Monday, 30 April 2007

Silly season

At the height of the tech boom in 2000, it seemed that even the flush of a CEO's toilet could send the shares of a tech company higher. We have seen similar movements in speculative resource stocks of late particularly uranium. But unwarranted movements in share prices are not the sole domain of speculative issues as last Thursday in New York showed. Dallas Federal Reserve president Richard Fisher has joined the chorus that believes the effects of the subprime mortgage fiasco haven't yet fully played out.

This might sound like negative news but apparently not. The Philadelphia housing sector index gained more than 3%. Leading the charge, Countrywide Financial Corp. (CFC) rose 3.2%, even after its earnings missed estimates. Woes in the subprime market, it said, subtracted 22% from its profits. Elsewhere Beazer Homes USA Inc. (BZH) rose 5% even after warning that

"it has yet to see any meaningful evidence of a sustainable recovery in the housing market"

and withdrew its outlook for the year. Ryland Group Inc. (RYL) said that it swung to a loss in the first quarter, that it does not expect to meet its prior earnings guidance and couldn't provide new forecasts. No wonder the stock rose 4.3% on such upbeat news.

Analyst's estimates of around 3% growth this quarter are looking overly pessimistic as current reports indicate earnings growth of 6-7%. Some market commentators believe that the better than expected results are the reason for the market's rally. However that would imply that markets had built some negative expectations into stock prices - hard to believe as indexes set new highs. In fact the market barely moves on the release of bad news whilst neutral to mildly positive news can produce 100+ point rallies. Another sign that silliness is well and truly back in season and from a contrarian point of view raises a big red flag.

Wednesday, 25 April 2007

US housing continues to slide

Sales of existing homes dropped 8.4% in March to a seasonally adjusted annual rate of 6.12 million, the lowest since June 2004. This represents the largest decline since January 1989, funnily enough just before the start of a severe housing recession. As I keep saying this is just the beginning. Housing is a leading indicator and the official line about the housing slump being contained is sounding sillier and sillier by the day. I was going to go on about the mounting evidence signalling a long a deep recession that will leave no sector of the US economy unscathed but why bother when Mike Whitney over at counterpunch has summarised the arguments much better than I could. Enjoy.

Is It Too Late to Get Out?

Housing Bubble Boondoggle


Treasury Secretary Henry Paulson delivered an upbeat assessment of the slumping real estate market on Friday saying, "All the signs I look at" show "the housing market is at or near the bottom."


Paulson added that the meltdown in subprime mortages was not a "serious problem. I think it's going to be largely contained."

Wrong again.

Paulson knows full well that the housing market is headed for a crash and probably won't bounce back for the next 4 or 5 years. That's why Congress is slapping together a bailout package that will keep struggling homeowners out of foreclosure. If defaults keep skyrocketing at the present rate they are liable to bring the whole economy down in a heap.

Last week, the Senate convened the Joint Economic Committee, chaired by Senator Charles Schumer. The committee's job is to develop a strategy to keep delinquent subprime mortgage holders in their homes. It may look like the congress is looking out for the little guy, but that's not the case. As Schumer noted, "The subprime mortgage meltdown has economic consequences that will ripple through our communities unless we act."

Schumer's right. The repercussions of millions of homeowners defaulting on their loans could be a major hit for Wall Street and the banking sector. That's what Schumer is worried about---not the plight of over-leveraged homeowners.

Every day now, another major lending institution unveils its plan for bailing out the housing market. Citigroup and Bank of America have joined forces to create the Neighborhood Assistance Corporation of America which will provide $1 billion for the rescue of subprime loans. This will allow homeowners to refinance their mortgages and keep them out of foreclosure. The new "30- year loans will carry a fixed interest rate one point below the prime rate, putting it currently at 5.5 percent. There are no fees, and the banks pay all the closing costs."

But why are the banks being so generous if, as Paulson says, "the housing market is at or near the bottom." This proves that the Treasury Secretary is full of malarkey and that the problem is much bigger than he's letting on.

Last week, Washington Mutual announced a $2 billion program to slow foreclosures (Washington Mutual's subprime segment lost $164 million in the first quarter) while Freddie Mac committed a whopping $20 billion to the same goal. In fact, Freddie Mac announced that it "would stretch the loan term to a maximum of 40 years from the current 30-year limit."

40 years!?! How about a 60 or 80 year mortgage?

Can you sense the desperation? And yet, Paulson says he doesn't see the subprime meltdown as a "serious problem"!

Paulson's comments have had no effect on the Federal Reserve. The Fed has been frantically searching for a strategy that will deal with the rising foreclosures. On Wednesday, The Washington Post reported that "Federal bank regulators called on lenders to work with distressed borrowers unable to meet payments on high-risk mortgages to help them keep their homes".


When was the last time the feds ordered the privately-owned banks to rewrite loans?

Never--that's when.

That gives us some idea of how bad things really are. The details of the meltdown are being downplayed in the media to prevent panic-selling among the public. But the Fed knows what's going on. They know that "U.S. mortgage default rates hit an all-time high in the first quarter of 2007" and that "the percentage of mortgages in default rose to a record 2.87%". In fact, the Federal Reserve and the five other federal agencies that regulate banks issued this statement just last week:

"Prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrowerInstitutions will not face regulatory penalties if they pursue reasonable workout arrangements with borrowers."

