Posts filed under ‘Financial Markets’
September Surge: Stop, Go, or Proceed Cautiously?
The stock market just posted its strongest September and third quarter performance in more than seven decades (S&P 500 +8.8% and +10.7%, respectively), yet people are still waiting for a clear green light to signal blue investment skies ahead. Well of course, once it is apparent to everyone that the economy is obviously back on track, the opportunities persisting today will either be gone or vastly diminished. I’m not a blind optimist, but a sober realist that understands, like Warren Buffett, that it pays to “buy fear and sell greed.” And fear is exactly what we are witnessing today. The $2.6 trillion sitting in CDs earning a horrendously low 1% is simple proof (Huffington Post).
Like the fresh memory of a recent hand burned on the stove, the broader general public is still feeling the pain and recovering from the financial crisis. Each gloomy real estate or unemployment headline triggers agonizing flashbacks (read Unemployment Hypochondria) of the 2008-2009 financial collapse and leads to harmful emotional investment decisions. However, for some of us finance geeks that have cut through the monotony of “pessimism porn” blasted over the airwaves, we have discovered plenty of positive leading economic indicators bubbling up below the surface, like the following:
- Continued Economic Growth: Gross Domestic Product (GDP) grew +1.7% in the second quarter and current estimates stand in the +2.0% to +2.5% range for third quarter GDP, which will mark the fifth consecutive quarter of growth.
- Growing Corporate Profits: S&P 500 earnings are estimated to expand by +45.6% in 2010 and are estimated to grow by another +15% or so next year (Standard & Poor’s September 2010).
- Escalating M&A: Mergers and acquisitions activity increased to $566.5 billion in the third quarter. The value of announced transactions is up +60% from a year ago according to Bloomberg. If you have a tough time comprehending the pickup in M&A, then take a peek here.
- Record Cash Piles: The top 1,000 largest global corporations held a whopping $2.87 trillion in cash (Bloomberg).
- Accelerating Share Buybacks: Share buybacks totaled $77.6 billion in the second quarter, up +221% from a record low last year – Barron’s).
- Dividends Galore: S&P 500 companies have lifted their payouts by $15 billion so far this year versus a reduction of $40 billion for the same period last year (The Wall Street Journal). Tech giant Cisco Systems Inc. (CSCO) announced the pending initiation of a dividend, while Microsoft Corp. (MSFT) increased its dividend by a significant +23%.
I’m not naïve enough to believe choppy waters will disappear for good, but despite the depressing headlines there are constructive undercurrents. Beyond the points above, equity market prices remain attractive relative to the broader fixed-income markets (see Bubblicious Bonds) . More specifically, the S&P 500 is priced at about a 25% discount to historic valuation averages over the last 55 years (currently trading at about 12.5 Price/Earnings ratio vs 16.5x historic Price/Earnings ratio – Bloomberg). Now may not be the time to recklessly run a red light, but if you fearfully remain halted in front of the green light then prepare to receive a pricey ticket.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and CSCO, but at the time of publishing SCM had no direct position in MSFT, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Why it’s NOT Different This Time
“Those who don’t know history are destined to repeat it.”
– Edmund Burke – British Statesman and Philosopher (1729-1797)
I wasn’t a history major in college, but I’ve learned two things by studying history books: 1) The unchanging psyche of human nature leads history consistently to repeats itself; and 2) There is never a shortage of goofballs willing to make zany predictions.
Robert Zuccaro is no exception to lesson number two, as evidenced by his 2001 book, Why it’s Different this Time…Dow 30,000 by 2008! Sticking one’s neck out is never too difficult when you have a multi-decade trend behind your back – I guess Dow “14,000” just didn’t sound sexy enough back then. Unfortunately the herd reacting to these bold, extreme predictions eventually realize (usually post-mortem) that they are quickly approaching a tail-end of a cycle. The cab driver, hair dresser, and mechanic realized the dangers of following the “New Economy” cheerleaders in 1999 when everyone was piling into dot-com stocks (see Bubblicious technology table ).
Dow 1,000 Here We Come!
- Source: Yahoo! Finance
Today, the Zuccaros of the world have been washed to the curb, and new “Armageddon” extremists have sprouted up to the surface, like perma-bear Peter Schiff and his call for Dow 2,000 or his $5,000 per ounce gold estimate. More recently, Robert Prechter has one-upped Schiff by forecasting Dow 1,000 with the assistance of the not-so ironclad Elliott Wave Theory philosophy (see Technical Analysis: Astrology or Lob Wedge). If you’re in the Prechter camp, either crawl back into your bunker or start digging that dream cave you always wanted.
