Shanghai: Mr. Wang’s Bad Timing

A staple of 19th century popular literature was the lurid expose of the glamour and grit of the modern metropolis, be it London, Paris or New York.   These books invariably highlighted the cruel contrast between airy boulevards lined with elegant townhouses and, right behind them in the middle of city blocks, ramshackle warrens of courts and alleys packed with malnourished inhabitants living in dark, dank, pestilential lodgings. The word “overcrowded” does not do justice; one slum in central London had 256 residents per acre.

Happily, inequality is not so stark in today’s Shanghai, but it’s still pretty dramatic. Aura Lounge, on the 52nd floor of the Ritz Carlton in Pudong, was fully booked at 4:00 PM on a Wednesday; beautiful people in fashionable garb enjoyed tea and scones as they peered out at the nearby financial towers, elegantly enveloped in smog. BMW’s, Porsches, Mercedes and other luxury vehicles are common in Shanghai, and the buyers are locals, not rich tourists.

Quite a few of these high-living nouveaux riches are what I call “Red Robber Barons”—government bureaucrats who miraculously struck it rich while orchestrating China’s modernization over the past few decades. They are not all big shots at the pinnacle of the Beijing bureaucracy. The China Daily told the story of a “low level official in Hebei province” who stashed $19.5 million in cash in his house, along with 37 kilograms of gold and 68 property ownership certificates. Who knew that being the “general manager” of a provincial state-owned water company could be so lucrative?

A Traditional Working-class Neighborhood

I got some sense of how “the other half” lives when we visited a neighborhood that is just a five-minute drive from the oh-so-chic and over-priced Peninsula Hotel. We were on a tour chronicling the history of Jews in Shanghai; this particular neighborhood is where Jews escaping the Holocaust had to live in the 1930s and 1940s. (It was not really a “ghetto” because Jews lived alongside Chinese citizens.)

We visited the house of Mr. Wang, in a neighborhood of 19th century two-and-three story brick buildings. Turning off a major street, we entered a narrow lane crowded with small shops, mini-bikes, bicycles and residents preparing food, playing cards, etc. One gentleman was squatting on the sidewalk, skinning a couple of live chickens. On one side of the lane is a pit, recently covered with a metal shield, where residents dump their chamber pots (there is little indoor plumbing in the neighborhood). Running off this lane are even more narrow passageways, only about eight feet wide, which provide access to block upon block of low brick tenements.

Mr. Wang moved to the neighborhood in 1947 and purchased a three-story house. Bad timing: The Communists seized control of China two years later and informed Mr. Wang he would be sharing his house with several other families. The front room of the first floor is a small, dark kitchen which was once used by at least three families. It has three tiny hot plates and three dim light bulbs dangling from the ceiling. To avoid disagreements over paying the electric bill, each hot-plate / light bulb combination runs on a separate electric meter. Brilliant solution to a perennial problem! I am not completely clear about how space was allocated in this small abode, but it became more crowded over time, and some families were compelled to live their lives in rooms no larger than a walk-in closet.

Big brother, or rather the local Shanghai government, decides the fate of old-style neighborhoods such as this. Some survive; others are torn down to make way for new office buildings and high-rise apartments. (Just a couple of blocks from this neighborhood, a new business district of giant office buildings is under construction.) When neighborhoods are razed, residents are relocated to one of the thousands of high-rise apartment buildings that surround Shanghai, in which case their “journey to work” may increase from a ten-minute walk to an hour and a half riding subways and buses.

Not only do residents have no say in the fate of their neighborhood; they do not even have reliable information about what the government plans to do. Therefore, any minor investment by the government in the area—new street lights, a fresh coat of paint on the side of a building—is heralded as hopeful evidence that Big Brother has decided not to eradicate the neighborhood. This is the dark side of the administrative efficiency lauded by gullible China cheerleaders like Tom Friedman of the New York Times.

Copyright Thomas Doerflinger 2014. All Rights Reserved.


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Shanghai: Will Big Brother Smother the Service Economy?

We cleared immigration in Pudong International Airport and staggered into the arrivals hall, dazed and confused after 20 hours of travel. Two airport functionaries—call them Mr. Li and Mr. Wang—noticed us and politely asked if they could help. No thanks, we said, we’re just looking for the Marriott courtesy desk. Wrong answer: we wandered away, but in a minute Mr. Li and Mr. Wang were back, asking where we were going and could they help. They would not take “no” for an answer. In China clueless tourists, wandering aimlessly in an airport until they get their bearings, are a big no no. In Newark Airport, you could wander for days and no one would notice. Not in China. Everything is noticed.

Surveillance cameras are everywhere. I mean everywhere–even back alleys too narrow to accommodate a car. If you leave something in a cab in Shanghai, you can go to the police station and their cameras will tell you which cab you left it in.

When you catch a train to another city, the ticket does not just state the train number, time of departure, destination, etc. It also specifies which waiting room you are to sit in. And in the waiting room, passengers for each departing train are assigned a specific seating area. Plus, there is a big sign reminding travellers “your train ticket must match your personal identification documents.”

Tourists’ visas are scrutinized closely by immigration officials and hotel personnel. The visa states your date of birth, so Big Brother graciously left a birthday cake for my wife in our hotel room. Tasty but creepy.

The Communist presence is not excessive, but you get the message. Enter a bookstore, and in the front is a prominently displayed a pile of a book—a very special book, the Collected Speeches of China’s President, Xi Jinping. On the famous Bund, the riverfront avenue that once functioned as Shanghai’s Wall Street, I counted no less than 36 PRC red flags, flying proudly over the no-longer-capitalist boulevard. In the hotel the only readily available newspapers are the Shanghai Daily and its big brother, the China Daily. They both spout the Party Line, though I did find many of the stories informative and amusing.

