Greener Pastures

Issue XXVII - Silver Decline

2011-05-23T10:59:00.000-07:00

Dear Readers,

On Sunday, May 1 I was still in Omaha following the Berkshire Hathaway annual meeting. Shortly before President Obama announced the death of Osama Bin Laden that evening, I made a routine check of Bloomberg to see how the Asian markets had opened. Silver futures trading in Hong Kong had fallen at the open from about $49 to lower than $42, settling overnight around $45 before resuming its decline the next morning in New York. By the end of last week, the price of Silver had fallen another 23% to $34. Predictably, the reaction from bloggers and commentators has been divided over whether this represents the end of the bull market in Gold and Silver, or whether it is just a correction in the midst of a secular bull for precious metals. The confluence of several factors led to its swift decline, and while no one can say for sure where the medium-term price bottom will be, right now the volatility is so high that it would be ill-advised to recommend long or short positions.

The decline happened for several reasons. First, CME Group, parent company of the COMEX exchange, increased the margin requirement to hold physical Silver several times over the past two weeks. Indeed, such an announcement after the close on Friday, April 29 contributed to the swift decline that began on Monday, May 2. Effective on May 9, the margin requirement for a single contract (5000 oz.) is $21,600, up from $11,745 just two weeks ago, a full 84% increase. Therefore, the margin requirement has jumped from 5% of the price of a contract to about 12% after May 9, if last Wednesday’s closing price is used. Not surprisingly, this has caused fund managers who hold physical Silver, such as George Soros, and Eric Sprott, who runs the physical silver ETF PSLV, to reduce their holdings. In turn, the rapid decline triggered repeated sell orders on the way down, further amplifying the decline in both physical Silver and the SLV ETF. The sheer size of this decline in the face of margin hikes helps to illustrate just how over-speculated the Silver market had become. Going forward, it is going to be much more expensive to own the physical contracts, as the CME has made it clear this will not be the last of the margin increases.

One of two things is happening; this is either a long-term (10+ years) bubble popping and Silver will not reach those highs for another few decades, or it is a major, long-in-the-making correction within a secular bull market for precious metals. There are reasons to expect that the corrections within this bull market will continue to be sharp and swift. First of all, the price-tracking ETF’s (SLV and PSLV are two of the largest) that many traders use to trade the price of Silver are required to adjust their reserves of physical Silver bullion depending on the daily closing price of the ETF. In effect, this means that if the price of physical Silver experiences a sharp run-up like it has since last August, the ETF’s act like a sponge. They have to buy up boatloads of physical silver on the way up, constraining supplies on exchanges like the COMEX and depleting inventories, which contributes to further price increases. The vicious cycle works on the inverse on the way down, as well. Just as the ETF’s absorb physical supply like a sponge on the way up, they have dumped physical Silver on the market as investors have dumped their shares over the past week, exacerbating the rapid price decline. In fact, because the ETF’s selling their supply tends to lag the price declines of the ETF, the physical supply does not hit the market until after the price has declined, potentially opening up the door to further price decreases.

As a result of the rapid decline, the double-short Silver ETF that was mentioned in the March 19 newsletter, ZSL, has gone from a low of around $13 on Friday, April 29 to a high of $24.38 on Thursday, May 5, more than an 85% increase in only four trading days. I mentioned that Silver and its related mining stocks appeared risky right before the New Year and that early 2011 could bear witness to a correction. Obviously, the prediction turned out to be a bit premature. After declining a bit the first few weeks of the year, from late January until Friday, May 3 the price of Silver nearly doubled, capping off a remarkable 200% increase since last July. To illustrate the degree to which SLV and the related ETF’s were traded/speculated, from April 20-May 3 the daily volume on the SLV ETF regularly exceeded that of the most popular S&P 500 ETF, SPY. Think about that for a minute. The trading volume of an ETF that tracks the price of a precious metal that only a tiny percentage of investors own was exceeding the volume on the most popular ETF to track the broadest US stock market index. If that isn’t indicative of a frothy market for a commodity, I don’t know what is.

At the same time, this correction is what many long-term precious metals bulls have been waiting for, but most will tell you that buying Silver right now is risky. For example, the price appeared to have stabilized over the first two trading days of this week, and many investors got caught in what appears to be a classic “bear trap,” that typically occurs after the initial stage of a large asset price reversal. After some investors re-initiated long positions, the price resumed its decline by falling 8% on Wednesday, May 11. Looking at the Silver corrections over the past decade, the current decline is more likely to take a few months. Additionally, the decline could be as sharp as the run-up of the past two months, overshooting to the downside. Perhaps the best thing to remember at this point is that the big/fast money has taken over. It’s best to go with the trend and not fight it, especially during times of great volatility like the past two weeks. Hedge funds and other big money players by and large were the ones who pushed the price up 100% in less than five months and they are now the ones who are selling, with a few inevitably making lots of money off of its collapse.

Furthermore, as a result of the price run-up, all of a sudden many more economic commentators are paying attention to Silver. One advantage of this is that there will be no shortage of opinions to read and compare that will be issued over the next six to twelve months as to when the bottom has been formed. I will be one of them, and will issue it at that time. For now, my opinion is that there is still money to be made in the ZSL ETF or by shorting SLV or double-leveraged Silver ETF’s like AGQ. Whenever Silver has experienced mid-term corrections since the bull market began in 2001, the decline has, on average, lasted for two to three months and usually the bottom has formed around the 200-day moving average, currently around $28.50 today. As mentioned, because of the robust nature (albeit fueled by speculators who have access to cheap financing) of the most recent price run-up, the correction could be equally as harsh and overshoot to the downside as we head into the summer season, historically a weak time for precious metals. If the 200-Day Moving Average is breached to the downside, it could very well signal that Silver could correct to the low $20’s, or even lower.

Another thing to keep in mind is that the fundamentals supporting precious metals haven’t changed, and until governments around the world fix their nations’ financial problems the bull market in precious metals will probably remain in place. Many who hold Silver are concerned that if the Fed starts raising rates, the bull market will end. Looking back at the last precious metals bull market, in 1979 President Jimmy Carter gave Federal Reserve Chairman Paul Volcker a mandate to crush inflation, no matter what the cost. Volcker immediately started raising rates, but precious metals did not peak until January 1980 (the collapse was initiated when the COMEX raised margins and the Hunt Brothers, who had used a massive leveraged position to try and corner the market, were forced to sell amidst the large resulting losses). Interest rates and inflation did not peak until mid-1981, when the US entered a recession that would last until late 1982. Therefore, the oft-repeated argument that the precious metals bull will be done at the moment Bernanke begins raising rates is insufficient, especially because in the event that inflation picks up it will take much higher rates than the current ones to lower it. In addition, the US currently has a national debt that is many multiples the size it was in the 1970s. Back then, the US was still the world’s largest creditor. To illustrate this, Volcker’s raising rates back then contributed to financial crises and subsequent government defaults in several Latin American countries that were in debt to the US and the IMF, including Mexico in 1982 and Peru later in the decade. This time around, it is not as easy to raise rates quickly because the US Government would need to greatly reduce its expenditures first to accommodate the extra costs for paying the debt that would be issued at the higher rates.

In closing, at the present moment this appears to be a much-needed correction within a secular bull market for precious metals, and I expect precious metals to stabilize sometime before the end of the year. If inflation begins to gather steam and interest rates are not raised high enough to lower it, the precious metals bull could potentially be in the 5th or 6th inning of 9, so to speak. However, if inflation does reverse course like the Federal Reserve has been predicting, this correction in the metals could quickly become a multi-year bear market. Therefore, it is impossible to say for sure whether the bull market in precious metals is over. Many commentators try to call bubbles whenever a particular asset runs up in price, but in reality bubbles are all but invisible until they burst, and thus are only definitively identified in hindsight. Rational reasons are always given for the soaring prices, and then these same reasons are suddenly proved irrelevant as the price falls. That said, there are still plenty of relevant reasons for precious metals to keep rising in price over the next five to ten years. For now, the speculators have been curbed, and going forward investors will need to demonstrate their commitment to Gold and Silver by paying higher margin costs to own the metal. If the fundamentals do not change and prices resume their upward climb, you can count on hedge funds and other sophisticated investors jumping right back in as they recognize the sheer robustness of the bull market and get more serious about staying invested in it for longer than a few days or weeks. If this proves to be the case, get ready to take advantage of lower prices for Gold, Silver, and the equities of their miners. If the S&P 500 declines as well, there could be a few situations where we see the best opportunities to invest in Gold and Silver mining equities since late 2008. Such an opportunity would be nothing less than fantastic.

Respectfully Yours,

Matthew R. Green

May 12, 2011

Issue XXVI - US Dollar Rally

2011-05-23T10:56:00.000-07:00

Dear Readers,

If Mark Twain were alive today, he could easily reference his own famous quote when speaking about the US Dollar; in short, rumors of the greenback’s death have been greatly exaggerated. After falling well over 15 percent since last June, the US Dollar appears to be setting up for a rebound, if not a multi-year recovery. Amongst all the negative commentary that has surrounded the greenback recently, the fact of that matter is that all fiat currencies will remain under pressure as the US and Europe continue to stagger through difficult financial times. With the looming problems concerning Medicare and Social Security, along with the recent budget impasses, many commentators believe that the Dollar will continue to fall. Over the longer term, this is likely true. Despite this, the impending end of QE2, the potential tightening of monetary policy, and technical signals point toward a bottom. In short, the US Dollar could be ripe for an upward reversal, potentially for the
short-to-medium term.

Even before the onset of the Great Recession and subsequent financial crisis in 2008, the US Dollar was in secular state of decline for most of the 2000s. The expenditures from the Iraq War, low interest rates in the US, massive budget deficits and the Euro coming into its own were among the reasons for the decline. The current massive amount of negativity surrounding the Dollar is being pushed by escalating fears of a potential US Government debt default, rising inflation and interest rates, speculation of a third round of money printing by the Fed, and the potential reduction of importance of the Dollar as the global reserve currency. These fears, while not unwarranted, are overblown and have resulted in the Dollar currently being oversold.

Due to its role as the reserve currency of the world, the performance of the Dollar has a greater effect than many, even seasoned professionals, realize. The value of the Dollar affects the equities markets, commodities, bonds, inflation, consumer confidence, and most of all, macroeconomic policy for not just the US but the rest of the world’s governments and central banks. In other words, economists, politicians, and just about everyone else who monitors financial markets study the Dollar’s movement because of its effects on their subsequent economies, policies, standards of living, and many other factors.

Recently in op-eds or on CNBC and Bloomberg, economists and commentators have covered the bullish and bearish cases thoroughly. First, the bearish argument. Public debt in the United States is already high, and continuing to rise at a staggering pace. On April 18, Standard and Poor’s downgraded the outlook for US government debt to “negative.” This followed a nearly 5% drop in the preceding month as Congress repeatedly failed to agree on the federal budget until the eleventh hour. If a formal downgrade of the US credit rating from the AAA level were to take place, it would immediately trigger selling of US Dollars by central banks around the world. This would likely be a harbinger of the US permanently losing its economic hegemony, although the arguments for and against this are too lengthy to discuss here. At any rate, this stems in part from the devaluation of the US Dollar due to the Federal Reserve’s quantitative easing programs since March 2009. While these programs have not been extended yet, last week Federal Reserve Chairman Ben Bernanke affirmed a commitment to exceptionally low interest rates for an extended period of time. This comes despite the Fed seeming to ignore rising inflation over the past year, as seen already in the prices of food and other everyday commodities. While a part of the rising prices of can be attributed to poor harvests in many food commodities and higher oil prices, the fact is that many economists and citizens alike are concerned that that Fed is counting on price rises to taper off, and are worried it may not happen. Rising prices would only hurt the Dollar more. The end of the Dollar as the world’s preeminent reserve currency could take place if one or a combination of the aforementioned events materialize. Additionally, a main concern of some economists is that if a watershed event such as a US debt downgrade occurred, the process could not be controlled. The Dollar’s decline would be exacerbated by central banks quickly moving to diversify their currency reserves, quickly selling Dollars and moving them into either gold or other currencies. To illustrate this, several prominent commentators have expressed concern at the fact that China holds approximately 70 percent of its reserves in US Dollars, and its future actions could lead the way in diversifying out of the Dollar. The concern stems in part on the fact that such a rapid decline of the Dollar could lead to a currency crisis and potentially hyperinflation.

The positive outlook arguments for the Dollar are largely contrarian in nature, and address the fact that at least a portion of the Dollar’s recent decline can be attributed to overblown fears. First and foremost, it needs to be considered that the extreme level of pessimism may already be priced into the current Dollar Index, which fell to as low as 72.70 last week before rising to close at 74.91 on Friday, a sharp increase that perhaps signals the beginning of a medium-term rally. The droves of investors that have been running to physical gold, silver, or precious metal ETF’s like GLD and SLV have been doing so in part to protect their portfolios from a collapse in the Dollar. While this was a major factor in the price run-up, the events of this past week in the precious metals sphere have revealed that it was at least in part being driven by speculation. Therefore, the rapid run-up and
equally swift decline of precious metals could be indicative that the big drop in the Dollar has already taken place, and it may be near or already has seen a medium-term bottom.

Second, a timely end to the second round of quantitative easing (QE2) could create further headwinds for the stock and precious metals markets. This was the case in 2009-10 with the start and end of the first round of quantitative easing (Refer to Chart 1). Note that the Dollar began to fall in 2009 after the March 2009 announcement of Quantitative Easing, and began to rise once again after the Dubai debt crisis in November 2009, continuing with the European Debt crisis and the end of QE1. The latest round of Quantitative Easing, along with the subsiding (but far from over) debt crisis in Europe, contributed to the Dollar’s slide since last summer that, in my opinion, has led to the Dollar being oversold. Indeed, tighter monetary policy has been argued for by members of Congress and the Federal Reserve Board alike. While the situation in Libya and the rest of the Middle East has contributed to higher oil prices, commodities in general have been rising. Tighter monetary policy in response to this will help ease inflationary concerns and help strengthen the Dollar. Although the Federal Reserve left rates unchanged at the latest meeting, it has thus far not expressed any intention to commence another round of quantitative easing, although maturing bond purchases will occur on a more limited basis.

Finally, a weak Dollar isn’t necessarily welcomed by the rest of the world, contrary to popular belief. For US trade partners with a large export sector, such as Germany and Japan, a low US Dollar is detrimental because that means lower levels of trade with the US and effectively puts a cap on future growth. A number of currencies, including all of the other currencies that make up the US Dollar Index, have appreciated against the Dollar. Therefore, it is possible the foreign central banks could increase their Dollar purchases in the name of slowing their own currency’s appreciation. This would help stabilize the Dollar, and perhaps even contribute to a medium-term rally.

Looking at the technical analysis, indicators are signaling, as they were in March, that the Dollar could be at or near a medium-term bottom. Looking at long-term charts, despite the Dollar’s pronounced downtrend over the past decade, it could potentially be setting up for a break to the upside. While the Dollar has dropped, the Moving Average Convergence-Divergence (MACD) has been rising. A positive divergence while the Dollar is in a downtrend could signal a pending reversal to the upside. This is also true of the short-term charts, as you can see from Chart 1. Looking at a chart of the Dollar over the past year, the charts are also showing divergence in the Relative Strength Index (RSI), which, despite the continuing drop in the Dollar, has failed to make significant new lows, instead floating around its previous lows (Refer to Chart 2). Such a divergence/chart pattern often precedes a reversal, in this case to the upside.

Therefore, with the robust upturn in the Dollar over the past week, the medium-term bottom may very well have been made. While all fiat currencies, at least amongst Western economies, will continue to be under pressure as currencies are devalued, for now the Dollar appears to be commencing a medium-term rally.

Respectfully Yours,

Matthew R. Green

May 8, 2011

Issue XXV - Japan S&P500

2011-03-19T12:43:00.000-07:00

Dear Readers,

Over the course of the past month, several headwinds have formed for markets around the world. The political uprisings in the Middle East and the ongoing natural disaster in Japan have brought the S&P 500 down nearly 8% off its late February highs and sent oil back over $100/barrel, although it has fallen back below that level in the wake of the Tōhoku Earthquake in Northern Japan. Precious metals and oil could experience significant pullbacks, particularly Silver. For example, Silver stocks such as Silver Wheaton (SLW) are being affected by both the S&P 500 pullback and Silver falling from its highest levels since 1980. Even before the events in Japan, technical indicators on the S&P 500 signaled that a mid-term top may have taken place, and in the days following the earthquake several key support levels have been breached to the downside. The events that have taken place could continue to put downward pressure on world markets because the market’s momentum and technical indicators have been reversed. In this issue, I will briefly summarize the situation leading up to the earthquake and a few ETF’s that can be used to capitalize on the correction in Oil, Silver, and the Equities market.

To begin, it should be noted that what will ultimately transpire in the three markets covered in this issue will be determined in part by the performance of the US Dollar. Indeed, the dollar’s steady decline since July 2010 is one reason that Silver, Oil, and the S&P 500 have continued to move up. The dollar appears to be oversold, perhaps putting in a technical double-bottom on its longer-term chart. Of course, the Federal Reserve could announce a large third round of Quantitative Easing and send it even lower, as it did when Bernanke announced the possibility of QE2 in August, 2010 and formally announced $600 Billion of additional bond purchases in November. However, with the sovereign debt situation in Europe continuing to flare up, most recently a few weeks ago, and Japan injecting what may reach $500 billion in emergency funds into their economy, it is probable the dollar will trend higher over the next few months. A rebound in the Dollar Index in the near-term could take the Index back to the low 80s.

For all the tragic devastation that occurred in a matter of minutes during the quake/tsunami and could result from the Fukushima Daiichi nuclear fallout, a currency crisis triggered by the simmering Japanese debt crisis could hit just as quickly and would be much more destructive for the future of Japan and subsequent generations. Many analysts are commenting about how this disaster will be positive overall for the Japanese economy because of the future robust rebuilding program. While that could work, the fact is that Japan is on the cliff of a man-made debt disaster, and this natural disaster could prove to be the breaking point. Even before the earthquake, in January Standard and Poor’s downgraded Japan’s sovereign debt to the AA- rating. Another Japanese recession as a result of the quake would cause an increase in the cost of welfare and unemployment payments, combined with continuing unfavorable demographics. When added to a costly rebuilding and relief program, it wouldn’t be surprising at all to see Japan’s credit rating reduced to “junk” levels within a few years, maybe even sooner.

Some commentators are pointing to the 1995 Kobe earthquake and its aftermath for guidance about how the Yen will perform in the short-term. The yen rose in the aftermath of that quake, and while the yen has risen against the dollar in the immediate aftermath of the March 11 quake, in 1995 Japan had not yet resorted to nearly thirteen years of Quantitative Easing and over a decade of near-zero interest rates, a policy begun in 1997. With a 200% Debt/GDP ratio fifteen years later, if a flight to safety occurs it will likely not be to the Yen. The repatriation of funds back into Japan in the aftermath of the quake has taken the Yen to all-time highs against the Dollar on March 15-18, but each time the Bank of Japan has taken emergency measures to stem the tide. The G-7 has joined in this fight over the past several days, as well. Since a stronger yen is the last thing that the export-driven Japanese economy needs in the wake of the earthquake, it is all but guaranteed that the BOJ will continue intervening in conjunction with the other G-7 Central Banks. This marks other key difference between 1995 and 2011; the intervention is happening right away. In 1995 the yen rose relentlessly until the BOJ intervened nearly a month after the Kobe earthquake. Compare that to the immediate response of the BOJ and G-7, along with pledges from all the players to keep the Yen/Dollar ratio above a level of 80.

I have been an unabashed bull with respect to precious metals since late 2008 when the US Congress, Treasury and Federal Reserve chose to bail out the banks, and precious metals were trading at beaten-down levels. While the prices recovered in early 2009, it was the onset of the Fed’s Quantitative Easing program that set Gold and Silver ineluctably on the path upward. I believe these patterns will continue to play out over the remainder of the next few years and perhaps even longer, until the United States and other western nations fundamentally fix their budgets and get spending under control along with raising interest rates to more normal levels. At the same time, the events of the past month may have caused a mid-term top in the price of non-food commodities, particularly with Silver. After the robust advance of Silver over the final months of 2010, the price level of the metals suddenly has become risky, as mentioned in the issue sent out right before the New Year. Silver was about $30.50 at that time. While a pullback did occur in January, the onset of the Middle East crisis and rampant internet rumors about a shortage in Silver pushed the white metal to nearly $35 in February and early this month, much to the surprise of many commentators. With tensions beginning to subside and the events in Japan, markets around the world are responding with a correction.

After dropping nearly 15% in January, Silver came roaring back in tandem with Oil as tensions flared in the Middle East. In addition, the allegations about Silver manipulation that were mentioned in the August 4, 2010 edition of this newsletter have grown, and are currently rampant throughout the financial blogosphere. This rumor and additional untrue rumors of a pending shortage in Silver have reached the mainstream media, for example a column last week by William Cohan of the New York Times (You can read the column here). Despite the alleged manipulation, the fact is that no market goes straight up or straight down. The market shock that is being caused by events across the pacific could be the impetus for Silver to correct downward to its 200-day moving average. Such a pullback would be typical of the way Silver has tended to correct since its current bull market began in the early 2000s. It has always corrected to the 200-dma after large, breakout runs in which it often doubles in price. As can be seen in the chart below, the upward breakouts typically last 6-8 months, and are then followed by 18-24 month consolidations. This is what happened in 2004, 2006, and 2008. The financial crisis in 2008 caused the price to fall more than 50% from its early 2008 high, providing the best buying opportunity in years. At its current price, Silver is currently farther above its 50 and 200-day trend line that it has been at any point in this bull market. Simply put, the risk far outweighs the reward of investing at these levels, even more than at the end of December. If you are currently long Silver, an easy, liquid instrument to hedge a long position is ZSL. It is a Double-Short ETF, so if there is a pullback, ZSL will make up for some of the losses on silver mining equities or bullion. If Silver drops below its 50-day moving average in the coming week, look for further correction to take place.

Third, Oil and the S&P 500. Two weeks ago, Oil surpassed $100 for the first time since 2008. Obviously, the threat posed to oil supplies due to the revolutions in the Middle East were the main driver behind this. With the easing of tensions, the near-absence of violence in Saudi Arabia and the Tōhoku Earthquake, Oil appears to be heading back toward $90 per barrel or even less if the dollar continues to strengthen. As is the case with Silver, there is a Double-Short ETN to capitalize on this, the ticker symbol is DTO. Interestingly, DTO was issued around the time oil peaked at $147 a barrel in July 2008. Issued at $20, it was over $200 by early 2009 as oil crashed. I’m not suggesting that will happen again, but the point is that it is a good way to capitalize if the price of crude continues to decline.

Finally, the S&P 500. Since the Fed announced the second round of Quantitative Easing, investors have cheered as the S&P 500 surpassed its pre-Lehman Brothers bankruptcy high, and just two weeks ago the Dow Jones Industrial Average reached a level 100% above the March 2009 low. The onset of the Middle East crisis sent oil prices higher, and the S&P 500 responded by pulling back from what could be a midterm peak on February 22. Currently, the effects of the Tōhoku Earthquake are sending markets tumbling around the world, and the S&P 500 and Dow Jones Industrial Averages broke through their 50-day moving averages (one of the least-complex technical signs of a correction) in the past week. Unless the US enters another recession, we’re not facing a repeat of 2008, but more likely a 10-20% correction in the equities markets. On March 15, the Federal Reserve announced no change in interest rates or the current round of Quantitative Easing. Unless an expansion of the program is announced that sends the dollar lower in the short-term, this correction could take the S&P 500 to its 200-day moving average or below. To capitalize on this and/or limit the downside on long positions, the Double-Short S&P 500 ETF is SDS. For the inverse S&P 500 ETF which is not leveraged, the ticker symbol is SH.

Respectfully Yours,
Matthew R. Green
March 19, 2011

Issue XXIV - Groupon

2011-02-23T12:12:00.000-08:00

Dear Readers,

The increased scrutiny that Groupon has faced recently is not limited to debate over what the company is worth. Other major challenges lie ahead for Groupon as it prepares for its IPO this year (no, the Tibet-themed Super Bowl ad is not one of them, although I must admit I liked the commercial but can see how others could view it as being in bad taste). First, it is debatable whether its business model is beneficial for its customers, particularly the small businesses. Second, Groupon is facing challenges from LivingSocial, Google and a host of other deal-of-the-day websites. In such an environment, will Groupon be able to effectively evolve as a business and maintain its competitive advantage? These challenges and how the company handles them will ultimately determine its long-term course. While it may not be the next Google or Facebook, decisions made today and in the near future will go a long way toward Groupon remaining a viable internet business that provides a crucial discount retail service.

First, a brief overview of Groupon’s business model might be helpful. The customer/merchant either contacts a Groupon sales associate or is solicited by one. The sales associate and Groupon then structure an offer. For example, a product that would normally cost $20 for $10; a 50% off deal that is sure to increase traffic on the day(s) the deal is offered. Then the merchant is featured on the website, and a cap is placed on the number of these deals that can be sold (the merchant can opt for packages ranging in number from about a dozen to many thousands). As these deals are sold on the website for $10, Groupon takes 50% of the revenue generated, in this case $5. The merchant then gets a $5 x 500 coupon redemption to be paid out over 90 days. A 500-coupon package at this price (assuming that the merchant could potentially be selling 500 items for $20 and adding in Groupon’s cut) will cost the merchant $7500. Compared to traditional methods of promotion via discounts, such as print ads or television, this is expensive, especially for small businesses.
In an economy like the present, Groupon is a haven for consumers who are looking for deals, not necessarily a merchant whom they can go back to on a regular basis. Thus, the subscribers that Groupon connects to the merchants inherently have a smaller chance of re-patronizing the businesses that are featured. For the merchant, it is up to them to entice the consumers to come back at full price, a task much easier said than done. Of course, some might come back, but coupon-clippers are a notoriously frugal demographic (just ask any seasoned consultant who is worth his or her billable hour). In this respect, Groupon is a beneficiary of fortuitous timing, launching at a time (late 2008) when even upper-middle class individuals began penny pinching and looking for deals. However, that doesn’t mean the situation is a win-win for all merchants.

The issue is not that a sizable percentage of merchants lose money on these deals (and close to 33% do, according to a 2010 Rice University study). A merchant who offers a Groupon deal, or for that matter any discount situation with the expectation to make a lot of money, is either naïve or missing the point of a deep discount. Discounts of any kind form the classic economic concept of a loss leader, intended to facilitate a sale that otherwise might not take place. The intention is not to make money, but to bring in new customers who otherwise would not have patronized that business. That said, many merchants are not only losing money on the deals, but are complaining that it didn’t result in a sustainable uptick in business. This is amplified within sectors where consumers have many choices as well as in sectors that are lower-margin businesses by nature. For example, there many deals for personal care services being offered among the deal-of-the-day websites. Many consumers in a big city will go across town for 50% off an expensive spa treatment or other such deal but would never be willing to pay full price (especially if doing so means going back across town). Of course, some do, but that is the exception. For smaller deals, i.e. 50% off a $20 men’s haircut, not as many are interested.

Even less interested are the merchants who shell out a bunch of half-price services and then don’t reap the benefits of repeat business. In the case of many small businesses, they usually are not using Groupon to clear out inventory. They are attempting to offer a discount, utilizing the marketing power of social media, to create awareness of their business. When that awareness doesn’t translate to higher profits and/or retained customers, they aren’t satisfied.
The aforementioned Rice University study surveyed 150 random businesses that ran Groupon deals between June 2009 and August 2010. Of those businesses, 42% said they would not offer another Groupon-type promotion again. The most commonly cited reason was that the customers were “extremely price sensitive, barely spending beyond a discounted product’s face value.” Repeat-purchase rates were found to be around 13%. It should be noted that spending beyond the coupon’s value was markedly higher in a few sectors, particularly restaurants, underscoring the fact that Groupon is more effective for certain business segments than others.

The study’s findings are consistent with decades of academic and corporate research that have found that price promotions do not produce many long-term benefits for businesses. Even worse, when promotions are repeated on a regular basis they chip away at brand value over time, and lead to customers who aren’t willing to buy without a deal. One of the first and most famous examples of these findings occurred back in the 1980s, when Sears had a revelation regarding discounts for its vaunted Craftsman tool line. Sears found that buyers of the tools waited for the weekly sale flyer, and then, would only buy what was on sale. If what they needed wasn’t on sale, then they would wait until it was before buying it. Effectively, Sears found that it was teaching its customers to wait for the sale. Businesses that run Groupon deals are faced with the same dilemma. Assuming the study is correct, even if all of the coupon users become repeat customers, only 13% would on their own volition and pay full price, while the rest would only be returning because they received yet another discount incentive. Over time, this effectively lowers the price for everything at a loss to the retailers.

Many of those who have defended Groupon in the business press and in the blogosphere tout the incredible amount of publicity that a merchant can get, especially a small business. That is definitely true. When selling deals, Groupon salesmen walk into various stores armed with spreadsheets containing hard numbers of the exposure that a business can expect to receive. But, as stated earlier, the fact is that this exposure is to consumers who are looking for deals, a group that is already preconditioned to not be willing to pay full value.

Groupon, LivingSocial and the other websites that have popped up since 2007 deserve credit for advancing yet another retail sector into the digital age: coupons. Realizing that discounts are just as effective, if not more effective, when distributed via the internet as opposed to newspaper clip-outs or television, many have jumped at the opportunity to provide merchants with such services. With more and more offers available as the sector has proliferated, the market can only get saturated more quickly, i.e. the number of viable, small-to-midsize merchants that are willing to run promotions can only be exhausted at an accelerated pace. But that is not to say that there will not be interested merchants. After all, over 60% of the merchants featured in the study made money off of their Groupon deal (other academic studies on Groupon will be published in the coming months; as of now the Rice study is the only empirical study available). The point is that it works for some merchants, and doesn’t seem to work for others. Eventually, the website’s customers could primarily be small and midsize businesses that find the promotions to be effective as well as large businesses. Indeed, deal-of-the-day websites are already increasingly offering deals from larger merchants, and are finding these deals to be very profitable.

