Monday, October 27, 2008

Older Bulls Wiser than Younger Bears? Maybe

Old bulls versus younger bears. This could be entirely coincidental. Has anyone noticed that bullish sentiment seems correlated with age?

Bullish and Buying

The most prominent U.S. stock market bull to surface in recent days is highly respected Mr. Buffett, who was born in 1930 and grew up during the Great Depression years. If as a child he was too young to comprehend the hard times and economic turmoil of the era, we can at least presume that, in his early adult years as a student of Ben Graham, Buffett absorbed the first-hand lessons garnered by his teacher, who had lost everything during the stock market crash of 1929, which apparently was the life-changing event that led Graham to formulate his well-known value-investing methodology. Quoting from Buffett's op-ed piece in the New York Times:

Warren Buffett (age 78): October 16, 2008. "Buy American. I am."
"The financial world is a mess, both in the United States and abroad. So . . . I’ve been buying American stocks. . . . I previously owned nothing but United States government bonds. If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."

Also notable is so-called "perma-bear" Grantham, whose switchover into the bullish camp can be considered significant, since he spent the past couple of decades marauding with the bears:

Jeremy Grantham
(age 69): October 18, 2008. "Silver Linings and Lessons Learned"
We "have moderately cheap U.S. and global equities for the first time in 20 years. . . . We at GMO [Grantham's investment management company] are already careful buyers. We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the s&P as a probable low."

I am not sure how much weight Glickenhaus's opinion carries today in the investor community, but he is said to be the lone voice who boldly spoke out when stocks fell 23% on Black Monday in 1987, confidently calling a market bottom and the start of the next bull market. FOX Business has interviewed Glickenhaus twice during the past few weeks, highlighting the relevance of his experience of having lived through the stock market crash of 1929 and seen how the government's actions (or inaction) impacted the severity of the Great Depression:

Seth Glickenhaus (age 94): October 27, 2008. "On the Verge of a New Bull Market. . . "
"We are making a painful but meaningful low. . . . This is a rare opportunity to buy stocks at substantially below their intrinsic values. . . . We are on the verge of a new bull market beginning within a week or two. . . ."
(Note: On October 15, 2008, on Neil Cavuto's show on FOX Business, Glickenhaus indicated that a new bull market would start "next week." That day, the S&P 500 closed at 908. Today, a week and a half later, the S&P 500 closed at 849, a fresh, new five-and-a-half-year low.)

Bearish and Avoiding Stocks

As might be expected, so-called "Dr. Doom," Marc Faber, sees the U.S. and world mired in a serious recession that will last a few years. However, he also sees potential for a near-term rally within the longer-term bear market:

Marc Faber (age about 60?): October 20, 2008. "Stocks May Rally, Won't Reach Records"
"We're extremely oversold at the present time. The market is in a position to rebound." However, Faber holds only a small equity position: "stocks make up 7 or 8 percent of his holdings, with cash, bonds and gold, his biggest position, accounting for the rest." Also, his opinion on the U.S. economy remains gloomy: "To rebuild economic health in the United States, you need a serious recession that will last several years. The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."

Next, here's the opinion of a firmly committed, unwavering bear, who is calling for a significantly lower bottom:

Gary Shilling (age in 60s): October 22, 2008. "We Haven't Seen the Worst Yet"
"The economy hasn't hit bottom yet. Neither, in all likelihood, have stocks. . . . If you're an equity investor with a long-only portfolio, it's not too late to take some money off the table. Remember 777--not the airliner but the low that the Standard & Poor's 500 hit in 2002. That's 21% beneath where we are today, but if it's breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us."

Finally, representative of the diversity of opinion, here's a market commentator who is one of the few courageous enough to state publicly that Buffett is, whether we like it or not, just plain wrong this time around:

Diane Francis (age in 40s): October 27, 2008. "Buffett Is Wrong: Avoid Stocks"
"Far be it from me to contradict one of the world's greatest stock sages and business analysts. But I will. Seems to me that we are in uncharted territory with this panic until the U.S. election is staged on November 4 and until the global community demonstrates that it is going to appoint sheriffs to patrol the global economy and stop the kind of jurisdictional arbitrage that led to the casino-ization of banking. . . . For me, buying and selling should not be an option at least until the U.S. election and probably until January 2009."

Does Age Matter?

