Sunday, August 31, 2008

is school too feminine and prone to deflation?

my friend's 11-year old son has stuggled at times in the academic environment. he sounds very bright and skilled with his hands, but does badly on tests. literature, culture and art bore him. he's happy dissecting animals and playing sports and doesn't want to bother with writing and poetry.

the school environment doesn't appeal to many boys because it's very female-dominated, according to my friend.

this has long been my general opinion about schools. by forcing boys into classrooms at ages 11-14, you can make them hate school forever. I have read anecdotal stuff suggesting this is the case for years... about 2 years ago, the new york times reported on colleges having too many female applicants because boys weren't trying to excel in academia.

I think male human beings are much more capable of appreciating culture and art when they're closer to 20-25 years old. in their early adolescent years, they are mainly interested in sports and blowing things up.

it also appears that education became less masculine as college-level education spread. there's no time for learning carpentry or welding -- which was taught 40 years ago. instead, there's just studying and competing on tests.

in my town in CT growing up, something like vocational training wasn't even an option. everyone was expected to attend college.

add in the easy money of government-backed student loans, and the higher-education bubble began to inflate.

once again turning to the new york times, a woman named hannah seligson compares academia with the real world:

... In my graduating class (more than half of which was female) there was a feeling of camaraderie, a sense that we were helping each other succeed.
Then I left the egalitarianism of the classroom for the cubicle, and everything changed. The realization that the knowledge and skills acquired in school don’t always translate at the office is something that all college graduates, men and women, must face. But for women, I have found, the adjustment tends to be much harder. It was certainly hard for me — I lasted only nine months in my first job out of college.


ever since I was a child I doubted this obsession with academia... it seemed strange to me being surrounded by tons of steel and concrete at school, riding in a car that magically just worked, eating food that came from boxes at the store.
unlike most humans in the long line of history, we moderns don't think about, or even understand, how our basic need for food and shelter is met. boys learned to hunt, farm or perform a trade from childhood. girls learned to be mothers.

until about 80-100 years ago, most children would be contributing economically to their families before the age of 10. by 20, they would be supporting their own families. they didn't have time to waste on non-essential things. they were too busy struggling to survive.


the post-WWII, higher-education oriented culture didn't ask children to make money or provide for their families. the parents who knew the great depression wanted something better for their kids.

but what if this avoidance actually reduced their attention span because it forced them to focus on matters that were literally "academic"? what if they knew the material wasn't directly helpful? would they stay engaged?

I believe schools gradually became more female-dominated in the post-WWII era. (it seems that things like markmanship and boxing used to be far more common, for instance.) at the same time in society, office work grew more common and industrial jobs declined.

I hope we can regain some positive momentum in our schools. but first, they will need to suffer as the money runs out. I have previously stated that education is another bubble that's breaking now. I dug into the historical CPI data and found some worrying data that should worry the entire educational establishment:


college tuition could be entering a deflationary cycle.

between 1984 and the end of 2007, it rose 453% if you look at the BLS's seasonally adjusted data. the overall CPI level increased just 110% over that same period.

since the end of 2007, college tuition rose just 3.8%, while total CPI rose 4.7%. it seems to be the first time education prices went up slower than everything else.

given the fact this is also a debt-financed asset, it is also vulnerable to deflation. people spending someone else's money have driven up the cost of academic training, spurring excessive and wasteful investment. now these institutions will have to retrench under a heavy cost load as students are able to afford less.

while I don't know much about education, I know it's not run like a normal industry. without a profit motive, people have no incentive to be efficient or minimize costs. young adults were steeped in a cultural bias in favor of a college education, then offered a pile of cash to go study.

nowhere along that route did anyone step in to say "you shouldn't run up $70,000 of debt studying english and drama"... at the same time, an entire educational industry was marketing itself to prospective students.

to boil it down: for years the universities got rich by telling students it was ok to mortgage their futures. for years, students accepted this premise. for years, investors gobbled up the billions of dollars of securitized student loans.

now kids see home mortgages inflicting pain on their parents. it seems they will be much more wary of debt in the future, and much less willing to borrow wantonly. at the same time, investors throughout the credit market are demanding more and more spread to compensate for any risk. this will drive up rates on people who are already feeling jaded about heavy debt loads.
once credit freezes up, prices will inevitably follow. some schools will start cutting prices to win students... some will go under. hopefully at the end of the process we'll have a healthier and better run university system. but getting there won't be fun.
this is what deflation looks like... change in college tuition every year - overall CPI. I call it "excess inflation". after years of running far in excess of normal inflation, college tuition is now running behind. this multiyear process is only now beginning.
the last data point is just comparing july with december, instead of december-december..



hopefully, in the future we'll revive vocational training and some of bill gates' billions will go to teaching solar technology to inner-city boys. colleges and universities will get squeezed.

Friday, August 29, 2008

mccain's gift to conservatives

I have one initial reaction to mccain's selection of sarah palin as his VP candidate.

as much as he has troubled conservatives, he might have just saved their movement with her selection. she is immediately approvable and popular. she neutralizes obama's novelty factor, while bringing anti-corruption, youth, energy and pro-life values.

I think mccain will now win this election and leave office after a first term. she would then stand down hillary in 2012. her youth immediately relieves mccain's basic age problem.

has he discovered the next TR?

an economic surprise?

the rest of the world needs the US consumer as a source of demand.

growth in the rest of the world has kept fuel prices high, hurting the consumer

what if death of us consumer deprives the rest of world of mkt

what if they slow , pushing oil lower

at same time, USA cos get a lagging strong wave of exports

at same time, people keep working hard to somehow find a way to pay bills.

this boosts production and income in USA

it could be another wierd feedback loop...

there is leverage in EM off usa consumer... we are the driver, they are the high-beta economic off shoot

the recent strong economic data makes me ask this.