Recent developments within the sector indicate that the momentum is shifting from small businesses to larger retailers. Some of the largest retailers in the country are now working with the deal-of-the-day websites. This trend first came to the forefront back last summer with Groupon’s August 20 deal with Gap (pay $25 and buy $50 of merchandise, nearly 500,000 of these deals were sold), and more recently, LivingSocial set sales records by offering gift cards worth $20 of goods at their partner Amazon.com for $10 (over 1,000,000 of these deals were sold in a 24-hour period).

Working with larger retailers may be where the sector’s ultimate destiny may lie. Small businesses will always be looking for exposure, but the fact is that larger companies have a greater wherewithal to absorb a few of these one-day discount deals once in awhile. Furthermore, although financials are not disclosed, I have a hard time believing that Groupon would take 50% from deal with such a large customer, as a large profit is virtually ensured even with lower margins. Within the small business sector, many of the upstart deal-of-the-day websites are charging less than the 50% that Groupon typically takes (LivingSocial is one of these), and thus the margins in the small-business deals are falling. As small businesses discover better deals offered by other websites, Groupon will eventually be forced to lower their margins. If the deals with large retailers/merchants prove to be more profitable and reliable for repeat business, then you can expect that this is where the sector will focus on in the coming years.

With so many questions that have yet to be answered about the sector, the biggest looming question is whether it will still be viable once the sheen of novelty has worn off. The answer is yes, as long as these websites can evolve and adjust. So far, they appear to be doing so. As stated previously, the dozens of deal-of-the-day websites that have popped up can only shrink the pool of interested merchants more quickly, continually forcing margins down. However, that may be a trend that keeps both parties coming back for more. As the merchants sense that there are better deals, they will go with those, and the more expensive players will be forced to adjust. In a few years, I could see local websites, perhaps sponsored by local newspapers that have seen their ad revenue eroded by Craigslist and other listing websites, launch deal-of-the-day sections to reconnect with local merchants who they are already familiar with, and who in turn could use them to reach their target local audience. If the margins are low enough, this could be a mutually beneficial venture. Additionally, there are new startups popping up within the sector that offer deals which are contingent on either repeat business from customers, or purchasing a certain amount beyond the deal’s value. If this catches on, expect merchants to favor that approach and for Groupon and the larger players to adapt.
On the other hand, even before their IPOs, Groupon and LivingSocial have begun buying up other deal-of-the-day websites not just in the US but all over the world. When these companies go public, expect them to attempt to purchase many of their competitors in order to obtain certain innovations their competitors may have pioneered, and thus maintain their competitive advantage. Thus, while the current social aspect/novelty of these websites may prove to be a temporary social fad, they aren’t going away. With adjustments that they will make either by choice or by necessity, you can expect deal-of-the-day websites to be an influence on the retail sector for years into the future.

Respectfully Yours,
Matthew R. Green
February 11, 2011

Issue XXVIII - Tech 2.0

2011-02-03T08:44:00.000-08:00

“Past may be prelude, but which past?” - Henry Hu

In the first week of December 2010, one of the major business stories involved Google’s (GOOG) $6 billion offer to purchase Groupon. Founded in 2008, Groupon has expanded at an extraordinary pace to become the largest deal-of-the-day website. Every day, Groupon e-mails subscribers an offer for heavily discounted items or services from a particular merchant in the subscribers’ local market. In the economic climate of the past few years, it has proven to be very popular. To the shock of many, Groupon CEO Andrew Mason turned down GOOG’s offer. Early in January 2011 GOOG announced it is launching a similar service, dubbed Google Offers, while Groupon is planning an IPO. Reports have put the anticipated size of Groupon’s IPO around a staggering $15 billion. The rapidly increasing valuations of websites such as Facebook and LinkedIn, as well as deal-of-the-day websites – reminiscent of the first wave of technology overvaluation – have raised concerns of another tech bubble in the making.

Despite the bad memories elicited by “tech bubble,” websites today such as Groupon are probably not going to be the next crop of high-profile flameouts like Pets.com or Webvan ten years ago. For one, Facebook is already so large that its position could be similar to that of GOOG in 2004, in which it can go public and subsequently use its IPO cash to acquire other companies, increasing its market share and gradually building value for investors. Therefore, the unfolding situation could have characteristics of the tech bubble and successes such as GOOG. Parallels to the past will inevitably exist, but the question is which scenario will be more closely mirrored, and for which startups. Ultimately, a lot of these websites may not be worth as much in a few years as they are today. At the same time, lessons learned from the first tech bust have resulted in today’s websites being in better financial shape as they prepare to go public. This is Part 1 of what will be a 2-issue topic. This week, the focus will be on the present valuations within the sector, and next week the focus will be on what the future may hold and what Groupon in particular will need to do to stay competitive as the sector evolves.

One of the factors in the high valuations within the tech sector is simple supply and demand. Assisted by SecondMarket and other facilitators of private-stock transactions, accredited investors are able to invest in startups such as Facebook and LinkedIn with relative ease. In such transactions, the selling party is often the startup’s employees cashing out their private shares in the company. Since these shares are relatively hard to come by and the market is not as liquid as it would be on an exchange, investors have bid up the prices relatively quickly. However, the valuations may be entering a territory in which legitimate arguments can be made that they are overvalued. SecondMarket’s latest share auction values Facebook at approximately $70 billion. This is half of what GOOG is valued at, despite GOOG having $25 billion in revenue, $10 billion in earnings, and, most importantly, higher operating margins than Facebook. I am not flat-out suggesting that those who have invested in Facebook via private transactions will not make money. It is entirely possible that Facebook’s valuation could surpass $100 billion before its IPO, which is expected to come before 2013. However, the higher the valuation climbs, the more likely it becomes that there could be a rapid exodus as lots of individual investors seek to get out once the lockup on their shares expires.

For those who doubt that this is a possibility, look no further than Yahoo! (YHOO) circa 1999. YHOO was the character of the first tech bubble that was most synonymous with the internet as a whole, not confined to a retail sector like Amazon or EBay. Adjusted for inflation, YHOO’s market cap at the end of 1999 was approaching $150 billion. Today, stripping away YHOO’s tangible book value, the market currently values the company at close to $0. That’s right, net of its cash position and other tangibles, such as investments, the market values YHOO at $0. I am talking about a business that generates $1 billion in cash flow on $5 billion of revenue. Needless to say, a decade later YHOO is no longer the gorgeous new girl on campus. While Facebook, LinkedIn, and Groupon are in great shape right now, if something better comes along, unless these websites evolve accordingly, then they will be on track to become as old as, well, YHOO.

With current valuations high, the time is ripe for these companies to go public. Wall Street is currently gearing up for what will undoubtedly be two of the hottest IPO’s in 2011, Groupon and the just-announced IPO of LinkedIn. While Groupon has not yet filed for an IPO, bankers are aggressively (and smartly) vying for the assignment. Although the valuation may be frothy, bankers know that in order to get the most successful IPO for a client in the rapidly-growing deal-of-the-day sector, now is the time to move forward. Even if the valuations do eventually deflate, Facebook and Groupon are more than likely here to stay and will be major clients for Wall Street in the future, just as YHOO, AMZN, EBAY, etc. were viable businesses that thrived and were active clients for Wall Street throughout the 2000s despite the tech crash early in the decade. Amidst the excitement about the pending IPO, many on Wall Street are concerned that Groupon is overvalued, even more so than Facebook. Concerns about the viability of Groupon’s business model compound these concerns.

To compare the two companies, Facebook has over 600 million users and a scalable business model with very low fixed costs. Most importantly, it is by far the most widely-used social network. Groupon, on the other hand, is finding itself in competition with a plethora of other deal-of-the-day websites. Thanks to the low barriers to entry provided by the internet and an easily replicable business model, many of these new players are undercutting Groupon’s margins to provide better deals for the featured merchants. As is the case with most industries/sectors that proliferate, as new participants enter the market profit margins will become thinner, profits will decline, and eventually revenue will stop growing and perhaps even fall. Additionally, with GOOG launching its own service and Amazon teaming up with DC-based LivingSocial, two large players with deep pockets will increasingly be nipping at Groupon’s heels. While Groupon has indeed achieved tremendous growth in a short amount of time (in fact, in August 2010 Forbes named Groupon the fastest-growing startup in history), to maintain growth it has had to add thousands of local salespeople and has to continue doing so to find new local and national merchants to feature. That is not as scalable of a business model as Facebook and many other websites. Yet, a $15 billion IPO is being planned in the midst of an increasingly saturated market.

Another challenge to Groupon’s valuation is the fact that the business sector led by Groupon is inherently lower-growth than many others on the internet. When GOOG’s offer for Groupon was announced, a few commentators compared it favorably to GOOG’s October 2006 acquisition of YouTube. However, significant differences between Groupon and YouTube would not have made Groupon as good of an acquisition as it may have seemed. A few analysts noted that GOOG bought YouTube for $1.65 billion when the latter’s revenue was a mere $11 million per year. On the surface this makes Groupon seem like a steal, as it is projected to earn somewhere between $1.3 and $1.5 billion in 2011. However, despite the meteoric growth rates of Groupon, it should be noted that YouTube’s customer base is simply any internet user who wants to watch or upload videos. For Groupon’s 40 million online subscribers, the service is very popular and growing. But those people are not the customers. Groupon’s customer base consists of the merchants who utilize it as a loss leader to bring the public into their stores, hopefully stimulating future business and/or purchases of other products at full price. Thus, Groupon’s customer base is inherently more fickle, especially those for whom the deal doesn’t work. Eventually, there will be a core group of merchants in any given local market who will be regular customers of Groupon and other such websites, and the rest won’t use it. That puts a lid on growth for the company in its current form. For YouTube, on the other hand, the user base and revenue-generating ad clicks are constrained only by the overall number of internet users, which is continually growing worldwide. Facebook is the same way, as it is constantly entering new countries around the world. Eventually there will be limits to its growth, but that is further off for Facebook than Groupon.

With a number of copycat websites eroding market share, even if Groupon does remain the sector’s leader, it may not be worth $15 billion in a few years. Although it incorporates the easy distribution and powerful marketing characteristics of social networking, Groupon is neither an all-encompassing hub for the world’s information like GOOG nor is it a social network like Facebook. It is more akin to a discount service provider while borrowing a few characteristics of a social network. Businesses in the discount service sector are typically not worth $15 billion. For example, Overstock.com has $1.2 billion of revenue and is valued at about $370 million. Just five years ago, that valuation was nearly $2 billion. In the brick-and-mortar discount retail sector, Dollar General has $14 billion of revenue and is valued at approximately $10 billion. Currently, a large part of Groupon’s valuation derives from, like GOOG and Facebook before, the prospects of exponential growth. However, the valuations of businesses like Overstock.com and Dollar General that are more similar to Groupon may give a better indication of what its true valuation should be, especially if Groupon’s growth prospects are increasingly limited.

Despite the increasing valuations for tech startups, this is not simply a repeat of the first tech bubble. If this were the late 1990s, Facebook, Groupon, LinkedIn, etc. likely would have gone public several years ago. After the successful Netscape IPO in August 1995, historically pointed to as the beginning of the tech bubble, tech startups were increasingly geared toward fast-track IPOs. Entrepreneurs, venture capitalists, and bankers alike all contributed to this against the backdrop of the soaring NASDAQ, which helped to mask the fact that not all of these startups could possibly be successful. YHOO was founded by Jerry Yang and David Filo in 1994 and went public two years later. Similarly, Jeff Bezos founded AMZN in 1994 and it went public in the spring of 1997. Yet, many others were taken public with little to no earnings of which to speak. Still others burnt through their venture capital even before going public. This isn’t the case today with Groupon, LinkedIn and Facebook. They are highly profitable and growing. Yet despite an improving IPO climate since 2008, they are waiting for the right moment to go public. Groupon would be the exception in this case, as it is two years old. Facebook and LinkedIn are seven and eight years old, respectively. Even GOOG did not go public until it was nearly six years old, in 2004. So there is definitely a prudence that may have been lacking in the late 1990s when the internet sector temporarily seemed to be invincible. Yet, a better managed process of growth doesn’t mean that these startups aren’t overvalued at present and could still be when they go public.

The verdict about whether these soon-to-be-public startups are overvalued is still out. While my opinion leans toward yes, it should be noted that in the case of Groupon there have been several well-respected parties, Google and Goldman Sachs among them, who have taken a peek at the numbers and clearly didn’t pick those $6 billion and $15 billion respective valuations out of a hat. Obviously, the valuations take into consideration the company’s rapid growth and potential to do so in the future. Thus, two main questions need to be answered to more accurately gauge the sector’s prospects.

First, will the deal-of-the-day sector become so crowded that it will become significantly harder for Groupon to compete in the future? The sector is evolving as quickly as it is growing (indeed, one of the main reasons an IPO would be helpful to Groupon is so it can have cash to evolve via acquisitions). The robust activity within the sector in December was furthered by Amazon’s $175 million investment into LivingSocial, the second-largest deal-of-the-day website. LivingSocial’s deal with Amazon has enabled it to quickly diversify its offerings beyond its subscribers’ local markets and perhaps represents a more intelligent route toward growth. Not surprisingly, Groupon is increasingly offering national retail deals as well.

Second, deal-of-the-day websites could prove to be a fad that fades away because the economy improves or because consumers/merchants tire of the concept. Will Groupon still be worth $15 billion in that case? Most likely not. However, as stated before Groupon is not going away. After all, consumers are always looking for deals in good economies and bad. If the sector fades it will be the weaker players who will vanish, leaving only Groupon and a few of the stronger competitors. An improving economy may reduce traffic to the deals, however. Additionally, there are serious questions about the viability of Groupon’s current business model above and beyond the aforementioned issues. Such will be explored further next week.

Respectfully Yours,
Matthew R. Green

February 3, 2011

Issue XXII - Lost Decade

2011-01-10T05:48:00.000-08:00

Dear Readers,

As the economic recovery drags on at a turtle-pace, several commentators have begun to make the inevitable predictions of a “lost decade.” This description is often thrown about when discussing Japan during the 1990s – although as Japan’s malaise continued into the 2000s, “lost era” is perhaps a more accurate description. Before this description is applied to the US, it is helpful to look first at whether the performance of the US economy over the past decade truly mirrors that of Japan. Moreover, what should be the metrics by which developed economies are measured against each other? By these measures, does the Japanese experience of the 2000s even qualify as a “lost decade?”

In the United States, the economic history of the 2000s began with the bursting of the technology bubble that, combined with September 11, created a circumstance about which former Federal Reserve Chairman Alan Greenspan said “historically can result in the undoing of a society.” In response, the Fed quickly initiated a series of aggressive interest rate cuts. Other central banks around the world followed suit in order to prevent, as several central banks directly stated at one point or another, a prolonged period of Japanese-style stagnation. Most economists, all the way up to Greenspan himself, did not anticipate the extent to which these interest rate cuts would inflate bubbles in the housing and credit markets.

After the housing collapse and subsequent credit crisis in 2007-08, central banks once again acted quickly to ease monetary policy and prevent a prolonged period of low growth. In addition to cutting rates to zero, the Federal Reserve initiated a program of quantitative easing in March 2009 and expanded the program by $600 Billion in early November 2010. One of the reasons given in defending this practice was to expedite the current recovery to the point that it becomes self-sustaining. This would prevent a double-dip recession that could, in turn, lead to a repeat of the Japanese experience.

As often as one may hear that the Fed is trying to prevent a “Japanese experience,” it is helpful to establish whether Japan truly underperformed given its circumstances. Since 1990, the Japanese economy has faced a real estate collapse and subsequent banking crisis more damaging than the recent US recession, battled deflation, and dealt with unfavorable demographics. While the banking problems are largely behind it, deflation and an aging population have continued to linger. Through that, Japanese GDP growth averaged 0.6% over the past decade according to the World Bank.

In general, the rationales behind much of the economic policymaking since at least the 19th century have been dominated by “lessons learned” that are drawn from throughout the course of economic history. However, it is debatable whether the example of Japan is an economic scenario that should be avoided entirely. Daniel Gros, Director of the Centre for European Policy Studies, stated recently that “the basis for the scare story about Japan is that its GDP has grown over the last decade at an average annual rate of only 0.6% compared to 1.7% for the US. The difference is actually much smaller than often assumed, but at first sight a growth rate of 0.6% qualifies as a lost decade.”

If that is the case, GDP growth in much of the Eurozone might also fit the popular definition of a lost decade. According to the World Bank, in the 2000s Germany experienced nearly the same growth rates as Japan (0.6%) and Italy was even worse (0.2%). France and Spain performed somewhat better, but the Eurozone as a whole was not much better off. With sovereign debt problems now engulfing the continent over the past year, growth rates for the 2010s will likely not be much better.

Nonetheless, while this may look like economic stagnation on the surface, it elicits the often-asked question of how to properly measure the economic performance of developed countries against one another. The answer lies in the economic trajectory of countries that industrialize, as emerging markets transition into developed countries. The development of industry brings hundreds of millions of people from the countryside into the cities, fueling a rising industrial sector. All of a sudden, a former farmer or migrant might be a factory worker, contributing a bigger, and more easily measured, piece of a national GDP. This happens to millions of workers who are within the “working-age population” (WAP), those who are not too old or too young. Therefore, a more accurate measurement of the economic performance of developed countries might be GDP per member of the WAP as opposed to the widely-accepted GDP per capita. With regard to Japan, this is important because of demographics.

In Japan, that 0.6% average GDP growth was achieved despite a contracting WAP. This number is shrinking rapidly as the Japanese population declines, as birthrates have fallen since the 1980s and Japanese couples have chosen to have children later in life - and have had less of them (the same trends that are currently taking place in the US). When charted, the Japanese population is taking the shape of an inverse pyramid, with the greatest percentage of its population over 60 years old. Consequently, Japan actually performed better than the US and most European countries during the 2000s based on GDP per WAP (GDP/WAP). Indeed, these demographic differences are relevant to comparing the US not only to Japan but to the developed economies of the Eurozone as well. By the GDP/WAP figure, many European nations, especially those with shrinking populations, have also done better than the US.

As mentioned, the difference between Japan and the US over the past decade was about one percentage point in favor of the US on an annual basis, but in terms of working-age population growth rates, the difference was about 1.5% annually. This is because the US’s WAP increased by 0.8% on an annualized basis (though not necessarily the workforce, if one considers illegal immigrants and such). In Japan, this same figure contracted by 0.8% annually over the past decade. Additionally, another reason the “lost decade” has been expanded to include the 2000s is that Japanese unemployment has remained more or less constant over the past decade. It has held around 4-5% even after the late 2000s recession. Compare that to the US, which approached 10% in 2010, although it fell slightly based on data released last week. Therefore, despite a stagnant unemployment rate and falling WAP, Japan managed to eke out growth. The point is not that the Japanese model is one to be emulated, but the fact that it has managed to grow in such an economic environment should be looked at by the Federal Reserve and corporate leaders who seek to squeeze out growth from an environment of deleveraging, increasingly unfavorable demographics, and stagnation.

What does this mean for the next decade? The use of GDP/WAP as presented here suggests that it can be used to predict the growth rates of the G-7 and other developed countries based on the growth/contraction patterns of their WAP. These can be predicted for at least two decades onward, as WAP consists of a country’s population aged 20-60, so the future workforce that will enter at age 20 has already been born. In the case of a few nations, particularly the US and the UK, immigration trends should be factored in, but obviously this cannot be predicted as accurately as the number of new births. Based on these facts, Japan will continue to fade as a major economic power, especially within Asia due to the rise of China. Nearly all of the Eurozone members are showing similar trends to Japan, albeit at an earlier stage. The WAPs of Germany and Italy are already in decline, and they and the rest of the Eurozone will have similar growth rates over the next decade. In the case of Germany, the decline will be even faster than Japan beginning shortly after 2015. In contrast, the US, UK, and France are likely to grow faster because the WAPs of all three are continuing to grow, even if it is at a slower pace than in previous generations.

There are two main takeaways from this confluence of demographics on economic growth. First, the popular notion of a Japanese-style “lost decade” may be misleading even if applied to its nation of origin. The slow growth in Japan was not entirely due to what one commentator described as “insufficiently aggressive macroeconomic policies.” Since Japan’s banking crisis in the 1990s, the stagnation has arguably been more demographically-caused. While these demographic trends have played a big role in Japan’s difficulties over the last two decades, the US will not be confronted with the same degree of difficulty in that respect due to an increasing WAP. Second, a decline in the growth rates of many developed countries appears to be unavoidable, particularly in the Eurozone, as the WAPs decline. Even in the western countries that are still in good shape in this respect (US, UK, France), population growth rates are declining. Within Europe, even some of the countries that are viewed as healthier because they have not experienced the debt problems that swept the continent in 2010 will eventually succumb to this, Germany in particular. For countries such as Italy, which have existing debt problems and an already-declining population, the outlook is even worse, with stagnation perhaps being a best-case scenario. Add in the inevitable austerity measures and budget cuts that will need to take place, and stagnation begins to look optimistic. In either case, it is going to be an interesting decade as governments throughout the western world will need to come to grips with these trends.

Respectfully Yours,

Matthew R. Green

January 10, 2011

Issue XXI - YHOO/MSFT Part II

2010-09-26T21:22:00.000-07:00

In the August 24 issue, I discussed the history, business climate, and the events that led to Microsoft’s (MSFT) offer to buy Yahoo Inc. (YHOO) in early 2008. In this issue, I plan to briefly discuss the implications of the deal if it had gone through, and what the effects on both companies and the industry would have been.

To begin, many question marks exist concerning the feasibility of the deal. In early 2008, the economy was just beginning to feel the effects of what would become the credit crisis and recession. In late January 2008, MSFT made an initial offer of $31 per share to YHOO management. As I highlighted last time, it was a good opportunity for stockholders that had seen Google (GOOG), Research in Motion, Apple and Amazon soar while YHOO got left behind during the 2000s to cut their losses and walk away. For that reason, many investors, institutions, and hedge funds were pushing for the deal to be consummated. In a clear sign of this, activist investor Carl Icahn took a stake in YHOO and a seat on its board to push for the deal in May, 2008. As far as investors were concerned, there should have been very few hurdles to the deal’s consummation. Obviously, the mandate of any company’s management is to maximize the stock price. YHOO’s management was already engaged in turnaround initiatives, and continually pushed for a better deal because they felt success was just on the horizon. Their overly optimistic projections for the next few years after 2008 were clearly unrealistic, and their unwillingness to bend to MSFT’s advances and the prodding of their own shareholders would prove to be the undoing of the deal.

Looking at the tech industry landscape at the time, an irony of the deal falling through lies in the fact that Microsoft was one of the only, if not the only, suitable partners for Yahoo. To begin, due to the sheer size/market capitalization, there are very few companies within the Internet sector that would have been large enough to acquire Yahoo. Looking at the larger group of companies under the Technology category, if a company such as Hewlett-Packard or Intel was looking to diversify into the internet services sector (an unlikely proposition), then the list can be expanded a bit. Looking at only those firms that were already in the Internet sector, however, MSFT was likely the only one with the financial resources to buy YHOO without using a huge amount of debt, and a small enough Internet search presence that its acquisition of YHOO would not raise the ire of antitrust regulators. As mentioned last time, after the initial YHOO/MSFT proposition fell through, YHOO tried to outsource its search operation to GOOG, immediately triggering the watchful eye of the Justice Department.

Throughout early 2008 and in the two years since, some commentators have suggested that other suitors could have come from private equity and the buyout sector. At the time, this was also an unlikely occurrence. First, in 2008, the LBO sector had just been through a second period of glory, the first of which came during the mid to late 1980s. By early 2008, the broader economy was just beginning to feel the strain from what would become the credit crisis. However, LBO deal volume was already falling as investment banks were already cutting back on lending to their Financial Sponsors clients. That raises the question of whether an LBO could have even been pulled off from the lender’s perspective. Second, from the buy-side perspective, the numbers simply do not add up. Obviously, the private equity firms that would have been able to pull this off either by themselves or as part of a consortium (Blackstone, Texas Pacific, KKR, etc.) are sophisticated investors. Working within reasonable projections for purchase price, debt, and leverage, the prospective returns would likely have not been high enough. With the amount of debt that would have been necessary, YHOO’s cash flow and EBITDA could not have been leveraged enough to make the deal work. Of course, unrealistic projections are not unfamiliar in this case, with YHOO’s management putting forth overly optimistic scenarios at the time of MSFT’s proposition. Either way, in the end the fact that private equity did not get involved could have been due to either the increasing lack of credit, or the conscious decision of such investors to not get involved.

As mentioned, YHOO management was forecasting an overly optimistic scenario going forward due to their still-in-progress turnaround effort that they hoped would come about as a result of these “Panama” initiatives. Their projections were above and beyond what many analysts at the time were projecting. MSFT was well aware of this, and with any merger, this could have led to internal frictions during the integration process. In this case, there may very well have been a higher amount of friction due to the aforementioned factors and another big question mark: the integration of the two companies.

The integration process, if undertaken, would have been very difficult for many reasons. First, the integration of two companies of YHOO and MSFT’s size is a tremendous undertaking. MSFT has nearly 90,000 employees, and YHOO has thousands as well. As is the case with most mergers, there would have been many redundancies on all levels of the company. Second, the integration of the companies’ technologies would have been quite tedious. The “different technologies” were not limited to their Internet search divisions, but everything from advertising systems to HR. This is one point of integration in which the challenges were much deeper than may have initially appeared on the surface.

In addition to the challenges of integration that are seen in any merger, the companies involved here are vastly different in terms of firm culture. Despite the fact that both MSFT and YHOO are relatively young within the grand scheme of the American business landscape (35 and 16 years old, respectively), within the world of computer and Internet technology, this age gap is huge -- MSFT is like a senior citizen while YHOO is middle-aged. As such, both companies have different primary businesses and came of age in very different eras, which translates into a vast difference in corporate culture. While MSFT’s culture is more traditional and formal, YHOO, coming of age during the late 1990s tech boom, embodies the dot-com, Bay Area culture of casual everything from dress codes to intra-office relations. This vast gap would have been very difficult to close during the integration period, and it could have caused difficulties after integration was complete.

Finally, the post-merger company likely would have not affected the overall Internet search landscape very much. Google is still the unquestioned leader in the Internet search category with over 70% of the market. Many commentators have pointed out that MSFT’s Bing will have over 30% of the market once the integration of their search engines is complete. While Bing was gradually eating away at Google’s market share for much of the past year after its initial release, recent figures suggest this may be coming to an end. Either way, it has not made a great difference. For example, I have yet to hear someone say, “I Binged it,” and I’m sure we’ve all said or hear others regularly say, “I Googled it.” As it stands now, MSFT and YHOO’s market share is about 30% and declining. In the event of a full merger, the integration challenges could very well have accelerated that decline.

As of now, it appears that a merger of MSFT and YHOO would not have been a tremendous success for either party, YHOO in particular. For YHOO, while the outcome was not applauded by shareholders at first, the ultimate outsourcing of YHOO search to MSFT’s Bing is a long-term positive for the company. The current search outsourcing deal enables YHOO to focus on its core competencies, while grabbing a healthy percentage of the revenues from MSFT’s Bing search engine. Since YHOO’s stock price declined in 2008 and has remained largely stagnant since, the ultimate outcome of the new arrangement could be a major factor in a future renaissance in the stock price, if other factors come together to make the company successful once again.

Finally, one thing that the deal definitely would not have affected is the M&A market for small tech companies. The large cash reserves of MSFT, YHOO, and GOOG (with MSFT being the only one of the three that pays a dividend), enable all three to be active buyers of small tech companies. A merger between MSFT and YHOO would not have changed that. If anything, it would have made GOOG a bit more aggressive in acquiring small tech firms. The robustness of M&A within the technology sector is perhaps most evident to its being at the forefront of innovation and the evolution of technology as an increasingly important sector of the American economy.

Respectfully Yours,
Matthew R. Green

September 27, 2010

Issue XX - Microsoft/Yahoo

2010-08-24T17:06:00.000-07:00

Dear Readers,

One of the major business storylines throughout the first half of 2008 was the possibility of Microsoft Corp. (MSFT) acquiring Yahoo Inc (YHOO). The deal had been in the works for several months before the formal offer was announced on January 31, 2008. After the initial offer, several rounds of negotiations commenced, ending in the early summer and eventually fading away from the news as the faltering economy overtook the headlines. I have spent the past month studying the circumstances surrounding the merger. The questions I sought to answer were simple. First, what were the causes, and motivations, behind this proposition? Second, could it have been consummated, and if so, would it have worked? My findings are contained in this two-part newsletter (Part 2 will come out next week).

The origins of MSFT and YHOO’s courtship, as is the case with most mergers, were not due to events solely involving the two companies. In particular, it was due to the new behemoth in all areas of the internet business during this decade: Google (GOOG). YHOO had spent the first ten years of its existence as one of the companies on the forefront of wide-scale internet use. As a result, even with the emergence of GOOG this decade, YHOO still enjoyed the luxury of a broader, more widespread audience. For example, despite the emergence of university and workplace-based e-mail systems after 1998-2000, and the debut of GOOG’s Gmail, millions of individuals still use their original @yahoo.com e-mail address after all these years.

GOOG was established by Larry Page and Sergey Brin in 1998. Unlike early sites such as YHOO and Lycos.com, which sought to be hubs of everyone’s internet activity, GOOG was originally conceived as a superior search engine, and has grown out of that in the years since. By the middle of the 2000s, GOOG had emerged in less than five years to dominate the online search market. It had its initial public offering in 2004, and by 2005 the company was diversifying into e-mail, maps, and many other businesses. By 2006, GOOG’s share of the search market was well over 60% and growing. (For an idea of how fast this was happening, GOOG’s market share in search was reaching above 70% by the time MSFT made its bid for YHOO.)

YHOO management was aware of these problems long before the unsolicited offer was announced in January 2008. In 2006, reports surfaced of growing tensions within YHOO about the company’s direction and strategy. A prominent YHOO manager, Brad Garlinghouse, issued an internal memo that has become known as the “peanut butter manifesto,” available here. It was leaked to the press in the middle of November of that year. The point of the metaphor was that YHOO had become spread too thin, like peanut butter on a sandwich. In other words, it was engaged in many different sectors of the internet business, and not doing any of them particularly well. Garlinghouse's recommendation was to hunker down, eliminate the many redundancies at the company, and focus on the few core sectors in which it could do well.