Admittedly, based on a sample size of just three opinions from each camp, we have at hand little more than anecdotal evidence and, consequently, cannot draw any conclusion that comes even close to being statistically significant. However, with the bull opinions coming from investors in approximately the 70-to-90 age group, versus the bear opinions from a younger cohort in the 40-to-60 age group, I suspect that investor age might be an indicator of stock market sentiment.

One interpretation is that the older generation, having closer first-hand experience with the crash of 1929 and economic hard times during the 1930s, have a deeper appreciation for today's unprecedented government efforts to stem the current financial crisis before it reaches depression-era proportions. If the bulls end up being correct, we will in a few years' time look back upon today and have to acknowledge that the older seers professed a certain "market wisdom" that the less experienced, younger generation lacked. On the other hand, if the bears win the battle and the actual market bottom turns out to be much lower, I can already almost hear the youthful crowd "writing off" the elderly bulls as having "gone senile," being "out to pasture," or at least being "out of touch" with these ever so "modern" times of ours.

For the sake of global economic stability, I certainly hope the old bulls really are the wiser. However, on days like today, with the market closing at a new low, we have to fear that the younger bears could be right in the short run.

Thursday, October 16, 2008

Potential secret weapon to battle our financial crisis: A trillion dollar debt-to-equity swap

While heavily indebted American consumers struggle to make mortgage and credit card payments, a larger shift is underway. News from Tokyo indicates that politicians in Japan, America's "friendly" creditor nation, are beginning to consider investing the country's massive horde of foreign reserves, to "take advantage of the opportunities opening up around the world" during this global financial crisis we are in.

The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.

In the earlier part of the subprime crisis, we saw high-profile investing of $21 billion by sovereign wealth funds (Singapore, Kuwait and South Korea) into U.S. financial institutions (Citi and Merrill). This week's closing of Mitsubishi UFJ's $9 billion capital infusion into Morgan Stanley is a private sector version of the same type of foreign investment. Given the, not billion, but trillion dollar scale of the foreign exchange reserves that China and Japan have amassed, any decision on their part to swap even a small portion of their fixed-income funds into equity-like investments will have a tremendous impact on the U.S. equity market.

Ponder this: The investments last January by smaller sovereign wealth funds in U.S. financial institutions helped to boost capital, but nevertheless Merrill is now being acquired by Bank of America and Citi's balance sheet is still under pressure. The U.S. government coordinated JPMorgan's acquisition of faltering Bear Stearns in March, but that did not prevent Lehman from going bankrupt in September. After an unprecedented $85 billion government lifeline to AIG last month, AIG needed another $38 billion just last week. Also, despite heightened government intervention in recent weeks--Paulson's $700 billion bank rescue plan signed into law on October 3, coordinated global rate cuts by many G-7 members and other countries last week, and the government's "no objections allowed" infusion of $125 billion capital into JPMorgan, Bank of America, Citi, Wells Fargo, Goldman, Morgan Stanley and other financial institutions announced on Monday--the economic outlook grows bleaker, people worry more about their jobs and retirement and cut back on consumption, and the stock market resumes its downward spiral while real estate prices sag further.

In short, each and every policy measure to date, however unprecedented and seemingly "radical" at implementation, has failed to stem the economic bleeding.

So, where do we turn at this juncture? Well, recall the proverbial "rich uncle," who is perennially forthcoming with money gifts when you are a kid, lends you the extra money you need for a down payment when buying your first house, and provides half the capital you need to start a new business. As our financial crisis runs its course, we Americans as owners of over-leveraged assets in our increasingly distressed U.S. economy really have only one place to go for the capital we so badly need. Because there is not enough capital internally within our national borders, the much-needed equity capital to stabilize our economy and restore confidence of consumers and among financial institutions must come from abroad.

Like it or not, for equity capital rather than just debt, American financial institutions, large corporations and our U.S. equity markets as a whole need to tap into the trillions of dollars of foreign exchange reserves on the books of governments throughout the world, and particularly the trillion dollar balances of each of China and Japan. Back in March, the House held a hearing on the role of foreign government investment in the U.S. economy and financial sector. More along these lines is needed.

My guess is that our equity markets will not find a firm bottom until cross-border government-level deals are struck to convert from debt to equity significant portions of the U.S. dollar-denominated foreign exchange reserves sitting overseas in Asia. How about a trillion dollar swap out of Treasuries and into a broad-based equity index like the S&P 500?

A substantial increase in foreign ownership of the American economy is probably a lot closer than we think.

Tuesday, October 07, 2008

Irony of Capitalism in Crisis: The rich lose more, but the poor and middle class suffer . . . and we need more government intervention, not less.