An Information-less Service Economy?

Here’s why tight social control matters to the economy. China’s days as a low-wage manufacturing powerhouse are ending. Once upon a time GDP could grow 10% annually because young people left tiny inefficient farms to work in gleaming new factories, where their productivity (output per hour worked) was ten times higher. Those days are over because of A) the law of large numbers, B) key export markets such as Europe and Japan are stagnant, C) wages are lower in Vietnam, Thailand, Cambodia and Malaysia. Meanwhile another key growth driver, housing construction, is slowing.

Accordingly, China wants to shift to GDP growth driven by domestic consumption and service industries. But services require the free flow of information, which does not exist in China. Consider:

  •  You literally cannot find a Wall Street Journal or Financial Times on any newsstand in Shanghai. If you’re lucky you might score a variant in your hotel, such as the Asia Wall Street Journal, with stale day-old articles.
  • Many western websites are blocked in Shanghai, including ones that have nothing to do with politics, such as the United Airlines website.  (For some strange reason, the Drudge Report is exempted.)
  • You don’t have a choice of Shanghai maps; the concierge gave us one and when we asked where we could go to buy a bigger and better map he seemed perplexed. One map fits all in Shanghai.

The information shortage hinders tourism, potentially a huge service export for China. For example a big potential tourist attraction is the city of Suzhou, a medium-sized city on the Grand Canal that is famous for its traditional Chinese gardens. Four of the gardens are considered “World Class;” several others are worth visiting. Only a half hour outside Shanghai by bullet train, it should be a great day trip for tourists based in Shanghai. But right now Suzhou is difficult to visit because there is almost no tourist-friendly information such as maps, bus routes, or clear signs indicating where the gardens are located. You walk out of the train station and are pestered by shady characters in pedicabs who speak no English and all hawk the same faded garden brochure. We wandered around the town, which admittedly was rather interesting, and eventually managed to find two excellent gardens. However, it was a tedious, tiring, frustrating day. The Suzhou silk museum was closed, and we ended up killing four hours in the train station.

While China’s service sector needs more free-flowing information, it has more than enough labor. The Shanghai area has millions of under-employed people working in tiny shops with tiny inventories, or operating pedi-cabs, or just hanging out on the sidewalk playing cards. It’s common to see eight or ten men (never women) attentively clustered around a card game.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Shanghai Brands: What’s Hot and Not

We spent ten interesting and usually enjoyable days in and around Shanghai. Here’s what I learned that is of interest to investors in U.S. stocks.

The Boeing 777’s that took us out and back were full of Chinese tourists; they were probably seeking more freedom and less pollution. There is also plenty of domestic air travel in China, even though trains are excellent. Airlines such as United and aerospace names like BA, UTX, GE etc. will remain good China plays. Tourism / business travel plays such as Marriott also seem well positioned, although I suspect there is over-capacity of luxury hotels in Shanghai.

The city has several Apple stores which were extremely busy, though probably more with lookers than buyers. Still, this is one of the best brand plays on China; “everyone” owns a smart phone in Shanghai and most probably aspire to own an Apple.

The most ubiquitous western brand on Shanghai streets is Haagen Dazs, (owned by General Mills which licenses the brand to Nestle in Canada and the U.S.).

Nike is a fairly ubiquitous brand that meets the needs and taste of Chinese consumers; New Balance is also common.

Shanghai consumers enjoy tea shops, coffee shops, and even a chocolate shop (Cocoa Colony).   Starbucks stores are ubiquitous and seemed busy though not mobbed. They face heavy competition from Costa and local brands. McDonald’s and KFC stores are common though less numerous than I expected. On the other hand, western big box stores such as Wal-Mart were not in evidence, with the exception of two IKEA stores in the suburbs.

There are several brands of Nestle bottled water—a necessity in a land where tap water is not potable. Coca-Cola is fairly common but far from a dominant brand. At a Shanghai history museum Coke had a brilliant promotion that is difficult to describe—a giant mirror set on a 45 degree angle, stretching over a horizontal space with fake window ledges, where kids could lie on their back. Parents took pictures in the mirror of their child appearing to hang from / stand on the ledge, with the Coke logo in the background. These photos will be shown again and again to relatives and friends.

Luxury Mall Glut. The official ideology of China’s Communist Party is “Socialism with Chinese Characteristics.” In Shanghai’s ritzy French Concession we discovered a gleaming “Short Hills Mall with Chinese Characteristics” or (for you parochial New Yorkers) “Madison Avenue with Chinese Characteristics.” All the big names were there—Prada, Fendi, Coach, Dolce Gabanna, etc. etc.—including a few names that, according to an expert on such matters (my wife), are not to be found in Short Hills Mall, such as de Beers and Baccarat. Unfortunately there are many similar malls in Shanghai, and while traffic is heavy on weekends the stores themselves are empty. In store after store, you see two or three eager store clerks but no customers. There are probably at least four factors at play:

  • too many stores (due to a building boom and the eagerness of firms to establish their brands in China),
  • the Internet is stealing sales from malls,
  • slowing consumer demand as housing slumps,
  • the government crackdown on “corruption” including gift-giving by officials.

