Recently I have closed my long position in the November 2009 fed fund futures contract at over 99.80 for an exceptional gain. I believe the market is pricing in too much tightening for 2010 so I have purchased the January and February 2011 contracts at an average price of 98.55.
Update: Buying November ‘09 Fed Funds Futures
Published on March 22, 2009
Last November I started going long November ‘09 fed fund futures at 98.25 (i.e. the market priced in an effective Fed funds rate of 1.75%). I was hoping that the Fed would slash rates to 0.50% and keep it there through November so that I could net a profit of over $5,000 per contract. As it turned out the Fed reduced its rate to fluctuate within a range of 0% to 0.25%. Since the economy has continued to deteriorate and I can’t see how a sustained recovery can take hold this year, the funds rate is likely to remain under 0.25% during the remainder of 2009.
Therefore, I think buying the November and December fed fund futures under 99.50 is highly likely to be profitable. I have substantially increased my position since my initial buy last November and I have paid as high as 99.49 per contract. Currently, both the November and December contracts are trading for over 99.50. I’m not planning to do any more buying and will sell my entire position once the contract price rises over 99.75.
A Rough 10 Years
Published on February 8, 2009
The New York Times has created an nice graphic which shows that for the 10-year period ending in January, the S&P 500 had its worst inflation- and dividend-adjusted performance in 82 years.
And if the stock market doesn’t surge over the next 12 months, the negative 5.1% annual return is likely to get worse this time next year because the S&P 500’s 20% appreciation in 1999 will no longer be counted.
Foreclosures are the Solution, Not the Problem
Published on February 2, 2009
In the WSJ, there is a well reasoned argument by Ramsey Su of why government attempts to prevent the current surge of foreclosures from occurring is actually harmful. A house is foreclosed on when either the homeowner is unable to make his mortgage payment or when he refuses to pay even if he has the capacity to make the payment because he has negative equity in his house. In the first case, a foreclosure relieves the homeowner of an expense that is too burdensome. In the second case, a foreclosure immediately improves his balance sheet because his mortgage debt is wiped out.
Some of the measures being proposed to stem the tide of foreclosures are intended to lessen the mortgage payments and/or balance as to improve the financial obligations of the homeowner. But this would be difficult to achieve under current laws since many mortgages were securitized where there are junior lien holders who would need to agree to such a modification. The problem is that such a modification would immediately wipe these investors out. They would be better off foreclosing and hoping to salvage some value later on.
Then there is the prospect of Congress passing mortgage cram-down legislation which will allow bankruptcy judges to force creditors to accept a reduction in mortgage principal and interest. This sort of government intervention only further adds uncertainty to the MBS and CDO markets and scares off prospective investors.
One of the main concerns with foreclosures is that they can cause a flood of homes to come on the market pressuring prices and worsening the current real estate downturn. But the current real estate downturn stems from the fact that the supply of homes greatly exceeds the demand. Therefore, a sharp decline in prices is needed to restore equilibrium. Foreclosures help to speed up this process and the time needed for the market to recover.
Crisis Investing for the Rest of the ’90s by Douglas Casey
Published on January 24, 2009
At certain points in our lives we come across individuals who profoundly alter our outlook on life. For me, one figure is Doug Casey, a writer and financial speculator. In 2004, when I decided to play the junior resource market, I subscribed to a number of newsletters dedicated to stock picking in that sector. Casey’s newsletter, the International Speculator, quickly became one of my favorites: not because of its stock picks (though, they were quite profitable), but because of Casey’s commentary of his radical viewpoints on everything from economics and philosophy to politics and science.
Casey describes himself as an anarchist, whom he defines as someone who believes in rule of no one. This differs from monarchy which means rule of one, oligarchy which means rule of few, or democracy which means rule of the people. He also subscribes to the Austrian school which believes what’s best for the world is a truly free market where there is no government intervention of any kind. While Casey is wildly optimistic about the long-term future where technological advancement will make us enormously productive, in the near term he is very negative believing that a depression is inevitable to cleanse the economy of government stimulated malinvestments.
