Here comes the money

Except for the not inconsequential fact of the market falling another 500 points, the week of October 20 wasn’t too bad.

More companies and municipalities were able to issue bonds, and more businesses were able to re-establish lines of credit with their banks. Another major bank (National City) went off the air without depositors or bondholders losing a penny as it was merged into a more healthy rival (PNC Bank).

The leading economic indicators for September were +0.3%, which gives some credence to my thoughts that the economy was about to turn the corner and move on to recovery just prior to Lehman Brothers going bankrupt and the financial scare sending the stock market down another 1,500 points.

Existing home sales also surprised on the upside, suggesting that perhaps the economy is starting to work toward balancing higher demand due to lower prices with escalating supplies due to the foreclosure problem. I don’t think the housing market has turned the corner, but sometimes just a small improvement at the margin (we not getting worse anymore!) can make a significant difference.

I still applaud the Federal Reserve, and to a lesser degree the Treasury, for their aggressive response to the crisis. We will definitely look back at this time period and have some criticisms. Did the taxpayers really just give Goldman Sachs $10 billion so that they could pay out obscene bonuses to the "Masters of the Universe" who engineered the recent collapse, or will Warren Buffett put a stop to such nonsense because he, too, needed to pony up to the bar to keep Treasury Secretary Paulsen's alma mater afloat?

Peter Fisher, a BlackRock Managing Director, noted that we may look back and conclude that Bernanke and Paulsen erred in March by issuing a public warning that all banks need to go out and raise more capital. "The only thing worse than yelling fire in a theatre," Fisher said at a recent Conference on De-leveraging, "is having the Fire Marshall do it for you." By the time that Lehman failed and the financial crisis began in earnest, the financial markets were primed with an unprecedented amount of fear. It's not clear that this climate could have been avoided. On the other hand, had the Lehman failure been contained (as was the Bear Stearns bailout), who knows what pain might have been avoided.

The market has re-tested its October 10 low, and thus far it has held up. It is a fragile victory at this point, but an important one. It seems to me that the U.S. market wants to bottom, but the global market sell-off, which now exceeds the U.S. market plunge, may not let it. If the foreign markets can't catch a bid, the current bottom may not hold.

In the meantime, we're probably going to get another round of interest rate cuts across the globe. Next week, the Treasury will start buying commercial paper (very short-term bonds) of real businesses - to enable companies that actually make and sell things to keep people working. Thus far, the banks are mostly sitting on the money they've (just) received from the Federal Reserve. They're using it to "de-leverage" their balance sheet, rather than using it to make new loans. They're using it to take over other failed institutions. They're using it to pay down debt. We need it to find it's way back into the economy. Perhaps General Electric, which has said that it will take advantage of the new Treasury program, will use it to pay down some accounts payable so that Joe the Plumber has some money next weekend to go out to eat.

The money from the Treasury is starting to flow into the system. However, in econ-o-speak, what has also happened is that the "velocity" of money has dropped considerably. People have a bit less of the green stuff, but even more importantly they're afraid to spend it because of the lingering uncertainty. Economic activity can come to a standstill if no one is willing to spend what they've got. At the bottom of the 1933 Depression, at his inaugural address, Franklin Delanore Roosevelt said, "the only thing we have to fear is fear itself." This problem, fortunately, is not structural - but rather psychological. After 9/11, the nation was similarly paralyzed. I would expect a similar economic reaction for the balance of 2008 and into 2009. There will be a sharp slowdown, but it need not result in economic disaster if the global selling can be contained and people gradually return to more free-spending ways.

In the future, the most leveraged companies and individuals will have to adjust. The de-leveraging of America has begun and will likely last for several years. Some of the adjustments will be painful, but a doom and gloom forecast suggests that the economy will come to a standstill and remain there for a long period of time.

I have more faith in the Fed than that. The Federal Reserve is bound and determined to get money back into the system to offset some of the wealth destruction that has occurred. Though Greenspan should have taken away the punch bowl a few years back, before the real estate market began to froth, now the punch bowl is back, full, and the government is handing out chasers to anyone near the front door.

So, does that mean we're about to put our remaining reserves back into this market? I'm now on my third week of waiting and watching, mostly. We went into individual portfolios to rebalance the current positions which, given the severity of the sell-off, left some positions under-represented while other, more defensive holdings (which hadn't sold off as quickly) were over-weighted. We evened out the weightings, but still have cash in reserve which we're hoping to reinvest while there is still upside to the market.

I've been digging deep into my research files to confirm that stocks go both ways, both down and up. It's getting hard to remember that, some days. As the money returns to the economy and nerves settle, I expect that we'll soon be reminded of the good side of stock volatility.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Plus or minus?

This week set a new record for the volatility index, though the wild swings to the plus side were offset by plunging prices into minus territory. By the end of the week, I was left with a market little changed, but we’re seeing many tiny signs of improvement in the state of the financial world. I would much rather buy the Dow Jones Industrial Average at 8,852 today (Friday) than when we were at similar levels last Monday.

The typical investor tends to underestimate volatility, though it may be a generation before they make that mistake again given the recent 100-year flood of volatility we’ve just experienced.

