Where the Financial Gurus Are Putting Their Own Money
By Eleanor Laise, The Wall Street Journal
Last update: 3:27 p.m. EST Jan. 29, 2009
In times of market strife, financial gurus often tell investors to think long-term and stay the course. Some of them even put their own money where their mouth is.
A sampling of high-profile industry veterans, academics and brokerage-firm chiefs reveals that many are hanging on to holdings battered by last year's market slide and busily hunting down new opportunities, particularly among bonds and beaten-down value stocks. Some are snapping up municipal bonds, inflation-indexed securities and steady-Eddie dividend-paying stocks.
And they're generally upbeat about the prospects for long-term retirement savers.
"I think this is a marvelous time to be investing," says Rob Arnott, the 54-year-old chairman of Research Affiliates LLC, an investment-management firm in Newport Beach, Calif. "There are more interesting opportunities out there now than any of today's investors have ever seen." Financial stars are facing some of the same retirement-planning headaches as ordinary investors. Many suffered substantial losses last year in a market that crushed nearly everything. But unlike many small investors, they're patiently waiting and watching for bargains rather than making a mad dash for havens like cash or Treasury bonds or drastically revising their asset-allocation plans. And where possible, they're even stepping up their savings to put more cash to work in the market.
Certain parts of the bond market are priced for a scenario that's worse than the Great Depression.
Great investing minds don't always think alike, of course. John Bogle, the 79-year-old founder of mutual-fund giant Vanguard Group, says he has only about 25% of his portfolio in stocks, for example, while David Dreman, the 72-year-old chairman and chief investment officer of Dreman Value Management LLC, says he has a roughly 70% stock allocation. They do appear to have one thing in common, though: patience -- a trait many small investors lack. Last year, 401(k) participants shifted around 5.7% of their balances, compared with just over 3% in a typical year, according to consulting firm Hewitt Associates. Money flowed out of stock funds and into bond investments, money-market funds and stable-value products. And many fed-up and tapped-out investors have stopped contributing to retirement accounts altogether.
But this is hardly the time to hunker down and take bets off the table, financial pros say. Don Phillips, managing director at investment research firm Morningstar Inc., says he invests his entire individual retirement account in the Clipper Fund, a large-cap stock fund that lost about 50% last year. Early this year, he made the maximum IRA contribution to that fund, just as he has for the last 20 years. "It's long-term money, and you have to look at it that way," he says.
Here's how some top investing experts are now allocating their own retirement savings and handling the heavy blows being dealt by a volatile market.
Bonds
While many financial gurus say they're starting to spot some great opportunities in stocks, they believe the bargains in select corners of the bond market are even better. "Certain parts of the bond market are priced for a scenario that's worse than the Great Depression," Mr. Arnott says.
I earn my money and spend my money in dollars, and I don't need to take currency risk.
One favored area is Treasury Inflation-Protected Securities, or TIPS, a type of Treasury bond whose principal is adjusted based on changes in the inflation rate. Ten-year Treasurys currently yield only about 0.9 percentage point more than 10-year TIPS, indicating that investors believe inflation will remain quite low in the coming years. Mr. Arnott says he boosted his TIPS allocation "in a very big way" in his personal taxable account toward the end of last year because he expects a substantial increase in inflation in the next three to five years.
Municipal bonds also look attractive to many longtime investors. Munis are typically exempt from federal and, in many cases, state and local income taxes. Many are now yielding substantially more than comparable Treasury bonds. In his taxable account, Mr. Bogle holds two muni-bond funds: Vanguard Limited-Term Tax-Exempt and Vanguard Intermediate-Term Tax-Exempt.
Burton Malkiel, a 76-year-old economics professor at Princeton University and author of "A Random Walk Down Wall Street," says he boosted his allocation to highly rated tax-exempt bonds in his taxable account late last year, since yields available on some of these bonds were "unheard of." Some market watchers believe that it's time to take on more risk in their bond portfolios. Even investment-grade corporate bonds offer high yields, and below-investment-grade junk bonds yield far more than that. Mr. Arnott boosted his allocation to investment-grade corporate bonds in his personal taxable account late last year because the market had reached "irrationally high yields," he says. And Jeremy Siegel, a professor of finance at the University of Pennsylvania's Wharton School and senior adviser to exchange-traded-fund management firm WisdomTree Investments, has recently raised his allocation for junk bonds.
"Stocks and high-yield bonds will move together as the crisis passes," rebounding from their depressed levels, the 63-year-old Mr. Siegel says.
Stocks
Financial gurus are picking through the wreckage of last year's stock-market meltdown to find the best bargains.
Emerging-markets stocks have 'gotten cheap enough to really give value now.'
Jeremy Siegel, the Wharton SchoolSome are looking for companies with strong market positions and juicy dividends. Muriel Siebert, founder and chairwoman of brokerage firm Muriel Siebert & Co., has recently been buying shares of companies like Pfizer (
PFE) Inc., Altria Group (MO) Inc., and General Electric (GE) Co. "I don't mind buying a stock on the bottom and waiting," says the 76-year-old Ms. Siebert. "But I do think when you get a market like this, you should be paid while you wait." Pfizer and Altria yield roughly 8%, while GE yields over 9%.
Some battered stocks in the energy sector also look like bargains, Mr. Dreman says. He likes oil and gas exploration and production companies like Anadarko Petroleum (APC) Corp., Apache (APA) Corp., and Devon Energy (DVN) Corp. If we don't have a long world-wide recession -- a scenario that Mr. Dreman thinks oil prices currently reflect -- "we'll see much higher prices for oil again," he says.
More From the Gurus
•
Though foreign stocks were generally hit harder than U.S. shares last year, some gurus aren't rushing to invest overseas. Mr. Bogle, who says he has a very small allocation for international stocks, notes that investors poured money into foreign funds in recent years, chasing their strong returns, while yanking money out of lagging U.S. stock funds. "To me that's a red warning flag on a very tall flagpole on a very windy day," he says. "I also earn my money and spend my money in dollars, and I don't need to take currency risk."
Other experts say that emerging-markets stocks, which were hit especially hard last year, are starting to look tempting. If these shares take another dip, they could become "extremely interesting," Mr. Arnott says. Mr. Siegel keeps one-quarter to one-third of his foreign-stock allocation in emerging markets, and "they've gotten cheap enough to really give value now," he says. He has bought some more of these shares as they've declined in recent months.
Jim Rogers, a 66-year-old veteran commodities investor based in Singapore, is putting new money into Chinese shares. He's focusing on sectors of the economy that the Chinese are pushing to develop, such as agriculture, water, infrastructure and tourism.
Market gurus are also finding some bargains among alternative investments. Mr. Rogers is putting some new money into commodities, particularly agricultural commodities. "We're burning a lot of our food in fuel tanks right now," he says. And Mr. Siegel recently added some U.S. real estate investment trusts to his portfolio, which got "very cheap" after declining sharply last year, he says.
Staying the Course
Sticking to principles they've developed over decades in the market allows people who live and breathe investments to be relatively relaxed about their retirement portfolios.
I don't mind buying a stock on the bottom and waiting. But I do think when you get a market like this, you should be paid while you wait.
Muriel Siebert, Muriel Siebert & Co.Morningstar's Mr. Phillips, 46, has made it easier to stay the course. He has relinquished responsibility for allocating his 401(k) account, leaving those decisions in the hands of a managed-account program run by a unit of Morningstar. The program, which he started using in 2007, has "actually been very good for me," Mr. Phillips says. "They started putting me into things like TIPS and high-quality bond funds that I'd never had in the portfolio before."
And when they do suffer substantial losses, they tend not to panic. Mr. Phillips remains committed to his battered Clipper Fund, though it lagged the Standard & Poor's 500-stock index by about 13 percentage points last year. Ms. Siebert says she took a "very substantial loss" in Wachovia Corp. stock, which plummeted last year before the company was sold to Wells Fargo (WFC) & Co., but she's hanging on to the Wells Fargo stock she received "until I see a reason not to."
She is, however, a bit sensitive when asked about her portfolio's overall performance last year. "Do you want to see a grown woman cry?" she asks.
Write to Eleanor Laise at eleanor.laise@wsj.com
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Forbes interviews Jeremy Grantham
THE GRANTHAM INTERVIEW
Intelligent Investing with Steve Forbes
[00:08 ] Welcome, I’m Steve Forbes. It's a privilege and a pleasure to introduce you to our featured guest, the great skeptic of Wall Street, Jeremy Grantham.
The bear
who called the stock bubble back in 1998 didn't jump back into U.S. Equities after
it burst the first time. Now, he finally sees opportunities in the equities markets.
[02:51] Grantham's Big Call
STEVE FORBES: Well, thank you Jeremy for joining us today. First, since you
have bragging rights in this situation, what made you a bear, great skeptic
between 1999 until about a couple of months ago you were saying, "Stay out?"
JEREMY GRANTHAM: Well, really very simple. Not rocket science, we take a
long-term view, which makes life, in our opinion, much easier.
STEVE FORBES: Well, everyone says it, but you certainly practiced it.
JEREMY GRANTHAM: We actually do it. Well, we tried the short-term stuff and
it was so hard, we thought we'd better do the long-term. We just assume that at
the end, in those days, of ten years, profit margins will be normal and price
earnings ratios will be normal. And that will create a normal, fair price. And more
recently, we've moved to seven years, because we've found, in our research that
financial series tend to mean revert a little bit faster than ten years, actually,
about six and a half years.So, we rounded to seven. And that's how we do it. And it just happened from
October '98 to October of '08, the ten-year forecast was right. Because, for one
second, in its flight path, the U.S. market and other markets flashed through
normal price. Normal price is about 950 on the S&P. It's a little bit below that
today.
And on my birthday, October the 6th, the U.S. market, ten years and four trading
days later, hit exactly our ten-year forecast of October '98, which is worth talking
about if only to enjoy spectacular luck. The P/E was a little bit lower than
average and the profit margins were a little bit higher, so they beautifully offset.
And given our methodology, that would mean that on October the 6th, the market
should have been fairly priced on our current approach. And indeed it was, that
was even more remarkable, 950, plus or minus a couple of percent.
STEVE FORBES: And what did you see during that ten-year period that made
you feel, other than your own models, that this was something highly abnormal,
that this couldn't last?
JEREMY GRANTHAM: Well, first of all, the magnitude of the overrun in 2000
was legendary. As historians, you know we've massaged the past until it begs
for mercy. And we saw that it was 21 times earnings in 1929, 21 times earnings
in 1965 and 35 times current earnings in 2000. And 35 is bigger than 21 by
enough that you'd expect everyone would see it. Indeed, it looks like a
Himalayan peak coming out of the plain.
And it begs the question, "Why didn't everybody see it?" And I think the answer
to that is, "Everybody did see it." But agency risk or career risk is so profound,
that even if you think the market is gloriously over-priced, you still have to get up
and dance. Because if you sit down too quickly--
STEVE FORBES: Famous words of Mister Prince.
JEREMY GRANTHAM: If you sit down too quickly, you're likely to get yourself
fired for being too conservative. And that's precisely what we did in '98 and '99.
We didn't dance long enough and got out of the growth stocks completely and
underperformed. We produced pretty good numbers, but they're way behind the
benchmark. And we were fired in droves.
I think our asset allocation, which is the division I'm now involved in, we lost 60
percent of our asset base in two and a half years for making the right bets for the
right reasons and winning them. But we still lost more money than any other
person in that field that we came across, which is a fitting reminder that career
risk runs the business.
STEVE FORBES: So, it's all right to be wrong as long as everyone else is
wrong.
JEREMY GRANTHAM: That's right. "I never saw it. Nobody saw it," that's what
they say about today's fiasco, which actually makes me quite disgusted because
almost everyone we talked to did see it coming. And I described it in June of last
year as the most widely-predicted surprise in the history of finance. And that's 18
months ago.
[07:24] A Whole New Bubble
STEVE FORBES: What was it about this bubble, do you think distinguished it, if
one can distinguish bubbles from past bubbles?
JEREMY GRANTHAM: Yeah, oh, I think this was distinguishable in many ways.
I described it, I think, accurately as the first truly global bubble. It had every
asset class, notably real estate, as well as stocks. But bonds were also
overpriced and fine arts, of course, were ridiculous. And secondly, it was global.
So, you know, Indian fine arts were going out of control. And Chinese modern
art --
- STEVE FORBES: But you still bought them, right? Indian fine arts, aren't you?
JEREMY GRANTHAM: I, perhaps, I participated too much in Indian antiquities,
which I have a soft spot for. But so, it was unique in breadth of asset class, in
breadth of reach, globally. Quite unlike anything else since the Depression and
even much broader than the bubble of 1929.
STEVE FORBES: You mentioned about career risk, that it's better to be with the
crowd than going against it and paying a price because people don't like what
you're saying. Did people really believe, do you think, their risk models that said
you can take this outsized risk but, 1) you've hedged it, and 2) if this goes up, this
goes down, and therefore, it's not-- as risky as it looks?
JEREMY GRANTHAM: Oh yes, I think they did. I think you should never
underestimate the ability of really serious quants to believe quant models. They
can really do faith big-time in those models. There's something about having a
PhD in some serious topic like particle physics or math that, when you've finished
a couple of years of hard work and you've produced a model, then your faith in it
can be intense. I think these people really did believe in that stuff.[09:24] Time To Buy
STEVE FORBES: And now that you feel the tide is turning, what should
investors do now? First of all, during that ten-year period, where did you invest
money when you saw this bubbly atmosphere? And what are you doing now?
JEREMY GRANTHAM: Most of our money is in specific funds for institutions.
So, we have an emerging market equity fund. And for institutions, they don't
want us messing around, moving up and down our cash balance. So, they're
fully invested in equities and we're trying to do the best job that we can. We have
an asset allocation group with about 40 percent of our money today.
And there, we are allowed to move around. but even there, we have a clear job
description so that in one account, for example, a fairly typical flavor, we are not
allowed to drop below 45 percent equity or go above 75. So, in the institutional
business, people are pretty hemmed in, most of the time, and we are. Most of
the last ten years, we have been promoting the idea of not taking a lot of
unnecessary risk and that's probably been the most constant theme.
The single exception to that, until quite recently, was emerging markets. We felt
that if you had this irresistible urge to take risk, you should exercise it on
emerging, because you'd get a better bang for your buck. And we were
overweighted for 12 years ending in this July. And we kind of blew the whistle in
July. We had been thinking that emerging was strong enough and fundamental
that we'd ride out the unpleasantness.
And then, on June the 26th, precisely, the penny dropped that I had been quite
optimistic on lots of little fundamentals. None of them, perhaps, profoundly
optimistic, but they accumulated to considerable optimism. And it was revealed
to me that I had just missed evaluated how bad things were going to be,
fundamentally. And one of the reasons was career risk. Because we were the
best, there was a kind of disinclination to wrack your brains to be even further off
the spectrum than you were already.
And since I was already considered a perma-bear, I thought, "Well, we're the
most bearish people around, let's leave it at that. Don't look for trouble." And
then, June the 26th, we had a Glaswegian arrive to kind of review the data with
us, an economic strategist. And he had this dour Glasgow accent. I think that
had something to do with it.
And I came out of the meeting thinking, "Holy cow, this is going to be really, really
awful." And I wrote a courtly letter immediately saying, "I recant on emerging.
Up until now, we'd been advising for two years, 'Take as little risk as you can,
except for emerging.' Our new advice is take as little risk as you can, period.'"
And we held up the letter for two weeks.
We did the biggest trade in our history. And for the first time in 12 years, we
went to underweight emerging across the board, which in some accounts meant
zero. And for the only time in my career, the emerging market immediately
nosedived. I mean, immediately, like the day after we did our trade it headed
south.
And three months later, it was down 40 percent. I mean, I've never seen
anything like that. So, we replaced it. We thought, "Well, 40 percent makes a lot
of difference to anybody." We were looking at 11, 12 percent imputed real
returns for seven years in emerging and we replaced the bet in October.
[13:20] Cheapest in 20 Years
STEVE FORBES: You went back in emerging markets.
JEREMY GRANTHAM: Back in emerging markets.
STEVE FORBES: And in terms of evaluating markets and stocks, in particular,
you have a pretty disciplined formula so you can say precisely 950 and--
JEREMY GRANTHAM: That's exactly right. It may be wrong, but it's precise.
And we've had a long history of doing it the way I described, that everything will
be normal in seven years. And it's turned out to be quite robust. And probably
pretty simple and straightforward-- an effective way of doing it. And right now,
what it says is that, since October, global equity markets have been cheap, not
dramatically cheap, not cheap like you and I have seen a couple of markets,
1982, 1974, that was very cheap, indeed.
This is merely ordinarily cheap. But it's the cheapest it's been for 20 years. For
20 years, we had this remarkable period when the markets were never cheap.
They got less expensive, you know, too, but they were never cheap. And so
now, you have this terrible creative tension between, on one hand, they're the
cheapest they've been for 20 years.
They're pretty decent numbers. For seven years, we expect seven and a half
real from the U.S., from the S&P. And perhaps nine and a half from EAFE and
emerging. These are not bad number for seven years. And on the other hand,
as historians, we all recognize that the great bubbles tend to overrun.
STEVE FORBES: Right.
JEREMY GRANTHAM: And they're not normally satisfied, you can't buy them
off by being slightly cheap. They insist on becoming very cheap. So, we've said
for several months that we thought this cycle would go to 600 or 800 on the S&P,
800 if it was a mild recession, ho-ho. Can throw that one away. And 600 would
be quite normal if it was a severe recession like '82, '74, which I think, I don't
know if you agree, is pretty well baked in the pie today. It may be worse, but it's
probably not going to be much less bad than '74 or '82.