I wrote email the evening of aug 27 .. I think it raises some key issues:

I am starting to feel a little more bullish about stocks. I think if this hurricane doesn't do much damage and the world doesn't end in russia, we might see a big rally after labor day. there is so much cash on the sidelines and some important trends are occurring in certain key industries.home builder stocks have hit a double bottom and have more room to bounce.the dollar may continue to rally. small cap still looks good. the russell 2000 is consilidating above its 200dma.right now, there is huge pessimism, short interest, and cash on sidelines. all of that can snap back and drive stocks higher. also, the homebuilders and the dollar are both rebounding from very long-term selloffs. they can rally a lot before stopping.as a bear, I worry about russia because I think that as long as we avoid nuclear war, it will be bullish. what I mean is that if it gets resolved or at least temporarily goes away, that will drive buyers into the market. I don't want to make decisions based on something as random as russia. but here I think the likely short term effect is either nonexistent or bullish. those are many potential things that could spring back into the bear's face, like evergreen branches in the new hampshire forest. the shorts will cover ... cash will come off the sidelines, and this market could make a move higher.I am not sure about the probability of this scenario. but I am seeing some potential lines of causation that could matter.on the bear side, I see few likely factors that can come into the market. we're already discounting an awful lot of bad news.

Wednesday, August 27, 2008

russia & georgia -- don't be reactionary

communists wanted to purge reactionaries... and they might have had a point. reactionary people are inherently weak and vulnerable to be killed in a battle.
if a fight must be had, it's always better to be the attacker.
I worry about georgia right now for many reasons.. most importantly, we need to focus on afghanistan, iraq, iran -- and maybe even north korea. georgia's only relevance is its oil pipeline. and, if the russians decide to march south again and cut off the pipeline, are we willing to stop them? the only lever we'd control at that point would be the rather heavy hand of nuclear war.

they know this. that's why they attacked. they were very cleverly proactive. they have chosen this battle at this time. (also when our next head of state is still being decided.)
if we decide to respond to their provocation now, we are being blindly reactive... learning the rules as we flail around.

we are fools if we decide to fight their terms. reaction is not a good policy in a company, a war or geopolitics. it's better to fight them when we can be proactive and choose the battleground.

it's time to save money

after watching this tiresome self-laudatory democratic convention, I started wondering what specific things should be done. it's easy to be cynical about our parties. they speak of things like $1000 tax credits for this, or vague references to universal healthcare -- without any mention of what form it will take. are we really to believe that the HMOs and drug companies, with their money and lobbying, will face any real challenges from this democratic party?

what bothers me is that they don't talk specifically about real problems.

broken education -- for years, americans have complained about public schools, but been able to take solace in their universities. problems looming in the student loan business, which recklessly lent billions to unsuspecting minors, threaten to strike at its soft financial underbelly.

education was its own bubble -- financed by a wave of cheap and easy money.

bubbles end badly. education won't be any better and we're only now starting to see the start of this process. it won't improve quickly.

broken production: for various reasons, economic production has been leaving the USA over the last 40 years. everything prompting this decline -- taxes, environmental and labor laws, plus the myriad issues I don't even know -- remains in place. I don't see a reason to expect a change soon. factories won't just magically spring up in this economy.

companies have been taking capital back out of the economy (more than $1.9 trillion of net stock buybacks since the start of 2005, according to the Flow of Funds report.)

executives don't see investment in the U.S. as very worthwhile. that's why capital expenditures by non-financial companies rose 40% between 2002 and 2007 (according to table f.102). but net stock buybacks rose 1277%.



broken consumption: over the last 10 years, it has relied on debt, not real income growth. that's why household debt outstanding it up 81% since the start of 2002, while the overall economy is only 36% bigger, according to tables L.1 and F.6. now that the big spenders, aka babyboomers, need to think about their retirements. the days of blowing hundreds on impulsive purchases of new sheets at the linens n things is over. people need to tighten belts now.

broken healthcare: need I say more?

broken institutions: whether's its OFHEO, the FAA or the FDA, they're messed up.
this really should be no surprise when you look at the entity carrying it out: the federal government... the federal govt has been a disaster on domestic issues since it was created in the 1790s. it was charged with taking care of indians and permitted their rapid genocide. its next big job was to protect freedman after the civil war; jim crow followed. then we asked it to prevent large monopolies in 1890s, and the greatest wave of corporate consolidation followed under JP Morgan.
still, the federal bureaucracy grew... especially in the 1930s and 1960s. but it's a terribly ineffective organization that has messed up healthcare and education.
(this is a basic structural problem that worries me about washington. too many people make money from the corruption and special interests. they will fight to hang on.
when you look at federal power closely, you realize much of it comes from an expansive reading of the interstate commerce clause: everything from workplace civil rights to environmental laws to labor standards is based on this reading.
this was never the intent of the founding fathers. if they had wanted the federal government to rule in these areas, they would have given it more oversight and more definition. they were masters of government. in the places they did structure government, they created things like the overlocking system of checks and balances we still revere today -- they wrote the book on seperation of power and written constitutional law.
aside from a handful of specific powers, such as issuing money, defining bankruptcy norms and running a post office, the federal government was given almost no authority under the constitution. the supreme court even ruled in 1875 that Washington has no direct power over cititzens. this ruling was upheld in 2000. (link)
quite simply, the federal government was never meant to do 80% of what it does on the domestic front. because things like medicare and medicaid were never designed by the genius of our founders, but by lobbyists, they can never work. )

so, what should be done? what sort of solutions, however implemented, would help?

it needs to begin with real costs affecting real people...

most importantly to me:
the government needs to seek ways to cut costs.

my idea is simple: the federal government already provides hundreds of billions for various healthcare programs. I propose that washington instead pays individual states to cut their health-care costs. the lower the healthcare part of their CPI report, the more money they get.
this would shift responsibility to the states, the same way progressivism worked in the 1890s. few people think about all the positive things STATE governments did long before FDR, etc.

at the same time, rotating councils of randomly chosen citizens selected by age, would monitor the situation in each state. no politically tainted public appointments.
the nice thing about our economy now is there are so many kinds of waste that can be taken out of the system. people can do more than just drive smaller cars. the internet will open up entirely new options in things like carpooling and remote office work.
houses that now bake under the sunbelt's glowering blaze can be covered with dirt, significantly reducing the their need for air conditioning. roads can be adapted to suit more scooters and smaller vehicles. the average person just doesn't need to carry around so many tons of steel.