“Standard deviation” is one measure of volatility. Over the long haul, the typical standard deviation for the market is almost 20%. That is the percentage by which the market will “typically” (19 times out of 20) deviate from the normal return. Many people hear a 20% standard deviation and, given a “normal” return to stocks of 10%, form a mental picture of the market swinging from 0% to 20% during most years. This underestimates normal stock market volatility. Forbes columnist, Ken Fisher, wrote a fantistic piece explaining how most people underestimate volatility, but unfortunately I didn't save it and I haven't been able to Google it to provide a link.

During some periods, like what we just experienced, the market may swing from 20% overvalued to 20% undervalued, for a top-to-bottom 40% swing. This is normal for the market, probably once every 20 years.

One reason to take this crash all in stride is because that’s just what markets do. They crash, and they soar, and when volatility is high sometimes the plusses and minuses balance each other out and you get a market like the one this week where the market moves more in a day than it typically moves over the course of a year, but with no significant move overall. The key to understanding volatility is to try to make the best of it. It is almost always the case that the worst thing you can do is let downside volatility frighten you out of the market.

Don’t get me wrong. We’re not in a “normal” market. We just experienced the worst crash in 100 years of U.S. stock market history. However, some context is important. And, to some degree, this is just what markets do.

Almost exactly a year, the Dow Jones Industrial Average peaked at 14,169. Assuming that it was 20% overvalued on that day, it would put “intrinsic value” for the Index, last October, at about 11,800. A year later, Bear Stearns and Lehman Brothers have disappeared from the scene and the market (hopefully) “bottomed” on October 10th at just below 7,900. Assuming that it was 20% undervalued on that day, “intrinsic value” for the market would be about 9,875.

Intrinsic value isn’t supposed to move around much. Intrinsic value is supposed to be fixed, while stock prices move around. Could intrinsic value possibly have fallen 17% from 11,800 to 9,875 in only a year? In my view, given the severity of the financial crises, the interventions required to halt the panic, and the long-lived repurcussions we will feel, the answer is yes.

In my opinion, it’s not the sub-prime mortgage mess that brought the economy to its knees, but rather the myriad of derivatives contracts and credit default swaps that acted as an accelerant and caused the fire to sweep quickly through to all banks and insurance companies, and which eventually caused the bond market generally to cease to function. When good companies couldn’t refinance their debt because no one knew how much counter-party risk anyone else has, our economic system ceased to function.

When the show trials begin, my hope is that it is these Wall Street casino operators who originated hundreds of trillions of dollars of investor-to-investor wagers who will be doing the perp walk. It is these “financial engineers” who made their fortunes building the current disaster. They collected their cut up front and have left the U.S. taxpayer on the hook for bailing out the system that they came all too close to destroying.

We are just now beginning to see some functions restored. IBM issued bonds last week. They were the first company to be able to do so since September 2nd. There were a couple of other new issues priced and sold, this week. The bond markets are starting to function again. We’re beginning to see banks re-extend lines of credit to some borrowers. The European banks have reduced, ever so slightly, the premium they’ve been charging to risk making loans to their American counterparts. We’re starting to see signs of life. There is still a lot of recovery that needs to happen.

The damage hasn’t been limited to the United States, of course. Foreign markets have plunged as well. To me, the falling value of oil prices has been a proxy for fears that the world economy will sink into the abyss. I think there are other things going on as well. Thanks to the casino operators, investors no longer trust paper assets. Ultimately, gold futures are paper assets. I think that commodity prices are depressed partly because investors are unwilling to speculate in derivates until we know which counterparties are going to survive to expiration day. I am reading that in some physical delivery markets, prices take place at a premium to the “spot market” (futures) price, and that vendors are far behind in being able to make physical delivery (i.e. there are shortages). The real economy maybe isn’t in as bad a shape as the futures markets are telling us. Maybe, what’s in really bad shape, is merely the futures markets themselves.

We continue to have money on the sidelines, available to invest in the market at much lower levels than a year ago. Ultimately, getting back some of what has been lost requires a willingness to invest. I have been willing to wait for some signs that things are getting better before being willing to commit capital to this market. I am relieved to see signs that things are turning up. By the time it is clear beyond a shadow of doubt, it will be too late.

If “intrinsic value” truly lies around 9,875 (for the sake of argument), the market could easily rally to the 10,000 to 11,000 level and stay well within its traditional volatility range of +/- 20%. We won’t be able to take advantage of this volatility if we’re still on the sidelines. The pressure, at this point, points toward getting back into the market so that we can take advantage of upside volatility before it’s too late.

Liquidity is returning to the market. Oil prices are stabilizing, suggesting hope for the global economy. Third quarter earnings, outside of the financial sector, haven’t been too bad. Patience paid off this week. However, I probably don’t have a lot longer before the plusses outweigh the minuses and this market takes off to the upside.

The economic statistics will get worse before they get better. The stock market, though, may have already factored in the “worst case” scenario. Hopefully we will start seeing volatility work in our favor. It may not signal a new bull market, but some recovery would be nice and it seems like we’re about due.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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After Capitulation, What?