STEVE FORBES: And so, in terms of the markets today, even though they're
cheap, you're going in gingerly or since it could theoretically go down to 600 and
given the emotions you get in these things.
JEREMY GRANTHAM: Yes, I would say two-to-one, by the way, my instinct
plus looking at the history books that it will go to a new low [in 2009]. So, this is
the problem. We're underweighted still, in an ordinary asset allocation account
that has 65 percent in equities, we have moved up to 55. So, we're still
underweight, even though they're cheaper than they've been and they're
reasonably cheap.
Now what happens? If we throw in the client's money and it goes down, indeed,
as I think it will [in 2009], they will complain quite bitterly that we weren't very
smart. We thought it was going down, and yet we threw their money in. So,
that's one kind of regret. And the other kind of regret is that we hang back and
the market runs away, the one-in-three comes up and they say, "You told us the
market was cheap. You told us that you had these nine or ten percent real return
opportunities and you're still underweight and the market's back up 200 points.
You're an idiot."
So, there's no way you can avoid some regret. You have to look at your own
personal balance sheet, how much pain can you stand? If you absolutely can't
stand a 20 percent hit, you'd better carry quite a lot of cash, because you're quite
likely to get it. If on the other hand, you're made of steel, you can concentrate on
the seven-year horizon and filter money in and having a lot of cash here is
probably a bit dangerous from the other point of view.
But in any case, it's a very personal judgment of risk avoidance and how tough
you are under stress. The worst situation that will befall probably quite a lot of
people is that they exaggerate their toughness. The market goes down 30
percent from here to 600 and they panic, dump their stocks and never get back.
And that's the worst outcome.
[17:45] Japan A Blue Chip?
STEVE FORBES: And one of the areas you seem to be interested in is
Japanese stocks?
JEREMY GRANTHAM: I think Japan may turn out, finally, in a curious way, to
be a blue chip here. They've been through a lot of the problems, their ordinary
corporations are no longer super-leveraged as they were, it took them 15 years,
but finally, they got there about three years ago. The banking system is not at
the cutting edge of all the problems, so they look relatively blue chip.
And yes, they're exposed to the global export problem, but when you look at
Japan, they are deceptively low exporting country. It's only 12 percent of their
GDP, it's much lower than most European countries, et cetera. So, I think they're
fundamentally a candidate for the blue chip and plus, they're stock prices, of
course, have been terrible.
STEVE FORBES: Right.
JEREMY GRANTHAM: It's taken them 17 years to lose 78 percent of their
money. This is what I say, that exhibit is called "stock for the very, very long
run." Aimed at Jeremy Siegel if you think that people are machines, then of
course you can tuck stocks away and hold them forever. But ordinary human
beings don't like to wait 17 years to lose 78 percent of their money or 28 years to
round trip in Japan.
They haven't made a penny in 28 years, including dividends, in real terms. And
people have dismissed that, "That's Japan, we're the U.S." And that is, in a way,
the most simple minded of logic. Of course, every country is different. But do
not think that we can't have terrible times. I sincerely hope we will not, and I
don't expect that we will. But you have to consider it a possibility.
[19:38] Emerging Markets- STEVE FORBES: Now, looking at emerging markets, what ones stand out as
particularly enticing right now, or do you try to emerge them all together?
JEREMY GRANTHAM: Merge the emerging, yes. We do, I think. Emerging
market is no longer at all monolithic. There is an exporting clutch, there is a
handful of eastern European that looks a little shaky. There are two or three that
have forgotten the rules of the Asian crisis and have accumulated some foreigndenominated
debt that leaves them very vulnerable. And increasingly, each one
looks separate. But in general, many of them have better finances than they had
in other crises.
STEVE FORBES: Any ones particularly stand out that you?
JEREMY GRANTHAM: Well, Brazil, of course, is much improved from the way it
used to be and has a nice position in natural resources. And on a very long
horizon, I like its style. I'm not making a recommendation based on today's price.
Indeed, I don't know today's price, they most so fast. We had one day the other
day when their entire fund and the index was up over 10 percent for the day. So,
the numbers change at bewildering speed these days.
[20:59] Buy Big US Stocks
STEVE FORBES: And U.S. blue chips, you--
JEREMY GRANTHAM: No, U.S. blue chips, I think is manna from heaven.
They're conservative in a risky world. The best companies on the face of Earth,
right? And from '02 to '07, they were considered boring and all the action was in
the racier, more leveraged stuff. They underperformed every single year from '02
onwards and five years in a row. So, when this trouble started to escalate, they
were about as cheap, on a relative basis, as they ever get.
They were not absolutely cheap, but they were relatively very cheap. And the
best bet, for my money, then and now, a year later, was to buy the great
franchise companies, the great quality companies and to go short the junkier,
more leveraged companies. That's been a very profitable strategy and one of the
few things that has been working this year. This year, of course, as you know,
has been the year from hell for money managers.
The value traps, the like of which we haven't seen since the 1930s, the great
value managers all made their reputation by being braver than the next guy, by
buying the WaMus of the world when they'd fallen to seven and they'd bounce
back to 28. And this time they went from seven to three and they doubled up
again and they went to zero.
It's been a nightmare. And the quants, who use momentum as well as value,
have had no better luck with momentum. And the quant techniques of balancing
- 28 -
risk have also failed, as we were discussing. So, this has been a dreadful year
for money management. And quality has been the one theme that has worked.
And interestingly, from our firm's point of view, it's not a theme that other people
seem to have adopted.
There are not quality funds, there are large cap and growth and value, but there
are no quality funds. And so, it's been hard for people to pick up that theme. But
it has been very, very good since September.
STEVE FORBES: What are a couple of examples of what you consider quality
companies?
JEREMY GRANTHAM: I'm not recommending these companies, except
generically.
STEVE FORBES: Right.
JEREMY GRANTHAM: But, no surprise is Coca-Cola, Microsoft, Proctor and
Gamble, Johnson & Johnson. These are the essence of the great franchise
companies. And collectively, they're not that dependable in bear markets, but
they're incredibly dependable when people's confidence in the fundamentals start
to go. In Japan, for example, the quality companies in Japan outperformed for
nine consecutive years when their troubles came.
They accumulated again against the Japanese market of 98 percent points.
They were brilliant in the Great Depression between '29 and '32. Even though
the Coca-Colas were relatively overpriced in '29, they still went down dramatically
less than the junky companies. But they're the great test of quality. So, you
wouldn't expect quality to be dependable unless we were having the kind of
environment that we seem to be having. And I think they will have legs, they will,
the high quality companies can outperform, handsomely still, from here.
[24:17] Stimulus!
STEVE FORBES: Commodities, you were short oil, your firm was short copper.
When do you go long, or is that just a sideshow?
JEREMY GRANTHAM: That's a very good question. I was thinking about that
in the taxi today. When you see oil breaking $40, I believe oil is the great
exception. I asked over 2,000 full-time professionals to find me a paradigm shift
in a major asset class and they never offered me one, so I was very pleased to
offer oil a couple of years ago. I thought it was the genuine paradigm shift. I
thought that after 100 years at $16 a barrel, it had jumped to maybe $36 or $37
in real terms. And I think it has probably jumped again. It will be revealed in 20
years to what level. But my guess is $60, $65, maybe even $70. But what
people underestimate, even in the oil industry, is how volatile the asset class is.
- 29 -
In other words, if the trend is $65, it is fairly routine for oil to sell below half, say
$30 and more than double, say $145.
And people never get that. So, you don't want to be too quick to buy into
weakness or sell into strength, necessarily. But it can go a long way. But below
40, I must say, I do get a bit interested. And below 30, I'm definitely a buyer.
STEVE FORBES: Wow.
JEREMY GRANTHAM: And copper, copper's done so brilliantly on the
downside, that you really begin to ask, it must be approaching cost of production
somewhere in the next ten or 15 percent, you have to say, "That was very nice,
thank you," and cover.
STEVE FORBES: Now, in terms of the U.S. economy, you've seemed to be
saying that the Fed is doing right, print all you can, and for the government, to
spend all you can.
JEREMY GRANTHAM: Yes, which I have to choke on, as I have no doubt, you
would. Because, normally, it's a terrible
STEVE FORBES: That's why I'm not drinking the water, I don't want to choke.
JEREMY GRANTHAM: It's normally terrible advice. It's only useful when it's the
real McCoy. And I think it is. And if there's unemployment, having the
government help reduce that unemployment, increase employment directly is a
pretty good idea. It's not driving out competition, it's not crowding out. As long
as there's excess unemployed people sitting around like the Great Depression,
you should do everything you can to get them employed and get the system
going again, just as a temporary stopgap, or I believe.
And I think by combining that with energy sufficiency, particularly labor-intensive
kind of energy avoidance, installing insulation, storm windows, very labor
intensive. Battering down solar cells on the roofs of Wal-Marts in California. I
think that will be some of the highest return investments that anyone ever makes.
Just return on capital is very, very high in efficient light bulbs. And therefore
should be done. And I don't mind the government accruing debts as long as
every dollar is spent effectively, with a high return. That works out fine. If you
accumulate debts and waste your money, that's, of course, a disaster. I know I'm
preaching to choir on that one.
STEVE FORBES: And what about tax rates? Isn't that the best stimulus?
Lowering tax rates, changing incentives?
- 30 -
JEREMY GRANTHAM: The trouble is, in these very rare occasions, that
sometimes does not work. Normally, of course, it's a lay-up. But if you give
Japanese corporations were the real crunch there. Here it's consumers.
Japanese corporations had so much debt, that as you threw money at them, they
paid down their debt. They didn't build new factories. They were waking up at
3:00 in the morning sweating that they were insolvent.
Of course, technically, they were insolvent. So, they paid down debt and they
paid down debt. Our consumers are so leveraged that you run the risk with a tax
cut that they're in the same boat. You write them a check, even, same thing as a
tax cut, really. Write then a check for $250 and they'll pay down their credit card
debt because they're getting desperate. They are hugely overstretched. So, it
doesn't necessarily work anymore, pushing on a string. And whereas, if you get
out there and spend money to employ people directly, bashing insulation into
your attic, that does work.
[28:53] Our Leaders Failed
STEVE FORBES: So, what is the one big misplaced assumption today when
you look around at this?
JEREMY GRANTHAM: Reviewing the last two years, of course, it's a misplaced
trust in the competence of our leadership, from the very top. But certainly,
notably, the Fed, the arch-villains of this piece, Treasury, little better, the SEC.
They were cheerleaders, all of them. And they encouraged reckless leverage
and low-quality debt, complicated, un-researched, generally disgraceful.
And they made no effort to resist it in any way. Even jawboning would have been
a great advantage over nothing. Greenspan encouraged, admired the ingenuity
of the new instruments for sub-prime. I mean, went out of his way to encourage
it. Some, as in Greenspan, beat back an attempt to do some regulating of
subprime markets. And I think it looked pretty bad.
Hank Paulson did not move fast enough to recognize that the impending decline
of house prices would create some problems. And Bernanke couldn't even see
the house bubble. On our data and Robert Shillers, it was a three-sigma, one-in-
100 year event. After 100 years of being flat, it soared after 2000. You could not
miss it. And right at the peak, October '06, Bernanke said, "The U.S. housing
market merely reflects a strong economy," unquote.
What was he looking at? Where were his statisticians? These are the guys we
picked out of millions to lead us in a crisis. And they can't see a three-sigma
bubble? Every single bubble of that kind has broken. Asset classes are
incredibly dangerous when they form a bubble and when the bubble breaks. And
Greenspan did not get that, and I've been screaming “abuse” forever. It seems
- 31 -
like as long as I can remember, but I wrote a piece in 2001 called “Feet of Clay,”
saying basically, "This bubble from 2000 will be hard to forgive."
And of course, it was the ancestor of the current problem and the housing
bubble. The housing bubble is even more dangerous because more people own
houses. It's more for the ordinary people. And borrowing is so much easier. So,
that is really the most dangerous. And to do two at once, this time around, and to
do it globally it to truly play with fire. We have lost, or will have lost, is my
estimate, at the bottom, $20 trillion of formerly perceived wealth, from $50 trillion
to $30 [trillion].
And at $50 trillion, we had $42 trillion of debt, of all kinds, which is a fairly
suspiciously high 80 percent ratio of assets. But at $30 [trillion], we will have $42
trillion of debt, which is much more than suspicious. And bankers, who always
get religion after the event, are now going to say that 60 percent ratio might look
better.
And 60 percent of $20 [trillion] is not going to make much of an impression on the
$42 trillion of debt that we have. So we have a lot of what I call "stranded debt,"
$15, $20 trillion. Even at fair price, which is, perhaps, $25 trillion. There's still a
lot of stranded debt. This is going to take years to work through the system, not
a year or two.
[32:37] Dysfunctional Markets
STEVE FORBES: So, what is the best financial lesson you've learned? You've
been in this business for decades.
JEREMY GRANTHAM: The market is incredibly inefficient and capable on rare
occasions of being utterly dysfunctional. And people have a really hard time
getting their brain around that fact. They want to believe that it's approximately
efficient almost all the time and it simply isn't true.
[33:07] China Bubble
STEVE FORBES: So, what is your bold prediction for the future, now?
JEREMY GRANTHAM: In the long run, things will be back to normal. In the
short run, I think China will be a bitter disappointment. I can't believe that the
hardest job in economic history, guiding a vast empire of people and assets,
growing at double-digit industrial production rates can be anything but difficult.
And they've had much less experience than most capitalist countries.
And they have been because of 20 years of wonderfully good luck and favorable
circumstances, we have all been seduced into believing that there walk on water.
- 32 -
And I don't think they do. I think they have a terrible situation, which will be under
stress from all sides.
They export 40 percent of their GDP. The global economy gives a passably
good impression of having run, head down, into a very thick cement wall. And I
can't imagine that their exports will be anything other than mildly disastrous. And
yet, two months ago, the official forecast was still that it wouldn't drop below nine.
I mean, that is at least faintly ludicrous.
STEVE FORBES: What are the other fault lines you see in China?
JEREMY GRANTHAM: I'm not a China expert, so I'd be happy to leave it.
STEVE FORBES: Well, the experts weren't, either.
JEREMY GRANTHAM: They have a very small consumer sector, so it's hard to
stimulate that. A very large capital spending sector, how low does an interest
rate have to get to build another steel mill when there are seven up the road
empty, not operating. It's not an easy situation, I think. Direct spending on roads
and so on is something that might work.
But can they do it big enough since they're already doing it at a dramatic level;
can they increase it enough to rev their economy? I don't think so. I think their
economy will be very flattish for a while. And that will be a bitter shock to
everybody who's learned to depend on them.
STEVE FORBES: And one last question on China, their financial sector, their
stock market, in your mind, is that still very primitive? Does it really provide
capital for genuine entrepreneurs, or is it still all still?
JEREMY GRANTHAM: I can't. I really am not an expert. You look back, and
what you do see about the Chinese market is that it was again, a classic bubble.
It's a beautiful shape, symmetrical, it rises, it peaks and it drops slightly faster
than it went up, which is actually quite typical. And it was a great opportunity that
I regret not having capitalized on more than I did.
STEVE FORBES: But now you're staying away.
JEREMY GRANTHAM: Well, now it's completed the obvious part of the bubble.
It's back to kind of trend line. It may not be, you know, on a long-term
perspective, particularly more vulnerable than others. Even though their
economy will be disappointing in the short-term, of course, it has enormous longterm
potential. I do think emerging is the place to be, in the long-run.
I think it has all the indicators that will be required for the next bubble. It has
wonderful top-lying growth relative to an increasingly sluggish developed world.
- 33 -
It has a very high savings rate and investment rate. And I think it will become a
cliché how passé we all are, the U.S., the U.K., Europe, Japan.
We're running out of people. The number of man-hours offered to the markets
have been dropping without anyone talking about it for ten or 12 years.
Collectively, the G7 is way off its old trend line. By next year, the U.S. will be 14,
15 points behind its long-term trend rates. It's never come close to since the
Great Depression.
STEVE FORBES: Trend line, meaning?
JEREMY GRANTHAM: Just to take the 100-year battleship trend line, which
never deviated at 3.4 or something like this. The Great Depression, it went back
to trend very quickly. And now, we have been drifting off for this is year 13 of
drifting blow trend. We're simply getting more mature and all the other developed
countries are doing the same thing. But emerging has not fallen off its trend line
and has a lot of people coming into the workforce and a huge savings rate.
I think it will do very well. Put it this way, it will appeal to investors. It may not
make any more earnings per share, in other words, I'm not talking about true
fundamental value. I'm talking about how people buy stocks. They love top-line
growth. If they're going to grow at four and a half and we're going to slow down
to two and a half, it's going to look like a no-brainer. So, I think the next big event
in emerging will be that they will sell it at a big P/E premium over us developed
countries, who are suffering from a terminal case of middle-aged spread, I think.
STEVE FORBES: Well, clearly, the way you look at life is anything but a nobrainer.
Thank you very much.
JEREMY GRANTHAM: Thank you. I enjoyed it.
Intelligent Investing with Steve Forbes
[00:08 ] Welcome, I’m Steve Forbes. It's a privilege and a pleasure to introduce you to our featured guest, the great skeptic of Wall Street, Jeremy Grantham.
The bear
who called the stock bubble back in 1998 didn't jump back into U.S. Equities after
it burst the first time. Now, he finally sees opportunities in the equities markets.
[02:51] Grantham's Big Call
STEVE FORBES: Well, thank you Jeremy for joining us today. First, since you
have bragging rights in this situation, what made you a bear, great skeptic
between 1999 until about a couple of months ago you were saying, "Stay out?"