I also have proposed a new financial paradigm to channel capital effectively into alternate investments: letting companies like Exxon Mobil set up green companies as subsidiaries that could be spun off as separate companies at advantageous terms. this would slow some of the disinvestment currently occuring via stock buybacks. (I believe Exxon is #1 on the list of stock buybacks... why not use that money to create jobs, promote alternate energy AND enrich shareholders all at the same time?)


(also, when I considered the education bubble before, I realized that a bubble is actually just localized inflation. it happens when the money supply matching an asset grows easy, especially when the money is provided by a profit-seeking lender ... such as housing. there are also the non-debt funded kinds of inflation, such as the stock market bubble in the 1990s or cases of real demand growth. but it's interesting to conceptualize it as localized inflation.)

Saturday, August 23, 2008

Pimco vs the ECB

some of the comments coming out of the Fed's annual symposium at jackson hole highlight big tensions on the global monetary scene:


"it's beyond me people in our business consider the fed is thinking about raising interest rates. part of it's because you have the inflation hawk/nutters who are talking all the time. [ the majority of fed governors ] has no intention of opening up more downside risk to the economy, financial system, by tightening interest rates now."
-- Paul McCulley, Pimco managing director and de facto spokesman for Fed Chairman Ben Bernanke.


"The medium term outlook for inflation is still crowded by inflation risk we simply need to take care of.
We get, of course, complaints from European enterprises that in terms of competitiveness it has eroded due to the exchange rate.
[ European companies ] ... have become more competitive out of their own strengths. Competitiveness is won conducting business. It's not won in the foreign exchange market.
We have to consider the economic impact the interest rate has but it's not a major target for our monetary policy conduct. There we focus on medium-term price stability." (bold added)

- Axel Weber, Member, Governing council of the
European Central Bank & President of
Deutsche Bundesbank (Germany's Central Bank)
both quotes were made on CNBC in response to questions from reporter Steve Liesman. (link to McCulley.. link to Weber. )
normally I would not include such long quotes, but these highlight strongly the bigger long-term trend happening in the global money system: quite simply, the US dollar is in a long-term process of decline. this will hamper the wealth of americans over the next 20 years and reduce our economic power, which will have significant political and even military consequences. comparing these two quotes emphasize more than ever that 20th century, the "american century", is over. we have entered a new era.
[ as a proviso, I should add that the US dollar will probably do pretty well over the next 4-8 months. over the longer term, it has major problems. ]
some quick background: WWII elevated the US to a dominant position in the global economy that no country had seen before or since. we supplied most of the war effort, and then proceeded to rebuild europe. under the bretton woods system, most global currencies were essentially pegged to the dollar. this caused the greenback to serve the same purpose as gold under the 19th century British system.
this system grew strained over the years as the european and asian economies developed. this caused the dollar to be devalued in in 1971. it continued to decline for the rest of the 1970s and inflation accelerated. at one point it got so bad the U.S. had to borrow in german marks.
this ignominy ended when Paul Volcker raised interest rates above 10%, which broke the back of inflation and restored confidence in the greenback. no one realized it at the time, but Volcker had unleashed perhaps the biggest, and most important bull market, of the 20th century. from december 1980 to december 1986, it surged 52% against the currencies of our main trading partners:



(click here for the source of the data)

the dollar then weakened throughout the 1990s, only to come roaring back in the late 1990s as the asian financial crisis caused people to seek safety in our currency.

importantly, whenever the dollar has gained in value, americans went deeper into debt. this was because foreigners don't just fill up their mattresses with cash -- they lend to the U.S., normally by buying our bonds. this makes money cheap to Americans and causes us to borrow.

this is essentially what caused the subprime mortgage crisis: excessive foreign money in our economy caused banks to use it recklessly. for instance, when gasoline is cheap, GM and Ford churn out gas-guzzling SUVs. if caviar was $2 a pound, you'd see it on sandwiches at subway.

getting back to the ECB and the Fed. over the past year, the Federal Reserve has cut interest rates more than half ( from 5.25% to 2% now) because of the subprime mortgage crisis. on paper, this allows banks to borrow at cheaper rates. the plunge in home prices has seriously reduced the value of mortgage loans backed by the those houses. this has triggered hundreds of billions of dollars in losses by the banks. when they lose money, they have to stop lending for a while until they rebuild their so-called capital cushion. one easy way to let them rebuild their capital cushion is to lower their borrowing rate. if they can get money from poor schmucks like me at you for 1-2% in our savings accounts, and buy safe treasuries yielding 3-4%, the resulting profit helps them rebuild their capital.

(this is what alan greenspan did in the early 1990s after the savings and loan crisis, when banks also faced huge losses. as noted above, the Fed's easy-money policy also caused the dollar to depreciate at the same time.)

the problems with cut interest rates is that it makes a currency worth less and stokes inflation -- which is what's been happening over the last 6 years, and is why oil prices have skyrocketed. that's why some members of the Federal Reserve (along with Paul Volcker himself) have expressed serious reservations about our rapid interest-rate cuts.