Translation: "Rewrite the loans! Promise them anything! Just make sure they remain shackled to their houses!"

Unfortunately, the problem won't be "fixed" with a $30 or $40 billion bailout scheme. The problem is much bigger than that. There is an estimated $2.5 trillion in subprimes and Alt-A loans---20% of which are expected enter foreclosure in the next few years. Any up-tick in interest rates or unemployment will only aggravate the situation.

Kenneth Heebner, manager of CGM Realty Fund (Capital Growth Management), provided a realistic forecast of what we can expect in the near future as defaults increase.

Heebner: "The Greatest Price Decline in Housing since the Great Depression" (Bloomberg News interview)

"The real wave of pain and foreclosures is just beginning.subprimes and Alt-A are both in trouble. A lot of these will go into default. The reason is, that the people who took these out never really intended to fully service the mortgage---they were counting on rising home prices so they could sign on the dotted line without showing what their income was and then 2 years later flip into another junk mortgage and get a big profit out of the house with putting anything down

"There's a $1.5 trillion in subprimes and $1 trillion in Alt-A the catalyst will be declining house prices which is already underway. But as we get a large amount of these $2.5 trillion mortgages go into default, we'll see foreclosed houses dumped on an already weak market where homebuilders are already struggling to sell there houses. The price declines which have started will continue and may even accelerate in some of the hotter markets. I would expect that housing prices in "2007 will decline 20% in a lot of markets".

"What you are going to see is the greatest price decline in housing since the Great Depression..The one thing that people should not do, is go near a CDO or a residential mortgage backed security rated Triple A by Moody's and S&P because these are going to get down-graded by the hundreds of millions---because they are secured by subprime and Alt-A mortgages where there'll be massive defaults".

Question: "Will the losses in the mortgage market exceed those in the S&L crisis?"

Heebner: "They're going to dwarf those losses because the losses could easily approach $1 trillion---that dwarfs anything that has ever happened. Enron was $100 billion---this will be far greater than that..The good news is that most of these loans are owned by Hedge FundsYou hedge funds buying these subprime and Alt-A loans and leveraging them at 10 to 1. They buy a pool of mortgages at 8% and they borrow against it in yen for 3% and then lever it at 10 to 1so you have a lucrative profit And the hedge fund you are running, the manager is going to get 20% of the gain---so even if it's a year before you go broke; you get rich until the fund is shut down".

Heebner added this instructive comment: "The brokerage firms created "securitization" they know the products are toxic. I don't think they are going to suffer losses; they simply passed them on to everyone else. The only impact this will have is the profits that flow from it will get less.But it is less than 3% of revenues in even the most exposed brokerage firm so THEY'RE NOT GOING TO GET CAUGHT."

Although Heebner believes the brokerage houses will do fine; the same is not true for the small investor. Nearly 70% of subprimes have been securitized. That means that the vast number of shoddy "no down payment, no document, interest-only" loans (that are headed for default) have been transformed into securities and sold to hedge funds. As the housing market continues to falter, these funds will plummet at an inverse rate to the amount of leverage that has been applied. That may explain why, (according to Bloomberg Markets) the "wealthiest Americans have been bailing out" of hedge funds at an alarming rate. A report in last Thursday's New York Times stated:

"Americans with a net worth of at least $25 million, excluding the value of their primary homes, reduced their exposure to hedge funds in 2006"-- The amount of money held by wealthy investors in hedge funds has dropped dramatically-- "The average balance, which was $2.8 million in 2005, was just $1.6 million last year, a 43 percent decline".

So, what do America's richest investors know that the rest of us don't?

Could it be that the over-leveraged hedge funds industry is about to get hammered by the subprime implosion?

If so, it won't be the brokerage houses or savvy insiders who get hurt. It'll be the little guys and the pension funds that take a drubbing.

In Henry C K Liu's "Why the Subprime Bust will Spread" (Asia Times) the author states that the bursting housing bubble will trigger a major pension crisis. After all, who are the "institutional investors? They are mostly pension funds that manage the money the US working public depends on for retirement. In other words, the aggregate retirement assets of the working public are exposed to the risk of the same working public defaulting on their house mortgages". (Liu)

The origins of the housing bubble are complex, but they are worth understanding if we want to know how things will progress. The housing bubble is not merely the result of low interest rates and shabby lending practices. As Liu says, "the bubble was caused by creative housing finance made possible by the emergence of a deregulated global credit market through finance liberalization. The low cost of mortgages lifted all US house prices beyond levels sustainable by household income in otherwise disaggregated markets". The deregulated cross-border flow of funds (via the yen low interest "carry trade" or the $800 billion current account deficit) have played a major role in inflating the US real estate market.

Liu adds, "Since the money financing this housing bubble is sourced globally, a bursting of the US housing bubble will have dire consequences globally."Since nearly 50% of "securitized" mortgage debt is owned by foreign investors; the subprime meltdown is bound send tremors through the entire global financial system.

The housing decline is further complicated by Wall Street innovations in derivatives trading which has generated trillions of dollars in "virtual" wealth and is affecting the Feds ability to control inflation through interest rate manipulation. As Kenneth Heebner said, "You have hedge funds buying these subprime and Alt-A loans and leveraging them at 10 to 1. They buy a pool of mortgages at 8% and they borrow against it in yen for 3% and then lever it at 10 to 1so you have a lucrative profit."