JEREMY GRANTHAM: Well, really very simple. Not rocket science, we take a
long-term view, which makes life, in our opinion, much easier.
STEVE FORBES: Well, everyone says it, but you certainly practiced it.
JEREMY GRANTHAM: We actually do it. Well, we tried the short-term stuff and
it was so hard, we thought we'd better do the long-term. We just assume that at
the end, in those days, of ten years, profit margins will be normal and price
earnings ratios will be normal. And that will create a normal, fair price. And more
recently, we've moved to seven years, because we've found, in our research that
financial series tend to mean revert a little bit faster than ten years, actually,
about six and a half years.So, we rounded to seven. And that's how we do it. And it just happened from
October '98 to October of '08, the ten-year forecast was right. Because, for one
second, in its flight path, the U.S. market and other markets flashed through
normal price. Normal price is about 950 on the S&P. It's a little bit below that
today.
And on my birthday, October the 6th, the U.S. market, ten years and four trading
days later, hit exactly our ten-year forecast of October '98, which is worth talking
about if only to enjoy spectacular luck. The P/E was a little bit lower than
average and the profit margins were a little bit higher, so they beautifully offset.
And given our methodology, that would mean that on October the 6th, the market
should have been fairly priced on our current approach. And indeed it was, that
was even more remarkable, 950, plus or minus a couple of percent.
STEVE FORBES: And what did you see during that ten-year period that made
you feel, other than your own models, that this was something highly abnormal,
that this couldn't last?
JEREMY GRANTHAM: Well, first of all, the magnitude of the overrun in 2000
was legendary. As historians, you know we've massaged the past until it begs
for mercy. And we saw that it was 21 times earnings in 1929, 21 times earnings
in 1965 and 35 times current earnings in 2000. And 35 is bigger than 21 by
enough that you'd expect everyone would see it. Indeed, it looks like a
Himalayan peak coming out of the plain.
And it begs the question, "Why didn't everybody see it?" And I think the answer
to that is, "Everybody did see it." But agency risk or career risk is so profound,
that even if you think the market is gloriously over-priced, you still have to get up
and dance. Because if you sit down too quickly--
STEVE FORBES: Famous words of Mister Prince.
JEREMY GRANTHAM: If you sit down too quickly, you're likely to get yourself
fired for being too conservative. And that's precisely what we did in '98 and '99.
We didn't dance long enough and got out of the growth stocks completely and
underperformed. We produced pretty good numbers, but they're way behind the
benchmark. And we were fired in droves.
I think our asset allocation, which is the division I'm now involved in, we lost 60
percent of our asset base in two and a half years for making the right bets for the
right reasons and winning them. But we still lost more money than any other
person in that field that we came across, which is a fitting reminder that career
risk runs the business.
STEVE FORBES: So, it's all right to be wrong as long as everyone else is
wrong.
JEREMY GRANTHAM: That's right. "I never saw it. Nobody saw it," that's what
they say about today's fiasco, which actually makes me quite disgusted because
almost everyone we talked to did see it coming. And I described it in June of last
year as the most widely-predicted surprise in the history of finance. And that's 18
months ago.
[07:24] A Whole New Bubble
STEVE FORBES: What was it about this bubble, do you think distinguished it, if
one can distinguish bubbles from past bubbles?
JEREMY GRANTHAM: Yeah, oh, I think this was distinguishable in many ways.
I described it, I think, accurately as the first truly global bubble. It had every
asset class, notably real estate, as well as stocks. But bonds were also
overpriced and fine arts, of course, were ridiculous. And secondly, it was global.
So, you know, Indian fine arts were going out of control. And Chinese modern
art --
- STEVE FORBES: But you still bought them, right? Indian fine arts, aren't you?
JEREMY GRANTHAM: I, perhaps, I participated too much in Indian antiquities,
which I have a soft spot for. But so, it was unique in breadth of asset class, in
breadth of reach, globally. Quite unlike anything else since the Depression and
even much broader than the bubble of 1929.
STEVE FORBES: You mentioned about career risk, that it's better to be with the
crowd than going against it and paying a price because people don't like what
you're saying. Did people really believe, do you think, their risk models that said
you can take this outsized risk but, 1) you've hedged it, and 2) if this goes up, this
goes down, and therefore, it's not-- as risky as it looks?
JEREMY GRANTHAM: Oh yes, I think they did. I think you should never
underestimate the ability of really serious quants to believe quant models. They
can really do faith big-time in those models. There's something about having a
PhD in some serious topic like particle physics or math that, when you've finished
a couple of years of hard work and you've produced a model, then your faith in it
can be intense. I think these people really did believe in that stuff.[09:24] Time To Buy
STEVE FORBES: And now that you feel the tide is turning, what should
investors do now? First of all, during that ten-year period, where did you invest
money when you saw this bubbly atmosphere? And what are you doing now?
JEREMY GRANTHAM: Most of our money is in specific funds for institutions.
So, we have an emerging market equity fund. And for institutions, they don't
want us messing around, moving up and down our cash balance. So, they're
fully invested in equities and we're trying to do the best job that we can. We have
an asset allocation group with about 40 percent of our money today.
And there, we are allowed to move around. but even there, we have a clear job
description so that in one account, for example, a fairly typical flavor, we are not
allowed to drop below 45 percent equity or go above 75. So, in the institutional
business, people are pretty hemmed in, most of the time, and we are. Most of
the last ten years, we have been promoting the idea of not taking a lot of
unnecessary risk and that's probably been the most constant theme.
The single exception to that, until quite recently, was emerging markets. We felt
that if you had this irresistible urge to take risk, you should exercise it on
emerging, because you'd get a better bang for your buck. And we were
overweighted for 12 years ending in this July. And we kind of blew the whistle in
July. We had been thinking that emerging was strong enough and fundamental
that we'd ride out the unpleasantness.
And then, on June the 26th, precisely, the penny dropped that I had been quite
optimistic on lots of little fundamentals. None of them, perhaps, profoundly
optimistic, but they accumulated to considerable optimism. And it was revealed
to me that I had just missed evaluated how bad things were going to be,
fundamentally. And one of the reasons was career risk. Because we were the
best, there was a kind of disinclination to wrack your brains to be even further off
the spectrum than you were already.
And since I was already considered a perma-bear, I thought, "Well, we're the
most bearish people around, let's leave it at that. Don't look for trouble." And
then, June the 26th, we had a Glaswegian arrive to kind of review the data with
us, an economic strategist. And he had this dour Glasgow accent. I think that
had something to do with it.
And I came out of the meeting thinking, "Holy cow, this is going to be really, really
awful." And I wrote a courtly letter immediately saying, "I recant on emerging.
Up until now, we'd been advising for two years, 'Take as little risk as you can,
except for emerging.' Our new advice is take as little risk as you can, period.'"
And we held up the letter for two weeks.
We did the biggest trade in our history. And for the first time in 12 years, we
went to underweight emerging across the board, which in some accounts meant
zero. And for the only time in my career, the emerging market immediately
nosedived. I mean, immediately, like the day after we did our trade it headed
south.
And three months later, it was down 40 percent. I mean, I've never seen
anything like that. So, we replaced it. We thought, "Well, 40 percent makes a lot
of difference to anybody." We were looking at 11, 12 percent imputed real
returns for seven years in emerging and we replaced the bet in October.
[13:20] Cheapest in 20 Years
STEVE FORBES: You went back in emerging markets.
JEREMY GRANTHAM: Back in emerging markets.
STEVE FORBES: And in terms of evaluating markets and stocks, in particular,
you have a pretty disciplined formula so you can say precisely 950 and--
JEREMY GRANTHAM: That's exactly right. It may be wrong, but it's precise.
And we've had a long history of doing it the way I described, that everything will
be normal in seven years. And it's turned out to be quite robust. And probably
pretty simple and straightforward-- an effective way of doing it. And right now,
what it says is that, since October, global equity markets have been cheap, not
dramatically cheap, not cheap like you and I have seen a couple of markets,
1982, 1974, that was very cheap, indeed.
This is merely ordinarily cheap. But it's the cheapest it's been for 20 years. For
20 years, we had this remarkable period when the markets were never cheap.
They got less expensive, you know, too, but they were never cheap. And so
now, you have this terrible creative tension between, on one hand, they're the
cheapest they've been for 20 years.
They're pretty decent numbers. For seven years, we expect seven and a half
real from the U.S., from the S&P. And perhaps nine and a half from EAFE and
emerging. These are not bad number for seven years. And on the other hand,
as historians, we all recognize that the great bubbles tend to overrun.
STEVE FORBES: Right.
JEREMY GRANTHAM: And they're not normally satisfied, you can't buy them
off by being slightly cheap. They insist on becoming very cheap. So, we've said
for several months that we thought this cycle would go to 600 or 800 on the S&P,
800 if it was a mild recession, ho-ho. Can throw that one away. And 600 would
be quite normal if it was a severe recession like '82, '74, which I think, I don't
know if you agree, is pretty well baked in the pie today. It may be worse, but it's
probably not going to be much less bad than '74 or '82.
STEVE FORBES: And so, in terms of the markets today, even though they're
cheap, you're going in gingerly or since it could theoretically go down to 600 and
given the emotions you get in these things.
JEREMY GRANTHAM: Yes, I would say two-to-one, by the way, my instinct
plus looking at the history books that it will go to a new low [in 2009]. So, this is
the problem. We're underweighted still, in an ordinary asset allocation account
that has 65 percent in equities, we have moved up to 55. So, we're still
underweight, even though they're cheaper than they've been and they're
reasonably cheap.
Now what happens? If we throw in the client's money and it goes down, indeed,
as I think it will [in 2009], they will complain quite bitterly that we weren't very
smart. We thought it was going down, and yet we threw their money in. So,
that's one kind of regret. And the other kind of regret is that we hang back and
the market runs away, the one-in-three comes up and they say, "You told us the
market was cheap. You told us that you had these nine or ten percent real return
opportunities and you're still underweight and the market's back up 200 points.
You're an idiot."
So, there's no way you can avoid some regret. You have to look at your own
personal balance sheet, how much pain can you stand? If you absolutely can't
stand a 20 percent hit, you'd better carry quite a lot of cash, because you're quite
likely to get it. If on the other hand, you're made of steel, you can concentrate on
the seven-year horizon and filter money in and having a lot of cash here is
probably a bit dangerous from the other point of view.
But in any case, it's a very personal judgment of risk avoidance and how tough
you are under stress. The worst situation that will befall probably quite a lot of
people is that they exaggerate their toughness. The market goes down 30
percent from here to 600 and they panic, dump their stocks and never get back.
And that's the worst outcome.
[17:45] Japan A Blue Chip?
STEVE FORBES: And one of the areas you seem to be interested in is
Japanese stocks?
JEREMY GRANTHAM: I think Japan may turn out, finally, in a curious way, to
be a blue chip here. They've been through a lot of the problems, their ordinary
corporations are no longer super-leveraged as they were, it took them 15 years,
but finally, they got there about three years ago. The banking system is not at
the cutting edge of all the problems, so they look relatively blue chip.
And yes, they're exposed to the global export problem, but when you look at
Japan, they are deceptively low exporting country. It's only 12 percent of their
GDP, it's much lower than most European countries, et cetera. So, I think they're
fundamentally a candidate for the blue chip and plus, they're stock prices, of
course, have been terrible.
STEVE FORBES: Right.
JEREMY GRANTHAM: It's taken them 17 years to lose 78 percent of their
money. This is what I say, that exhibit is called "stock for the very, very long
run." Aimed at Jeremy Siegel if you think that people are machines, then of
course you can tuck stocks away and hold them forever. But ordinary human
beings don't like to wait 17 years to lose 78 percent of their money or 28 years to
round trip in Japan.
They haven't made a penny in 28 years, including dividends, in real terms. And
people have dismissed that, "That's Japan, we're the U.S." And that is, in a way,
the most simple minded of logic. Of course, every country is different. But do
not think that we can't have terrible times. I sincerely hope we will not, and I
don't expect that we will. But you have to consider it a possibility.
[19:38] Emerging Markets- STEVE FORBES: Now, looking at emerging markets, what ones stand out as
particularly enticing right now, or do you try to emerge them all together?
JEREMY GRANTHAM: Merge the emerging, yes. We do, I think. Emerging
market is no longer at all monolithic. There is an exporting clutch, there is a
handful of eastern European that looks a little shaky. There are two or three that
have forgotten the rules of the Asian crisis and have accumulated some foreigndenominated
debt that leaves them very vulnerable. And increasingly, each one
looks separate. But in general, many of them have better finances than they had
in other crises.
STEVE FORBES: Any ones particularly stand out that you?
JEREMY GRANTHAM: Well, Brazil, of course, is much improved from the way it
used to be and has a nice position in natural resources. And on a very long
horizon, I like its style. I'm not making a recommendation based on today's price.
Indeed, I don't know today's price, they most so fast. We had one day the other
day when their entire fund and the index was up over 10 percent for the day. So,
the numbers change at bewildering speed these days.
[20:59] Buy Big US Stocks
STEVE FORBES: And U.S. blue chips, you--
JEREMY GRANTHAM: No, U.S. blue chips, I think is manna from heaven.
They're conservative in a risky world. The best companies on the face of Earth,
right? And from '02 to '07, they were considered boring and all the action was in
the racier, more leveraged stuff. They underperformed every single year from '02
onwards and five years in a row. So, when this trouble started to escalate, they
were about as cheap, on a relative basis, as they ever get.
They were not absolutely cheap, but they were relatively very cheap. And the
best bet, for my money, then and now, a year later, was to buy the great
franchise companies, the great quality companies and to go short the junkier,
more leveraged companies. That's been a very profitable strategy and one of the
few things that has been working this year. This year, of course, as you know,
has been the year from hell for money managers.
The value traps, the like of which we haven't seen since the 1930s, the great
value managers all made their reputation by being braver than the next guy, by
buying the WaMus of the world when they'd fallen to seven and they'd bounce
back to 28. And this time they went from seven to three and they doubled up
again and they went to zero.
It's been a nightmare. And the quants, who use momentum as well as value,
have had no better luck with momentum. And the quant techniques of balancing
- 28 -
risk have also failed, as we were discussing. So, this has been a dreadful year
for money management. And quality has been the one theme that has worked.
And interestingly, from our firm's point of view, it's not a theme that other people
seem to have adopted.
There are not quality funds, there are large cap and growth and value, but there
are no quality funds. And so, it's been hard for people to pick up that theme. But
it has been very, very good since September.
STEVE FORBES: What are a couple of examples of what you consider quality
companies?
JEREMY GRANTHAM: I'm not recommending these companies, except
generically.
STEVE FORBES: Right.
JEREMY GRANTHAM: But, no surprise is Coca-Cola, Microsoft, Proctor and
Gamble, Johnson & Johnson. These are the essence of the great franchise
companies. And collectively, they're not that dependable in bear markets, but
they're incredibly dependable when people's confidence in the fundamentals start
to go. In Japan, for example, the quality companies in Japan outperformed for
nine consecutive years when their troubles came.
They accumulated again against the Japanese market of 98 percent points.
They were brilliant in the Great Depression between '29 and '32. Even though
the Coca-Colas were relatively overpriced in '29, they still went down dramatically
less than the junky companies. But they're the great test of quality. So, you
wouldn't expect quality to be dependable unless we were having the kind of
environment that we seem to be having. And I think they will have legs, they will,
the high quality companies can outperform, handsomely still, from here.
[24:17] Stimulus!
STEVE FORBES: Commodities, you were short oil, your firm was short copper.
When do you go long, or is that just a sideshow?
JEREMY GRANTHAM: That's a very good question. I was thinking about that
in the taxi today. When you see oil breaking $40, I believe oil is the great
exception. I asked over 2,000 full-time professionals to find me a paradigm shift
in a major asset class and they never offered me one, so I was very pleased to
offer oil a couple of years ago. I thought it was the genuine paradigm shift. I
thought that after 100 years at $16 a barrel, it had jumped to maybe $36 or $37
in real terms. And I think it has probably jumped again. It will be revealed in 20
years to what level. But my guess is $60, $65, maybe even $70. But what
people underestimate, even in the oil industry, is how volatile the asset class is.
- 29 -
In other words, if the trend is $65, it is fairly routine for oil to sell below half, say
$30 and more than double, say $145.
And people never get that. So, you don't want to be too quick to buy into
weakness or sell into strength, necessarily. But it can go a long way. But below
40, I must say, I do get a bit interested. And below 30, I'm definitely a buyer.
STEVE FORBES: Wow.
JEREMY GRANTHAM: And copper, copper's done so brilliantly on the
downside, that you really begin to ask, it must be approaching cost of production
somewhere in the next ten or 15 percent, you have to say, "That was very nice,
thank you," and cover.
STEVE FORBES: Now, in terms of the U.S. economy, you've seemed to be
saying that the Fed is doing right, print all you can, and for the government, to
spend all you can.
JEREMY GRANTHAM: Yes, which I have to choke on, as I have no doubt, you
would. Because, normally, it's a terrible
STEVE FORBES: That's why I'm not drinking the water, I don't want to choke.
JEREMY GRANTHAM: It's normally terrible advice. It's only useful when it's the
real McCoy. And I think it is. And if there's unemployment, having the
government help reduce that unemployment, increase employment directly is a
pretty good idea. It's not driving out competition, it's not crowding out. As long
as there's excess unemployed people sitting around like the Great Depression,
you should do everything you can to get them employed and get the system
going again, just as a temporary stopgap, or I believe.
And I think by combining that with energy sufficiency, particularly labor-intensive
kind of energy avoidance, installing insulation, storm windows, very labor
intensive. Battering down solar cells on the roofs of Wal-Marts in California. I
think that will be some of the highest return investments that anyone ever makes.