Source: Elliott Wave International
“Hey, Look Here at My Crazy Forecast!”
Publicity doesn’t necessarily rain praise on those parroting the consensus view (although the warmth of job security is appreciated), but rather the extreme outliers love to bask in the glow of media attention. The extremists consistently repeat “why it’s different this time.” What is different is the set of circumstances, but what history shows us over and over again is the emotions of fear and greed feeding the bubbles of excess are exactly the same. Whether you’re talking about the Tulip-Mania of the 1630s, the Nifty Fifty stocks of 1973-1974, the technology Four Horsemen of the mid-1990s, or the Icelandic Banks of 2008, what we learn from the lessons of history is that human nature will never change and fear and greed will continue creating and bursting future bubbles.
People playing the game long enough understand, “It’s NOT different this time.” Not only have we endured repeated wars, recessions, banking crises, currency crises, but we have also survived every exotic animal disease known to man, including Mad Cow, Swine Flu, Bird Flu, West Nile, etc.
Robert Zuccaro and Robert Prechter may get an “A” for their attention grabbing forecasts, but thus far the grade earned on accuracy is closer to an “F.” More specifically, Zuccaro’s prediction never came close to 30,000 by the end of 2008 (only off by about 21,000 points), and guess what, Bob Prechter has a long way to go before reaching his Dow 1,000 target. So here is my proposition: Why don’t we just split the difference between Zuccaro’s 2008 and Prechter’s 2016 forecasts and take the average? If it turns out they are equally bad forecasters, then Dow 15,500 by 2012 should be no problem ([30,000 + 1,000] ÷ 2)!
Regardless of the ultimate outcome of this market (double-dip or sustained recovery), what I do know is there will continue to be wacky outlandish forecasters rationalizing why a trend will go on for infinity and why “this time is different.” In reality these attention mongers will always be around ensuring this time (or next time) will never be different…just the same fear and greed as always.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Professional Double-Dip Guesses are “Probably” Wrong
As you may have noticed from previous articles, I take a significant grain (or pound) of salt when listening to economists and strategists like Peter Schiff, Nouriel Roubini, Meredith Whitney, John Mauldin, et.al. Typically, these financial astrologists weave together convincing, elaborate, grand guesses that extrapolate every short-term, fleeting economic data point into an imposing (or magnificent) long-term secular trend.
With all this talk of “double-dip” recession, I cannot help but notice the latest verbal tool implemented by every Tom, Dick, and Harry economist when discussing this topic… the word “probability”. Rather than honestly saying I have no clue on what the economy will do, many strategists place a squishy numerical “probability” around the possibility of a “double-dip” recession consistent with the news du jour. Over recent weeks, unstable U.S. economic data have been coming in softer than expectations. So, guess what? Economists have become more pessimistic about the economy and raised the “probability” of a double dip recession. Thanks Mr. Professor “Obvious!” I’m going to go out on a limb, and say the probability of a double-dip recession will likely go down if economic data improves. Geez…thanks.
Here is a partial list of double-dip “probabilities” spouted out by some well-known and relatively unknown economists:
- Robert Shiller (Professor at Yale University): “The probability of that kind of double-dip is more than 50 percent.”
- Bill Gross (Founder/Managing Director at PIMCO): The New York Times described Gross’s double-dip radar with the following, “He put the probability of a recession — and of an accompanying bout of deflation — at 25 to 35 percent.”
- Mohamed El-Erian (CEO of PIMCO): “If you wonder how meaningful 25 per cent is, ask yourself the following question: if I offered you that I drive you back to work, but there’s a one in four chance that I get into a big accident, would you come with me?”
- David Rosenberg (Chief Economist at Gluskin Chef): In a recent newsletter, Rosenberg has raised the odds of a double-dip recession from 45 per cent a month ago to 67 per cent currently.
- Nouriel Roubini (Professor at New York University): “As early as August 2009 I expressed concern in a Financial Times op-ed about the risk of a double-dip recession, even if my benchmark scenario characterizes the risk of a W as still a low probability event (20% probability) as opposed to a 60% probability for a U-shaped recovery.”
- Robert Reich (Former Secretary of Labor): According to Martin Fridson, Global Credit Strategist at BNP Paribas, Robert Reich has assigned a 50% probability of a double dip, even if Reich believes we are actually in one “Long Dipper.”
- Graeme Leach (Chief Economist at the Institute of Directors): “I would give a 40 per cent probability to what I call ‘one L of a recovery’, in other words a fairly weak flattish cycle over the next 12 months. A double-dip recession would get a 40 per cent probability as well.”