Also, I suspect that as Chinese consumers become more sophisticated luxury malls are becoming passé. In the French Concession there are a few ground-level shopping compounds in old, converted buildings that feel more like London than Shanghai; the shops are indigenous rather than global brands.  Anyhow, whoever owns the big luxury malls will be taking big write-downs eventually.

Luxury cars are hot in China, though not many can afford to own them. Next to our hotel (the JW Marriott) were Mercedes and Porsche dealers; a Maserati dealership was about to open around the corner. When you get married in Shanghai, you are driven to the altar in a Bentley, BMW, Mercedes, etc. I suppose this bodes well for Tesla. By the way, due to pollution concerns you have to bid for a license to own a car; the going price is $10,000.

I saw no signs that the building boom is “grinding to a halt;” there are still plenty of half-finished skyscrapers and apartment buildings in and around Shanghai. (We took two day-trips 50-120 miles outside city.) They are starting work on a major new business district in Shanghai. However, when you see how much has already been built—the huge airport, elaborate highway system, giant train stations, bullet trains, the dozens of huge skyscrapers in the Pudong Financial District, and thousands upon thousands of apartment buildings in the city and suburbs—it is easy to believe that building activity is slowing simply due to the “law of large numbers.” Admittedly, the situation may be different further to the West.

Copyright Thomas Doerflinger 2014. All Rights Reserved


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U.S. Equities Can Grind Higher in a Weak World

Stocks are behaving pretty much as I expected:

  •  In early September I said strategists were “disturbingly bullish” and a correction would not be surprising. We did get a correction, though arguably it was not scary enough to sweep away the complacency.
  • In mid October, based on very early Q3 results, I wrote, “I believe investors will conclude in mid November that third quarter profits were fairly good and better than feared.” That appears to be correct.

Most strategists are using $126 for SPX profits next year, which seems doable. If we stay at a trailing PE of 17x, we hit 2142 by year-end 2015, up 6%, with a total return of 8%. With the world awash in liquidity, short rates near zero, and the U.S. standing out as the last bastion of capitalism, it would not be shocking if stocks do better than that. A Republican Congress would improve the regulatory backdrop, which matters more than most economists and strategists recognize because they can’t plug regulatory policy into their models.

That said, you have to be worried that Japan and Europe are using monetary easing to keep their economies afloat, when the real problem is structural flaws that are impervious to monetary policy. Both regions need a Thatcher or Reagan to revive capitalism. Meanwhile the BRICs are crumbling. (The exception is India which, having already crumbled, is trying to rebuild under Modi.) Growth in China will continue to slow as the credit crunch hits real estate, which in turn restrains consumption. No Street economist wants to be the first to forecast GDP growth under 7%, which might offend the government. Brilliant independent strategist Jonathan Anderson has no such qualms; he is quoted in the FT saying,

“I’m confident we won’t see a collapse or a financial crisis in China, but, as credit conditions tighten in the next year or so, things are going to get ugly and we will have much less growth . . . . What we will inevitably have is a big shakeout on the supply side because that’s where all the credit has gone and we may see companies start going bankrupt in droves.”

Somehow that does not make me feel better—no credit crisis in China, just companies going bankrupt in droves.

Buy-backs: Funded by Debt?

When it comes to job creation, liberals need to get their story straight. Hillary says “don’t let anybody tell you, that, you know, it’s corporations and businesses that create jobs. You know, that old theory, trickle-down economics. That has been tried. That has failed. That has failed rather spectacularly.”  Weirdly, Hillary claims that her husband’s time in office invalidated “trickle down” when the opposite is true. With Republicans in Congress restraining Federal spending and (with Bill Clinton’s approval) cutting capital gains taxes in 1997, we had a technology boom, a stock market boom, a briefly balanced Federal budget, a plunging unemployment rate, and rising real wages across the income spectrum. It was the best time for low-income workers since the mid-1960s—even though inequality increased sharply.

Anyhow, many liberal pundits writing in the NYT and FT disagree with Hillary. They are criticizing companies for buying back shares instead of investing in their business and creating jobs. And it’s not just pundits who hate buy-backs. Many stock market bears argue that one of the channels by which central banks’ “easy money” inflates stock prices is companies borrowing heavily to finance share buy-backs. This is not “real growth,” the bears argue, but unsustainable “financial engineering” that will be derailed by an eventual rise in interest rates.

DJIA Buy-backs

I decided to find out for myself whether companies really are leveraging up to fund share buy-backs. I examined the 30 Dow Industrial companies to answer, for each individual company, two questions:

  • Did the number of shares outstanding decline between 2010 and 2014?
  •  Did the debt / equity ratio increase between 2010 and 2014?

The short answers: Yes and No.

Yes, buy-backs were pervasive among these thirty “blue chips.” Between 2010 and 2014, share counts declined for every company save two (JNJ and VZ).  The median share count decline over the four years was 8.6%, implying that buy-backs boosted earnings per share by around 2.2% per year—a lot when the secular EPS growth of the S&P 500 is 6%. The companies with the biggest share count declines were HD (-19.3%), IBM (-19.8%), PFE (-21.4%), TRV (-24.1%) and V (-25.3%).

On the other hand, No, companies did not load up on debt to finance these buy-backs. The median debt / equity ratio rose only very slightly, from 38.1% to 39.7%, even though companies had ample incentive to borrow more as the economy improved and interest rates stayed low. Six companies, four of them financials, slashed their debt / equity ratios dramatically while only two (HD and IBM) increased their leverage ratio substantially. It’s true that IBM should have been doing fewer buy-backs and more investment in its business; it has fallen behind the cloud curve. But IBM is very much the exception, not the rule.

