Monday, June 30, 2008

what happened to truth?

I was recently listening to Jim Cramer's Mad Money. he made the point that GM and Ford can go all the way to 0 because of their massive debt loads. this is the simple truth that many stock investors forget most of the time: credit ratings matter. it's amazing to think about: people would consider CCC rated debt, such as GM's, highly risky. but they wouldn't worry for a second about going even lower in the capital structure: common stock.

we take debt and equity for granted, but at times like this, it's worth examining their natures more closely...

DEBT is a defined obligation, whether it's fixed at a number like 6% or pegged to a floating index like libor or prime. as long as the borrower meets this defined obligation, the creditor is happy.
when a company pays its debts on time, bondholders have essentially no rights. they only gain control when the contract is breached. then they can take all actions necessary to demand the contract be fulfilled. all they care about is getting their legally defined payments.

EQUITY is everything else -- ownership net of obligations. as long debts are paid on time, the equity (stock) holders have complete control. they hire management teams, who are sworn to enhance their wealth. (this is called "fiduciary" duty.)

unlike debt investors, stock investors have no defined rights to get any money from anyone. they hope for dividends and stock price appreciation. their only right is to demand that management at least try to make them money. that's why people like carl icahn buy stocks and try to change things to make them go higher. common stock can go up forever, and exists solely to enrich its owners.

essentially, stock investors have the potential to collect infinite profits -- as long as they pay their debts.
and debt investors have the absolute right to recieve defined payments -- and they can take eveything from the stock investor to get that amount.

people buy stocks on hope. after all, you never know how many times it will double.
people buy bonds on need because they have expenses to cover... they are insurance companies, or pensions, that make defined cash payments to their own customers.

I think this explains the difference in temperment between stock and bond investors. credit investors, who I know better, pour over the details of companies' assets, doing great amounts of math and estimates. they consider how much they will get back if the company defaults, etc. I would often ask how anyone can do so much work for a mere 6% interest rate? the reason is that the coupon is all they get: they're not shooting for the stars, they're just looking to plug a gap in their cash flow 5 years from now.

on one hand, you have the valiant stock portfolio manager, heroically chalking up double-digit gains with clever stock picking. people put him on TV and treat him like a rock star.
on the other hand, we have a bookish accountant-type. one who's more confortable with columns of numbers and hedges everything with statements like "the evidence would suggest." he's more of a financial scientist. instead of going on TV, he speaks before groups like the NYSSA, a huge fraternity of CFA nerds and accountants.
as Cramer pointed out, this pocket protector crowd (I have seen used in real life at bond conferences) can become quite nasty when their interest payments aren't met. they take everything, leaving common stock holders with nothing.

it's amazing that a company like GM, a cornerstone of american society for nine decades, can lose half its value in less than two months. in another 2-3 months, it could be halved yet again. in a year, it may be worth nothing. people thought they had real value here. after all, it was "GM".. or it was "Citigroup" or "Lehman"... names have been so reliable for so long.. companies like that can't really collapse!
it turns out these companies are worth a lot less than people thought. when your debts equal 90% of all your assets -- as in the case of lehman brothers -- do people really want to buy the stock? what if you're lehman and your assets -- things like mortgage securities -- lose 10% of their value? what if they can't roll over their $428 billion of short term their? (I still can't believe I typed that number. can you believe that between feb 29 2008 and one year later, lehman brothers will have to pay back or refinance the entire Swiss economy??)

in the next year, GM has $6bln of debt coming due, a little less than their entire market cap...

when you have debt like that, things we all took for granted stop being true. this is true for companies like GM and Lehman, and it's true for people who borrowed heavily to against their homes. things we thought were true seem to dissolve.

this crisis of truth in the stock market is no exception to the general condition of our society and culture. veracity is becoming an increasingly scarce commodity.

let's consider the blatant lies of people like our president and treasury secretary. they speak endless about the need for a strong dollar, then watch it lose value. the same president then complains how china isn't doing enough to make its own currency stronger. he never acknowledges this actually means a weak dollar... an entire media corps covers wall street and politics, and I have never heard anyone cite this obvious contradiction. (again, how can you be for a strong dollar and a strong renminbi at the same time? currencies trade in pairs.)

another example is the notion that inflation will subside on its own as the economy slows. this is pure faith, unfounded in any serious example of real cases. inflation is a monster that must be killed. it cannot be tolerated, or coddled because it doesn't seem that dangerous. there is no reasoning with this brute. it must simply be destroyed.
as I noted in a recent posting, inflation is so dangerous because it creates leaves a series of repressed price increases. these spring at people unexpected, ripping into companies and individuals with big price increases.