- Ed McKelvey (Sr. U.S. Economist at Goldman Sachs): “We think the probability is unusually high — between 25 percent and 30 percent — but we do not see double dip as the base case.”
- Avery Shenfeld (Chief Economist at CIBC): “The probability estimate is likely more consistent with a slowdown rather than a true double-dip recession but, given the uncertainties, fiscal tightening ahead and the potential for a slow economy to be vulnerable to shocks, we will keep an eye on our new indicator nevertheless.” This guy can’t even be pinned down for a number!
- National Institute for Economic and Social Research (NIESR) : “The probability of seeing a contraction of output in 2011 as compared to 2010 has risen from 14 per cent to 19 per cent.”
- New York Fed Treasury Spread Model (see chart below): Professor Mark J. Perry notes, “For July 2010, the recession probability is only 0.06% and by a year from now in June of next year the recession probability is only slightly higher, at only 0.3137% (less than 1/3 of 1%).”
Listening to these economic armchair quarterbacks predict the direction of the financial markets is as painful as watching Jim Gray’s agonizing hour-long interview of Lebron James’s NBA contract decision (see also Lebron: Buy, Sell, or Hold?). Just what I want to hear – a journalist that probably has never dribbled a ball in his life, inquiring about cutting edge questions like whether Lebron is still biting his nails? Most of these economists are no better than Jim Gray. In many instances these professionals don’t invest in accordance with their recommendations and their probability estimates are about as reliable as an estimate of the volatility index (see chart below) or a prediction about Lindsay Lohan’s legal system status.
I can virtually guarantee you at least one of the previously mentioned economists will be correct on their forecasts. That isn’t much of an achievement, if you consider all the strategists’ guesses effectively cover every and any economic scenario possible. If enough guesses are thrown out there, one is bound to stick. And if they’re wrong, no problem, the economists can simply blame randomness of the lower probability event as the cause of the miscue.
Unlike Wayne Gretzky, who said, “I skate to where the puck is going to be, not where it has been,” economists skate right next to the puck. Because the economic data is constantly changing, this strategy allows every forecaster to constantly change their outlook in lock-step with the current conditions. This phenomenon is like me looking at the dark clouds outside my morning window and predicting a higher probability of rain, or conversely, like me looking at the blue skies outside and predicting a higher chance of sunshine.
Using this “probability” framework is a convenient B.S. means of saving face if a directional guess is wrong. By continually adjusting probability scenarios with the always transforming economic data, the strategist can persistently waffle with the market sentiment vicissitudes.
What would be very refreshing to see is a strategist on CNBC who declares he was dead wrong on his prediction, but acknowledges the world is inherently uncertain and confesses that nobody can predict the market with certainty. Instead, the rent-o-strategists consistently change their predictions in such a manner that it is difficult to measure their accuracy – especially when there is rarely hard numbers to hold these professional guessers accountable for.
Economists and strategists may be well-intentioned people, just as is the schizophrenic trading advice of Jim Cramer of CNBC’s Mad Money, but the “probability” of them being right over relevant investing time horizons is best left to an experienced long-term investor that understands the pitfalls of professional guessing.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in GS, NYT or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Private Equity: Hitting Maturity Cliff
Photo source: 1Funny.com
Wow, those were the days when money was as cheap and available as that fragile, sandpaper-like toilet paper you find at gas stations. Private equity took advantage of this near-free, pervasive capital and used it to the greatest extent possible. The firms proceeded to lever up and gorge themselves on a never-ending list of target companies with reckless abandon (see also Private Equity Shooting Blanks). Now the glory days of abundant, ultra-cheap capital are history.
Rather than rely on low-cost bank debt, private equity firms are now turning to the fixed income markets – specifically the high yield market (a.k.a. junk bonds). As The Financial Times points out, more than $170 billion of junk bonds have been issued this year, in large part to refinance debt issued in the mid-2000s that has gone sour due to overoptimistic projections and a flailing U.S. economy. In special instances, private equity owners are fattening their own wallets by declaring special dividends for themselves.
Even though some of these over-levered, private equity portfolio companies have received a temporary reprieve from facing the harsh economic realities thanks to these refinancings, the cliff of maturing debt in 2012 is fast approaching. Some have estimated that $1 trillion in maturing debt will roll through the market in the 2012-2014 timeframe. Either the economy (or operating performance) improves enough for these companies to service their debt, or these companies will find themselves falling off these maturity cliffs into bankruptcy.
