The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Barron’s Bob O’Brien says that after the S&P 500 fell to a 12-year low on March 9th, it then experienced a v-shaped recovery shooting 23% off the March Lows. Is this a true rally with staying power, or is the data a fake to the head?

Dear Reader: Please give me 8 minutes to explain the $1.1 trillion federal government Public-Private Investment Program (PPIP).

Start here with this simple example. It’s a coin toss. Heads you win $100; tails you get nothing. How much would you pay to play? You can play as many times as you wish. Answer: not more that $50. For less than $50, you would play as often as you can. $50 is your breakeven; only a fool would pay more.

Now add Tim Geithner as your partner. He matches what you invest but you, and only you, get to set the price to play. Answer: you put up no more than $25 as the investor and that means he matches your number. At under $25 you play as much as you can. $25 is your breakeven as the investor; $50 is still the breakeven for the coin flip.

Now let’s add some of the leverage from the FDIC.

Suppose that the FDIC will loan you $40 as a non-recourse loan. You and Geithner each put up $5 for a total of $10 and, adding in the loan money, you pay $50 to play, just as before. If you get heads, you pay off the loan of $40, and you and Geithner split the rest. That means you get $30 for your $5 and so does he. Remember, you set the price to play. If you get tails you get nothing and lose $5, Geithner loses $5, and the FDIC loses $40.

Now suppose we have an auction to decide who will play.

The highest bidder wins the right to play as many times as he wishes. With this example the breakeven price rises from $50 to $70. At $70 you put up $15; Geithner puts up $15 and the FDIC still loans $40. Half the time you will win $100 and use $40 to pay off the FDIC, leaving $60 for you to split with Geithner. You will get $30 back for each $15 you play, when you win. The other half of the time you will get zero, since it’s still a coin flip risk.

Notice that the price to play went from a $50 breakeven to a $70 breakeven. This happened while the odds remained a 50-50 coin flip.

Also notice that the leverage ratio was low when you put up $15, Geithner put up $15, and the FDIC put up $40. Under the Treasury PPIP plan the leverage ratio can go as high as 6 to 1. Using the full 6:1 leverage ratio, a coin-flip breakeven point would be about $3.57 for the investor.

Here is how I get that number. You put up $3.57; Geithner puts up $3.57; the total investor’s equity is $7.14. The FDIC loans 6 times $7.14, or $42.84. Total price to play is $49.98. Let’s call it $50, which is the amount to play each time.

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Ernest Kurnow, a 96-year-old business school professor at New York University, finished his own schooling in the middle of the Great Depression. Now his current students are faced with finding a job in the floundering world of finance after graduation.

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click for video

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Words from the (investment) wise for the week that was (March 23 – 29, 2009)

Following Fed Chairman Ben Bernanke’s “money printing” announcement of last week, the action stayed on Capitol Hill with Treasury Secretary Timothy Geithner detailing his Public Private Investment Program (PPIP) as well the initial salvo on “new rules of the game” for the US’s broken system of financial regulation.

The US Treasury on Monday morning announced its highly-anticipated Private Public Investment Program (PPIP), rekindling investors’ hopes that the worst might be over for the beleaguered banking sector and the global economy is close to a bottom.

Up to $1.0 trillion will be spent in an attempt to support the balance sheets of financial institutions by removing toxic assets – mostly mortgage-backed securities. The Treasury plans to invest between $75 billion to $100 billion from its existing Troubled Asset Relief Program (TARP), and also to establish a separate initiative that will use the Fed’s Term Asset-backed Securities Lending Facility (TALF) and Federal Deposit Insurance Corporation (FDIC) funding to finance the PPIP.

Source: About.com

In reaction to the Obama administration’s plan, global stock markets extended their gains and the US dollar reclaimed a stronger footing, but government bonds suffered from indigestion on issuance worries and the haven appeal of commodities waned. The performance of the major asset classes is summarized by the chart below, courtesy of StockCharts.com.

Stock markets, led by financials, surged on the unveiling of the Treasury’s plan to deal with troubled assets, adding to the gains of the rally that commenced on March 10 (see table below). The Dow Jones Industrial Index moved up 497 points (+6.8%) on Monday, its fifth largest one-day point gain and 23^rd biggest one-day percentage gain on record.