His opinion that governments serve no useful purpose seemed shockingly ridiculous when I first came across it. But after understanding his reasoning the idea gradually grew on me and I soon adopted his philosophy. I would go on to read anything he wrote that I could get my hands on and I would try to make it to a few investment conference where he spoke. It was refreshing to hear or read someone who is willing to get across what’s on his mind without any regard for political correctness.
Casey has written several books, the favorite of mine being Crisis Investing for the Rest of the ’90s which was first published in 1993 and later updated in 1995. Despite its current obscurity, it’s one of my all-time favorite books and I recently had Casey sign it when I got the opportunity to sit down for a drink with him. Along with investing strategies and recommendations, some of which are outdated, he clearly expresses his economic and political views. The chief argument he makes in the book is that the US will soon experience a depression. Now that a depression looks like a high probability event, I thought it was worthwhile to revisit the book.
To give a little background, Casey’s first investment book, Crisis Investing, was published in 1979. In it, he recommended buying small energy stocks, selling bonds, selling real estate, and buying gold and gold stocks — all of which paid off. However, he also predicted a financial crisis that would lead to a wave of bank failures, which didn’t occur until much later during the S&L crisis.
Casey wrote a second book in 1982 titled Strategic Investing in which he recommended buying blue chip stocks and utilities; buying gold only to serve as insurance rather than as a vehicle for speculation; selling South African gold stocks which subsequently declined by around three-quarters in value; buying little known North American junior gold mining companies which enjoyed two separate runs of 1000% gains during 1982-1983 and 1985-1987; and holding off to buy real estate until the market bottoms in 1984, which in retrospect was a year off but still useful advice.
While Casey’s first two books were mostly on the mark with their investment recommendations, they both got the macroeconomic outlook wrong with both calling for what Casey termed the “Greater Depression” — a depression even worse than the Great Depression. Instead the US economy enjoyed solid growth for most of the ’80s and ’90s. In Crisis Investing for the Rest of the ’90s, Casey admits his forecasting mistake and cites several reasons why the Greater Depression was avoided during the ’80s.
First, the Fed took the necessary, but painful step of tightening monetary policy which caused many of the excesses of the economy to be wrung out. Second, there was a worldwide movement towards economic liberalization as regulation and taxes were reduced. Third, the computer revolution dramatically increased productivity. Fourth, the swift movement of women into the labor force increased family incomes. Fifth, the large expansion in the money supply mostly flooded into asset markets rather than affecting consumer prices. Sixth, the huge growth in personal, corporate, and government debt. And seventh, large US trade deficits caused many surplus nations to use their massive reserves to purchase US bonds, thereby lowering interest rates.
According to Crisis Investing for the Rest of the ’90s, the Greater Depression can’t be avoided for much longer because almost all of the previous stimuli seem to have run their course: economic liberalization is reversing; technological revolutions which cause dramatic improvements in productivity tend to be rare and short-lived phenomena (almost every single person now owns at least one computer); most women have already joined the workforce and households have become as dependent on their paychecks as they are on those of men so if either person in the household loses a job, the household would have trouble meeting its financial obligations; the expanding money supply cannot continue to flow into asset markets forever and at some point it will cause consumer prices to rise; growing debt is unsustainable and must at some point be reduced; similarly the trade deficit can’t continue indefinitely, and eventually those foreign reserves of US dollars will be dumped onto foreign exchange markets causing the dollar to plummet and prices to skyrocket.
In retrospect, Casey, in his third book, again seems to be way too early in his call for a Greater Depression. Although there were several economic collapses around the world, the US escaped largely unscathed. How was Casey’s Greater Depression postponed once more? I think for all the same reasons he cited for being early in his previous calls. The US basically experienced a debt fueled economic boom that lasted from 1982 to 2007 with only minor hiccups during the S&L crisis and the post-2000 tech collapse. But I do believe credit expansion has finally ended and Casey’s Greater Depression has finally arrived and most people’s standard of living will drop significantly over the next few years, if it hasn’t already.