Just return on capital is very, very high in efficient light bulbs. And therefore
should be done. And I don't mind the government accruing debts as long as
every dollar is spent effectively, with a high return. That works out fine. If you
accumulate debts and waste your money, that's, of course, a disaster. I know I'm
preaching to choir on that one.
STEVE FORBES: And what about tax rates? Isn't that the best stimulus?
Lowering tax rates, changing incentives?
- 30 -
JEREMY GRANTHAM: The trouble is, in these very rare occasions, that
sometimes does not work. Normally, of course, it's a lay-up. But if you give
Japanese corporations were the real crunch there. Here it's consumers.
Japanese corporations had so much debt, that as you threw money at them, they
paid down their debt. They didn't build new factories. They were waking up at
3:00 in the morning sweating that they were insolvent.
Of course, technically, they were insolvent. So, they paid down debt and they
paid down debt. Our consumers are so leveraged that you run the risk with a tax
cut that they're in the same boat. You write them a check, even, same thing as a
tax cut, really. Write then a check for $250 and they'll pay down their credit card
debt because they're getting desperate. They are hugely overstretched. So, it
doesn't necessarily work anymore, pushing on a string. And whereas, if you get
out there and spend money to employ people directly, bashing insulation into
your attic, that does work.
[28:53] Our Leaders Failed
STEVE FORBES: So, what is the one big misplaced assumption today when
you look around at this?
JEREMY GRANTHAM: Reviewing the last two years, of course, it's a misplaced
trust in the competence of our leadership, from the very top. But certainly,
notably, the Fed, the arch-villains of this piece, Treasury, little better, the SEC.
They were cheerleaders, all of them. And they encouraged reckless leverage
and low-quality debt, complicated, un-researched, generally disgraceful.
And they made no effort to resist it in any way. Even jawboning would have been
a great advantage over nothing. Greenspan encouraged, admired the ingenuity
of the new instruments for sub-prime. I mean, went out of his way to encourage
it. Some, as in Greenspan, beat back an attempt to do some regulating of
subprime markets. And I think it looked pretty bad.
Hank Paulson did not move fast enough to recognize that the impending decline
of house prices would create some problems. And Bernanke couldn't even see
the house bubble. On our data and Robert Shillers, it was a three-sigma, one-in-
100 year event. After 100 years of being flat, it soared after 2000. You could not
miss it. And right at the peak, October '06, Bernanke said, "The U.S. housing
market merely reflects a strong economy," unquote.
What was he looking at? Where were his statisticians? These are the guys we
picked out of millions to lead us in a crisis. And they can't see a three-sigma
bubble? Every single bubble of that kind has broken. Asset classes are
incredibly dangerous when they form a bubble and when the bubble breaks. And
Greenspan did not get that, and I've been screaming “abuse” forever. It seems
- 31 -
like as long as I can remember, but I wrote a piece in 2001 called “Feet of Clay,”
saying basically, "This bubble from 2000 will be hard to forgive."
And of course, it was the ancestor of the current problem and the housing
bubble. The housing bubble is even more dangerous because more people own
houses. It's more for the ordinary people. And borrowing is so much easier. So,
that is really the most dangerous. And to do two at once, this time around, and to
do it globally it to truly play with fire. We have lost, or will have lost, is my
estimate, at the bottom, $20 trillion of formerly perceived wealth, from $50 trillion
to $30 [trillion].
And at $50 trillion, we had $42 trillion of debt, of all kinds, which is a fairly
suspiciously high 80 percent ratio of assets. But at $30 [trillion], we will have $42
trillion of debt, which is much more than suspicious. And bankers, who always
get religion after the event, are now going to say that 60 percent ratio might look
better.
And 60 percent of $20 [trillion] is not going to make much of an impression on the
$42 trillion of debt that we have. So we have a lot of what I call "stranded debt,"
$15, $20 trillion. Even at fair price, which is, perhaps, $25 trillion. There's still a
lot of stranded debt. This is going to take years to work through the system, not
a year or two.
[32:37] Dysfunctional Markets
STEVE FORBES: So, what is the best financial lesson you've learned? You've
been in this business for decades.
JEREMY GRANTHAM: The market is incredibly inefficient and capable on rare
occasions of being utterly dysfunctional. And people have a really hard time
getting their brain around that fact. They want to believe that it's approximately
efficient almost all the time and it simply isn't true.
[33:07] China Bubble
STEVE FORBES: So, what is your bold prediction for the future, now?
JEREMY GRANTHAM: In the long run, things will be back to normal. In the
short run, I think China will be a bitter disappointment. I can't believe that the
hardest job in economic history, guiding a vast empire of people and assets,
growing at double-digit industrial production rates can be anything but difficult.
And they've had much less experience than most capitalist countries.
And they have been because of 20 years of wonderfully good luck and favorable
circumstances, we have all been seduced into believing that there walk on water.
- 32 -
And I don't think they do. I think they have a terrible situation, which will be under
stress from all sides.
They export 40 percent of their GDP. The global economy gives a passably
good impression of having run, head down, into a very thick cement wall. And I
can't imagine that their exports will be anything other than mildly disastrous. And
yet, two months ago, the official forecast was still that it wouldn't drop below nine.
I mean, that is at least faintly ludicrous.
STEVE FORBES: What are the other fault lines you see in China?
JEREMY GRANTHAM: I'm not a China expert, so I'd be happy to leave it.
STEVE FORBES: Well, the experts weren't, either.
JEREMY GRANTHAM: They have a very small consumer sector, so it's hard to
stimulate that. A very large capital spending sector, how low does an interest
rate have to get to build another steel mill when there are seven up the road
empty, not operating. It's not an easy situation, I think. Direct spending on roads
and so on is something that might work.
But can they do it big enough since they're already doing it at a dramatic level;
can they increase it enough to rev their economy? I don't think so. I think their
economy will be very flattish for a while. And that will be a bitter shock to
everybody who's learned to depend on them.
STEVE FORBES: And one last question on China, their financial sector, their
stock market, in your mind, is that still very primitive? Does it really provide
capital for genuine entrepreneurs, or is it still all still?
JEREMY GRANTHAM: I can't. I really am not an expert. You look back, and
what you do see about the Chinese market is that it was again, a classic bubble.
It's a beautiful shape, symmetrical, it rises, it peaks and it drops slightly faster
than it went up, which is actually quite typical. And it was a great opportunity that
I regret not having capitalized on more than I did.
STEVE FORBES: But now you're staying away.
JEREMY GRANTHAM: Well, now it's completed the obvious part of the bubble.
It's back to kind of trend line. It may not be, you know, on a long-term
perspective, particularly more vulnerable than others. Even though their
economy will be disappointing in the short-term, of course, it has enormous longterm
potential. I do think emerging is the place to be, in the long-run.
I think it has all the indicators that will be required for the next bubble. It has
wonderful top-lying growth relative to an increasingly sluggish developed world.
- 33 -
It has a very high savings rate and investment rate. And I think it will become a
cliché how passé we all are, the U.S., the U.K., Europe, Japan.
We're running out of people. The number of man-hours offered to the markets
have been dropping without anyone talking about it for ten or 12 years.
Collectively, the G7 is way off its old trend line. By next year, the U.S. will be 14,
15 points behind its long-term trend rates. It's never come close to since the
Great Depression.
STEVE FORBES: Trend line, meaning?
JEREMY GRANTHAM: Just to take the 100-year battleship trend line, which
never deviated at 3.4 or something like this. The Great Depression, it went back
to trend very quickly. And now, we have been drifting off for this is year 13 of
drifting blow trend. We're simply getting more mature and all the other developed
countries are doing the same thing. But emerging has not fallen off its trend line
and has a lot of people coming into the workforce and a huge savings rate.
I think it will do very well. Put it this way, it will appeal to investors. It may not
make any more earnings per share, in other words, I'm not talking about true
fundamental value. I'm talking about how people buy stocks. They love top-line
growth. If they're going to grow at four and a half and we're going to slow down
to two and a half, it's going to look like a no-brainer. So, I think the next big event
in emerging will be that they will sell it at a big P/E premium over us developed
countries, who are suffering from a terminal case of middle-aged spread, I think.
STEVE FORBES: Well, clearly, the way you look at life is anything but a nobrainer.
Thank you very much.
JEREMY GRANTHAM: Thank you. I enjoyed it.
Entrepreneur.com - How to Get Your Emails Read
Thursday, January 15, 2009
Top Secret: Get Your E-mails Opened
Derek Gehl
Entrepreneur.com
As the economy continues along its unsteady path, many small-business owners have been asking me what they can do to keep their businesses financially healthy over the coming months.
I recommend you start by leveraging the tools you already have, and making sure you're using them as efficiently and effectively as possible.
Take your e-mail marketing, for instance. When you stay in touch with your regular customers and subscribers--and send them valuable information--they'll view you as a credible resource, an expert in your field, and most important, someone who's watching out for their best interests.
And they'll reward you with their loyalty (and continued purchases).
But first you have to get those e-mails opened.
With floods of e-mail arriving every hour, most people are ruthless about deleting anything they even suspect won't interest them. Not only that, they're also just as likely to report unwanted e-mails as spam as they are to delete them. So if you're not writing compelling subject lines that get the e-mails opened, all your hard work is lost.
Here are five tips for writing effective e-mail subject lines that can easily double the open (and click-through) rates on your next e-mail.
Tip #1:Use personalization for added attention
Sending out an e-mail with a personalized subject line is the equivalent of calling someone's name in a crowd: It has that same power to grab his attention.
By now, using the recipient's name in your subject line is pretty standard. But that's only the start. You can take personalization further by adding another personal detail to the subject line, like the city your customers live in.
Start with a subject line that looks like this: "Janet, want to get out of the city this weekend?"
Then make it really compelling by adding personal details: "Janet, want to get out of Tucson this weekend?"
A DoubleClick survey found that the most important factor in generating a response was offering a product the recipients wanted at the time. You can accomplish that by segmenting your market, allowing you to personalize the offers or the information in your e-mails to make them timely and relevant.
That means collecting as much data as possible on each person on your mailing list. Then you can create separate campaigns that will appeal to each segment of your audience (e.g., subscribers; people who have purchased once; and people who have purchased more than once).
If your offer is highly personalized, your subject lines can be, too.
And the great thing is that there are plenty of tools out there that can manage and merge in your data to create targeted e-mail campaigns. (We likeiContact.com.)
Tip #2:Keep your subject lines short
Here's a test: Take a look at the subject lines in your inbox. Are there any that stand out more than others? Any that you read first or get you interested in learning more? Chances are it's the shorter subject lines that grab you, right?
It's actually been proven that subject lines with 41 characters or under get higher opening and click-through rates than longer ones. So keep it short and sweet. You don't need to explain in detail what the e-mail is about in the subject line; you just need to give enough information to make people want to open the e-mail to read more. E-mails alerting recipients to a regular subscription product or downloadable information can be longer--test and see what works.
Make sure you put your benefit, offer or most important element in the first few words of the subject line, too. That way, if someone's e-mail program cuts off the end of the subject line (which is pretty common) you'll still get your main point across.
Tip #3:Keep the formatting simple and understated
If you sent an e-mail to a friend, would you type your subject line like this?
"Free Beer And Pizza -- You're Invited!!"
Or how about like this?
"FREE BEER AND PIZZA -- YOU'RE INVITED!!"
It's pretty unlikely, right? So why would your e-mails to your customers and subscribers have subject lines that were formatted like that?
The more your subject lines look like personal e-mails from friends, family members or business associates, the more likely it is that they'll be opened. The more they look like a hard-sell sales pitch, the less effective they'll be.
So avoid capitalization, exclamation marks and dollar signs, which can increase the chances of having your messages flagged as spam, and will be sure to set off warning bells with your recipients.
Tip #4:Use a compelling angle to get your readers interested
Of course, getting your readers to open your e-mails requires more than personalization and formatting. You'll still need to come up with an interesting angle that grabs your customers' attention and makes them want to open the e-mail.
Here are some ideas for subject lines that we've had success with in the past:
Make an announcement or share news: People want to be the first to find out new things, especially if your site covers a specific industry.
Make your reader curious: Suggest that the reader is missing out on an important offer or piece of information. When you use this technique, make sure you leave something to the imagination. For example: "Paul, are you making this common mistake?"
Create a sense of urgency: Consider creating a sense of urgency in your subject line by limiting time ("Frank, only three days left") or quantity ("Mary, only 250 copies available").
Emphasize benefits: Another powerful approach for your subject line is to state how your readers will benefit from your e-mail. If you can tell them how they're going to save money, save time, make their lives easier, etc., by opening and reading your message, you'll have the most success.
Tip #5:Make sure your subject line relates to the content of the e-mail
Nobody likes to be fooled or tricked, so make sure your subject line is related to your actual message--in fact, it's a legal requirement under the CAN-SPAM Act that the subject line be authentic and not misleading.
If your subject line says "Mary, three ways to save money," you need to make sure you actually are talking about that, and preferably within the first few lines. Otherwise, your visitors will feel cheated, and that will hurt your credibility.
And don't forget about the preview pane. Statistics from MarketingSherpa show that 26.6 percent of consumers read e-mails that way. And 69 percent of people reading e-mail at work do so with the preview pane turned on. You risk losing those readers if you don't follow up your subject line almost immediately in the body of the e-mail.
It's time worth spending to come up with subject lines that will entice people to open your e-mails. Those five or six words are vital to your business because they connect you with your most valuable potential customers. So never stop testing them and trying new ones.
Derek Gehl is Entrepreneur.com'se-business columnistand CEO of theInternet Marketing Center. He's an internationally renowned internet marketing expert whose techniques and strategies for building a successful online business have been implemented by hundreds of thousands of businesses worldwide. His comprehensive internet marketing guide, The Insider Secrets to Marketing Your Business on the Internet, has been an online bestseller for 10 years.
Top Secret: Get Your E-mails Opened
Derek Gehl
Entrepreneur.com
As the economy continues along its unsteady path, many small-business owners have been asking me what they can do to keep their businesses financially healthy over the coming months.
I recommend you start by leveraging the tools you already have, and making sure you're using them as efficiently and effectively as possible.
Take your e-mail marketing, for instance. When you stay in touch with your regular customers and subscribers--and send them valuable information--they'll view you as a credible resource, an expert in your field, and most important, someone who's watching out for their best interests.
And they'll reward you with their loyalty (and continued purchases).
But first you have to get those e-mails opened.
With floods of e-mail arriving every hour, most people are ruthless about deleting anything they even suspect won't interest them. Not only that, they're also just as likely to report unwanted e-mails as spam as they are to delete them. So if you're not writing compelling subject lines that get the e-mails opened, all your hard work is lost.
Here are five tips for writing effective e-mail subject lines that can easily double the open (and click-through) rates on your next e-mail.
Tip #1:Use personalization for added attention
Sending out an e-mail with a personalized subject line is the equivalent of calling someone's name in a crowd: It has that same power to grab his attention.
By now, using the recipient's name in your subject line is pretty standard. But that's only the start. You can take personalization further by adding another personal detail to the subject line, like the city your customers live in.
Start with a subject line that looks like this: "Janet, want to get out of the city this weekend?"
Then make it really compelling by adding personal details: "Janet, want to get out of Tucson this weekend?"
A DoubleClick survey found that the most important factor in generating a response was offering a product the recipients wanted at the time. You can accomplish that by segmenting your market, allowing you to personalize the offers or the information in your e-mails to make them timely and relevant.
That means collecting as much data as possible on each person on your mailing list. Then you can create separate campaigns that will appeal to each segment of your audience (e.g., subscribers; people who have purchased once; and people who have purchased more than once).
If your offer is highly personalized, your subject lines can be, too.
And the great thing is that there are plenty of tools out there that can manage and merge in your data to create targeted e-mail campaigns. (We likeiContact.com.)
Tip #2:Keep your subject lines short
Here's a test: Take a look at the subject lines in your inbox. Are there any that stand out more than others? Any that you read first or get you interested in learning more? Chances are it's the shorter subject lines that grab you, right?
It's actually been proven that subject lines with 41 characters or under get higher opening and click-through rates than longer ones. So keep it short and sweet. You don't need to explain in detail what the e-mail is about in the subject line; you just need to give enough information to make people want to open the e-mail to read more. E-mails alerting recipients to a regular subscription product or downloadable information can be longer--test and see what works.
Make sure you put your benefit, offer or most important element in the first few words of the subject line, too. That way, if someone's e-mail program cuts off the end of the subject line (which is pretty common) you'll still get your main point across.
Tip #3:Keep the formatting simple and understated
If you sent an e-mail to a friend, would you type your subject line like this?
"Free Beer And Pizza -- You're Invited!!"
Or how about like this?
"FREE BEER AND PIZZA -- YOU'RE INVITED!!"
It's pretty unlikely, right? So why would your e-mails to your customers and subscribers have subject lines that were formatted like that?
The more your subject lines look like personal e-mails from friends, family members or business associates, the more likely it is that they'll be opened. The more they look like a hard-sell sales pitch, the less effective they'll be.
So avoid capitalization, exclamation marks and dollar signs, which can increase the chances of having your messages flagged as spam, and will be sure to set off warning bells with your recipients.
Tip #4:Use a compelling angle to get your readers interested
Of course, getting your readers to open your e-mails requires more than personalization and formatting. You'll still need to come up with an interesting angle that grabs your customers' attention and makes them want to open the e-mail.
Here are some ideas for subject lines that we've had success with in the past:
Make an announcement or share news: People want to be the first to find out new things, especially if your site covers a specific industry.
Make your reader curious: Suggest that the reader is missing out on an important offer or piece of information. When you use this technique, make sure you leave something to the imagination. For example: "Paul, are you making this common mistake?"