Although stocks succumbed to profit-taking towards Friday’s close, indices nevertheless managed to register a third straight week of gains – only the third time since the bear market began 78 weeks ago. With two trading days to go, March has the potential of producing the third best monthly return for the broad market since 1950.

Elsewhere in the world stocks also performed strongly, with the MSCI World Index gaining 4.4% (YTD -10.4%) and the MSCI Emerging Markets Index ahead by 6.9% (YTD +4.3%). These indices have risen by 19.8% and 21.8% respectively since the low of March 9. Returns ranged from top-performers Peru (+17.4%), India (+12.6%) and Hong Kong (+10.0%) to Uganda (-5.7%), Côte d’Ivoire (-4.7%) and Bangladesh (-4.4%), which are still languishing in the red.

The Shanghai Composite Index (+3.9%) had another good week and remains at the top of the field for the year to date with a 30.1% gain in US dollar terms. (Click here to access a complete list of global stock market movements, in local currency terms, as supplied by Emeginvest.)

Emerging markets are showing mature markets a clean pair of heels, as can be seen from the rising trend line of the MSCI Emerging Markets Index relative to the Dow Jones World Index since late October. The fact that developing countries are now outperforming the developed ones is a sign that global investors are beginning to take more risk – a necessary ingredient for stock markets in general to improve further.

Source: StockCharts.com

As far as US exchange-traded funds (ETFs) are concerned, John Nyaradi (Wall Street Sector Selector) reports that the strongest funds this week were Claymore/MAC Global Solar Energy (TAN) (+32.1%), Market Vectors Solar Energy (KWT) (+25.8%) and iShares Dow Jones US Home Construction (ITB) (+20.8%). On the other end of the performance scale United States Natural Gas (UNG) (-12.6%), PowerShares DB Agriculture Fund (DBA) (‑4.6%) and iShares Silver Trust (SLV) (-3.4%) performed poorly.

Among the ten US economic groups, the Financial Select Sector SPDR (XLF) (+12.3%) led the way, with defensive funds such as Health Care Select Sector SPDR (XLV) (+3.0) and Utilities Select Sector SPDR (XLU) (+1.8%) falling behind, as one would expect in a rising market.

In the coming week, as reported by the New York Times, the US administration is likely to extend more short-term aid to General Motors and Chrysler, but impose a strict deadline for bondholders and union workers to make concessions that would help the ailing automakers become viable businesses and avert bankruptcy.

Also on the agenda next week, is the summit of the Group of 20 in London – a “make or break event”, according to George Soros (via Reuters). In addition to the one-time increase of the IMF’s resources, there ought to be substantial annual special drawing rights (SDR) issues, say $250 billion, as long as the global recession lasts, he said. SDRs are an international reserve asset created by the IMF in 1969 that has the potential to act as a super-sovereign reserve currency.

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Opinion on the AIG Bailout, Bonuses

Balachandran:

FORA 04 min 33 sec

Investors, we are told, demand a risk premium for investing in stocks rather than bonds.
Without that extra return, why invest in risky stocks if you can get guaranteed
returns in bonds? This week we look at a brilliantly done paper examining
whether or not investors have gotten better returns from stocks over the really
long run and not just the last ten years, when stocks have wandered in the
wilderness. This will not sit well with the buy and hope crowd, but the data is
what the data is. Then we look at how bulls are spinning bad news into good and,
if we have time, look at how you should analyze GDP numbers. Are we really down
6%? (Short answer: no.) It should make for a very interesting letter.

And for the last time, let me remind you of the Richard Russell Tribute Dinner this
Saturday, April 4 in San Diego. We have had over 400 of Richard’s fans (I guess
you could say we are all groupies) sign up. A significant number of my fellow
writers and publishers have committed to attend. It is going to be an
investment-writer, Richard-reader, star-studded event. You are going to be able
to rub shoulders with some very famous analysts and writers. If you are a
fellow writer, you should make plans to attend or send me a note that I can put
in the tribute book we are preparing for Richard. And feel free to mention this
event in your letter as well. We want to make this night a special event for
Richard and his family of readers and friends. So, if you haven’t, go ahead and
log on to https://www.johnmauldin.com/russell-tribute.html
and sign up today. The room will be full, so don’t procrastinate. I wouldn’t
want any of you to miss out on this tribute. I look forward to sharing the
evening with all of you. I am really looking forward to that evening.

