Get Set for Grexit

Posted on April 6, 2015 by tomdoerflinger

Investors should prepare for Greece to leave the Eurozone—not a disaster but likely to cause significant volatility, especially for U.S. and European financial stocks. George Soros, who has made billions betting on currency market ructions, believes there is a 50% chance of a Grexit. Even if Grexit does not occur there will be a lot of nail-biting brinkmanship causing markets to behave as though there is a very high probability it will happen.

The problem is that Greeks love socialism but hate to pay their taxes, which is not a sustainable business model. Greece snuck into the Eurozone the old-fashioned way—by lying and cheating and misrepresenting the size of its budget deficit. Then it dug a bigger financial hole for itself by borrowing on Germany’s balance sheet until the financial crisis. It did in fact tighten its belt after the crisis and reined in the primary budget deficit, but the necessary “structural reforms”—including stricter tax enforcement—were never made.

Then the country voted in a socialist government whose leaders (especially the oh-so-cool Finance Minister in his black leather jacket) have managed to alienate their peers across Europe. But far worse than the bad optics and hard feelings are the hardline socialist policies of the new government, which pretty much guarantee the Greek economy will stall and fail to generate the necessary tax revenue. Consider an article in the Financial Times titled “Athens digs in over golden opportunity.” It seems that Eldorado Gold, a Canadian mining company, was “making steady progress” toward opening a Euro 1 billion mine, but it has been “stymied” by Panayotis Lafazanis, the new minister for a department with the improbable name “Productive Recovery, Energy, and the Environment.”  According to the FT, Mr. Lafazanis has “focused on reversing earlier pro-market policies agreed between Greece and its international lenders, hampering Athens’ attempts to unlock urgently needed bailout money. He has cancelled the planned privatization of state-controlled electricity assets….” This gentleman is not a big fan of private enterprise; he “maintains that private companies should be excluded from developing the country’s natural resources.”

So this simply is not a government the Euro-crats can play ball with. It has neither the will nor even the ability to accomplish the things that need to be done to stay in the Eurozone. Not surprisingly, investors are voting with their feet, transferring their Euros out of Greek banks before they turn into drachmas. It is hard to engineer the economic turnaround of a nation when the balance sheets of its banks are shrinking.

It’s Not All About Germany and Greece

Some commentators believe super-Angela will “find a way” to avoid a Grexit but—despite the nasty high-profile sniping between the Greeks and Germans–it is not up to the Germans alone whether Greece stays or goes. In sparring with the Greek government, some of the toughest negotiators have been the Spaniards. Spain, Portugal and Ireland did in fact make the “tough structural reforms” that Greece failed to make; they inflicted great pain on their citizens in the process, and unemployment is still sky-high. Extreme political parties pose a serious threat to the incumbent leaders in these countries; they fear that voters will revolt if Greece gets yet another bailout that allows it to avoid the reforms endured by other European countries.

Another reason why Grexit is likely is that at this point, with most Greek debts owned by “official” creditors such as the IMF rather than European banks, it would not be a disaster for Europe—just for Greece. Stay tuned, and keep some cash available, to put to work during periods of “volatility.”

Copyright Thomas Doerflinger 2015. All Rights Reserved.

 

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White Privilege: Universities Should Educate, not Exploit, Black (and White) Athletes

Posted on March 28, 2015 by tomdoerflinger

When you’re watching the sweet sixteen, elite eight, final four, and championship game, keep in mind that many of the players are not getting a decent education that will allow them, upon graduation, to thrive in the workplace and be leaders in their communities. These players, many of them black, are being exploited by the universities that employ them but do not educate them. They are generating big bucks for the schools and thrilling entertainment for the (mostly white) students, faculty and alumni and receiving little in return besides a shot at playing in the pros.

Racially Correct, Educationally Corrupt

Which is more than a little ironic, because American universities are the epicenter of racial correctness. They fancy themselves oases of enlightened tolerance in a wasteland of prejudice—a bulwark against intolerant white Republicans. Yet universities recruit thousands of young blacks to play football and basketball and then graduate without being able to read and write at a collegiate level. Instead of elevating the academic competence of these under-educated athletes, universities let them “get by” in sham courses, with the connivance of “academic counselors.”

And it’s not just the Big Ten, but also prestigious schools like UNC at Chapel Hill (see below) and Harvard. As a graduate student at Harvard, I was a teaching assistant in an American history survey course. One of my students was a football player from South Boston who was built like a refrigerator and unfortunately wrote like one too. I got tutoring help for him, but the truth is he should never have been admitted. Tragically, a couple of years later he was caught plagiarizing a paper and expelled. Go Crimson—please.

Many African Americans and working-class whites would be far better off if universities required that all varsity players first pass a rigorous test demonstrating college-level proficiency in math, reading, and writing. Obviously this reform would have to be phased in over several years. It would put salutary pressure on thousands of high school students, parents, coaches, teachers and school administrators to make sure kids were really learning in grammar school and high school. People come up with all sorts of excuses for low academic achievement, but a primary cause is lack of urgency and effort. Which is why poor Asian immigrants excel academically despite many disadvantages.

Explicitly tying athletic achievement to academic success would work wonders. After all, we are talking here about remarkable and admirable young men and women who have the poise and discipline to excel at big-time sports. In college they should be able to read and do math at an 11th grade level, not just an elementary school level, which is the case for quite a few of them (see below).