Junk is Not Risk-Free
Driving this trend of loan recycling is risk aversion to stocks and a voracious appetite for yield in a yield desert. Stuffing the money under the mattress, earning next to nothing on CDs (Certificates of Deposit) and money market accounts, will not help in meeting many investors’ long-term objectives. The “uncertain uncertainty” swirling around global equity markets has nervous investors flocking to bonds. The opening of liquidity in the high yield markets has served as a life preserver for these levered companies desperate to refinance their impending debt. This high-yield debt refinancing window is also an opportunity for companies to lower their interest expense burden because of the current, near record-low interest rates.
But as the name implies, these “junk bonds” are not risk free. For starters, embedded in these bonds is interest rate risk – with a Federal Funds rate at effectively zero, there is only one upward direction for interest rates to go (bad for bond prices). In addition, credit risk is a concern as well. In the midst of the financial crisis, many of these high-yield bonds corrected by more than -40% from their highs in 2008 until the bottom achieved in early 2009. If the economy regresses back into a double-dip recession, many of these bonds stand to get pummeled as default rates escalate (see also, bond risks).
Pace Not Slowing
Source: Dealogic via WSJ
Does the appetite for high yield appear to be slowing? Au contraire. In the most recent week, Dealogic noted $15.4 billion in junk bonds were sold. The FT sees the pace of junk deals handily outpacing the record of $185.4 billion set in 2006.
The Wall Street Journal used the following deals to provide a flavor of how companies are using high-yield debt in the present market:
“First Data Corp. sold $510 million of 10-year notes this week, at 9.125%, to pay down bank debt due in 2014. Peabody Energy sold $650 million of 6.5%, 10-year notes to pay off the same amount of higher-priced debt due in three years. MultiPlan Inc., a health-care cost-management provider, sold $675 million of notes this week, at 9.875%, to help fund a buyout of the company. Cott Corp., a maker of store-branded soft drinks, sold $375 million of debt at 8.125% to fund its purchase of another company, Cliffstar Corp.”
The roads on the junk bond highway appear to be pothole free at the moment, however a cliff of debt is rapidly approaching over the next few years, so high-yield investors should travel carefully as conditions in the junk market potentially worsen. As we witnessed in 2008-2009, it can take a while to hit rock bottom in the riskier areas of the credit spectrum.
Read full Financial Times and Wall Street Journal articles on the high yield market.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including HYG and JNK), but at the time of publishing SCM had no direct position in First Data Corp., Peabody Energy (BTU), MultiPlan Inc., Cott Corp. (COT), Cliffstar Corp., or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
“De-Risking” – It’s All Greek to Me
Source: Photobucket
In the classic comedy Animal House John Belushi (who played the character Bluto) gave new meaning to the Greek toga party (who cares if the Romans actually invented the garment?). Belushi also added some flare to Sam Cooke’s timeless song, Wonderful World:
“Don’t know much about history
Don’t know much biology
Don’t know much about the science book
Don’t know much about the French I took.”
Another line should have been added: “Don’t know much about Wall Street jargon.”
“Derisking” – New Wall Street Word Du Jour
Wading through and keeping up with the ever expanding dictionary of Wall Street lingo and acronyms can be a difficult task – much like deciphering the Greek writings of Plato, the famous ancient philosopher.
A recent term repeated constantly by CNBC commentators and hedge fund managers at the annual SALT (SkyBridge Alternatives) conference in Las Vegas, Nevada deserves some more attention…“derisking.” Elegant, simple, chic, and yes, pure B.S. Why not use “mis-risking,” “un-risking,” “dis-risking?” I suppose when charging people 2 and 20 (a 2% management fee plus 20% of profits above a hurdle), one must try to make the most prosaic terms and expressions sound mysterious and dazzling.
Asking one hedge fund manager after another, CNBC commentator David Faber continually asked managers at the May conference what investing strategies were being employed. Faber asked Marc Lasry, CEO and Co-Founder of Avenue Capital Group, the following:
“I have spoken to number of other large hedge fund managers this morning. Derisking, that’s what they are all talking about Marc. So, given that, are you derisking at all?”
Translation: “The market is going down, so are you following all the other lemmings and becoming more conservative because of the panicked-induced headlines we’re shoveling 24/7?”
Glenn Dubin, Co-Founder and CEO of Highbridge Capital Management, a hedge fund company owned by JP Morgan (JPM) got in the “derisking” mood too: “At this point…we are seeing massive de-risking.”