for example, a one-month unlimited pass to ride NYC subway now costs about $78. I think it cost $70 when I moved to the city more than 4 years ago. I know an 11% increase may sound like a lot, but I suspect it doesn't go far enough to cover the 380% increase in oil prices over the same period. (after all, they operate plenty of buses and other vehicles as well.) somehow, they will hide this problem in their complex web of capital spending, but at a certain point, it costs them money. as a government body, they have limited ability to hike fares. so, the increase sits there, unmet, like a sprung coil. then when everybody thinks everything is ok, and inflation's ok because the economy is slowing, the MTA raises its fare 30-40%. then everyone else who's in pain raises their fares. taxis win increases.. then all the car services follow.
even if the economy goes into recession, millions of these price-increase traps are laid and inflationary pressures continue -- even after GDP goes negative.

the only real solution, of course, is to raise interest rates. but that would be mean to all the companies like lehman or all the homeowners.

our own political system is riddled with lies. yes, I know politicians say anything. but consider this: much of our political growth after the 1920s and 1930s required the absolute distortion of our constitution's plain meaning.
most important... the interstate commerce clause: "congress shall have power ... to regulate commerce ... among the several states " (article 1, section 8). it was barely used until the 1930s, when the new deal expanded it to mean the entire national economy. consider things like the americans with disabilities act and the endangered species act, which regulate businesses and people directly. what does it have to do with trade "among the several states?"

the answer, of course, is nothing. rather, we must accept an open lie. we have to break our own constitution to do what we believe is right. we want to clean up the environment, promote workplace safety and protect the cute animals on nova. so we tolerate a lie because we think we're doing the right thing.
it's somewhat like Enron CFO Jeffrey Fastow saying he committed fraud to protect the shareholders. after all, if the company's true state were known publicly, all those teachers' pension funds and grandmothers would lose money!

we americans have tolerated many lies on a similar line of reasoning. these things seemed like the right thing to do, so they must be ok. after all, who has ever stood up to challenge the notion of "freedom of speech?" on the surface, what's more american than that?

in truth, the history is a giant paradox:
FACT: the bill of rights (amendments 1-10 of the US constitution) was originally created to restrict the Federal Government. in the 1780s, many states were scared of this new government and demanded the bill of rights to ensure it wouldn't encroach on their liberties. at no point in the 18th century is there any notion the bill of rights was meant to restrict the states. everyone knew it was to limit the federal government only. that's why the states-rights people accepted the constitution. they only ratified it once the bill of rights was added.

it's an incontrovertable piece of historical fact: the bill of rights was intended to restrict the federal government.

then in 1925, the gitlow case comes before the court. they take the completely novel step of deciding that the states must respect first amendment free speech rules. (the court had recently invented the "clear and present danger notion" .. basically, Congress can only bar people from "yelling fire in the theater"...). amazingly, no one really cared at the time. the gitlow case was expanded in coming years, producing red-hot issues like abortion, prayer in public schools, gay rights, miranda, manger scenes, etc.

we all love to argue about these issues. but to me, these are not the real issues. the issue is how we have managed to twist reality so that up becomes down. how is it possible that the first amendment, intended to protect states from federal power, is now used to subject states to federal power?

the truth is it isn't possible. it's a lie we've been forced to endure as a body politic. and like all lies, it's kind of like inflation. it lays all kinds of traps forcing people to distort reality... like the house appraisor who collects $100 to price a condo based on a computer program -- without even seeing the home. good things are built on bad foundations when you lie.

(it may be the symptom of the common law, where bizarre lies are common place, such as a lord closing a gate once a year to prevent people from claiming a permanent right of way through his property. ... see this..

much of the last 90-100 years has been a lie. "houses never lose value". "I didn't inhale" "we're for a strong dollar"... "iraq has weapons of mass destruction" .. etc.