What’s a depression? Casey defines a depression as a period when the standard of living of most people drops significantly. It is the opposite of prosperity. The Greater Depression could be either deflationary, as in the ’30s, or inflationary. Prior to 1929 depressions were sharp and brief. This was because unemployed workers and struggling business owners had to lower their prices to avoid starvation. The Great Depression, on the other hand, was deeper than any depression before it because the Fed, as lender of last resort, provided an incentive to banks to hold a smaller reserve cushion which, in turn, caused a credit bubble that proved very painful when it burst. Also, the Great Depression was the most prolonged depression because the government implemented price and wage controls that few could afford to pay, and its public work projects and welfare programs retarded the rebuilding of capital and productive employment of labor.
On the other hand, to get a sense of what a hyperinflationary depression looks like in a major economy, one needs to go all the way back to Weimar Germany during the early ’20s. Hyperinflationary depressions occur when the government prevents the collapse of inflationary credit to wipe out banks, which would cause asset prices to drop and businesses to fail. The government does this by pumping money into the economy to devalue the currency and increase the public’s inflationary expectations, thereby reducing its demand for money and bringing about an increase in spending. However, if too much money is printed, a breakdown in confidence in the currency would ensue and prices would skyrocket as people get rid of it as soon as they get it. In nominal terms, prices of everything surges, but in real terms economic activity contracts.
Will the Greater Depression be inflationary or deflationary? According to Casey:
Betting on inflation has been the winning strategy since the bottom of the last depression, but a financial accident could change all that overnight. The inflationists will certainly be right in the long run, but they may get wiped out in the short run. In any event, the moment of truth is approaching, and there likely will be a titanic struggle between the forces of inflation and the forces of deflation. Each will probably win, but in different areas of the economy. As a result, we’re likely to see all kinds of prices going up and down like an elevator with a lunatic at the controls. It will not be a mellow experience.
Since the Great Depression, there have been numerous small recessions in the US, any one of them which could have snowballed into another deflationary depression. They didn’t because the government has had an unprecedented amount of power to stimulate the economy and forestall a financial collapse. But preventing a depression also prevents the necessary correction of previous malinvestments. Each successive recovery leads to greater excess capacity and each successive recession leads to greater government stimuli. The governments actions have linked all the previous recovery-recessions cycles into a much larger supercycle which now seems to have peaked. And the coming economic catastrophe will be made worse by people’s innate desire to have the government do something as the going gets tough. The government will respond with socialist policies as it did during the The Great Depression.
In Crisis Investing for the Rest of the ’90s, Casey believed that the Clinton administration and the Fed would have more difficulty resuscitating the economy after the next downturn because interest rates and inflation were already too low to be further reduced to stimulate the economy. Also, the government had less flexibility than in the past to increase spending, despite its increasing power, because it had become highly indebted. As it turned out, the Fed was able to bring down interest rates even further and Bush, who presided over the last recession was able to pass a substantial tax stimulus and take on more debt.
Can the government and the Fed again prevent the current recession from morphing into a depression. I’m skeptical. The Fed has already reduced the overnight rate to zero, yet total debt continues to contract. The Obama administration is about to pass a major spending stimulus, but in my view, government spending actually lengthens the downturn. The problem with the economy is that there is excess capacity in almost everything from housing to manufacturing. Government infrastructure spending will add additional capacity, which will lengthen the time required for demand to catch up to supply. Also, the spending provides a temporary increase in the demand for labor which keeps wages from falling as they should so that business can afford to hire again. These are the reasons why I believe the current economic contraction will be the deepest and most prolonged in the post-war period. Casey’s Greater Depression has likely arrived.
Casey makes the point that government money printing, regulation, and taxes (all of which have been increasing in response to public pressure) actually benefit the wealthy at the expense of the masses. The rich have the capital and access to credit to purchase hard assets and protect themselves from inflation, while wages that most people depend on to survive tend to be sticky and don’t rise as quickly as prices do in response to inflation. The rich can afford to hire lawyers and accountants to use regulatory loopholes to get around the rules that the rest of the population is forced to abide by. And although the rich pay the bulk of the governments tax receipts, they also pay most political donations and lobbying to influence the government to spend in a way that benefits them. Always the most socialistic and centrally planned economies tend to have the most uneven distribution of wealth.