Paul McCulley mocks these "inflation hawk/nutters." he thinks it's more important to let the banks recover and to keep the U.S. economy out of recession.
this makes sense to a limited degree. inflation tends to slow during a recession because weaker demand pushes prices lower. also, when banks stop lending, assets such as houses collapse in value, which is also deflationary. this is why the textbook says to cut interest rates during a recession. (many academics have rightly observed that tight interest rates, which made it harder for banks to lend money, prolonged the Great Depression.)
I am not sure if McCulley fears "deflation" per se, but some observers, like former CNBC contributor Ron Insana have expressed concern about a spiraling effect of price declines. to me, there is one major problem with the deflation thesis: exchange rates. every instance I can find in economic history of "deflation" came after a country's currency appreciated in value:

1- the UK had deflation in the 1920s because it tried to return to the gold standard, which made the currency too strong

2- the USA had deflation in the 1920s because it had amassed great gold reserves during WWI, which made the dollar stronger. the great economic slowdown of the Great Depression then made deflation much worse, but it cannot be ignored that currency appreciation, not depreciation, preceded the crisis.

3- japan had deflation in the 1990s after the yen roughly doubled in value.

4- hong kong had deflation from about 1998-2004 after the asia crisis. while neighboring countries devalued their currencies after the asian financial crisis, the hong kong dollar remained pegged to the U.S. dollar. that was a de facto form of currency appreciation.


the U.S dollar is now in a totally different position than any of these cases above. it has lost about 18% of its value versus major trading partners since 2003. while this isn't a massive devaluation, it's still a devaluation. furthermore, our external trade has accelerated recently. all of these forces oppose the deflationary process.

in an earlier posting, I argued that the ECB's next action would be to raise, not lower interest rates. at the time, this ran counter to every expert and strategist on Wall Street. sure enough, on july 3, the ECB boosted its rate by 25bp.
it didn't take any stroke of genius to predict this. all I did was listen to the words of the central bankers themselves who adamently maintained they were going to keep raising rates.
this time, weber is still giving us the same message: inflation is too high and we need to make it go down. we want it at 2% and it's currently 4%. furthermore, he says the recent negative GDP readings were caused by seasonal factors. but most importantly, he stresses that europe is not experiencing a general credit crunch.

this is the key difference between the USA and the eurozone. the USA is now facing up to a 50-year process of leveraging by the consumer: mortgages, credit cards, home equity loans, autos and student debt. it's spread throughout the economy like termites on the frame of a wood house. millions of people have huge debt coming due over the next few years. it's either coming due in the form of mortgage resets or things like auto leases expiring. they're all slightly different in how they work, but they will all have a similar effect: pushing down the price of assets.

after all, if you choose not to keep your SUV after a 3-year lease, you as a consumer isn't hurt, but the leasing company is. now that big SUV's are worth less, it has a smaller asset against the debt it owes. that means it has less capital to buy more cars going forward.

now, things like credit cards and student loans are not tied to any single asset. but every dollar people spend to pay these off takes money out of the economy -- it's one more bill to pay. the easiest solution is to simply reduce the value of money. in other words: inflation and depreciation.

this is the dirty little secret people like McCulley don't want to emphasize. in fact, he has spoken of the need to "manage" the dollar's decline. and if you listen to his boss, mohamed el-arian (one of my financial heroes), the dollar will continue to lose value.

when you contrast this with major euro economies like germany and france, you find they have much less debt at the consumer level. yes, they have long-term government liabilities tied to social security, etc, but they aren't hamstrung by a debt-riddled consumer. if anything, they have been experiencing a wage-price spiral much more similar to the US in the late 1970s. if you look back to the 1970s, the Fed responded by hiking rates, which triggered a dollar rally. now the ECB is refusing to cut rates... my question is: what if they pull a volcker? what if they decide they can tolerate a slowdown to kill inflation? what if they keep interest rates high or lift them again? what happens to the US dollar?

one final thing to worry about on the inflation front: deficit spending in the USA. the deficit will probably exceed $500bln in 2009 and could continue to expand in coming years because of falling asset prices (which mean less capital-gains tax revenue) and weak income growth. then the democrats are already talking about the need for a second stimulus package, and I would also add the minimum wage will also be increased. this would also be inflationary.

this is my fundamental worry with the current situation. inflation is often caused by complacency and a desire to protect the economy from contagion. it's easy to do because inflation only becomes a real problem over time. it discourages people from investing in the economy or putting money into financial assets. it drives money from bank accounts, where it can be lent out to help businesses, and into perverse things like gold or foreign currencies.

while I think the dollar will probably do pretty well over the remainder of the year, its underlying problems will last for years. I still think we face a situation similar to latin america in the 1980s. their economies had enjoyed massive inflows of capital, which resulted in large, unsustainable debt loads. their ultimate response was to print money and devalue their currencies, resulting in triple-digit inflation rates. it probably won't get that bad here, but the paralells are numerous. I was in latin america in the late 1990s and saw the result of this long process -- it was decay, capital flight, a lack of investment and stagnate incomes.

one more thing worth looking at on the inflation front is commodity prices. they fallen a ton since the middle of july. it's hard to predict the duration of this correction, but global demographic factors should keep commodities in tight demand. let's look at the ages of the USA, India and China:





the last time the dollar fell significantly was the early 1990s. that helped reduce imports and trigger one of the best economic booms in history. also lending a hand then were falling global commodity prices and a perfect demagraphic situation in the US as the babyboomers hit their prime earnings years.
this time things are different. we have an older population, less slack in food and energy, and much nearer-term debts coming due (mortgages plus social security). and, we're a less attractive country to invest than most others (there's a reason jobs and capital have been leaving.) add to that the likelihood of a worsening political crisis in washington (I'll get to that in another blog entry) and the US faces some major headwinds. going forward, we're going to see more and more of the world's economic growth simply bypass the USA.
comparing the comments of the pimco vs ECB help to see what's really going on.

Wednesday, August 20, 2008

more bear paws on the street

I recently returned from rural new york. while bears were nowhere to be seen, I found many droppings under an apple tree. and plenty more apples are on the tree, their feast should resume soon.