UNC at Chapel Hill: 18 years of Academic Fraud

Last year an independent investigator hired by the prestigious University of North Carolina at Chapel Hill prepared a 131 page study showing that over an 18-year period at least 3,100 athletes (and likely many more) took sham “paper courses” that required little or no work in order to boost their GPA and maintain their academic eligibility to play football and basketball. Rumors of the scandal had been circulating for several years; top administrators resisted an investigation for as long as possible. Most of the “courses” were in the African American Studies Department. Quite a few people in the university knew about the academic fraud. An e-mail exchange reveals how an “academic advisor” could secure the necessary grade for a “recycled” (plagiarized) paper:

Crowder: As long as I am here I will try to accommodate as many favors as possible. Did you say a D will do for [name of basketball player]?  I’m only asking that because 1. no sources, 2. it has absolutely nothing to do with the assignments for that class and 3. it seems to me to be a recycled paper.  She took AFRI in spring of 2007 and that was likely for that class.

Boxill: Yes, a D will be fine; that’s all she needs.  I didn’t look at the paper but figured it was a recycled one as well, but I couldn’t figure from where!  Thanks for whatever you can do.

The courageous individual who blew the whistle on UNC, Mary Willingham, was for five years attacked by the UNC administration for her trouble. She is bringing a whistle-blower suit. According to CNN, Willingham “said that she had worked with dozens of athletes who came to UNC unable to read at an acceptable level, with some of them reading like elementary schoolchildren.” Of 183 players she surveyed, 60% read between 4th and 8th grade level, and 8-10% read below a third-grade level. No wonder UNC needed “academic counselors” to help athletes stay in school.

UNC Is Far from Unique

If you think UNC is unusual in this respect, I have two big white buildings at opposite ends of Pennsylvania Avenue that I would like to sell to you. CNN tried to survey 38 colleges about the SAT and ACT scores of “revenue generating” athletes and got responses from only 21. Based on that survey, which is very probably skewed in a positive direction, 7-18% are reading at an “elementary school” level – i.e. 4th-grade to 8th-grade level. So, it seems likely that 25-35% cannot read at an 11th grade level necessary to do college-level work.

Universities: Athletic Sweatshops

Universities are highly culpable for exploiting athletes while failing to provide a decent education. If the liberals who dominate both universities and public education were serious about improving the lot of working-class Americans, they would end this charade and require students who wanted to be involved in big-time collegiate athletics to pass a test showing they can work at a collegiate level.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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European Sojourn

Posted on March 25, 2015 by tomdoerflinger

First stop: Bruges, Belgium, which at the end of the 14th century was the commercial capital of northern Europe. Then its population was about 40,000, including hundreds of merchants from all over Europe—Italy, Germany, England, and of course Flanders. Spices and dyes were imported from the Levant via Italy; wool was brought in from England and Scotland to supply the Flemish textile industry; wine came northward from France and Portugal; lumber, furs and occasionally wheat were imported from the Baltic region. In addition to cloth, Bruges exported religion, or at least thousands of small, beautifully illustrated prayer books. Commerce requires credit, so Bruges was a major banking center, second only to Florence.

The city’s stature peaked in 1400; it has been downhill ever since. Which is a good thing, because its ornate medieval architecture and intricate network of canals have survived intact, making it one of the most picturesque cities in Europe. When in doubt, medieval architects always added the extra embellishment—a gilded bear here, an ornate wrought iron sconce there, an angel standing in a corner alcove, a dragon staring down from above a doorway, a narrow tower to give the building a more interesting profile.

Even better than the architecture is the food. The citizens of Bruges seem to subsist on a diet of Belgian chocolate, whipped cream, French fries, and beer. Yet no one gets fat. I discovered why one chilly morning. To commute to work, few people walk, and even fewer people drive cars; everyone is riding bicycles or—if they have a couple of small children—a bicycle hooked up to a miniature two-seated rickshaw. Belgians take their bicycles very seriously. All the train stations have parking lots for bicycles, which look like shiny junkyards if you whizz by them at 120 MHP in a bullet train. Bicycles are one reason why, in Belgium, per capita energy consumption is only 78% of the U.S. level; in the Netherlands it is even lower at 70%.

Zabar’s on a Truck

Wednesday was market day in the Markt—the giant central square, ringed by imposing medieval buildings and paved with (what else?) Belgian blocks. But there was nothing quaint or old-fashioned about this farmer’s market. No rickety tables with a limited selection of fruits, veggies and useless crafts. No no no. Overnight, a fleet of trailers had invaded the Markt and turned it into a high-class supermarket. Comparable vehicles don’t exist in America. An entire side of the trailer is opened up to reveal a complete deli counter, at least as big as the Zabar’s meat department. One trailer was a bakery; several others sold cheese; still others sold pork and beef, barbecued chickens, candy, and flowers.

Clearly this superb selection of fresh foods, conveniently available in the center of town, poses tough competition to the local stores. U.S. investors should pay close attention. According to the U.S. Department of Agriculture, there are 8,200 farmers markets in the U.S., up 76% since 2008. Many of them already sell a wide variety of foods, beyond the familiar fruits and vegetables. If these markets become as sophisticated as Belgian markets, that’s very bad news for Safeway, Wal-Mart, Whole Foods and Kroger.