The best course of action for the government is to do nothing and let the depression cleanse the economy. Sure, we could see a financial meltdown where the entire banking system defaults and millions of Americans lose their jobs. But according to Casey:
The physical world is unlikely to be changed much by the Greater Depression, but the way people relate to the world will change a great deal. A real estate collapse doesn’t mean buildings will tumble. But their prices will and their owners may change. A corporation’s bankruptcy doesn’t mean that the factories or technology it owned will vanish; they will become the property of a different corporation. A government default on its bonds doesn’t mean the country (which is not at all the same thing as the government) is bankrupt. It just means that those who held the bonds are poorer and those who otherwise would have been taxed to pay the bonds are richer. In other words, all the real wealth will still be there, but its ownership will change. And some commodities will become more (or less) valuable relative to other commodities. The people who wind up wealthy as the Greater Depression unfolds will, predictably, be those who understand what’s going on.
There have been numerous financial collapses around the world during the past century. But those countries that embarked on economic liberalization as a medicine such as post-war Germany and recently Russia, were rewarded with quick recoveries. The US could as well by simply abolishing the Fed, instituting a 100% gold-backed dollar, restricting the government’s role to national defense and protecting personal and property rights, and eliminating almost all regulations and taxes. Since none of this is going to happen, we can expect the government’s actions to soften the Greater Depression from what it otherwise would feel like, at the cost of significantly prolonging it.
How do we protect ourselves from the Greater Depression? A conventional portfolio includes stocks, bonds, real estate, and cash. But in the event of a financial collapse a conventional portfolio would suffer severe losses. According to Casey, a hedge portfolio allows one to keep an exposure to these assets as well as own assets that thrive when most assets struggle. A good portfolio should balance safety, yield, growth, and liquidity.
Casey prefers to use a “10 x 10″ strategy in which he divides his portfolio into ten unrelated areas, each of which have the potential to increase tenfold over the course of a business cycle. This method has the benefit of diversification while still offering a high return. If 10 different ideas can’t be found, then restrict any investment to 10% of your portfolio and hold onto your cash balance for future opportunities. Ideas which offer ten-to-one returns won’t be found with large-cap stocks or mutual funds. Where they can be found are in low-cap stocks and using leverage to trade commodities, bonds, options, convertibles, or real estate.
An alternative approach, one in which capital preservation is given utmost importance, is the Permanent Portfolio which was developed by Harry Browne and Terry Coxon. The main idea is to put a fixed percentage of your savings into investments that move inversely to each other so that your portfolio is hedged against every possible economic environment whether it’s prosperity, recession, depression, inflation, or deflation. The recommended asset allocation is as follows: gold 20%, silver 5%, Swiss franc assets 10%, real estate/resource stocks 15%, US stocks 15%, and T-Bills and T-Bonds 35%.
Casey recommends placing half of your capital in the Permanent Portfolio and the other half in speculative investments. Additionally, hedge strategies can be a good idea when you’re unsure about the overall market direction. You can go long one stock which you like and short another stock you think is overpriced. The same strategy can be applied to commodities as well.
To know when to buy stocks and which stocks to buy, Casey falls back on the methodology developed by Benjamin Graham. Graham would analyze a company’s financial statements and buy its shares only if they met certain well-defined criteria for both high value and low risk. In a cheap market, one can find numerous companies that fit the billing. However, if a market is dangerously overpriced it will be hard to find any. Graham’s criteria are:
- an earnings yield that is at least twice the current AAA yield;
- a P/E less than 40 percent of its previous five-year high;
- a dividend yield of more than two-thirds the current bond yield;
- a share price of less than two-thirds book value; and
- a share price of less than two-thirds net current assets;
While these criteria may help to uncover value, a stock may be cheap because it’s in danger of going bankrupt. So Graham required a company to have at least one of the following characteristics to test for safety:
- the company should have total debt less than book value;
- the company’s current assets should equal at least twice its current liabilities;
- the company’s earnings should have grown at a compound rate of more than 7 percent for the last ten years; and/or
- the company should have no more than two drops in earnings of more than 5 percent in the last ten years.