I know not many people will agree with me or see the relevance of the bill of rights...
but there's one lesson we all should take from any asset bubble bursting: truth matters and is real. things like culture and money (all of which are based upon people's ability to assume a lot of things in common) can let people ignore truth for very long times. but the truth always comes out in the end. even if we think we were doing the right thing by spreading the freedom of speech, or protecting the environment, we ruined it when we lied to accomplish our goal.
as we enter a period of $4 gasoline, falling home prices, banks with broken kneecaps and plunging confidence, we're likely to see many former truths questioned. the notion that you could live a middle-class lifestyle somewhere like NJ, running up debts and consuming energy wantonly -- that was "true" for the last 40 years. what happened this year?

a related point to the bill of rights: building basic rights upon a big lie is rather sloppy. we have been similarly negligent in running other parts of the government.. and it is these key areas that our country needs help immediately: health care, riddled with government funding and regulations, is a mess. subsidies programs to farmers, etc. the whole thing is really just a big mess.
because we've been so sloppy, fixing things will take years. barney frank will be playing the blame game on capitol hill while the entire banking industry slips to GM-like levels (BAC at $23!!?!?! 7 years of gains erased?!?)

we've had many bubbles.. many are part of a larger bubble that has manifested itself ever since the 1980s or so: a complacency bubble.

after being taught to think of common ideals (WWII egalitarianism, the great great society, etc), it was suddenly ok for people to raid companies, fire workforces, gut assets and walk away. we swung from the america of JFK's inauguration to the land of gordon gekko.
people in the 1970s wanted to save the environment and to cut oil use. then oil prices plunged in the 1980s and we ditched all of those notions. we tried to do "the right thing" and cut energy use, and we couldn't afford it. then we did "the wrong thing" like buying SUVs and building more sprawl...

we did "the wrong thing" and were rewarded each time..we got richer. everyone was happy. comforted by the assurances of people like ayn rand and milton friedman, we accepted the new reality and everything was fine.. no problem.

another key aspect of the bubble is that it destroys the morale of its opponents: house prices shot up for years. everyone said it was a bubble and people got killed shorting home builders. those people then are afraid to come out and help the next time around. (it's kind of like how inflation leaves little spring loaded surprises ready to inflict injuries on an economy.)
this is all part of how our complacency bubble developed. along the way it created financial bubbles and enabled politicians. it will be huge multi-stage process affecting all aspects of our society. sometimes it will feel like the end of the world... a facinating time to live. but probably a bad period for for stocks.

Saturday, June 21, 2008

some numbers on inflation

I have been extremely busy and unable to write as much as I have wished. but it's important to address the growing inflationary trends. they're starting to get scary.

as a financial journalist, I read a lot of economic and corporate research. I have noticed a growing number of warnings on inflation from different kinds of analysts... here are a few of the outstanding points raised:

1-morgan stanley warns that the producer price index (PPI, which affects companies) have risen faster than consumer prices (CPI). businesses are reluctant to raises prices because they don't want to lose customers... this is especially worrisome to them when consumers are already feeling squeezed by $4 gas. in the short run, they simply eat the profit margin to keep the revenue coming in.

earnings will collapse and stocks will make another move lower... I have already predicted the S&P500 will fall all the way to the 1000 point area.. this will take about 2 years to happen...

anyway, this chart from morgan stanley does a lot of things, and is pretty interesting overall.

the solid line shows the difference between cpi and ppi.. when it goes up, it means companies are raising their prices faster than their own costs are going up. that makes profit margins (the dotted line) widen, in general. now that they're eating price increases, the process has reversed. I fear the great profit boom of 2004-2007 is over.

2-food and fuel inflation eventually pulls core cpi higher... this one from jim bianco:

the blue line is general, or headline, inflation. the red line is "core CPI", which excludes food and energy. for years it made sense to exclude these because they created a lot of statistical noise and didn't constitute an important part of people's and businesses' budgets. faster headline inflation will pull everything else higher. one thing ironically that's protecting many americans now is the surplus of cheap items such as clothing because stores are shutting down and selling inventory. (apparel is the only thing with negative inflation in the last few months.. in fact, it's accelerating, suggesting that inventory liquidation is underway.)

3-also from bianco.. inflation is faster right now than it's been in years.. here are the annualized rates over different periods of time... you can see it had been stable around 3% until the last 1-2 years.

3mo == 9.64% -- HOT
6mo == 6.22% -- GETTING HOT
12 month == 4.17%
3 yrs == 3.67%
5 yrs == 3.37%
10 yrs == 2.90%
20 yrs == 3.11%

4-from goldman sachs ... this shows what happens to stock mutliples when inflation picks up. -- basically, stock prices take a hit:

overall, as I said here, profits are going to get hurt. steel, ashphalt, etc.. these are the things that will kill the economy by discouraging large scale investment. the integrated financial model makes a lot less sense in an inflationary period. we will see elimination of real economic capacity.. abandoned shopping centers, etc. houses, even ...