Rational Cash Use Supports Stocks

Hefty share buy-backs by the corporate giants in the DJIA is bullish, not bearish. Many of the problems of big, mature firms are self-inflicted—excessive capex, dumb expansion overseas, stupid acquisitions.   Such mistakes are likely to be fewer and smaller if companies pay a decent dividend and boost EPS growth with buy-backs.

More broadly, one reason why bearish deflationists have been far too bearish on profits is that companies have figured out how to deliver an 8-10% total return to shareholders through a judicious combination of organic growth, acquisitions, share buy-backs (which collectively generate, say, 7% EPS growth) plus a dividend yield of 2%. That’s mighty attractive when treasuries yield 2.3%.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.

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Politics Uber Economics: Europe’s “War Between the States”

Today’s Wall Street Journal carries an article by Princeton economist Alan S. Blinder titled “Enough With European Austerity, Bring on the Stimulus.” The Financial Times carries similar columns every day of the week and two or three times in the weekend edition.  Come to think of it, I have written a few such articles myself.

Back to the Future

In reality, we are all missing the point. To get the proper perspective, forget about Europe for a moment and think back to the founding of the United States in the 18th and early 19th century. The nation was created by the Constitution ratified in 1788, but that document papered over the divisive issue of slavery with the “three fifths clause,” which apportioned Congressional representation based on 60% of a state’s slave population and 100% of its free population.

But as the U.S. expanded westward the slavery issue—the fundamental question of whether the U.S. would be a “free labor” nation or one that actively tolerated slavery—kept flaring up, threatening national unity. It was deftly finessed by politicians in the Missouri Compromise of 1820 (which admitted Maine as a free state and Missouri as a slave state) and the complex Compromise of 1850, but the “popular sovereignty” solution in the Kansas Nebraska Act of 1854 led to open warfare in those states. The Civil War finally settled the issue, making the U.S. “one nation, indivisible” that was free of slavery, but still extremely racist.

Nation Building in Europe

Europe is going through a similarly tortuous and torturous process of nation building that may continue for decades. Although its economic benefits have been touted over the years, the European Union was created primarily for two political reasons:

  • Avoid World War III by getting Germany and France to embrace;
  • A united Europe would be a Great Power, coequal with the U.S., China and (once upon a time) the Soviet Union.

The goal is unity and national greatness—but on whose terms? The terms of Germany (orderly, efficient, disciplined, rational, ever on guard against inflation) or France and Italy (far less so on all counts). Germany believed the strict rules requiring balanced budgets would force France and Italy to pursue economic policies consistent with German values; there would be gradual economic, political and social convergence.

But Germany’s expectations of national convergence turned out to be incorrect. Erasing profound national differences that developed over many centuries cannot be erased in a few years. And it doesn’t help that the E.U.’s structural design—one currency, one central bank, multiple fiscal policies, distinct labor markets—is simply dysfunctional, because it prevents weak national economies from having an accommodative monetary policy and weak currency.

The great divide between Europe’s North and South was revealed to me when we were vacationing in Florence a few years ago and hired a driver to take us out to Villa Gamberaia, a beautiful garden in the suburbs that overlooks the city. The driver was bitterly criticizing the corrupt politicians in the Italian legislature, who get big salaries and lots of perks for not much work. I asked the driver, “Is there a split between Italy’s hardworking businesslike North, centered on Milan, and the more easy going mores in the South, centered around Naples?” He replied that there really was not much difference between North and South—except, of course, that the South was substantially controlled by the mafia.

Oops. That’s what Germany is worried about. It does not want to let its balance sheet be used to subsidize organized crime in Italy and socialism in France.

The Germans are not dumb. They understand perfectly well the Keynesian arguments made by Alan Blinder, Paul Krugman, the FT’s Martin Wolf, etc. But they are playing for higher stakes than next year’s GDP print. When we see Germany demand that France and Italy balance their budgets and carry out “structural reforms” such as cutting taxes, allowing firms to fire workers without going to court, and getting rid of France’s 35-hour work week, we are not just witnessing an argument over economic policy. We are witnessing a political struggle about the character of Europe, similar to the standoff between America’s North and the South prior to the Civil War.

The problem for Europe is that while this political stand-off goes on the European economy stagnates, unemployment hangs around 10% and much higher for the young, and extremist political parties gather strength. Average voters won’t put up with decades of misrule by a well-compensated, ineffectual elite. I have no idea how this ends, but it won’t be pretty. Hopefully Europe can build a united nation more amicably than the United States managed to do in the nineteenth century.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Cuomo and de Blasio Must Be Reading My Blog

A couple of days ago I suggested the Obama administration should provide some positive incentives for doctors and nurses to help out in West Africa, in order to get beyond the ideological stalemate over quarantines.  I recommended they be paid $15,000 when they completed their quarantines.

Comrades Cuomo and de Blasio have followed my advice. The New York Post reports, “The state and city will ensure that workers who travel to Ebola-afflicted areas will not lose their jobs or benefits while abroad, according to the plan. The state also will reimburse returning workers who are quarantined and their employers.” It’s nice to see that someone in government has the imagination to take some constructive actions to fight Ebola in West Africa, instead of merely engaging in arid posturing about what “the science” does or does not dictate. The Obama Administration should take note.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.



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Outbreak! – Lessons from London (1665) & Philadelphia (1793)

We are not hearing much about the horrific tribulations of the folks in West Africa, but we can start to appreciate their suffering by considering Philadelphia’s yellow fever epidemic of 1793. With a population of about 45,000, it was America’s political, economic, financial and cultural capital. When the fever struck, nearly everyone who could leave town did so; those who stayed in town used all manner of strategies and substances to ward off the fever.