Create a sense of urgency: Consider creating a sense of urgency in your subject line by limiting time ("Frank, only three days left") or quantity ("Mary, only 250 copies available").
Emphasize benefits: Another powerful approach for your subject line is to state how your readers will benefit from your e-mail. If you can tell them how they're going to save money, save time, make their lives easier, etc., by opening and reading your message, you'll have the most success.
Tip #5:Make sure your subject line relates to the content of the e-mail
Nobody likes to be fooled or tricked, so make sure your subject line is related to your actual message--in fact, it's a legal requirement under the CAN-SPAM Act that the subject line be authentic and not misleading.
If your subject line says "Mary, three ways to save money," you need to make sure you actually are talking about that, and preferably within the first few lines. Otherwise, your visitors will feel cheated, and that will hurt your credibility.
And don't forget about the preview pane. Statistics from MarketingSherpa show that 26.6 percent of consumers read e-mails that way. And 69 percent of people reading e-mail at work do so with the preview pane turned on. You risk losing those readers if you don't follow up your subject line almost immediately in the body of the e-mail.
It's time worth spending to come up with subject lines that will entice people to open your e-mails. Those five or six words are vital to your business because they connect you with your most valuable potential customers. So never stop testing them and trying new ones.
Derek Gehl is Entrepreneur.com'se-business columnistand CEO of theInternet Marketing Center. He's an internationally renowned internet marketing expert whose techniques and strategies for building a successful online business have been implemented by hundreds of thousands of businesses worldwide. His comprehensive internet marketing guide, The Insider Secrets to Marketing Your Business on the Internet, has been an online bestseller for 10 years.
The TARP Banks - Bloomberg Chart of the Day
TARP Bank Shares Dwarf Decline in S&P 500: Chart of the Day
By Ari Levy
Jan. 27 (Bloomberg) -- Since the U.S. Treasury began investing in banks through its Capital Purchase Program, a gauge of participating companies’ share prices has lost four times as much as the Standard & Poor’s 500 Index.
The CHART OF THE DAY shows that an index of 201 publicly traded companies to receive funding in the plan, part of the Troubled Asset Relief Program, has plunged 45 percent since Oct. 28, compared with an 11 percent decline in the S&P 500. The 81- company S&P 500 financials group has dropped 41 percent. The TARP index is weighted by the amount each company took.
“I don’t think anyone behind the TARP plan thought this would be a get-rich-quick scheme,” said Jack Ablin, chief investment officer at Harris Private Bank in Chicago, which oversees $55 billion. “The jury is still out on this stuff.”
Citigroup Inc. and Bank of America Corp., which make up a combined 13 percent of the TARP index, have been the biggest drags on the Treasury’s investment, each dropping more than 70 percent. The companies reported fourth-quarter net losses of $8.29 billion and $1.79 billion, respectively, because of soured mortgages and related securities. Only 15 members have gained, led by Morgan Stanley, which climbed 26 percent.
The six biggest lenders in the index make up 57 percent of the group’s value. They’ve dropped an average of 39 percent since Oct. 28.
To contact the reporter on this story: Ari Levy in San Francisco at alevy5@bloomberg.net.
Last Updated: January 27, 2009 00:27 EST
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America's Banks (Financial Times)
America’s banks need to hold a yard sale
By Meredith Whitney
Published: January 21 2009 19:33 | Last updated: January 21 2009 19:33
A clear lesson learnt from this credit crisis has been to sell and sell early. However, it appears as if US banks are setting out to make some of the same mistakes of the past 18 months all over again. In many instances, those mistakes determined who survived and who did not.
Throughout 2007 and 2008, when I asked managements why they were not more aggressive in disposing of assets, the common answer I received was that they believed current prices were too distressed and did not reflect the true underlying value. Unfortunately, the longer they waited, the less these assets were in fact worth. Such a strategy cost Merrill Lynch and Citigroup more than half of their per share capital. In the case of Lehman Brothers and Bear Stearns, capital all but vaporised. These are just some examples but in reality this applies to too many financial institutions.
Throughout 2008, hundreds of billions of dollars were raised to recapitalise US financial institutions, but this money simply went to plug holes created by holding on to assets with declining values. Until the fourth quarter, monies were raised from willing investors. However, beginning in the fourth quarter with troubled asset relief programme capital created to recapitalise these institutions, US taxpayers became the default investors.
Now, when the average taxpayer finds him or herself overextended, he or she is forced to backtrack and, in situations of duress, sell stuff (otherwise known as a yard sale). In these cases, selling a set of snow skis for $15 or a prized record collection for $10 is not desirable but is necessary. Why should the US taxpayer be forced to fund behaviour that he or she would never have the luxury of indulging in?
Citigroup provides a prime illustration to support this argument. Last Friday, Vikram Pandit, Citigroup’s chief executive, stated: “We are not in a rush to sell assets.” This comes from a company that has incurred more than $51bn (€39bn, £36bn) in writedowns and has called upon more than $45bn in Tarp money from the taxpayer. At a minimum, this seems like a company currently operating under a different rule book from that used by taxpayers.
What is more, taxpayer dollars will have increasing demands on them. Thirty eight states are underfunded: already California and Arizona have begged for more than $10bn in federal dollars, while at least 36 more states have shortfalls in their 2009 budgets totalling more than $30bn. I believe they will be forced to sell assets such as toll roads and airports. It is worth noting that the US is well behind the rest of the world in terms of private ownership of such assets.
The fact is that there is money on the sidelines looking for opportunities to invest. One constant question I get from investors, who need somewhere to put their money, is: if I had to own something, what would it be? I am not very helpful to them at the moment as my answer is that I would own nothing. I do tell them that I believe that later in the year there will be fabulous opportunities to invest in new combinations of businesses that are currently “off the menu” to individuals. What I mean by this is that the system will eventually force disposals of assets: here I am just arguing that we need to get to it sooner rather than later.
Funding is the critical challenge to outsiders’ ability to bid more aggressively for assets. Many of these potential investors have clean balance sheets and, if provided with the appropriate funding concession (guarantees of long-term, low-cost capital from the government), could also more ably lubricate the financial system by making actual loans. These investors could be private-equity firms or existing public companies. The key here is government providing a funding concession and the banks being forced to sell assets that could raise capital and provide some tax relief to taxpayers.
No one doubts that losses will go higher, so asset sales are certain to be heavily discounted just as initial bids for collateralised debt obligations and retail mortgage-backed securities were. However, in retrospect, those “discounts” were far less than the writedowns companies took just months later. While it is never pleasant to sell one’s “crown jewels”, the strain of this credit crisis and the overextension of many bank balance sheets will require that they sell what they can and perhaps not what they would like. After all, that is what the average taxpayer would be forced to do.
The writer is managing director of Oppenheimer & Co
Copyright The Financial Times Limited 2009
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Marketwatch: Aflac Slumps on Preferred Impairment
Aflac slumps on concern about investments
Insurer may be exposed to hybrid securities issued by troubled financial firms
By Alistair Barr, MarketWatch
Last update: 6:44 p.m. EST Jan. 22, 2009
SAN FRANCISCO (MarketWatch) -- Shares of Aflac Inc. lost more than a third of their value Thursday on concern about exposures within the insurer's investment portfolio.
Aflac said it's "comfortable" with its current capital position and will provide more details about its investments when the company reports fourth-quarter results on Feb. 2.
The insurer may be exposed to investment losses stemming from a recent slump in the value of hybrid securities issued by European financial institutions such as Royal Bank of Scotland PLC, according to Morgan Stanley analyst Nigel Dally.
Aflac (AFL) has $7.9 billion of exposure to hybrid securities, Dally wrote to investors Thursday. He estimated, using the statutory filings, that roughly 80% of this exposure is to European financial-services firms, with U.K. banks including RBS , Barclays PLC , and HBOS among the holdings.
"The hybrid-security prices related to these institutions were already under pressure at the end of last year," Dally said. "However, those price declines pale in comparison to the sharp fall-offs we have seen in the past week, where the investor concerns over the possibility of nationalization of some institutions has led many of these securities to decline 30% or more."
If institutions are nationalized, holders of their hybrid and preferred securities could be wiped out, according to John Nadel, an analyst at Sterne, Agee & Leach.
When Fannie Mae (FNM ) and Freddie Mac (FRE) were seized by the U.S. government last year, the preferred securities of the mortgage giants became essentially worthless, he noted.
The PowerShares Financial Preferred Portfolio (PGF) , an exchange-traded fund that tracks preferred and hybrid securities issued by financial firms, has slumped 27% in the past week on concern about the potential nationalization of RBS and other banks. The ETF fell 7.2% on Thursday.
If even a small portion of the losses on Aflac's hybrid holdings are realized, the hit to the insurer's capital ratios could be "substantial," and its overall capital adequacy could be significantly less than most investors believe, Dally warned.
Aflac shares slumped 37% to close at $22.90 on Thursday. That's the lowest level for the stock since early 2000.
"We're comfortable with our current capital position and are constantly monitoring our investment portfolio," said Laura Kane, a spokeswoman at Aflac. "We will be issuing our earnings release on Feb. 2 and specific details will be available then."
Too big to fail
Aflac has long been considered among the most conservative insurers based on its investment portfolio and the amount of capital it keeps on hand to pay claims. The company avoided big investment losses from the subprime mortgage meltdown and has always bought investment-grade securities, Dally noted.
However, the credit crisis has hit so many parts of the financial sector that even companies like Aflac may now be affected.
Indeed, State Street Corp. (STT) , known as a steady, custodial bank where investors store their securities, lost almost 60% of its market value on Tuesday after disclosing $3 billion of mark-to-market investment losses from the fourth quarter. See full story on State Street.
Aflac invested roughly 80% of its $7.9 billion hybrid preferred securities portfolio in large European financial institutions because the insurer thought governments in the region would step in to prevent the companies failing, Morgan Stanley's Dally said on Thursday.
"This indeed has proved to be accurate," he wrote. "However, there is a question of what components of the capital structure the government will backstop."
"If some financial institutions are nationalized, there is the possibility that both the common stock, regular preferred stock, and callable preferred could be essentially wiped out," Dally added.
New capital?
If Aflac suffers a 10% loss on its overall hybrid securities exposure, the insurer would still have a relatively strong risk-based capital ratio of roughly 370%, Dally estimated.
The risk-based capital ratio, or RBC, measures the amount of capital an insurer has to support its operations and the risks it has taken on.
If Aflac suffers a 15% loss on its hybrid exposures, its RBC ratio could fall to about 339%, a level that could put the insurer's credit ratings at risk and force it to raise new capital, Dally said. End of Story
Alistair Barr is a reporter for MarketWatch in San Francisco.
How to Use Inverse Exchange Traded Funds on Marketwatch
ETF INVESTING
Short plays only
Holding leveraged and inverse ETFs too long distorts objectives
By John Spence, MarketWatch
Last update: 3:32 p.m. EST Jan. 18, 2009BOSTON (MarketWatch) -- The market rout in 2008 has exposed the dangers of leveraged and leveraged inverse exchange-traded funds, designed to capture two or three times the movement in a particular stock index or provide 100% opposite results, as investors learned the hard way about the tax and performance distortions inherent in the funds.
These relatively new financial products are "among the fastest growing segments of the U.S.-listed ETF market" with $21.6 billion in assets and $17.4 billion in average daily trading volume, Morgan Stanley analysts led by Dominic Maister wrote in a research note last week.
Leveraged and inverse ETFs are "appropriate tools for some investors looking to make short-term tactical trades if they perceive a high likelihood of a strong market move occurring in a relatively short time period," said Maister.
In other words, traders and speculators can get more bang for their buck if they're trying to exploit quick market swings. Of course, losses are also magnified when markets move against the trade.
However, the effects of compounding "and the daily re-levering or de-levering that occurs within leveraged and leveraged inverse ETFs can lead to unexpected results over the long-term," Maister said. Investors probably don't want to hold leveraged and inverse ETFs more than a few days, experts warn.
The key point is that these ETFs provide leverage on a daily basis. Simply, investors are mistaken if they think they can buy a twice-leveraged ETF, hold it for a year, and end up with double the market's return.
"We cannot stress enough that these aggressively leveraged products are not suitable as long-term investments," said John Gabriel, ETF analyst at Morningstar.
Understanding performance
Market volatility can also play havoc with performance over longer periods. Some analysts have seized on the performance of leveraged ETFs tracking energy stocks during a wild 2008. The sector rose early in the year but corrected hard during the back half.
ProShares Ultra Oil & Gas ( ProShares Ultra Oil
DIG) lost 72% in 2008, according to ProShares. The bearish leveraged version, ProShares UltraShort Oil & Gas ( DUG) , also lost money last year, shedding nearly 11%. Yet on a daily basis, the ETFs delivered their targeted leverage like clockwork, so they behaved exactly as they should have.
In fairness, the providers of leveraged and inverse ETFs are upfront about the performance issues over the long term on their Web sites and in the prospectus.
"A common misconception is that ProShares should also provide 200%, -200% or -100% of index performance over longer periods, such as a week, month or year," ProShares says on its site. "However, ProShares' returns may be greater than -- or less than -- what you'd expect over longer periods." See the document at ProShares.com.
Therefore, if investors do stay in leveraged funds for any extended period of time, they should consider rebalancing frequently and keep a close eye on performance.
ProShares Chief Executive Michael Sapir said the firm wants all its investors to understand the math of compounding returns and how it affects its leveraged financial products.
"We think we've done a good job in trying to disclose the information," Sapir said in an interview. "We welcome every opportunity to get the word out."
ETFs on steroids
ProShares is one of a trio of investment managers overseeing leveraged and inverse ETFs that also includes Rydex Investments and Direxion Funds.
Leveraged ETFs managed by ProShares and Rydex are designed to provide 200% of the daily performance of their targeted indexes. Their inverse ETFs shoot for 100% of the inverse, or opposite, daily return, so they can be used to bet against markets or hedge.
Leveraged inverse ETFs aim for negative 200% returns on a daily basis. So if the target benchmark fell 2% in a trading session, these leveraged inverse ETFs are geared to rise about 4%, minus fees and transaction costs.
More recently, Direxion Funds has launched ETFs to provide even more leverage, at 300%, of daily index returns in both directions. The funds have gotten off to a strong start in terms of attracting assets and trading volume.
Some traders like juiced-up ETFs because the funds allow them to get leveraged exposure to the market or individual sectors in liquid vehicles that can be bought and sold during the day. Investors don't have to open up a margin account to tap leverage.
Meanwhile, inverse ETFs let investors profit from market declines or hedge their long positions.
Why taxes work differently from 'vanilla' ETFs
The tax efficiency associated with plain-vanilla ETFs that track stock indexes is a result of the specialized way in which shares are created and redeemed. Although the "in-kind" creation and redemption process is complex, these stock ETFs can protect against the potential tax hits often seen in mutual funds when managers are forced to sell stock and raise cash to meet shareholder redemptions.
However, leveraged and inverse ETFs keep their assets in a pool of cash and use swaps and derivatives to deliver performance -- a key difference.
"If the fund goes into net redemptions and starts to shrink in assets, the managers must sell some of the derivatives they used to replicate their benchmark instead of passing them off to the authorized participants," wrote Morningstar's Gabriel in a recent report.
Authorized participants are institutional traders responsible for keeping orderly markets in ETFs by creating and redeeming shares based on demand.
Leveraged funds typically use daily swaps to gain their exposure, and these contracts are always settled in the short term, added Paul Justice, an ETF strategist at Morningstar.
"Most of the ETF assets are held in Treasury accounts, but the leveraged performance is generated by using short-term swaps and futures contracts. Those funds that performed well accumulated large capital gains when the funds spiked in October," he said.
"But when many shareholders liquidated their positions, those taxable gains were later split amongst fewer shareholders," Justice said. "Unfortunately, some investors that hung on too long are in for an unpleasant tax surprise."
In late December, for instance, ProShares announced capital gains distributions for 35 of its 76 leveraged and inverse ETFs. At Rydex, the Rydex Inverse 2X S&P Select Sector Energy ETF ( REC) paid out capital gains of more than 70% of net asset value, according to investment researcher Morningstar Inc. Those gains caught some investors off guard. Read more on this ETF surprise at WSJ.com.
However, the analysts said the distributions aren't grounds to avoid short and leveraged ETFs, just a reason for caution.
"These funds still have the trading advantages of liquidity, timeliness, and low commissions just like every other ETF. They still provide hedging and speculative opportunities that are otherwise inaccessible to the individual investor," Gabriel said. "They do not possess the impressive tax advantages of most ETFs, but they should still perform no worse than a similarly structured traditional open-end mutual fund on this point."
The old saw merits repeating here -- investors should always consult with a tax adviser.
John Spence is a reporter for MarketWatch in Boston.
Short plays only
Holding leveraged and inverse ETFs too long distorts objectives
By John Spence, MarketWatch
Last update: 3:32 p.m. EST Jan. 18, 2009BOSTON (MarketWatch) -- The market rout in 2008 has exposed the dangers of leveraged and leveraged inverse exchange-traded funds, designed to capture two or three times the movement in a particular stock index or provide 100% opposite results, as investors learned the hard way about the tax and performance distortions inherent in the funds.
These relatively new financial products are "among the fastest growing segments of the U.S.-listed ETF market" with $21.6 billion in assets and $17.4 billion in average daily trading volume, Morgan Stanley analysts led by Dominic Maister wrote in a research note last week.
Leveraged and inverse ETFs are "appropriate tools for some investors looking to make short-term tactical trades if they perceive a high likelihood of a strong market move occurring in a relatively short time period," said Maister.
In other words, traders and speculators can get more bang for their buck if they're trying to exploit quick market swings. Of course, losses are also magnified when markets move against the trade.