With credit tight and real estate and stocks at multi-year lows, who wins and who loses? Certainly, any trader short the market or long put options is making out like a bandit, while anyone long real estate and stocks is experiencing painful net worth erosion.

But, in the midst of the financial turmoil we're in, how's the "average American" faring? For insight, let's first have a look at household balance sheets.

Household Balance Sheets

According to the Fed's triennial Survey on Consumer Finances (using 2004 data--results of the 2007 survey come out in early 2009), assets owned and debt held by 10% or more of all American families, along with the median dollar value of holdings among the specified percentage of families holding the particular asset or debt, are:

Financial assets:
  • Checking or other transactional account: 91% of families, $4k
  • CDs: 13% of families, $15k
  • Savings bonds: 18% of families, $1k
  • Stocks: 21% of families, $15k
  • Mutual funds and other pooled assets: 15% of families, $40k
  • Retirement accounts: 50% of families, $35k
  • Life insurance products with cash value: 24% of families, $6k
Nonfinancial assets:
  • Car or other vehicle: 86% of families, $14k
  • Primary residence: 69% of families, $160k
  • Other residential property: 13% of families, $100k
  • Business equity: 12% of families, $100k
  • Mortgage on primary residence: 48% of families, $95k
  • Car loan or other installment loan: 46% of families, $12k
  • Credit card balance: 46% of families, $2k
Clearly (and this should come as no surprise, particularly in light of the mortgage-related crisis we are in), the most significant asset owned by most American families is our primary residences, against which we carry sizable mortgages.

The Poor, the Middle Class and the Rich

The landscape gets more interesting when we probe one layer deeper, to see who owns what and against how much debt. Taking a look at three distinct groups classified by net worth (again in 2004 dollars), we can list assets and debt commonly held by 40% or more of the households in each group:

The Poor (below 25th percentile): $2k median net worth

  • 75% have checking accounts with median value $1k
  • 70% own car(s) with median value $6k
  • 48% have car loans or other installment loans with median value $11k
  • 40% carry credit card balances with median value $2k
Typical leverage: Debt/assets = 0.8 (estimated based on net worth)

The Middle Class (50th to 75th percentile): $171k median net worth

  • 98% have checking accounts with median value $6k
  • 62% have retirement accounts with median value $34k
  • 92% own car(s) with median value $17k
  • 93% own their primary residence having median value $159k
  • 66% carry a mortgage on their home with median value $97k (60% implied loan-to-value)
  • 49% have car loans or other installment loans with median value $13k
  • 53% carry credit card balances with median value $3k
Typical leverage: Debt/assets = 0.4 (estimated based on net worth)

The Rich (above 90th percentile): $1.43 million median net worth

  • 100% have checking accounts with median value $43k
  • 63% own stocks with median value $110k
  • 47% own mutual funds with median value $160k
  • 83% have retirement accounts with median value $264k
  • 44% own cash value life insurance products with median value $20k
  • 93% own car(s) with median value $31k
  • 97% own their primary residence having median value $450k
  • 46% own other residential property with median value $325k
  • 41% own business equity with median value $527k
  • 58% carry a mortgage on their home with median value $186k (40% implied loan-to-value)
Typical leverage: Debt/assets = 0.1 (estimated based on net worth)

On the asset side of the household balance sheet, the picture that emerges is pretty much as expected: the rich own everything that the poor and middle class do, and have more of everything, item by item. The typical middle class household owns a checking account, car, house and retirement account. By comparison, rich households own what their middle class brethren do, plus a long list of investment assets: stocks, mutual funds or hedge funds, insurance annuities, second homes or investment real estate, and private businesses. At the other extreme, the majority of poor households have only a checking account and a car.

The situation flips, however, when we look at the liability side of the balance sheet: although the rich have higher absolute dollar amounts of debt, their debt-to-assets ratio is the smallest among the three groups. Borrowing is most prevalent among the middle class, where two-thirds of the households have mortgages on their homes, half have car loans, and half carry balances on their credit cards, resulting in typical household leverage of about 0.4. Among the poor, slightly fewer than half have car loans and about four out of ten households have credit card debt. However, it is actually the poor who are most overburdened by debt, with a high debt-to-assets ratio of about 0.8. This trend of the "asset-poor" being the most "debt-rich" can easily be seen by looking at the fraction of car owners in each group who have car loans and other installment debt: the poor (48%/70% = 0.7), the middle class (49%/92% = 0.5), the rich (27%/93% = 0.3).