At the time of the SALT conference, European economic concerns were top of mind for all the fast-money traders, as fears of a credit contagion spreading from Greece to larger countries like Italy and Spain felt more palpable to many. Some nine weeks later, the European bank stress tests have been completed, some overseas economic indicators have come in better than anticipated (i.e., U.K. GDP, German business confidence, exports), and some European markets are up about +10% from the “derisking” phase. So, I wonder what those same hedge funds and traders are doing now?
Perhaps they are “rerisking?” I just made that one up out of thin air, but if I hear “rerisking” on CNBC or see it in the Wall Street Journal, I demand a credit in the Merriam-Webster dictionary, or a citation in Wikipedia at a minimum.
The “derisking” wave did not stop at the SALT conference, but remains alive and well today. In fact, a conference has been created in its honor: The 3rd Annual De-Risking Strategies Summit for Pension Funds, Foundations, and Endowments on October 25 – 27, 2010 in New York.
Obviously, this is just one of many terms, acronyms, and euphemisms that the Wall Street machine is constantly churning out. If “derisking” doesn’t float your boat, then why not try on a “swaption” and “straddle” or “contango” and “crawling peg?”
If the never-ending list of Wall Street jargon is weighing you down and a financial professional is speaking Greek to you with confusing financial terminology, then do yourself a favor and slap that person into silence. More often than not, these financial concepts can be explained to a fifth grader (or Bluto). Unfortunately, a convoluted combination of jargon and acronyms is often used in an attempt to impress the listener. The result is usually confusion and a blank stare.
If you are frustrated with learning the language of Wall Street, you are not alone. I recommend you “derisk” your education by adding Greek 101 to your coursework. If you are going to be confused, you might as well do it with a gyro and some Ouzo in hand.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in JPM or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Marathon Investing: Genesis of Cheap Stocks
It was Mark Twain who famously stated, “The reports of my death have been greatly exaggerated.” So too has the death of equities been overstated. Long-term stock bulls don’t have a lot to point to since the market, as measured by the S&P 500 index, has done absolutely nothing over the last 12 years (see Lost Decade). Over the last 10 years, the market is actually down about -20% without dividends (and about flat if you account for reinvested dividends). So if equities belong at the morgue, why not just short the market, burn your dollars, and hang out in a cave with a pile of gold? Well, behind the scenes, and off the radar of nanosecond, high frequency, day-trading CNBC junkies, there has been a quiet but deliberate strengthening in the earnings foundation of the market. In the investing world it’s difficult to move forward through sand. Even without a sturdy running foundation, sprinters can race to the front of the pack, but those disciplined runners who systematically train for marathons are the ones who successfully make it to the finish line.
Prices Chopped in Half
What many pundits and media mavens fail to recognize is S&P corporate profits have virtually doubled since 1998 (a historically elevated base), despite market prices stuck in quicksand for a dozen years. What does this say about the valuation of the market when prices go nowhere and profits double? Simple math tells us that all stock market inventory is selling for -50% off (the market multiple has been chopped in half). That’s exactly what we have seen – the June 1998 market multiple (valuation) stood around 27x’s earnings and today’s 2010 earnings estimates imply a multiple of about 13.5 x’s projected profits. With the rear-view mirror assisting us, it’s easy to understand why pre-2000 (tech bubble) valuations were expensive. By coupling more reasonable valuations with a 10-Year Treasury Note trading at 3.19% and lofty bond prices, I would expect stocks to be poised for a much better decade of relative performance versus bonds. The case becomes even stronger if you believe 2011 S&P 500 estimates are achievable (12x’s earnings).
In order to make the decade long valuation contraction more apparent, I wanted include a random group of stocks (mixture of healthcare, media, retailer, consumer non-discretionary, and financial services) to liven up my argument:
Data sources: S&P, ADVFN & Yahoo! Finance
What Next?
From a stock market standpoint, there are certainly plenty of believable “double dip” scenarios out there along with thoughtful observers who question the attainability of next year’s earnings forecasts. With that said, I do have problems with those bears like John Mauldin (read The Man Who Cries Wolf) who just last year pointed to a market trading at a “(negative) -467” P/E ratio, only to subsequently watch stocks advance some 80%+ over the following months.
Regardless of disparate economic views, I contend objective market observers (even bearish ones) have trouble indicating the market is ridiculously expensive with a straight face – based on current corporate profit expectations. At the end of the day, sustainable earnings and cash flow growth are what ultimately drive durable, long-term price appreciation. As Peter Lynch stated with technical precision, “People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”
Running a marathon is always challenging, but with a sturdy foundation in which prices have been chopped in half (see also Market Dipstick article), reaching the goal and finish line for long-term investors will be much more achievable.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, WMT, and PAYX, but at the time of publishing SCM had no direct positions in ABT, CI, DIS, FRX, KO, KSS, MDT or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Private Equity Sitting on Stuffed Wallet
The clock is ticking and private equity (PE) firms need to put some $445 billion in their wallets to work. Otherwise, the dreams of outsized returns and hefty fees will have to wait for another Golden Era of deal making. Why such a hurry to use the cash? According to Andrea Auerbach, a Managing Director at Cambridge Associates, “Most funds legally have five or six years to invest that capital…it’s use it or lose it.”