Here Come the Americans

Bruges’ tourist business was thriving in mid-March, and few of the visitors were from the U.S. When Americans take advantage of the weak Euro this summer, the town will be mobbed with tourists. Two or three full days are enough to see the city, including a couple of superb small art museums, in a leisurely manner. Fair warning: In the summer heat, the canals stink of duck shit, but at least that enhances the medieval ambience.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

 

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To Attack Crony Capitalism, GOP Should Shut Down Fannie & Freddie

Posted on March 8, 2015 by tomdoerflinger

The GOP should run to the left of Democrats on financial issues in 2016 by positioning Democrats as the party of crony capitalism. Exhibit A is Fannie Mae. Exhibit B is Freddie Mac. Both were in bed with Democratic Party, and the Bush Administration—though not blameless on housing policy–repeatedly tried to strengthen regulation of F&F but could not get legislation past Democrats in Congress. The 2016 GOP standard bearer should promise to shut down Fannie and Freddie. This will put Hillary or Elizabeth or whoever on the defensive, while putting the GOP on the side of working class and middle class voters who were screwed by the Democratic crony capitalists as well as, eventually, by Wall Street.

Two excellent books analyze F&F’s role in the financial crisis from different angles: Reckless Endangerment by Gretchen Morgenson and Joshua Rosner, and Hidden in Plain Sight, by Peter Wallinson.   Morgenson, a New York Times investigative reporter, is no friend of Wall Street; Wallinson was a lonely Republican on the FCIC, the Committee that supposedly analyzed the causes of the financial crisis and blamed it on loose regulation of Wall Street while arguing, absurdly, that F&F did not play a “primary” role in the crisis.

The housing bubble was based on a false premise embraced by Democratic activists and politicians: Even though they had every incentive to make as many good loans as possible, banks were systematically refusing to make mortgage loans to qualified low-income and minority individuals. A study by Alicia Mundell of The Boston Fed claimed to document this discrimination. It was later debunked by the simple fact that mortgage default rates were the same in black and white neighborhoods; if lending standards were tougher for blacks than white, default rates should have been lower in black neighborhoods; in fact they were the same.

For several decades housing finance was a safe and sane business where banks and S&L’s made loans to people who had documented income, a 20% down payment, and a good credit history. This was all blown up by a law passed in the early 1990s that enabled HUD (Department of Housing & Urban Development) to set the level of “Non-traditional mortgages” to minorities and in “under-served areas” that Fannie and Freddie had to purchase from banks. This level was ratcheted up over time, particularly by Andrew Cuomo who became head of HUD in 1997. So Democrats were constantly pressuring the central players in housing finance to lower underwriting standards by purchasing ever more sub-prime mortgages that later would be called “predatory loans.” Rep. Maxine Waters advocated for no-down-payment loans. To meet its ever-rising quotas, Fannie had a special arrangement to buy loans from Countrywide Financial, the biggest sub-prime lender, charging the firm a discounted fee for insuring its mortgages.

One of Wallison’s prime contentions is that Fannie had many more subprime mortgages on its balance sheet than it admitted. This has been disputed by pundits like Paul Krugman and Joe Nocera. There’s just one little problem with their position: if Fannie and Freddie did not have many sub-prime loans, why did they both go bankrupt in the autumn of 2008?

Barnie Frank’s “Great Mistake”

What is incredible is that the Democratic policy mandarins and “community activists” never considered the financial risks they were encouraging low-income borrowers to take. Owning a home is a big financial responsibility involving not just paying the mortgage but real estate taxes, maintenance, utilities, and occasionally major repairs. As none other than Barnie Frank, Fannie’s biggest defender in the House of Representatives, later said, “I hope by next year we’ll have abolished Fannie and Freddie. . . . It was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.”

F&F competed with Wall Street firms to acquire mortgage loans from lenders to package into mortgage-backed securities. Morgenson and Roser do a superb job of showing how Fannie used liberal ideology, financial clout and political in-fighting to maintain its franchise as a public / private firm that, because of its implicit Federal backing, had a lower cost of funds than private firms. Fannie’s CEO in the 1990s was Johnson, a Democratic operative. As Ralph Nader said, “It’s all a matter of know who, not know-how. They’ve perfected all the techniques of lobbying and pay massive salaries for Rolodex hiring to ensure against any change.” Democratic “big thinkers” like Peter Orszag and Larry Summers supported F&F, as did liberal think tanks like the Urban Institute.

Regulatory Failure at All Levels

Much has been said about the end of Glass Steagall in the late 1990s and the sweetheart relationship between a clueless Greenspan/Bernanke Fed, Clinton’s Treasury Department headed by Bob Rubin and big Wall Street firms, particularly Citigroup (which would soon hire Rubin, paying him much to do little).

Fair enough, but in different ways both books show that this really was not crux of the problem. Regulators were clueless throughout the Federal Government. Wallison notes that four major banks—IndyMac, Wachovia, Washington Mutual, and Citigroup—were subject to traditional regulation but still went belly-up or, in Citi’s case, had to be rescued more than once.. The same was true of smaller mortgage lenders like Fremont Investment; very late in the game (the spring of 2007) Fremont was hit by the FDIC with a cease and desist order because of its many shortcomings. As Morgenson and Rosner note, “The laundry list of ills was so voluminous that it suggested that Fremont’s bank examiners had, like Rip Van Winkle, been asleep for years.”