5-wage growth adjusted for inflation was already weakening. throw in higher prices and real wages will take a significant hit. here's a chart from credit suisse:

6-people are responding by cutting spending on non-essential items. another chart from credit suisse:

one interesting thing emering from all of this: political discontent.... a credit suisse survey shows that republicans have suffered rapidly declining consumer confidence this year.. democrats already had lower consumer confidence. we're starting to see all the pieces come together for a real national crisis:

1-slowing economy

2-declines in wealth

3-rising unemployment

4-sinking wages

5-rising inflation

6-a sick currency

the economy is beginning a long-overdue process of structural adjustment. it will be extended and painful to varying degrees. we're also at the stage where problems are going to accelerate for the next 1-2 years. why? because most people are only starting to realize how bad it will really become. things will change for the worse as the new reality sinks in.

furthermore, are new inflationary pressures building? one line stood out to me in a recent Situation Room from B of A:

Overall, the results indicated that amid soaring costs, businesses are trimming production and attempting to control inventories.

this is proof that demand outside the USA is now driving many price increases. 10-15 years ago, producer prices could never rise so fast without american companies in growth mode.

this gives me fear in 1-3 years. .. let's consider what I think will probably happen ...

the economy will weaken as the summer wears on. it will be in full-blown contraction as americans hunker down for winter with fuel oil at $4-6 a gallon. (this will hit traditionally democratic northeastern states like NY, MA, CT and VT hard... not sure whether that might have any significance.)

the new president, regardless of party, will be cajoled into a second "stimulus" package. this and other government-mandated programs will at first seem beneficial. but it will soon emerge that retailers and other companies don't have enough inventory to meet demand.

stores have been widdling down their supplies for the previous 1-2 years. the governement money will make them rush out to buy stuff, causing a rapid surge in prices... this will be the icing on the inflationary cake -- almost like afterburners on a jet, adding a splash of fuel to an already hot situation. (this is an example of why inflation is so hard to fight, it creates many coiled up springs ready to explode higher when they get a chance.)

there will be a rush of economic euphoria, followed by a troubling sense of dread and fear as prices shoot higher. companies that previously could afford to buy cheap merchandise from asia now are renogiating contracts and finding the price advantages have disappeared. people living in suburban areas full of costs will find their economic conditions increasingly precarious. with gasoline at $1, a lot of things made sense. people could live places like NJ, making $40-60k a year.. plenty of people made livings under those conditions. as prices climb higher, entire ways of life will be questioned. it will cause major transitions in our culture and civilization.

one final set of charts from me to end this panoply of data:

they show how personal consumptions expenditures (PCE) have taken over GDP and how debt has grown.

2 immediate conclusions:

the driving force behind the economy has been consumer spending growth. it has peaked and needs to contract. but millions of jobs and lifestyles are dependent on it. important economic and cultural interests such as governments, school and pensions are linked to it.

adjustments are already clearly underway as some sectors respond with export growth. but overall, the contraction of the consumer will have wide ranging impact on the economy... they're only starting now.

it's interesting to compare the US economy to GM. both grew for years by expanding consumer growth. over time, they took on medical and retirement liabilities. but investors trusted their name so lent to them...

companies tend to add debt as they mature. investors lend to them because their long standing assets are comforting to credit analysts. companies stop growing and use free cash flow to pay dividends or repay debt. this can be seen across the auto industry, the newspapers, telecom, etc.

throughout this process, the borrower is benefiting from the momentum of previous years of greatness. GM was too big to fail, so people felt comfortable to lard it up with social-spending costs. the US is the world's only superpower, so countries willingly pour trillions into treasuries. it's ok because everybody does it.

I fear that we're like GM in 1995 or so. at that time, they knew they had long-term problems. but they still had the balance sheet and size to lever up and take on higher costs and pursue bad SUV-heavy strategies. as a result, I believe the next big thing will be a surging government deficit, followed by huge treasury bond issuance. everyone is writing about how 10 year note yields need to rise and the curve must steepen.

one thing people forget is that the bubble that's bursting was not just a real estate bubble or a mortgage bond bubble. it was a US dollar fixed income bubble -- US dollar/debt

it was attached to anything in US dollars. securites like corporates and mortgage bonds can do great once the treasury market is in place. many bombs have gone off in credit, but none have yet touched upon the foundation: solid US creditworthiness. the crumbling of this institution is the next chapter of the crisis...

this US primacy was manifest in the late 1990s when capital fled asia and poured into the nasdaq. it was clear in early 2001 when the dollar surged to record levels against all other currencies. bubbles are built upon such senses of stabilty. (houses never lose value)

people have trusted in the US dollar (which is backed by US treasuries anyway), and thus been willing to accept US dollars as payment and to lend to our government and our people (via the bond market). that's what drove yields so low in the first place: massive demand for US debt... that's why wall street had to go out and reinvent new kinds of debt instruments like CDOs, etc.