Now that we’ve passed through all the valuation floors and fear dominates not only the trading floors, but the nation’s psyche as well, there’s no doubt we’ve reached the capitulation stage where investors surrender to fear, sell at any price (no matter how irrational) just because the pain of watching it go lower is too much to bear.

Capitulation is normally a one day sort of affair. What has made this one the worst in a century is that it has lasted for several days.

• What’s next?

What typically happens next is that investors realize that General Electric still needs to manufacture gas turbines, Chevron still needs to bring gasoline to a nation of drivers, and Safeway still needs to deliver food to a hungry nation. Commerce needs to go on. Furthermore, stocks purchased during this sort of sell-off typically rebound to the benefit of investors. In the 5 instances since 1970 when stocks have sold off 18% or more within an 8-week period, the market was up an average of 15% six months later. The essence of “buy low, sell high” is to invest during these troubled times.

There are many reasons to be more optimistic than the market (which isn’t saying much) from this point. First, the Fed and the Treasury Department have been very proactive in trying to get money flowing again. I have a list of more than a dozen major efforts to stimulate the economy using methods that just six months ago I would have thought impossible (and probably unconstitutional). These are steps taken save bondholders and depositors, to keep the doors open on companies determined to be “too big to fail,” and to get the bond markets moving again. The government has nationalized Freddie Mac and Fannie Mae, offered private equity financing to AIG, forced Bear Stearns and Wachovia to sell themselves to competitors, bailed out IndyMac Bank depositors, re-regulated the Fed discount window to give Goldman Sachs access to the government storehouse, insured money market fund deposits, arbitraged 0.75% T-Bill rates in order to buy much higher yielding commercial paper…and the really creative stuff has yet to be announced. Just think of the ideas that didn’t make it into the final plan!

In recent days, other nations have joined the effort with the European Central Bank, the Banks of England and Canada, the Swedish Bank, Hong Kong, China and others cutting interest rates and putting capital into their own private banking companies. Australia cut rates by 1%. Moreover, longer-term interest rates are falling internationally, which will eventually help get things moving again.

The bailout bill boosted FDIC insurance so that worried investors would bring money into the banking sector, rather than taking it out (as happened during the depression). The Treasury’s latest proposal, to invest directly into banks through buying preferred stock, may be ten times more effective than simply buying sub-prime assets off the bank’s books. The notion of the U.S. Government investing directly in U.S. companies through the purchase of commercial paper (very short-term bonds) could be extremely helpful, but all of these steps take a few days to get started and the market has never been known for its patience.

There’s no doubt that capitalism and “free markets” have a big, black eye. There will be many opportunities to place blame, at some point in the future. For now, though, the objective is to (as Warren Buffett said a few days ago in a great Charlie Rose interview) get the cardiac arrest patient up off the floor and moving again. There will be ramifications for the actions we’ve taken. However, the consequences of doing nothing would have been much worse.

Based on valuations, investors should buy stocks today. Unfortunately, based on valuations alone the rally probably should have started at least 2,000 points ago. For the most part, what I’m waiting for is some sign that all this money that the Treasury is putting into the banking sector is beginning to find its way into the hands of the businesses that need it. I need the bond markets to start functioning again, so that a sound bank or insurance company (if that’s not an oxymoron) will be able to roll over maturing debt on reasonable terms to the lender.

I am hearing that some institutional money market funds have closed to new deposits (of $25 million or more) because they don’t have any place to invest it. Commercial paper issuers have withdrawn from the market, or perhaps those funds are choosing to buy only Treasury Bills, but they cannot find enough bonds/notes in the market to invest new money. That is a great sign. Liquidity may be starting to pile up on the sidelines.

There are many reasons to be optimistic from here. Fear is the investor’s enemy. Where has the “don’t fight the Fed” crowd gone? Or the “lower oil prices are good for the economy” bunch?

I remain focused on how to take advantage of the sell-off by buying back in. When we get past this frightening phase, the market should be higher. I, frankly, don’t want to wait too long to buy. However, I do want to see signs that the massive liquidity add is having an impact before committing capital.

Douglas B. May, CFA, is President of May-Investments, LLC and author of GJretire.

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2006 Economic Forecast Update

In our October 2006 Economic Update luncheon for clients, we expressed fears of a 30% market sell-off, comprised of a 20% decline in earnings and a reduction in the Price/Earnings ratio from 16X earnings to 14X earnings. From the 2007 peak, this 30% sell-off would have taken the market down to 1085. If you start from where the market was in October 2006 (1350), the 30% sell-off would take the market down to 945 on the S&P 500 Index.

Today the market hit (bottomed out at?) 1008 and closed at 1056, above the October 2006 projection but below the October 2007 peak-to-trough forecast.

Furthermore, the sell-off resulted from the real estate problems that we highlighted in October 2006. The trepidation we felt in 2006 is now widely shared. The recession is no longer an intellectual construct, but rather a day-to-day (if not hour-by-hour) headline.

Today’s liquidity crisis is worse than we’d anticipated. In any case, it feels worse than we were prepared to feel. However, if psychology can pinpoint a market low, then it can’t get much worse than this. If I were going on psychology, alone, this would clearly be a buying opportunity.

• So what have we done about it?