In other words, low interest foreign capital has flooded US markets and contributed to distortions in housing prices.

In her recent article "War Drags the Dollar Down", Ann Berg refers to Wall Street's "swirling galaxy of exotic finance" which has "worked magic for the government and the elite", but has yet to weather a severe downturn in the economy.

But how will market deal with sudden downturn in the hedge fund industry? Will the dodgy subprimes and shaky collateralized debt obligations (CDOs) trigger a crash or has the risk been wisely dispersed through derivatives trading?

No one really knows.

As Berg says, "Derivatives numbers are staggering. The Bank for International Settlements estimates that the notional amount of derivatives traded on regulated exchanges topped a quadrillion dollars last year and that the outstanding unregulated off-exchange (called over-the-counter OTC) amount stood at $370 trillion in June 2006. Because the OTC market is composed of endless strings of bilateral transactions the systemic risk is unknown."

The comments of the President of the New York Fed, Timothy Geithner, help to clarify the abstruse activities of the modern market:

"Credit market innovations have transformed the financial system from one in which most credit risk is in the form of loans, held to maturity on the balance sheets of banks, to a system in which most credit risk now takes an incredibly diverse array of different forms, much of it held by nonbank financial institutions that mark to market and can take on substantial leverage."

Geither's right. The markets now operate as unregulated banks generating mountains of credit through massively leveraged debt instruments---a monster credit bubble larger than anything in the history of capitalism.

So, where is all this headed?

No one really knows. But when the housing bubble crashes into Wall Street's credit bubble,; we can expect the "big bang". That may explain why America's wealthiest investors are running for cover before the whole thing blows. (A number of investors have already cashed out and put there holdings into foreign funds and currencies)

One thing is certain ---time is running out. With $1 trillion in subprimes and Alt-A loans headed for default the system is facing its greatest challenge. US- GDP has been revised to a measly 1.8%, foreign investment is down, and the dollar is losing ground to the euro on an almost weekly basis.

Falling home prices have already precipitated a number of other problems. For example, Gene Sperling reports in "Housing Bust Meets the Equity Blues" that "The Fed data showed an amazing expansion (in Mortgage-Equity Withdrawal). In 1995, active MEW had been $37 billion. By the fourth quarter of 2005, it soared to $532 billion annualized, a 14-fold expansion". These equity withdrawals have translated into consumer spending which accounts for at least 1 full percentage point of GDP. Declining house prices means that extra boast for the economy will now disappear.

Foreclosures are soaring and expected to get worse for the next two years at least. In California foreclosure filings jumped 79% in March alone. Other "hot markets" are reporting similar figures.

The glut of new homes for sale on the market has slammed sales of the nation's major builders; most are reporting profits are down by 40% or more.

The collapse of the subprime mortgage market is also pushing some big U.S. homebuilders toward Chapter 11. According to Bloomberg News, "Some builders are staying out of bankruptcy by relying on the profits they made when sales boomed" in 2004 and 2005. Starting next year they must begin to repay $3.6 billion in public debt in what will certainly be a falling market. The prospects don't look good.

Also, Credit card debt is way up (nearly 7% in one year) and economists are predicting that the trajectory will continue now that home equity is vanishing. Americans savings rate is in negative numbers and the steep increase in credit card debt (with its high interest rates) only compounds the problem. The American consumer has now compiled more personal debt than anytime in history.

The Grim Reaper Meets the Housing Bubble

Those who follow developments in real estatehave heard many of the wacky anecdotes related to the housing bubble. Stories abound of young people buying homes just to pay off tens of thousands of dollars of collage loans with their "presto"-equity ---or low paid construction laborers securing 105% loans without any proof of income and a poor credit history. One of the stories that got national attention was about Alberto and Rosa Ramirez, who worked as strawberry pickers in the fields around Watsonville each earning about $300 a week. They (somehow?) qualified for a loan of $720,000 which paid for a "new" four-bedroom, two-bath house in Hollister.

It's sheer madness!

Obviously, those days are over. The speculative frenzy that was generated by the Fed's low interest rates, the banks lax lending standards, and the deregulated global credit market is drawing to a close. The fallout from the collapse in subprime-loans will roil the stock market and hedge funds, but, as Heebner says, the investment banks and brokerage firms will escape without a bruise.

Where's the justice?

Despite Hank Paulson's cheery predictions, we are no where "near the bottom". In fact, a recent survey showed that only 1 in 7 Americans believe that house prices will go down. Even now, very few people grasp the underlying issues or the potential for disaster. We're on a treadmill to oblivion and they think it's a merry-go-round.

As housing prices tumble, more homeowners will experience "negative equity", that is, when the current value of their home is less than the sum of their mortgage. This is the very definition of modern serfdom.

We can expect to see an erosion of confidence in the market, a rise in inventory, and a steady increase in defaults.More and more people will walk away from their homes rather than be hand-cuffed to an asset that loses value every day. This could transform a "housing correction" into a nation-wide financial calamity.

Many peoples' futures are linked directly to the "anticipated" value of their homes.It is impossible to determine how shocked they'll be when prices retreat and equity shrivels. The housing flame-out has all the makings of a national trauma"another violent jolt to the fragile American psyche.