With regards to fixed income instruments, Casey views bonds as a triple bet on the solvency of the issuer, on the value of the currency, and on the level of interest rates. On March 1993, when Casey wrote his last book, interest rates were at their lowest levels since the early 1960s. Also, the level of debt for the US government and many corporations were at historically high levels. And inflation was always a serious concern as long as the currency was not backed by anything tangible. Casey didn’t like bonds then and since the same conditions apply today he doesn’t like them today either.
Casey firmly believes gold is best suited to serve as money because it satisfies Aristotle’s properties of an ideal money: it’s durable, divisible, convenient, consistent, and has intrinsic value. And not surprisingly gold as been widely used as money for thousands of years through most of human history. The US dollar which can no longer be redeemed for gold has become the unsecured liability of a bankrupt government. As the Greater Depression unfolds people will rush to the security of gold because the economic turmoil will lead to emergency stimulative spending, and when coupled with falling tax receipts, government deficits will explode. The only way it can be financed is by printing huge amounts of dollars which would devalue all existing dollars and increase the value of any competing currency which has a stable amount of supply like gold.
Gold coins should be purchased rather than bullion because they are convenient to carry and you don’t need a scale or calipers to know what you’re getting. The best coins to purchase are Austrian 100 Coronas, Krugerrands, Maple Leafs, Eagles, and Sovereigns. Casey predicted gold to rise well over $1,000 during the Greater Depression. Gold has already touched $1,000 and if the government is successful in creating inflation, then gold should increase much more.
In a rising gold price environment, gold stocks should perform well, but Casey cautions before buying them. Gold stocks represent fractional ownership interests in a business that may or may not be successful. Gold stocks, especially those of the juniors, are some of the most volatile securities in existence, so timing is extremely important. But if you get that right then you could easily make multiples of your initial investment. In early 1993 Casey felt that sentiment on both the major and junior gold stocks was very negative. The juniors, for example, were down 97 percent from their peak reached in the summer of 1987. Today the juniors find themselves in the same environment after a couple of bull markets. Casey thinks the juniors represent a good speculation.
Silver should perform well for the same reasons as gold because of silver’s historic role as money. Industrial demand may drop off during the Greater Depression, but safe haven buying should more than make up for it. At the time of writing, Casey believed silver at under $4 was at a classic bottom. He reasoned that the gold/silver ratio was at an all-time high of 90 to 1, silver was selling far below its cost of production, and in real terms silver was cheaper in 1993 than it was 25 years previously. Pre-1966 US silver dimes, quarters, and half dollars which at the time of writing sold for a mere 1 percent to 5 percent above melt value represented excellent buys to Casey, especially considering that in the past they sold for premiums of up to 35 percent. At today’s price of around $10, silver is again historically cheap compared to gold.
Casey believed copper wasn’t a good speculation because demand will drop off along with economic activity and all the new deposits were very low-cost meaning that they will stay in production and new ones will keep coming on stream. The same could be said today, although copper prices have already fallen significantly.
The historical trend for commodities is down as technological advances and the accumulation of capital reduce the cost of production. However, Casey correctly predicted a counter-cyclical rise in commodity prices. New suburbs eating into the most productive farmland, lack of water availability for irrigation, and negative long-term effects of chemical fertilizers and pesticides on the soil all should cause short-term supply problems. With prices at historical lows and below the cost of production, the late ’90s were an ideal time to buy agricultural commodities. I’m sure Casey still likes agriculture, but perhaps not as much as before.
In Crisis Investing for the Rest of the ’90s, Casey believed small oil stocks represented good values. He argued that although the world is never going to run out of oil, the price of oil should rise because it’s as cheap as its ever been. If shortages occur, it would be because of government wars, embargoes, price controls or production quotas. That said, the geological supply of oil is declining every year. Even during an economic contraction demand will only take a temporary dip because Third World demand is very inelastic. Today, Casey is still bullish on oil because at around $40, it’s again historically cheap.