I think this is an apt metaphor for wall street these days. after a month of charging bulls, I think they're running out of energy. below is a commentary I wrote to a friend last night after returning from my upstate journeys:

I have been watching this market bounce and think it's time to be bearish again. it looks like the sp-500 is failing to hold the 50dma. on aug. 19, it also failed to hold the uptrend established since the july low. and it failed to break SIGNIFICANTLY above what I considered important resistence around 1273. if you compare it to other recent breakdowns, it doesn't look good for the longs. we broke above that resistence by just 2.5%, so I think the recent high on aug. 11 or so were a "false breakout". intraday on aug. 11, we also bounced off a trendline dating back to to the closing levels on may 19 and june 5.

fundamentally, this recent bounce off the july lows didn't make much sense. supposedly, strong foreign economies were keeping us out of recession. now that europe and japan are hurting, what's left to be bullish about? this whole "strong dollar" rally never carried water to me.

however: I see three problems now with the bear-market trade, just to view the other side of the argument:

1-the global economy gets really bad and oil collapses further.

2-lots of cash remains on the sidelines and short interest is still considerable.

3-the US economy may still has a trick or two up its sleave... first, businesses seem to be rebuilding inventories from very low levels (this is the reason we don't have breadlines now)

also, with so many people in debt, I suspect unemployment won't pick up considerably. plenty of babyboomers owe tons of money and have kids in college etc, plus their retirements to fund. they're not going to just stop working. they will find something to do.

I know that's pretty abstract stuff, but it could prevent key numbers like the monthly payroll report from falling off a cliff. that means that the dollar might hold its recent gains and keep a lid on oil prices.

still, I think we're setting up for a bounce in oil and energy in general. fundamentally, OPEC is now talking about cutting production and no one is pricing in the danger of things getting worse with russia. and, the shorts have failed to break the key support level at 110, even with a benign hurricane season.

also, many china watchers expect them to ramp their economy back up after the olympics. technically, crude has held that support level, which also corresponds to the 200dma, so that's bullish. and, the downward momentum is waning, with the oscillators looking poised for stability, if not a turn higher.

still, I don't expect a prolonged rally. I doubt we'll even challenge the recent high on oil. that means it might be time to short the airlines. I know that was a lot to say. but there are more uncertainties now than there were back in may, which was such a perfect bearish setup.

the european economic outlook is much less certain now, and that will have much more relevance to US markets than it did before because of the oil/dollar angle. this makes me less of a raging bear than I was before.

to sum I up, I'd say I think the market will try to rally some on Aug. 20. I would look to sell into strength, especially if the sp-500 gets above 1280. but then we'll drift lower, probably to retest the july low. (MER is looking pretty sick in particular.) I think the airlines might be a good place to get short as well. they are up big and might look to raise some capital.

here's another good long-term reason to be a bear... think about the fed vs other central banks. we've already cut rates about as low as they can go, and haven't even had a negative GDP reading yet. europe and other economies (like australia) are slowing down, but have plenty of room to cut rates.what it means is that, unlike the rest of the world, we can't cut rates.

any strength in our economy is a reason for the fed to raise rates, which is bad for stocks. either that or they just let inflation run away (which I think it pretty likely as well because it's the easiest way for us to get out of all this debt), which would also be bad for stocks.

Sunday, August 17, 2008

squeezing Big Food

in an earlier post, I mentioned that the "integrated corporate" model will face increasing pressures in the coming years. more news has come out on this theme....

first, to define the "integrated corporation".. this is something like Campbells Soup or Coca-Cola (which I own). it's called "integrated" or "vertically integrated" because, unlike earlier kinds of businesses, everything from production to sales and marketing is organized under one roof.

just 150 years ago, there were no food brands. farmers harvested vegatables and raised livestock. either they sold it themselves or some kind of middle man would buy it to sell in urban markets. while there were differences in quality, people had to make these distinctions and decisions on their own. the key thing is that each stage of the economic activity is done on its own, by separate parties, each following their own interests.

this lasted until James Buchanan Duke created what became the American Tobacco Company in the 1880s. why did this happen when and where it did? the answer: technological change made production easier and opened up completely new realities.

in the case of Duke, it was the automatic cigarette-rolling machine. this device suddenly made it possible to churn out butts on a greater scale than anyone previous had imagined. facing a potential glut of his own product, Duke built a network of sales and marketing offices whose personnel visited local stores on a regular basis, making sure they sold Duke's products such as Lucky Strikes. they took charge of who sold what and tracked rival products to undersell the competion. they also maintained consistent quality by taking back unsold items after a certain amount of time.

this is how brands were built. by the early 20th century this management structure was spreading rapidly throughout the country and the world. (others included Kellogg, Coca-Cola, Standard Oil, etc.. in fact, this kind of company played a big role in the 1920s stock-market run-up).

one important thing many people don't realize about this structure is that it is utterly interconnected with the mass-production model. if you're going to sink millions -- or billions -- of dollars into factories, you better make sure someone is going to buy what gets churned out. that means a constant stream of orders, aided by a fleet of trucks, to keep paying the bills.

in essence, the brands we all know and love are designed to pay for the machines of corporate executives and their investors.

this was a wonderful arrangement because mass production let companies make Corn Flakes, Mac & Cheese and Fritos cheap enough for the average person to see value in them. inexpensive fuel and a road-building government also allowed trucks to reach retailers spread across the increasingly sprawled suburban landscape.

it's obvious these factors are changing. fuel and commodity costs are up 40-100% in the past year. even though they have pulled back recently, prices will continue to rise as millions of indians and chinese enter the middle class. for instance, in kellogg's latest earnings release, the company's profit rose a mere 4%, despite an 11% growth in sales.
(management tried to exaggerate profit by borrowing money to repurchase their own stock... they have added about $350mln of debt this year, leaving them with a smaller book value than they had in december. don't be fooled.)

but something deeper is happening in addition to the food-and-fuel price squeeze. this is from a recent press release by Unilever:

The top five categories where shoppers would reduce their expenditure if the economy continues to struggle include: air fresheners; cookies; beer/wine; frozen dinners; and soda/pop.

this might not come as much of a surprise. but if you look more closely, you realize these are the kind of high-margin items that allow the classic integrated food company to profit. things like frozen dinners and air fresheners... now, it might not sound like a big category.. but I think it means something more than just these two items. when people are struggling to make ends meet, they will avoid the more expensive items that come in fancy packaging. they're also more inclined to buy in bulk, seek items on sale, and use more coupons.