So far, we're still in the first phase of a process that will probably play out for 10 years or more. (Judging by Japan's decades-long decline) None of the bailout plans are large enough to make any quantifiable difference.The numbers are just too big.

Housing prices are coming down and the real estate market will return to fundamentals. That much is certain. The law of gravity can only be ignored for so long.

Just don't count on a "soft landing".

Tuesday, 24 April 2007

Containment, US 1Q07 earnings, Aust CPI

First on the containment of the U.S mortgage meltdown, General Motors (GM) CEO Rick Wagoner said that auto sales would be impacted by the housing market whilst the biggest U.S home mortgage lender Countrywide Financial (CFC) said that tighter regulations would lead to an increase in foreclosures. Remember boys and girls this is just the beginning.

On the earnings front in the U.S with less than 25% of companies having reported so far 1Q07 earnings for the S&P 1500 (comprising of the S&P 500, S&P Midcap 400 and S&P Smallcap 600) has been tracking around 4.3%, quite a drop from the 14.1% registered in 4Q06. Earnings have been weighed down by financials and semi-conductors however the earnings growth rate is tipped to improve as more reports come in.

Some very benign inflation figures out of Australia today put a real dampener on an interest rate rise at the next RBA meeting in May. The Australian economy posted it's lowest annual inflation rate for three years rising just 0.1% in the March quarter for an annual rate of 2.4%.That all but knocks on the head an interest rise in May and puts one off at least until July but may even signal the end of rate rises for the year. It will be interesting to see if this slowdown is more than just a blip on the radar in the coming months. I suspect it will be and besides, since I earn most of my money in yen it wouldn't hurt to squash expectations of an Aussie rate rise.

Friday, 20 April 2007

Tracking the US Housing meltdown

As mentioned in a post last week US homebuilder D.R. Horton Inc (DHI) said sales orders had slumped 37% from a year ago for the quarter ended March 31st 2007. Yesterday the company announced an 85% drop in profit to go along with the slump in sales for the quarter. And whilst some are still hoping for a rebound in sales for the Spring selling season D.H. Horton Chief Exceutive Donald Tomnitz doesn't sound so optimistic stating:

"We're still faced with a liquidity crisis in the mortgage industry and I think that's going to get worse over the next two to three quarters as opposed to better,"

The company also announced that they had cut just over 25% of their workforce from last spring.

Also this week another large US homebuilder, Pulte Homes Inc. (PHM) announced that new orders fell 21% in 1Q07 from a year ago and expected their net loss to be in the range of 34 - 38 cents per share, a lot worse than their previous estimate of between break-even to a loss of 10 cents a share.

From the evidence so far 1Q07 earnings are meeting or slightly bettering expectations of around 7.5% growth across the S&P 500 universe of stocks and whilst it represents a significant slowing in earnings from the previous 13 quaters of double digit growth it is by no means disastrous. However it is a little early to guage the full effect of the mortgage lenders and homebulders on other sectors but expect the earnings infection to spread as the year progresses.

Wednesday, 18 April 2007

Food for thought.

I read this over at Signs of the Economic Apocalypse and thought it was worth repeating here for anyone interested.

Doomsday for the Greenback?

Dollar Madness


"Of all the contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with paper money."

-- Daniel Webster

The American people are in La-la land. If they had any idea of what the Federal Reserve was up to they'd be out on the streets waving fists and pitchforks. Instead, we go our business like nothing is wrong.

Are we really that stupid?

What is it that people don't understand about the trade deficit? It's not rocket science. The Current Account Deficit is over $800 billion a year. That means that we are spending more than we are making and savaging the dollar in the process. Presently, we need more than $2 billion of foreign investment per day just to keep the wheels from coming off the cart.

Everyone agrees that the current trade imbalances are unsustainable and will probably trigger major economic disruptions that will thrust us towards a global recession. Still, Washington and the Fed stubbornly resist any change in policy that might reduce over-consumption or reverse present trends.

It's madness.

The investor class loves big deficits because they provide cheap credit for Bush's lavish tax cuts and war. The recycling of dollars into US Treasuries and dollar-based securities is a neat way of covering government expenses and propping up the stock market with foreign cash. It's a "win-win" situation for political elites and Wall Street. For the rest of us it's a dead-loss.

The trade deficit puts downward pressure on the dollar and acts as a hidden tax. In fact, that's what it is--a tax! Every day the deficit grows, more money is stolen from the retirements and life savings of working class Americans. It's an inflation bombshell obscured by the bland rhetoric of "free markets" and deregulation.

Consider this: In 2002 the euro was $.87 on the dollar. Last Friday (4-6-07) it closed at $1.34-- a better than 50% gain for the euro in just 4 years. The same is true of gold. In April 2000, gold was selling for $279 per ounce. Last Friday, at the close of the market it skyrocketed to $679.50---more than double the price.

Gold isn't going up; it's simply a meter on the waning value of the dollar. The reality is that the dollar is tanking big-time, and the main culprit is the widening trade deficit.

The demolition of the dollar isn't accidental. It's part of a plan to shift wealth from one class to another and concentrate political power in the hands of a permanent ruling elite. There's nothing particularly new about this and Bush and Greenspan have done nothing to conceal what they are doing. The massive expansion of the Federal government, the unfunded tax cuts, the low interest rates and the steep increases in the money supply have all been carried out in full-view of the American people. Nothing has been hidden. Neither the administration nor the Fed seem to care whether or not we know that we're getting screwed --it's just our tough luck. What they care about is the $3 trillion in wealth that has been transferred from wage slaves and pensioners to brandy-drooling plutocrats like Greenspan and his n'er-do-well friend, Bush.