Similar dilemmas have been seen countless times in American business history. A quick example: Procter & Gamble (PG). Having long been one of the most comprehensive consumer-products companies, by the mid-to-late 1990s the strategy of the company’s management was increasingly skewed toward growth via innovation and introducing new brands. While a few of these brands were hits and are company staples today (e.g., Swiffer), the failure of a number of new brands and the slowing of the economy combined to produce an earnings miss in February 2000. As PG was one of the first companies to miss earnings during the early 2000s slowdown, the market was not expecting it, and the stock was cut in half in a matter of weeks. After a change in management, new CEO A.G. Lafley refocused the company’s strategy on what had long been its core businesses of personal care and household cleaning items. High-growth sectors like hair coloring and shaving were also included in this strategy, thereby leading to the acquisition of Gillette in January 2005, among others. Historic, yet stagnant brands (e.g. Folgers Coffee, a $1 billion brand that was profitable but low-growth), were spun off or sold. Like PG, GOOG has achieved success by focusing on its core business of internet search. Recognizing this, Garlinghouse put forth his vision for YHOO.

In the search advertising market, the business model is simpler than it may initially seem. Briefly, when an ad gets clicked, GOOG, MSFT, YHOO, or whichever other search engine displays the ad gets paid, and the advertiser gets a potential customer. While this might not seem like much at first glance, millions of clicks add up. Since Americans are spending more time online every year, the potential market is worth billions and growing exponentially. By 2007, GOOG dominated this market with 70% market share, while YHOO and MSFT were fighting over the scraps at 18% and 9%, respectively.

With regard to search advertising, the main issue for YHOO was that while it had a larger audience amongst its many features due to its legacy as one of the oldest internet firms, it did not effectively monetize its search engine. This was, of course, GOOG’s forte. While YHOO was a very proud brand with a long-established brand name, the fact that GOOG was conceived and focused on search and monetizing that business is what made the difference. In short, YHOO had the audience, but GOOG did a better job making money in their core business. Therefore, in late 2006 YHOO management began to explore ways to combine YHOO’s superior audience with GOOG-style monetization. The success of MSFT’s Bing search engine thus far is evidence that a better-executed initiative at YHOO may have been successful. Bing will have nearly 30% of the market when fully integrated, although long-term growth concerns are currently surfacing.

To highlight the wide difference in monetization success, at the time of MSFT’s offer, analysts estimated that GOOG got approximately 20 cents for each click, compared to less than a dime at YHOO. As mentioned, YHOO’s management was well aware of this and launched several initiatives throughout 2007 to improve this; the most prominent became known as the “Panama Project” with tepid results. While YHOO made progress with regard to monetizing the searches, GOOG’s market share continued to increase throughout the year, effectively nullifying the gains in monetization.

Meanwhile, 800 miles north of Silicon Valley in Redmond, MSFT management was debating about how to best increase the market share of their MSN.com services. Knowing of YHOO’s internal squabbles, and knowing that YHOO had a large, broad audience that they did not have on the internet, MSFT saw the potential synergies in doing a deal. Therefore, while YHOO was making its efforts to improve its search monetization throughout 2007, MSFT began making subtle hints in the press and opened up formal discussions with YHOO. MSFT’s management team recognized that YHOO had many areas of redundancy and felt they could better diagnose and solve YHOO’s underlying issues.
At the time, many questioned why MSFT would want to expand into the internet when its specialty is software. Simply, any well-seasoned businessman knows that you can’t rest on your laurels; you need to be expanding, improving, or both. In the 2000s, MSFT had expanded into video games (Xbox), and a larger internet presence was a natural next step via an internal initiative to overhaul their MSN.com properties or an acquisition. Seeing YHOO in a vulnerable position beginning in mid-2006 made this more of a possibility.

Thus, on January 31, 2008, MSFT made an offer of $31 per share for YHOO. Less than two weeks later, YHOO rejected the offer, saying that it substantially undervalued the company. In early March, formal talks took place between the two companies’ leaders, followed by similar summits over the next two months. In May, YHOO co-founders Jerry Yang and David Filo rebuffed MSFT CEO Steve Ballmer’s raised offer of $33, announcing their price as $37 per share. At this point, Ballmer publicly announced that he had “had enough” with YHOO. Several weeks later, YHOO retracted and reopened the ongoing discussions, now willing to sell for $33 or $34 per share. After a few more meetings, YHOO cut off talks and signed an agreement with GOOG.

Not surprisingly, there was intense media interest in the prospects of the deal from the very beginning. Since GOOG already held more than 70% of the search advertising market, antitrust concerns made for the fact that MSFT was one of the only, if not the only, viable suitors. $45 billion deals are few in number to begin with, and on a worldwide basis the proposed YHOO/MSFT merger would have been one of the 30 biggest deals of all time. After the deal collapsed, YHOO tried to outsource its search engine to GOOG. The Department of Justice immediately stepped in and voiced its concerns, because GOOG would have had more than 90% market share in the sector. Among these regulatory concerns and an increasing divide over pricing between YHOO and GOOG, the deal was called off in late 2008. MSFT and YHOO re-initiated talks, and in 2009 YHOO outsourced its search engine to MSFT’s new Bing search platform, which is the current arrangement today.

Leading those opposed to the deal were, not surprisingly, those who built the company and the board of directors. Many commentators at the time pointed out the fact that YHOO was still a company run by its founders who were extremely proud of their brand. Jerry Yang was still CEO, and co-founder David Filo was still involved with company management as well. They had already initiated their turnaround strategy, and were confident that it would work. Their optimism can be seen in their overly optimistic projections for the company going forward from early 2008. Clearly, Yang and the rest of the management team were determined to see through their own redemption with the YHOO shareholders. When this did not come to pass, Yang stepped down as CEO in
the wake of the tumult to be replaced in January 2009 by Carol Bartz.

In conclusion, with an offer of $31 per share, MSFT could make its offer appear to be a very good deal to shareholders and not overpay for YHOO, if at all. As mentioned, YHOO’s board was well aware of this and did not want to sell out so easily. However, the lesson here is what ultimately matters is the opinion of shareholders. By early 2008, the Panama initiatives had yet to bear fruit, and shareholders were not yet confident in YHOO management’s turnaround strategy. Additionally, 2006 and 2007 had been especially brutal on the share price, at a time that the “Four Horsemen” tech stocks of Amazon (AMZN), Research in Motion (RIMM), Apple (AAPL), and GOOG were leading the market upward (See Charts 1 and 2). This was fresh on the minds of YHOO shareholders in January 2008, as the market was still relatively high at the time and their stock had lots of ground to make up. For this reason, the initial refusal of YHOO management to accept the deal and subsequent dragging out of the negotiations did not bode well for the deal from the outset.

Next week, I will be running through what a combined MSFT/YHOO would have looked like and what challenges would have existed for the company’s integration.

Respectfully Yours,

Matthew R. Green

August 24, 2010

Chart 1: YHOO Share Price 2004-Present

Chart 2: YHOO (Blue) compared to AMZN, RIMM, GOOG and AAPL 2004-Present

Issue XIX - Financial Regulation/ Precious Metals

2010-08-05T06:23:00.000-07:00

Dear Readers:

As we approach the end of summer, recent developments along with seasonality make this an ideal time to revisit precious metals. The last time I covered the precious metals sector was back in February. At that time, I discussed the possibility that the prices of precious metals are held down in part because of large, concentrated short positions by large institutional investors. Some of these positions were inherited; in JPMorgan’s case, the bulk came via the Bear Stearns acquisition but has largely been maintained since. The recent financial regulation bill that was passed and signed into law last month could potentially be the catalyst for a reduction in these commercial short positions. If these short positions are unwound, even gradually, this will provide support for the price of silver as the summer comes to an end. Additionally, the months of September to January, even during commodities bear markets such as the 1980s and 1990s, are historically the best-performing months for the precious metals sector. As such, with the current price of precious metals not far off their highs, the confluence of events could lead to a very robust fall season for the sector, with silver leading the way to new all-time highs.

In my February 18 newsletter, I provided a brief history of the Commodity Futures Trading Commission (CFTC), and the fact that President Obama had increased its budget, seemingly with the intention to expand its scope of power. The financial regulation bill that Obama signed into law on July 21 does just that. Within the bill, there is a provision that requires the CFTC to impose position limits within 180 days of the bill’s passing. On the surface, this does not bode well for the small contingent of banks that hold the bulk of the large commercial short position in precious metals. However, it is more complicated than may seem. As I have said before, many commentators in the financial media and blogosphere have suggested that a collusive effort exists to keep the price of gold and silver down. This is the work of ambitious hedge fund managers and other long-time investors in the metals trying to attract attention, using the media as a conduit to promote action. Some of their suggestions border on being conspiracy theories, which, in my view, are counterproductive. Nevertheless, regardless of whether there is manipulation taking place, the fact of the matter is that position limits could cause a short squeeze in the price of silver.

The real significance of the large commercial short position lies in the fact that it is large investors who are overwhelmingly short compared to smaller investors. While this may not seem like a problem at first glance, the issue lies in the fact that non-commercial entities are restricted to 6,000 futures contracts under current regulations. This is not the case for traders in the “commercial” category, making these large short positions perfectly legal. Currently, there are five large banks that together constitute well over 50% of the commercial short position. The CFTC issues a Commitment of Traders Report (COT) every week that reports on the overall positions among different categories of traders for all commodities. In February, the COT clearly illustrated the divide between smaller investors and the large banks (refer to Table 1)

Table 1: CFTC Commitment of Traders Report for Silver – 2/9/10 and 7/27/10

Silver COT Report – Futures & Options Combined - February 9, 2010

Large Speculators Commercial
Long Short Spreading Long Short
32,131 8,003 42,341 41,254 81,431

Change From Last Report
(4,434) 2,554 1,113 3,484 4,727

Silver COT Report – Futures & Options Combined - July 27, 2010

Large Speculators Commercial
Long Short Spreading Long Short
37,730 7,937 35,373 38,232 85,390

Change From Last Report
688 2,311 (3,160) 530 (1,098)

Source: CFTC.gov

Comparing COT reports from February and last week, not much has changed since February, and as of yet does not appear to be greatly affected by the signing of the bill. According to last week’s report, the commercial short position has increased slightly over February’s numbers. The opposite is true amongst traders that are subject to limits. In this group, the overall long position since February has increased from 32,131 contracts to 37,730. This represents an increase from a 4-to-1 long/short ratio in February to nearly 5-to-1 today. This clearly illustrates the gulf between the bullish smaller investors and the bearish large players. The outcome remains dubious, however.

What is clear in the bill is that the CFTC has a six month window during which it will impose position limits for all investors. However, the outcome is dependent on the extent of the restrictions that are instituted. Many commentators have suggested that a cap of 6,000 contracts be instituted for the commercial shorts, with a few expressing this view at the March CFTC hearings in Washington. Other, more radical commentators have put forth numbers as low as 1,500 for an across-the-board limit. While the latter is clearly infeasible, a 6,000 contract limit is not out of the question. More realistically, given the lobbying environment and a desire to minimize market disruption, the limit will likely be around 10,000. Even if the limit is slightly higher, the majority of the commercial shorts will need to reduce their positions. As of earlier this year, JPMorgan and HSBC constitute more than 40% of the silver short positions on the COMEX. Over the course of 2009, JPM’s short position alone averaged 30,000 contracts. In fact, the average commercial short position is over 10,000 contracts. If the limit is close to that number, give or take a few thousand, there will be an across-the-board buyback of contracts. Whether this process will be catalyzed by the market via an increasing price or by the newly imposed limits is yet to be seen. Regardless, the scenario potentially presents an opportunity and should be on the radars of serious investors.

Finally, the last time I covered the precious metals sector, the prices for gold and silver were down from their early December highs. I suggested that gold and silver were dipping, with gold a buy in the $1,100-1,150 range and silver a definite buy in the $12-16 range. I also recommended a few mining stocks that are reaping the benefits of the bull market in precious metals. So far, those predictions have held, and with the prime season approaching the run is likely far from over. Gold closed yesterday at $1,186 and silver at $18.40. As mentioned, the prices for both are slightly down within the summer season, but have held up nicely. As for the stocks, if an investor had put the same amount of money into each security I mentioned in February, they would have received a 6.7% return in six months. Therefore, these stocks have performed relatively well through the tepid summer. With the prime season approaching (refer to Chart 2) and the positive outlook for the sector, I expect the overall return for the portfolio to be well north of 15% by the end of the year.

Chart 2 – Historic Monthly Performance of Gold 1969-2009

Although silver is more volatile, e.g., higher percentage gains and losses, it follows roughly the same monthly trends as gold.

I plan to add to this list of equities in the coming months as I find other mining companies that have potential. Here is how the individual stocks I mentioned in February have performed since:

Hecla Mining Company (HL) – Based in Coeur D’Alene, Idaho, Hecla is the top silver producer in the U.S. It is also the second and third largest producer of zinc and lead, respectively. Despite beating earnings on July 28, the stock currently trades at a modest P/E of around 15-16, and the stock has yet to break and hold resistance in the $6 range. One factor has been lingering concerns over an Alaska mine called Green’s Creek that Hecla purchased in early 2008. At the time of the purchase, silver prices were about the same as they are today, but the collapse in prices immediately after has led to speculation that the company overpaid. As long as the price of silver continues its march toward $20, with continued solid earnings, I am confident that these fears should be overcome. If anything, the hesitance of investors over this stock should be considered a buying opportunity.

Bottom Line: 2/18 Closing Price: $5.30 High Since: $6.47 on 5/12. 8/3 Closing Price: $5.03. Return since 2/18: -5.1%.

Silver Wheaton Corporation (SLW) - A silver streaming royalty firm that finances miners in exchange for a partial or complete silver royalty stream now or in the future. They produce an initial capital outlay or outlay to be paid in the near future in exchange for these streams. The heart of their business model is that they agree to purchase the silver produced for a fixed price. As of late 2009, this average was around $4.50 with a maximum 1% annual inflation adjustment. This business model is more closely tied to the price of silver itself, and this has done well as silver has continued to approach its 2008 highs.

Bottom Line: 2/18 Closing Price: $15.71 High Since: $21.89 on 6/28.
8/3 Closing Price: $19.29. Return since 2/18: 22.8%

Silvercorp Metals (SVM) - SVM is one of the largest silver producers in China. Silvercorp is on pace to produce almost five million ounces of silver this year at a cash cost of approximately negative $6.50 per ounce (this terminology is commonly used the sector when talking about a mining company’s profitability). Hecla, by comparison, only produced for negative $2 per ounce. The company continues to grow its resource base through exploration and acquisitions.

Bottom Line: 2/18 Closing Price: $6.56 High Since: $9.05 on 5/12. 8/3 Closing Price: $6.70. Return since 2/18: 2.1%

Respectfully Yours,

Matthew R. Green

August 4, 2010

Issue XVIII - For-Profit Education

2010-07-19T07:53:00.000-07:00

Dear Readers,

As the job market has gotten tighter and more competitive over the past decade, it has become well known that a high school diploma or GED is no longer sufficient to provide a secure future. Consequently, one of the largest growth sectors this decade has been the for-profit education sector. A few of the biggest publicly-traded providers of for profit-education are Apollo Group (University of Phoenix, APOL), DeVry Inc. (DeVry College, DV), and Corinthian Colleges (Everest University, COCO). These schools claim that due to their setup as for-profit institutions, they are able to systematically make teaching more efficient and more responsive to the needs of adult learners.

Recent developments, along with higher unemployment, have shed light on the practices of these institutions. Stories range from inadequate career training to degrees of limited value because they are from non-accredited programs (although the school itself may be accredited) to countless students who are unable to find jobs while being saddled with debt. As these problems have surfaced, concerns about the business model of these institutions have been voiced by everyone from investors to the Department of Education. The problems, however, are much deeper. Unbeknownst to many outside the realm of education, US taxpayers may be on the hook for these students’ debts if they default on their loans. With these problems and the increasing possibility of more regulation, the stocks of publicly-traded for-profit colleges have dropped in recent months. Although the plight of many for-profit alumni is a story in and of itself, I will be focusing on the financial side of this business and the outlook regarding the for-profit business model.

Due to continuing high unemployment and the rising cost of private colleges and even state universities, community colleges across the nation have been filling up in record numbers. Therefore, a sector that had primarily been “open enrollment” is suddenly more selective. For those who are left out, many have chosen to enter the realm of for-profit education. Advertisements for these colleges are everywhere, as are their campuses, despite the fact that many of their degrees can be earned online. The ads inspire visions of an education sufficient to achieve a stable, even prestigious, career.

A major point of attraction to many working adults, the for-profit's target demographic, is convenience. For example, classes often begin each month as opposed to the perceived constraint of the semester system. Additionally, prospective students are offered easy access to loans. The reason it is so easy to obtain financing is because the schools aggressively encourage students to take them out, often utilizing high-pressure sales tactics to maintain enrollment through granting loans. The root of the concern among most observers is that the constant need to increase enrollment (translation: profits) is resulting in the overall commercialization or “McDonaldization” of the educational experience.

In May, hedge fund manager Steve Eisman made a presentation at the Ira Sohn Research Conference in which he characterized the for-profit sector as a group of “marketing machines with the purpose of sucking up government funds disguised as universities.” This came as a surprise, considering that many others at the conference, such as John Paulson and Stephen Mandel of Lone Pine Capital, are long-term investors in the sector. Thus, a clear dichotomy exists between investors' opinions about the sector, its growth prospects, and its business model. It’s not surprising that most investors are long. Since Apollo Group (APOL), the parent company of the University of Phoenix, went public in 1994, it has produced a nearly 4,000% return for investors. However, it is currently down 50% since peaking in April 2004. By any measure, that is a remarkable run. However, as Eisen put forth in his presentation, a look at the company’s business model reveals eerie parallels to the housing crisis that rocked the economy several years ago, and from which we have not recovered.

One of the root causes of the housing crisis was the fact that mortgage originators were paid based on the volume of loans that they provided to the big banks, regardless of how those loans performed down the road. In the same way, for-profit school admissions counselors are paid based on the number of students that they “close.” In the May 4, 2010 edition of PBS’s Frontline, former University of Phoenix admissions counselors reflected on the high-pressure sales tactics they were required to use to get students to sign off on loans needed for enrollment. One counselor, who wished not to be named, reflected on closing individuals who were clearly not prepared to do college-level work. Despite having basic admissions standards (e.g. a high school diploma or GED), the lack of preparation of many students leads to a much higher dropout rate at the for-profits, and this drives defaults higher as these dropouts are stuck with the debt.

It’s no surprise that the for-profits engage in these practices. Just as the housing market needed people to continue taking out mortgages to keep growing, for-profit education needs to keep growing to satisfy the growth expectations of investors. Another reason the loans are so aggressively pushed is not solely because of the need for volume, but because Federal Pell grants and Stafford loans are the lifeblood of many for-profit institutions. The schools, like the mortgage originators, get paid and then have no further liability. The students are stuck with the loan, and the taxpayers with the bill if they default. While there is currently no financial penalty for the schools if their students are unable to attain what is increasingly being referred to as “gainful employment” after graduation, changes could be on the horizon.

What for-profit schools don’t have is the luxury of no financial penalty if student enrollment drops. Thus far, consistently increasing enrollment has not been an insurmountable problem for them. However, one of two scenarios could trigger a downward spiral for the for-profits. First, if the employment situation improves markedly, then enrollment will drop. Second, and more likely in the short-term, for-profits will be in trouble if Congress limits their access to student loans. According to the US Department of Education, in the 2008-09 school year, nearly 24% of federal Pell grants financed students at for-profit schools. This is nearly double the percentage of a decade ago.

In addition, Federal Stafford loans to for-profit institutions jumped from under $5 billion in 2000 to $26.5 billion last year. At some for-profits, this accounts for nearly 80% of their overall revenue. According to the College Board, community college students made up only 10% of the total Stafford loan volume in 2007-08, and usually take out less than $10,000 per student. In the case of for-profit colleges, that number was 88%, and nearly 20% of students graduate with at least $30,000 in debt. These borrowing rates reflect the higher costs and lack of financial aid associated with for-profit colleges, where tuition costs are typically higher than at public or non-profit colleges. If the government limits for-profits' access to students loans in any small way, then the schools' ability to churn out loan volume will be cut. Without this ability, enrollment at the for-profits will inevitably drop precipitously, and so will their earnings. With a disproportionate amount of federal loan money currently going toward for-profit schools that offer educations of questionable value, it is time to take a serious look at whether for-profit colleges in their current form are good for America. Eisen noted in his presentation that the taxpayers could be on the hook for $275 billion in for-profit student loan defaults over the next decade if current trends continue unabated. Considering the government's large current deficits, a comprehensive review would be prudent.

Although congressional scrutiny of the for-profits has increased over the past several years, such inquiry is not new. The first hearings on this topic were spearheaded by Georgia Senator Sam Nunn in early 1990. An excerpt from the 1990 hearing could very easily have come from the congressional hearings this year. Nunn said,

"Unwary Americans are being lured into so-called educational schools by sophisticated sales pitches that offer promises of bright futures, high paying jobs and Federal loans for financing. In fact, the students often end up with little or no training, no job and a large bill to repay the student loan. In some cases the students recognize the training is useless and they withdraw midway and end up liable for the entire loan while the school operators pocket a handsome profit. As a result, the student is worse off than ever, often defaults on the loan, and the American taxpayer ultimately picks up the tab.”

In more recent Congressional hearings, lobbyists for the industry have testified that the rate of default for students that graduate from these institutions is no different than graduates from community and public colleges. However, the manner in which the data is measured renders these readings nearly meaningless. Under current laws, the official measurement of educational loan risk used by the US government is the “cohort-default rate.” Published by the Dept. of Education, the rate measures the percentage of borrowers who default in the first two years of repayment. While this is used to penalize underperforming colleges, defaults outside of the two-year window are not taken into account.

Therefore, only a portion of the loans that eventually default are measured. As any lender knows, it usually takes more than two years for a borrower to default. Using the housing crisis as a comparison, even the worst subprime loans that were made during the housing bubble took 18-24 months to default. Even after the expiration of so-called introductory “teaser” rates, many buyers pushed back default as long as possible. Therefore, you can expect the for-profit lobbying camp to fight any proposed changes in measuring default rates so as to mask the true default rate of their group.

According to data from the Dept. of Education, 11.9% of federal loan recipients who attended for-profit colleges have defaulted on their loans within two years. This compares to 6.2% among recipients who attended public colleges, and 4.1% who attended private colleges. When the time frame is extended beyond the two-year cohort period, the for-profit figure jumps to 21.2% of federal loan recipients. This trend continues as the years pass. For-profit colleges made up 16% of all federal Stafford Loans issued from 1995 to 2007. However, they made up 34% of the defaults over the same period. Compare that to public and private four-year colleges, with rates of 15.1% and 13.6%, respectively.

A for-profit lobbyist at the 2010 congressional hearing was quoted as saying that it would be “unfair” for the government to penalize them for serving a riskier sector of the population. That is akin to mortgage lenders saying that it would be unfair to penalize them for originating the “liar” and “ninja” (no jobs, no income) home loans to a risky sector of the population that clearly did not have the ability to pay them back. For-profit institutions clearly want to maintain their image of providing a necessary service to working class students, despite providing a substandard level of instruction and then expecting them to pay back debts which they cannot handle with the jobs they end up getting.

Yet, Congress is more likely to take the case of predatory student lending much more seriously than some might think because student loan debt cannot be discarded under current bankruptcy law. Unlike an underwater mortgage, students can’t just walk away from them. If they default, they are disqualified from further federal aid, thus becoming ineligible for further education. Additionally, they may have their tax refunds and wages seized by the government. Their negative credit makes it harder to obtain housing, cars, etc. When they can get a loan/consolidation, they pay higher interest rates. This situation is happening with alarming frequency as the job market has tightened.

Less than two years removed from the failure of Lehman Brothers and the subsequent bailout, the US taxpayer could potentially be on the hook for another few hundred billion dollars if alumni of for-profit institutions continue to default and Congress passes a relief bill. As this debate has hit the news over the past few months, the stocks of Apollo Group, DeVry University, and Corinthian Colleges have plummeted in the range of 30-50%. It should be noted that these stocks were top performers throughout 2008, when they were viewed as beneficiaries of the recession which has sent many back to school. The more Congress scrutinizes these companies’ business models and practices, the more likely it is that their stocks will continue to go down. As we know from oil and financials in 2008, when a sector is targeted by a group of short sellers, it can go down swiftly and relentlessly, regardless of how far below equity or enterprise value the resultant stock valuations might be.

The current situation was not always the norm with for-profits, even at the Apollo Group’s University of Phoenix. When my family lived in Arizona in the 1980s, my mother taught nursing at the University of Phoenix before it began its massive national expansion. Even though it was a for-profit institution, it had not yet McDonaldized college education via watered-down online coursework, short term schedules, and convenient, office-like campuses. Back then, it was similar to a normal community college experience, offering day or evening classes. Students were given a great amount of individual attention and adhered to a normal two-term and/or summer semester. However, after Apollo Group went public and the focus shifted to profit growth, it was akin to a successful small-town business expanding and in the process losing focus on its core mission. Therefore, Congress should view its mission as focusing on measures that make sure the level of instruction is sufficient, and to prevent the objective of these colleges from simply expanding enrollment to ensure profit growth.

America's leaders have pledged for America have the highest percentage of college graduates in the world by 2020. As the world economy changes and US-based jobs become more knowledge-oriented, a college education is all but mandatory for individual success. Despite their problems, for-profit institutions are likely not going away. After all, since community colleges have been unable to accommodate the demand for spots, for-profit institutions are picking up the slack, as they are able to expand capacity more quickly. That said, in their current form their business model is unsustainable and arguably not beneficial for America. We the People and Congress need to recognize them for what they currently are: for-profit corporations. A for-profit’s board of directors has a fiduciary obligation to the shareholders, not to the students or alumni. They will stay for-profit, but we need to make sure the pursuit of profit does not overtake their stated mission to educate Americans for the future.

Respectfully yours,
Matthew R. Green
July 19, 2010

Issue XVII - Municipal Finances

2010-07-05T12:21:00.000-07:00

Dear Readers,

As renewed uneasiness about the economy creeps into the public consciousness, one subject of rising concern among economists and government officials alike is the public finances of all levels of government. The range of specific concerns is vast, from underfunded state pension funds to the increasingly precarious task of financing municipalities by issuing bonds. With the increased scrutiny, many questions have been raised about the viability of local and state debt, and rightfully so, as municipal and state bonds are investments to which a great portion of the investing public has direct or indirect exposure. In a few recent issues, I have focused on the situation in Europe, which is potentially a harbinger for what could eventually happen in the US. This issue focuses on municipal governments, whose problems seem to get progressively more unflattering with each new story that makes the news. With the current legal framework regarding local and state bankruptcies, this situation is potentially another problem where the strains will work their way up to the states, and eventually the federal government will be forced to take on the burden.

While it is making its way to the forefront of the public consciousness, the fact of the matter is that municipalities declaring bankruptcy is nothing new. What is different this time, and at the heart of many concerns, is the sheer number of municipalities that are potentially facing bankruptcy. While Chapter 9 filings are much less common than personal and corporate bankruptcies and the ramifications are not as severe as one might think, what carries severe consequences is the possibility of many happening at once. The US Bankruptcy Code for municipalities, collectively known as Chapter 9, ensures that the repercussions are not immediate in nature.

Prior to the 1930s, there was very little in terms of legal infrastructure designed to address municipal bankruptcies. Once the US entered the throes of the Depression, a growing number of municipalities across the nation (particularly in the Dust Bowl, which suffered from crop loss and the subsequent exodus of population) became unable to pay their workers and outstanding debts. To remedy this, laws were altered within the US Bankruptcy Code beginning in 1934-35. Because the 10th Amendment of the US Constitution places limits on the influence the federal government can exert upon the states, Chapter 9 filings are by and large local issues and are resolved on that level. The Chapter 9 process involves several steps. First, a municipality must go to their state for approval (this process varies by state). Second, the municipality generally must prove itself to be insolvent, unable to meet present and/or future obligations. Finally, it must make a good faith effort to negotiate with its creditors before filing. As is the case with corporate bankruptcies, it is often in the creditors’ best interest to do this as well, since they could both potentially lose more in a bankruptcy.

The primary duty of the judge in a Chapter 9 filing is to ensure a municipality is eligible to file, and then place a stamp of approval on its plan for paying off the debt. Judges cannot force a municipality to liquidate assets to pay its creditors. Slate magazine, while reporting on San Diego’s financial debacle in 2005, quoted a lawyer who worked on Miami’s 1996 Chapter 9 filing as saying, “They can’t come and pick up the fire engine(s).” Furthermore, unlike a personal or business bankruptcy, a Chapter 9 filing is not made with the intention of ridding a municipality of its debt. Instead, its purpose is to allow reorganization by assisting a municipality in terminating unsustainable contracts and to ease the process of raising lower-interest financing. For this reason, the city does not need approval of the judge to borrow money and/or engage in other financial transactions, which would be necessary in a corporate or personal bankruptcy.

As is the case with personal and corporate bankruptcy, the causes are predictable and often years, if not decades, in the making. Faced with falling revenue from the loss of an industry or population, a city begins to operate with a deficit, and more often than not gets in the habit of it. This is not a bad thing in and of itself, as utilizing debt markets allows a city to sustain its credit. While this is commonplace in the short-term, during economic downturns it is a situation that can quickly turn ugly, particularly if a government has not planned accordingly.