As for residential real estate Casey states the following:
A house is just an expensive consumer item, like a suit or a car; each has a service life, after which it must be scrapped. The houses built today become total write-offs in thirty to forty years. Any residual value is strictly in the land.
According to Casey, the best indicator for valuing a house is to calculate what it will rent for. Before the 1970s, when real estate was sound value, the rule of thumb for property rentals was 1 percent of market value per month. At the time of writing, mortgage rates were at their lowest levels in twenty years. When rates start to move up prices will decline.
Casey recommended staying away from urban and suburban areas where technological advances in telecommunications make being in a particular place to conduct business less important and traffic congestion makes it hard to get to where you want anyway. Thus cities will fade as economic centers. He recommended selling properties that have already significantly appreciated. The return on the property should it be rented should, after all costs, be significantly above the bank deposit yield, or at least 6 percent per year in real terms. Also, a house or building shouldn’t be considered a bargain unless it’s available considerably below replacement costs, say around 50 cents on the dollar. The most profitable real estate purchases will be unique and upmarket properties that the rich would want: not what the average American would want because he is going to lose what he’s got, not be buying more.
Casey was early in his bearishness on real estate. As it turned out, the bubble got even bigger before bursting. But to his credit, Casey believed certain real estate would prosper; in particular resort towns because the rich will increasingly want insulation from all the problems the cities offer and they are fun places to live in. He felt qualities one should look for in a good resort town are natural beauty, ambiance, facilities, and isolation. And it was best to buy property with at least 10 acres of land and not more than a twenty minutes drive from town. Casey’s favorite town was Aspen.
When Crisis Investing for the Rest of the ’90s was written, commercial real estate was nearing the end of the longest boom in history and vacancy rates already reached historic highs. Casey believed the sector would crash because interest rates would soon rise and cause the vacancy rate to rise further leading to more loans going bad and more property being sold. Instead interest rates fell even further, and aside from a minor correction at the turn of the millennium, the commercial real estate crash has only now commenced.
Certain international real estate offers much more upside for much less risk than can be found in the US. A big advantage of foreign property is diversification. Three approaches to buying in foreign countries are to buy in countries that are politically distressed and have currencies even weaker than the dollar (essentially you’re betting on a turnaround), buying in countries that are basically sound and near countries that are experiencing turmoil and are positioned to profit from their neighbors’ problems, and to buy in countries that are very sound with ingrained free-market traditions that can be counted on to do well despite the conditions elsewhere.
In a terrific call, Casey believed Japan’s real estate and stock markets were still extremely overvalued based on traditional valuation metrics despite their corrections and, in fact, recommended shorting them in Crisis Investing for the Rest of the ’90s. He would probably still be bearish on Japan as long as the Greater Depression remains.
Although Casey is bearish in the near term on the economy and most financial assets, it’s important to point out that the he is incredibly optimistic about the long-term future:
Herman Kahn, the late military strategist and futurist, held the view point that humans, who “until just 200 years ago were few, poor, and at the mercy of forces of nature; but 200 years from now they will be numerous, rich, and largely in control of the forces of nature”. Kahn believed things will turn out well. I believe his projections will prove highly conservative both in how good things will be and in how quickly they will be come so.
Casey’s optimism for mankind is based on its work ethic, political freedom, and technology which have been a factor since the prosperity boom ushered in by the Industrial Revolution 200 years ago and will continue to be in play in the future. While continued economic progress will be the long-term trend, in the short-term a Greater Depression is inevitable to cleanse the economy of past malinvestments and put it on a solid footing for the future. 200 years from now the Greater Depression will look like a small bump in the road similar to how we today view any of the depressions that occurred during the 19th century.
Casey’s Crisis Investing for the Rest of the ’90s is one of my favorite books because it was able to clearly explain why the prosperity that Americans enjoyed during the past two decades was created by credit expansion and temporary government spending, neither of which were sustainable. Although his Greater Depression didn’t unfold as quickly as he predicted, he did point out that financial collapses are incredibly difficult to time. If indeed this current recession turns out to be Casey’s Greater Depression, then most of his investment recommendations should pay off. I am personally employing his strategies to protect my portfolio.