These policies have had a devastating effect on the dollar which has been slumping since Bush took office in 2000. Now that foreign purchases of US debt are dropping off, the greenback could plunge to even greater depths. There's really no way of knowing how far the dollar will fall.

That puts us at a crossroads. We are so utterly dependent on the "charity of strangers" (foreign investment) that a 9% blip in the Chinese stock market (or even a .25 basis point up-tick in the yen) sends Wall Street into a downward spiral. As the housing market continues to unwind, the stock market (which is loaded with collateralized mortgage debt) will naturally edge lower and foreign investment in US Treasuries and securities will dry up. That'll be doomsday for the greenback as central banks across the planet will try to unload their stockpiles of dollars for gold or foreign currencies.

That day appears to be quickly approaching as the 3 powerhouse economies are overheating and need to raise interest rates to stifle inflation. This will make their bonds and currencies all the more attractive for foreign investment; diverting much needed credit from American markets.

Just imagine the effect on the already-hobbled housing market if interest rates were suddenly to climb higher to maintain the flow of foreign capital?

The ECB (European Central Bank), Japan and China are all cooperating in an effort to "gradually" deflate the dollar while minimizing its effects on the world economy. In fact, China even waited until the markets had closed on Good Friday to announce another interest rate increase. Clearly, the Chinese are trying to avoid a repeat of the 400 point one-day bloodbath on Wall Street in late February 07.

Japan has also tried to keep a lid on interest rates (and allowed the carry trade to persist) even though commercial property in Tokyo is "red hot" and liable to spark a ruinous cycle of speculation.

But how long can these booming economies avoid the interest rate hikes that are needed for curbing inflation in their own countries? The problem is, of course, that by fighting inflation at home they will ignite inflation in the US. In other words, by strengthening their own currencies they weaken the dollar--it's unavoidable.

This is bound to hurt consumer spending in the US which will ripple through the entire global economy.

The problems presented by the falling dollar can't be resolved by micromanaging or jawboning. In truth, there's no more chance of a "soft landing" for the dollar than there is for the over-bloated real estate market. Greenspan's bubble economy is headed for disaster and there's not much that anyone can do to lessen the damage. As housing prices fall and homeowners are no longer able to tap into their equity, consumer spending will slow, the economy will shrink and the Fed will be forced to lower interest rates.

Unfortunately, at that point, lowering rates won't be enough. Interest rates need at least 6 months to take hold and, by then, the steady drumbeat of foreclosures and falling real estate prices will have soured the public on an entire "asset class" for years to come. Many will see their life savings dribble away month by month as prices continue to nose-dive and equity vanishes into the ether. These are the real victims of Greenspan's low interest rate swindle.

The Federal Reserve is fully aware of the harm they have inflicted with their low interest rate boondoggle. In a 2006 statement the Fed even acknowledged that they knew that trillions of dollars in speculation was being funneled into the real estate market:

"Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission."

"Monetary transmission" indeed?!? Trillions of dollars in mortgages were issued to people who have no chance of paying them back. It was a shameless scam. Still, the policy persisted in a desperate attempt to keep the US economy from collapsing into recession. The upshot of this misguided policy was "the largest equity bubble in history" which now threatens America's economic solvency.

Author Benjamin Wallace commented on the Fed's activities in an article in the Atlantic Monthly, "There Goes the Neighborhood: Why home prices are about to plummet"and take the recovery with them":

"Let's assume for a moment that enough people get fooled, and the refinancing boom gets extended for another year. Then what? The real problem hits. Because if you think Greenspan's being cagey on refinancing, the truth he's really avoiding talking about is that we're in the midst of a huge housing bubble, on a scale only seen once before since the Depression. Worse, the inflated housing market is now in an historically unique position, as the motor of the rest of the economy. Within the next year or two, that bubble is likely to burst, and when it does, it very well may take the American economy down with it."

Or this from Robert Shiller in his "Irrational Exuberance":

"People in much of the world are still overconfident that the stock market, and in many places the housing market, will do extremely well, and this overconfidence can lead to instability. Significant further rises in these markets could lead, eventually, to even more significant declines. The bad outcome could be that eventual declines would result in a substantial increase in the rate of personal bankruptcies, which could lead to a secondary string of bankruptcies of financial institutions as well. Another long-run consequence could be a decline in consumer and business confidence, and another, possibly worldwide, recession".

If it is not handled properly, the housing collapse could result in another Great Depression. America no longer has the (manufacturing) capacity to work its way out of a deep recession. While the Fed was sluicing $11 trillion into the real estate market via low interest loans; America's manufacturing sector was being carted off to China and India in the name of globalization. Without capital investment and increased factory production, economic recovery will be difficult if not impossible. The so-called "rebound" from the 2001 recession was due to artificially low interest rates and easy credit which inflated the housing market. It had nothing to do with increases in productivity, exports, or paying off old debts. In other words, the "recovery" was not real wealth creation but simply credit expansion. There's a vast chasm between "productivity" and "consumption" although Greenspan never seemed to grasp the difference.