However, the effects of compounding "and the daily re-levering or de-levering that occurs within leveraged and leveraged inverse ETFs can lead to unexpected results over the long-term," Maister said. Investors probably don't want to hold leveraged and inverse ETFs more than a few days, experts warn.
The key point is that these ETFs provide leverage on a daily basis. Simply, investors are mistaken if they think they can buy a twice-leveraged ETF, hold it for a year, and end up with double the market's return.
"We cannot stress enough that these aggressively leveraged products are not suitable as long-term investments," said John Gabriel, ETF analyst at Morningstar.
Understanding performance
Market volatility can also play havoc with performance over longer periods. Some analysts have seized on the performance of leveraged ETFs tracking energy stocks during a wild 2008. The sector rose early in the year but corrected hard during the back half.
ProShares Ultra Oil & Gas ( ProShares Ultra Oil
DIG) lost 72% in 2008, according to ProShares. The bearish leveraged version, ProShares UltraShort Oil & Gas ( DUG) , also lost money last year, shedding nearly 11%. Yet on a daily basis, the ETFs delivered their targeted leverage like clockwork, so they behaved exactly as they should have.
In fairness, the providers of leveraged and inverse ETFs are upfront about the performance issues over the long term on their Web sites and in the prospectus.
"A common misconception is that ProShares should also provide 200%, -200% or -100% of index performance over longer periods, such as a week, month or year," ProShares says on its site. "However, ProShares' returns may be greater than -- or less than -- what you'd expect over longer periods." See the document at ProShares.com.
Therefore, if investors do stay in leveraged funds for any extended period of time, they should consider rebalancing frequently and keep a close eye on performance.
ProShares Chief Executive Michael Sapir said the firm wants all its investors to understand the math of compounding returns and how it affects its leveraged financial products.
"We think we've done a good job in trying to disclose the information," Sapir said in an interview. "We welcome every opportunity to get the word out."
ETFs on steroids
ProShares is one of a trio of investment managers overseeing leveraged and inverse ETFs that also includes Rydex Investments and Direxion Funds.
Leveraged ETFs managed by ProShares and Rydex are designed to provide 200% of the daily performance of their targeted indexes. Their inverse ETFs shoot for 100% of the inverse, or opposite, daily return, so they can be used to bet against markets or hedge.
Leveraged inverse ETFs aim for negative 200% returns on a daily basis. So if the target benchmark fell 2% in a trading session, these leveraged inverse ETFs are geared to rise about 4%, minus fees and transaction costs.
More recently, Direxion Funds has launched ETFs to provide even more leverage, at 300%, of daily index returns in both directions. The funds have gotten off to a strong start in terms of attracting assets and trading volume.
Some traders like juiced-up ETFs because the funds allow them to get leveraged exposure to the market or individual sectors in liquid vehicles that can be bought and sold during the day. Investors don't have to open up a margin account to tap leverage.
Meanwhile, inverse ETFs let investors profit from market declines or hedge their long positions.
Why taxes work differently from 'vanilla' ETFs
The tax efficiency associated with plain-vanilla ETFs that track stock indexes is a result of the specialized way in which shares are created and redeemed. Although the "in-kind" creation and redemption process is complex, these stock ETFs can protect against the potential tax hits often seen in mutual funds when managers are forced to sell stock and raise cash to meet shareholder redemptions.
However, leveraged and inverse ETFs keep their assets in a pool of cash and use swaps and derivatives to deliver performance -- a key difference.
"If the fund goes into net redemptions and starts to shrink in assets, the managers must sell some of the derivatives they used to replicate their benchmark instead of passing them off to the authorized participants," wrote Morningstar's Gabriel in a recent report.
Authorized participants are institutional traders responsible for keeping orderly markets in ETFs by creating and redeeming shares based on demand.
Leveraged funds typically use daily swaps to gain their exposure, and these contracts are always settled in the short term, added Paul Justice, an ETF strategist at Morningstar.
"Most of the ETF assets are held in Treasury accounts, but the leveraged performance is generated by using short-term swaps and futures contracts. Those funds that performed well accumulated large capital gains when the funds spiked in October," he said.
"But when many shareholders liquidated their positions, those taxable gains were later split amongst fewer shareholders," Justice said. "Unfortunately, some investors that hung on too long are in for an unpleasant tax surprise."
In late December, for instance, ProShares announced capital gains distributions for 35 of its 76 leveraged and inverse ETFs. At Rydex, the Rydex Inverse 2X S&P Select Sector Energy ETF ( REC) paid out capital gains of more than 70% of net asset value, according to investment researcher Morningstar Inc. Those gains caught some investors off guard. Read more on this ETF surprise at WSJ.com.
However, the analysts said the distributions aren't grounds to avoid short and leveraged ETFs, just a reason for caution.
"These funds still have the trading advantages of liquidity, timeliness, and low commissions just like every other ETF. They still provide hedging and speculative opportunities that are otherwise inaccessible to the individual investor," Gabriel said. "They do not possess the impressive tax advantages of most ETFs, but they should still perform no worse than a similarly structured traditional open-end mutual fund on this point."
The old saw merits repeating here -- investors should always consult with a tax adviser.
John Spence is a reporter for MarketWatch in Boston.
Historic Bear Markets (MSNBC) - using the past as prologue, what can we expect?
MSNBC.com
Fact file 11 historic bear markets
--------------------------------------------------------------------------------
Introduction
By one common definition, a bear market occurs when stock prices fall for a sustained period, dropping at least 20 percent from their peak. Using the broad S&P 500 as a benchmark, we are in the 11th bear market since World War II.
Here is a look at some notable bear markets of the past 80 years, with the crash of 1929 shown for comparison.
--------------------------------------------------------------------------------
September 1929 to June 1932
The stock market crash of Oct. 29, 1929, marked the start of the Great Depression and sparked America's most famous bear market. The S&P 500 fell 86 percent in less than three years and did not regain its previous peak until 1954.
S&P 500 high: 31.86
Low: 4.4
Loss: 86.1 percent
Duration: 34 months
--------------------------------------------------------------------------------
May 1946 to June 1949
Less than a year after the end of World War II, stock prices peaked and began a long slide. As the postwar surge in demand tapered off and Americans poured their money into savings, the economy tipped into a sharp "inventory recession" in 1948.
S&P 500 High: 19.25
Low: 13.55
Loss: 29.6 percent
Duration: 37 months
--------------------------------------------------------------------------------
December 1961 to June 1962
The economy expanded, but the Bay of Pigs attack of April 1961 and Cuban Missile Crisis of October 1962 sparked Cold War jitters and a brief bear market.
S&P 500 high: 72.64
Low: 52.32
Loss: 28.0 percent
Duration: 6 months
--------------------------------------------------------------------------------
November 1968 to May 1970
Rapid-fire growth ended with a mild recession, accompanied by relatively high inflation of about 6 percent annually. The bear market began just as Richard Nixon was elected president after a tumltuous year of assassinations and riots. The weak economy added to a tense national atmosphere dominated by the growing U.S. involvement in Vietnam.
S&P 500 high: 108.37
Low: 69.29
S&P 500 loss: 36.1 percent
Duration: 18 months
--------------------------------------------------------------------------------
January 1973 to October 1974
Israel's Yom Kippur War and the subsequent Arab oil embargo sent energy prices soaring, sparking a lengthy recession. The annual consumer inflation rate topped 10 percent. The Watergate scandal forcing President Nixon to resign.
S&P 500 high: 119.87
Low: 62.28
Loss: 48.0 percent
Duration: 21 months
--------------------------------------------------------------------------------
November 1980 to August 1982
After nearly a decade of sustained inflation, the Federal Reserve raised interest rates to nearly 20 percent, pushing the economy into recession. The combination of high inflation and slow growth -- known as stagflation -- was a factor behind Ronald Reagan's victory over President Carter in 1980.
Duration: 21 months
High: 140.52
Low: 101.44
S&P 500 loss: 27.8 percent
--------------------------------------------------------------------------------
August 1987 to December 1987
After a prolonged bull run, computerized "program trading" strategies swamped the market and contributed to the Black Monday crash of Oct. 19. Investors were also nervous after a heated debate between the U.S. and Germany over currency valuations, sparking fears of a devaluation of the dollar. As a result the Dow fell 22.6 percent -- the worst day since the Panic of 1914. Yet while the days after the crash were frightening, by early December the market had bottomed out, and a new bull run had started.
S&P 500 high: 337.89
Low: 221.24
Loss: 33.5 percent
Duration: 3 months
--------------------------------------------------------------------------------
March 2000 to October 2002
The bursting of the dot-com bubble followed a period of soaring stock prices and exuberant speculation on new Internet companies. Companies with little or no profits had market values that often equaled or exceeded that of established "old-economy" corporate giants. The Nasdaq composite index, which soared in value thanks to the listings of hundreds of tech start-ups, plunged 50 percent in nine months and never again came close to its 2000 peak.
S&P 500 high: 1527.46
Low: 776.76
Loss: 49.1 percent
Duration: 30 months
--------------------------------------------------------------------------------
October 2007 to present
A long-feared bursting of the housing bubble became a reality beginning in 2007, and the rising mortgage delinquency rate quickly spilled over into the credit market. By 2008, Wall Street giants like Bear Stearns and Lehman Bros. were toppling, and the financial crisis erupted into a full-fledged panic. The selling accelerated in September, with the market off 23 percent in little over five weeks.
S&P 500 high: 1565.15
Low: 752.44, as of Nov. 20
S&P 500 loss: 51.9 percent, so far
Duration: 13+ months, so far
Source: Global Financial Data, MSNBC research.
Updated: 5:42 p.m. ET Nov. 20, 2008
© 2009 MSNBC.com
URL: http://www.msnbc.msn.com/id/27072080?pg=3#Biz_BearMarkets
Fact file 11 historic bear markets
--------------------------------------------------------------------------------
Introduction
By one common definition, a bear market occurs when stock prices fall for a sustained period, dropping at least 20 percent from their peak. Using the broad S&P 500 as a benchmark, we are in the 11th bear market since World War II.
Here is a look at some notable bear markets of the past 80 years, with the crash of 1929 shown for comparison.
--------------------------------------------------------------------------------
September 1929 to June 1932
The stock market crash of Oct. 29, 1929, marked the start of the Great Depression and sparked America's most famous bear market. The S&P 500 fell 86 percent in less than three years and did not regain its previous peak until 1954.
S&P 500 high: 31.86
Low: 4.4
Loss: 86.1 percent
Duration: 34 months
--------------------------------------------------------------------------------
May 1946 to June 1949
Less than a year after the end of World War II, stock prices peaked and began a long slide. As the postwar surge in demand tapered off and Americans poured their money into savings, the economy tipped into a sharp "inventory recession" in 1948.
S&P 500 High: 19.25
Low: 13.55
Loss: 29.6 percent
Duration: 37 months
--------------------------------------------------------------------------------
December 1961 to June 1962
The economy expanded, but the Bay of Pigs attack of April 1961 and Cuban Missile Crisis of October 1962 sparked Cold War jitters and a brief bear market.
S&P 500 high: 72.64
Low: 52.32
Loss: 28.0 percent
Duration: 6 months
--------------------------------------------------------------------------------
November 1968 to May 1970
Rapid-fire growth ended with a mild recession, accompanied by relatively high inflation of about 6 percent annually. The bear market began just as Richard Nixon was elected president after a tumltuous year of assassinations and riots. The weak economy added to a tense national atmosphere dominated by the growing U.S. involvement in Vietnam.
S&P 500 high: 108.37
Low: 69.29
S&P 500 loss: 36.1 percent
Duration: 18 months
--------------------------------------------------------------------------------
January 1973 to October 1974
Israel's Yom Kippur War and the subsequent Arab oil embargo sent energy prices soaring, sparking a lengthy recession. The annual consumer inflation rate topped 10 percent. The Watergate scandal forcing President Nixon to resign.
S&P 500 high: 119.87
Low: 62.28
Loss: 48.0 percent
Duration: 21 months
--------------------------------------------------------------------------------
November 1980 to August 1982
After nearly a decade of sustained inflation, the Federal Reserve raised interest rates to nearly 20 percent, pushing the economy into recession. The combination of high inflation and slow growth -- known as stagflation -- was a factor behind Ronald Reagan's victory over President Carter in 1980.
Duration: 21 months
High: 140.52
Low: 101.44
S&P 500 loss: 27.8 percent
--------------------------------------------------------------------------------
August 1987 to December 1987
After a prolonged bull run, computerized "program trading" strategies swamped the market and contributed to the Black Monday crash of Oct. 19. Investors were also nervous after a heated debate between the U.S. and Germany over currency valuations, sparking fears of a devaluation of the dollar. As a result the Dow fell 22.6 percent -- the worst day since the Panic of 1914. Yet while the days after the crash were frightening, by early December the market had bottomed out, and a new bull run had started.
S&P 500 high: 337.89
Low: 221.24
Loss: 33.5 percent
Duration: 3 months
--------------------------------------------------------------------------------
March 2000 to October 2002
The bursting of the dot-com bubble followed a period of soaring stock prices and exuberant speculation on new Internet companies. Companies with little or no profits had market values that often equaled or exceeded that of established "old-economy" corporate giants. The Nasdaq composite index, which soared in value thanks to the listings of hundreds of tech start-ups, plunged 50 percent in nine months and never again came close to its 2000 peak.
S&P 500 high: 1527.46
Low: 776.76
Loss: 49.1 percent
Duration: 30 months
--------------------------------------------------------------------------------
October 2007 to present
A long-feared bursting of the housing bubble became a reality beginning in 2007, and the rising mortgage delinquency rate quickly spilled over into the credit market. By 2008, Wall Street giants like Bear Stearns and Lehman Bros. were toppling, and the financial crisis erupted into a full-fledged panic. The selling accelerated in September, with the market off 23 percent in little over five weeks.
S&P 500 high: 1565.15
Low: 752.44, as of Nov. 20
S&P 500 loss: 51.9 percent, so far
Duration: 13+ months, so far
Source: Global Financial Data, MSNBC research.
Updated: 5:42 p.m. ET Nov. 20, 2008
© 2009 MSNBC.com
URL: http://www.msnbc.msn.com/id/27072080?pg=3#Biz_BearMarkets
from Sunday's NY Times - A Long Term Investment Perspective
January 11, 2009
The Way We Live Now
Go Long
By ROGER LOWENSTEIN
In October, Columbia University’s business school honored its most famous investing guru, Benjamin Graham, with a series of panel discussions loosely connected to the market crash, which was then accelerating. The panelists, of which I was one, had contributed to an updated version of Graham’s 1930s textbook, whose signature themes are caution, avoidance of speculation and — at all costs — the preservation of capital. The day we met, the Dow Jones industrial average fell 350 points en route to one of its worst months ever.
J. Ezra Merkin, a Wall Street sage, noted philanthropist and professional money manager, seemed to embody more than any of the other panelists the fear that was gripping traders. When it was suggested that the government should stop intervening in markets and bailing out banks, Merkin rejoined that the system had cracked and desperately needed help. As the world now knows, Merkin had entrusted close to $2 billion of his investors’ money to someone even less dependable than the Dow — that is, the accused Ponzi artist Bernard Madoff. I have no reason to think that Merkin, at the time, had any knowledge of the fraud that was soon to secure his 15 minutes of fame, but that afternoon at Columbia now seems pregnant with latent connections. Perhaps Madoff’s investors lost a greater percentage of their money, and lost it more suddenly, than the rest of us. But beyond these mere matters of degree, is there really any difference?
At least for investors of attenuated time horizons, there is not. Public-securities markets are a wondrous artifice precisely because they offer permanent capital to industry and short-term liquidity to investors. Think about it: a General Electric or a Google sells stock to the public and then retains the proceeds — the capital — indefinitely. Even if the companies earn a profit, by selling more light bulbs or Internet ads, they are under no obligation to pay out the gains in dividends. How, then, do the shareholders claim their reward? Why, by selling their stock to other investors, of course. This means that, in the short term at least, each investor is dependent on the willingness of other investors to hop on board. If other investors go away, prices (even of solvent companies) plummet, to devastating effect on those who sell.
In a Ponzi scheme, there is no G.E. or Google underneath the pyramid: only air. Outgoing investors are paid from the money put up by new ones. And the game for Madoff ended, as Ponzi schemes always do, when he ran out of suckers.
In theory, stocks and bonds are more valuable than air. But when investors get hooked on trading securities (as distinct from owning them), especially ones that are overvalued, they are courting disaster. In retrospect, this was true of the legions that invested in mortgage-backed securities and in the banks that owned them, not to mention the many other companies affected indirectly. Nobody was thinking about what these companies were worth, only about the next quotation on the screen.
This was doubly true for the banks that held those wearily complex and difficult-to-value mortgage bonds. Look at the post-mortem issued by UBS, one of the world’s largest banks, which has suffered mortgage-related losses of some $50 billion (enough to bail out the auto industry several times over). Discussing one particular write down, the bank admitted, “The super senior notes were always treated as trading book (i.e., the book for assets intended for resale in the short term), notwithstanding the fact that there does not appear to have been a liquid secondary market.” Legally, UBS was a bank; conceptually, it was investing with Bernie Madoff.
There is, of course, an alternative to this madness. Which is to invest for the long term, independent of the market action on any given day or year. This is what most small investors pretended, and maybe believed, they were actually doing.
Robert Barbera, the chief economist at ITG, an investment firm, says there are really three schools of investing. There are people who think they can identify superior stocks and bonds over the long term and selectively invest in those that they deem to be undervalued. Second, there are people who recognize that they don’t have this ability and resolve to salt away a fixed portion of their savings, month after month, in a generic and diversified portfolio. Though the first approach requires considerably more talent and is not recommended for novices, both should work.