The city’s esteemed medical community was clueless about how to fight the disease, though some doctors were more clueless than others. Aggressive treatment involved bleeding patients with leeches, inducing vomiting, and feeding them mercury. The fever was thought by many to be contagious and caused by the “miasma” emanating from decaying organic matter; a prime suspect was a pile of coffee rotting on the Arch Street wharf. Actually, yellow fever is spread by mosquitoes; the fever finally ended with the onset of frost. A splendid 1949 book, Bring Out Your Dead, by J.M. Powell, conveys the horror and mayhem caused by the disease, which killed a tenth of the city’s population. A few excerpts:

“Some cases began with violent chills and temperatures, others with languor and nausea. Stupor, delirium, vomit, slow pulse, bloodshot eyes, yellowness regularly succeeded. Sometimes patients remained sensible and conscious to the last. One man shaved himself just before he died.” [A common symptom was black vomit.]

“At once the very appearance of the street changed. People stayed indoors scouring, whitewashing, ‘purifying’ their houses, burning gunpowder, tobacco, and nitre, sprinkling vinegar. Those who had to walk abroad carried their tarred ropes or camphor bags and chewed garlic constantly, doused themselves with vinegar…” [Another supposed remedy was shooting guns and cannons.]

“Children were wandering in the streets, their parents dead at home. A laborer with the improbable name of Sebastian Ale hired out as a gravedigger. An old man, he had long since lost the sense of smell. He opened a grave to bury a wife with her husband who had died a few days before. His shovel struck and broke the husband’s coffin, from which emitted such an ‘intolerable and deadly stench’ that Sebastian Ale sickened immediately and in a day or two died.”

“Calamities multiplied beyond number. A man named Collins buried his wife, two daughters, a son, his son’s wife and child; he married again, buried his new wife, and died himself….” [Dolly Todd lost her husband, an up-and-coming Quaker lawyer, to the fever and later married Congressman James Madison of Virginia.]

The city’s government and social services broke down when they were needed most. They had to be reconstituted by exceptionally courageous citizens, one of whom was a one-eyed French merchant named Stephen Girard, who reorganized and operated the city’s makeshift fever hospital, a mansion called Bush Hill. Girard went on to become one of America’s richest capitalist, with a fortune of well over $3 million when he died in 1831.

Residential Quarantine in London

 The White House and CDC could learn a lot from A Journal of the Plague Year by Daniel Defoe, the prolific author who wrote Robinson Crusoe. It’s an unusual book. It’s a first person, you-are-there account of the rat-and-flea borne plague that ravaged London in 1665. Only Defoe was not there; he published the book in 1722 by piecing together contemporary accounts from newspapers, memoirs, etc.

A big issue for London then, as for the U.S. now, was quarantines and how to enforce them. The Lord Mayor and Aldermen of the City of London decreed that:

“No Person to be conveyed out of any infected House.” So if you, a family member, or one of your servants got sick with the plague, you were a prisoner in your own house, even if you were not ill. This could be a death sentence; as Defoe wrote, “This shutting up of houses was at first counted a very cruel and Unchristian Method, and the poor People so confin’d made bitter Lamentations.”

“Every visited House to be marked” with a big red cross on the front door.

“Every visited House to be Watched” by two government-appointed watchmen, one for the day and one for the night. These watchmen would run errands such as fetching food, fuel, etc.

Here was an extraordinary situation—the government making ordinary citizens prisoners in their own houses, even if just one member of the household came down with plague. The citizens did not cooperate. They sent the watchmen off on errands to buy food, and then broke the lock, or used a second key to open the lock, or broke through the wall to the next house, or bribed the watchman. On one occasion the watchmen heard violent shrieking and wailing in a shut house. They pounded on the door to learn what was the matter. No answer. At length they used a ladder to peer into the second floor bedroom; there they saw a woman dead on the floor. They opened the front door and discovered that the rest of the household had stolen away in the night.

Beyond “Science:” a Proactive and Rational Quarantine

 Contrary to the condescending “scientific” assurance of Federal officials, Ebola is not that difficult to get. Many well-trained western doctors have contracted the disease in Africa, as have two nurses in Texas. And it turns out that self-quarantines don’t work; we have three cases of people who had (or might have had) the disease traveling widely in America—the nurse who flew round trip from Dallas to Cleveland, the reporter back from Africa who got take-out from a Princeton eatery, and the doctor who spent an action-packed day jogging, bowling, dining and subway-riding in Manhattan right before (we hope) he became symptomatic. Basically, Americans today do not like to be “shut up” in their houses any more than Londoners did in 1665.

Clearly, then, it makes sense to quarantine anyone entering the U.S. from West Africa who potentially came in contact with Ebola. The Feds claim this will “isolate” West Africa by dissuading healthcare workers from traveling there. A simple solution is to enforce a stay-in-your house quarantine for all returning travelers, but to pay returning healthcare workers $15,000 for enduring the 21-day quarantine. The government could provide luxury quarters for those who did not wish to be quarantined in their house. This tells the health workers, “We love you, and we want you to help out in West Africa, but we won’t let you put millions of Americans at risk.”

Once again Obama has “led from behind” with disjointed, incoherent, indecisive half measures, instead of aggressively and proactively addressing a crisis. His ineptitude forced Governors Christie and Cuomo to improvise a policy that will inconvenience a handful of people but cut the risk that Ebola spreads in the U.S.