All we’ve done, recently, is put new money to work. Accounts that brought in new cash in the past month may have had more money sitting on the sidelines (thankfully) than most, and those reserves have now been invested.

Most portfolios, however, still have money on the sidelines waiting for the market to turn around. In fact, at this point the trades are loaded and we’re just waiting for the right opportunity to invest.

I’ve been looking for a big sell-off (1,000 points down on the Dow) with a spike in the volatility index for a couple of weeks, now. We haven’t seen that magical combination, though the Dow sank 777 points last Monday, and was down over 800 points at one point today. Also, we’re down well over 1,000 points since I first started looking for that sell-off.

Stocks are very cheap, as compared with bond yields. Some market bloggers are speculating about the “mother of all snapbacks” when this sell-off ends. It could be that my volatility spike will come on the upside, rather than the downside. Woudn’t that be nice!

• What might make us buy?

In addition to this painful exercise of “how low can it go,” I’m looking at a couple of specific indicators for a signal that the tide is ready to turn. Signs that the liquidity crisis is lessening, or that the markets have completely priced in a global recession, would signal a reasonable re-entry point. The market is now off more than 30% from its high. Financials stock prices have been cut in half. The commodity sector has experienced its worst sell-off in 50 years (since 1956). Clearly, now is a better time to buy stocks than it was a year ago (when most investors were far more willing to do so).

The liquidity crisis will gradually resolve itself. The Fed and the U.S. Treasury are creating new and innovative ways to pump money into the system. After the 1987 crash, the Fed was on the phone with member banks, asking if any customers needed money (and indicating that the Fed was willing to make certain that they got it). I have little doubt that those same promises are being attempted today.

The Fed is paying interest on banking reserves that never used to receive interest. The bailout bill brings a new buyer into the market for hard-to-value (and liquidate) Level 3 assets. Last week’s bill also makes it possible for the S.E.C. to suspend mark-to-market accounting, and hopefully the S.E.C. will announce measures to that effect sooner rather than later, reducing the pressure on banks to dump assets. Raising FDIC insurance limits will hopefully bring in new deposits to the banks, increasing their balance sheet and hopefully the banks will be able to re-enter the corporate bond market on the buy side, since we haven’t seen many buyers, lately, even in that reasonably safe asset class.

Signs that the liquidity mess is beginning to improve might soon include lower corporate bond rates, higher junk bond prices, and lower spreads between Europe’s LIBOR rates and the U.S. Fed Funds rate, which signals the unwillingness of banks on the continent to lend money to its upstart brethren here in the New World.

I’m also looking for signs that the global recession has been fully priced into the global equity markets. In the last 3 months, Latin American stocks are down almost 35%, the Europe ETF has fallen about 20%. Japan is off nearly as much, and Asia stocks (ex-Japan) are down about 23%.

In my mind, the U.S. banking crisis bottomed out on July 15, and we’ve been trying to put a bottom in the liquidity crisis ever since then.

What’s caused the most pain recently, however, has been the gradual recognition over the past 3 months that the U.S. has exported its problems overseas. The world is now anticipating a global recession, and the commodity and international equity markets are adjusting rapidly to this new reality. The good news is that Central Banks around the globe are now preparing plans to add stimulus to offset the global credit crunch.

When we see the impact of these stimulus measures reflected in a stabilization of global energy prices, that will likely be an important turnaround point. At the end of the trading day, today, energy prices appeared to remain weak, even though the stock market rallied about 450 points off its low. Had energy prices been leading the way, I might have bought into the market. As it is, I thought it best to take another look at things tomorrow.

Though energy prices have certainly fallen recently, oil prices are still up 17% over where they were a year ago, and natural gas prices remain 7% higher. Stock prices in the energy sector are down closer to 20% over the same time frame. It feels like we’ve gone from a two standard deviation overvaluation in June to a two standard deviation sell-off event in September/October. In spite of this, the multitude of steps that the Fed is taking to get money into the financial system seems bound to put downward pressure on the dollar during the months to come, which generally puts inflationary pressure on the price of commodities.

Though we’ve bemoaned the high and rising energy prices in months past, I would really like to see energy prices stabilize just north of $100 per barrel. My guesstimate for “fair value” is actually around $115. If energy prices were to stabilize, I’d say that the global equity markets are starting to find equilibrium again and now reflect the unpleasant reality, which we first talked about late in 2006, that a recession is in the cards.

At times like this, it is sometimes hard to remember that what follows a “recession” is typically a recovery. Helicopter Ben (Bernanke), so-named because of a paper he wrote about preventing another depression hypothesized that ultimately the government could simply drop dollars out of a helicopter in order to get things moving again, is dead set on providing liquidity any way he can.

Whether or not today marked the bottom, I don’t know. In the long-term scheme of “Buy low, sell high,” however, I think we’ll find in retrospect that we’ve reached a buy point.

I decided to wait another day, for signs that the liquidity situation is improving, or that energy prices are ready to stabilize. We’ll see if “wait and see” proves to be a costly decision. Up until today, it hasn’t.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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A Prize For the Most Useless?