Shop ‘til Wallet Drops
As easy as it sounds, spending half a trillion dollars can be difficult. Here’s how IBD’s Norm Alster characterizes the challenge:
“To realize the outsize profits investors expect, private equity firms would have to borrow two or three times that amount. But for the most part, credit spigots for such deals are still dry. At the same time, pinning down buyout targets is not that easy. Many potential sellers are balking at parting with corporate assets in the midst of a serious downturn.”
The 2010 private equity environment is quite a bit different than the LBO boom era from a handful of years ago, as you can see from the chart below. Thanks to cheap, free-flowing funding from the banks, $1.4 trillion worth of deals were consummated in 2006 and 2007, including large deals like First Data Corp. ($27 billion deal – KKR); Alltel ($28 billion – Goldman Sachs/ Texas Pacific Group); and Harrah’s ($30 billion – Apollo Management/Texas Pacific Group). Unfortunately, deals done during this period were done when valuations and leverage were at extremely high historical levels.
Chart source: Thomson Reuters via IBD
Deal Timeout
What’s causing the current dearth of deals? In many instances, business owners have not calibrated valuation expectations downward enough to account for the bruising financial crisis. Given the 77 leveraged buyout defaults in 2009, investors have become more reticent in committing capital as well. Refinancing the mountains of debt associated with the troubled 2006-07 vintage of deals will require patience and creative financing skills from the banks.
Because of the logjam of deals created by the financial crisis, PE firms are actively looking for exit strategies relating to their portfolio companies. Since private equity inherently involves illiquid investments, typically the industry creates liquidity through initial public offerings (IPOs), merger & acquisitions, and/or recapitalization structures that partially or fully return investor capital.
If the economic malaise lingers and valuations remain depressed, I have no doubt owners will eventually return to the negotiating table while waving a white towel in hand. Until then, private equity firms will continue begging for capital from the banks (i.e., using “other peoples’ money”) and beating down sellers into submission with regards to price expectations. If PE firms are not successful in using that wad of cash by the end of the fund’s term, then investors will be free to walk away with their money without paying lucrative fees to the PE firms.
Don’t Forget Benefits
The PE field is facing its fair share of trials and tribulations, but PE’s diversification benefits should not be forgotten. The success of the “Yale Model,” implemented by David Swensen, has come under attack with the recent bursting of the credit bubble, but with the ever-swinging performance pendulum of various asset classes/styles moving in and out of favor, I am confident a consistent strategy integrating PE as a portion of a diversified portfolio will yield respectable risk-adjusted returns over the long-run. Like other areas in the financial services industry, fees are being scrutinized and transparency requests by investors (limited partners) have been on the rise. But first things first – before attractive PE profits can be made as part of a diversified portfolio, the wad of cash in the wallets of PE firms must find a home in portfolio companies.
Read Norm Alster’s full IBD article originally referenced on TRB
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including S&P 500-like positions), but at the time of publishing SCM had no direct positions in GS, Harrah’s or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Margin Surplus Retake
Like a B-rated horror movie using the same old cliques (i.e., girl home alone with serial killer on the loose or a concealed intruder hidden in the back seat of a car), one of the financial cliques that persists today is the belief that the United States trade deficit will result in financial ruin for our economy. The recent widening of the trade deficit to $40.3 billion makes this economic issue a topical discussion. Enter Andy Kessler, former hedge fund manager and author of Running Money. He believes the stale, exploding trade deficit arguments are hogwash, primarily due to his “margin surplus” theory articulated in his book and Wall Street Journal article entitled, We Think, They Sweat.
Profiting from Trade Deficits
The absolute numbers used by Kessler in his Toshiba laptop example might have changed since his book was first published in 2004, but this margin surplus theory example is just as relevant today as it was back then. Here is an excerpt from his book:
“Let’s open up that Toshiba laptop. With a $300 Intel chip (which has at least $250 in profit for Intel) and a $50 Windows license ($49.95 margin to Microsoft), the laptop is then sold by Toshiba back into the U.S. for $1,000. Toshiba and every other supplier are lucky if they make $50 profit, combined, on the deal.”