Unilever continues:
Consumers would like manufacturers and retailers to be creative in product packaging and sales approaches. There were several shopper preferences including introducing larger pack sizes, smaller package sizes at lower price points, and modestly reduced package sizes with the same price point. ... [ shoppers ] are taking a new approach to shopping as our study found that quick trips to the grocery store are declining and major stock-up trips that allow consumers to replenish their cupboards for a long period of time are on the upswing.”

I might be jumping to conclusions here, but when I read that people are buying more stuff at once, seeking bargains and bigger containers, while avoiding quick trips and convenience foods, I see that consumers themselves are shifting to lower-margin items. not only are the food-company margins being squeezed by food and fuel .. they're also being squeezed by people's choices.

this is from Fitch Ratings most recent Leveraged Finance Weekly (aug. 15, 2008):
"Until recently, the larger packaged food companies have been able to cover their commodity cost increases through higher prices and efficiency measures while maintaining volume growth," says Philip Zahn, senior director with Fitch’s retail and consumer team. "However, it is becoming increasingly clear that, for most companies, this is not sustainable."
while Fitch was referring to European food companies, I believe the situation will be roughly the same in the U.S.

finally, underlying all of this is the revolution in information.

on one hand, the big integrated industrial companies I discussed above benefitted from their ability to feed cash into their mass-producing factories. but here's another way of understanding this: big, vertically integrated companies enjoyed a huge advantage in terms of access to information. a network of sales and marketing people tracked many different geographic areas and market segments: they reported back to the big suits where new grocery stores were opening and who was buying what. these same executives recieved information from procurement people who tracked agricultural trends and commodity prices, production people who could apply cost-saving techniques to the entire enterprise, and finance people who could find the cheapest ways to pay for everything. because it united all this under a single roof, the real advantage of the integrated corporation was its consolidated base of knowledge. (another way to understand the importance of information is to consider the proliferation of white-collar jobs in the 1950s and 1960s -- armies of workers who wielded numbers and reports rather than hammers or ploughs.)

the internet is already chipping away at this advantage for many industries. the record and newspaper industries seem to be the first victims. (both made huge profits by monopolizing access to information in the analog world, when the transmission of knowledge was finite and restricted to physical media.)

while it might seem that big integrated companies in industries such as food are immune to this, don't count on it. executives at these companies would tell you their market knowledge and sales networks are some of their biggest competitive advantages. (these are essentially assets... now that there are more information assets in general, theirs by definition would be worth less.)

I know people who are now buying beef and poultry directly from farmers, and the "buy local" movement is in its earliest stages. farmers' markets are also growing increasingly common.

while some big companies like wal-mart will find ways to piggyback on this trend, it's inherently negative for the big integrated food companies that rely on buying from far away, expending lots of energy to process and ship food, only to then spend more money on advertising trying to convince you to buy it. ordinary people are getting more access to the same kinds of information the big companies have and will cut out Big Food, which is essentially a middle man between farmer and consumer.

if any lesson is clear from the last 10-15 years, it is that access to information drives middle-men out of business. this has happened in financial markets and online with things like eBay.

I am not saying any of these companies will go out of business... my point is that large consumer-products companies are starting a long process it will be a long and slow process of experiencing this squeeze. and, I suspect it will happen more in categories such as food than items such as cleaning supplies.

it's a secular trend that is only now beginning.

Thursday, August 14, 2008

worries on wall street

I have to admit being surprised by the strength of the bounce in stocks recently. I had expected more follow-through to the downside instead of this rebound higher.. this was partially because of the continued weakness in oil.

however, I see many things shaping up that are all bad for stocks.

first of all, the geopolitical situation has the potential to become less stable. the conflict in georgia and the looming departure of musharraf in pakistan could result in an number of unpleasant outcomes.

secondly, oil is not done with its upside. I would expect to see another rally in a month or two. few things in the stock market currently look as bullish as an oil chart.. most other industries are in full-fledged collapse and the evidence points to further economic weakness ahead.

we're bouncing higher at this point, but I wouldn't expect it to last. I would be surprised to see the sp500 close above 1320. I think we'll move sideways around the current 1290 level for another week or so before resuming the trend lower.

our insane foreign policy establishment

theodore roosevelt's guiding principle in foreign policy was to "speak softly and carry a big stick." when it comes to our handling of the current situation with russia, the approach seems to be to "speak loudly and carry no stick."

russia has completely disregarded the west's interests in georgia, laying bare our complete impotence in the region. now talk of adding georgia to NATO has collapsed and our secretary of defense is warning the kremlin: "pull out, or we'll say mean things about you." the very notion of adding georgia to NATO was unwise in the first place because it would commit the US to war against anyone who might attack -- including russia.

aside from an oil pipeline, georgia has little importance to anyone in the bigger world. it's a small, unstable country wedged between russia and iran, controlled by moscow over most of the last several centuries. does anyone consider it a worthwhile place to start WWIII?

in reality, our pushing for its NATO membership was always a dangerous provocation to russia. when moscow tried to place missiles in cuba, the US correctly resisted. if canada were to suddenly withdraw from NATO and ally itself with Russia, we might also object.