• Gary S. Becker

In 1992, Gary S. Becker won his Nobel Prize for extending microeconomics to a broad array of subjects, including discrimination, crime and punishment, human capital, family dynamics, and politics. He sounds, frankly, like a lot of the students I counseled at the Stanford Career Planning & Placement Center, who couldn’t decide between economics and political science. Most wanted the economics degree because they thought it might help them get a job after graduation. The job they most wanted, though, was President of the United States, so the political science gig might come in handy. Ultimately, the liberals ended up in journalism writing political essays disguised as economic analysis, while the more conservative grads went into investment banking and now own several Senators of their own.

Some things just aren’t taught at the undergraduate level.

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Becker spent most of his career as a member of the University of Chicago’s distinguished faculty. He was even considering leaving economics entirely until he met world renowned monetarist Milton Friedman who convinced him that economics was not a game played by clever academicians but rather a powerful tool to analyze the real world. A rejuvenated Becker began extending theories of rational choice to areas previously unblemished by economic analysis. Becker’s studies generated a great deal of criticism and many economists didn’t really consider him a student of economics at all, which (again) probably goes back to the fact that he wanted his research to be useful beyond the walls of the university. Becker even went so far as to agree to become a regular columnist for Business Week magazine, submitting his ideas and research to the general reader instead of just publishing in obscure journals.

Ultimately, Becker took the fundamental precepts of economic analysis (ludicrous assumptions obscured by complex mathematics) and applied them to other areas of debate. With a libertarian mindset and a fistful of equations, Becker proved things like legalizing illegal drugs and slapping on a tax would be more effective than prohibiting drugs like methamphetamines. And who wouldn’t question a study based on meth users doing what’s in their own rational best interest? Except, maybe, for anyone conscious of the paradoxical notion of a rational meth user. What exactly do they look like? Perhaps he’s really envisioning a young meth user with dentures, because the older ones couldn’t possibly be accused of having behaved rationally unless they’ve always harbored a secret desire to look like a pruned version of Gollum from “Lord of the Rings.”

Becker’s central premise is that rational economic choices, based on self-interest, govern most aspects of human behavior, and not just purchase and investment decisions that are traditionally the purview of economic analysis. Becker used charts and graphs and calculus to make assumptions and draw conclusions about racial discrimination in labor markets, job training, family size, divorce, criminal behavior and the role of women in the workplace. It’s going beyond the Peter Principle. It’s reaching beyond your own circle of incompetence and expanding into new service areas. It is the opposite of focusing on your core strength.

I know of several super regional bank trust departments which failed, year after year, to beat the market with their investment management model, which have decided they should tackle “both sides of the client balance sheet” and have begun offering a broader array of advice on a wider range of investment alternatives and decisions regarding both asset and liability decisions. In other words, since they didn’t do a very good job of investing client assets, they decided to expand their scope of services to include advising clients on how much they should borrow and invest in the new, probably also unsuccessful, investment strategies. All this is being done in the name of offering “wealth management services” to their affluent clients.

If an advisor can’t manage a long-only stock portfolio, how in the world does it propose to make competent real estate decisions as well? If it won’t take a stand on stocks versus bonds, how do they expect to offer expertise in deciding among complex hedge fund strategies? If running is a problem, try walking. Don’t start designing cars.

Becker is sort of like the carpenter for whom every problem requires a hammer. We all look at problems with our own biases and from our own point of view. Successful investors, however, find that when their view of the world conflicts with reality based on faulty underlying assumptions, it is their pocketbook which is incurs a sub-optimal result.

• Douglass North

Douglass North, a 1993 Prize winner, may be as important as John Maynard Keynes was to macroeconomics, the traditional branch of economics that deals with the performance, structure, and behavior of the national economy as a whole. These two branches, microeconomics and macroeconomics, form the core curriculum of many economics programs.

My roommate at Stanford and I would debate the key questions of economics, sometimes for hours – depending on whether or not we ran out of beer. The key question is, “which is the most worthless, micro- or macro-economics. There was no question, really, that they were both worthless. The only real point of contention was which was worse.

Micro focuses in on the smaller unit, such as an individual consumer or small business entity. Macro, on the other hand, considers the grand scheme of things. It looks at national statistics, international trade, and price and inflation statistics. I’ve always been a fan of entrepreneurs, so was somewhat sympathetic to the microeconomists I’ve met. Not because they are in any way useful, of course, but at least they seem to be rooting for the right team. My roommate argued that because the microeconomists were always assuming perfectly efficient companies and perfectly rational consumers, any conclusions drawn from their resulting charts and graphs must be fundamentally flawed. After all, when was the last time you met someone who worked for a perfect business? And let’s be honest, just how rational is your spouse when it comes to spending money?