A penny borrowed is not the same as a penny earned"although both may cause a slight bump in GDP. Greenspan's attitude was aptly summarized by The Daily Reckoning's Addison Wiggin who said, "GDP measures debt-fueled consumption--it really only measures the rate at which America is going broke".


America's biggest export is its fiat-currency which foreigners are increasingly hesitant to accept.

Can you blame them?

They have begun to figure out that we have no way of repaying them and that the "full faith and credit" of the United States is about as reliable as a Ken Lay-managed 401-K retirement plan.

The fragility of the US economy will become more apparent as Greenspan's housing bubble continues to lose air and consumer spending remains flat. As we noted earlier, home equity withdrawals are drying up which will slow growth and discourage foreign investment. The meltdown in subprime loans has drawn more attention to the maneuverings of the banks and mortgage lenders and many people are getting a clearer understanding of the Federal Reserve's role in creating this economy-busting monster-bubble.

The 10% to 20% yearly increases in property values are unprecedented. They are "pure bubble" and have nothing to do with increases in wages, demand, productivity, capital investment or GDP. It was all "froth" generated by the world's greatest Frothmeister, Alan Greenspan.

As Addison Wiggin notes, "There is only one real source of wealth: a healthy and competitive environment involving the exchange of goods coupled with control over deficit spending."

Elites at the Federal Reserve and in the Bush administration have steered us away from this "tried and true" course and put us on the path to debt and catastrophe. It won't be easy to restore our manufacturing base and compete again in the open market, but it must be done. Strong economies require that their people produce things that other people want. This is a fundamental truism that has been lost in the smoke and mirrors of Greenspan's shenanigans at the Fed.

Regrettably, we are probably facing a decades-long economic downturn in which the dollar will weaken, stocks will fall, GDP will shrivel, and traditional standards of living will decline.

The trend-lines in the real estate market will most likely be the inverse of what they have been for the last 10 years. This will dramatically affect consumer spending (70% of GDP) and put additional pressure on the dollar.

The dollar is already in big trouble--the only thing keeping it afloat is foreign purchases of US debt by creditors who don't want to be left holding trillions in worthless paper.(US debt is Japan's single greatest asset!) These "net inflows" have created a false demand for the dollar which will inevitably dissipate as central banks continue to diversify.

Last week the IMF issued a warning that there would have to be a "substantial" decline in the dollar to bring the trade deficit to sustainable levels. That, of course, is the intention of the Fed and Team Bush"to reduce the debt-load by deflating the currency. It's a crazy idea. No one destroys the buying power of their currency to pay off their debts. It just illustrates the recklessness of the people in charge.

Also, on March 20, 2007 the Governor of China's Central Bank Zhou Xiaochuan announced "that China will not accumulate more foreign reserves and will cut a small amount of current reserves for the formulation of a new currency agency". Zhou's statement is a hammer-blow to the dollar. The US needs roughly $70 billion in foreign investment per month to cover its current trade deficit. China is one of the largest purchasers of US debt. If China diversifies, then the dollar will fall and the aftershocks will ripple through markets across the world.

The Chinese are very careful about how they word their economic statements. That's why we should take Zhou's comments seriously. Three weeks ago he issued an equally ominous statement saying, "China will diversify its $1 trillion foreign exchange reserves, the largest in the world, across different currencies and investment instruments, including in emerging markets." (Reuters)

This should have been a red flag for currency traders, but the media buried the story and the markets dutifully shrugged it off. The truth is that our relationship with the Chinese is changing very quickly and the days of cheap credit and a "high-flying" dollar are coming to an end.

70% of China's currency reserves are in US dollars. The effect of "diversification" will be devastating for the US economy. It increases the likelihood of hyperinflation at the same time the housing market is in its steepest decline in 80 years. When currency crises arise at the same time as economic crises; the problems are much more difficult to resolve.

Doomsday for the Greenback

It is impossible to fully anticipate the effects of the falling dollar. The dollar is a currency unlike any other and it is the cornerstone of American power"political, economic and military. As the internationally-accepted reserve currency, it allows the Federal Reserve to control the global economic system by creating credit out of "thin air" and using fiat-scrip in the purchase of valuable manufactured goods and resources. This puts an unelected body of private bankers in charge of setting interest rates which directly affect the entire world.

Iraq has proven that the US military can no longer enforce dollar-hegemony through force of arms. New alliances are forming that are reshaping the geopolitical landscape and signal the emergence of a multi-polar world. The decline of the superpower-model can be directly attributed to the denominating of vital resources and commodities in foreign currencies. America is simply losing its grip on the sources of energy upon which all industrial economies depend. Iraq is the tipping point for America's global dominance.

When foreign central banks abandon the greenback the present system will unwind and the "unitary" model of world order will abruptly end.

This may be a painful experience for Americans who will undoubtedly see a sharp fall in current living standards. But it also presents an opportunity to disband the Federal Reserve and restore control of the nation's currency to the people's legitimate representatives in the US Congress.

This is the first step towards removing the cabal of powerbrokers in both political parties who solely represent the narrow ambitions of private interests.

The War on Terror is a public relations ploy that is intended to disguise the use of military and covert operations to secure dwindling resources to maintain dollar supremacy. It is a futile attempt to control the rise of China, India, Russia and the developing world while preserving the authority of western white elites.