most people don't appreciate that this was a bubble as well. like all bubbles, it will have a period of rampant production of the bubble asset.
let's consider other bubbles:
1-in the late 1990s, people loved stocks. so wall street invented companies to meet that demand.
2-in the 2005-2006 period, builders kept adding structures despite rising inventories of homes.
3-in the 2006-2007 period, lenders satisfied massive demand from credit investors with novel products to finance those homes.

as the new supply floods the market, traditional investors say "screw this" and start selling their holdings. a period of distribution begins -- this is how trends work.

the US treasury market is a very old and established, so this will take decades and play out in subtle ways. and it won't really happen until the final surge of supply as the government spends foolishly to prop up the economy and pay entitlements.

combine extremely low treasury rates (essentially negative real rates, adjusted for inflation), with a second stimulus package. the government will see income taxes plunge in the next 1-2 years. they will respond with huge deficit spending, funded with a big growth of treasury debt.

this surge, and subsequent collapse, has not yet been comprehended by the market. I have not heard anyone else express it, though it must be understood by many. all bubbles are the same. this one comes at the end of a very long multi-decade run. it's a very long-term trend, but it's still a trend. they all end the same way -- with collapse.

one also has to raise real worries longer term for the US as a AAA sovereign credit. the process of credit deterioration is underway. trends of this nature do not reverse quickly. more problems lie ahead.

Saturday, June 14, 2008

the case for coal

sometimes extremely promising investment opportunities present themselves. the coal industry currently offers on such chance for huge long-term upside with relatively low risk.

coal stocks have started moving higher in the last 6 months or so. I believe they're still in the early stages of a large trend that has the potential to enrich investors for years. it will also bring bring wealth to areas in the U.S. that have long been considered economic backwaters, such as west virginia. the way to profit from these trends will be to buy coal stocks and west virginia real estate. for disclosure, I own Peabody Energy (BTU) and the coal-sector ETF (KOL).

why coal? several reasons:

1- relative to other sources of energy, it's very cheap.

  • one ton of coal has about 20mln BTUs and costs $50-$100. that's 200k-400k btu per dollar
  • one thousand cubic feet of natural gas has 1mln BTUs and costs about $8. that's 125k per dollar
  • one barrel of oil has 5.8mln BTUs and costs about $130. that's 44.6k per dollar.
2-coal exports are rising rapidly and will continue to surge. coal exports rose 19% to 59.1mln short tons in 2007. helping this argument, china's currency remains on a one-way path upwards, which will make our dollar-denominated coal increasingly attractive to them. consol energy, for instance, said it might expand its export facilities in baltimore to accomodate strong international demand.

3-coal prices only started moving higher early this year... below is a chart from the Energy Information Association web site:

4-coal companies are raising their earnings and sales estimates. peabody energy raised its EBITDA guidance by $500mln, while alpha natural resources raised its estimates for both overall production and the price it gets per ton.

5-coal inventories are low and need to be built up. this is more of a short-term consideration, but it should keep coal hot for several months.

  • Consol Energy indicated low stockpiles at its customers on the east coast and mines.
  • China's "social coal reserves" (whatever that is) fell 4% in the first 4 months of 2008. source
  • UBS raised its forecast for coking coal prices because of tight supplies
6-coal pricing is shifting to the spot market from the long-term contract market. typically, coal is sold under contracts with prices locked in over a period of several years. increasingly, it will be priced according to daily trading markets. that means speculators can enter and drive prices much higher.

interestingly, oil was also priced under so-called "official prices" until the embargos of the 1970s, when the spot trading became the dominant way to value the commodity.
I have long hypothesized that the shift from contract to spot pricing will augur well for coal. consol energy CEO j brett harvey confirmed this in the company's last earnings report:

"What is most significant about these developments is the influence spot pricing is having on long-term transactions for delivery beginning in 2009. "

finally, most US coal production comes from the powder river basin in montana and wyoming. but I suspect west virginia real estate will be a big beneficiary. so far, there has been little but anecdotal stories about mines hiring more workers. overall, the state's coal production has been flat for years. with rising prices globally, it seems like companies will ramp up production (maybe that's why I've been hearing about increased hours being worked at the mines). that will mean spending in the local economy and rising incomes. so far, it's just a hunch.
I think some kind of commercial real estate would be the ideal play. the people in that state have been burned many times and feel beaten down by nature. it might be possible to buy land in key locations at cheap prices before the locals even know what's happening.