I, however, always presented the case against macroeconomics. Economics majors, like Literature majors, are great fans of irony. Indeed, one of the big factors behind Arrow’s Nobel Prize win was the fact that he had a paradox named after him. Arrow’s paradox, also known as “Arrow’s impossibility theorem” examined various economic criteria, including the “independence of irrelevant alternatives.” I mean, doesn’t that phrase have “Laureate” written all over it? It doesn’t matter a whit that nobody understands what it means (and sounds like the definition of the word “trivia”). The phrase is steeped in so much cosmic irony that it practically demands that students do a word search in Shakespeare to see if Arrow lifted the concept from an old book. Economists delight in irony the same way that conservative pundits savor the fact that Al Gore, the inventor of the internet, received a C- in Natural Sciences and a D in Man’s Place in Nature during his stay at Harvard (where he spent much of his sophomore year shooting pool in the Dunster House basement lounge, watching television, eating hamburgers, and hacking his way into the Defense Department’s ARPA net to steal code). It’s that geekish sense of intellectual humor of a brainiac screaming “notice how smart I am!” In Arrow’s case, Alfred Nobel’s minions in Stockholm, Sweden chuckled at the irony of his famous phrase and voted him into the club. (In Gore’s case, they are said to have actually guffawed.)

Outside of the merry pranksters in Sweden, however, few people actually paid much attention to Arrow, North, or Becker, so not many people could be hurt. No harm. No foul. Things were done in the traditional spirit of Ivy League antics with no one really getting hurt except for the parents of underclassmen who were saddled with the tuition bills. The next four gentlemen to win were pushing theories that reached out and touched investors portfolios and proved to be a little more dangerous.

Next post: A Prize For The Most Useless - Part II

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Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Irrational Instability

Since when is a rescue bad news?

AIG is a BIG insurance company. A couple of years ago, it had a market value of $190 billion. Last Christmas it owned over $1 trillion in assets, but was leveraged roughly 10:1. For every $1 in equity, it owned $10 in assets and had $9 in liabilities. This is not necessarily unusual for an insurance company, however it does leave them vulnerable in the event that irrational instability spreads like wildfire through the financial system.

AIG made a few bum investments, but the Q2 write-offs of around $10 billion shouldn’t wipe out a company with a market capitalization of $190 billion. Now the rumor is that write-offs for the company will soar to perhaps $60-70 billion, but even that shouldn’t take the company to the brink.

At the end of last year, AIG had $380 billion of “current liabilities,” which is usually defined as coming due within a year. By mid-2008, however, bond buyers went on strike. Though AIG was highly rated, the rating agencies no longer have any credibility. In fact, the rating agencies helped drive a stake through the heart of AIG just this week by downgrading the company in the midst of crisis, and even then the bonds remained investment grade. With no investors willing to buy their bonds, and $380 billion coming due through the course of the year, the clock kept ticking.

AIG, like hundreds of other companies in the financial services sector, have been forced to reduce the size of their balance sheet, selling assets at the worst possible time. This has caused the price of corporate bonds, junk bonds, mortgage-backed securities and all things paper to drop. Because new accounting rules implemented in November of 2007 require that these assets be “marked-to-market” (price) so with each succeeding wave of liquidations, prices go lower, more write-offs are required, and the problems spiral out of control.

Mark-to-market accounting makes sense for assets held in short-term inventory for sale, but not for long-term investments. Were individuals subject to mark-to-market accounting during the real estate boom, they would have been forced to mark up the value of their homes each year and pay income taxes on these phantom gains. Worse yet, now that home prices are sinking, homeowners would have to subtract the losses from income which would reduce your income tax burden, but leave you subject to having the bank step in and call-in your mortgage given that your negative income suggests that you can no longer afford the home you’re living in. Forget for a moment that your real (cash) income hasn’t changed. If the bank comes knocking on your door and forces you to refinance, but no one else will loan you the money because they also think you have negative income, the end result is that you’re out in the street with nowhere to live while the bank sells your house out of foreclosure for less than its worth, and next year it’s your neighbors who are out on the street because they had to mark their houses down in value.

Do you see how irrational this is? That’s the situation we’re facing in the markets today.

A modern day “run on the bank” doesn’t necessarily involve tellers pulling money out of an institution. Today the financial institutions are so dependant on the bond market providing liquidity that a buyers’ strike in the bond market creates havoc.

Who are these bond buyers? Many are pension funds. However, only a small portion of bond money is dedicated to the junk bond market. If a company (like AIG) is at risk of falling to junk status, most of the pension fund money will look elsewhere. Financial institutions, themselves, are major bond investors – but remember, these companies are shrinking their balance sheets, which only adds to the problem. Closed-end funds are sometimes buyers, but many of them are being forced to de-leverage as well, so they tend to be net sellers at the moment. You’re left with a few retail mutual funds with money to buy, but they finished spending their available cash in August of 2007, and shareholder redemptions are forcing them to liquidate as well. AIG has $380 billion of paper to refinance, but everywhere they go they get the cold shoulder.

AIG, and other companies like it, are reasonably sound entities being forced into the unwilling arms of the government because their short-term debt is maturing and no one is willing to buy their paper.

The government has been criticized for bailing out rich Wall Street shareholders. But the real end game is to bail out bond holders. AIG has lost $185 billion in market value, and that’s okay. Stock investors take that sort of risk every day – it’s just that it’s a rare day that they actually have to absorb that sort of loss. The Secretary of the Treasury is trying to protect AIG’s $900+ billion in creditors by making a bridge loan to help the company survive the credit crunch. Those creditors include annuity holders who are depending on AIG to provide them a lifetime income stream. They include retirement plan participants who bought bonds through their pension plan because until this week AIG had one of the highest ratings out there.