The strength of the euro portends increasing competition for the dollar and a steady decline in America's influence around the world. This should be seen as a positive development. Greater parity between the currencies suggests greater balance between the states--hence, more democracy. Again, the superpower model has only increased terrorism, militarism, human rights violations and war. By any objective standard, Washington has been a poor steward of global security.

The falling dollar also suggests growing political upheaval at home brought on by economic distress. We should welcome this. America needs to remake itself"to recommit to its original principles of personal freedom, civil liberties and social justice--to reject the demagoguery and warmongering of the Bush regime"to reestablish our belief in habeas corpus, the presumption of innocence and the rule of law. Most important, we need to reclaim our honor.

Big changes are coming for the dollar; it's just a matter of whether we allow those changes to bog us down in recriminations and pessimism or use them to create a new vision of America and restore the principles of republican government. It's up to us.

Monday, 16 April 2007

PBP's little legal problem

Well I can't say I wasn't warned. On March 15th PBP announced they had acquired some branded pharmaceutical products from Johnson & Johnson. In that same announcement they also mentioned that in their short term provisions account was an amount of $100,000 in relation to an intellectual property claim against PBP and others going back a number of years. PBP stated that:

"claims made by the plaintiff against the other defendents which, if substantiated, could result in the plaintiff's claims against Probiotec being materially higher than the amount Probitech has provisioned for."

Today PBP's little legal tangle has gotten bigger announcing that:

"all of the 8 respondents to the Phoscal Claim, including three companies in the Probiotech Group, have been ordered jointly and severally, to pay the claimant's costs."

As an added bonus the other respondents don't have the funds so PBP may have to cover all the costs. If that wasn't enough a seperate decision on damages is yet to heard.

Interestingly the prospectus mentioned nothing about the legal case. Last month the possibilty of a liability was mentioned and now today the possibility has become reality with PBP likely to be forking out for other parties and with damages claims yet to come. Clearly the revelations are getting worse and sentiment justifiably so has turned very negative, the stock closing down 13.4% at $0.90. PBP claims that the bulk of their liability will be attributable to the costs orders and not damages however that is hardly reassuring given the events so far.

Management assurred me today that the recently announced acquisition will be unaffected and that prospectus forecasts will be met. That is before taking into account abnormals of course. The claim against PBP will of course be classified as an abnormal and as such it doesn't affect my valuation of the stock signifcantly. I have raised the discount rate to 16% to reflect the increased risk of the stock bringing my valuation down to $1.00. However that doesn't mean I'll be rushing out to buy more. The legal proceeding is expected to drag on for months as the extent of PBP's liability is determined.

Small questions I had over the capability and integrity of management have turned into big ones. The kind that would have been useful before entering the stock. Needless to say I didn't do my due diligence as well as I could have. However I find it hard to sell at current prices since it is already trading below fair value and the business itself is performing well.

During the next week confirmation by the ACCC on the acquisition will take a back seat as the focus will be on how PBP proceed with the Phoscal claim. The ride so far has been an interesting one for all the wrong reasons and I expect it to get bumpier in the short term.

Saturday, 14 April 2007

The P/E = value myth

Of late there has been an increase in the the popular pastime of market commentators pointing to the P/E as an indicator that the market is not overvalued. The P/E ratio is also used as a popular tool for individual stock selection. Those who employ this kind of measure would say that a company trading on a low P/E is cheap and a high one expensive. They may even be more sophisticated and say that a company trading on a high P/E may not necessarily be expensive because of high rates of growth in profits.

However the P/E ratio tells you nothing about how that profit growth is achieved. It doesn't tell you whether growth is achieved organically or with the aid of large injections of equity or debt or both. The P/E ratio doesn't help investors identify businesses with superior economics. It doesn't tell you the proportion of dividends paid out to the owners (shareholders) of the business and therefore how much of its profits can be reinvested at high incremental rates of return. If you were to point these shortcomings out to those who embrace the P/E as a measure of value you would probably be greeted with a blank stare or a hostile rebuke. Below is a short article from the Stockval website that neatly summarises the shortcomings of the P/E as a measure of value.

The Price/Earnings (P/E) ratio is simply the market price of a company's shares divided by the company's earnings per share. It is widely (and wrongly) regarded as a measure of value - supposedly a way to quickly determine if a company's shares are cheap.

Market commentators, amateur investors and even some professionals use it because it is easy to calculate. But for investment success the path of least resistance is not reliable.

Two companies, each with $10 of equity, producing a return on equity of 5%, and each trading on a P/E ratio of 10, would produce entirely different returns to the investor if there was any variation in the dividend payout ratios. For this reason the P/E ratio of 10 has told the investor nothing about which company is better value.

Put simply, Price is what you pay, but Value is what you get. Because the P/E ratio uses price it cannot estimate value.

Wednesday, 11 April 2007

What will 1Q07 earnings tell us?

1Q07 earnings season kicked off in the US this week with Alcoa reporting a robust 9% increase in earnings. This is tipped to be the first quarter in 14 to register less than 10% growth across S&P500 stocks. Senior investment strategist at Standard & Poor's, Stan Stovall is expecting a 5% increase in earnings down from the 8% originally forecast whilst Thomson Financial expects earnings to rise only 3.3% for 1Q07. Whatever the number it is certain to be lower than the 12%+ recorded in 4Q07.