What does not work is believing you are following either strategy No. 1 or 2 when you are actually engaging in the third approach — which is, essentially, following the crowd, day by day and hour by hour. At the top of the market, investors told themselves they were disciplined and in for the long haul. Now they are selling or refraining from investing. Some misjudged their liquidity needs and have come under pressure to raise cash; others have simply lost heart. Either way, they are dependent on new money to come in for them to get out.
Benjamin Graham’s premise (which he did not abandon, even in the depths of the Great Depression) was that, sooner or later, markets will reflect underlying corporate values. Thus, he wrote, long-term investors had a “basic advantage” over others, because they could ride out bubbles and crashes rather than be gulled during such highs and lows into, respectively, buying or selling. In other words, for those who invest with prudence and an eye toward long-term values, the market need not be a Ponzi scheme. While stocks periodically go for roller-coaster rides, the earning power of the U.S. economy, albeit with serious fluctuations, endures. The people who chased unrealistic returns at the top, like those who are selling now, have simply cashiered their “advantage” to play a game that more nearly resembles Bernie Madoff’s.
Roger Lowenstein, an outside director of the Sequoia Fund, is a contributing writer for the magazine. His most recent book is “While America Aged.”
The Way We Live Now
Go Long
By ROGER LOWENSTEIN
In October, Columbia University’s business school honored its most famous investing guru, Benjamin Graham, with a series of panel discussions loosely connected to the market crash, which was then accelerating. The panelists, of which I was one, had contributed to an updated version of Graham’s 1930s textbook, whose signature themes are caution, avoidance of speculation and — at all costs — the preservation of capital. The day we met, the Dow Jones industrial average fell 350 points en route to one of its worst months ever.
J. Ezra Merkin, a Wall Street sage, noted philanthropist and professional money manager, seemed to embody more than any of the other panelists the fear that was gripping traders. When it was suggested that the government should stop intervening in markets and bailing out banks, Merkin rejoined that the system had cracked and desperately needed help. As the world now knows, Merkin had entrusted close to $2 billion of his investors’ money to someone even less dependable than the Dow — that is, the accused Ponzi artist Bernard Madoff. I have no reason to think that Merkin, at the time, had any knowledge of the fraud that was soon to secure his 15 minutes of fame, but that afternoon at Columbia now seems pregnant with latent connections. Perhaps Madoff’s investors lost a greater percentage of their money, and lost it more suddenly, than the rest of us. But beyond these mere matters of degree, is there really any difference?
At least for investors of attenuated time horizons, there is not. Public-securities markets are a wondrous artifice precisely because they offer permanent capital to industry and short-term liquidity to investors. Think about it: a General Electric or a Google sells stock to the public and then retains the proceeds — the capital — indefinitely. Even if the companies earn a profit, by selling more light bulbs or Internet ads, they are under no obligation to pay out the gains in dividends. How, then, do the shareholders claim their reward? Why, by selling their stock to other investors, of course. This means that, in the short term at least, each investor is dependent on the willingness of other investors to hop on board. If other investors go away, prices (even of solvent companies) plummet, to devastating effect on those who sell.
In a Ponzi scheme, there is no G.E. or Google underneath the pyramid: only air. Outgoing investors are paid from the money put up by new ones. And the game for Madoff ended, as Ponzi schemes always do, when he ran out of suckers.
In theory, stocks and bonds are more valuable than air. But when investors get hooked on trading securities (as distinct from owning them), especially ones that are overvalued, they are courting disaster. In retrospect, this was true of the legions that invested in mortgage-backed securities and in the banks that owned them, not to mention the many other companies affected indirectly. Nobody was thinking about what these companies were worth, only about the next quotation on the screen.
This was doubly true for the banks that held those wearily complex and difficult-to-value mortgage bonds. Look at the post-mortem issued by UBS, one of the world’s largest banks, which has suffered mortgage-related losses of some $50 billion (enough to bail out the auto industry several times over). Discussing one particular write down, the bank admitted, “The super senior notes were always treated as trading book (i.e., the book for assets intended for resale in the short term), notwithstanding the fact that there does not appear to have been a liquid secondary market.” Legally, UBS was a bank; conceptually, it was investing with Bernie Madoff.
There is, of course, an alternative to this madness. Which is to invest for the long term, independent of the market action on any given day or year. This is what most small investors pretended, and maybe believed, they were actually doing.
Robert Barbera, the chief economist at ITG, an investment firm, says there are really three schools of investing. There are people who think they can identify superior stocks and bonds over the long term and selectively invest in those that they deem to be undervalued. Second, there are people who recognize that they don’t have this ability and resolve to salt away a fixed portion of their savings, month after month, in a generic and diversified portfolio. Though the first approach requires considerably more talent and is not recommended for novices, both should work.
What does not work is believing you are following either strategy No. 1 or 2 when you are actually engaging in the third approach — which is, essentially, following the crowd, day by day and hour by hour. At the top of the market, investors told themselves they were disciplined and in for the long haul. Now they are selling or refraining from investing. Some misjudged their liquidity needs and have come under pressure to raise cash; others have simply lost heart. Either way, they are dependent on new money to come in for them to get out.
Benjamin Graham’s premise (which he did not abandon, even in the depths of the Great Depression) was that, sooner or later, markets will reflect underlying corporate values. Thus, he wrote, long-term investors had a “basic advantage” over others, because they could ride out bubbles and crashes rather than be gulled during such highs and lows into, respectively, buying or selling. In other words, for those who invest with prudence and an eye toward long-term values, the market need not be a Ponzi scheme. While stocks periodically go for roller-coaster rides, the earning power of the U.S. economy, albeit with serious fluctuations, endures. The people who chased unrealistic returns at the top, like those who are selling now, have simply cashiered their “advantage” to play a game that more nearly resembles Bernie Madoff’s.
Roger Lowenstein, an outside director of the Sequoia Fund, is a contributing writer for the magazine. His most recent book is “While America Aged.”
Outlook for 2009 from RGE monitor - predicting a LONG Recession
RGE Monitor - 2009 U.S. Economic Outlook
Christian Menegatti, Arpitha Bykere, Elisa Parisi-Capone and Mikka Pineda | Jan 7, 2009
It is clear that 2008 was not a very good year and it is official that the current U.S. recession started already in December 2007. So how far are we into this recession that has already lasted longer than the previous two (1990 and 2001 recessions lasted 8 months each)? We believe the U.S. economy is only half way through a recession that will be the longest and most severe in the post war period. U.S. GDP will continue to contract throughout 2009 for a cumulative output loss of 5% and a recession that will last close to two years.
One last look at 2008 will reveal a very weak fourth quarter with GDP growth contracting -6%, in the wake of a sharp fall in personal consumption and private domestic investments. We see the real GDP growth contraction playing out through the year as follows: Q1 2009 -5%; Q2 2009 -4%; Q3 2009. -2.5%; Q4 2009 -1%, adding up to a yearly real GDP growth of -3.4% for the U.S. in 2009.
Personal Consumption
The resilient U.S. consumer started to give up in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up over two-thirds of aggregate demand, the outlook for the U.S. consumer is at the center of the dynamics that will play out in the real economy in 2009.
In our view, personal consumption will continue to contract throughout 2009 quite sharply as a result of negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008, mounting job losses, tighter credit conditions and high debt servicing ratios (the debt to income ratio went from 70% in the 90s, to 100% in 2000 to 140% now). This retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will eventually restore the saving rate of a decade ago.
The wealth losses for households related to the fall in home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall –eventually reaching the $6-8 trillion range (compatible with a 30-40% fall in home prices peak to trough). With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500bn. And negative wealth effect from fall in equity prices – on the wake of a bleak 2009 for corporate profits – will also contribute to the contraction in personal consumption by an estimated $100bn (compatible with a 25% contraction in the stock markets).
This adjustment is consistent with a rebalancing of the economy that will over time bring the saving rate to a positive level of roughly 5-6% where it was a decade ago, for this to happen consumption has to contract by an amount close to $800bn.
Housing Sector
The 4th year of housing recession is well on course.
Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate (SAAR) peak of January 2006 all the way to the 625 thousand SAAR of November 2008 (the last data point available), an all time low for the time series that started in January 1959. Single-family starts built for sale are down 75% from their Q4 2005 peak (seasonally adjusted data are not available, we performed our own seasonal adjustment).
On the demand side, new single-family home sales are down 65% from their July 2005 peak. Both demand and supply of homes are therefore still falling very sharply which does not bode well for inventories. Inventories are the mortal enemy of prices for any goods-producing sector, including housing.
Starts need to fall substantially below sales so that the excess supply in the housing market is reabsorbed. Inventories persist at record highs and the gap between one-family starts (for sale) and one-family sales (-92K annual rate in Q3 2008 according to our estimates) is at levels that cannot promote a fast work–off of inventories. To put these numbers in perspective, compare this with a measure of vacant homes for-sale-only. Vacant homes for-sale-only were at 2.2 million in Q3 2008, an all time high. In the decade between 1985 and 1995 it oscillated around 1 million units on average and 1.3 million units between 2001 and 2005. This implies that we have to deal with an excess supply that ranges between 0.9 and 1.2 million units, of which roughly 85% are single-family structures.
The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side is bound to persist and we believe that supply will have to fall further, given also the great wave of foreclosures that is adding to the excess of supply in the market. We see starts falling another 20% from current levels.
We believe that home prices will not bottom out until the middle of 2010. Our target is a 38% peak to trough (so far prices have fallen 25% from the peak) but given the worsening conditions on the real side of the economy, we see a meaningful chance for over-correction that would bring prices down 44% from the peak reached in the first half of 2006 (Case-Shiller is the reference index for these predictions.)
Labor Markets
With continued credit crunch and significant cut down in consumer and business spending, the monthly job losses will continue in the 400-500k and 300-400k range during the first two quarters of 2009 respectively, bringing the unemployment rate to 8% by mid-2009. The severe contraction in private demand until early 2010 will keep lay-offs high and the unemployment rate elevated over 8%.
Economy wide job cuts are expected, with big corporations and small enterprises, residential and commercial construction, financial services and manufacturing continuing to shed jobs at a strong pace. Moreover with structural shifts in the economy since the last recession, job losses this time will be more severe in the service sector, including retail, business and professional services and leisure and hospitality. Unless the fiscal stimulus addresses the deficit problem for state and local government, job losses at the government level will also gain pace. In turn, income and job losses will further push up default and delinquency rates on mortgages, consumer loans and credit cards. Moreover, the loss of high paying corporate and financial sector jobs will be a big negative for tax revenues over the next two years.
Lay-offs are bound to continue thereafter as cost-cutting gains pace with the beginning of the (sluggish) recovery period in early 2010. Even as consumer demand might show some signs of recovery, firms, like in the past, will begin by hiring only part-time and temporary workers initially. The unemployment rate might peak at close to 9% in Q1 2010, almost two years after the recession began. However, the hiring freeze across industries that began in late 2007 will continue at least until 2010 causing discouraged workers to leave the work force and containing the extent of the spike in the unemployment rate. Further, the decline in labor utilization will add to the deflationary pressure in the economy. An aging labor force, lower capital spending and potential growth over the next few years might also result in lower productivity growth and an increase in the natural rate of unemployment (NAIRU).
Capital Expenditure
Firms have been drawing down inventories beginning in Q4 2008. As the slump in domestic and foreign demand and difficulty in accessing short-term credit persist over the next four quarters, business investment is bound to contract in double-digits throughout 2009. Industrial production, spending on equipment and durable goods will also remain in red through 2009. Moreover with a sluggish recovery in private demand even during 2010, firms will start building inventories and contemplate capex plans only at a slower pace.
Trade
Exports contraction that began in late 2008 will gain pace in 2009 as more and more emerging economies slip into slowdown following the G-7 countries. On the other hand, easing oil prices and secular downward trend in consumer spending and business investment will help imports to shrink. In fact, this might cause the trade deficit to contract in 1H 2009 since the contraction in imports might well exceed the decline in exports, thus containing any negative contribution of trade to GDP growth.
Dollar Outlook
The fate of the U.S. dollar in 2009 rests on the global growth outlook. After profit-taking on long USD positions ends and trading volumes pick up as investors return from their holidays, the dollar may temporarily recover its relative safe haven status in H1 2009. Since markets have yet to fully appreciate the impact of the commodity slump and financial crisis on the rest of the world, risk appetite may collapse again on signs of a deeper- or longer-than-expected recession outside the U.S.. Further de-leveraging of USD-denominated liabilities could provide an additional boost to the dollar as a funding currency. The bond yield outlook could be a further source of strength: while the Fed is already at ZIRP, other central banks will cut rates further to stimulate growth, putting downward pressure on currencies like the Euro. Alternating with these upside risks to the dollar may be downside risks from 1) a supply crunch in commodities that lifts commodity prices and producers' economies, 2) inability of the market to absorb increased Treasury supply at low yields.
Downside risks to the dollar seem more likely to outweigh upside risks in the latter half of 2009 and in 2010. Yet at the same time, similar downside risks exist for other currencies – growing fiscal deficits will weaken a range of currencies. With emerging markets continuing to have trouble attracting capital and Asian economies, hammered by export contractions, will be reluctant to allow their currencies to appreciate against or with the dollar – China allowed some depreciation of the RMB at the recent euro-dollar peak.
Once crucial support from deleveraging wanes, however, the dollar may be left with only foreign central bank reserve accumulation, which has already waned on the reversal of capital flows, to finance the large U.S. current account deficit. Continued repatriation of assets and higher enforced domestic savings rates will at least reduce pressure on the dollar in the short-term.
Inflation/Deflation
Annual U.S. inflation, as measured by official producer and consumer price indices, is likely to slow in 2009 and even fall into technical deflation despite increases in the monetary base and fiscal measures to boost spending power. Slumping commodity prices may drag down the average annual headline CPI inflation rate to around -2% - a technical deflation which may morph into genuine deflation if falling prices generate expectations that they will continue to fall. Meanwhile, the growing slack in product and labor markets will keep core consumer inflation subdued at an average year-over-year rate of 1-2%. Steep discounts to get rid of unsold retail inventory, rising job losses and lower wage growth will reinforce the trend of stagnant or falling prices. Loose labor markets and weak demand for commodities and goods/services will keep producer prices at bay. Risks to the outlook include 1) a commodity supply crunch or geopolitical shock that leads to a sustained rise in commodity prices and 2) an earlier than expected global economic recovery.
Credit Losses Still Ahead
Back in February 2008, Nouriel Roubini warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion. As of mid-November 2008, the threshold of $1 trillion in global financial writedowns was finally reached. Given that national house prices expected to drop another 20%, we expect credit losses of $1.6 trillion.
An in-depth analysis of current and expected loan losses per asset class and separately of mark-to-market writedowns per securities class based on current prices indeed confirms RGE’s initial loss range estimates (outstanding loan and securities amounts as in IMF GFSR, Table 1.1) For our calculations we assume a further 20% fall in house prices, and an unemployment rate of 9%. With respect to credit losses on unsecuritized loans, recent research by the Fed Board using comparable assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are going to default (i.e. $150bn out of $300bn). The loss trajectories for Alt-A loans are similar resulting in a 25% default rate ($150bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies, implying an approximate 7% default rate when the potential for ‘jingle mail’ is taken into account ($266bn out of $3,800bn).
The cycle has also turned in the commercial real estate (CRE) arena with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (net recovery, via Fed data) are projected to increase to up to 17% by Fitch assuming a 25% fall in prices ($408bn out of $2.4 trillion.) In the consumer loan area, we estimate credit card charge-off rate could increase to 13% in the worst case scenario. Adding a typical 5% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $252bn out of $1.4 trillion (see The U.S. Credit Card Industry in 2009, by RGE’s Mathias Kruettli.)
The IMF warned that commercial and industrial loans (C&I) charge-off and delinquency rates are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and serious delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn out of $170bn unsecuritized leverage loans.
Based on these calculations, RGE expects total loan losses to reach about $1.6 trillion out of $12.4 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. The IMF assumes that the U.S. banking system carries about 60-70% of unsecuritized loan losses (and about 30% of mark-to-market losses on securitizations). Even assuming that future loan losses are fully discounted at current market prices, deploying the remaining TARP funds towards recapitalizing the banking system would still be warranted.
The Disconnect Between Bond and Equity Markets
U.S. government bonds were on a tear in 2008, while equities plummeted in a nasty bear market. Bond yields at the long end hit all-time record lows, while the short end even dipped into negative territory. Only TIPS suffered as deflation risks rose. Stocks, on the other hand, had their worst year since the Great Depressions: DJIA lost 34%, S&P 500 -38.5%. At its 2008 low on November 20, the S&P 500 was down 49% for the year and 52% from its October 2007 peak. Stocks rallied in December though, resulting in an apparent disagreement between the stock and bond markets over the outlook for the U.S. economy. Bond markets seemed to be discounting a recession in 2009 while stock markets have been gaining since late November. This disconnect may vanish in 2009 though if the stock market rally was really just a bear market rally due to portfolio re-balancing and thin year-end trade volumes.
However, there have been intimations that the bond market is in a bubble about to burst in 2009. Indeed, with ultra low bond yields, investors may be tempted to switch into higher-yielding equities - which are now considered by many to be undervalued. Valuation, however, is not the be-all and end-all of asset performance. The credit freeze needs to end before equities can see the end of the bear market. However, considering the likely economic stagnation ahead, bonds should be a better bet than equities for some time. We see meaningful downside risks to stock prices as bad macro news – worse than expected – continues to dominate in 2009. Using the S&P 500 as benchmark, earnings per share will stay in the $50-60 range – and earnings will fall further. If, and it is not unusual during recessions, P/E ratio falls in the 12-14 range, we could see another 25% slide in stock prices.