Weathering the Financial Storm

Who fares best: the over-leveraged poor, the debt-laden middle class, or the asset-endowed rich?

As real estate and stock prices fall, here's how each group is affected:
  • The poor, who do not typically own real estate, stock or mutual funds, are not immediately affected by falling markets. However, a small yet significant subset (12% in 2004, presumably higher today) of these households in the lowest quartile of net worth are homeowners carrying mortgages and, being the most highly leveraged group, are undoubtedly the most adversely impacted by depressed home prices. Further, having little to no savings, this group is the first to fall behind in loan and credit card payments when job losses escalate as the economic downturn runs its course.
  • The middle class comprises the bulk of homeowners with substantial mortgages who are feeling the brunt of the fall of the housing market. These households also have retirement accounts with stock and mutual fund positions that shrink as stock prices slide. In the event of a job loss, most of these families can cover their bills for at least a few months by relying on their savings and, if needed, early withdrawals from their IRAs and 401ks. But, if the downturn lengthens and unemployment rises further, many of these households will unfortunately suffer through home foreclosures and the like.
  • The rich experience the fewest financial dislocations, despite the fact that their vast holdings of stocks and real estate are immediately impacted when prices fall, putting downward pressure on the equity in their private businesses as well. Although rich households lose the most money in absolute terms when prices fall, their minimal household leverage (debt-to-assets ratio of just 0.1) makes true financial hardship a foreign concept to most in this group. Because very few of the rich have large mortgages on their homes (and even if they do, they usually have liquid assets they can sell off to reduce leverage), foreclosures among this group will be almost unheard of, however severe the economic downturn becomes.
Policy Implication

The recent chain of events is becoming all too familiar: real estate and stock markets fall, investor sentiment (i.e., among the rich) turns negative, headlines carry news of our ensuing financial crisis, smaller investors (i.e., the middle class) either sell out or hesitate to buy, consumers (all groups) spend less on goods and services, businesses earn less, the economy stalls, layoffs begin, sentiment worsens, and market prices fall further, bringing us full cycle--but at a lower level.

If this downward spiral continues, the over-leveraged poor lose their jobs, cars and homes (through foreclosure if they own them, or eviction if they are renters); the debt-laden middle class exhaust their savings and deplete their dwindling retirement accounts trying to stave off foreclosure of their homes (but many lose their homes anyway); and the asset-endowed rich watch their asset values plunge but keep their homes and still own America. While an extended economic recession is definitely not desirable for any group, note that:

Economic pain and suffering is inversely proportional to wealth: the poor suffer the most, the middle class are next, and the rich, well, they become a little less rich.

The public policy implication should be clear: at this point, whatever can be done to stabilize the markets should be done. President Bush distributed cash to families last year through his fiscal stimulus package, which helped the consumer and temporarily kept the economy afloat. The recent moves of the Fed, FDIC and government--in rescuing Bear Stearns and AIG, saving Fannie Mae and Freddie Mac, coordinating orderly takeovers of WaMu and Wachovia, increasing deposit insurance levels from $100k to $250k, preparing to buy $700 billion of "toxic" mortgage-related assets from the banks, and buying commercial paper in the markets today--have all helped.

But, one problem remains: we're not yet on solid ground.

Australia cut rates this morning by 100 b.p., twice as much as anticipated. Pimco's Bill Gross is right to push the Fed for a similar massive rate cut later this month. A coordinated global rate cut is also in order.

For any advocates of laissez faire capitalism, this "visible hand" of persistent government intervention in the markets must be appalling, particularly following the apparent successes of American-style capitalism over Cold War communism during the past few decades. However, we are now in a "leveraged asset" crisis and the only way to stop the bleeding is do what it takes to stabilize asset prices, and the only entity capable of acting on a large enough scale to make a difference is the government.

From Economics 101, we know that the four factors of production are innovation, labor, physical resources and money. Despite this financial crisis we're in, America and the world still have plenty of entrepreneurial ideas, people willing and able to work, and all the (arguably diminishing) natural resources we always have had. What is lacking is capital, and at this point only the government has deep enough pockets to keep the money flowing.

With the U.S. government stepping in so often in recent months and taking ownership (or warrants) in our prime financial institutions, it may be surprising to many that America is involuntarily slipping through some convoluted "looking glass" into a society with increasing government ownership of businesses, where the state, by default, has become the largest market participant.

Such is the irony of modern capitalism, with more government intervention, not less, being needed to keep the ship above water as the economic tide sloshes all around us--poor, middle class and rich alike.