As mentioned, while municipal bankruptcies occur much less frequently than personal or corporate bankruptcies, they are never out of the question. During the 20th century, there were over 400 municipal bankruptcies in the US, including the near-filings of a few major cities. One of the reasons Chapter 9 is not frequently used is that for politicians, the ends often do not justify the means. In other words, many municipalities that could potentially benefit from Chapter 9 might be hesitant to file because the process would involve tax increases and unpopular service cuts. Thus, the risk of political fallout is extremely high. As is well-known and remembered, in 1975 New York City came close to filing for Chapter 9. This is most remembered by New Yorkers for the cuts in the police force and sanitation departments, and also for the famous New York Post headline covering President Ford’s reluctance to bail out the city: “Ford to City - Drop Dead.” However, at the time it was actually quite difficult for a large city to meet the eligibility requirements for Chapter 9. In response, Congress altered the Chapter 9 bankruptcy codes in early 1976, making it easier for large cities to utilize Chapter 9. A few years later, in 1978, Cleveland defaulted on a few short-term loans, but through the valiant work of their city council managed to push through an 11th hour increase in the city’s income tax to avoid Chapter 9.

Today, California has been attracting attention as one of the hubs of public finance debacles on both the local and state level. Besides the well-publicized state budget problems, the Golden State has a long recent history of financial problems on the local level. The 1976 revisions in the Chapter 9 code are what enabled Orange County to file for bankruptcy in 1994. One of the county’s investment managers had parked its pension funds in derivatives that went sour, causing a sudden $2 billion loss. Even while the real estate market in Southern California was flying high in 2005, candidates campaigning for mayor in San Diego openly talked about filing for bankruptcy to close a swelling pension deficit. Four years later, they haven’t closed the gap. After teetering precariously on the edge of Chapter 9 for the last few years, recent news stories have reported that grand jury investigations into the city’s finances found that San Diego regularly skipped payments destined for the pension fund, while continuing to raise the pensions and benefits of public employees. Each year, avoiding Chapter 9 in San Diego has become a more arduous task, yet politicians seem to be playing the classic game of kick the can down the road.

Another California city brought to its knees by public pensions was the Northern California city of Vallejo in 2008. In this case, it was rather simple, brought about via high fixed costs in employee salaries and pension expenses. This reflects a greater problem throughout California and much of the United States. Due to the fact that California is generally a desirable place to live, the cost of living is high. As a result, public employee unions, which especially in Northern California have the ears of left-leaning politicians, have repeatedly secured lucrative contracts for their members, often in the form of campaign promises. Over the next few years, look for Chapter 9 to be used more often by municipalities across the nation to force renegotiations on public employees.

Obviously, this problem isn’t solely caused by generous contracts for public employees, nor is it confined to California. Along with the recent troubles in California, cities such as Harrisburg, Detroit, Phoenix, Cleveland, and even New York City are struggling to balance their budgets, and will likely witness budget standoffs on a yearly basis until the US experiences a sustained economic recovery. In response to the problems at local levels, states are emerging as the ones who seem willing to initiate cuts. The problems, as is the case on the municipal level, range from the usual suspects of underfunded pensions to outdated governmental structures and bureaucracies. Time magazine recently reported on the efforts of Nebraska state senator Rich Pahls to merge many of his state’s 93 counties. Similar programs in England during the 1960s and 1970s brought about today’s system of counties, while the old borders became “historic” counties. In Nebraska, this means forcing consolidation of road services, vehicle registration, and law enforcement, eliminating many local government jobs in the process. Pahl’s efforts have been quashed thus far, in part because “it seemed too frank an acknowledgement of the passing of small-town America.” With 16 of Nebraska’s counties having less than 20,000 residents, with a handful under 2,000, such measures will no doubt be necessary in the coming years.

Pensions, just as they are on a local level, are increasingly being revealed as dead weight that needs to be reduced in the new economic climate. For years, politicians have wooed public employee unions’ votes via promises of pension raises and benefit security, assuming the funds would always be there. In a tabloid mecca like New York City, there has been no shortage of stories covering relatively lavish retirements for selected public employees. The New York Times recently reported that nearly 3,700 retired New York State public employees earn more than $100,000 a year in pension payments, many who are barely in their 50s. Other such tales have made the news all over the nation recently. It is reflective of a growing public divide between public and private employees and the fact that public employees have found themselves living in parallel, yet separate, economic realities over the past decade. It is unfortunate to potentially need to cut the benefits of those who protect our property and teach our children. However, the fact is that during the past decade private sector employees, particularly in the auto, airline and a slew of other industries, have experienced constant downsizing, stagnant or decreasing wages, and are paying more for health care. Traditional pensions are a thing of the past for the private sector, now almost solely confined to the tax-supported public sector. Private sector employees fund their own retirement via 401(k)s and other such plans, which are subject to the oscillations of the economy. On top of that, public sector workers have always enjoyed a higher level of job security, which is one reason that it has always been a big deal when these sectors have experienced cuts.

As the economy remains uneasy, there is no doubt in my mind that a number of cities will end up filing for Chapter 9 as local and state budgets continue to deteriorate. However, this is unlikely to create a state of anarchy, although there will no doubt be a public outcry by any number of affected parties. With the way such occurrences have played out in the past, business will go on as usual for everyone except those who hold large portfolios of municipal bonds, and of course municipal employees. For practical reasons, when a city declares Chapter 9, it is able to continue its operations. The bigger problem with a Chapter 9 bankruptcy lies in store for a city’s creditors. Municipal bonds, due to their tax advantages, have long been a preferred investment for institutions all the way down to individual investors. While a Chapter 9 filing does not free a city from its debt obligations, it can be a mechanism through which municipal bonds can be terminated before their maturity. The last time so many municipalities had problems at once was, not surprisingly, the Great Depression. Considering that we have just experienced the worst economic downturn since the Great Depression, and municipalities across the country are currently reporting financial troubles, it is reasonable to surmise that municipalities are not out of the woods.

The day of reckoning is closest for municipalities, simply because the ramifications of an individual Chapter 9 filing are much less than a state becoming insolvent. Thus far, states have shown a better ability to push back their problems, while the municipalities deal with them first. Unless a true economic recovery takes hold, things will continue to make their way up the totem pole. A rash of local bankruptcies would place added pressure on states like California to fix the problems on the state level, and do it quickly. However, if that doesn’t happen, the problem would then be passed to the federal level. In the same way that when mortgage originators went bankrupt, next in line were banks that bought the soured loans and repackaged them. When the banks had trouble, eventually the government had to bail them out, adding to its own debt. The public finance debacle could shape up in a similar way. While I am not a doomsayer with regard to the possibility of high inflation from the debasement of our currency, if the government ends up bailing out the states in one way or another, the chances of higher inflation will immediately increase. This provides a reason to hope that governments on the local and state level, employees and elected officials alike, can get their act together. Just as the private sector has been forced to cut and hunker down, all levels of government also need to learn to live with the new realities.

Respectfully yours,
Matthew R. Green
July 5, 2010

Seasonality of Silver Data 1984-2009

2010-06-30T13:00:00.000-07:00

Bear with me here, as I can't import an Excel Spreadsheet directly.

All prices are The London Fix Silver/oz. in USD.
Open and Closing Dates are the First and Last trading days of each respective month.
1984 1985 1986 1987 1988 1989 1990
May Open $8.93 $6.15 $5.11 $7.94 $6.36 $5.65 $4.95
May Close $9.12 $6.09 $5.20 $7.69 $6.60 $5.22 $5.07
Difference $0.19 ($0.06) $0.09 ($0.25) $0.24 ($0.43) $0.12
June Close $8.39 $6.11 $5.05 $7.14 $6.65 $5.17 $4.84
Difference ($0.73) $0.02 ($0.15) ($0.55) $0.05 ($0.05) ($0.23)
July Close $7.11 $6.34 $5.05 $8.32 $6.80 $5.15 $4.85
Difference ($1.28) $0.23 $0.00 $1.18 $0.15 ($0.02) $0.01
Aug Close $7.45 $6.25 $5.17 $7.55 $6.46 $5.07 $4.83
Difference $0.34 ($0.09) $0.12 ($0.77) ($0.34) ($0.08) ($0.02)
Sept Close $7.44 $6.05 $5.52 $7.64 $6.17 $5.28 $4.79
Difference ($0.01) ($0.20) $0.35 $0.09 ($0.29) $0.21 ($0.04)

Gain/Loss ($1.49) ($0.10) $0.41 ($0.30) ($0.19) ($0.37) ($0.16)
% -16.69% -1.63% 8.02% -3.78% -2.99% -6.55% -3.23%

1991 1992 1993 1994 1995 1996 1997
$3.97 $4.01 $4.27 $5.29 5.7 5.33 4.68
$4.13 $4.06 $4.71 $5.50 5.3 5.34 4.86
$0.16 $0.05 $0.44 $0.21 ($0.40) $0.01 $0.18
$4.45 $4.03 $4.48 5.25 5.33 5.03 4.72
$0.32 ($0.03) ($0.23) ($0.25) $0.03 ($0.31) ($0.14)
$4.06 $3.95 $5.30 $5.29 5.1 5.11 4.38
($0.39) ($0.08) $0.82 $0.04 ($0.23) $0.08 ($0.34)
$3.81 $3.72 $4.84 $5.36 5.32 5.2 4.73
($0.25) ($0.23) ($0.46) $0.07 $0.22 $0.09 $0.35
$4.13 $3.77 $4.03 $5.62 5.53 4.88 5.17
$0.32 $0.05 ($0.81) $0.26 $0.21 ($0.32) $0.44

$0.16 ($0.24) ($0.24) $0.33 ($0.17) ($0.45) $0.49
4.03% -5.99% -5.62% 6.24% -2.98% -8.44% 10.47%

1998 1999 2000 2001 2002 2003 2004
6.17 5.33 5.01 4.34 4.54 4.66 6.1
4.97 4.94 4.9 4.43 5.05 4.56 6.17
($1.20) ($0.39) ($0.11) $0.09 $0.51 ($0.10) $0.07
5.36 5.22 5.02 4.34 4.87 4.51 5.91
$0.39 $0.28 $0.12 ($0.09) ($0.18) ($0.05) ($0.26)
5.53 5.45 4.95 4.22 4.66 5.08 6.32
$0.17 $0.23 ($0.07) ($0.12) ($0.21) $0.57 $0.41
4.79 5.08 4.91 4.2 4.57 5.11 6.74
($0.74) ($0.37) ($0.04) ($0.02) ($0.09) $0.03 $0.42
5.39 5.58 4.89 4.59 4.53 5.12 6.67
$0.60 $0.50 ($0.02) $0.39 ($0.04) $0.01 ($0.07)

($0.78) $0.25 ($0.12) $0.25 ($0.01) $0.46 $0.57
-12.64% 4.69% -2.40% 5.76% -0.22% 9.87% 9.34%

2005 2006 2007 2008 2009
6.85 13.92 13.45 16.64 12.15
7.13 12.9 13.25 16.85 15.52
$0.28 ($1.02) ($0.20) $0.21 $3.37
7.1 10.7 12.54 17.65 13.94
($0.03) ($2.20) ($0.71) $0.80 ($1.58)
7.15 11.34 12.93 17.48 13.63
$0.05 $0.64 $0.39 ($0.17) ($0.31)
6.74 12.6 11.95 13.76 14.54
($0.41) $1.26 ($0.98) ($3.72) $0.91
7.53 11.55 13.65 12.96 16.45
$0.79 ($1.05) $1.70 ($0.80) $1.91

$0.68 ($2.37) $0.20 ($3.68) $4.30
9.93% -17.03% 1.49% -22.12% 35.39%

Average Loss: -7.49% Median: -5.62%
Average Overall: -0.27%
Average Gain: 9.57% Median: 8.02%

Since 2003: Average Loss: -19.57%
Average Gain: 13.20% Median: 9.87%

Average Overall: 3.84%
w/o 2008/09: 2.72%

Monthly Performance:
1984 1985 1986 1987 1988
May %'s 2.13% -0.98% 1.76% -3.15% 3.77%
June %'s -8.00% 0.33% -2.88% -7.15% 0.76%
July %'s -15.26% 3.76% 0.00% 16.53% 2.26%
Aug %'s 4.78% -1.42% 2.38% -9.25% -5.00%
Sept. %'s -0.13% -3.20% 6.77% 1.19% -4.49%

1989 1990 1991 1992 1993 1994
-7.61% 2.42% 4.03% 1.25% 10.30% 3.97%
-0.96% -4.54% 7.75% -0.74% -4.88% -4.55%
-0.39% 0.21% -8.76% -1.99% 18.30% 0.76%
-1.55% -0.41% -6.16% -5.82% -8.68% 1.32%
4.14% -0.83% 8.40% 1.34% -16.74% 4.85%

1995 1996 1997 1998 1999 2000
-7.02% 0.19% 3.85% -19.45% -7.32% -2.20%
0.57% -5.81% -2.88% 7.85% 5.67% 2.45%
-4.32% 1.59% -7.20% 3.17% 4.41% -1.39%
4.31% 1.76% 7.99% -13.38% -6.79% -0.81%
3.95% -6.15% 9.30% 12.53% 9.84% -0.41%

2001 2002 2003 2004 2005 2006
2.07% 11.23% -2.15% 1.15% 4.09% -7.33%
-2.03% -3.56% -1.10% -4.21% -0.42% -17.05%
-2.76% -4.31% 12.64% 6.94% 0.70% 5.98%
-0.47% -1.93% 0.59% 6.65% -5.73% 11.11%
9.29% -0.88% 0.20% -1.04% 11.72% -8.33%

2007 2008 2009
-1.49% 1.26% 27.74%
-5.36% 4.75% -10.18%
3.11% -0.96% -2.22%
-7.58% -21.28% 6.68%
14.23% -5.81% 13.14%

Average: May %'s 0.87%
June %'s -2.16%
July %'s 1.18%
Aug %'s -1.87%
Sept. %'s 2.42%

Since 2003: May %'s 3.32%
June %'s -4.80%
July %'s 3.74%
Aug %'s -1.37%
Sept. %'s 3.44%

Up Down
May 62% 38%
June 31% 69%
July 58% 42%
August 38% 62%
Sept 58% 42%

Issue XVI - Mergers 2010

2010-06-18T09:07:00.000-07:00

Dear Readers,

After Mergers and Acquisitions activity picked up in the second half of 2009, commentators, economists, and bankers alike were divided with regard to what 2010 held in store. The divide was vast, ranging from predictions of a “perfect storm” for M&A by Goldman Sachs to expectations of another downturn. While predictions of a robust comeback have yet to pass, after what has transpired the past few years M&A is doing better than expected. After a steep drop in 2008 and again in 2009, the value of overall deals has leveled out so far in 2010. When history is considered, even a breakeven year in the wake of such an economic contraction is something to feel good about. In the grand scheme of things, 2010 is currently on pace to transpire as a lukewarm year for M&A.

As I covered in January, M&A activity through the first half of 2009 was dominated by a few mega-healthcare deals (Wyeth/Pfizer and Schering/Merck), and a great percentage of investment banking revenue came via assignments to help companies of all sizes shore up their balance sheets. Activity on both the traditional M&A and Private Equity sides began to pick up at the end of the summer. The final three months of 2009 featured activity from industries across the board. Highlights included Exxon buying XTO energy, Warren Buffett buying Burlington Northern Santa Fe, and Comcast buying NBC Universal.

Looking back on M&A activity during the past three recessions, the cycle has been about two or three years from peak to nadir. This has been the trend regardless of the downturn’s severity. M&A experienced three down years during and after the 1990-91 recession, and two years after the 2001 dot-com bust. The latter was a particularly tough period, as bulge bracket firms were also reeling from the loss of revenue from underwriting tech IPO’s. Based on current numbers, this year could be shaping up to follow this pattern yet again. As of last week, total deal volume so far in 2010 is merely 1% off last year’s pace. After peaking in 2007, M&A saw year-over-year drops of 41% in 2008 and 22% in 2009, according to Bloomberg. While things are still touch and go, given the two-year cycle and this year’s pace, the M&A market appears to be holding up nicely while not getting ahead of itself.
Additionally, as we all know, the most recent recession has been deeper than the previous two in both its severity and longevity. According to data from the Bureau of Economic Analysis, the 1990 recession saw three consecutive quarters of negative GDP growth from Q3 1990 to Q1 1991. The 2001 recession saw two non-consecutive quarters of negative growth, in Q1 and Q3 of that year. Compare that to five out of six quarters of negative growth from Q1 2008 to Q2 2009, the one exception being Q2 2008 when the government’s stimulus checks helped out. ThomsonReuters columnist Rolfe Winkler wrote last week that, “considering the depth of the latest recession compared to the prior two, one might think dealmakers would still be in hibernation.” That said, it is all the more remarkable that M&A appears to be resilient, sticking to its two-to-three year cycle (refer to Chart 1).

Chart 1 – Annual M&A Volume 1988-2008

Partly in response to the pickup in late 2009, many were quick to predict that 2010 would be a robust year for M&A. A report endorsing this viewpoint was produced by Goldman Sachs in late 2009. Goldman’s view was based on the fact that companies have lots of cash on their balance sheets, with levels rising through and after the recession. In addition to rising cash levels (refer to Chart 2), the report pointed to the environment of low interest rates and the search for non-organic growth potentially leading to what was described as a “perfect storm for M&A.” Thus far, this has not come to pass. That is not to say that the report was completely inaccurate in its predictions, however. While the activity in late 2009 was promising, the momentum seems to have stalled somewhat in the first months of 2010. There are several reasons for this.

Chart 2 – Corporate Cash Balances September 2004 - 2009

First, the reduced activity during the first quarter of 2010 was partially the result of continued volatility in the equity markets. The Dow Jones Industrial Average ranged from just below 10,000 to above 11,200 within the first few months of the year. Heavy volatility is not conducive to M&A activity because buyers and sellers want to have a fairly stable equity environment before they act/make an offer. But that is not to say that big deals did not take place. Energy and Utilities led the way early in the year, with Schlumberger acquiring Smith International and FirstEnergy acquiring Allegheny Energy. As volatility lowered in April, activity saw an uptick, accelerating into May after the so called “flash crash” on May 6. Companies have taken advantage of the lower stock prices since then to make moves. A few all-cash examples of this include Hewlett-Packard’s acquisition of Palm on April 28 and SAP’s acquisition of Sybase on May 12.

Second, despite the largesse of cash on balance sheets, this in and of itself does not mean that companies will be going on buying sprees. While large cash positions increase the potential for activity, in the aftermath of 2008 companies have been treading carefully with regard to using cash for acquisitions, and especially for buybacks of stock. However, after going through an aggressive cost-cutting cycle through the recession, it is possible that companies will be looking in the near future for potential acquisitions where they can cut costs while creating growth, which is inherently difficult to do in a low-growth economy. A few recent examples are the aforementioned FirstEnergy/Allegheny Energy merger, the United/Continental merger, and Century Link’s acquisition of Qwest Communications. Although the latter transaction is all-stock, it is one of the best examples of a synergy-based deal so far this year. While both companies have been cutting costs, they are hoping the synergies from their merger, announced on April 26, will provide more than $500 million in new cost savings, according to ThomsonReuters.

Finally, another sector within M&A that could see a pickup in 2010 is one of its main engines: Private Equity. The reason is that not only do PE firms have lots of cash sitting on the sidelines, they are also potentially racing the clock with regard to investor’s funds. Private equity has largely been on the sidelines since 2007-08 due to the lack of credit, which provides the leverage needed to generate promised returns for investors. Obviously, this is a far cry from the over $1 trillion in buyout deals that were consummated in 2006-07 (refer to Chart 3). An editorial last week in Investor’s Business Daily reported that PE firms have $445 billion sitting on the sidelines that was raised during what is rapidly becoming known as the Second Golden Age of Private Equity (the first was during the 1980s). To have such a sum in one’s coffers doesn’t sound bad at all, but it’s more complicated than that. In short, when a PE firm raises a new fund, it usually has a pre-set time frame in which it can put those funds to work. Most funds have a five to seven year window in which they can legally invest capital, after which investors can start pulling their capital out to look for returns elsewhere. There is a popular saying within the industry that goes, “use it or lose it.”

Chart 3 – Total LBO Deal Volume 2006-2010

Indeed, there is a great amount of capital that will be lost if it is not put to work. Therefore, many firms may accept the reality of lower returns and start investing once again. Of course, this carries the risk that some bad deals may take place. That said, we have seen an uptick in PE deals so far in 2010 compared to 2009. A few of the bigger deals have included the acquisition of Interactive Data by Silver Lake Partners and Warburg Pincus, as well as the acquisition of Dyncorp by Cerberus Capital Management.

For the remainder of the year, there are two main factors that could set the tone for how the M&A sector plays out. First, as always, the equity markets. The events of May 6 sent the VIX to nearly 40, but it has since fallen back to the level it was at just before that day. However, with many market observers pointing to tepid economic data and expecting a pullback, this could change. Volatility could reassert itself, and that could potentially inhibit activity for the rest of the year. Second, as mentioned, private equity will have to continue negotiating with lenders to take advantage of the low-interest rate environment to make use of their investor’s funds. Their success or lack thereof in this will be a major determinant for M&A the rest of this year. Finally, another factor that could make a difference is the situation in the Gulf, which could lead to a few consolidations within the petroleum industry and the associated sectors. Already, the volume of M&A activity in the energy sector has doubled to date this year compared to the same time frame in 2009, according to ThomsonReuters. Total deal volume in the sector stands at $128.5 billion as of last week, compared to $57 billion in the same period in 2009, which also outpaces the volume of $122 billion during same period in 2007. With a robust second half, M&A in the energy sector could surpass the 2007 high-water mark.

In summary, it is reasonable at this time to assert that M&A will have a reasonably good year, possibly breaking the downtrend, but not great compared to some of the boom years. Deal volumes continue to recover and we continue to see companies across with board with cash-rich balance sheets, the same situation existing in private equity. Therefore, the real question should be how much potential activity is built up, and whether or not that potential can be unleashed within the current economic environment. The surest way for this to happen would be an improved economy that leads to increased lending by the banks. It adds a reason to hope the economic recovery continues through the remainder of the year.

Respectfully Yours,

Matthew R. Green

June 18, 2010

Issue XV - Correlations

2010-06-04T10:48:00.000-07:00

Dear Readers,

Although many date the start of the current economic crisis to the July 2007 collapse of two Bear Stearns internal hedge funds that were heavily invested in fixed-income mortgage securities, to me, the first event that was a “snap out of it” moment came in late February 2007. On February 27 of that year, the Shanghai Composite Index fell 9% in one trading session. This would be followed shortly by the collapse of Irvine, California, based New Century Financial, the first major mortgage originator to fail.

In the wake of the events since, much has been written and said about what warning signs existed, if any, prior to the crash of the US housing market. Of the warning signs, most pundits have pointed to the overheated housing market and other symptoms of excess liquidity (i.e., banks lending for leveraged buyouts at 8-10 times cash flow, with relatively few covenants). From following and studying the precious metals market during the past few years, I have noticed that a few unusual correlations existed prior to the first signs of trouble in early 2007. I am seeking to take a look at what the big picture was, what available data indicated at the time, and what, if any, warning signs can be deduced.

By early 2007, everything from equities to real estate was up. This occurrence can be attributed to several things. First and foremost, the capital unleashed by Greenspan’s interest rate cuts needed to find a home somewhere. That alone contributed to all asset classes being pushed up. Second, China’s role in the global economy contributed to subdued US inflation, rather than the level of inflation that might have been expected due to then-historically low interest rates. Finally, the modern measure of volatility, the VIX, was at all-time lows. This did not allow for proper risk management, allowing dangerous levels of leverage to be built up. As such, all asset classes were held up, and this paved the way for a swift decline when it all ended.

A mass of liquidity was unleashed in the early 2000s by central banks around the world, led by Greenspan’s Fed. This was due to the economic slowdown in 2000-2002 and the shock of 9/11. This global flood of capital saturated everything from emerging markets to equities around the world, but especially the US housing market. By early 2007, while banks were still making lots of money, uncertainty was creeping into the economy from the stalled housing market. No one was really sure what the effects would be, and around this time economists increasingly found themselves at odds with each other with respect to their predictions. However, there was a feeling that at the very least, the Federal Reserve would be able to engineer a soft landing for the economy, as Greenspan had been credited with doing five years earlier. For the time being, an air of euphoria prevailed in late 2006 and into 2007.

This giddiness was not only caused by the billions that had been made in real estate, but across all markets. The correlations that existed in late 2006 were unlike any that had ever been seen before. Gold, equities, and bonds, government and corporate, were all up. Such an across-the-board correlation, particularly between US government debt and gold, is rare. Gold finished 2006 up at a then-eye-popping $637 per ounce, up more than 20% for the year. The S&P 500 was up 14% on the year, rising after two relatively tepid years in 2004 and 2005, when it was largely range-bound. Finally, US government bond futures finished the year up 6%. As such, yields between the 5, 10 and 30-year bonds had not only risen but converged as well.

While the full faith and credit of the United States government was alive and well, an increase in gold implies uncertainty in the monetary system and, more often, the perception that inflation is going to rise. After all, inflation was significantly up in 2006 and 2007. The rise of emerging markets, such as Brazil, China, and India, and the resulting increases in demand for oil and food staples had helped to steadily push inflation up during the 2000s. However, in that case fixed-income investments would not be expected to do as well. The inverse correlation between Uncle Sam’s debt and gold was mentioned by a few commentators at that time. Dennis Gartman, the Virginia-based economic commentator and author of The Gartman Letter, wrote in December 2006 that, “one would expect gold and the debt market to move in contravention, for strong gold means rising inflation which is, of course, an anathema to debt investments. The only reason we can ascertain to push both higher is weakening economic environs, deflation and serious economic dislocations” (refer to Charts 1 and 2).

Chart 1 – Price of Gold, January-December 2006

Chart 2 – US Government Debt Yields, 2000-2010

In addition to contributing to the increases in the price of commodities, China’s role in the global economy allowed interest rates to stay low without immediately generating inflation due to the lower prices for its goods. It also contributed to lower rates and the property boom by, as I have previously written about, a voracious appetite for US debt. By early 2007, as Greenspan was enjoying the close of his first year of retirement, he was the most celebrated central banker in history (in all reality his legacy will be as such, no matter how much we know that he made mistakes). What was the perhaps the first tremor of what would become the Great Recession arrived in late February while Greenspan was addressing a large European fixed income conference in London. There, he advised the attendees that there was a chance the US could fall into recession in late 2007. The next day, a tremor came out of China that reverberated around the world.

On February 27, it became known that the Chinese government was creating a task force to explore ways to curb speculation on the Shanghai Composite Index (SSE). Investors panicked at the prospect of the Chinese government suddenly curbing their access to its capital markets. The SSE, which had doubled in 2006, fell by 9% in one trading session, to 4000. Suddenly, the markets were on edge. Although the SSE recovered along with US and European markets to post all-time highs in October 2007, it served to illustrate the newfound importance of China, even at a time when its importance was not completely understood by those who had the most at stake.

The rise of China and its role as a factory for the world created economic conditions that served to mask the true situation. This had many ripple effects on the global economy, some more obvious than others. The “money loop” that was established enabled goods to be produced at lower prices, contributing to subdued inflation at the point of sale in the US and Europe. Another effect was that the resultant, ballooning trade deficit left the Chinese flush with cash. As was the case with the US, this capital had to find a home somewhere. The Chinese ramped up their buying of treasuries throughout the 2000s. Indeed, it was one reason that US government debt prices went up with the market in 2006. China’s purchases of US government debt increased from $72 billion in 2000 to $420 billion in 2007. China bought other, higher-yielding debt implicitly guaranteed by the US government (translation: Fannie Mae and Freddie Mac debt) in large numbers, further contributing to the property bubble. Of course, to political leaders in the US and Europe, this was a win-win situation. Subdued inflation was a key ingredient in maintaining economic stability despite low interest rates. The juiced housing market created construction and real estate jobs (these sectors created over 1/3 of the new jobs created from 2003-06, according to official Dept. of Labor data). In this manner, China’s role of helping to pay for the American Dream was crucial to keeping the American machine running, which in turn had to run in order to keep China’s factory machine running, and so on.

By early 2007, economists and central banks across the globe found themselves increasingly divided about the future prospects for the US economy. Residential real estate prices across the nation had stopped appreciating or were in swift decline, particularly on the coasts and across the Sun Belt. At the same time, as we know, there was still plenty to smile about. One month before the first signs of trouble, the mood was jovial at the 2007 World Economic Forum in Davos, Switzerland. As mentioned, prices for most assets were still at relative highs, and there was emerging talk of a secular “Great Moderation” among a growing cadre of academics. One central tenet of this theory was that modern banking systems and risk management had brought volatility to new, permanent lows. Thus, the implication was that we were in an age of lessened, if any, financial shocks. Since the early 1990s, the primary measure of volatility has been the VIX index. In late 2006, the VIX was at multi-decade lows.

The VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index. Briefly, it has been disseminated since 1993, and is constructed by formulas that measure the fluctuations of S&P 500 futures activity. Although there are now derivatives that trade based on its fluctuations, the VIX itself is not backed by anything. It is solely for the purpose of measuring volatility in the market. The VIX measured in the 40’s after the tech bubble burst, and fell steadily from the upper 20’s in 2001-02 before dropping below 10 for the first time in late 2006 (refer to Chart 3). The driving up of asset prices across the board had led to lower profits and returns on investment. However, this also served to drive down volatility. Although I have generally disagreed with Nouriel Roubini’s economic predictions since the beginning of 2009, his initial prediction about the US real estate market and the derivative-led shock waves across the banking system proved to be spot-on. While he was predicting the ripple effects of the real estate downturn, he was also noting that the excess of liquidity was resulting in diminished returns as well as less volatility. In turn, this caused rates of leverage to grow at alarming rates (after all, traders thrive on volatility, no matter which way the market goes). At Davos in January 2007, while part of a panel discussion, Roubini prophetically noted that, due to leverage more than anything, “the risk of something systemic happening is rising.”

Chart 3 VIX Index 1993-Present

By late 2006, nearly every widely-used measure of market risk did not point to heightened volatility in 2007, let alone a sharp downturn, and much less than what would eventually transpire. One of the reasons that I point to the SSE fall in February 2007 is that on that day, the VIX posted its largest one-day jump ever up to that point, and this sent global markets ineluctably on the path to heightened volatility that would define the next two years. Prior to that day, however, volatility was low across the global markets, and yields continued to flatten across the atlas of credit. Money managers found themselves needing to take on more risk to achieve the returns demanded by clients, or to merely replicate/exceed past performance.