Fiscal and Monetary Policy
Fiscal Policy
A lot of hope is being placed on the expected fiscal stimulus package of around $750 bn spread over 2009-10 including 40% of the stimulus in tax cuts for households and firms. Around half of the stimulus is expected to kick-in starting Q2 2009 and through 2010. But this will fall short of the pull-back in private demand of close to $1 trillion during this period.
Infrastructure spending, in spite of being highly effective, might not be timely, stimulating the economy only in late-2009 and 2010 when it has well passed the severe recession phase only to exacerbate the ballooning fiscal deficit. Nonetheless, around $100bn of infrastructure investment might be able to kick-in during 2009. Moreover, job creation in infrastructure might be overestimated given limitations in moving laid-off workers from other sectors to the infrastructure projects. As such, any job creation via government spending and tax incentives for firms will significantly fall short of the ongoing lay-offs.
Given the drawback of the ‘spending’ component of the stimulus, the government may be enticed to implement more tax cuts. While tax incentives for households like payroll and child tax credit might be well-targeted at the group with high propensity to spend, tax cuts in general will be less effective in stimulating demand given a secular rise in the saving rate expected over the next few years. Likewise, tax breaks for firms hiring new workers or investing in new equipment will be rather ineffective since businesses see little viability in doing so during a slump in domestic and export demand. At the most, tax stimulus in spite of being timely and well-targeted will cause only a temporary rebound in the economy for a month or a quarter merely shifting the spending decision period just like tax rebates did in 2Q 2008.
Expansion of unemployment benefits, food stamps and other incentives will have a high bang-for-buck effect in 2009 and will only assuage the impact of the recession. The stimulus will also include up to $100 bn for state and local governments to meet their severe budget shortfalls including grants, Medicaid and unemployment insurance funds, preventing cutbacks in public services, investment and jobs in several recession-hit states. But again, fiscal aid for states often suffers from time lags.
Fiscal stimulus, TARP spending, GSEs-related expenditure along with further slowdown in corporate and individual income tax revenues will push the fiscal deficit to around $1.3 trillion in FY2009.
Monetary Policy
The Fed has enacted a wide and unprecedented range of measures to mitigate the credit crisis and stimulate the economy. It has already cut its target range for the Fed funds rate down to 0-0.25% (essentially ZIRP) but, more importantly, it has created currency swap lines and an alphabet soup of programs to provide liquidity to the financial system and clean out toxic financial assets. The Fed experimented with different forms of financing itself in order to enable a sharp expansion of its balance sheet to accommodate these liquidity facilities. In addition to rate cuts and quantitative easing, the Fed has directly aided failing financial institutions. Now, the Fed is considering issuing its own debt and/or purchasing long-dated Treasuries and Agency debt. Will the monetary easing work? So far, the increase in money supply has not been accompanied by an increase in the velocity of money. In other words, credit growth remains stagnant as banks are reluctant to lend back out the money provided by the Fed and, at the same time, borrower demand has fallen.
Christian Menegatti, Arpitha Bykere, Elisa Parisi-Capone and Mikka Pineda | Jan 7, 2009
It is clear that 2008 was not a very good year and it is official that the current U.S. recession started already in December 2007. So how far are we into this recession that has already lasted longer than the previous two (1990 and 2001 recessions lasted 8 months each)? We believe the U.S. economy is only half way through a recession that will be the longest and most severe in the post war period. U.S. GDP will continue to contract throughout 2009 for a cumulative output loss of 5% and a recession that will last close to two years.
One last look at 2008 will reveal a very weak fourth quarter with GDP growth contracting -6%, in the wake of a sharp fall in personal consumption and private domestic investments. We see the real GDP growth contraction playing out through the year as follows: Q1 2009 -5%; Q2 2009 -4%; Q3 2009. -2.5%; Q4 2009 -1%, adding up to a yearly real GDP growth of -3.4% for the U.S. in 2009.
Personal Consumption
The resilient U.S. consumer started to give up in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up over two-thirds of aggregate demand, the outlook for the U.S. consumer is at the center of the dynamics that will play out in the real economy in 2009.
In our view, personal consumption will continue to contract throughout 2009 quite sharply as a result of negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008, mounting job losses, tighter credit conditions and high debt servicing ratios (the debt to income ratio went from 70% in the 90s, to 100% in 2000 to 140% now). This retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will eventually restore the saving rate of a decade ago.
The wealth losses for households related to the fall in home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall –eventually reaching the $6-8 trillion range (compatible with a 30-40% fall in home prices peak to trough). With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500bn. And negative wealth effect from fall in equity prices – on the wake of a bleak 2009 for corporate profits – will also contribute to the contraction in personal consumption by an estimated $100bn (compatible with a 25% contraction in the stock markets).
This adjustment is consistent with a rebalancing of the economy that will over time bring the saving rate to a positive level of roughly 5-6% where it was a decade ago, for this to happen consumption has to contract by an amount close to $800bn.
Housing Sector
The 4th year of housing recession is well on course.
Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate (SAAR) peak of January 2006 all the way to the 625 thousand SAAR of November 2008 (the last data point available), an all time low for the time series that started in January 1959. Single-family starts built for sale are down 75% from their Q4 2005 peak (seasonally adjusted data are not available, we performed our own seasonal adjustment).
On the demand side, new single-family home sales are down 65% from their July 2005 peak. Both demand and supply of homes are therefore still falling very sharply which does not bode well for inventories. Inventories are the mortal enemy of prices for any goods-producing sector, including housing.
Starts need to fall substantially below sales so that the excess supply in the housing market is reabsorbed. Inventories persist at record highs and the gap between one-family starts (for sale) and one-family sales (-92K annual rate in Q3 2008 according to our estimates) is at levels that cannot promote a fast work–off of inventories. To put these numbers in perspective, compare this with a measure of vacant homes for-sale-only. Vacant homes for-sale-only were at 2.2 million in Q3 2008, an all time high. In the decade between 1985 and 1995 it oscillated around 1 million units on average and 1.3 million units between 2001 and 2005. This implies that we have to deal with an excess supply that ranges between 0.9 and 1.2 million units, of which roughly 85% are single-family structures.
The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side is bound to persist and we believe that supply will have to fall further, given also the great wave of foreclosures that is adding to the excess of supply in the market. We see starts falling another 20% from current levels.
We believe that home prices will not bottom out until the middle of 2010. Our target is a 38% peak to trough (so far prices have fallen 25% from the peak) but given the worsening conditions on the real side of the economy, we see a meaningful chance for over-correction that would bring prices down 44% from the peak reached in the first half of 2006 (Case-Shiller is the reference index for these predictions.)
Labor Markets
With continued credit crunch and significant cut down in consumer and business spending, the monthly job losses will continue in the 400-500k and 300-400k range during the first two quarters of 2009 respectively, bringing the unemployment rate to 8% by mid-2009. The severe contraction in private demand until early 2010 will keep lay-offs high and the unemployment rate elevated over 8%.
Economy wide job cuts are expected, with big corporations and small enterprises, residential and commercial construction, financial services and manufacturing continuing to shed jobs at a strong pace. Moreover with structural shifts in the economy since the last recession, job losses this time will be more severe in the service sector, including retail, business and professional services and leisure and hospitality. Unless the fiscal stimulus addresses the deficit problem for state and local government, job losses at the government level will also gain pace. In turn, income and job losses will further push up default and delinquency rates on mortgages, consumer loans and credit cards. Moreover, the loss of high paying corporate and financial sector jobs will be a big negative for tax revenues over the next two years.
Lay-offs are bound to continue thereafter as cost-cutting gains pace with the beginning of the (sluggish) recovery period in early 2010. Even as consumer demand might show some signs of recovery, firms, like in the past, will begin by hiring only part-time and temporary workers initially. The unemployment rate might peak at close to 9% in Q1 2010, almost two years after the recession began. However, the hiring freeze across industries that began in late 2007 will continue at least until 2010 causing discouraged workers to leave the work force and containing the extent of the spike in the unemployment rate. Further, the decline in labor utilization will add to the deflationary pressure in the economy. An aging labor force, lower capital spending and potential growth over the next few years might also result in lower productivity growth and an increase in the natural rate of unemployment (NAIRU).
Capital Expenditure
Firms have been drawing down inventories beginning in Q4 2008. As the slump in domestic and foreign demand and difficulty in accessing short-term credit persist over the next four quarters, business investment is bound to contract in double-digits throughout 2009. Industrial production, spending on equipment and durable goods will also remain in red through 2009. Moreover with a sluggish recovery in private demand even during 2010, firms will start building inventories and contemplate capex plans only at a slower pace.
Trade
Exports contraction that began in late 2008 will gain pace in 2009 as more and more emerging economies slip into slowdown following the G-7 countries. On the other hand, easing oil prices and secular downward trend in consumer spending and business investment will help imports to shrink. In fact, this might cause the trade deficit to contract in 1H 2009 since the contraction in imports might well exceed the decline in exports, thus containing any negative contribution of trade to GDP growth.
Dollar Outlook
The fate of the U.S. dollar in 2009 rests on the global growth outlook. After profit-taking on long USD positions ends and trading volumes pick up as investors return from their holidays, the dollar may temporarily recover its relative safe haven status in H1 2009. Since markets have yet to fully appreciate the impact of the commodity slump and financial crisis on the rest of the world, risk appetite may collapse again on signs of a deeper- or longer-than-expected recession outside the U.S.. Further de-leveraging of USD-denominated liabilities could provide an additional boost to the dollar as a funding currency. The bond yield outlook could be a further source of strength: while the Fed is already at ZIRP, other central banks will cut rates further to stimulate growth, putting downward pressure on currencies like the Euro. Alternating with these upside risks to the dollar may be downside risks from 1) a supply crunch in commodities that lifts commodity prices and producers' economies, 2) inability of the market to absorb increased Treasury supply at low yields.
Downside risks to the dollar seem more likely to outweigh upside risks in the latter half of 2009 and in 2010. Yet at the same time, similar downside risks exist for other currencies – growing fiscal deficits will weaken a range of currencies. With emerging markets continuing to have trouble attracting capital and Asian economies, hammered by export contractions, will be reluctant to allow their currencies to appreciate against or with the dollar – China allowed some depreciation of the RMB at the recent euro-dollar peak.
Once crucial support from deleveraging wanes, however, the dollar may be left with only foreign central bank reserve accumulation, which has already waned on the reversal of capital flows, to finance the large U.S. current account deficit. Continued repatriation of assets and higher enforced domestic savings rates will at least reduce pressure on the dollar in the short-term.
Inflation/Deflation
Annual U.S. inflation, as measured by official producer and consumer price indices, is likely to slow in 2009 and even fall into technical deflation despite increases in the monetary base and fiscal measures to boost spending power. Slumping commodity prices may drag down the average annual headline CPI inflation rate to around -2% - a technical deflation which may morph into genuine deflation if falling prices generate expectations that they will continue to fall. Meanwhile, the growing slack in product and labor markets will keep core consumer inflation subdued at an average year-over-year rate of 1-2%. Steep discounts to get rid of unsold retail inventory, rising job losses and lower wage growth will reinforce the trend of stagnant or falling prices. Loose labor markets and weak demand for commodities and goods/services will keep producer prices at bay. Risks to the outlook include 1) a commodity supply crunch or geopolitical shock that leads to a sustained rise in commodity prices and 2) an earlier than expected global economic recovery.
Credit Losses Still Ahead
Back in February 2008, Nouriel Roubini warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion. As of mid-November 2008, the threshold of $1 trillion in global financial writedowns was finally reached. Given that national house prices expected to drop another 20%, we expect credit losses of $1.6 trillion.
An in-depth analysis of current and expected loan losses per asset class and separately of mark-to-market writedowns per securities class based on current prices indeed confirms RGE’s initial loss range estimates (outstanding loan and securities amounts as in IMF GFSR, Table 1.1) For our calculations we assume a further 20% fall in house prices, and an unemployment rate of 9%. With respect to credit losses on unsecuritized loans, recent research by the Fed Board using comparable assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are going to default (i.e. $150bn out of $300bn). The loss trajectories for Alt-A loans are similar resulting in a 25% default rate ($150bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies, implying an approximate 7% default rate when the potential for ‘jingle mail’ is taken into account ($266bn out of $3,800bn).
The cycle has also turned in the commercial real estate (CRE) arena with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (net recovery, via Fed data) are projected to increase to up to 17% by Fitch assuming a 25% fall in prices ($408bn out of $2.4 trillion.) In the consumer loan area, we estimate credit card charge-off rate could increase to 13% in the worst case scenario. Adding a typical 5% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $252bn out of $1.4 trillion (see The U.S. Credit Card Industry in 2009, by RGE’s Mathias Kruettli.)
The IMF warned that commercial and industrial loans (C&I) charge-off and delinquency rates are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and serious delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn out of $170bn unsecuritized leverage loans.
Based on these calculations, RGE expects total loan losses to reach about $1.6 trillion out of $12.4 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. The IMF assumes that the U.S. banking system carries about 60-70% of unsecuritized loan losses (and about 30% of mark-to-market losses on securitizations). Even assuming that future loan losses are fully discounted at current market prices, deploying the remaining TARP funds towards recapitalizing the banking system would still be warranted.
The Disconnect Between Bond and Equity Markets
U.S. government bonds were on a tear in 2008, while equities plummeted in a nasty bear market. Bond yields at the long end hit all-time record lows, while the short end even dipped into negative territory. Only TIPS suffered as deflation risks rose. Stocks, on the other hand, had their worst year since the Great Depressions: DJIA lost 34%, S&P 500 -38.5%. At its 2008 low on November 20, the S&P 500 was down 49% for the year and 52% from its October 2007 peak. Stocks rallied in December though, resulting in an apparent disagreement between the stock and bond markets over the outlook for the U.S. economy. Bond markets seemed to be discounting a recession in 2009 while stock markets have been gaining since late November. This disconnect may vanish in 2009 though if the stock market rally was really just a bear market rally due to portfolio re-balancing and thin year-end trade volumes.
However, there have been intimations that the bond market is in a bubble about to burst in 2009. Indeed, with ultra low bond yields, investors may be tempted to switch into higher-yielding equities - which are now considered by many to be undervalued. Valuation, however, is not the be-all and end-all of asset performance. The credit freeze needs to end before equities can see the end of the bear market. However, considering the likely economic stagnation ahead, bonds should be a better bet than equities for some time. We see meaningful downside risks to stock prices as bad macro news – worse than expected – continues to dominate in 2009. Using the S&P 500 as benchmark, earnings per share will stay in the $50-60 range – and earnings will fall further. If, and it is not unusual during recessions, P/E ratio falls in the 12-14 range, we could see another 25% slide in stock prices.
Fiscal and Monetary Policy
Fiscal Policy
A lot of hope is being placed on the expected fiscal stimulus package of around $750 bn spread over 2009-10 including 40% of the stimulus in tax cuts for households and firms. Around half of the stimulus is expected to kick-in starting Q2 2009 and through 2010. But this will fall short of the pull-back in private demand of close to $1 trillion during this period.
Infrastructure spending, in spite of being highly effective, might not be timely, stimulating the economy only in late-2009 and 2010 when it has well passed the severe recession phase only to exacerbate the ballooning fiscal deficit. Nonetheless, around $100bn of infrastructure investment might be able to kick-in during 2009. Moreover, job creation in infrastructure might be overestimated given limitations in moving laid-off workers from other sectors to the infrastructure projects. As such, any job creation via government spending and tax incentives for firms will significantly fall short of the ongoing lay-offs.
Given the drawback of the ‘spending’ component of the stimulus, the government may be enticed to implement more tax cuts. While tax incentives for households like payroll and child tax credit might be well-targeted at the group with high propensity to spend, tax cuts in general will be less effective in stimulating demand given a secular rise in the saving rate expected over the next few years. Likewise, tax breaks for firms hiring new workers or investing in new equipment will be rather ineffective since businesses see little viability in doing so during a slump in domestic and export demand. At the most, tax stimulus in spite of being timely and well-targeted will cause only a temporary rebound in the economy for a month or a quarter merely shifting the spending decision period just like tax rebates did in 2Q 2008.
Expansion of unemployment benefits, food stamps and other incentives will have a high bang-for-buck effect in 2009 and will only assuage the impact of the recession. The stimulus will also include up to $100 bn for state and local governments to meet their severe budget shortfalls including grants, Medicaid and unemployment insurance funds, preventing cutbacks in public services, investment and jobs in several recession-hit states. But again, fiscal aid for states often suffers from time lags.
Fiscal stimulus, TARP spending, GSEs-related expenditure along with further slowdown in corporate and individual income tax revenues will push the fiscal deficit to around $1.3 trillion in FY2009.
Monetary Policy
The Fed has enacted a wide and unprecedented range of measures to mitigate the credit crisis and stimulate the economy. It has already cut its target range for the Fed funds rate down to 0-0.25% (essentially ZIRP) but, more importantly, it has created currency swap lines and an alphabet soup of programs to provide liquidity to the financial system and clean out toxic financial assets. The Fed experimented with different forms of financing itself in order to enable a sharp expansion of its balance sheet to accommodate these liquidity facilities. In addition to rate cuts and quantitative easing, the Fed has directly aided failing financial institutions. Now, the Fed is considering issuing its own debt and/or purchasing long-dated Treasuries and Agency debt. Will the monetary easing work? So far, the increase in money supply has not been accompanied by an increase in the velocity of money. In other words, credit growth remains stagnant as banks are reluctant to lend back out the money provided by the Fed and, at the same time, borrower demand has fallen.
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