“Deflation: Making Sure ‘It’ Doesn’t Happen Here” by Ben Bernanke
Published on December 15, 2008
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Remarks by Governor Ben S. Bernanke
Before the National Economists Club, Washington, D.C.
November 21, 2002
I have previously stated my concern with the challenges facing the banking system and the likelihood of its deflationary collapse in the absence of any government intervention. This might actually be the best medicine for the long term health of the economy, but I will have to expand on this point in another post. What matters for investors is that the government will indeed intervene more forcefully, though the scope and effects of its actions are not clear.
I have positioned my portfolio to capitalize on increasing market fear of deflation, but I recognize that the government might be able to eventually print enough money to create inflation and preserve the current financial system; and perhaps print so much money to produce hyper-inflation.
So to get a better sense of how scared the Fed is of deflation and to anticipate its future policies, I thought it would be worthwhile to examine a popular speech made by Bernanke in which he suggests how the US can overcome deflation. This speech was made in 2002 when the US was in recession and consumer prices as measured by the CPI were barely increasing causing many to worry about the onset of deflation.
The following is my outline of Bernanke’s speech:
———————
Deflation: Making Sure “It” Doesn’t Happen Here
- The chance of significant deflation in the US is extremely small.
- US economy is resilient and has the structural ability to withstand such shocks.
- Flexible and efficient markets for labor and capital, an entrepreneurial tradition, ability to cope with technological change.
- Strong financial system.
- Federal Reserve has sufficient powers to preserve price stability.
Deflation: Its Causes and Effects
- Deflation is defined as a general decline in prices.
- Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.
- Deflation is in almost all cases a side effect of a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.
- Deflation of sufficient magnitude would lead to nominal interest rates of zero; and the real interest rate would equal the expected rate of deflation.
- Fed would be unable to utilize its traditional method of stimulating economic activity by lowering short term interest rates
Preventing Deflation
- Maintain an inflation buffer zone of 1-3% during normal times.
- Ensure financial stability in the economy.
- Smoothly functioning capital markets.
- Well capitalized banking system.
- At times of extreme threat, Fed should stand ready to use discount window and other tools.
- When economic fundamentals deteriorate and inflation is already low, Fed should aggressively cut rates.
Curing Deflation
- Lower medium- and long-term interest rates.
- Commit to holding the overnight rate at zero for a specified time period.
- Enforce ceilings for yields on longer-maturity Treasury debt.
- Purchase agency debt.
- Offer fixed-term loans to banks at low or zero interest while accepting a wide range of private assets (corporate bonds, bank loans, mortgages) as collateral
- Purchase foreign government debt and reduce the value of the dollar in relation to foreign currencies, though this would not be a desirable way to fight domestic deflation.
Fiscal Policy
- A money-financed tax cut would stimulate consumption and investment.
- Increase government spending and acquire real or financial assets; the additional debt issued should be purchased by the Fed with newly created money.
Japan
- Why Japan has not ended its deflation?
- Problems in the banking sector have muted the effects of monetary policies and the heavy overhang of government debt has made officials reluctant to pursue aggressive fiscal policies; the US does not share these problems.
- Necessary economic reforms have been avoided by policymakers for fear of the large costs imposed on the economy in the short run.
- Japan’s deflation problem is real and serious; but political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has.
———————
My belief is that money supply growth that until now has been fueled by bank credit is now moderating. Commodities are now sharply correcting because of a stronger dollar and demand destruction. Therefore, consumer prices should follow asset prices and begin falling. This would lead to the “deflation” environment that Bernanke is afraid of.
Bernanke is certainly acting preemptively as the CPI falls within the buffer zone of 1-3% from its current rate of 3.7%. In the meantime, I expect he will continue to provide liquidity to the financial sector recognizing that it’s health is important for creating inflation. The TAF, TSLF, and PDCF programs are going to remain in place for a very long time. These programs help banks with short-term funding problems, but they don’t address the solvency issue the banking system is facing. This is why the TARP was implemented. It pumps capital into banks so that they don’t fail.