Lower volatility, to a trader, meant it was theoretically safer to take risk. That directly translated into more leverage. In particular, a key driver of the hedge fund industry’s growth from 2000-2007 was the fact that many institutional investors had fallen behind when the tech bubble burst. This was particularly true within the realm of pension funds. To get back on track, more robust returns were sought. Hedge funds, ready to use leverage via the environment of readily available credit, were the perfect candidates to accept this assignment. Money managers would lose clients if returns were not high enough to meet or exceed investor expectations, so the vast majority of them used leverage. The first hedge fund tremor came five months before February 2007, in September 2006. A trader at Amaranth Advisors, one of the many hedge funds that opened up in Greenwich, CT, in the 2000s, had wagered with 9-1 leverage that the value of the March and April 2007 natural gas futures contracts would converge. When the spreads instead widened, Amaranth was forced to liquidate after losing more than $5 billion in one week.

According to Michael Lewis’s Bloomberg column from January 11, 2007, the Amaranth debacle was the most widely-read story on Bloomberg since 9/11 when it broke on Monday, September 18, 2006. Additionally, several of the follow-up stories were in that year’s Top 20. That speaks volumes about what Wall Street was concerned about in the months that led up to February 2007. Besides the obvious reasons (cutthroat competition, firms wanting to know who the winners in the trade were, wanting to know who would buy the portfolio, etc.) it is also indicative of what may have been shared concerns. What I mean is that other Wall Streeters appear to have been concerned about the use of leverage and risk. They could conceive of their own firms having the same problems. However, the conclusion by way of the prevailing market measurements at the time was that all was well. Indeed, in spite of Amaranth, the VIX continued to fall for several more months afterward.

In the end, this lack of preparedness for the events of 2007-2009 was an issue of unprecedented historical market correlations brought on by the excess of liquidity. Because it had never happened on a global scale, and therefore had no historical precedent, the effects and outcomes were nearly impossible to predict. Therefore, it should serve as a reminder that this was not completely a matter of the financial and political crème de la crème being asleep at the wheel, as countless pundits have asserted in the three years since.

Respectfully Yours,

Matthew R. Green

June 4, 2010

Issue XIV - Currencies

2010-05-21T10:20:00.000-07:00

Dear Readers,

All the news coming out of Europe has made for an interesting week in the markets, particularly the currency markets. The Euro has continued to plunge against the Dollar and other currencies on concerns ranging from doubts about whether the bailout of Greece will work to speculation about the future viability of the Euro. As I wrote in February, while I believe the Dollar is continuing to climb into overvalued territory, volatility and/or upward pressure will likely continue until a) the focal point of currency crises shifts to the US, or b) the crisis is resolved in a manner about which the market is confident. Neither of these has happened. As the situation plays out, I view the skeptics who doubt the Euro’s viability as misguided. A breakup of the Euro, particularly a disorganized piece-by-piece dismantling, is counterproductive and would only harm the EU as a whole. Second, the Euro’s plunge against other world currencies could trigger currency crises in other heavily indebted countries outside the Eurozone, such as Japan.

The volatile action of the Euro, accelerating during the past two weeks, is symptomatic of trading action that is less fundamentally driven than it is by news and gut instinct. As I write this, markets are being battered by Germany’s announcement that it will ban naked short-selling of shares of its top financial institutions and also of its bonds. Similar measures were put into place in the US during the fall of 2008 by the SEC in an attempt to bolster the battered shares of financial services companies. With these measures coming from a country that is looked upon as arguably the most fiscally sound in the entire EU, the ramifications have shaken the market. As a result, on Tuesday night the Dollar Index shot over 87, but retraced sharply back during the past few days. Such action also suggests large, concentrated short positions in the Euro by large trading desks all the way to small hedge funds. The sharp reversal could be indicative of a one-sided market that is ripe for a correction.

That said, the Euro is looking more oversold right now than at any point since 2007, and the Dollar is consequently looking more overbought than at any point within that time frame. Some commentators have suggested this action indicates that the market is beginning to price in the possibility of a Euro breakup and/or demise, or a correction to a permanently lower exchange rate with the dollar (refer to Charts 1 and 2). Both measures are in extreme territory, and the sustainability is questionable. However, the volatility and resultant irrationality will no doubt continue as long as such crises keep popping up.

Chart 1 – Euro Index May 2007 - Present

Chart 2 – US Dollar Index May 2007 - Present

Another story affecting the market has been the emerging speculation that Greece could be forced out of the European Union. I have serious doubts about this possibility. First, there is no established process in the EU’s protocol for the removal of a member nation. Moreover, any attempt to do so would be seriously disruptive, not to mention counterproductive. At a time when Rome is burning, so to speak, more disruption is the last thing that Europe needs. As such, I would interpret such speculation for what it is: mere speculation. Second, taking apart the European Monetary Union will inevitably be more difficult than putting it together. Marc Chandler, global head of currency strategy at Brown Brothers Harriman, stated this week that, “As there is no mechanism for this, we are dubious about the veracity. There is unlikely to be much of a consensus for this move.” The latter part of the statement touches on the bigger, real problem of the European situation. The problem is not confined to Greece, and expelling financially rogue members from the EU is not a long-term solution to the problem.

The real issue of a Greek ouster would be the implications for the rest of the little PIIGS. Portugal, Italy, Ireland, and Spain should be shaking at the possibility of a Greek ouster from the monetary union, as such would set a precedent for the same to happen to them. Therefore, there should be serious doubts that eliminating Greece would be conducive to the long-term viability of either Greece or the EU. If forced to exit, Greece will simply devalue its new currency, immediately resulting in inflation. In that case, there has been talk of reintroducing the drachma (Greece’s pre-Euro currency). This would entail a currency reintroduction with the specific intent to devalue. Greece would immediately see higher interest rates and thus a steeper wall to climb out of the current recession.

It is counterproductive from the EU’s perspective as well, since, as mentioned, getting rid of Greece would not put its problems behind it but merely shift the focus to the other, fiscally weaker members. The fundamental problem that enabled the PIIGS to dig these massive fiscal holes is that the Eurozone policymakers did not prepare a comprehensive fiscal overlay to support and enforce deficit/debt standards within what became a low interest rate monetary union; unfortunately, this union included some members who clearly did not deserve such low rates. The long-term goal of European policymakers is, obviously, maintaining the union. A mere decade into its existence, removal of any members would further undermine what is already being referred to by some as a “failed experiment.” Many commentators have mentioned that a swift breakup of the Euro would enable the indebted nations to devalue, inflate, and get on with their lives, while removing the burden from the more fiscally sound states. If this was viewed as the best solution, Greece would be close to or out the door already. But it is not. Since monetary union is the long-term goal, front and center on the solution-creating agenda should be the future enforcement of fiscal standards. While a mechanism for removal of fiscal outliers may not come to pass, at the very least rigid enforcement of fiscal standards will.

Having observed the various ways that financial contagion and systemic risk have manifested in the past few years, surmising potential effects of the events in Europe is prudent. Taking a look at the global macro picture, the next currency domino to fall could be Japan. The reasons stem from the potential effects on trade and the export-heavy Japanese economy. More importantly, the reason lies in the exporters that Japan directly competes against, Germany and the United States. One commentator pointed out this week that “exports from [Japan and Germany] are in direct competition on many aspects. In terms of products, both are strong in auto and precision equipment. In terms of export countries, both heavily rely on the US and China.” More importantly, Japan finds its currency rising against the Euro, and it comes at a time when Japan’s two largest export destinations, the US and China, are still mired with stagnant economic growth and/or the prospect of a double-dip recession. Indeed, the EUR/JPY exchange rate has fallen more than 35% since 2008 (refer to Chart 3). Germany’s largest export destinations have always been its neighbors in continental Europe. With the belt-tightening austerity measures in Greece and similar burdens likely to be placed by upon the other little PIIGS, Germany may need to look elsewhere to push its export sector, and its economic recovery, forward. As such, a lower Euro is a welcome prospect to the Germans. Therefore, I would look closely at the possibility of Germany and Japan seeing increased competition with each other, and the possibility of continued malaise in the Japanese export sector triggering a currency crisis.

Chart 3 – Euro/Yen Exchange May 2007 – Present

Not surprisingly, China has recently surpassed the US as the top export destination for Japanese goods. Although China’s long-term growth fundamentals are solid, in the short term many investors are wary, and rightfully so, about China’s need to put a damper on inflation and an overheating real estate market. With a second leg of the recession looking certain for Europe and still very possible in the US, Japan’s exports will likely be under pressure for some time. Therefore, the last thing Japan needs is increased competition with other exporters.

Obviously, the main reason why I focus on Japan is their 200% debt/GDP ratio. This is nothing new, having built up gradually over the past 20 years. However, one of the main reasons that a major currency crisis has not come to pass is because of Japan’s culture, “collectivist,” as one commentator aptly put it. In other words, Japanese citizens are more willing than one would think to pour their life savings into helping the government if it was in trouble. Combine that with a high domestic savings rate, and the result is that Japanese citizens and corporations own well over 80% of Japanese Government Bonds (JGB’s). The collectivist bent of the population and domestic savings rate are not going away. At the same time, a population that is ready and willing to help can only delay a crisis to an extent. Without resiliency in the export sector, the task will become much more difficult.

In conclusion, the situation in Europe will provide for an interesting narrative in the weeks and months to come. The possibility of a Euro breakup, while unlikely, has been exposed and is clearly being taken seriously by the market. Yet, if the focus of the crisis were to shift to elsewhere, perhaps to Japan, the Euro might suddenly rebound. Right now, one might wonder why the Euro was ever priced at 1.50 US Dollars given what is now known, but this and the current movements should not be taken as a sign the US Dollar is any safer in the long term. Fiat currencies around the world will face a serious test of their viability over the next two decades. The pace at which these tests will occur is yet to be determined, but will no doubt be heavily influenced by decisions made now and in the next few years.

Respectfully Yours,

Matthew R. Green

May 21, 2010

Issue XIII - Airlines

2010-05-07T13:10:00.000-07:00

Dear Readers,

On Sunday evening, United Airlines and Continental Airlines announced that they would merge their operations. This follows in the footsteps of another combination of major carriers, Delta Air Lines’ acquisition of Northwest Airlines in October 2008. Over the past decade, we have seen four major US airlines (TWA, America West, Northwest, and Continental) swallowed up by, or merged with, one of their peers. The remaining “legacy” airlines are the “Big Three” of Delta, United, and American, along with a few smaller legacy carriers such as US Airways and Alaska Airlines. The trend of consolidation within the US airline industry stems from the governmental deregulation of the airline industry in 1978. In the post-deregulation era, three trends have defined the evolution of the airline industry. First, a largely unionized workforce and high cost structure prior to deregulation meant that downward pressure was inevitably placed on employee wages and benefits in the post-deregulation era. Second, new low-fare airlines with business models built around lower cost structures emerged and to this day continue to take away significant market share from the legacy airlines. Finally, competition and the subsequent need to expand led the better-positioned airlines to acquire or merge with the weaker ones, thus leaving only a fraction of the original legacy airlines in business today. With the latest round of consolidation, we have reached a point where future mergers will likely be multinational due to antitrust concerns. Equally likely is the prospect that legacy airlines will attempt to take over low-fare carriers in order to retain them as low-cost subsidiaries, but reorganize the competition in their own favor.

As the railroad industry suffered from rapidly declining traffic in the 1960s, air travel was on the rise, even though it was still a relative luxury for most Americans. Additionally, air transport was a highly regulated industry. The structure was rigid, highly inefficient, and fares were high. The government’s Civil Aeronautics Board (CAB) regulated routes, pricing, and maintained high barriers to entry for newcomers. Even the existing airlines often had to wait years to get new routes approved. One of the most famous stories involved Western Airlines waiting over a decade for approval to fly to Hawaii. It got it in 1969, after years of red tape and attorneys’ fees. Nevertheless, the industry was profitable and airline employees enjoyed relatively high salaries and benefits, made possible in part by the unionization of the workforce. With the CAB virtually ensuring profits, the companies could afford the high salaries, and the system was allowed to work in favor of the carriers and their employees.

It is a harsh reality that all forms of mass transportation are only marginally profitable at best. This is true across the industry, whether it is trucking, shipping, or rail. The airline industry was reminded of this when the 1973 oil crisis forced the airlines to raise fares, which the CAB readily approved. Despite this, the subsequent recession and declining passenger traffic caused the airlines to experience losses. With the massive 1970 Penn Central Railroad bankruptcy a recent memory, (Penn Central was the product of the 1968 merger of the Pennsylvania and New York Central Railroads, a necessity due to the desperate railroad situation), voices in Congress began to express concern that the same thing could happen to the airlines. Subsequently, hearings on airline deregulation began in 1975, spearheaded by Ted Kennedy. In 1977, President Carter appointed Cornell University economist Alfred Kahn as Chairman of the CAB. This was a notable because, as a marginal-cost economist, Kahn was known as an academic who favored deregulation regardless of the industry in question. As congressional hearings continued, the airlines, who favored the rigid system despite its flaws, began to lobby against the proposed legislation. Kahn envisioned an industry with lots of midsize carriers in competition with each other, where reduced profits brought about by competition would largely be balanced out by an increase in passenger numbers resulting from lower fares. Many industry veterans knew better. American Airlines’ Robert Crandall, who would later be known as one of the fiercest post-deregulation CEO’s, stood up in one congressional hearing and chastised the committee that “you’re going to ruin this industry!” Nonetheless, the bill found little resistance in Congress, and President Carter signed the bill into law on October 24, 1978.

While deregulation was necessary to open up air travel to the masses, there were several factors that Kahn and the other deregulators did not address. The most important factor was one for which the airlines found themselves completely unprepared prior to deregulation: highly unionized workforces made it difficult to adjust cost structures without tense labor relations and costly strikes. Not surprisingly, the 1980s brought about harsh realities for many airline employees. The post-deregulation environment immediately exerted downward pressure on the generous wages and benefits of airline employees, a process that continues to this day. Frank Lorenzo, a Queens, NY native, established himself as arguably the most prominent airline executive during the 1980s by building Texas Air into a holding company that would later purchase Continental, PeopleExpress, New York Air, and the once-mighty Eastern, all the while establishing himself as a vicious cost-cutter.

In 1983, Continental declared bankruptcy, and Lorenzo used the courts to force necessary cuts on the unions, emerging shortly thereafter as a lower-overhead, profitable carrier. After former astronaut-turned executive Frank Borman sold Eastern Airlines to Lorenzo in 1986, constant labor struggles ensued. Eventually, a six-month machinists strike in 1989 led Eastern to declare bankruptcy. During this time, Lorenzo was quoted as saying “I'm not paid to be a candy ass; I'm paid to go and get the job done.” By 1990, Lorenzo was a poster boy for the airline industry’s lousy labor relations. That year, he left Texas Air/Continental upon its second bankruptcy filing. His aggressive actions throughout the decade indicate that Lorenzo arguably knew better than any other airline executive what was necessary for the industry’s long-term financial health. Despite this, his tactics poisoned labor relations and made it harder for future airline executives to make necessary cuts due to the lingering atmosphere of distrust. An airline tycoon had become a pariah in just a few short years. His tarnished legacy was apparent in 1994, when Federico Pena’s Department of Transportation rejected an application to launch a new airline from an investor group that included Lorenzo, partially on the grounds that he was involved.

Throughout the rest of the 1990s, a good economy resulted in prosperity for the legacy carriers. However, well-publicized labor struggles remained. With low fuel prices aiding to produce several years of billion dollar-plus profits, the unions, particularly the Air Line Pilots Association (ALPA), began to demand more lucrative contracts. American’s CEO Bob Crandall needed President Clinton’s help to avert a 1997 pilot strike, which Clinton did by invoking the Railway Labor Act (amended to include airlines in the 1930s). The next year, Northwest was forced to impose a lockout on its pilots for two weeks. As the airlines’ profits remained steady into 1999 and 2000, ALPA members significantly lifted their demands. United’s pilots in particular demanded that their pay levels return to pre-deregulation levels, adjusted for inflation.

At the turn of the century, United was indeed flying high, confirming its slogan at the time, “United: Rising.” On the strength of its West Coast network, United rode the tech bubble to profitability. SFO briefly became the sixth-busiest airport in the world, providing United with a great amount of premium and business fares. Frustrated, United’s pilots took action by refusing to fly overtime. United was forced to cancel major portions of its summer schedule and largely acquiesced to its pilot’s demands later that year. Delta’s pilots used this as leverage to do the same in 2001, just months prior to 9/11. In a clear illustration of the union’s unwillingness to accept lower wages, despite the industry bleeding red ink after 9/11, Delta’s pilots refused to accept concessions until 2004, when oil prices began to strain the carrier’s finances.

After three decades of wage and benefit cuts, the legacy airlines remain union-heavy. However, the airlines have experienced the toughest decade in their history in the aftermath of 9/11 and with higher fuel prices. This has forced the unions to accept more flexible cost structures. The list of bankruptcies is extensive. US Airways went through bankruptcy twice, in 2002 and 2004. American narrowly averted bankruptcy in 2003 by winning large wage concessions. United was in bankruptcy from 2002 to 2006, and Delta and Northwest filed Chapter 11 on the same day in 2005. With the bankruptcies of this decade more drawn out than in the past, the airlines have been able to adjust their cost structures downward like never before. This offers hope that the airlines will be able to cope with the possibility of higher oil prices and industry difficulties in the future. Unfortunately, it took 30 years and a revolving door history of bankruptcy for unions and airlines alike to accept the new realities.

The lower barriers to entry post-deregulation led to the other two secular industry trends: the rise of low-fare airlines, and the commencement of a Darwinian race to survive among the legacy carriers. First, a look at the history of deregulation start-ups and a new breed: low fare carriers.

Immediately after deregulation, new upstart passenger airlines began to take to the skies. Midway Airlines of Chicago was planned pending the legislation, and thus began operating in 1979 from its namesake airport. The new, competitive environment meant that passengers suddenly had a choice of which airline to fly, because multiple airlines were competing on the same routes. More importantly, the lack of CAB fare regulation meant that passengers usually flew with the carrier who offered the lowest fare. This was not lost on several entrepreneurs, in particular a man named Donald Calvin Burr. In the late 1970s, the Harvard-educated Don Burr was working for Texas Air under future union foe Frank Lorenzo. Seeing the potential for low-fare airlines, he resigned in 1980 and moved back to the Northeast, setting his sights on Newark Airport. A sleepy airport during much of the 1970s, Burr found that the Port Authority was willing to lease Newark’s deteriorating North Terminal at fire lease rates. He also found that there were many Boeing 737’s on the market that were old, but well-maintained and in good flying shape.

In 1981, Don Burr’s PeopleExpress took to the skies out of Newark, forever changing the industry by redefining the concept of low-fare and no-frills service. The only thing included in the fare was the transportation. To check a bag or to get a snack or beverage on board involved an extra charge – “added value” - as Burr put it. To better utilize flight attendants, the company collected fares on board, and never had a toll-free phone reservation line, preferring local toll numbers for each of its destinations. The no-frills experience and low cost structure enabled Burr to profitably offer lower fares than his competitors. Passengers did not mind the no frills experience, and PeopleExpress grew exponentially as the public embraced low fares.

While PeopleExpress was synonymous with, and can be credited with catalyzing the growth of low-fare carriers in the 1980s, the art of running a low fare carrier was perfected by Dallas-based Southwest Airlines, which quietly rose to prominence throughout the 1980s and 1990s. After struggling as an upstart carrier in the early 1970s, Southwest introduced a new business plan emphasizing low costs. It employed a largely nonunion work force and initiated aggressive fuel hedging strategies, which both continue to be the foundation of its low cost structure today. Southwest was also on the cutting edge of utilizing its aircraft to the maximum by targeting short turnaround times, maintaining simplicity by only flying Boeing 737s, and focusing on point-to-point service rather than the hub-and-spoke system embraced by the legacy carriers in the 1980s. Southwest’s growing clout was apparent by 1993, when it opened shop on the East Coast. It began by initiating service to Baltimore, quickly followed by a large expansion to Florida, thus tapping the lucrative leisure market to and from the Sunshine State. New, upstart airlines continued to emulate the PeopleExpress/Southwest model, whether they started as small operations such as Valujet and AirTran, or large, well-capitalized startups such as JetBlue. By the 2000s these airlines were a prominent thorn in the side of the legacy carriers, further putting fare pressures on the large airlines and subsequently on the wages of the old-line employees.

Finally, the third secular trend of the past three decades has been the survival of the fittest. The original Big Three that emerged in the early 1990’s remain the dominant triumvirate to this day. First, a brief history on the mergers that led to this. After deregulation, many legacy carriers immediately began to struggle. Pan American World Airways, for decades America’s flag carrier to so many nations, found itself grossly unprepared for deregulation because of its lack of a domestic network to feed its flagship international operations. To remedy this, Pan Am purchased National Airlines in 1980. This was a harbinger of what would become the trend throughout the 1980s. After the industry was shocked by the sudden collapse of Braniff during the 1982 recession, the better-positioned airlines went on a buying spree. In order to acquire the “critical mass” to weather the new environment of cutthroat competition from deregulation upstarts and old foes alike, airlines began to purchase stakes in smaller airlines to establish feeder or “express” networks. Then, later in the decade, they began to acquire their competitors.

The industry experienced rapid consolidation in 1985 and 1986. Carl Icahn (then a famous corporate raider, different from his current practice of shareholder activism) purchased TWA in 1985, and immediately purchased St. Louis-based Ozark Airlines in 1986. That same year, Northwest Airlines purchased Minneapolis-based Republic Airlines. Pan Am’s marriage with National was not a happy one, and the struggling carrier sold its valuable transpacific routes and San Francisco hub to United in early 1986. Don Burr’s PeopleExpress, seeking to grow and gain a presence in the western US, purchased Denver-based Frontier Airlines in 1985. Unfortunately (and ironically with this week’s merger), Continental and United responded by initiating a bloodthirsty fare war in Denver. After a proposed sale to United fell through, the Frontier division of PeopleExpress was placed into bankruptcy in 1986. Burr was able to avert the bankruptcy of the entire company by selling to his old boss, Frank Lorenzo, in October of that year. Finally, 1986 ended with Delta doubling its size by purchasing Western Airlines, while American purchased AirCal.

By 1990, the “Big Three” of American, United, and Delta were more well-positioned than ever before to feed on the remains of other legacy carriers who continued to struggle. The Gulf War and subsequent oil spike proved to be the final nail in the coffin for several carriers. Eastern, having sold off major portions of its network and fleet, attempted to come back but ceased operations in February 1991. Midway, the original deregulation upstart carrier, attempted an ill-fated expansion at the same time fuel prices rose, and ceased operations in late 1991. Pan Am’s struggles continued to mount, accelerating after the Pan Am 103 terrorist attack in December 1988. After declaring bankruptcy in January 1991, Pan Am sold its crown jewel - its JFK hub and transatlantic routes, to Delta along with its Northeast Shuttle operation in exchange for cash and financial support. With that move, Delta became the world’s largest carrier overnight. Over the course of the year, Pan Am attempted to reorganize around its original Latin American routes and negotiated with Carl Icahn to merge with TWA. Sadly, before a merger could materialize, Delta cut off its support, and our nation’s most historic airline was forced to shut down in early December. American subsequently cemented its Latin American dominance by purchasing the Miami hub and Latin American routes. As mentioned earlier, the prosperous 1990’s led to a period of relative stability for the major carriers, but that all changed with 9/11.

Even before 9/11, United had entered into merger talks with US Airways, but due to antitrust concerns from John Ashcroft’s Justice Department, the plan was quashed mere weeks before 9/11. (Considering that both airlines declared bankruptcy in 2002, in United’s case lasting more than three years, the antitrust concerns were somewhat unwarranted given the subsequent events and the fact that much larger mergers have now taken place.) TWA, unable to regain its former glory, especially after the 1996 Flight 800 disaster, was purchased by American in 2001. The last remaining deregulation upstart survivor, America West, was bought by US Airways in 2005. The accelerating rise of oil prices after 2005 led to Delta purchasing Northwest in 2008, gaining a valuable transpacific network in the process. This in part necessitated the merger of United and Continental.

Concerning the future of the industry, it is necessary to look at the global picture. In Europe, the past decade has seen countries lose their historic flag carriers. Belgium’s Sabena went bankrupt in 2001. Some airlines have been bought and are now subsidiaries of others, but are kept as separate brands partially because of national identity and pride (the Netherland’s KLM is now owned by Air France). Others have gone bankrupt only to have their assets transferred by their creditors and re-launched under a new name for the sake of keeping a national flag carrier (Swissair, bankrupt in 2002, was reorganized by Credit Suisse and UBS as Swiss International Air Lines).

In the future, consolidation will likely become a global phenomenon. It is possible that we may see the airlines within alliances spearheaded by American, United, and Delta (Oneworld, Star Alliance and SkyTeam, respectively) begin to merge with each other. The fact that some countries can no longer support even one flag carrier in today’s economic environment supports the notion that the US was an anomaly with six to eight major carriers ten years ago. Without European-style government subsidizing of the airlines, it is likely that airline consolidation will continue in the US. The question is which strategy will the Big Three adopt? In the US, we have reached a point where future airline mergers may need to be multinational in order to avoid antitrust actions. If any of the Big Three announced merger plans with one another, antitrust concerns would immediately complicate the prospects of a deal. It will be interesting to see at what point, if any, the Justice Department steps in. Another possible step could be low-fare carriers being bought or merged with the legacy carriers. This would likely cause fares to rise, as less low-fare competition would make it easier for the Big Three to keep fares at more profitable levels.

Taking a final look at the big picture, airline deregulation in the US has more than fulfilled its main objective of making flying cheaper, and therefore more accessible to the general public. The winner has been the American consumer; the nominal price of an airline ticket is up just 45% since 1978. (By comparison, the price of many food staples is up over 100%, while a college education is up over 500%.) The losers have been those who invest in the airlines, and most of all the employees. Deregulation exposed the rigid union cost structure as inadequate for such competition and unpredictable cost fluctuations, particularly the price of oil. Bob Crandall summed up the post-deregulation industry when he said, “I've never invested in any airline. I'm an airline manager. And I always said to the employees of American, 'This is not an appropriate investment. It's a great place to work and it's a great company that does important work. But airlines are not an investment.’” Indeed, since deregulation, over 150 airlines have gone bankrupt, the vast majority small startups that could never effectively compete with the large airlines, most folding within a few years. Those that still exist have to cope with cutthroat competition and the fact that the transportation industry, even in the good times, is only marginally profitable. Yet, we are able to get from city to city much cheaper than we were 30 years ago. In the end, it depends on one’s perspective, particularly the degree to which a traveler or employee may harbor nostalgia for the way the industry used to be.

Respectfully Yours,
Matthew R. Green
May 7, 2010

Issue XII - Biflation

2010-04-25T13:06:00.000-07:00

Dear Readers,

As you probably know, in recent months there has been a heated debate among economists and politicians regarding inflation and deflation. The camps are divided over the direction of our economy with regard to both scenarios. As you may remember, I covered the arguments for and against both inflation and deflation before the New Year. While most investors are concerned with the prospects of either scenario ravaging their portfolios, many have failed to examine a little known theory on the subject that combines both inflation and deflation. What may be the situation at hand is a scenario where both parties are correct to a certain degree. With the current economic situation in the United States as well as the changing geography of the global economy, it could be that both camps are right, but neither argument can describe the situation entirely. Meet biflation, the stagflation of the 21st century.

Biflation is a relatively new economic concept¬¬¬ that was initially outlined by the economist F. Osborne Brown in 2003. Some commentators have been quick to view biflation as stagflation all over again. However, there are clearly defined differences. The ingredients of stagflation are simply a stagnating or recessionary economy against a backdrop of inflation across the board, with price increases in nearly all categories. Since biflation is an emerging concept, many economists are in disagreement with regard to its definition. In spite of that, several private economic research organizations have loosely defined biflation as an economy where inflation of commodity-based assets occurs alongside the deflation of debt-based assets.

First, let’s take a look at the inflationary aspect of biflation. Many economists and commentators, myself included, have argued that the money supply injected into the economy by central banks worldwide will lead to higher inflation in the future. If the economy goes through a biflationary stage, this is destined to be at least partially correct. The prices of commodity-based assets such as food, oil, and metals will increase. With the developing economies in Asia, demand for such assets, particularly food, will continue to grow. The price increases will be exacerbated further by the excess money supply pursuing the limited supply of goods. Such is the inflationary aspect of biflation.

One of the most prominent voices in predicting inflation has been financial guru Jim Rogers. After establishing the Quantum Fund with George Soros in 1970, Rogers went into semi-retirement in 1980. After stints as a professor, traveling extensively, and writing about his motorcycle trips around the world (Investment Biker and Adventure Capitalist, both great reads if you are interested), he moved to Singapore in 2007 to be in closer proximity to the growing Asian economies. He has emerged in the past few years as one of the strongest proponents of future inflation. When asked in a recent interview if he feels that the US will be hit by inflation due to Bernanke’s actions, he quickly cut the interviewer off, saying, “Not just the Federal Reserve. All central banks are part of the problem. We’re going to be paying more for just about everything down the road.” When asked if he foresees a 1970s-style period of stagflation ahead, Rogers replied with a smirk, “I hope it’s that good. It might be much, much worse.”

Every new set of data that points to inflation seems to be offset by an accompanying set of data that suggests otherwise, leading to mixed conclusions. We have seen oil continue its robust recovery from the violent, margin-induced selloff of late 2008 (refer to Chart 1). For the first time in nearly two years, the prospect of $100/barrel oil is once again a possibility with the spring and summer driving season approaching. The price of oil is now identical to that of October 2007, when the S&P 500 reached its all-time high. Gold, while still $75/oz. off its early December high, has also recovered 50% from the late 2008 interim lows. Across the world, government statistical agencies are reporting increasing levels of inflation. Last week, India’s annual inflation rate for March was reported at 9.9%, up from less than 2% last September. Consequently, on Tuesday the Reserve Bank of India (RBI) announced its intention to continue the trend of raising rates in the foreseeable future. The RBI’s governor described the situation as “worrisome.” This sudden increase is not limited to Asia. Inflation has now hit the UK, rising to 4% according to the most recent data. This exceeds the Bank of England’s internal 3% inflation target.