Why Bother With Bonds?

If stocks outperform bonds by as much as 5% over the long run then, for our truly
long-term money, why should we bother with bonds? Why not just ignore the
volatility and collect the increased risk premium from stocks? That is the
message of those who believe in “Stocks for the Long Run” and also from those
who want you to invest in their long-only mutual fund or managed account
program. Indeed, it is always a good day to buy their fund.

One of my favorite analysts is my really good friend Rob Arnott. Rob is Chairman of
Research Affiliates, out of Newport Beach, California, a research house which
is responsible for the Fundamental Indexes which are breaking out everywhere (and
which I have written about in past letters), as well as the only outside
manager that PIMCO uses, for his asset allocation abilities. He has won so many
industry awards and honors that I won’t take the time to mention them. In
short, Rob is brilliant.

He recently sent me a research paper that will be published next month in the Journal of Indexes, entitled “Bonds: Why Bother?” The publisher of the journal, Jim Wiandt, has graciously allowed me to review it for you prior to it actually being sent out. The entire article will
be available when the Journal of Indexes
goes to print in late April, at www.journalofindexes.com.
Qualified financial professionals can also get a free
subscription there to pick up the print copy. There is some very interesting
research at the website. But let’s look at a small portion of the essay. I am
reducing 17 pages down to a few, so there is a lot more meat than I can cover
here, but I will try and hit a few things that really struck me.

It is written into our investment truisms that investors expect their stock
investments to outpace their bond investments over really long periods of time.
Rob notes, and I confirm, that there are many places where investors are told
that stocks have about a 5% risk premium over bonds.

By “risk premium,” we mean the forward-looking expected returns of stocks over
bonds. As noted above, if you do not think stocks will outperform bonds by some
reasonable margin, then you should invest in bonds. That “reasonable margin” is
called the risk premium, about which there is some considerable and heated
debate.

Most people would consider 40 years to be the “long run.” So, it is rather
disconcerting, or shocking as Rob puts it, to find that not only have stocks
not outperformed bonds for the last 40 plus years, but there has actually been
a small negative risk premium.

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I mentioned the “cult of equities” earlier this morning; An article in the Atlantic on the Cult of Finance is making the rounds:  The Quiet Coup.

I found it very similar to Bailout Nation. If this sort of stuff floats your boat, then you will love the book — it gets much more granular than the Atlantic piece does.

Anyway, this is the section that I thought was pulled right out of chapter 20. Casting Blame. Regular readers of TBP will recognize most o these elements:

From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:

• insistence on free movement of capital across borders;

• the repeal of Depression-era regulations separating commercial and investment banking;

• a congressional ban on the regulation of credit-default swaps;

• major increases in the amount of leverage allowed to investment banks;

• a light (dare I say invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;

• an international agreement to allow banks to measure their own riskiness;

• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.

The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.

What he calls the Cult of Finance I would describe as the “Deification of Markets” . . .

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Source:
The Quiet Coup
Simon Johnson
Atlantic, May 2009

http://www.theatlantic.com/doc/200905/imf-advice

Wally Wallington has demonstrated that he can lift a Stonehenge-sized pillar weighing 22,000 lbs and moved a barn over 300 ft. What makes this so special is that he does it using only himself, gravity, and his incredible ingenuity.

2006

Since the credit crisis began, I have frequently found myself in agreement with Paul Krugman. Not everything, but for the most part, especially on many major points, we are sympatico: He has been correct about Moral Hazard, about the folly of these many bailouts, about the advantages of nationalizing the banks. And, I suspect he is right that the economy would benefit (short term) from a bigger rather than smaller stimulus.

Where we part ways is on his criticism of Securitization. I simply do not see it as a proximate or even secondary cause of the crisis and collapse. It is a tool, and whether it is used for good or evil is a function of too many things beyond what its purpose is.