Is it fair that a run on the bank caused by idiots at Lehman Brothers, Bear Stearns, IndyMac and a bunch of independent mortgage company brokers that offered mortgages to deadbeats on overpriced rental condos in the vacation hot spot of your choice with little money down and no income verification --- is it fair that the credit crisis that followed imperil retirees depending on AIG for their grocery money?

Probably not.

We have reached the point where the credit crisis is unfair and probably irrational. The Treasury is doing whatever it can to restore stability. When trust is destroyed, however, a restoration of faith cannot be mandated by government fiat. The only credit that buyers trust, at this point, is the government itself. That is why the government now explicitly backs the bonds of Fannie Mae and Freddie Mac. That is why the government is able to raise $85 billion which is lent to AIG (at an 11% interest cost).

• What does this mess mean for stockholders?

For owners of financial services companies, it means that it will be a long time before you can get a meaningful rally in the sector. The stocks can pop 50% overnight (or lose as much), but the sector won’t really recover until the balance sheets are downsized, trust and credibility are restored (good luck with that!), and the companies have reinvented themselves as profitable and stable. We’ve said before that the next stock market rally won’t be led by financials, and the fact that they had been leading the market up (in August) had been troubling us.

The rest of the market can keep falling until it is so incredibly cheap that buyers come in even in spite of Wall Street’s lack of credibility. Drug stocks have reasonably stable earnings and sell at 12X earnings. Is that cheap enough? Big oil sells below 8.5X earnings. Is that cheap enough? Software companies are selling at about 14X earnings and have attractive growth prospects. When do buyers step in? At 13X? At 10X?

The May-Investments fund portfolio has 30% in bonds and much of the equity portfolio in historically defensive sectors like healthcare and consumer staples and pharmaceutical companies. The May-Investments portfolios did not sell-off today as much as the market, which fell 450 points (-4.7% today for the S&P 500 Index). Still, the market feels like it’s wound tight as a spring and could rocket down more, just as it could (and I hope will) rocket up.

To me, the government deciding to throw its support to AIG bond holders was a good thing. The stock market can go to hell, but if the bond market stops working the whole country is in a world of hurt. It seems to me that the Treasury understands that.

Rather than springing up, though, the market tanked some more. Not just financials, but across the board the sell-off was severe. Though I remain an optimist (…this too shall pass), at the end of the day when the mid-day rally failed to hold, we sold our position in industrial stocks and for a few days, at least, will let the money sit in cash.

We told investors that when the market is tanking, our philosophy is to take some steps to “get out of the way.” The sell-off in commodities and international stocks is consistent with a world view that says the U.S. recession (which still hasn’t been classified as such by the economists) has spread to the rest of the globe. I don’t know if I agree with this observation, but in a liquidity crunch the resulting irrational instability can even force good companies into bankruptcy, and cause prices to sink far below “fair value.”

We might be setting up another “once in a lifetime” buying opportunity, a la 1974, but if that is what’s actually happening the entry point will more likely come somewhere below 9,000. All we’ve got at this point is a run-of-the-mill attractively valued market.

If the market falls from here, we’ve got 40% in bonds or cash equivalents that we can redeploy in stocks at much more attractive levels.

If the market rockets UP from here – as I truly hope it does – we will have locked in a loss on our industrials and left a little more money on the table. That market, however, would mark the beginning of a new, rationally stable capital market, and I would welcome that outcome even if it means a little short-term underperformance up front.

Yesterday’s post admitted that I am optimistic, but have little confidence in my forecast. For that reason, we have shifted back to our most defensive position in the face of persistent selling. Though the Treasury is taking heroic steps to support the market, the bond buyers strike shows no signs of abating.

The good news is that I believe that the current bout of instability is irrational. The bad news is that the market doesn’t care one iota about what I think. Prepare for the worst. Hope for the best. Don’t freeze, but remain watchful. Keep your bearings along the way.

Volatility creates opportunity. This just happens to be one of those days where it isn't a very pleasant sensation.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Weekend at Bernanke's

Four different stories came out of Wall Street this weekend, any one of which would have made an interesting start to the week.

First, sub-prime mortgages brought down Lehman Brothers house of cards. Lehman closed its doors to forestall creditors. Like Bear Stearns, which experienced a run on the bank earlier in the year, Lehman was a major fixed income investment bank. Home to the popular Lehman Bond Indicies, the bank manufactured a large percentage of the sub-prime loans that have triggered the 2008 financial crisis. Apparently they weren't able to dump all of the toxic paper to clients, and retained enough that these bonds, for which almost no market exists, when "marked-to-market" were marked down to almost worthless. Lehman reported a $4 billion loss last week, but still was able to report assets, a positive book value, and positive cash earnings (the mark-downs are a non-cash charge). Thus, even though Lehman was probably profitable on a cash basis, the fact that buyers would no longer finance its operations was too much for it. Several last minute attempts to sell Lehman to foreign banks failed because the Fed refused to make another sweetheart deal, as they'd done in March for Bear Stearns.