Chart 1 – Light Crude – Continuous Contract: April 2007-Present

Note that the 50-week moving average (Blue Line) is about to cross upward through the 200-week moving average, which despite the 2008 selloff, has remained steady due to oil’s recovery.

Now for the deflationary aspect. When the talking heads engage in this debate on CNBC's Squawk Box, Charlie Rose, or other programs, the general argument for deflation is that there is a large housing glut that will take years to wear off, in addition to excess capacity in manufacturing and many other areas of the global economy. The economy has been held down by increasing unemployment and decreasing purchasing power even as the recession has begun to abate. With individuals and families cutting back on spending, a greater amount of household income is directed toward buying essential items. Therefore, large purchases (read: debt-based assets such as McMansions, appliances, automobiles, etc.) increasingly fall into lower demand. Prices for these items remain stagnant, if not decreasing, and these sectors of the economy experience the deflationary aspect of biflation.

At the same time we have been receiving inflationary reports and data, other economists continue to ring the deflationary alerts. As I have mentioned in previous commentaries, the prospect of our economy falling into a destructive cycle of deflation is a scenario that our country’s fiscal leaders are willing to do nearly anything to prevent, up to and including debasing our currency. Despite that, some deflationary risks remain. The real estate market, after stabilizing in 2009, potentially could take another downturn via commercial real estate and a great overhang of housing supply that is not even on the market, often referred to as the “shadow housing inventory.” Many stories appearing in the financial media in the past several months have pointed out that despite foreclosures falling in number, the number of properties eligible for foreclosure has continued to climb through 2009. Fifty percent more US home mortgages are now seriously delinquent than during the heart of the financial crisis in late 2008. The rate is 9.67% now compared to about 6% then (refer to Chart 2). In fact, it is estimated that five to six million properties are eligible for foreclosure but have not been repossessed. I have seen a range of predictions, but the median estimate of economists is that it will take about three years for the housing market to digest the excess housing inventory.

Chart 2 – Seriously Delinquent US Home Mortgages 2005- Present

Deflationists are also supported by the lack of credit available to most small consumers and businesses, which continues to keep a lid on economic growth. In early February, the Core CPI figure fell by 0.1%, the first such occurrence since the early 1980s. This sparked fresh fears over a return to a deflationary environment, but moreover it reminded many that the recovery is modest at best, and therefore prices have good reason to remain contained. As with the inflation camp, there are some who feel it is a sign of things to come. Mizuho Securities Chief Economist Steven Ricchiuto said in February that even though core wholesale prices rose 0.3% in January 2010, they have only risen 1% in total since January 2009. Further, Gluskin-Sheff economist David Rosenberg, formerly of Bank of America, sees deflation as the “primary risk” to investments in the near future, noting that “it is truly difficult to believe inflation is going to be revived in the intermediate term.”

So what’s the verdict? I think it is reasonable to say that our economy is showing both ingredients of biflation, regardless of a universally-accepted definition. The prices of oil and food staples appear to be headed higher while home prices have begun to slide once again. According to home price tracker Zillow.com, house prices slid more than 6% in February and March. Obviously, the relative lack of credit is still a thorn in the economy’s side, and with the first-time homebuyer tax credit coming to an end, there is potentially another down leg coming up in real estate. If figures begin to tilt on the deflationary side, central banks may increase their intervention once again, propping up sectors of the economy that are experiencing deflation but having the inverse effect on the inflationary sectors. Along with rising worldwide demand for food and commodities, it could become a vicious cycle of biflation until home prices begin rising once again on a sustained basis, and rates are raised to the point that prices can be contained. Needless to say, raising rates with the situation the US is up against will be a heated topic of debate if inflation does take over. Unlike in 1980 when the US enjoyed the status of being the world’s largest creditor, such is not the situation today. Raising rates in earnest to crush inflation could be difficult with the debt our government will need to continue issuing. But this is a discussion for the future. Until then, biflation could be the situation for some time.

Respectfully Yours,

Matthew R. Green
April 22, 2010

Issue XI - Boomers/Demographics

2010-04-08T13:12:00.000-07:00

Dear Readers,

They called them the Baby Boomers, history’s most prosperous and powerful generation. With the first members of this vaunted generation now transitioning into their retirement years, there have been numerous documentaries produced recently (CBNC’s Boomers, PBS’s Frontline, etc.) reporting on the challenges that many Boomers will face going forward. In the course of American economic history, the heyday of the Boomers in the workforce ran alongside the greatest economic expansion ever. Indeed, Boomers contributed directly to its rise and fall, whether via the secular trend of buying stocks for retirement or conspicuous consumption, assisting to create the stereotypical mold of the American consumer. With these trends ending, catalyzed by the recession and subsequent need to save for retirement, the economy finds itself at a crossroads. Does the economy need the Boomers as much as they need it, and vice versa? Both statements may be correct.

The typical period that most people consider their “adult” life (roughly the time they exit college to retirement) is about 40 years in length. History is a collection of long and short term trends, and economic trends in particular are driven by a nation’s position within the world and demographics. When an individual’s lifestyle has been driven by these trends, it is reasonable to think that they, and indeed their entire generation, would come to recognize what had transpired to be normal. For the Boomers, I fear that many have yet to recognize that within the context of economic history, the past 40 years were anything but normal, driven by the rise and fall of their own, prosperous generation. Fiat money and expansion-friendly demographics resulted in four decades of successive booms and busts in many markets. Put together, it can be argued that they all fed into a larger, secular bubble that was demographically-fueled at its heart. We have found ourselves unprepared for the fallout from this bubble with no easy answers, especially for those in my generation.

Before the Boomers even got out of college, Lyndon Johnson was shaping their economic future without them knowing it. The budgetary strain of the Great Society programs and Vietnam were the final nails in the coffin for the Bretton Woods monetary system. This directly led to Nixon taking the US off the Gold Standard in August 1971. Even though the US was one of the last economic powers to do so, the system was widely regarded among economists as a relic that constrained economic growth. The significance of the move lay in the advantage that it gave to the Baby Boomers; it eventually would enable them, in middle age, to take on debt unlike any previous generation.

The shorter-term consequence of the brand-new era of fiat currency, when added to the oil embargoes of the 1970’s, was stagflation and the subsequent boom in commodities. Detroit kept producing gas guzzlers for Americans even as US oil production peaked early in the decade, and the Middle Eastern crises sent oil prices on an upward trajectory from an inflation-adjusted $15-17 a barrel to over $100 a barrel in 1981. In 1974, private ownership of gold was made legal for the first time since the Great Depression. Gold rose from its $35/oz fixed value to $850/oz (non inflation-adjusted) in 1980. This was the peak of an uptrend in commodities, with an accompanying secular low in the value of stocks. Things began to change when Paul Volcker replaced Arthur Burns as Chairman of the Federal Reserve.

Besides his well-known accomplishment of breaking the back of inflation, what is lesser known is that the Fed under Volcker also changed the definitions of inflation. Aiding the rise of inflation during the late 1970’s was the subsequent bidding up of wages by then-stronger unions and retirement systems alike. Many economists, including Yale economist Robert Shiller, have argued that the removal of the actual cost of home ownership within the CPI, replaced by the Owner’s Equivalent Rent, has created a distortion that has in turn contributed subdued inflation since then. Thus, once interest rates began to fall and the economy picked up in 1982, inflation did not follow due to the combination of new inflation definitions and a worldwide oil glut.

For the next decade, Boomers entered the heyday of their wage earning. Having retained the robust savings rate of their parents up until that time, Boomers began to invest those savings into the stock market and into other safe fixed-income investments. Simultaneously, the credit markets began to innovate and expand at an unprecedented pace. As the number of home-buying Boomers increased, Congress passed new regulations that enabled mortgage-backed securities to explode. Bonds, a backwater during the inflationary 1970’s, suddenly were the best department in which to work at the investment banks amongst the mortgage- and junk-bond booms. The trend of debt was not limited to Wall Street. US household debt began to rise above 20% around 1985, the first time this had occurred in the Boomer’s lifetimes. This initiated a secular increase in US household debt that would not be broken until 2008. At the time, it only served to further buttress economic growth.

The 1980’s ended with a few localized real estate bubbles popping in California, Arizona, and a few other locales across the US. Michael Milken’s Drexel Burnham Lambert went bankrupt in February 1990, bringing the junk bond’s glory days to a close. However, the biggest bubble of them all during the 1980’s was across the Pacific in Japan. All Japanese assets, with real estate dwarfing everything else, soared to unprecedented heights. It was not uncommon to see Japanese companies trading at P/E ratios of over 100 in 1989. By late 1989, even respected fund managers such as Fidelity’s Peter Lynch bought into the idea, albeit temporarily, that this Japanese growth was permanent. “The total value of Japanese stocks actually surpassed that of US stocks in April 1987,” he noted in his 1989 book One Up on Wall Street. After peaking the week after Christmas in 1989, the bubble burst. Few lessons appeared to be learned, and it was a preview of what would transpire the next decade on this side of the Pacific.

Despite the US stock market’s crash on Black Monday (10/19/87), and the pesky, multi-year Savings and Loan Crisis, the Baby Boomers kept on earning. After a recession in 1990-91 (which, more than any other factor, cost George H.W. Bush the 1992 election), the market steadily increased through the first four years of the decade. With the help of a few interest rate cuts by Greenspan and relatively new forms of retirement planning (401(k)’s, etc.), the Boomers continued to invest their money in the stock market. After a fixed-income crisis in 1994 that claimed the investment bank Kidder Peabody, Greenspan once again began lowering interest rates. This contributed to a 28% increase in the Dow Jones Industrial Average in 1995, clearing the way for the final stage of the bubble. Then the final ingredient was introduced: the internet.

In 1996, Greenspan gave his famous “irrational exuberance” speech, warning of what he viewed as excesses in many areas of the economy. The next year, many internet companies began to go public. Simultaneously, the percentage of the public with access to the internet increased by more than 50% each year from 1995-1999. The recipe was perfect for the technology bubble that took the Dow, NASDAQ, and S&P 500 along for the ride. The Asian Financial Crisis in 1997 and the Russian Debt/LTCM crisis in 1998 did little to stir the tide, though it did produce a mini-crash on October 27, 1997, and again in August/September 1998. As Amazon, Yahoo, eBay, Qualcomm, and many other internet stocks began to see 400% increases, the NASDAQ soared 84% in 1999 to just over 5000 in March 2000. Not a peep was heard from Greenspan, who began to make speeches around this time embracing what was being referred to as the “new economy.”

Americans soon found out that for every Amazon, there were at least three examples of “dot-compost” such as Webvan, Pets.com, and Kozmo. Like what had happened in Japan, Americans failed to realize that companies trading at P/E ratios of over 50 are more often than not overvalued. There were stories of a few select Baby Boomers investing sizable portions of their wealth into IPO’s of companies that were nowhere close to breaking even, losing everything in the process. In the broader picture, after spending the 1990’s watching their portfolios appreciate, many Baby Boomers saw dreams of early retirement put on hold. It wasn’t over yet. A key difference existed between the Japanese bubble and post-tech bubble America. Japan in the 1990’s saw two major bubbles deflate at once. For Americans, the other, more destructive half of the bubble would come later.

With the economy already struggling in the wake of the deflating tech bubble, the 9/11 terrorist attacks shocked the nation. Alan Greenspan said in a 2008 interview that 9/11 was the kind of event that “historically could result in the undoing of a nation.” Whether that statement was a stretch or not, he immediately began a series of sharp interest rate cuts (refer to Chart 1). The results came within a year. With the credit spigot wide open, Americans began to shop again and to buy and develop real estate. (I remember that when I went on college visits in July 2002, nearly every campus that I visited was initiating a major construction project. Not surprisingly, this was more pronounced at the well-endowed colleges in the Northeast.)

Chart 1 – Federal Reserve Prime Rate 1954 - 2009

Although the stock market had been in a secular bull mode since 1982, the US housing market had (albeit in hindsight) experienced only a few localized bubbles. Occasionally, the corrections took down an overzealous investor or developer who leveraged themselves too much; Donald Trump’s difficulty during the early 1990’s is perhaps the most famous example. Regardless, nobody, not even the nation’s best economists, foresaw the magnitude to which Greenspan’s interest rate cuts would juice the housing market. Signs of a bubble were being pointed at by skeptics as early as 2002-03, but typical bubble behavior took over as annual refinancing by homeowners to tap into home equity became commonplace in 2003-06. Baby Boomers and Generation X’ers alike got into this habit. Such frequent refinancing was symptomatic of the expansion of all forms of credit, not just housing. Consequently, 2004-07 saw the biggest leveraged buyouts since the 1980’s and a subsequent second golden age for private equity. Real estate prices peaked in 2006, and by late 2007 were in serious decline. We all know what subsequently happened in 2008.

That brings us to today. For the past 40 years, the Baby Boomers’ earning power helped to fuel, and therefore ran concurrently with, a large secular bubble of US assets. Was it all an aberration, or was it the new normal? A March 9, 2010, article in the Wall Street Journal offered some insight as to whether stock valuations for the past generation have been normal. In short, they have not (refer to Chart 2). Those who called for a bottom in stocks in early 2009, saying it was a once in a lifetime low, have looked like geniuses in the interim. They are likely to be disappointed. The market may not fall back to those lows, but the inevitable devaluation of the dollar will have the same effect in terms of real money (refer to Chart 3).

Chart 2: This chart appeared in the Wall Street Journal on 3/9/10. Even after the 2008 crash, stocks are still historically overvalued as measured by multiples of company profits.

Chart 3: S&P 500 priced in Gold 1980-2009

As mentioned earlier, it has been almost 40 years since Nixon ended the dollar’s peg to gold. The era of fiat money, running parallel with the adult life of the Baby Boomers, brought with it a series of successive mini-bubbles, first in commodities, then real estate, and then stocks. Eventually, each mini-bubble repeated itself on a grander scale than before. All the bubbles were connected by the free flow of credit, directed by Maestro Greenspan, and subsequently came to an end in 2007-08. The US, and indeed the rest of the western world, finds itself trapped with debt from entitlements and cleaning up the mess of the past two years. A verdict on the fiat era is yet to be returned, but it is safe to say that many have doubts about the merits of this system that they would not have entertained the thought of 10 years ago.

With the population of the world continuing to increase, many investors are caught between anticipation and fear of a future bubble in commodities. As consumers, the fixed supply of our planet’s natural resources meeting an endless stream of paper money is a scenario about which we should not be excited. Alas, many questions and possibilities remain. At the least, a positive trend will be the resurgence of the debate with regard to what sound money is and is not. I am not saying we are going to have a return to the Gold Standard. After all, as mentioned earlier, by 1971 the Bretton Woods Gold Standard was looked upon as a relic that clamped down economic growth. However, the concept of free flowing credit within a fiat money system is clearly far from perfect as well. Facing an uncertain future, cooperation will be required in the next decade to work toward a new, sound financial system for the entire world. Asia will provide the Baby Boomers of the future. Even though they may not be as wealthy on a per capita basis, the numbers will result in the aggregate economic effect being just as big, or even bigger. Therefore, ideally a new monetary system that addresses the needs of American Baby Boomers, Generation X’ers, Millenials, and indeed the new, emerging middle classes in Asia can hopefully be devised. Whether that can actually be accomplished is yet another debate.

Respectfully Yours,

Matthew R. Green

April 8, 2010

Issue X - Buffett

2010-03-19T19:55:00.001-07:00

Dear Readers,

Over the past thirty years, Warren Buffett has emerged as the most admired all-around investor in the world. His simple, yet deep-rooted investment philosophies and an uncanny ability to simplify what many find extremely complicated helps to explain his all-around appeal to everyone from novice investors to seasoned market veterans. As a result, the self-written annual reports of Berkshire Hathaway, the conglomerate which he heads, have become required annual reading for many on Wall Street and Main Street alike. This issue of Greener Pastures contains some of my reactions to Berkshire’s 2009 acquisitions and Annual Report, released on February 27.

For those who may be unfamiliar with the setup of Berkshire Hathaway, it originally was a textile manufacturing company based in Massachusetts. Buffett bought it in 1965, and it has become a holding company for his investments. For the companies he buys, Buffett is perhaps the most hands-off owner in the world. The head office in Omaha has less than 15 employees (Buffett likes to point out this number is 14.8, because there is a woman who only works four days a week, and that it really ticks him off when people ask if he is the .8). Therefore, when Buffett buys a company, he leaves it intact and lets the CEO, often the same person who established and built the company, continue their work unimpeded. Indeed, the personality and brand-building talents of the CEO are something that Buffett seeks in a purchase. Al Ueltschi, the founder of Berkshire subsidiary FlightSafety International once said, “I feel like the company is still mine and that I still run it, I just swapped my publicly-traded stock for his publicly-traded stock.” For these reasons, the “Buffett CEO’s” are a vaunted group of individuals that are equally grateful for the assurance that Buffett will never sell their business.

One interesting thing from this year’s Annual Report is that Buffett explicitly mentioned that he believes Berkshire Hathaway is worth far more than its book value. He does this several times throughout the letter. I was a little surprised to read this at first, since Berkshire “A” Shares were trading around $118,000 when the Annual Report was released, 40% more than the year-end book value of $84,487. However, the shares have been on a tear since the beginning of the year, so this may not have been the case when he began the process of writing the letter. One passage states, that “in aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie [Munger, his long-time partner] and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value.” Buffett further references the insurance distortion when he states, “Our property-casualty (P/C) insurance business has been the engine behind Berkshire’s growth and will continue to be. It has worked wonders for us. We carry our P/C companies on our books at $15.5 billion more than their net tangible assets, an amount lodged in our “Goodwill” account. These companies, however, are worth far more than their carrying value.”

In the past year, Buffett’s most notable purchase was his biggest ever: the acquisition of Fort Worth, Texas-based Burlington Northern Santa Fe Railway (BNSF). Buffett already owned 22 percent of the railway, so he was familiar with their operations. It is a long-term bullish bet on the health of not only the US economy but that of China as well, since because BNSF provides access to major ports on the west coast. Therefore the company benefits whether it is shipping China-bound goods west or China-made, Wal-Mart bound goods on the return. In particular, Buffett, in the Annual Report, extols the benefits of having not only the railroad but access to its data as well. He quotes BNSF CEO Matthew Rose in characterizing the railroad as a “kaleidoscope” that offers insight on global trade flows. In fact, for years Buffett has said that rail data is among the economic data to which he pays the most attention. Berkshire’s portfolio already includes manufacturing, home builders, home furnishers, jewelers, real estate, credit, insurance, and air transportation; with the addition of ground transportation, it can be argued that Buffett now has constant access to a bank of US economic data that is second to only the Federal Reserve, although I’m sure many would argue his is actually better.

Since the acquisition, a lot of speculation has floated around with regard to the use of Berkshire Hathaway stock to pay for a portion of the railroad. Furthermore, criticism has arisen from his decision to classify BNSF within Berkshire as a Utility. Many long-time Buffett followers had expected him to establish a “Railroad” segment. He defended the decision in the Annual Report, arguing that both Utilities and Railroads are highly regulated and have high capital expenditures, among other things. Buffett biographer Alice Schroeder (a CPA, and author of Snowball, the best-selling 2008 Buffett biography) recently said that she was disappointed by this classification. She argued that it makes Berkshire “less transparent,” adding that he is including a transportation company to a segment that includes Mid-America Holdings, a holding company of public utilities. She recently posted on her blog that “If being a regulated and capital intensive business is what creates an operating segment for financial reporting, the insurance businesses would also be combined with Mid-America.”

Additionally, many have criticized the BNSF acquisition on the grounds that Buffett simply paid too much for the company. This is particularly important because railroads, as mentioned earlier, are highly capital-intensive in addition to being highly cyclical. Cash flow is good when the times are good, but capital expenditures are always present. That said, some commentators have brought up the fact that Buffett paid almost 9 times trailing cash operating income (EBITDA), 20 times trailing earnings, and 2.7 times book value. He addressed this issue in the Annual Report: “Charlie and I decided that the disadvantage of paying 30% of the price through stock was offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and liked for the long term. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We also like the prospect of investing additional billions over the years at reasonable rates of return. But the final decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made no sense. We would have then been giving up more than we were getting.”

My own reaction is that Buffett partially used his company’s stock because he believes it is still at a premium. After all, if it wasn't, then why use it? Additionally, the tone he takes in this passage can roughly be translated into “trust me on this one.” Not a problem for most Berkshire Hathaway shareholders, especially when you consider that Warren Buffett holds the distinction of having minted more millionaires, and indeed more billionaires, than anyone else in the world. Such a statement may initially seem odd for outsiders, but this is more or less typical of Buffett. It also reinforces another Buffett trait -- the trust and regard that Buffett holds for his CEO’s, the newest of whom is Matthew Rose.

In a similar manner to his treatment of BNSF, Buffett has Clayton Homes (a manufacturer of prefabricated homes) under the category of “Finance and Financial Products.” I found this odd, but it began to make sense as I read through that section of the Annual Report. His main problem is the newfound competition with the government’s housing programs. He states that “currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 5 1⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels. In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan.” If I’ve understood that correctly, Buffett is complaining is because the government’s actions are hindering his ability not to sell the homes themselves as much as they are hindering his ability to finance them. No wonder he categorized Clayton as he did. He goes on to say that Berkshire can’t borrow at a rate approaching that available to Fannie Mae and Freddie Mac. This will hurt sales, and “a multitude of worthy families who long for a low-cost home.” Even though I am a diehard Buffett fan, I disagree with him here.

Even though S&P stripped Berkshire of its AAA rating last month in the wake of the BNSF purchase, Buffett always has the advantage of his reputation. I would think that even without that rating, Buffett can command favorable terms on just about anything, a great example being the terms he got when purchasing preferred stock in Goldman Sachs during the financial crisis. In the Annual Report, Buffett estimates that Clayton’s buyers are paying to Berkshire are about 375 basis points more than those offered by Fannie and Freddie. Apparently, it’s not an issue of credit. Buffett insists that Clayton’s buyers are no different than everyone else, stating “Clayton’s delinquencies and defaults remain reasonable and will not cause us significant problems.” As I mentioned, if he really wanted to, he could negotiate a smaller spread than 375 basis points. I truly believe that he does want to sell more homes, it’s his company. But his categorization offers a window to what might be the real issue. Of course he could sell more mobile homes if buyers could get rates closer to conventional mortgages. However, he would lose the massive profits he makes on financing them. Furthermore, I get the impression that if this continues much longer, he may make a political statement or two on the subject.

Before I conclude, I will say that I could have made this 10-15 pages long, as I am a big fan of Warren Buffett and have a lot to say about the subject. Topics that I’ve left out include his relative lack of commentary on two subjects; his investment in Goldman Sachs, and also concerns he might have about the near future with regard to his municipal bond insurance business. With the recent bankruptcies of AMBAC and MBIA, Berkshire Hathaway is now the second-largest municipal bond insurer in the country, second only to Assured Guaranty. With the increasing media coverage about the financial woes of California and many other municipalities across the nation, I am surprised he did not share his views on this business in the Annual Report.

Finally, the Berkshire Hathaway Annual Report is the quintessential, witty Warren Buffett in action. Every year the report features passages that are quoted for years thereafter, whether they summarize an aspect or problem about Berkshire Hathaway or the economy in general. Highlights this year included his view on how to cure the housing glut in the US. “There are three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers; or (3) reduce new housing starts to a number far below the rate of household formations.” Another highlight was a general statement about small value destroying acquisitions as opposed to a large one, attributed to Charlie Munger: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?”

Respectfully Yours,
Matthew R. Green
March 19, 2010

Issue IX - Treasuries

2010-03-05T16:47:00.000-08:00

Dear Readers,

United States Treasury Bonds have been considered the safest investments in the world for the greater part of the past century. They are universally liked by foreign governments, sovereign wealth funds, pension funds, all the way down to the average investor. Backed by the implicit full faith and credit of the US Government, the status of Treasuries as a safe investment was highlighted most comprehensively by the swelling demand for them during the nadir of the financial crisis. In September-November 2008, public and private investors wanted nothing but the safest paper, and the flight-to-quality that began late that summer resulted in the greatest short-term rally that Treasuries have ever seen. Consequently, those prices came back down to earth in 2009. However, as the deficits continue to pile up, and hundreds of billions in unfunded liabilities continue to smolder, there has rightfully been speculation with regard to the full faith and credit of the US Government.

Two hypothetical scenarios have emerged in recent months. The first is the possibility that China, the largest purchaser of Treasuries, will scale back on such purchases, causing yields to rise. The other theme of recent speculation, as mentioned by PIMCO’s Bill Gross in a recent fixed-income outlook, is whether corporate bonds are potentially a better investment than US Government bonds.

In late 2009, US Treasury department data revealed that China was no longer the largest holder of US Treasury Bonds. However, two weeks ago revised numbers were released showing that China was still the largest buyer, holding $894.8 Billion of Treasuries. Nevertheless, this number is down from its mid-2009 peak of over $900 billion, as China reduced its holdings of US Treasuries by about $45 billion. While it is too early to determine whether this is a permanent trend, it represents a definite stall in the rise of US debt owned by the Chinese, which had been rising for the last decade (refer to Chart 1).

Chart 1 – China’s Holdings of US Treasury Bonds 2000-2009

A recent guest on Bloomberg Radio speculated that an impending disaster would occur if China were to scale back its purchases of Treasuries to the level of a decade ago. Yes, of course that would be a disaster, but it is not likely unless China’s economy completely and utterly collapses. According to the World Bank, China's GDP more than tripled from $1.2 trillion in 2000 to $4.33 trillion in 2008. With continuing diversification, it is reasonable to say that if China scaled back on its purchases of Treasuries, it could return to 2006-07 levels, but even that would represent a 40-50% retracement, which is unlikely. The Chinese need safe investments to protect their ever-increasing wealth, especially with the current economic uncertainty within their own borders.

In China, there is currently a real estate bubble for which its government is attempting to engineer a soft landing. One of the measures undertaken is the raising of reserve requirements to prepare Chinese banks for the hit they may take. When the bubble inevitably pops and the Chinese demand safe investments, it is likely that their appetite for US Treasuries will at least be sustained. With yields on longer-dated US Treasuries already rising, this appears even more likely. Therefore, while I do not see the Chinese selling off Treasuries on any sizable scale, a steep Chinese recession could sap demand and cause yields to rise, contributing to inflation.

Furthermore, as government deficits around the world increase, we are potentially entering an era where the paper of selected corporations appears safer than selected nations’ sovereign debt. This was not the case previously and is still generally not. However, there is an emerging debate among fixed-income commentators about whether the highest-rated corporations could consistently trade at yields below that of their home country’s debt. Bond guru Bill Gross (CEO of PIMCO) recently commented on the current fixed-income landscape in his March 2010 investment outlook. He stated that “the narrowing in spreads since late November solicits an interesting proposition: government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous ‘unicredit’ type of bond market. If core sovereigns such as the US, Germany, UK, and Japan ‘absorb’ more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee.”

This poses the question of whether the numerous sovereign debt crises that have been sprouting up can be truly resolved by issuing more debt. The answer depends on the initial debt levels of the economies in question. The more indebted the nation, the more spreads will narrow for that country’s paper if their policymakers are successful in their efforts. Gross further stated, “When sovereign issues become more credit-like, as evidenced in Greece, Spain, Portugal, and a host of others, they move closer in yield to the corporate and agency debt that supposedly rank lower in the hierarchy.” Therefore, the answer depends on the combination of future inflation, the result of quantitative easing programs, and the recoveries of individual economies. More importantly, going forward sovereign debt investors will be on the lookout. Those economies that continue to bail out their institutions and fail to incorporate fiscal discipline will be more closely scrutinized. Finally, if the world economy relapses into recession from its current fragile state, it will be interesting to see what the appetite will be for Treasuries, PIIGS Bonds, UK Gilts, etc. No disrespect to Sinatra, but love may not always be lovelier the second time around.

With regard to China, in my opinion there is no such thing as an economic “soft landing.” Alan Greenspan was initially commended for having supposedly engineered such a scenario for the US economy in 2001-02. That praise waned with the onset of the financial crisis. He said in a 2009 interview that “September 11 was the type of event that historically could result in the undoing of a nation.” With the nation in shock, plus an economy already reeling from the bursting of the technology bubble, Greenspan began a series of sharp interest rate cuts to spur activity. While this fueled the housing boom and assisted the subsequent five –year bull market, the increased private debt that it encouraged (personal and corporate) ultimately made the 2008 fallout much worse than it otherwise would have been. I am not saying that it would not have happened, but in hindsight I think most would agree that a sharp 1-2 year recession, perhaps ending in 2003, rather than a mild nine-month recession would have been okay if it had prevented the housing bubble from growing out of hand which, as we know, is the root of the economic malaise of the past three years.

If the debt situation becomes unmanageable, my sense is that our leaders will first resort to raising taxes. When the ability to raise taxes fails, inflation will be the solution. It will need to be controlled, however. It could easily get out of hand, and when the political outcry becomes too great, then maybe, just maybe, our leaders will finally cut entitlement spending. This, however, is always an option of last resort because of the negative consequences for those in office. Furthermore, external default would not be enough to solve the problems the US faces, besides the fact that it would strain economic relations with the rest of the world. In a worst case scenario, US assets could potentially be seized by foreign governments, along with many financial institutions failing in the US and abroad. China can’t stop buying our debt because that would force the US to cut spending immediately, perhaps causing a recession in which the US consumer will stop buying Chinese products, and the economic interdependency would manifest itself in the worst way. There are no easy answers. The pain has to go somewhere, and because times were so good for so long we were able to delay the problem. It has only had the effect of building up the eventual pain that will need to be felt.