Copyright Thomas Doerflinger 2014. All Rights Reserved.


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FT: Obamanomics Failed, but Don’t Blame Obama

In a Financial Times column titled “The riddle of black America’s rising woes,” Edward Luce spins a convoluted alibi to absolve Barack Obama of his egregious policy failures. He may have been President for the past six years, and Democrats may have controlled Congress for two of them, but it’s all the fault of the racist Tea Party, don’t you know.

Let’s begin by giving Mr. Luce credit for noticing something U.S. liberals studiously ignore: Based on median household income, median net worth, labor force participation and other metrics, Obamanomics has been a disaster for black Americans. They fared far better under the heartless George W. Bush. But Mr. Luce assures us that “Obama is not to blame” for his sorry record because “by any yardstick – the share of those with subprime mortgages, for example, or those working in casualized jobs – African Americans were more directly in the line of fire” of the recession. “By no honest reckoning,” Luce avers, “can Mr. Obama be blamed for the decline in black America’s fortunes.”

Sorry. You Can’t Separate Obama from Obamanomics

Where to begin? The Luce narrative makes no sense because if blacks were particularly hard hit by the recession that would set up what Wall Street calls “easy comparisons” that made it all the easier for Obama to lift the incomes of poor blacks during the ensuing economic recovery. That didn’t happen; black median household income was lower in 2013 than the recession year 2009. Furthermore, Mr. Luce is actually insulting President Obama by insisting he was effectively a bystander during his own administration and had no substantive impact on the economy. Would that it were true. In reality Obama and the Democrats are responsible for the worsening plight of poor Americans, black and white (which is why inequality is increasing):

  • Obamacare discourages businesses from having more than 50 full-time workers, so part-time employment is proliferating. The U.S. labor market is starting to resemble that of Italy, where there are strong incentives for firms to have fewer than 15 workers.
  • Obamacare discourages hiring low-wage workers by promoting substitution of cheap capital (thanks to the Fed) for increasingly costly labor.
  • Transfer payments such as Food Stamps and Obamacare have the perverse effect of making it financially irrational for poor people to work more. The CBO estimates the equivalent of 2 million jobs will not be filled due to Obamacare; other estimates are higher. It is impossible for a poor person to “get ahead” if he or she doesn’t work. Result: lower social mobility and greater inequality.
  • Obama excoriated “millionaires and billionaires” (aka job creators) while sharply raising their taxes. Not exactly a confidence builder for entrepreneurs.
  • Dodd Frank cut small business lending by wrapping community banks in red tape.
  • Obama opposes charter schools, school vouchers, and school choice for inner city parents; terrible public schools are good enough for poor kids but not for Obama’s own daughters.
  • Obama attacked fossil fuels, thereby killing jobs and raising the energy costs of the poor.
  • Obama failed to reform America’s dysfunctional corporate tax code, which kept $2 trillion stranded offshore.
  • Obama failed to negotiate new trade agreements that would promote exports.

Mr. Luce attributes the loyalty of blacks to President Obama, despite his economic failures, to the racism of the Tea Party, as evidenced by such “dog whistles” as Newt Gingrich accurately calling Obama “the food stamp President” and a Congressman calling Obama a “liar” during a State of the Union Speech. Luce must have a very low opinion of blacks if he thinks they lay greater emphasis on those trivial ephemera than on substantive economic blunders that consign millions of Americans to poverty.

Here is what the Tea Party (including such blacks as Herman Cain, Dr. Ben Carson, Senator Tim Scott, Thomas Sowell and Lieutenant Colonel Allen West) really think. Obama’s statist policies have been just as harmful to poor Americans as Tea Party folks feared back in 2009. My own prognostications in this regard have been depressingly accurate. What is needed to move poor people off “the liberal plantation” and toward economic independence is a decisive shift from Obama’s paternalistic statism to a dynamic, fast-growing free enterprise economy that fosters strong job growth and rising incomes. That is what we had in the late 1990s under President Clinton and a Republican Congress led by Newt Gingrich, who cut the capital gains tax in 1997. Despite “rising inequality” during the tech bubble, the unemployment rate plunged to 4% and the median household income of black families rose a stunning 18% between 1995 and 2000.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.

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Q3 Earnings: Off to a Strong Start

Based on results so far, I believe investors will conclude in mid November that third quarter profits were fairly good and better than feared. The big exception, which will surprise no one, is the energy sector, which will weigh on overall profit results even as weak energy prices buoy real growth in the U.S. economy (see below for details). Consider the early results:

Industrial looks OK so far. Fastenal, which is a bellwether because it distributes all kinds of industrial fasteners throughout the U.S., had an in-line quarter, with revenue growing 14.3%. Alcoa is a decent indicator of global demand in aerospace, autos and packaging. The CEO (who admittedly is chronically bullish) provided a positive, detailed, segment-by-segment, assessment of global aluminum demand. He continues to expect 7% growth in 2014.

Transportation; Fed-Ex, trucker J.B. Hunt (a leading player in the inter-modal market) and railroad CSX all handily beat estimates. Because these firms haul all sorts of products, from coal to semiconductors, this is positive for GDP.

Big Banks (JPM, WFC, C) all met or beat estimates, despite headwinds from weak mortgage demand and declining net interest margin due to low rates. Loan growth was strong; WFC’s CEO said “we had strong broad-based loan growth with our core loan portfolio up almost $51 billion or 7%.” Strong IPO and M&A activity show that “animal spirits” have improved in corporate America, notwithstanding global growth jitters.