Another incredible regulatory failure was that, just a few years after Enron used off-balance-sheet items to mislead investors, regulators allowed firms like Citi to have enormous off-balance-sheet businesses, variously called SIVs (Special Investment Vehicles) or Asset-backed commercial paper conduits (ABCP’s) that basically enabled firms to borrow short by selling commercial paper to Money Market Funds and lend long by buying mortgage backed securities. Wall Street analysts knew nothing about this business because it was not on the balance sheets released each quarter. Still another regulatory failure, redolent of the SEC’s non-regulation of Bernie Madoff, is the hedge fund manager who repeatedly – for several years – warned the SEC about the risky operations of NovaStar, yet the SEC did nothing. As the hedgie explained, “Amy was a very nice person. But she didn’t know shit about subprime mortgages. We used to have conference calls with her on the gain-on-sale accounting, the crappy loan originations, how NovaStar was playing games with the branches. . . .Meanwhile, this things starts out crazy and goes to outrageous.”

The point here is not that the big Wall Street firms were blameless—far from it. The point is that A) Fannie and Freddie. and their enablers in the Democratic Party, were at the center of a 15-year process of lower lending standards and blowing a huge housing bubble that eventually popped and B) The central problem was not a lack of regulation—there was plenty of regulation, but the regulators were clueless and complicit in many parts of the Federal Government.

So, the GOP should insist on killing Fannie and Freddie to prevent a repeat of this housing disaster, a disaster that was particularly bad for the low-income people Democrats claim to help. To help low-income people amass the funds for a downpayment of 20%, everyone should be allowed to have a 401K plan.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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B&T, Watch Wendy Do the “Impossible”

Posted on March 5, 2015 by tomdoerflinger

Yesterday on Bloomberg two respected Street professionals—blogger Barry Ritholtz and strategist Tony Dwyer of Canaccord Genuity—were discussing the topic of long-term investing in equities, Buffett style. They basically concluded it was impossible for the average individual investor to be a long-term investor. I quote, with slight changes in wording to improve clarity:

Ritholtz: “Most people can’t do what he [Buffett] does, it’s that simple. . . .They lack the belief system, they lack the discipline and they lack the long-term perspective. You can’t invest like Warren, so why even try? “

Dwyer, when asked about investors who hold stocks not just for 5-7 years but for 12-15 years: “The issue is, it is impossible [to invest for 12-15 years] unless you are investing as though you own the business instead of a stock symbol . . . because the odds are that at some point over a five or seven year period there will be a recession or a credit event and you will shake most people out.”

Three reactions to the wisdom of Barry and Tony (B&T)

First, as a characterization of how “most” individuals invest, they are correct; most people don’t own stocks for years and years.

Less obviously, they are also describing how most Wall Street pros invest. Worried about fund performance, portfolio managers try to dump stocks that are out of phase with the economy or are going through a difficult period. Conversely, many PM’s crowd into “what’s working” – healthcare, at the moment; tech in the late 1990s; energy in the late 1970s. The mediocre performance of most mutual funds suggests this is difficult to do successfully, especially after taxes. And it is very risky to aggressively overweight a popular sector.

Third it is ridiculous to claim that people “can’t” be long-term investors or that it is “impossible” to invest with a fifteen-year horizon. On the contrary, this is the way most individual investors should invest—hold their good stocks for decades and dumping the mistakes. They should own a mix of mature but still growing “blue chips” and some smaller, high-quality growth companies that either pay a dividend or eventually will do so. I call this  “creating your own conglomerate” which has four advantages:

  • Low commissions and low or no management fee.
  • Low taxes: You pay tax on dividends, but you don’t pay capital gains tax for years and years. If you own the stock until you drop dead, you never pay capital gains tax because the cost basis is stepped up to the market price when you die.
  • No market timing. Investors tend to get in near the top and out near the bottom.  And if you own individual businesses that you understand, rather than “the market” you are much less likely to panic in bear markets.
  • No guessing whether other investors consider a given PE ratio “attractive” or “over-priced.”  Provided you pay a reasonable PE multiple, changes in PE won’t matter too much, because in 20 years EPS will rise 570% if it rises 10% per year.

An underlying premise of “create your own conglomerate” is that macro trends are not predictable. As Larry Summers recently noted, economists never accurately predict recessions. And totally weird, unpredictable stuff (like a 50% drop in oil prices or zero Fed funds rate six years into an economic expansion) happens all the time.  Focus on buying good businesses that benefit from secular economic and social trends.

Mother Biggs, Inc.

A good example of what I am talking about is the mother of the late, great Morgan Stanley strategist Barton Biggs, whose investments were described in Mr. Biggs’ excellent book Hedge Hogging. Mother Biggs turned a small fortune into a large one by owning a portfolio of growth stocks selected by her sons, who made occasional adjustments to the portfolio.