Respectfully Yours,
Matthew R. Green
March 5, 2010

Issue VIII - Silver

2010-02-18T21:54:00.000-08:00

Dear Readers,

In my continuing research of the commodities markets, I have come across several commentators who suggest that the prices of certain commodities have been tied down by a small contingent of big banks. One of the arguments is that the silver market is manipulated, with a few large players controlling the market via a massive paper short position. Curious, I pored over many reports of the Commodities Futures Trading Corporation (CFTC). After looking extensively, I feel that the commercial short position is big enough to present the potential for manipulation, but I don’t think that it is taking place. I think that finger pointing is counterproductive and pushes aside an opportunity: whether the markets are manipulated or not, one can set themselves up to make a lot of money when the price corrects upward.

The real concern I have with such a concentrated commercial short position is whether the physical silver could actually be delivered if called. This, when combined with the current world supply of silver, presents the potential for a shortage in the future. There also exists the potential of a COMEX default that would send the white metal soaring. Combined with the fact that silver is currently undervalued compared to its historical ratios (covered in my January 20 letter), a major increase in the price of silver over the next 18-36 months is a real possibility. Central to my hypothesis is a shortage in physical silver causing a sharp price increase, which could catalyze a short squeeze, especially if silver is in the range of $25-35. Many traders calling their silver at once could cause a shortage of deliverable physical silver, causing the price to soar even further.

Silver’s primary venue of exchange is the COMEX, a division of the New York Mercantile Exchange (NYMEX), which was purchased by the Chicago Mercantile Exchange (CME Group) in 2008. Within the trading pits of the COMEX, a massive commercial short position in silver has been built up over time, dominated by about four banks. Such a concentrated position carries several implications. First, as I mentioned, if there is a sudden, sharp increase in the price of silver that would cause losses to these banks, a “short squeeze” could occur.

The issue of the commercial short position is more complicated than it may seem. One may be surprised to find out that having such a large position is perfectly legal. JPMorgan, HSBC, and the other major shorts are defined by the CTFC as “commercial traders.” The COMEX position limit for an individual speculator is 6000 contracts. Commercial traders are not subject to these limits, and use the position mostly for hedging purposes. JPMorgan alone constitutes approximately 40% of the silver short positions on the COMEX; over the course of 2009, its short position averaged 30,000 contracts. A COMEX Silver Futures contract comprises 5,000 ounces. Therefore, at Thursday’s closing price of $16.15, JPMorgan alone is short silver to the tune of $2.42 billion. In fact, the average commercial short position is over 10,000 contracts. Now, if silver were to increase by 50%, JPMorgan would lose $1.2 billion, hardly anything compared with the tens of billions lost by other banks via the toxic CDO’s and Credit Default Swaps, but still a sizable loss. More importantly, that position would inevitably be greatly reduced long before a loss of that magnitude would occur. This would cause the price to increase sharply.

The CFTC issues the Commitment of Traders report on a weekly basis, which reports the activity of commercial traders. In the most recent report from February 12 (refer to Figure 1), you can see that the total commercial short position exceeds the long position by nearly a 2 to 1 ratio. Compare this to individual traders, or “Large Speculators,” who are subject to the 6000 contract limit. As you can see, this class of silver investors is overwhelmingly long in its positions, by nearly 4 to 1!

JPMorgan inherited the bulk of its silver position from the purchase of Bear Stearns. Indeed, the white metal rallied in early 2008, in part because the market began to anticipate Bear going bust. A Bear liquidation could have sent the price soaring on the heels of a huge short position buyback. Indeed, the price cratered when JPMorgan took over and the market saw that there would be no forced buyback. After the announcement, the price of silver fell by $4 in one trading week (March 17-21, 2008), more than in any other week during the past five years (refer to Chart 1).

Chart 1 – Price of Silver, March 2007-Present

Many online commentators feel that the large players use their positions to keep a lid on the prices of many commodities, especially silver. Furthermore, there are silver commentators out there who are adamant that JPMorgan is simply a puppet bank of the US Government, and the purchase of Bear Stearns was orchestrated to prevent exposing the decades-long manipulation of precious metals. I don’t buy into these conspiracy theories. I also do not buy the argument that manipulation occurs on a day-to-day basis. Having such sizable positions, as I mentioned, is legal. However, that doesn’t mean they aren’t potentially a ticking time bomb, and the ingredients to the dismantling of these positions may be falling into place.

First, there is an impending shortage of physical gold and silver, both on the market and around the world in general. According to a January 2009 National Geographic article, the total amount of gold mined throughout history is just enough to fill two Olympic-size swimming pools; well over 95% of that gold is still in vaults, jewelry, etc. The opposite is true for silver. While silver is classified as a precious metal, it has a plethora of industrial uses as well. For example, it is the best conductor of electricity and the best thermal metal, albeit an expensive one. Therefore, silver is only used in trace amounts in most of these applications. However, this also means that most of the silver that is mined eventually is discarded. In short, unless many new mines are developed in the next decade, the world could face shortages within the next ten years. Another important silver ratio to watch is the amount of silver that we use relative to the amount that exists in the ground, in other words, proven reserves. In a recent interview with Forbes, economist Stephen Leeb said, “every year, we are mining about 1/10th of the reserve base of silver. Barring a complete collapse of China or another unforeseen worldwide catastrophe, silver is a great investment for the next few years. There is very little of it, and we need it for everything.” As is currently the case with oil, we will need to increase the proven reserves dramatically, find alternatives in short order, or face shortages.

This growing shortage presents the potential scenario of a COMEX silver default in the future. In terms of deliverable supply, the level of COMEX-approved gold warehouse inventories is about 9.2 million ounces. One COMEX gold futures contract is 100 ounces, so therefore approximately 92,000 contracts. With silver, the COMEX-approved deliverable supply is just over 115 million ounces. Given silver’s contract size of 5,000 ounces, that is the equivalent of just 23,000 contracts. On that basis, the COMEX silver inventory is about one quarter the size of its gold inventory. If a shortage was to occur, or a major holder of futures wanted to take physical delivery, it is possible that not all the silver would be available. This would spark a default and cause a flight-to-quality of sorts where many holders of precious metals would demand physical delivery. The 800 lb. gorilla in the room is whether the massive short positions could be unwound and the physical silver guaranteed without some kind of government intervention. Of course, even the full faith and credit of the US government, or governments in general, is its own issue in and of itself.

The situation in gold is no different, except that it is not concentrated in as few hands. Last week’s Commitment of Traders report revealed that commercial traders were short 21,342,700 ounces of gold. Given the amounts of gold that exist in COMEX depository warehouses, it isn’t a stretch to say the commercial traders short gold with little to no intention of ever physically delivering well over 90% of their position. This is true despite market mechanisms that require them to have the physical capacity and means to do so. What if China, India, or any number of Sovereign Wealth Funds wanted to buy 800-1000 tons of gold? It would be physically impossible to even partially fulfill this order.

On Wednesday evening, the International Monetary Fund announced the sale of 191.3 tons of its gold reserves. Although this news caused an immediate fall from $1120 to $1100 in the gold futures market, it does not change the long-term fundamentals for gold. The IMF stated that “it would stagger the sales in order not to affect the markets too much.” However, since sovereign buyers of gold cannot get anywhere near the amount of gold they desire from the futures markets, the reality is that the IMF could probably put all 191 tons on the market in one month and it would be instantly absorbed by China, India, and Middle Eastern sovereign funds before any other Central Banks could get their hands on any of it.

In addition to possible shortages, recent changes at the CFTC are another potential development that could lead to the dismantling of the massive short positions. The CFTC is an independent government agency, separate from the SEC, Federal Reserve, and US Treasury. On February 1, President Obama approved a 55% increase in its budget, which represents a great shift from past administrations. For years, the CFTC was a backwater of US financial oversight. Its most prominent former chairman, Brooksley Born, was aggressively shot down by the triumvirate of Larry Summers, Robert Rubin, and Alan Greenspan when she prodded Congress to regulate derivatives, beginning in 1997. Though her efforts gained some traction in the wake of the Long-Term Capital Management fiasco in 1998, she ultimately lost out in an episode that included a few testy Senate hearings. Greenspan has recently admitted in interviews that he should have taken her seriously.

The current chairman, Gary Gensler, worked for Goldman Sachs for 18 years, becoming a partner at the tender age of 30. He appears to have left those days behind according to a February 12 Bloomberg article. While he does not like being called a convert to the pro-regulation camp, he was quoted as saying, “I don’t see myself going back to Wall Street, that’s very liberating.” He seems determined to introduce a basic regulatory structure for the derivatives market, including futures, aimed at preventing excessive speculation. Even without the mandate of the CFTC, it is possible that the COMEX could implement new contract limits in the months ahead. Any new limits will likely be geared toward curbing the type of speculation that pushed oil to $147 a barrel in July 2008, and this in turn would imply new restraints on commercial traders.

Besides the pile of dry kindling that the short position potentially represents, as you already know I do not believe that the recent movement in the price of silver reflects the real value of the metal. Silver is undervalued from a historical perspective and it is a definite buy in the $12-16 range. I give that range because it could go lower still. After market hours on Thursday, the Fed raised the Discount Rate, which is a harbinger of a rising Federal Funds rate. However, with the January Producer Price Index (PPI) signaling rising inflation and Friday’s reading of the Consumer Price Index (CPI) likely to signal the same, along with the world’s debt problems, I stick to my bullish view.

The financial media has not yet turned bullish on precious metals (although they appear to be addicted to the fees brought in by rip-off Cash4Gold-type companies). A perfect example of this hit the newswires on Wednesday. Last month at the World Economic Forum in Davos, Switzerland, CNBC’s Maria Bartiromo asked billionaire investor George Soros whether he had been buying gold. He refused to answer the question, instead saying that gold was the “ultimate bubble.” Many prominent financial columnists, bloggers, and commentators interpreted this as Soros being short metals, saying gold had already peaked and he was probably selling. During the last quarter of 2009, according to the latest SEC filings of his hedge fund, released this week, Soros doubled his holdings of the popular ETF SPDR Gold Trust (GLD). In total, he holds over $660 million in physical gold and gold ETF’s, following the lead of other hedge fund managers John Paulson and David Einhorn. My interpretation of his comments, in addition to the possible ulterior motive of talking down the metal to get a better entry point, was that gold will be the last bubble to pop after the successive bubbles of real estate, stocks, treasuries, and fiat currencies. Of course, he could have sold it all in January, since the data only represents his holdings through December 31. For some odd reason, I doubt that he did.

I will conclude with three stocks that I think will do well over the next few years, along with a brief description of each. I plan make recommendations periodically in the future with respect to other sectors, but not with regularity as I am not an active trader. In the meantime, feel free to research these on your own accord.

Hecla Mining Company (HL) – Based in Coeur D’Alene, Idaho, Hecla is the top silver producer in the U.S. It is also the second and third largest producer of zinc and lead, respectively. It eliminated its debt last year and currently trades at a P/E of about 12. It readily beat 4th quarter earnings expectations on Wednesday. 2/18 Closing Price: $5.30

Silver Wheaton Corporation (SLW) - A silver streaming royalty company that finances miners in exchange for a portion or complete silver royalty stream now or in the future. They produce an initial capital outlay or outlay to be paid in the near future in exchange for these streams. The heart of their business model is that they agree to purchase the silver produced for a fixed price. As of late 2009, this average was around $4.50 with a maximum 1% annual inflation adjustment. 2/18 Closing Price: $15.71

Silvercorp Metals (SVM) - SVM is one of the largest silver producers in China. Silvercorp produced 1.2 million ounces of silver last quarter at a cash cost of negative $6.33 per ounce. Hecla, by comparison, only produced for negative $2 per ounce. The company has $79 million in cash and no long-term debt. Silvercorp is currently working to grow its resource base through exploration and acquisitions. 2/18 Closing Price: $6.56

Respectfully Yours,

Matthew R. Green

February 18, 2010

BCC Error

2010-02-05T09:35:00.000-08:00

Dear Readers,

I split up my distribution list into several parts. Today, one of those lists I did not BCC when I sent out the commentary. For those on that portion of the list, please disregard. I apologize for the mistake.

- Matt

Issue VII - Sovereign Debt 2/5/10

2010-02-05T08:12:00.000-08:00

Dear Readers,

The US Dollar has continued to strengthen after briefly falling in the first couple of weeks in this year. What has transpired goes against much of what I have written so far in this newsletter regarding the Greenback. As I write this (Thursday morning), sovereign debt concerns in Europe with regard to Greece have spread to Spain. This continues to drag down the Euro. The Dollar Index is now over 80 for the first time since early July 2009. I continue to see flawed logic in this. First, the composition of the Dollar Index (USDX) is a relic that does not accurately reflect the Dollar’s position within the global economy. The Index’s composition does not guide investors away from the real problem: that sovereign debt issues are affecting, and will continue to affect, all Western economies. Second, investors need to realize that the United States has the same, if not worse, problem sas Europe. Why investors are fleeing the Euro for the “safety” of the Greenback is mind-boggling, yet can be understood in the context of a post-2008 crisis world.

The Dollar Index is a trade-weighted measure of our currency’s strength versus a basket of six other currencies. It is weighted as follows; 57.6% against the Euro, 13.6% against the Japanese Yen, 11.9% against the British Pound, 9.1% against the Canadian Dollar, 4.2% against the Swedish Krona, and 3.6% against the Swiss Franc (Refer to Chart 1 for a visual rendering). The index was established in 1973 in the wake of the dismantling of the Bretton Woods monetary system, which formally ended with the Smithsonian Agreement after Nixon took the US off the Gold Standard in 1971. The main reason for the Euro’s heavy weighting is due to the combination within the USDX of the former currencies of France, Germany, Italy, and Spain upon the introduction of the Euro in 1999. As investors have become more skittish about the health of Western currencies, the USDX has become a primary determinant in the day-to-day fluctuations of the markets. This practice is flawed. We live in a global economy, yet the value of the USDX is 86.4% determined by Western currencies; the other 13.6% being Japan, a poster child for profligate spending.

Chart 1 - Composition of the Dollar Index

In my opinion, to accurately weigh the US Dollar in relation to the global economy, the currencies of Mexico, Russia, Australia, Brazil, China, and a few of the petro states at the very least should be included in the basket that makes up the USDX. (China still pegs their currency, the Yuan, to the Dollar.) Furthermore, the composition of the Dollar Index has not changed for more than a decade. The possibility of China decoupling its currency from the Dollar has been the subject of debate recently, and I will be commentating on this in a future newsletter. In short, the USDX does not accurately reflect the true position of the Greenback within the world economy, instead measuring it against a basket of currencies whose backing governments have similar debt problems.

European markets are tumbling today on the concerns of a debt contagion (Spain’s Bolsa Index was down 5% on Thursday), and as a result the US Dollar is continuing its rally that began on November 26 with Dubai’s debt scare. This is nothing less than absurd. It takes a great leap of faith to surmise that the Euro zone’s fiscal problems are greater than those of the US. For example, the Greek economy, ground zero for the Euro’s problems, comprises merely 2% of the Euro zone economy. Compare that to California, representing 13% of the U.S. economy. Greece cannot print its own money to get out of a fiscal bind because it is part of a currency union, and the same goes for California. Thursday morning, the Euro’s problems were compounded by fresh concerns, this time over Spain’s debt. Spain’s economy represents 13% of the Euro zone’s economy, comparable to California. However, keep in mind that in the US, states that make up more than 5% of GDP, such as Illinois, and Florida, are not far behind California in terms of fiscal problems. (California’s current budget gap for 2010 could be as high as 50%, Illinois’ as high as 45%). In the same manner, Portugal and Ireland could be next in line in the Euro zone (Refer to Figure 1 at the end). Neither of these nations approaches the size of the bigger US states, which means that their troubles would impact the Euro less than a larger US state would impact the Greenback. Either way, what will ultimately transpire is either the default of individual states or a series of bailouts, which in the end will hammer both currencies.

Financial journalist Daryl Montgomery blogged earlier this week, “While it is generally not recognized, US states are part of a de facto currency union for the dollar. Their fiscal problems should be considered as analagous [sic] to European countries that are part of the Euro zone. California is essentially in default and is only being kept afloat by constant cash infusions from a number of federal stimulus programs. It represents a much bigger drain on the US dollar, than Greece does for the euro.” Indeed, California’s ongoing budget crisis is a canary in the coal mine, a representation of the bigger problems to come. In June 2009, the Obama administration refused to guarantee the promissory notes (IOU’s) that were issued by California to close its budget gap, saying that it had no legal authority to do so, and that the state should solve its own problems. It will be interesting to see what transpires as the problems get bigger. In a similar manner, the European Union has not expressed willingness to bailout its individual troubled nations, yet with Spain, Ireland, Portugal and others next in line, this could change.

Finally, the flawed logic of seeing the Dollar as being stronger than the Euro is illustrated on the federal level as well. To begin, Greece’s debt fears began to ease earlier this week when it submitted to the EU a plan to slash its budget deficit to 3% by 2012. Regardless of whether that happens, there is no way the US will be slashing its deficit to anywhere near that by 2012. It will be fortunate if we are below current levels in two years. On Monday of this week, President Obama submitted the 2011 Federal Budget. It contains a deficit of 11% of GDP. Looking closer at the numbers, 40 cents of every dollar will have to be borrowed or printed. Compounding those problems are the aforementioned problems with the states. Eventually, California (the 8th largest economy in the world if taken by itself, one place ahead of, coincidentally, Spain) will need a massive federal government bailout, and it’s only one of several US states that have serious fiscal problems. Why, in spite of this, are traders selling the Euro and buying the Greenback? Because the US is viewed as being in better fiscal shape than the Euro zone? Am I missing something here? Both currencies are well on their way to being devalued.

The economist Nouriel Roubini mentioned earlier this week that currencies of commodity-based economies such as the Brazilian Real and Aussie Dollar will outperform other currencies in the next few years. This appears to be a complete reversal from Roubini’s earlier position that the US economy will experience a deflationary cycle. Does he believe that the Dollar will decrease in value? He didn’t go so far as to say that, but such was implied. Unfortunately, the USDX will not reflect this because it is made up of only Western currencies and one Asian currency from a nation that, more or less, has been in recession for the past 20 years. Obviously, all of the Western currencies will trade down against their Eastern counterparts in the Forex markets, but my concern is that, like we saw today, too many investors will take the USDX and its strengthening to heart. They should be looking at the big picture, the global economy.

Postscript to my last commentary:

Originally, I planned to continue my Gold/Silver ratio argument this week and predict what might happen to those on the short side of the trade if Silver were to rise above the $20 mark. Yet, Silver has continued to fall this week on the heels of the strengthening Dollar, so I decided to push it back.

That said, in the two weeks since my last newsletter, the ratio has risen from the low 60’s to as high as 73 at one point Thursday morning, closing just under 70. Silver alone lost 6% on Thursday. This was the most volatility that the ratio has seen since October 2008. If Silver falls to $14.75, that would represent a 61.8% Fibonacci retracement (in other words, $14.75 is a major support level). If the price does not hold at that level, it is likely that the ratio could exceed 75 in the short-term. As history has shown, those levels do not sustain for long. Investors should be salivating over the opportunity that could present itself. Despite the volatility, I stand by my previous letter’s prediction that the ratio will fall back below 60, and possibly as low as 50-55 in 2010.

Respectfully yours,

Matthew R. Green

February 5, 2010

Figure 1:

Top 10 US States in GDP Overlaid within World GDP Rankings

Country (US states in bold) 2006 GDP (millions)

1 United States of America 13,843,825
2 Japan 4,383,762
3 Germany 3,322,147
4 China 3,250,827
5 France 2,772,570
6 United Kingdom 2,560,255
7 Italy 2,104,666
8 California 1,812,968
9 Spain 1,438,959
10 Canada 1,432,140
11 Brazil 1,313,590
12 Russia 1,289,582
13 Texas 1,141,965
14 New York 1,103,024
15 India 1,098,945
16 South Korea 957,053
17 Australia 908,826
18 Mexico 893,365
19 Netherlands 768,704
20 Florida 734,519
21 Illinois 629,570
22 Turkey 607,419
23 Pennsylvania 531,110
24 Ohio 466,309
25 New Jersey 465,484
26 Sweden 458,966
27 Belgium 453,636
28 Indonesia 432,944
29 Switzerland 423,938
30 Poland 420,284
31 North Carolina 399,446
32 Georgia 396,504

Source: International Monetary Fund

Issue VI - Gold/Silver Ratio 1/21/10

2010-01-21T06:17:00.000-08:00

Dear Readers,

As you know, many investors and central banks the world over have been turning to precious metals in the past year to protect against inflation. While gold is enjoying the best bull run it has seen in a generation, its little brother silver is currently underpriced when one considers the historic gold/silver ratio. Additionally, given its additional uses as an industrial metal, along with a potential shortage lurking in the wings, silver potentially offers more robust returns for the duration of the bull market in commodities. Knowing the history of this monetary ratio in the United States is necessary to understand its relevance today.

Silver is about 17.5 times more abundant than gold in the earth’s crust (.07 parts per million to .004 ppm, respectively, according to the US Geological Survey). This ratio was recognized by civilizations as they developed currency systems over time. Thus, in 1792 the newly formed US Congress passed the First Coinage Act. The Act officially established the Dollar as our currency, defining one Dollar as a weight of pure silver, 371.35 grains to be exact. A Quarter Eagle ($2.50), was defined as 61.875 grains of gold. The Act legally set the gold/silver ratio at 15.

In 1834, Congress passed the Second Coinage Act, slightly tweaking the gold/silver Ratio from 15 to 16. This better reflected market values at the time and drew it closer to the natural ratio. In 1858, silver was discovered at Comstock Lode, Nevada, and the resulting influx of ex-49er’s and subsequent discoveries (Eureka, Pioche, etc.) led to the proliferation of silver mining as an industry in the 1860’s. Needless to say, this threatened to collapse the price of the metal. In response, the 1873 Fourth Coinage Act discontinued the minting of silver Dollars, and decreed that silver coins above $5 were no longer legal tender. Thus, the gold/silver ratio was allowed to rise. Silver advocates and miners for the next generation would refer to this statute as the “Crime of ’73.” The closest the US came to reintroducing silver as a monetary metal was when William Jennings Bryan advocated bimetallism during his ultimately unsuccessful 1896 presidential campaign, arguing that it would induce inflation and help indebted farmers and the rest of working-class America, who had lived in a deflationary economy from 1873-96. The debate over this at the time was made indelible by the metaphor of the Yellow Brick Road in L. Frank Baum’s The Wonderful Wizard of Oz, originally published in 1900. Indeed, the name “Oz,” as in ounce, implied that bimetallism was the “golden road” to prosperity. (Refer to Chart 1.)

Chart 1: The Gold/Silver Ratio from 1900 – 2008

In the early years of the 20th century, the ratio rose to the low 40’s but fell back into the teens during the Roaring Twenties. After Roosevelt confiscated gold from the American people in 1933 and devalued the US Dollar by revaluing an ounce of gold from $20.67 to $35, the ratio nearly cracked 100 in 1939. (I referred to this devaluation in my January 1st commentary on Chairman Bernanke.) After Bretton Woods and against the backdrop of economic prosperity of the Post-War era, the ratio fell to around 20 until Nixon abandoned the Gold Standard in 1971. As the price of the yellow metal floated, gold outperformed silver until the fallout from the 1973 oil crisis, and then for the remainder of the decade silver outperformed gold as the ratio fell.

This culminated with a mega-spike in the price of silver in late 1979 and early 1980 when the Hunt Brothers tried to corner the market. The gold/silver ratio hit a bottom of about 16 at this time. As traders exited their positions en masse and the Hunts were wiped out, silver fell even faster than gold, which itself crashed from $850 to $600 in just three months (refer to Charts 2 and 3 and my subsequent comments). By May 1980 the ratio was back at 40.

Charts 2 and 3: The Gold/Silver Ratios 1970 – 2009

Chart 2 is Gold, Chart 3 Silver. Overlaid on both is the Gold/Silver Ratio. Note the extreme activity in 1979-80 on both. In percentage terms Silver rose, and eventually fell more, hence the crashing and then rocketing ratio.

For the duration of the decade and into the early 1990’s, the ratio continued to rise because gold outperformed silver, but only because it did not lose as much of its value. While the ratio reverted back to its 20th century average by 2000, gold and silver did not bottom until 2001 and 2003, respectively. At that time, silver once again turned up and the ratio began to fall. This trend continued until the onset of the 2008 Financial Crisis. The 2007-2008 spike in the ratio provided a very attractive entry point for those with the means to take advantage of it.

This brings us to today (refer to Chart 4). The ratio spiked to over 80 in 2008, and was at 70 as recently as last July, currently standing at 62.17 as of yesterday’s close. The trajectory is downward, which creates a potential advantage for investors in 2010. In short, silver is still undervalued. Of course, it’s not going to fall to its pre-1873 ratio of 15 or 16 anytime soon. Despite the historical ratio and the natural ratio, the fact is that after the Industrial Revolution and through the 20th Century, the ratio’s average was roughly in the range of 47-50. However, a lower ratio is not out of the question if the current bull market in commodities sustains for long enough. During inflationary times such as the 1970’s, the ratio averaged between 20 and 40, falling below 20 during the final spike in early 1980. Given the current trend, in 2010 I expect it to fall below 60, and possibly even break 50.

Chart 4: The gold/silver ratio January 2007 - Present

If inflation begins to pick up in the next few years, there is no reason that the ratio will not fall back into the 20-40 range or even below. Even then, if the gold/silver ratio fell to just 50, and prices held at their current levels, gold would be worth about $1,110 but silver would rise to $22.20, representing a 24% increase from the January 20 closing price of $17.90. Thus, if gold merely surpasses its early December 2009 high of $1,225 and the ratio continues to revert to its 20th century average, $24-25 silver would not be out of the question by the end of 2010. For that reason, silver potentially offers more lucrative returns than gold.

As I write this, a pullback is occurring in precious metals. Current events, including continued worries about Greece’s financial woes, China’s curbing of bank lending, and Scott Brown’s Senatorial victory in Massachusetts, led to silver selling off by 3% today, with gold down slightly less. In my opinion, this is because for silver, China’s continued expansion is particularly important because of the metal’s plethora of industrial uses. I have no doubt that will continue, and today’s movement merely reflects the short-term focus that permeates today’s markets. Additionally, the Dollar Index, after falling for the past week, shot back up over 78 solely due to the weakening of the Euro. The USD has actually continued to fall so far in 2010 against the pound and other currencies in the six-currency-basket Dollar Index (refer to Charts 5 and 6). In fact, gold and silver priced in Euros were only down slightly today. For 2010, I am confident that the long-term trends that favor precious metals will reassert themselves, including that of the gold/silver ratio.

Respectfully Yours,

Matthew R. Green

Chart 5: US Dollar vs. British Pound July 2009 - Present

Chart 6: US Dollar vs. Euro July 2009 – Present

Note the jump that began with the Dubai debt scare in late November/early December, and the spike this week due to the Greek finance debacle.

Issue V - M&A - 1/8/2010

2010-01-10T09:17:00.000-08:00

Dear Readers,

The Mergers and Acquisitions market in 2009 ranged from the doldrums of the “winter of discontent” to showing real signs of life by the end of the year. M&A activity toward the end of the year (Warren Buffett purchasing Burlington Northern railroad and Exxon Mobil buying XTO Energy, etc.) was certainly indicative that strategic acquisitions are making a comeback. However, it is too early to say that we have hit bottom for several reasons.

I am suspicious that the number of announced deals in 2009 is indicative of a very large pickup in activity. I have seen several prominent M&A group heads quoted on TV and in the Wall Street Journal noting that since 1990, M&A activity has been about a 2-year cycle from peak to trough. By such criteria, 2009 should be the bottom. It is a cyclical business by nature, which goes in tandem with the US economy. Several headwinds exist against the argument that the activity in late 2009 is the advent of a new M&A boom. First, many companies spent 2009 repairing their balance sheets, and many, particularly manufacturing companies, are still in that process. Second, the equity markets were very volatile in 2009. Volatility in the equity markets is usually not conducive to M&A because companies want a fairly stable equity environment before they act, whether their intentions involve making an offer or issuing stock, etc. Finally, even with the comeback of strategic acquisitions over the second half of the year, such deals were often greeted with lukewarm reception from the market.

If this recession proves to be a double-dip recession, we could see another downturn in M&A activity as well. In early 2009, during the depths of the recession, the majority of M&A assignments involved strengthening clients’ balance sheets. We saw this across the entire spectrum from mid-sized companies to components of the Dow and S&P 500 such as Alcoa and US Steel. In Alcoa’s case, Morgan Stanley and Credit Suisse helped raise $1.3 billion via an offering of both stock and convertible debt. This “Rescue M&A” was the focus until about April/May, and acquisitions were about the last thing on the CEOs’ minds.

In December, Paul Parker, global head of M&A at Barclays Capital, said, "If you look deeper into 2009 and you back out rescue financings, which were counted as M&A transactions, we're closer to $1.6 trillion in traditional M&A. So much of this year has been nontraditional M&A and a few mega healthcare deals.” Indeed, the few deals that were executed early in the year involved clearly defined companies, were very conservative in nature, and did not go outside the companies’ core businesses. Perhaps the two best examples of this were Pfizer’s acquisition of Wyeth in January and Merck’s reverse merger with Schering-Plough in March.

In September and October, things began to get interesting. Xerox announced the acquisition of ACS, and Michael Dell announced he was buying Perot Systems. Later, on December 14, Exxon made headway into the Natural Gas business by buying XTO Energy. Suddenly, transformative deals were back in the news - deals where a company was going outside the realm of its core business. The market did not initially digest these deals as well as one would have hoped. The reaction was lukewarm at best (see Charts 1, 2, and 3). However, it should also be noted that by the end of the year, this trend began to show signs of abating. Warren Buffett’s acquisition of Burlington Northern and Comcast’s purchase of NBC Universal (announced on November 3rd and December 4th, respectively) were well-received and both stocks have reacted favorably since. Nevertheless, the trend over most of the year was not favorable toward strategic acquisitions, as was reflected in the respective stock prices against the backdrop of a great rally in the equity markets.

This presents a problem that many chief executives are now experiencing; they are finding themselves trapped between a rock and a hard place. A CEO will get punished if he or she presides over a low-growth business. However, in an economic environment like that of 2008-09, if he or she attempted a strategic acquisition, they often got punished because the market interpreted the move as one that was going outside their realm of expertise. What carries the most significance never changes - it is the return on invested capital, which in the long-term is best for the shareholders.