Consumer: Costco, PepsiCo, Kroger and Domino’s Pizza all posted solid quarters, but YUM was more mixed due to continued problems in China.

JNJ reported a solid quarter and raised 2014 guidance (with the top end of the range above current consensus), but the stock traded down due to strength in a product that will be hurt by a new offering from Gilead.

Tech: Intel reported another strong quarter paced by strength in PC’s and servers, though mobile remains unprofitable. Linear Tech slightly missed estimates.

It is way too early for strategists to estimate with confidence what third quarter S&P 500 EPS will actually be, but we know enough to conclude that earnings will be acceptable, though not great. From a stock market perspective, this basically means “more Goldilocks” – gradual profit growth of 5-7%, faster dividend growth of 10-12%, and a super-easy Fed.

There simply is no evidence here of an implosion in global demand. Europe is weak, but what else is new? Yes, France and Italy remain near recession, but the UK is fairly strong and Germany can support growth with much-needed infrastructure spending, if it wants to. China continues to grow. As for the U.S., which still accounts for two thirds of S&P 500 revenue, its economy is decidedly stronger now than over most of the last three years.

As for the impact of weak oil prices on profits, the story is complicated and usually mangled by the financial media and the experts they interview. Especially in the near term (i.e., Q3 and Q4 and probably next year), weak energy prices are a net negative for profits. They clobber the profits of the energy sector (about 10% of S&P earnings) and also hurt industrial suppliers of everything from steel piping to compressors to trucks. This weakness is only partly offset by the positive effects of weak energy prices, namely A) lower costs for energy users such as transports and chemicals, B) stronger revenue for retailers, restaurants, etc. as consumers spend less on fuel for their vehicles and dwellings.

On the other hand, investors will be more impressed by a positive EPS surprise at a Starbucks, Delta Airlines, or Macy’s than by weak results at Exxon or Chevron. Another positive: lower energy costs help to prolong the economic expansion by boosting consumer spending and reducing inflationary pressures, which gives the Fed more leeway to keep rates low.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Seven Stock Picking Themes

I have argued that investors should “create their own conglomerate” of high quality companies, mostly growth companies that pay dividends, and own them for long periods of time. I know this sounds like just another dumb investment platitude. Now we have a practical example of what it means, in terms of real world decision making.

OMG, the Dollar Is Soaring

Wall Street is in a tizzy about the strong dollar, which will hurt the reported earnings of multinationals and depress commodity prices as denominated in dollars, which is bearish for energy stocks, gold stocks, other commodity stocks, and the industrial companies that supply them with capital goods. Analysts, strategists, and economists are busy revising their forecasts to take account of the strong dollar.

What should you do with your portfolio in response to the strong greenback? You should do very little, for a few reasons. For one thing, currencies are not forecastable, so you are wasting your time thinking much about them. (I, like many others, have incorrectly expected the Euro to weaken for the last three years.) For another thing, whatever effect a strong dollar has on companies’ earnings is already priced in; it’s too late. But most importantly, currency is not that important to a multinational firm with operations around the globe. Yes, eventually (like two years from now) the strong dollar may reduce U.S. exports, but it will increase European and Japanese exports, so the underlying impact of a strong dollar on the dividend paying ability of a large company is modest. And, to the extent the strong dollar reduces inflation and interest rates in the U.S., the reduction in earnings is offset—in terms of the stock’s price—by a higher PE ratio, because the discount rate for valuing the stock is lower. (This was apparent in the Fed minutes released yesterday; the strong dollar and weak growth in Europe, which are closely related, gives the Fed more leeway to keep monetary loose.)

As an aside, a recent report from BAC reported that only 20% of fund managers were beating the S&P 500 so far this year. One reason is that—because their performance is evaluated annually—they have to try to react to things like currency swings, even though they cannot do it successfully. They just run up transaction costs and their clients’ tax bills.

Think Thematically

Forget about currency and save your brain power for something more important: Identifying long-term trends in the world economy and high quality companies that stand to benefit from those trends, enabling them to pay a decent dividend and to raise that dividend over the next decade. This is a two-part process:

  1. identify the trend
  2. identify the winners, as well as the losers you should sell or not buy.

Here I only do (1) by suggesting seven specific themes; for (2), talk to your broker or do your own research, in order to find good companies that really are leveraged to the theme. (Some themes are far more “investable” than others; it is hard, for example, to find stocks that are leveraged to the looming global water shortage.) Thinking thematically is not only a good way to identify stocks to buy; it is also a good way to identify stocks to sell and stocks not to buy even though they appear to be “cheap.” I also like thematic thinking because it gets you away from abstract “strategy speak” dualities such as high beta / low beta, cyclical / defensive, large cap /small cap, domestic / foreign; instead you are thinking about the “real world” — real businesses and what they do for a living, and how their prospects are affected by real world trends.

Why the Street Pays Little Attention to Themes

Note that many themes last for years and years. I first started writing about income inequality and the need to avoid the “mediocre middle,” such as department store chains, in the 1980s. The theme is still valid, especially with Obamanomics hurting the poor and middle class. Despite all the brain power on Wall Street, it does a poor job of identifying, and acting upon, themes. The most important clients, hedge funds, want short-term ideas with a “catalyst.” Wall Street thrives on “incremental information” – the “new news” that no one else knows yet, even if it is not particularly important news. A portfolio manager will hang up on a salesman who tells him that Nike is a good long-term play on the fitness craze and the emerging market consumer; that same PM will listen to the salesman if she says, “our analyst was on the road with the Nike CFO, and he seems more bullish on demand in China.” Analysts often ignore obvious themes – such as the fact that Coca-Cola makes you fat, so people will drink less and less as they get older — for a couple of reasons. For one thing, analysts are constantly talking to managements in the industry (who are chronically bullish), and to investors who own millions of shares of the stock. Another reason: analysts almost “have” to recommend something in their industry because they have clients who want to know what is their “best idea in the space” (in this case, beverages).