it doesn't take a genious in foreign policy to understand that washington's embrace of tbilisi was a poke in russia's eye. the most worrisome thing is that it was one of many delivered against the russians in recent years. others include:

  • the recognition of Kosovo as an independent country
  • the plan to station anti-missile defenses in poland
the kremlin provided ample warning in both cases it opposed the measures. the georgia incident cannot be understood in a vacuum. russia has been attacked at least three times by europe (napoleon, WWI, WWII), and already supplies the continent with much of its natural gas. now the europeans are trying to encircle them and establish political supremacy by imposing their will in the balkans. there's little surprise the kremlin gets worried.

the US currently has major military and diplomatic commitments in iraq and afghanistan, and would like to excert some influence in Iran. these are major responsibilities where russia's help would be of some use -- especially in iran and afghanistan. instead of looking at these realities, our foreign policy establishment is committed to expanding and strengthening this behemouth called NATO. how will kosovo independence help us in Iran? how will missiles in Poland or hot air over georgia help us combat terrorists or ensure a positive outcome in next year's election in Iran?

if anything, it will fail on these fronts... after all, it proves the US is nothing but a paper tiger: after giving moral support and military training to the georgians, we leave them twisting in the wind when the rubber hits the road. why would a new regime in Iran want to work with such an unreliable power? how can the next government of pakistan, whatever that is, feel confident working with us?

as I posted in an earlier blog entry, the US needs to seriously reconsider its foreign policy objectives. we need to carefully identify our interests and our natural allies. in my view, russia is our strongest natural ally. aside from the cold war, when the kremlin extended beyond its normal sphere of interest, russia has always been the ally of the english-speaking atlantic power. aside from the crimea war of 1854-65, I know of no time that russia and england were not friendly with each other. russia was also one of the first countries to recognize the USA after indepence, sold us alaska and found itself on the same side as us in WWI and WWII.

unlike our relations with other countries, such as mexico or china, russia and the USA have nothing to fight over. we have no territorial or military disputes. the only reason we have a disagreement now is that the USA extended its sphere of interest deep into europe. in fact, since the end of the cold war, we've pushed even further from our own shores and closer to russia, while they have withdrawn their tentacles. who is the imperialist?

much of this reflects problems I see in our existing foreign policy establishment:

1- the state department is the product of the cold war. when countries had to choose between soviet tyranny or american paternalism, they might not have liked it, but chose the latter. this allowed us to become like spoiled children who always get their way. but spoiled children don't make good diplomats.

2- we've become too tied up in too many endeavors... whether it's trying to cure AIDS, fighting a global war on drugs or trying to liberate cuba, the state department has its fingers in too many pies.

3- the federal government in general is very ineffective at most things it does. during my time in caracas in the late 1990s, educated professionals told me about their multi-year efforts to get visas to live in the US (of course, at the same time, millions of less educated mexicans were entering illegally every year.) I knew one woman who married an american and then was forced to spend more than a year in venezuela waiting for her paperwork to come through. (and this was before 9-11.) and, there have been documented cases of iraqis who have risked their lives to serve as interpretters for US troops who have been denied entry into the US.

it's worrisome to think we trust something as important as our relations with other countries to such a confused and incompetent organization.

perhaps it is time to return to the words of our wise founders.. george washington said it was our "true policy to steer clear of any permanent alliances with any portion of the foreign world" and asked "Why, by interweaving our destiny with that of any part of Europe, entangle our peace and prosperity in the toils of European ambition, rivalship, interest, humor, or caprice?"

thomas jefferson followed this by promising "peace, commerce, and honest friendship with all nations, entangling alliances with none."

let's now take a look at NATO: it has joint force command headquarters in Brunssum (Holland), Naples and Lisbon, rapid deployable corps in turkey, italy, germany and spain and standing naval forces in the mediterranean, atlantic and english channel... not to mention an electronic warfare advisory committee and its own defense college.

what's the purpose of all this structure? in case of an "armed attack against one or more of them in Europe or North America ... each of them .. will assist the Party or Parties so attacked by taking forthwith, individually and in concert with the other Parties, such action as it deems necessary, including the use of armed force." (italics added.)

in other words, it's an organization designed for war. because of its joint-defence structure, anyone attacking one country is like declaring war on all of them.

NATO is a giant web with the potential to draw the US nuclear arsenal into WWIII. while this was needed to prevent a soviet conquest of war-torn europe in 1949, its useful lifespan has passed. most sane people would seek to limit, or even disband, such a potentially dangerous entity. instead, our state department is seeking to englarge it.

it's time Americans ask "what does NATO do for me?" how does it make my life or family safer? it's time to ask whether NATO has become, in fact, the very thing Jefferson and Washington both warned against.

their wisdom, restraint and character gave us our freedom and prosperity. what happens to us if we ignore their lessons now?

Thursday, August 7, 2008

the error of HBO



I just finished watching HBO's "John Adams". while I first enjoyed the visual accuracy of the story, two major shortcomings dismayed me.

first was a simple error.
in the movie, abigail adams dies and then benjamin rush urges adams to resume his friendship with thomas jefferson.
in reality, adams wrote his first letter to jefferson in 1812 (source)... abigail didn't die until 1818 (source).

this kind of sloppiness might almost be tolerated, if only they didn't have benjamin rush tell adams as he grieves abigail's death:
"what about mr jefferson? I am sure he will wish to share your sorrow ... "

in reality, adams actually told jefferson:

"All of my family, whom you formerly knew, are well..." (no mention of any dead wife.)
adams also recounts how his daughter had successfully undergone a mastectomy, which the film does relate. she went on to die the following year, according to wikipedia. in fact, wikipedia also says rush died in 1813. (that means hbo was off by five years.)

this is not consistent with great film making. I thoroughly appreciated the subtleties such as the characters' filth and disgusting teeth. but, if you're going to devote such energy to details such as historic costumes and the pestilence of the time, you might as well get the basic sequence of events right.