As important as the actual numbers will be the outlook given by companies for the rest of FY2007. The full impact of the sub prime story and the housing slowdown is yet to play out. Reassuring lines of containment continue to flow from the mouths of officals in high places whilst the data suggests otherwise.

Homebuilder D.R. Horton Inc. (DHI) provided the latest to piece of evidence suggesting the hoped-for housing recovery is still on hold. 1Q07 net sales orders slumped 37% from a year earlier whilst the rate of cancellations in 2Q07 were basically unchanged from the previous quarter at 32%. CEO Doanld Horton stated that the Spring sales season:

"has not gotten off to its usual strong start." "Market conditions for new home sales continue to be challenging in most of our markets as inventory levels of both new and existing homes remain high,"

Last week another homebuilder Ryland Group Inc.(RYL) warned that they expected to post a loss for 1Q07 citing asset writedowns of about $65m. CEO Chad Dreier stated:

"At the end of the fourth quarter, we were cautiously optimistic that pricing had begun to stabilize." "However, as the first quarter progressed, it became clear that aggressive pricing strategies persisted in several markets, requiring us to write down the value of some of our assets,"

Below are some more quotes from analysts in the last few weeks about the state of the housing market, earnings and the impact of the subprime meltdown that make for interesting reading.

"The severity of the subprime mortgage meltdown has increased our concerns about the outlook for the housing market," "Specifically, we are increasingly concerned that the combination of reduced credit availability and increasing foreclosures will put significant downward pressure on what we believe to be an already-unstable housing market," "Indeed, based on our analysis of current levels of excess supply, we believe housing prices need to fall at least 10% before the market can stabilize." - Stifel Nicolaus analysts.

The U.S. housing market is "out of balance, with substantial further adjustment to the inventory of new homes needed." - Citigroup

Key causes of lower orders in the housing market are:"A combination of tougher price competition, as more builders shift their pricing strategy to chase volume, and further deterioration in market conditions at the start of the key selling season." Also cancellations will continue to squeeze home prices "as home builders typically discount [speculative] homes more aggressively." - Daniel Oppenheim, Banc of America

"We expect [cancellation] rates to remain elevated in [2007], as the benefit from price reductions is offset by the negative impact from tighter credit standards." "In turn, this will generate further margin pressure and delay the timing for a recovery." - Margaret Whelan, UBS.

"Subprime concerns could affect a lot of industries." "That's why corporations are going to be very cautious in their outlooks." - Peter Cardillo, Avalon Partners.

Sunday, 8 April 2007

My Portfolio: 5 month return

After 5 months My Portfolio is up 13.8% as compared to an 11.8% rise in the All Ords. Once again there is little to be gained from reading into the performance of long term investments over such a relatively short time frame.

Last month I made the comment that my portfolio had been remarkably less volatile than the broader market. Looking at the graph below it seems I opened my mouth too soon. Volatility is back in a big way and my portfolio has been no exception. With uncertainty surrounding global financial markets continued volatility should be expected in the near term.

Thursday, 5 April 2007


Repeated assurances from Fed officials about the contained nature of the sub-prime debacle are starting to sound hollow. Actually for those who were paying attention they always did. On Wednesday Electronic retailer Circuit City Stores Inc. (CC) issued a downbeat forecast for 1H07 citing "macroeconomic headwinds" such as higher energy prices, the housing market and the volatility in subprime lending.

Also on Wednesday head of the Dallas Fed Bank Richard Fisher remarked:

"While the subprime damage is largely contained, I do not mean that the market will or should refrain from punishing those who neglected time-proven rules of prudence. Nor am I suggesting that the neglect of prudent practices has not bled into other types of credit -- such as the Alt-A market,"

"the housing markets may "feel some short-term pain" because 40% of home buyers last year were nonprime, either subprime or Alt-A loans. This pain will make it "less clear whether housing construction has bottomed and how long the housing downturn may last."

So basically the sub-prime problem is contained but we can't tell how contained it is. It's all about degrees. An interesting question might be; at what point is it considered not to be contained? After his reassuring tones Fisher then asked his audience of Texas mortgage Bankers for suggestions of reasonable measures to make sure the problems in the subprime sector do not lead to "systemic contamination" in the financial sector. One wonders what Fisher would be like as an MD. "Well sir we think your cancer is contained but do you have any suggestions on how we might stop it from spreading?"

Tuesday, 3 April 2007

RBA yay or nay? Does it really matter?

All eyes in Australia are focussed on the RBA's decison on interest rates tomorrow. About half the nations economists believe the RBA will raise rates 0.25% to 6.5%. In the last few weeks there has been ample evidence to support the case for a rise. Strong retail sales figures for February, housing approvals up 10% and inflation on the increase.

The market of course will take any rate rise negatively. Traditional logic tells us that higher interest rates make equities less attractive and cash more attractive. However rising interest rates also tell us something about the state of the economy. Indeed in Australia we have a tight labour market, high levels of business investment and robust consumer spending. Corporate profits for the year to June 30 will be strong. The housing market is showing signs of a turnaround or is it a false start?

But does any of this really matter? So what if the housing market has made a false start or the US or Chinese economy implodes tomorrow. If you are invested in excellent businesses with strong economics and have purchased them at reasonable prices what have you got to worry about? Precisely nothing, leave the short term guessing game to the speculators and be safe in the knowledge that you have invested intelligently.