shares.

Ed Yardeni's latest newsletter also has a nice summary of the bearish economists on Wall Street. It all comes down to the outlook on consumer spending.

Is a consumer-led recession likely in 2008? While most economists aren't forecasting one, we have all been raising the odds of such a downturn. I am at 30%. Moody's is at 40%. Alan Greenspan and Marty Feldstein are at 50%. There are a few economists who have crossed over to the dark side. Pimco's Bond King Bill Gross thinks a recession might have started in December, but should last no more than six months as the Fed is forced to continue cutting the federal funds rate. Pequot's strategist Byron Wien agrees, and so does Steve Roach. David Ranson thinks it may be imminent based on the recent widening of credit quality spreads in the bond market... At the end of last year, Merrill's David Rosenberg concluded that the probability of a recession is 100%. He based his sure-thing forecast on a modified version of a yield curve model developed and tracked by economists at the Federal Reserve Bank of New York. More recently, he said that depending on which econometric model or indicators are used in a forecast, the probabilities for a recession currently are anywhere from 50% to 100%.

For fun (depending on your definition of fun), I was interviewed on December 31 by Gary Eichten on Minnesota Public Radio's midday program. It's an annual event where Gary airs my predictions from last year--and I make some prognostications for the coming year. Gary is a terrific host. Mike Pengra offered up some mean drum roles. You can judge on how well I answered the questions.You can listen to it at minnesota.publicradio.org/display/web/2007/12/31/midday1/

No matter how you cut it, today's unemployment report was awful. The headline 18,000 nonfarm payroll increase is bleak enough, but the news is even more depressing reading further into the report. For instance, jobs in the private sector fell by 13,000. Government employment accounted for the miniscule gain.

The odds of a recession are high and mounting. It looks like the Fed will be forced to cut its benchmark interest rate by a dramatic half-a-percentage point at its next meeting at the end of the month. The Fed will feel the pressure to act despite ongoing worries about inflation with the price of oil breaking $100 a barrell, the tandom rise in the price of food, and the decline in the dollar. My guess is that the Fed will try to contain any potential global capital market fallout by coordinating its actions with foreign central banks.

I also expect more talk out of Washington for tax cuts despite the budget deficit. As Richard Nixon famously remarked, "we're all Keynesians now". Or maybe Washington find solace embracing supply side economics when it come to dealing with a downturn in the economy.

For more than three decades, students and their parents funded a college tuition bubble with borrowed money. Two-thirds of college students finish school with debt, up from less than half in 1993. Yet, reminiscent of the dynamics in the recent housing market downturn, investors are suddenly wary of the $78 billion student loan business. The borrowing boom could go bust.

Case in point: Returns on all the publicly traded student loan lenders are down sharply over the past year. Most striking is Sallie Mae, the market’s 800 pound guerrilla. Since last July, 60% of its market value vaporized, a price decline about double the drops suffered by troubled lenders Citigroup and Merrill Lynch. In its latest regulatory filing with the Securities and Exchange Commission Sallie Mae's management says it will become more selective in its loan originations. I think investors perceive a fundamental change in that industry that goes beyond the normal correction process. We're at a threshold point when loans for financing college topped what can be supported.

Recent research explodes the widespread myth that student loan default rates are low. To be sure, the federal Dept. of Education has announced for years that the default rate was a modest 4% to 5%. Problem is, the federal agency only looks at the first two years of debt repayments. Longer term studies find far more dire results. For instance, reaching back into the early 1990s and following students over the subsequent decade, students with loans totaling $15,000 or more had nearly triple the default rate of those with $5,000 or less in loans--20% versus 7%--according to a study by the National Center for Education Statistics came up with similar results. Compounding the financial stress on lenders is a new law limiting federal subsidies to them.

To be sure, the mantra has been that student loans pay for themselves with post-graduate earnings and opportunities. Yet the real earnings gap in constant dollars between a worker with a college sheepskin and her peer with a high school diploma increased by a mere $1,033 for women from 1995 to 2005 (after adjusting for inflation), and only $3,500 for men from 1995 to 2005--about $100 a year and $350 a year respectively. That's hardly a reassuring return on education for a generation that has taken on unprecedented debt burdens. Over the past decade the average student loan debt burden has jumped by an inflation-adjusted 50%.

What does it mean for students and their parents? It's a mixed bag for now. On the one hand, borrowers will have to pay more for their college education, either through savings or higher borrowing costs. Still, a growing number of colleges and universities realize that the loan business is out of hand. Harvard may have garnered the most notice when it announced cut rate tuition to families earning up to $180,000 a year. They'll pay a maximum of $18,000 a year versus the full tab of more than $30,000. Caltech, Colby College, Duke, Indiana University, Pomona, and 33 other colleges have eliminated or mostly cut out loans for students, especially those from low-income families. The pressure is growing on other private and public colleges to follow suit.