First, lets go to the professor’s Friday column, then see where we part ways:

“Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

Sooner or later, things were bound to go wrong, and eventually they did. Bear Stearns failed; Lehman failed; but most of all, securitization failed . . .

A quick definition before proceeding further:

“Securitization is a structured finance process that involves pooling and repackaging of cash-flow-producing financial assets into securities, which are then sold to investors. As a portfolio risk backed by amortizing cash flows – and unlike general corporate debt – the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss.¹

Under normal circumstances, securitization works fine. But the 1998 – 2008 period was filled with all manner of aberrational issues. Much of that era terribly skewed financial activity. Consider:

-Fed Chair Alan Greenspan took rates to 1% — so low as to cause an enormous credit bubble;

-The Fed refused to supervise/regulate the new “innovative” mortgage lenders. Hence, millions of ill advised loans took place;

-For most of history, credit transactions were based on the borrowers ability to sevice the debt (i.e., repay the loan); For a 5 year window (2002-07), that no longer mattered. What dominated the lending decision was the lenders ability to sell the loan to Wall Street; Hence, the lend-to-securitize model was born;

-These firms sold mortgages to Wall Street with an unconscionably short warranty: They guaranteed these mortgages would not default for a mere 90 days. This removed the lenders incentive to find qualified borrowers.

-AAA: The major rating agencies (Moody’s, S&P and Fitch) failed to perform their functions. These firms were wholly corrupted by their new business model of getting paid by underwriters, as opposed to the bond buyers. This pay-to-play model is little more than good old fashioned “Payola.” They slapped a Triple AAA rating on pretty much anything they could get a fee on.

-Without these AAA ratings, most of this paper could not have been sold to the various funds, central banks, and SIVs that bought them;

-Credit Default Swaps on the securitized products were wholly unregulated.

All of the above is painfully detailed in to Bailout Nation.

Do not forget that Securitization had been around for decades without major problems. And over the entire period of time in question, credit card loans, auto financing, and student loans were securitized without incident (other than expected cyclical recessionary downturns).

The same can be said about derivatives. Handled properly, they are tools that serve a function. Let loose with no regulation/supervision/transparency/reserve requirements,  you have the making of a disaster . . .

We can even say the same about Mortgages.  Would you draw the conclusion that because the lending industry made so many bad loans, that mortgages were the problem, and therefore we should do away with them? You have to look at the context in which the loans took place.

Securitization is no different.

Under normal circumstances, it works fine. And if we tweak a bit around the edges — make sure that securitizers cannot shed liability as easily as they have, and adjust incentive compensation away from the current hit & run style of faux profits but real bonuses, Securitization will work just fine.

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Source:
The Market Mystique
PAUL KRUGMAN
NYT, March 26, 2009

http://www.nytimes.com/2009/03/27/opinion/27krugman.html

1. Raynes, Sylvain and Ann Rutledge, The Analysis of Structured Securities, Oxford U Press, 2003, p. 103 via wikipedia

Interesting discussion in Barron’s this week that questions a basic premise of the “cult of equities” — that Stocks usually outperform Bonds, and by healthy margins, too.

As it turns out, not always, and not as much as you might think.

Via Rob Arnott:

“It’s especially dangerous for investors, from individuals to endowment to pension funds, who were counting on equities to outrun fixed-income holdings and deliver supersized returns.

From 1802 to 2008, Arnott says, stocks outpaced bonds by 2.5 percentage points annually. But that superior showing can be deceiving because there were long stretches in which stocks underperformed, most recently in the 41-year period that ended on Feb. 28. True, the Standard & Poor’s 500 lagged behind the 20-year Treasury bond by a mere two basis points (two hundredths of a percentage point) a year in this lengthy span, but that’s enough to render it a substandard performer.

Bonds also beat stocks from 1803 to 1871, and from 1929 to 1949. But there were other multi-decade spans, such as the period from 1932 to 2000, when “stocks beat bonds reasonably relentlessly,” Arnott says.

On balance, he writes, stocks have had “long periods of disappointment, interrupted by some wonderful gains.”

Interesting stuff . . .

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Source:
Stocks vs. Bonds
Lawrence C. Strauss
Barron’s March 27, 2009

http://online.barrons.com/article/SB123819638720161459.html?page=sp