What It’s Not

Just to be clear, here is what “Create your own conglomerate” is not. It is not:

  • Trading hot IPOs and momentum stocks
  • Buying “turnaround” stocks that look cheap but are often value traps
  • Shifting funds toward the “hot” region of the globe—currently Europe.
  • Trying to catch the bottom in cyclical situations – such as the energy sector now, or the Big 3 autos in 2009 (it worked for Ford but not GM and C).
  • Buying names that “activist” investors such as Carl Icahn are involved in.

Don’t get me wrong; these are perfectly fine ways to make money in stocks. They’re just not part of the “create your own conglomerate” approach and in any case are best left to professionals who have the time and expertise to execute these strategies effectively.

B&T, Meet Wendy

She’s no Warren Buffett, but she is better looking. And she is a long-term investor (and a relative of mine) who does what B&T deem to be “impossible” – buy boring blue chips and mid-sized “growth stocks” and hold them for years and years. She showed me the brokerage statements documenting a few of her more successful holdings:

  •  She bought shares of JNJ in January 1996 at a price of 23.7; now they are trading around 100. The dividend yield on her purchase price is 11.8%.
  • She bought some Starbucks shares (not enough!!!) in July 1996 at a price of 3.1; now the stock is 93. Yield on her purchase price: 40.7%.
  • She bought Altria in May 1991 for 5.38 a share; now the stock trades around 56. Yield on her cost: 38.7%
  • Admittedly copying Saint Warren, she bought Wells Fargo in January 2002, six years before the financial crisis. Not great timing, but the stock is still up 134% and yields 6% on her purchase price.
  • She bought Thermo Fisher in 2005 for 30.6; the stock has more than quadrupled and yields 2% on her purchase price.

Admittedly these are some of her better investments, and there were times in the past when they looked like duds. For example, during the 2008 real estate bust Starbucks (which had over-built to meet Wall Street’s expectations) plunged 74%; the company had to shut 500 stores and bring back the founder to revive the company. Altria was cut in half in the 1993 “Marlboro Friday” sell-off, when it announced an earnings disaster after losing market share to discount cigarettes. Wells Fargo was cut in half during the financial crisis; Borg Warner declined 68% and eliminated its dividend.

Another admission from Wendy: A few investments in apparently solid, widely owned “blue chip” stocks turned out to be disasters. Wendy bought shares of General Electric for 42 in 2001; now the stock is languishing at 25. And don’t even ask about the Lucent shares she bought in 1999. Wendy claims to have gotten better at avoiding bubble stocks like Lucent, and selling losers before they turn into terminal disasters. I have my doubts.

Three Co-Conspirators Against Long-term Investing

Wall Street pros, such as B&T, who try to own the right stocks for a given economic environment. They are constantly on TV and Radio opining about the best stocks to own, given current macro trends, valuations, and investor sentiment.

Wall Street sell-side firms that peddle whatever is “new and different” because new products that have not yet been commoditized have higher profit margins. Because they are geared to selling, brokerage firms tend to push whatever is in vogue and easy to sell.

The financial media, which is culpable on two fronts:

  • It is endlessly flogs a handful of glamour stocks—right now it’s biotechs, Tesla, Facebook, Alibaba, Apple, Apple, Apple, and Apple.
  • It is always doing its best to scare investors, turning every macro trend into an incipient disaster. Recently it was, “Oh my God, the strong dollar and declining oil prices are causing deflation!!!!” (Remember when declining oil prices were a bullish “tax cut for consumers”?)

We need more articles providing level-headed advice about how to construct a sensible portfolio of high-quality stocks you can own for the long term. Wall Street firms should put more effort into helping clients do this, charging a reasonable fee for same.

Copyright Thomas Doerflinger 2015.  All Rights Reserved.

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Get Set for Fed Rate Hikessssss

Posted on March 4, 2015 by tomdoerflinger

Item: In a major new report, a blue-ribbon panel of economists estimates that if all the brain power expended over the past 20 years forecasting the next move by the Federal Reserve had, instead, been used for productive endeavors, U.S. GDP would be 12% higher today.

So let’s discuss the next move by the Fed. It is a no-brainer it should raise rates later this year, even if it upsets equity and bond markets, not to mention central bankers in emerging markets. It’s not just that the ever-brilliant Larry Summers (if you don’t believe me, ask him) believes Fed tightening would be a huge mistake. It’s the anecdotal evidence that is most persuasive; the official data will catch up later. Consider:

  • Wal-Mart is raising wages for most of its 550,000 employees. Many other giant retailers, such as TJX and Ross Stores, appear to be following suit.
  •  Aetna has announced a major wage increase.
  • The California dock workers went out on strike.
  • Members of the United Steel Workers employed by oil refineries have gone out on strike.
  • Disney raised the cost of a theme park 4-6%.

These are not alarming headlines. They are typical headlines for an economy that is chugging along in the middle of an expansion, with the labor market getting tighter and workers having a bit more bargaining power. The economic expansion is maturing but shows no signs of tipping into a recession.

The problem is that current monetary policy is wildly inappropriate for an economy that is “chugging along in the middle of the cycle.” The Fed is still in panic-mode, with zero short rates. It’s way past time to start “normalizing” rates. In twelve months we will start to see telltale signs of wage pressure and corporate pricing power pushing up inflation. At that time investors will conclude the Fed is way, way “behind the curve” and must raise rates aggressively. Then we’ll see really severe “volatility” as investors wonder whether the Fed’s tardy response to inflation pressures will tip the economy into recession.