Too many CEO’s, especially in times like these, are being forced by their boards and shareholders to look for growth regardless of the economic setting. This is a phenomenon that is seen close to the peak of any bull market. This is especially relevant as we near the 10th anniversary of the ill-fated AOL-Time Warner merger, announced January 10, 2000. That deal marked the peak of the Technology Bubble (Time Warner’s stock shot up almost 40% the day that the deal was announced), and today serves as perhaps the most egregious example of what can happen when CEO’s focus on growth simply for the sake of growth. Again, what CEO’s have to look at is not market values, but at the big picture with respect to their company’s position.

In 2009, there is one deal that stands out in my mind that best followed these guidelines. On August 4, PepsiCo announced its intention to re-takeover its distributors Pepsi Bottling Group and PepsiAmericas (it had previously spun them off in 1999). PepsiCo CEO Indra Nooyi and her board wanted to retake control of a core part of their business that they thoroughly knew, and the market rewarded the move (see Chart 4). CEO’s should never forget that bold moves where a company stays within their realm of expertise will be rewarded in almost any environment.

Besides seeing decreased activity in the “corporates” sector, the other major reason 2009 was such a lean year for M&A activity was that its other engine, private equity, has largely been on the sidelines since 2007. Ever since banks became reluctant to lend money for classic leveraged buyouts, their lifeblood of credit has become scarce. Of course, PE bigwigs such as Henry Kravis, Stephen Feinberg, and Ted Forstmann are known for being very smart and innovative. Deals are what they thrive on, and they will find a way to make money in most environments. Therefore, while they are likely be absent from the $5 billion-plus acquisitions, they are initiating highly structured deals to put their investors’ money to work. Many assets were on the market in 2009, and they often pounced if they found a deal to be attractive.

A great example was the Sept. 17 Kohlberg Kravis Roberts deal for Kodak. KKR came in, assisted with Kodak’s balance sheet, and will buy $400 million in senior secured notes due in 2017, at an interest rate of 10% to 10.5%. As part of the deal, KKR could control about 20% of Kodak's shares via warrants. In typical Kravis fashion, he also received two board seats. At the end of the day, it was a vote of confidence in Kodak’s film-to-digital transformation and long-term health. Of course, that does not change the fact that the M&A market is looking forward to banks becoming more willing to lend money for deals with higher leverage, so that private equity firms and corporations can begin to compete on deals once again.

To close, the M&A market appears to be showing some signs of an uptick, but in the grand scheme of the economy it appears to not have gotten ahead of itself. Jeffrey Kaplan, global head of M&A and financial sponsors at BofA-Merrill Lynch, told ThomsonReuters in December, "You need a sustainable economic recovery. You cannot expect the M&A market to flourish without favorable economic conditions. The best deals often are done at the beginning of a recovery. Post-bubbles create opportunities to get great values but are not always the best times for sustained M&A activity." Indeed, the numbers tell the story. M&A totaled about $2 trillion in 2009, down 32 percent from 2008 and down 53 percent from the record high in 2007, according to data from the Wall Street Journal. It all adds to the reasons to hope for a continued economic recovery in 2010.

Respectfully Yours,

Matthew R. Green

1/8/2010

Chart 1 – Xerox (XRX) August 2009-Present

Xerox announced its acquisition of ACS on Monday, September 28, 2009. As you can see, the market did not react favorably. Subsequently, the stock fell off the late 2009 rally until mid-December.

Chart 2 – Dell (DELL) August 2009-Present

This deal was announced on September 22, 2009. The market’s reaction was not favorable, and the stock is still 15% below its 2009 high, despite a December rally.

Chart 3 – Exxon (XOM) August 2009 – Present

Exxon announced its acquisition of XTO Energy on December 14, 2009, perhaps the most strategic deal of the year. The market has not reacted favorably in the three weeks since.

Chart 4 – PepsiCo (PEP) August 2009 – Present

PepsiCo announced its acquisition of Pepsi Bottling and PepsiAmericas on August 4, 2009. This was perhaps the best-received acquisition of the year, and the company’s stock has been rewarded with a nearly 10% increase since.

Issue IV - Deflation - 1/1/10

2010-01-10T09:06:00.000-08:00

Dear Readers,

“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

– Ben Bernanke, Speech to the National Economist’s Club, November 21, 2002 (emphasis added).

A schism is developing among economists as to what will happen to the US Dollar as a result of the 2008 financial crisis and subsequent actions taken by the Federal Reserve. In my last letter, I focused on monetary inflation and why I think it could become a problem in the coming years, although the US will not likely face a situation of hyperinflation. This week’s letter explores the opposite: deflation. Notably, Nouriel Roubini and Marc Chandler (author of the popular “Gloom, Doom & Boom” report) feel that deflation is the current problem that the Federal Reserve must confront. Regardless of which group is correct, the fact of the matter is that the Fed’s actions of the past year are geared toward preventing deflation by all means possible. The background of Fed Chairman Ben Bernanke further illustrates this point. Finally, technical analysis of the US Dollar suggests that further declines in the currency are on the docket for the first few years of this decade.

Monetary deflation is often associated with extended economic contractions, which can lead to a vicious cycle of falling asset prices. Japan has experienced deflation since the early 1990’s (refer to Chart 1 and my subsequent comments), and indeed deflation was a major factor in causing the Great Depression in the 1930’s. After an economy enters a cycle of deflation, it often takes decades to break out of it. In calling for near-term deflation, Roubini and other economists point to the large gluts in housing, industrial capacity, etc. That being said, the response of the US Federal Reserve to the 2008 financial crisis has been the polar opposite to the response during 1930-32, which was lassiez-faire. The difference in response can be attributed in great proportion to one man: Federal Reserve Chairman Ben Bernanke. As perhaps the most respected scholar on the Great Depression, even before the 2008 crisis Bernanke made clear that aggressive central banking actions were necessary to prevent deflation. His responses to the crisis have made it clear that he intends to use every policy tool at his disposal to prevent deflation. Depending on one’s view of his actions, the fact that he is the Fed Chairman who faced the crisis is either a blessing or an unfortunate circumstance. I believe the American people are fortunate to have had his mindset and actions in charge during and in the immediate aftermath of the crisis. However, in the long run the forecast is not as rosy.

It is extraordinary that Ben Shalom Bernanke was appointed Chairman of the Federal Reserve two years before the broadest, most severe financial crisis since the Great Depression began. If Bernanke was not in the Federal Reserve, in my opinion he would have been at the top of the list of individuals to be consulted for advice on understanding the crisis and, more importantly, how to construct policy in response. Bernanke served on the Federal Reserve’s Board of Governors from 2002 to 2005, and briefly as the Chairman of the President’s Council of Economic Advisors before his appointment as Chairman of the Federal Reserve. As soon as he arrived from Princeton, his first speech as a member of the Board of Governors (on the occasion of the great Milton Friedman’s 90th Birthday), outlined his theories for fighting inflation. The ideas put forth in the speech have come to be known as the “Bernanke Doctrine.” The speech as a whole has become eerily prophetic in the aftermath of the 2008 crisis.

By late 2002, in the wake of the deflating technology bubble, Alan Greenspan had slashed short-term interest rates to 1%. Yet, uncertainty lingered in the aftermath of the 9/11 attacks and the Enron and WorldCom scandals. The Dow and NASDAQ did not bottom until October 9 of that year. Thus, over the course of 2002 deflation had been mentioned as a potential problem by several economists and economic policy groups. As mentioned, Bernanke took the opportunity of his first speech as a member of the Fed to address the potential problem and how to deal with it.

In his speech, Bernanke outlined seven steps to prevent deflation. First, increase the money supply (M1 and M2). This point was backed up by the quote that introduced this letter. Obviously, in 2002 the strength of the US Dollar was not a pressing concern, as is the case today. Bernanke went on to mention the prospect of the Fed purchasing US Treasuries (this was initiated in March 2009 by Bernanke in cooperation with Geithner’s Treasury), and also the implied purchase of stakes in companies using newly printed money (sound familiar to TARP and the GM Bailout?). Finally, Bernanke condoned a more direct method of devaluing of the dollar, to augment the printing of money. In extolling the Fed’s actions under Roosevelt in 1933, he said:

"It's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly."

Fast forward seven years. When Bernanke speaks about the US Dollar today, his words are carefully crafted to finesse the point and to avoid creating volatility in the currency markets. After all, the mandate of the Federal Reserve involves, among other things, maintaining the strength of the US Dollar. Thus, he would likely not be so blunt today. Regardless, Bernanke’s philosophy toward fighting deflation was well-formed long before he assumed the office of Chairman of the Federal Reserve. Given his knowledge of the Great Depression, Bernanke appreciates more than anyone else what could happen if the United States were to fall into a deflationary spiral. Hence, it can be argued that he helped save the United States from what could have become a “Second Great Depression.” Yet, the actions of his Fed have greatly undermined the long-term health of the Dollar. These actions could lead to a weaker dollar and inflation during the new decade.

The argument against deflation is further enhanced via technical analysis of the US Dollar. The dollar is in the midst of a secular, multi-decade decline (refer to Chart 2). In my opinion, this decline was inevitable due to US output as a percentage of the global GDP gradually declining and the emergence of the Euro and other reserve currencies, among other factors. From a technical standpoint, this decline is not likely to stop. Of course there will be short-term corrections, this past month being a perfect example (refer to Chart 3 and my subsequent comments). Trading at the upper range of both the Bollinger Bands and Stochastic (50-Day over 200-Day Moving Average), the majority of this short-term correction has likely run its course. Keep in mind that the flight to safety that began in mid-2008 resulted in the Dollar Index jumping from 72 in July 2008 to about 90 in March 2009. This occurred while the Fed more than doubled its balance sheet and commenced quantitative easing. The decline that began last March was inevitable and will likely continue.

In my November 27 letter, I predicted that there would be volatility in the wake of the Dubai debt scare. At the time, I predicted the dollar would resume its decline “anywhere from two weeks to a month from now.” Beginning last month with Dubai and Europe’s exposure to their debt, and more recently with debt concerns in Greece and Spain, the Euro has been hammered against the US Dollar, falling from 1.50 USD to 1.43 on December 31. Due to the heavy weighting of the Euro within the Dollar Index, some currency specialists are predicting the bounce in the Dollar to continue into the early part of this year.

Regardless, I remain unconvinced that the recent dollar rebound is anything other than a temporary head fake. The Dollar Index has been treading water between 77.50 and 78.45 for the past two weeks. If several important technical barriers are broken early in the new year, we could see continued dollar strength for the next few months. However, with another $871 billion balance sheet expansion on the docket (the health care bill), barring a few countries in the Eurozone defaulting or another unforeseen geopolitical event (Iran, Israel, etc.), the dollar will likely continue to decline in 2010. A sustained climb in the Dollar Index would be a sign of deflation, but with a deflation watchdog like Bernanke running the Fed, it is not likely to happen.

Respectfully Yours,

Matthew R. Green

The full text of Chairman Bernanke’s speech can be found on the Fed’s Website:

www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

Chart 1: Nikkei 225 Index 1965 – Present

This chart illustrates what a deflationary spiral can do to a country’s capital markets. The Nikkei peaked on December 31, 1989 and is today more than 70% below that. Granted, the US economy will likely never see a bubble on the scale of what the Japanese economy experienced from 1985-89. To illustrate my point, in late 1989 the Financial Times reported that the land in central Tokyo beneath the Imperial Palace and its grounds was more valuable than the entire state of California.

Chart 2: US Dollar Index 1986-Present

The USD’s fall in the mid-1980’s was a direct result of the 1985 Plaza Accords. This agreement was a planned devaluation of the USD vs. the German Mark and Japanese Yen (indeed, it contributed to the Japanese Asset Price Bubble). For Americans, the best part of the 1990’s was that the market was rising along with the value of our dollars. By contrast, in the 2000’s the market was volatile, ending the decade with little to no gain, while the dollar lost more than 20% of its value.

Chart 3: US Dollar Index - January 2005 to December 2009

The Dollar’s move in 2008 should be viewed as an aberration. Without it, the short (blue), mid (red), and long (green) term moving averages would all be lower. Notice that combined with the Dollar’s correction this year, the Long-term moving average is virtually unchanged since September, 2008. The rise in the dollar the past few weeks (the Dollar Index closed on 12/31 at 77.95), has allowed it to approach its mid- and long-term moving averages. This is an interesting circumstance. Normally, a security’s mid-term average crossing through the long term average on a downward trajectory is a bearish signal. However, dollar strength in early 2010 could result in the Dollar Index crossing both levels of resistance. This would be a bullish signal and likely pave the way to further dollar strength in 2010. At the same time, the short-term Stochastic and MACD indicate that the Dollar is overbought in the short term. Bottom line: the market will be keeping a close eye on the Dollar Index in the next few weeks for direction in 2010.

Issue III - Inflation - 12/10/2009

2010-01-10T08:58:00.000-08:00

Dear Readers,

As we all know, the past two years have borne witness to the sharpest, most severe economic contraction since the Great Depression. Recent sets of economic data have suggested that the recession is abating, if not having ended already. Simultaneously, many economists have suggested that the extraordinary measures initiated by the Federal Reserve and other entities point toward another looming crisis: Inflation and the debasement of our currency. In my last letter, I argued this with respect to the current Dollar Carry Trade, and how that trade, while there may be corrections from time to time, will remain the trend as long as the practice of systematic devaluation remains in place. I believe the devaluation of the US Dollar will continue as long as Bernanke and Co. is running the show. At the same time, we need to pause before we immediately begin to convert our US Dollars into Australian Dollars or Norwegian Kroner (these countries are both already in the process of raising rates, refer to Charts 1 and 2 at the end). Indeed, inflation has its cons, but it has pros as well. The fact is that it has more pros than its evil stepsister, deflation. Additionally, the experience of Argentina from 1976-1991 reveals that inflation does not necessarily undo a society. It is necessary to consider the position of the United States within the world economy compared to other countries that have experienced high levels of inflation.

The last three generations of Americans have come to regard inflation as a fact of life. Retro advertisements that tout a bottle of Coca-Cola for 5 cents are now used as décor in countless households. Those over 60 recall purchasing candy and ice cream for pennies. Controlled inflation over time is an acceptable economic scenario. Rising asset prices make their way through the system, from stocks to real estate. For example, as prices gradually rise, it is easier for companies to report rising earnings year-over year. Good earnings result in higher stock prices. Such is the opposite in a deflationary scenario. Prices are forced lower, which forces companies to cut costs and lay off workers. This can become a vicious cycle (examples: US Great Depression and Japan Post-1990). Since Paul Volcker’s Fed was able to get inflation under control in 1981-83, it has been low and manageable for the longest stretch in history. In fact, in the five years leading up to the Credit Crisis, many economists, including Alan Greenspan, suggested that late 20th century banking practices had led to a new age dubbed “The Great Moderation,” in which volatility in inflation, GDP, unemployment and many other economic variables would be permanently low. The Credit Crisis and its implications have tossed this paradigm out the window.

The monetary base of the United States has been expanded more than ever before due to the Federal Reserve’s response to the Credit Crisis and subsequent recession. The end result of this will be higher inflation. In a letter to his (no doubt extremely happy) investors, hedge fund manager John Paulson argues, “the monetary base has expanded to an absolutely exponential degree. Typical year-over-year changes in monetary base were under 20%. When the crisis occurred, that year-over-year change skyrocketed to 128%. Additionally, the correlation between the monetary base and money supply is very close, almost 1:1 as the monetary base finds its way to the money supply.” What he means is that while the monetary base has swelled, the money supply has not, at least not yet. This is due to the velocity of money plunging, accelerating after the other Paulson (Hammerin’ Hank) allowed Lehman Brothers to go bankrupt. The heart of John Paulson’s argument is that inflation has lagged money supply growth by 2-3 years. Thus, now is the time to be preparing for it. In his case, he is currently raising outside money for, and placing $250 million of his net worth into a new Gold-centered hedge fund.

Examples in modern history show that even decades of inflation will not lead to the undoing of a nation, as many pundits may inevitably suggest in order to sell books, get face time on TV, etc. The Weimar Republic is not a good historical example, as the main trigger of the 1922 hyperinflation was the forced debts on the Republic via the Treaty of Versailles to pay for the rebuilding of Europe after World War I. Argentina is a better comparison in that it is not only more modern, but brought about by untamed government spending (sound familiar?) Additionally, the example of Argentina fits well in that it is still a proud, First World nation today after nearly twenty years of crushing inflation. Finally, the icing on the cake is that the US enjoys several economic advantages that Argentina did not. It is these advantages by which hyperinflation will likely never happen.

The South American nation of Argentina experienced steady inflation, including short bouts of hyperinflation, from 1976 to the early 1990’s (for perspective, refer to Figure 1). The Argentine Finance Ministry would initiate currency reforms in 1983, 1985, and finally in 1992. In the midst, the 1985 currency reform introduced a new currency, the Austral. After another round of hyperinflation in 1990-91, the 1992 currency reform introduced the “New” Peso. One New Peso equaled 100 billion pre-1983 pesos. The hyperinflation during this period was largely due to populist spending sprees, such were the legacy of Juan Peron and years of dictatorship. Other factors included building stadiums and improving infrastructure for the 1978 World Cup, and even waging a bold war they had no real chance of winning, the 1982 Falklands War. The money for these expenditures was essentially printed, contributing to the final inflationary spike that led to the 1983 currency reform. Seeing their savings and peso-denominated assets deteriorate, Argentines began to park large portions of their money in US Dollars. Wealthier Argentines sent their money to US Banks, while working class Argentines often kept $100 bills in safes. The country did have its problems. Poverty increased to around 40% in that time period, although it is markedly lower today. There were periods of rioting, although from an historical perspective they were roughly comparable to the US at some points in the 1960’s. No coup d’etat ever occurred. The first part of my point is that despite this decade and a half of difficulty, in addition to a more recent crisis in 2001, Argentina was and remains a First World country and G-20 member today. They have managed to short up their finances such that their Debt/GDP ratio is now lower than the US and many other industrialized countries.

Moreover, the United States, due to its position in the world and the accompanying economic interdependence of so many other nations, will likely never face the type of hyperinflation that defined life in Argentina for nearly twenty years. First and foremost, Argentina never had the advantage of their currency as a global reserve currency. The role of the US Dollar has gradually built up to the current economic interdependence between the US, Europe, Japan, and China, with particular emphasis on China. If the US Dollar enters a period of swift decline, these countries’ massive holdings of US debt will be reduced in value as well. This will be in addition to everything that is priced in USD (oil, food, other commodities) rising as the dollar is falling. This will not just be a US problem; this will be a global problem. We saw bits and pieces of this in early 2008 with the food riots that occurred in Latin America and the poorer regions of East Asia. In the off chance that we do have a currency crisis in the next five years, I personally think that we will see unprecedented efforts by governments worldwide to prop up the US Dollar. Central Banks will take measures to let their own currencies decline against the Dollar to keep it propped up until a new, global reserve currency can be introduced (this concept, highly interesting to me, is a possible topic for a future newsletter).

I believe we are looking at a decade or more of high deficits and higher inflation with neither likely to ever truly get out of hand (although the range of what constitutes “getting out of hand” is vast, especially among talking heads). Despite the massive 2009 budget deficit, the Public Debt/GDP ratio of the United States does not exceed that of the European Union or Japan (Japan is closing in on 200%!), and about a dozen other smaller countries. Don’t misinterpret, this trend needs to be reversed. The point is that we have a long way to go before we will really be in trouble relative to the current state of other world economies. Although not as dominant as before the introduction of the Euro, the health of the US Dollar is still vital to the global economy more than any other currency. Other countries are aware of this. The recent, colorful debate between Hu Jintao and President Obama over the former’s refusal to let his nation’s currency appreciate is more about the immediate situation than the future. If China immediately lets its currency appreciate, one of the immediate effects will be that some (not many, but some) manufacturing jobs could make their way back to the United States. Reversing this trend of the last twenty years could jeopardize the continued rise of the Chinese middle class. For this reason, while the yuan’s appreciation could help the US economy in the short-term, Jintao has no interest.

In the meantime, relax. Allocate 5-10% of your portfolio to precious metals and/or other commodities, and allocate more than that if you fear a currency crisis. Inflation and the debasement of our currency have resulted in 95% of the dollar’s purchasing power being erased since 1913. However, during that time the Dow has risen 12,000%. You only lose if you put your money under the mattress or in a simple checking account. Personally, I am a fan of Silver more than Gold as an inflation hedge, but this will also be the topic of a future newsletter. As long as Ben Bernanke has his way, we will not be doomed to a Japanese-style deflationary cycle. At the same time, we as a nation need to get our deficits under control in order to completely avoid an Argentina-style experience. Low inflation on a year-in year-out basis is acceptable. High inflation which could destroy the savings of middle-class citizens is not.

Respectfully Yours,

Matthew R. Green

12/10/2009

Charts 1 & 2

Chart 1 is Gold when priced in Australian Dollars; Chart 2 is Gold in USD. As you can see, Gold (or any other commodity) is actually down over the course 2009 when priced in AUD. This illustrates the AUD’s strength.

Figure 1 - Illustration of Inflation in Argentina 1975-1991

January 1975: Highest denomination is 1,000 Pesos.
Late 1976: 5,000 Peso note introduced.
1978: 10,000 Peso note introduced
Late 1981: 1,000,000 Peso note introduced
1983: First Currency Reform: 1 Peso Argentino = 10,000 Pesos
1985: Second Currency Reform: 1 Austral = 1,000 Pesos Argentinos
1992: Third Currency Reform: 1 “New” Peso = 10,000 Australes

Bottom Line: 1 1992 Peso = 100,000,000,000 Pre-1983 Pesos (100 Billion)

Source: International Monetary Fund

Issue II - On the Dollar Carry Trade - 11/27/09

2010-01-10T08:43:00.000-08:00

Dear Readers,

“Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the market.”

- John Maynard Keynes, 1935

The 20th century British economist John Maynard Keynes was a veritable trove of quotable quotes. The above may be the most famous, yet many others are appropriate to economic circumstances time and time again. Today is no exception. The above quote is taken from his 1935 book The General Theory of Employment Interest and Money. To paraphrase, we Americans are very good at following the pack. Whether this applies to the stock market or the housing market, this trait comes back to bite us. It has, time and again.

The propensity to gravitate toward the trend also helps explain why those whose viewpoints eschew the trend make easy headlines. In recent years, they are often not taken seriously until after a particular economic bubble has popped. Some of these individuals buck the trend, only to be wiped out for calling the top too early. In 1998, the great hedge fund manager Julian Robertson became convinced that the Nasdaq had run its course. He began to actively short the tech sector. The resulting short position losses, along with several bad long positions (notably US Airways), and bad currency bets, ended with Robertson shutting Tiger Management in February 2000. The Nasdaq peaked on March 10, 2000, a mere three weeks later. Such an example illustrates another notable Keynes quote; “The market can stay irrational longer than you can stay solvent.” Others, like John Paulson in 2007, had more fortuitous timing and made a killing when their target (in his case, subprime mortgages) deflated.

Currently, one of the top trades in the news is the Dollar Carry Trade. A quick explanation; A carry trade occurs when a trader borrows money denominated in a certain currency order to buy assets in that currency. He does this with the expectation that the real value of the debt will erode over the time period he will own it, because the underlying currency will decline. With respect to the Dollar Carry Trade, many eyes in the investment world are paying very close attention to this trade due to its close relationship to other markets, especially the Gold trade (no uncrowded space at the moment) and the global equity markets. In the past month, several prominent economists have publicly predicted a swift, destabilizing unwind to this trade. Of these, Nouriel Roubini has been the most prominent.

On Wall Street, Roubini has earned the name “Dr. Doom” since 2006 for not only predicting the real estate collapse, but the rapid domino-effects it would have on the banking system and consequently the financial markets. In a recent Financial Times editorial, and also in trading verbal punches at a conference with commodities investor Jim Rogers, Roubini has made his view clear: the Dollar is due for a swift appreciation that will reak havoc on the markets. However, one needs to interpret the most extreme viewpoints with a degree of moderation. While a currency trade, especially one that is crowded, can turn on a dime, an investor needs to take a long look at the current position of the US Federal Reserve, and also the history of carry trades, in formulating a comprehensive thesis. In the opinion of this writer, Roubini is now playing the part of the epithet he most definitely earned, and little else.

In the past year, the Federal Reserve Bank of the United States has unleashed an unprecedented amount of liquidity into the world economy. As a noted scholar of the Great Depression, Chairman Ben Bernanke surely knows more than the average central banker of the potential destruction caused by deflation. High inflation is bad, but deflation is much worse (the logic behind this will be the topic of a future commentary). After six months of dollar appreciation, the Fed responded to the looming possibility of a depression-like vicious cycle of deflation. In his March, 2009 testimony to the House Financial Services Committee, Bernanke announced that the Fed would commence a program of Quantitative Easing. (This took the form of the Fed purchasing its own Treasuries, in order to keep rates artificially low). It was at this point (Refer to Chart A) that the US Dollar resumed its downward trend. Among other tools in their arsenals, other Western governments have been doing much of the same thing. The end result is the devaluation of the US Dollar and other fiat currencies. Thus, the trend remains in place for traders to borrow the USD to fund asset purchases, with the expectation that the real value of the debt will erode, because the underlying currency will decline.

Chart A

US Treasury Secretary Timothy Geithner announced that the Fed ended its QE program after the latest Treasury Auction earlier this month. Nevertheless, the Federal Reserve remains determined, by all means possible, to prevent what happened in 2008 from happening again. One method they continue to utilize is the devaluation the US Dollar via low interest rates, and therefore inflation. Inflation year in and year out is nothing new. In fact, since the Federal Reserve was created in 1913, the US Dollar has lost 95% of its purchasing power. The bulk of this decline has been since President Nixon took the US off the Gold Standard in 1971. Since then, it has lost 80% of its purchasing power. Prices going up overtime, and the dollar being gradually devalued are part of a continual trend.

Additionally, the Federal Reserve has very little room to maneuver with respect to interest rates and indeed the US Dollar. If rates are raised, the Fed threatens to derail the fragile economic recovery. For recent news conferences, Bernanke and Geithner have concocted very carefully worded statements regarding their stance on the dollar. They continue to claim that they support a strong dollar. Yet their actions of the past year suggest otherwise, including the fact that they have not expressed any intention to begin raising rates for “quite some time,” which many on Wall Street have translated into around late 2010. According to the transcript of the most recent Federal Reserve Board of Governors meeting, several members, including the Governors of the St. Louis and Dallas branches, are beginning to express concern that such low rates could lead to high inflation in the next five years. Given the state of the current economic recovery (or lack thereof, some might argue), combined with Bernanke’s track record and his philosophy of inflation over deflation, I fully expect these concerns to be ignored for the time being. The Fed will likely condone a steady decline in the dollar now and in the near future. This paves the way for the Dollar Carry Trade to continue for years.

Using a certain currency for Carry trades is encouraged via the systematic devaluation of a country’s currency, whether it is Argentina in the 1980’s, Japan in the 1990’s, or the US today. With systematic devaluation, there is not a great danger of any particular carry trade blowing up in the midst of such policies. Since the mid-1990’s, many currency traders have used the Japanese Yen as a funding currency. This began when, in the wake of the deflationary fallout from the Japanese Real Estate Bubble, the Japanese government began lowering interest rates in earnest. A 0% rate was ultimately instituted in 1997. Since then, and indeed for the greater part of this decade, the Yen was the carry trade of choice throughout the financial world. It took until 2007 for the Yen’s real effective exchange rate (simply put, the exchange rate when adjusted for inflation) to reach its low. As the credit crisis began in 2008, the Yen rapidly shot upward against other currencies, notably against the Australian Dollar (Refer to Chart B). In mid-2008, the US Dollar was hitting its lowest levels in decades against numerous other world currencies. With the onset of the credit crisis, this trade quickly unwound beginning in August 2008, until March 2009 (Refer to Chart A). This “flight to quality” lasted until March, when the Federal Reserve announced its Quantitative Easing program. As mentioned earlier, this is (not coincidentally) when the US Dollar resumed its decline. Therefore, the US Dollar is gradually replacing the Yen as the carry trade of choice, in addition to the October-March uptick being unwound. Both are contributing factors to the growth of the Dollar Carry Trade in the past six months. As with the Japanese example, carry trades have the potential to last for years, if not decades.

Chart B

Once again, I will repeat that Dr. Roubini is correct in that a currency trade can snap in either direction quickly and relentlessly. This is particularly true in any trade which is crowded. A swift reversal can result in a selloff, or a swift tick upward can result in a “short squeeze” if the crowded trade is on the short side. As one can see in the charts, Roubini is indeed right that a currency reversal can be swift and disruptive. This is particularly true for the US Dollar, by which commodities and many other financial instruments are traded.

As I am writing this, it has been announced that the Emirate of Dubai is asking its creditors for a delay in the repayment of over $50 Billion in debt. This was the debt taken on this decade to transform Dubai into the metropolis it has become (and less than 33% occupied, with the world’s tallest building at that!). The US Dollar is rising more today than it has at any other time in the past eight months. The reversal is quick, and the short-term outlook is volatile. Roubini will inevitably get additional facetime on CNBC and Bloomberg if the dollar has a brief uptick for the next two weeks to a month. Ultimately, I think this will prove to be a head-fake. Compared to European Banks (Standard Chartered and HSBC in particular) and indeed Governments, the US has relatively little exposure to Dubai, although I am by no means an expert on the matter. What I do know is that the Federal Reserve’s policies are in place for a gradual devaluation of the US Dollar. Therefore, Dubai should not prove to be a very disruptive event, and I forecast the dollar to resume its secular decline anywhere from two weeks to a month from now. In any long-term pattern, there will be corrections. This will prove to be no different than countless others throughout history.

I hope everyone had a Happy Thanksgiving. Have a great week.

Respectfully Yours,

Matthew R. Green

November 27, 2009

Welcome to Pastures Online

2010-01-10T08:32:00.000-08:00

Dear Readers,

Welcome to Pastures online. Here you will find all of my previous and future posts. I hope you enjoy them and please share with any interested colleagues or friends.

Respectfully yours,

Matthew R. Green