By the time I read about it, late Sunday night, it was old news. As the clock passed the midnight hour, the reports were of Lehman employees going in on Sunday to clean out their desks, enjoy one last beer and pizza with (former) co-workers. Lehman declared its parent company bankrupt. Subsidiaries are still open for business on Monday. But a broker with no access to funding is necessarily in a liquidating stage. The asset management subsidiaries will be sold to others. Who knows what Lehman creditors will receive. Shareholders have lost everything, as should have been the case with the Bear.

The Lehman saga, however, was only part of the story.

With Lehman gone, attention was bound to turn to Mother Merrill. One blogger is said to have speculated that Lehman was brought down by big Wall Street interests at Goldman who were wanting to hedge their own positions in Goldman shares, but owned restricted stock and were thus prohibited from shorting their own stock. Lehman, it was speculated, was merely a proxy for GS. With Bear and Lehman now gone, Merrill would be the next best short, given that they couldn't short their own shares. Merrill knew that it could never withstand the sort of shorting pressure and intense market pressure that killed off the other two free standing investment banks, so it struck up merger talks with Bank of America after being encouraged to do so by the Fed.

Elsewhere in New York, ten major banks are said to be putting together a $70 billion pool to help financial companies in distress. The Federal Reserve, having spent a great deal of its balance sheet bailing out Bear Stearns, needs help. The big banks figure that if they don't hang together, they will hang separately.

Perhaps the real question is demonstrated by the fourth story coming out of the Big Apple, that the giant insurance company, AIG, has approached the Fed looking to borrow as much as $40 billion because it, too, is having difficulty rolling over debt. The Treasury allowed investment banks to tap into the Federal Reserve in March, in an attempt to keep Lehman and Merrill alive. AIG figures that would help them out, too, and would also like help from Uncle Sam. The question is, if it takes $40 billion to bail out AIG, just how far is that new bank pool of $70 billion going to go?

• How could this happen?

The good news is that most of this news is "old news," simply confirmation of what we already knew, that banks had lost their senses and the markets were going to discipline them severely, with or without help from the regulators. The regulators, it seems, have been much too cozy with these big Wall Street firms for much too long. When Congress passes "privacy laws" that are essentially meaningless, the big firms on Wall Street figured out a way to turn these new laws into a big stick to wield against brokers who try to change firms, which has nothing to do with the original intent of the legislation but is just another example of how the regulators roll over for Wall Street. Some of the biggest buyers of these problems loans and credit derivatives are the highly regulated big national banks. The Adjustable Rate Security crisis happened right under the nost of the Securities and Exchange Commission.

Investors need to realize that the age old joke about, "I'm from the government and I'm here to help" is as big a joke on Wall Street as anywhere else. The S.E.C. isn't going to protect them from Wall Street greed.

Only common sense can do that. Had Wall Street and its regulators demonstrated a bit more common sense in the past decade, the current episode of debt destruction might not have been necessary. Instead, the market is acting like a slow moving car crash and I don't have any idea how many times the car is going to roll. As one Minyanville blogger recently noted, "Rome wasn't burnt in a day."

• Has the May-Investments Outlook Changed?

We're still pretty much on the sidelines when it comes to owning financial stocks, and especially banks and brokerages. However, this sell-off has advanced to the stage where "safe havens" are few and far between. Not even our bond positions have been able to catch a bid. The biggest problem for our portfolios hasn't been Lehman going off the air, but oil prices crashing to below par ($100).

We're in a "no place to hide" market and the only good thing that I can say about that is that high volatility, "throw the baby out with the bathwater" markets are generally experienced more near a market bottom than a market top. Let's hope that is the case this time as well.

In January of 2008 we told clients to expect a difficult first half but that markets would recover by year-end. We observed that after predicting a recession in 2007 (starting with our October 2006 economic update) that we were happy to report that things were not as bad as we'd anticipated; the job market was not as bad and profits outside of the financials and consumer cyclicals sector were hanging in there. The tax rebate earlier in the year also helped keep the economy moving along. After all, it's now September of 2008 and despite this weekend's headlines, the economists are still debating whether or not we're actually in a recession.

Even at our mid-year Economic Update, I gladly announced that our rosy conclusion was that the glass was absolutely half full!

Unfortunately, the last two months of economic statistics haven't been encouraging and the unemployment situation has taken a turn for the worse. Consumer sentiment, which was starting to turn back up (from very depressed levels) will now probably roll over. I keep looking for some good news on the horizon, but it's harder to find than a non-partisan politician. Our prediction for a year-end upturn is clearly at risk and the last thing I want to do is hold on to my forecast just so I don't have to admit it was wrong.

Though I am still officially an optimist at the moment, my confidence level in that outlook is practically nil. The markets are very volatile and will likely "break" in one direction or the other.

Some major piece of good news could result in a strong move up that could turn things around. For instance, if the Federal Reserve would temporarily suspend "mark-to-market" accounting requirements for financial companies, some of the pressure to dump assets would be eliminated. The Fed might want to re-introduce restrictions against naked short sales to make it harder for short sellers to force these companies into a "bank run" sort of scenario where a collapsing stock price sends a signal to the bond market to stop buying a certain company's debt.

There is some good news lurking out there. Tomorrow morning would be a great time for it to make an appearance!

Only 15 days left in September. And counting....

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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