Seven Themes

More and Safer Rail Cars: The fracking boom and irrational government opposition to pipelines have vastly increased demand for rail cars to transport oil, as well as inputs such as sand. But oil-by-rail is dangerous, as shown by a disastrous accident that destroyed the Canadian town of Lac-Mégantic and killed about 45 people (the figure is approximate because some victims were vaporized). Regulators are belatedly demanding better / safer rail cars, both new ones and retrofitted cars. Apart from energy, demand for rail cars is robust due to strength in such areas as agriculture and chemicals (see below) as well as a shortage of drivers for long-haul trucking. This is bullish for certain industrial companies involved in making or rebuilding rail cars, as well as the railroad industry generally.

The Cloud Commoditizes Tech. This is one I don’t know much about. But basically computing power is shifting from individual customers having their own customized hardware and software (provided by companies such IBM, HPQ, ORCL, etc.) to the cloud – i.e., giant server farms. The server farms use huge numbers of cheaper computers, which threaten the margins of incumbents. (This is similar to the shift in the electricity industry in the 19th and early 20th centuries from every building having its own generator to buying power from a utility company such as Commonwealth Edison.) The shift to the cloud is good for some companies, bad for others. One implication is that some apparently cheap stocks will get cheaper and eventually go out of business. A smart hedge fund with access to the best Wall Street analysts could probably put together a nifty long-term long/short trade on winners and losers.

More pork and chicken with that rice. Chinese consumers want to eat better, which means eating more meat. But producing meat, whether chicken, hogs or beef, requires large amounts of feed such as corn and soybeans. That is bullish for the big agribusiness companies. The biggest U.S. export to China is not airplanes but soybeans. As the CEO of Deere recently noted, the profits of ag stocks have been hit by an unforeseen “extreme weather condition” – good growing conditions around the world, which have depressed corn and soybean prices. But strong Asian demand for corn and soybeans as feed for livestock, plus the likelihood that weather conditions will change for the worse, suggest that now is not a bad entry point for long term investors to buy the best global ag companies. They have strong franchises because of big R&D budgets, sprawling dealer networks, and close ties to farmers who are disinclined to take risk a growing season on new and unfamiliar suppliers of seeds, equipment, fertilizer, etc. Performance minded fund managers are scared of weather-dependent stocks, but long-term investors don’t have to worry much about the weather. A smart friend of mine who has worked for some of the best strategists and economists on both the Buy and Sell-side of the Street told me he is buying these names because they look cheap based on normalized earnings.

Spending More on Healthcare. This is a no-brainer, which suggests I don’t have a brain because I only acted on it in the past few months. Obamacare is taking money out of the pockets of tax payers and individuals who had what they considered adequate health insurance (and now have to pay much more for Obama-mandated plans) while funneling it to uninsured people who will spend more on healthcare. (For example, the health bills of 30,000 Wal-Mart workers are going up.) The trend is broadly negative for consumer spending but bullish for healthcare, which is the S&P 500 sector with the strongest earnings trends—both in the recent past and in analysts’ estimate revisions.

The Electronic Fuel-efficient Car. Whether or not they go electric, cars and trucks will contain more and more electronic content which will make them safer and more fuel efficient. It is ridiculous that new cars and trucks still have “blind spots” making it hard to change lanes; nor do they have automatic braking systems so that vehicles don’t plough into stopped traffic, creating catastrophic accidents such as the one on the New Jersey Turnpike that injured Tracy Morgan and killed James McNair. The new technology would pay for itself via lower insurance and litigation expense. As improvements are made, vehicles’ electronic content—the number of chips, connectors, wires, etc.—will increase, and so will demand for things like turbochargers that make them more fuel efficient. A buy-side strategist for a big firm told me he expects Apple to move into the vehicle space, which I had not thought of.

Purity Plays. In a rapidly globalizing world, Ebola is just the latest example of contaminants that governments, companies, and consumers need to monitor in order maintain health and safety. (Other examples: SAARs, AIDs, fake Chinese medicines, tainted meat, tainted fish, lead paint on toys, mercury smokestack emissions.)  Companies that aid in that process, whether by producing lab equipment, sanitizing factories and hospitals, testing food for salmonella and e-coli, measuring / minimizing factory emissions, providing laboratory services, etc. will continue to experience strong secular demand. Around the world, government regulations to maintain purity are becoming ever more stringent.

Reconfiguring the U.S. (and Global) Energy Infrastructure. The fracking boom and rapid drop in oil and especially natural gas prices are making the U.S. energy industry—broadly defined to include oil refining, chemicals, plastics, fertilizers, LNG exports, etc.—extremely competitive globally. Eventually Washington will permit exports of oil and gas, something Tom Friedman recently recommended on economic and strategic grounds (we made the case last March). U.S. firms are building their new plants in Louisiana and Texas rather than Saudi Arabia and Dubai. Foreign firms, including giant German chemical companies facing skyrocketing energy costs at home, are also migrating to the U.S. gulf coast. U.S. industrial firms will continue to benefit from these trends.

Copyright Thomas Doerflinger 2014. All Rights Reserved.


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