I was doing some research into investing, and I came upon these profound insights in the General Theory by John Maynard Keynes. It has been awhile since I read them. His observations have been upheld by subsequent quantitative research. But these passages remain one of the most eloquent discussions on why it's so hard for professional managers to consistently do well.

But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.[4] For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

I found this something of a chilling summary. The legendary investor Dean LeBaron notes on his website that John Kenneth Galbraith's classic account of the Great Depression lists five major weaknesses of the U.S. economy in 1929: an unequal distribution of income; bad corporate governance; a weak banking structure; a 'dubious' balance of trade position; and bad economic advice.

Sound familar?

This is a good commentary on fiscal stimulus by Mike Mandel, chief economist at BW.

News January 17, 2008

What Could Stave Off a Recession

Government spending on education and health—two growth areas—might be enough to buoy the economy

A consumer crunch now seems inevitable. The housing market is in free fall, and home-equity loans, which many people used as piggy banks, are becoming more expensive and harder to get. Now big credit-card issuers such as American Express (AXP) and Citigroup (C) are reporting a rise in delinquencies, which will lead to tighter lending standards. The net result will be a squeeze on consumer credit that could bring even irrepressible shoppers to a halt.

Or policymakers can do something different: boost outlays on education and health. Remember that in the 1930s, John Maynard Keynes forcefully advocated the idea that government spending could bolster the economy in a downturn. Today, increasing federal health and education grants to the states, while politically controversial, could be a quick and effective way of slowing the cutbacks in jobs when tax revenues turn down. If so, Keynes could be back--and coming to schools and hospitals near you.

The markets are always dominated by narratives, attempts to make sense of the world. Only a few weeks ago, going into the New Year, the dominant story was yes, the U.S. might sink into a recession, but the rest of the world would keep on growing. The jargon phrase was "decoupling." Over the long weekend that story stopped working. Instead, the realization grew that if the U.S. sank into recession it would have a dramatic impact on business in China, India, and elsewhere.

What has the Fed accomplished with its 0.75% slash of its benchmark interest rate. The Fed, along with other central bankers, will stop a global financial collapse. And that's vital.

But a U.S. recession seems inevitable (if we aren't already in it). Consumers are still pulling back. So are bankers. And the housing market is spiraling lower.

The real danger is if investors have truly lost confidence in the Fed. After all, fiscal policy is a disgrace. So, closely watch what happens to gold, the dollar, and U.S. Treasury Inflation-Protected securities over the next couple of weeks.

I'd love suggestions on books to read or research about poverty in the U.S.

I just finished two useful books: The first is: "The Persistence of Poverty: Why the Economics of the Well-Off Can't Help the Poor", by Charles Karelis. He's a professor of philosophy at George Washington University.

The other is: "Fighting Poverty in the US and Europe: A World of Difference", by Alberto Alesina and Edward L. Glaeser. Both are Harvard University economists.

I'm also looking at three others right now:

"Higher Ground: New Hope for the Working Poor and Their Children" by Greg J. Duncan, Aletha C. Huston, and Thomas S. Weiner.

"Working and Poor: New Economic and Policy Changes Are Affecting Low-Wage Workers" editors Rebecca M. Blank, Sheldon H. Danziger, and Robert F. Schoeni.

"Mobility and Inequality" edited by Stephen L. Morgan, David B. Grusky, and Gary S. Fields

The $7.2 billion fraud at France's SocGen, the world's leading equity derivative trading house, is breathtaking.

But I'm skeptical about the claim that its was all the work of one "genius". And, if it was, we should all worry even more about the risks of derivatives.

According to the Financial Times, SoGen "quickly unwound the positions he had amassed," estimated at 40 billion to 60 billion Euros. Okay, so where did he get the money? That's a huge position. He financed that much--and the bank didn't notice? How much else is out there that isn't being monitored, watched, or understood?

Here's my reaction to the government's GDP report and the Fed rate cut...

Is another big name from the 1970s attempting a comeback? Stagflation, the worst-of-both-worlds scenario in which weak growth is accompanied by robust inflation, may be on the radar again. It's enough to conjure memories of President Gerald Ford's ill-fated campaign to talk down prices through a "Whip Inflation Now" (WIN) campaign. The risk is evident in the latest economic numbers. Indeed, Marc Faber, the widely followed global investment adviser based in Asia believes that "we're already in stagflation: no real economic growth--or recession--amidst inflation" in his latest Gloom Boom & Doom Report.

.... The risk for business, consumers, and investors is the emergence of a different kind of stagflation--call it "stagflation-lite." It would be defined by higher-than-expected inflation rates (say, a 5.6% increase in the CPI) and lower-than-expected growth rates (like a 0.6% economic expansion).

You can read the full article at www.businessweek.com.