In this illustration, government statistics would recognize a $1,000 contribution to our bloating trade deficit figures, even though nearly 90% of the laptop profits would be flowing (“surplus-ing”) back to the U.S. Hmmm, maybe this trade deficit thing isn’t as evil as it is portrayed in the popular media, or perhaps we are measuring it incorrectly? Kessler makes the case that Gross Domestic Product (GDP) is not the most important economic gauge, but rather the real crucial GDP metric is actually Gross Domestic PROFIT. He adds the best indicator for economic profits is the stock market, and as foreigners seek more productive returns on their cash beyond the 3% Treasury yields, they will eventually filter back their dollar currency reserves into stocks and other more productive asset classes.
Brain Driven Economy
You don’t have to be a brain surgeon to realize our roots as an industrial economy have shifted to an intellectual property economy. So while we may be exporting low-skilled labor jobs to China and other low-cost regions, our country is also creating higher-skilled, higher-paying jobs at innovative growing companies such as Google Inc. (GOOG) and Apple Inc. (AAPL). Case in point, flip an Apple iPod over and read the fine print on the back – it reads, “Assembled in China…Designed by Apple in California.” Once again, the commoditized aspects of slapping together a widget have been outsourced to workers in far-off lands for a small fraction of what American workers earn. If improving the standard of living is our goal, then transferring low paying jobs to foreigners should not be a concern. According to Kessler, $70 in iPod profits (versus $4 for the Chinese assemblers) from this unique, differentiated device has generated millions in profits, which in turn can be used for the creation of desirable, high-paying jobs here in the U.S.
Selling the Farm
Warren Buffets has a different view about our trade deficits and the directional value of the U.S. dollar. He perceives our economy as a fixed size farm that is selling $2 billion pieces of the farm to foreigners on a daily basis. Buffet adds:
“We’re like a very rich family; we own a farm the size of Texas but want to consume more. If you force-feed $2 billion a day to the rest of the world, they get somewhat less enthusiastic over time – and the dollar is worth less.”
Over time, Buffett believes future generations will resent paying for the gluttony of consumption by prior generations and foreigners will demand a higher interest rate for their loans. What I believe Buffet fails to consider is that the farm is not static. As we sell off $2 billion chunks of the farm, portions of those proceeds are being used to adjoin additions, buy new farms, build adjacent wind turbines, and/or incorporate other productive uses. Now if the proceeds were used to solely purchase bon-bons and doughnuts, then indeed we would be in trouble. Ultimately, the financial markets will be the true arbiter of how efficiently the foreign capital is being invested and will dictate the level of rates paid on the loans. From a pure cash management standpoint, stretching out payables (net imports) is a sound practice (i.e., it’s desirable to collect early and pay late).
The flip side of the argument explains how the farm sale proceeds from our asset sales to foreigners (such as our real estate, our Treasuries, and our stocks) can be employed in a productive manner. The Buffett argument states that our farm will eventually be completely sold to foreigners or they will hold a gun to our head asking for higher interest rates to fund our deficits. The problem with that argument is that the money received from the farm sales (Treasuries, stocks, real estate, etc.) can be (and is) used to build new farms. And that is the key question…are all these deficit building dollars being used to create new, innovative, job creating companies like Google and Apple, or are these dollars being redeployed into unproductive uses (e.g., worthless t-shirts and lead-filled toys from China, or funding of bailouts and cash-for-clunkers waste) ?
At the end of the day, money goes where it is treated best – meaning global capital seeks the royal treatment in markets where profits reign supreme. So rather than relying on rusty, obsolete statistics measuring the balance of trade (i.e., trade deficits and GDP), investors would be better served by taking a page from Andy Kessler’s book. Following the principles of “margin surplus” will increase the probabilities of profiting from global capital flows.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, Treasury securities, GOOG, and AAPL, but at the time of publishing SCM had no direct positions in Toshiba, INTC, BRKA/B or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Gravity Takes Hold in May
Warner Bros. picture of Wile E. Coyote’s failed apprehension of Roadrunner
Wile E. Coyote, the bumbling, roadrunner-loving carnivore from Warner Bros.’ Looney Tunes series spends a lot of time in the air chasing his fine feathered prey. Unfortunately for Mr. Coyote his genetic make-up and Acme purchases could not cure the ills caused by gravity (although user error was the downfall of Wile E’s effective Bat-Man flying outfit purchase). Just as gravity hampered the coyote’s short-term objectives, so too has gravity hampered the equity markets’ performance this May.