Of course, bumping up Fed Funds to 0.75% or 1% will have little impact on the economy. Once the rate hikes start, speculation in financial markets will quickly shift from “When does the Fed hike rates?” to “How far and how fast?” Rising rates may spook global bond markets, which have become overly dependent on easy money.

Inflationary risks have been exacerbated by the supply-side damage inflicted by Obamanomics. Fortunately Obama’s attack on fossil fuels failed. But Obamacare and other transfer payments create disincentives for employers to hire workers full-time, and for employees to work too much, lest they lose benefits. Tax hikes on high earners curb incentives to work and invest. America’s crazy corporate tax code continues to strand $1.5 trillion in corporate cash offshore, where it cannot be invested to expand U.S. economic capacity.

Not unlike 1997-98, when commodity prices collapsed during the “Asian Financial Crisis,” plunging oil prices have given the U.S. a reprieve from inflationary pressure. But that is transitory. A year from now the underlying inflationary pressures in the U.S. will be all too evident. With the dollar strong and other regions such as China having over-capacity, those pressures initially will not be severe, but they will be enough to force the Fed to keep raising rates.

Rising rates will weigh on the equity market. Stocks are no longer cheap, earnings growth is tepid, and rising wages will pressure profit margins somewhat. In a smart bullish report on U.S. equities, BAC strategist Savita Subranamian lists “10 reasons to stay long the S&P 500.” Reason number 7 is that “Valuations aren’t stretched.” Maybe not, but of the 16 valuation metrics she lists, the only ones where equities look inexpensive versus history are metrics that compare returns from stocks with current bond yields. So if long rates rise 150 bps, one of the chief props for the S&P 500’s valuation will disappear.

How to Spot a Mania

Identify bizarrely inappropriate and unsustainable economic conditions that go on so long they start to seem “normal” and irreversible—the sky-high PE ratios of NASDAQ 5000, cab drivers buying $400,000 houses with no money down in 2005, and—yes—zero Fed Funds in the sixth year of an economic expansion. During a mania, anyone who says “This has to end” is condescendingly reminded “You could have said that any time in the last four years and you would have been wrong.” They forget that “Past performance is no guarantee of future results.”

Pointing Eastward with Pride

In an article titled “China cuts interest rates as fears rise over deflation and slowdown” the Financial Times writes that China “faces the prospect of a much sharper slowdown than previously anticipated.” Not by us. Nearly two years ago (July 12, 2013) I wrote, “if you apply a little logic it is reasonable to conclude China growth will be much worse than current consensus.” It was obvious then that China was swimming in over-capacity and could not keep growing via investment and exports; the transition to growth driven by domestic consumption looked difficult, to say the least.

The new news since 2013 is that the crack-down on corruption is turning into a political purge that is A) scaring the Party elite, who are key economic decision makers, and B) freezing up the Internet, the central nervous system of a modern economy. Evidently Xi Jinping wants China’s economy to look more like Putin’s Russia.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

 

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Growth Offers the Best Value

Posted on February 17, 2015 by tomdoerflinger

In this week’s Barron’s Lawrence C. Strauss has an interesting article on the “growth versus value” debate. It is is a dumb concept invented by quantitative analysts and pension fund consultants that has little utility for real investors who actually understand the companies they own. A “growth stock” with an above average PE multiple can be a much better value than a slow-growing “value stock” with a low PE multiple, low price-to-book multiple, and high dividend yield. The keys are A) not to pay an excessive PE for growth and, B) make sure the company really will grow as fast as you expect. Item “B” is much harder than it looks. I recall writing thematic research reports where we asked each analyst for his or her best growth idea; looking at the names a few years later, many of them turned out to be duds. (If you don’t believe me, take a look at a 2-year chart of 3D Systems.)

The most useful insight to be found in Mr. Strauss’ column is a quotation from Oakmark’s Bill Nygren, who notes that today “investors are overpaying for high yields, which usually implies slower growth, rather than overpaying for high growth.” In other words, you are more likely to find good value among growth stocks that don’t offer particularly high dividend yields.

To test this hypothesis, I carried out a simplistic but nevertheless instructive analysis of the 30 stocks in Dow Jones Industrial Average. For each company I calculated:

  • Expected EPS growth in 2015
  • Dividend yield
  • PE on 2015e EPS.

Despite weak overseas economies, a strong dollar, and difficult comparisons after five years of S&P 500 earnings growth, a true “growth stock” should be able to grow at least 5% in 2015, given that the U.S. economy will grow about 3%. Here’s what I discovered:

  • Slow Growers: The 20 companies with less than 5% growth have a median yield of 2.9%; their median 2015 EPS growth is just 1.3%. This implies a “total return” (yield plus growth) of just 4.3%
  •  Fast Growers: The 10 companies with more than 5% growth have a median yield of just 1.4%, but their median growth is a lofty 9.3%. This implies total return of 10.7%–far better than the 20 slow-growers.
  • So, how much of a PE premium do you have to pay for the fast growers offering more than twice as high a total return in 2015? Very little. The median PE’s of the slow growers is 16.9x; that of the fast growers is just modestly higher at 17.7x.