"I don't think any film that's been done about this all-important part of our story has every been done with such authenticity," David McCullough solemnly blathers in a self-congratulatory documentary on the DVD. I wonder how many millions of dollars he will make from this project, when it's all said and done.

second grievance: little was done to tell the bigger historical picture. good costumes and sets are one thing, but the writers didn't use minor characters and sub-plots to show the passage of time. there is no mention of the constitutional convention or the death of alexander hamilton, for instance.

I think as a result, they spent a lot of time and money accurately portraying mud, smallpox, and pre-modern breast removal. I would have preferred a little more historical context. getting the basic facts right would've been nice as well.

Saturday, August 2, 2008

catching up

I have been neglecting this blog horribly. one reason is I feel I have been largely right on many trends such as oil prices and the squeeze on corporate profits. both of these scenarios as playing out as I expected.

I am not sure if these ideas will play out as much, but they're worth thinking about:

who will provide the american consumer with goods over the next 20 years? for the last 20-40, asian producers have taken over large parts of our supply chains. now their currencies are destined to appreciate and our trade gap is narrowing. the trend of using the global economy to cut procurement costs is nearing its end -- especially because of fuel costs. consider this in today's NYT:

When Tesla Motors, a pioneer in electric-powered cars, set out to make a luxury roadster for the American market, it had the global supply chain in mind. Tesla planned to manufacture 1,000-pound battery packs in Thailand, ship them to Britain for installation, then bring the mostly assembled cars back to the United States.
But when it began production this spring, the company decided to make the batteries and assemble the cars near its home base in California, cutting more than 5,000 miles from the shipping bill for each vehicle.

link

basically, we need to rebuild the productive capacity in the USA. we need to build electronics, machinery, etc.

I have at least three major concerns:

1- the causes of off-shoring and out-sourcing remain. production has been leaving the USA since the 1960s because of problems with taxes and regulation.

2-the US financial system is now under distress, discouraging investment in new factories and companies.

3-the trend in CFO-land has been away from investment and in favor of shareholder returns. given the bubble in capex in the late 1990s, management has generally preferred to buy back stock than to invest in the USA. this prejudice has to be unlearned. (in the long run, it's bad for stocks because lets capital to leave the equity market in general.)

these trends seem to be playing out right now. and, of course, there is the CREDIT CRUNCH as well. when people can't borrow, it reduces the earnings power (and thus value) of normal equity investments. this creates a perverse incentive to hoard capital... which is why money market accounts now have near-record balances.

DEFLATION is another worrry. first, let me say I am not worried about deflation. our declining currency and negative real interest rates will prevent us from facing a real deflationary problem.

but people are right to worry about the possibility of deflation. when banks are impaired, they lend less, meaning that less new money comes into existence. this has a broadly deflationary and depressionary effect.

Mastercard's second-quarter earnings illustrate what may be going on. this is the change in the gross dollar volume (GDV) of transactions:
Q4, 2007: +10.6%
Q1, 2008: +8.9%
Q2 2008: +6.2%

the slowing pace of growth reflects less money moving through the economy, one of the key elements of deflation.

(management cited the continuing shift away from consumer discretionary to non-discretionary items. given that many people and assets (stores, etc) are linked to non-discretionary activities, this means other problems lay down the road for the US economy.)

to sum it up... we have the:

DEFLATIONARY pressures of a damaged banking system

combined with the

INFLATIONARY pressures of low interest rates and a declining currency

this seems to be a similar situation as was found in latin america in the 1980s, but I still need more data on that. I am not sure how distrssed the banks were. it's very different from the case of japan in the 1990s... their deflation problem resulted largely from the doubling of the yen in the 1980s.

I think it's a bearish situation. because we have deflation, people don't want to invest in new businesses.

hopefully, capital will flow into the areas where products are the most inflated: fuel and food.

right now, there are so many inefficiencies to overcome -- it's actually quite exciting to think about. for example, why in NYC must we consume carbon to ship large amounts of heavy organic food waste to landfills 100s of miles away? why don't we have restaurants put their food waste separately and charge them per pound of other waste. why don't we have a municipal swine yard someone on staten island? the city could turn waste into real revenue (by selling meat).
I see a world where suburbanites grow things like potatoes in their yards rather than rely as much on trucks and companies to deliver them from far away.

but in the next few years, I think the trend will be toward contraction and problems before they start to be solved.

in sum, we're only now starting to feel the real economic effects of the problems in the financial market. the truth is, this isn't just about financial markets. it's a question of the assets in our country. many were built with certain assumptions in place (such as "we can always refinance when the loan resets" .. or "gasoline will be under $3 a gallon" or "the consumer will always have money to spend" ) ..

those assets were largely debt financed. as they lose value, banks will lose money. (which is happening right now.)

when banks have losses, they need to TAKE money from the economy in the form of new investments. note that this is a 180 degree turn from their normal function, which is to GIVE money to the economy.

I think one more irony is emerging in this credit crunch. we are now finding that debts secured by a certain asset, such as a home mortgage or car, are falling apart. yet credit card defaults have not risen as much. I believe that once assets fall out of favor, debtors will be less willing to honor liabilities tied to them.

if you know houses are falling in value, you don't want to own one... that means you don't see any reason to need a mortgage, and you don't have to worry about your credit score... so, why not walk away? people may link the debt to the collateral.

on the other hand, a credit card is tied to their personal spending, and thus lifestyle. cash is a giant hassle -- especially with more and more commerce moving online.

essentially, it's more important to keep a functioning credit card then a functioining mortgage. it's also much cheaper for most people. as a result, they will continue making at least their minimum payments.

it's just another intesting irony that the collateral itself, intended to reduce the risk, might actually be the source of the risk.