So far the adage of “Sell in May and walk away” has been the correct course of action. Just one day prior to the end of the month, the Dow Jones Industrial and S&P 500 indexes were on pace of recording the worst May decline in almost 50 years. If the -6.8% monthly decline in the S&P and the -7.8% drop in the S&P remains in place through the end of the month, these declines would mark the worst performance in a May month since 1962.
Should we be surprised by the pace and degree of the recent correction? Flash crash and Greece worries aside, any time a market increases +70-80% within a year, investors should not be caught off guard by a subsequent 10%+ correction. In fact corrections are a healthy byproduct of rapid advances. Repeated boom-bust cycles are not market characteristics most investors crave.
It was a volatile, choppy month of trading for the month as measured by the Volatility Index (VIX). The fear gauge more than doubled to a short-run peak of around 46, up from a monthly low close of about a reading of 20, before settling into the high 20s at last close. Digesting Greek sovereign debt issues, an impending Chinese real estate bubble bursting, budget deficits, government debt, and financial regulatory reform will determine if elevated volatility will persist. Improving macroeconomic indicators coupled with reasonable valuations appear to be factoring in a great deal of these concerns, however I would not be surprised if this schizophrenic trading will persist until we gain certainty on the midterm elections. As Wile E. Coyote has learned from his roadrunner chasing days, gravity can be painful – just as investors realized gravity in the equity markets can hurt too. All the more reason to cushion the blow to your portfolio through the use of diversification in your portfolio (read Seesawing Through Chaos article).
Happy long weekend!
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in TWX, VXX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Soros & Reflexivity: The Tail Wagging the Dog
Billionaire investor George Soros, who is also Chairman of Soros Fund Management and author of The Crash of 2008¸ is well known for his theory on reflexivity, which broadly covers political, social, financial, and economic systems. Soros built upon this concept (see also Soros Super Bubble), which was influenced by philosopher Karl Popper. With all the fear and greed rippling through global geographies as diverse as Iceland, California, Dubai, and Greece, now is an ideal time to visit Soros’s famous reflexivity theory, which may allow us to put the recent chaos in context. With the recent swoon in the market, despite domestic indicators trending positively, a fair question to ask is whether the dog is wagging the tail or the tail wagging the dog?
The Definition of Reflexivity
Simply stated, reflexivity can be explained as the circular relationship that exists between cause and effect. Modern financial theory teaches you these lessons: 1) Financial markets are efficient; 2) Information flows freely; 3) Investors make rational decisions; and 4) Markets eventually migrate towards equilibrium. Reflexivity challenges these premises with the claims that people make irrational and biased decisions with incomplete information, while the markets trend toward disequilibrium, evidenced by repeated boom and bust cycles.
Let’s use the housing market as an example of reflexivity. By looking at the housing bubble in the U.S., we can shed some light on the theory of reflexivity. Americans initial buying love affair with homes pushed prices of houses up, which led to higher valuations of loans on the books of banks, which allowed the banks to lend more money to buyers, which meant more home buying and pushed prices up even higher. To make matters worse, even the government joined the game by adding incentives for people who could not afford homes. As you can see, the actions and decisions of an observer can have a direct impact on other observers and the system itself, thereby creating a spiraling upward (or downward) effect.
Now What?
Now, the reflexivity tail that is wagging the dog is Europe…specifically Greece. The bear case goes as follows: the Greek financial crisis will brew into a stinky contagion, eventually spreading to Spain and Italy, thus hammering shut a U.S. export market. The double dip recession in the U.S. will not only exacerbate the pricking of the Chinese real estate bubble, but also topple all other global economies into ruin.
Certainly, the excessive sovereign debt levels across the globe have grown like cancer. Fortunately, we have identified the problem and politicians are being forced by voters to address the fiscal problems. More importantly, capital flows are an unbiased arbiter of economic policies. Over time – not in the short-run necessarily – capital will move to where it is treated best. Meaning those countries that harness responsible debt loads, institute pro-business growth policies, remove unsustainable and insolvent entitlements, and incentivize education and innovation will be the countries that earn the honor of holding their fair share of vital capital. If the politicians don’t make the correct decisions, the hemorrhaging of capital to foreigners and the painfully high unemployment levels will force Washington into making the tough but right decisions (usually in the middle of a crisis).
Reflexivity, as it pertains to financial markets, has been a concept the 79 year old George Soros has passionately espoused since his 1987 book, The Alchemy of Finance. Perhaps a better understanding of reflexivity will help us better take advantage of the tail wagging disequilibriums experienced in the current financial markets. Time will tell how long this disequilibrium will last.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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