Yield-starved investors are overpaying for stocks with juicy yields of 2.5% or more, even though many of these businesses face serious fundamental challenges that are stunting growth. I do not by any means claim to be an expert on all these companies, but here are some of the companies that may fit this description, followed by their 2015e EPS growth and 2015e PE:

  •  AT&T    1.2% EPS growth / 13.6 PE
  • Caterpillar   -25.1% / 17.8x
  • Coca-Cola    -1.5% / 20.9x
  • DuPont    2.5% / 18.5x
  • IBM    -3.1% / 10.0x
  • Intel    2.6% / 14.5x
  • J&J    4.0% / 16x
  • McDonalds    4.8% / 18.9x
  • Merck    -2.9% / 17.3x
  • Pfizer    -7.5% / 16.6x
  • P&G    3.2% / 20.6x
  • Wal-Mart    4.2% / 16.5x

I don’t hate all these stocks; in fact I own four of them. Some names may have temporarily weak earnings growth this year because of the strong dollar, the energy collapse, product cycles or special factors that won’t last forever. That said, it is fair to say that some of them—such as KO, IBM, MCD, MRK, PFE, PG & WMT – have fundamental problems that are likely to restrain earnings growth over the next few years, if not l longer. (Most obviously, Coke and McDonald’s are simply on the wrong side of the better and better-for-you healthy eating trend and show no signs of adjusting successfully.) Yet the average PE of the 12 names is a rather high 16.8x (median 17.0x). They are not great investments, in my opinion.

Now let’s look at the growth companies in the DJIA that are expected to grow faster than 5% this year. Of the 10, the 7 that appear to have the best fundamentals are:

  •  3M    9.2% EPS growth / 20.3X PE
  • Disney    10.3% / 20.8x
  • Home Depot    16.5% / 21.4x
  • Microsoft    7.7% / 16.4x
  • Nike    13.1% / 24.7x
  • UnitedHealth    8.8% / 17.7x
  • Visa    14.5% / 25.1x

Their average PE is 20.9x (median 20.8x); the average yield is 1.5% which is not great but not nothing either. Their dividends are likely to grow rapidly; earnings growth is strong and the average payout ratio is 30% versus 50% for the 12 slow growers discussed above. Interestingly, for these seven growth stocks the PE-to-total return ratios (i.e., PE divided by 2015 EPS growth plus dividend yield) are mostly in a remarkably tight range of 1.65 to 1.81; HD is the outlier at just 1.18.

To find good growth names to buy, you could do worse than to look at the top holdings of Bill Nygren’s Oakmark Funds, which is available on the website.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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Famous Random Events in American History

Posted on February 15, 2015 by tomdoerflinger

Item: President Obama opined that Americans were right to be concerned that in Paris there were “violent vicious zealots who behead people or randomly shoot a bunch of folks in a deli In Paris.” His spokesman Josh Earnest said the individuals in the Jewish “deli” were killed “not because of who they were but because of where they randomly happened to be. . . . these people were not targeted by name. This is the point. There were people other than Jews that were in that deli.” A State Department spokeswoman deflected a question concerning the motivation of the “deli” killer, saying that was a question “for the French government to decide.”

Despite the mindless carping of Fox News and the Israel Lobby, the White House is on solid ground. Frequently in American history, dispassionate historical research demonstrates, events that at first appeared to be carefully planned were, in fact, “random,” as the President perspicaciously observed with respect to the avowed Muslim terrorist who had already killed a police woman and just happened to seize hostages in a Kosher food store in the most prominent Jewish neighborhood in Paris. For example:

Forget the “grassy knoll” and all those conspiracy theories. In November 1963 Lee Harvey Oswald was leaning out of a Texas Book Depository Building, cleaning his high-power rifle, when it accidentally discharged, killing President John F. Kennedy and wounding Texas Governor John Connolly. Hey, accidents happen.

On September 11, 2001 rowdy passengers took control of two airliners and just happened to crash them into the twin towers of the World Trade Center. What a coincidence!

On September 15, 1963, a month after Martin Luther King Jr.’s historic “I Have a Dream” speech, someone bombed a church in Birmingham Alabama. It happened to be an African American church and four black children were viciously murdered. Using the logic of Presidential spokesman Josh Earnest, this must have been a “random” bombing because “no one was targeted by name.” Obviously, it was not random. It was the work of a white racist thug, just as the Paris Kosher “deli” killings were the work of an Islamic terrorist thug.

Now, President Obama is not stupid; the dumb comments made by him and his spokeskids about a “random” attack of a Muslim terrorist on a Kosher food store were a calculated attack on Jewish interests, as was Obama’s admonition to New Jersey Senator Robert Menendez—ranking Democrat on the Foreign Relations Committee and a respected expert on foreign policy—not to “listen to his donors” when deciding what to do about Iran’s nuclear ambitions.

Here’s the real question: How stupid are Jewish liberals? Will they continue to line up behind Obama and Hillary as the Democratic left targets Jews in Europe and Israel? Stay tuned.

Copyright Thomas Doerflinger 2015.  All Rights Reserved.

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Emerging Market Masochism: an Update

Posted on February 3, 2015 by tomdoerflinger

As I argued on  December 25, it is unwise for non-specialists to invest directly in emerging market stocks because:

  • You can get exposure to EM economies with far less risk by buying U.S. or European multinationals.
  • Emerging markets are very risky due to intrinsic financial weakness, corruption, high exposure to commodity prices, weak corporate governance, etc.

A couple of new data points underscore EM risks:

Dirty Oil

Petrobras, the giant Brazilian oil company that Wall Street loved after huge off-shore oil finds in 2007-2008, is, as The Financial Times put it, “awash in corruption.” According to the FT, “One lower tier executive has offered to repay $100 million.” As much as $20 billion may have been stolen. There is no valuation discount that would get me interested in such a stock. But I don’t mind owning Schlumberger, which I assume sells plenty of services to these guys.

China’s Purge Threatens Growth

The crackdown on corruption in China is starting to raise serious questions about the country’s growth prospects. Clearly, a great many projects were built by local governments over the past six years not because they made economic sense but, rather, because they would enrich corrupt officials and businessmen. This syndrome is hardly unique to China; nineteenth-century American railroad booms were great for bankers, builders and suppliers but not for European bondholders. Which is not exactly reassuring, because each of those railroad booms was followed by a multi-year depression. But, aside from the cyclical economic issues, Xi Jinping’s corruption crackdown is starting to look like a purge that will hurt long-term growth. According to the FT, “the crackdown has so far led to warnings or disciplinary action for about a quarter of a million cadres.” That’s a lot of warnings. Apparently the best way to protect your family from the crackdown is to commit suicide, which has become so common Beijing circulated a detailed questionnaire to families to get the measure of it.  Here is why this is so worrisome: Party members are key economic decision makers; now doing their jobs properly is less important than staying alive and out of jail. One way to do that is to avoid launching big new projects. That can’t be good for growth.

It gets worse. I learn from The New York Times that China’s government is also reducing Internet freedom by interfering with Virtual Private Networks. This makes life miserable for knowledge workers ranging from scientists to bankers to commercial artists. When we were in Shanghai our hotel could not access the United Airlines website. This is no way to promote China’s shift from a low-wage exporter to a modern service economy.

Copyright Thomas Doerflinger 2015.  All Rights Reserved.

 

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Equity Market Outlook: Still Mediocre but Not Terrible

Posted on February 3, 2015 by tomdoerflinger

January’s 3% decline in the S&P 500 is consistent with my observation on December 30 that “Stocks Are Expensive, Offer Mediocre Risk / Reward.” The main issues are:

  • Investors and strategists have become bullish and complacent; they were far more bearish two years ago, when stocks were cheaper.
  • Stocks are rather expensive versus history given that we are late in the cycle when profit growth is fairly weak. (See the Dec. 30 post for details.)
  • Tighter U.S. monetary policy is somewhat negative for stocks. QE has ended and the Fed will likely raise rates later this year.
  • Most foreign economies, which account for 35-40% of S&P earnings, are weak, including Europe, Japan, China and many other emerging markets (Russia, Brazil, Africa, the Middle East). The EU-Greece standoff and rise of extremist political parties elsewhere may hurt business confidence in Europe.
  • The oil price plunge hits S&P earnings hard. Energy companies’ earnings (11% of earnings in 2014) will collapse this year; suppliers such as CAT also take a hit. Contrary to what some observers believe, these effects are not fully offset by the benefit that certain companies get from lower energy prices, via lower costs (notably transports) and more discretionary spending. Said differently, a plunge in oil prices transfers income from the corporate sector to consumers; consumers save some of the money and spend much of it with non-S&P 500 companies.
  • The strong dollar is hurting earnings, and this may get worse. Looking at the average level of the monthly Fed Dollar Index, it was up 5.3% y/y in Q4 2014. If it stayed at January 2015’s level in February and March, it would be up 8% y/y in Q1 2015. If the dollar strengthens this year its average level could easily be 10-12% above 2014.

My impression from reading Street research is that Q4 earnings were subdued but about as expected, with Apple’s huge beat offsetting weakness elsewhere. Consult your local strategist for details. The Street is split on 2015 earnings, with some smart people still at $127 and others at only $120 (versus about $118 in 2014). Given the factors discussed above, I suspect the bears will win the argument.

There are, however, a couple of extenuating circumstances that may mean stocks can rise modestly this year despite flattish profits, much as they did in another year of commodity deflation, 1998. Energy stocks are valued on “normalized” earnings not current earnings. Investors will to some degree “look through” profit weakness caused by unfavorable currency translations, which affect reported profits but not underlying cash flows. Furthermore, dividends should grow at a double-digit pace in 2015; a 2% yield on stocks looks attractive versus bonds.

Bottom line: the S&P 500 should rise 5% this year, delivering a total return of 7%. Not bad when 10-year bonds yield 1.6%.

The Starbucks Effect

SBUX traded up 7% on in-line Q4 earnings because same store sales were stronger than feared. The bear case, which had been weighing on shares for the better part of a year, was disproved. Probably lower energy prices helped here, as consumers decided they could afford one more caramel macchiato low-foam extra hot latte. This will probably happen to other high-quality consumer companies. But avoid names, like Tiffany, that sell a lot to foreign tourists impacted by the strong dollar.

Copyright Thomas Doerflinger 2015.  All Rights Reserved.

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