I expect the Fed to cut rates until they get closer to zero and signal its intention to keep them low for a long time. But a low Fed funds rate won’t translate into higher bank lending because financial institutions are hoarding capital to restore their balance sheets, consumers are already highly indebted, and businesses will not borrow money and invest in an environment of lower consumer spending. This is very similar to the situation Japan faced in the ’90s.
The Fed has recently recognized the ineffectiveness of further lowering its short-term interest rates. Soon, Bernanke’s suggestion of manipulating medium- and long-term interest rates will be carried out. The Fed will likely purchase longer-maturity Treasury and agency debt with newly printed money in a much more aggressive fashion. Simultaneously, the government will sharply increase its spending in such areas as infrastructure which create jobs. It will also begin purchasing real and financial assets such as real estate, stocks, and bonds. All of this will be financed by selling Treasuries to the Fed which will finance the purchase, again, with newly printed money.
This period of money printing will need to be closely monitored by investors since it will determine whether the rate of inflation will accelerate. But, in my opinion, we are several quarters away from this. Only once the excess capacities of several sectors of the economy are adjusted to meet demand will the Fed’s money printing start to affect prices… but this will take time.
Valuing Stocks Relative to Bonds
Published on November 11, 2008
A popular method for determining whether equities are cheap is to compare the stock market’s dividend yield with the yield on long-term government bonds. Using the amount of dividends paid by companies in the S&P 500 index during the past 12 months, the dividend yield is currently 3.22%. Meanwhile a ten-year treasury yields 3.75%. The following is a historical look at how dividend yields and long-term treasury yields compare.
Currently, the spread is as tight as it has been since the early ’60s. Does this mean stocks are cheap relative to treasuries? Or is it likely that going forward stocks will yield more than treasuries as was the case for most of the period before 1958.
Treasuries have zero default risk, but plenty of inflation risk since the amount of the coupon is fixed. Stocks, on the other hand, have little inflation risk (because companies can increase profits in inflationary conditions), but carry default risk.
During periods of high monetary inflation, where the value of money is losing value at a rapid pace, the market will assume that inflation will continue to be very high in the future and demand a higher yield from bonds than from stocks to compensate them from future loss of purchasing power. At the other end of the spectrum are periods of deflation when the money supply contracts. Deflations cause corporate profits and dividends to decline in nominal terms, though they may increase in real terms. Therefore, expectations of deflations usually result in stocks having higher yields than treasuries.
Independent of inflation or deflation, the economy could be growing or contracting. Over long periods of time the economy usually expands. Ignoring any effects from changes in the money supply, investors will be willing to accept lower dividend yields than treasury yields because dividends are likely to increase over time. On the other hand depressions, which are economic contractions that last for many years, can increase the risk of bankruptcy causing investors to demand greater yields from stocks than from treasuries.
Combining the effects from monetary inflation and economic growth on treasury and stock yields give the following table:
I have inserted question marks for deflationary economic growth which characterized most of the 19th century when corporate profits steadily increased in real terms, but not necessarily in nominal terms; during such times there should be no significant difference between treasury and stock yields. Also, there should not be much of a difference in yields during highly inflationary depressions because it is not clear whether businesses can increase profits in nominal terms.
The table does a good job of explaining why dividend yields exceeded treasury yields during the time frame from 1871 to 1957 if one considers that this was a mostly disinflationary period punctuated by a couple of deflationary depressions. Consider that during this entire period of 87 years, inflation, as measured by the CPI, increased by 128% and corporate earnings rose by an average of 5.2% annually.
But since 1957, a period of just 50 years, the CPI has increased by 634% and corporate profits grew by an average of 7.9% annually. Thus, it should be of no surprise that since 1957 investors have demanded greater yields from treasuries than from stocks when the rate of inflation has been so high and there was not a single depression. Dividend payouts steadily increased throughout the period except for only a few short-term reductions.
So to form an opinion on whether stocks should yield more than treasuries one needs to know if the economy has entered a period of inflation or deflation and if a depression will be avoided. It is my belief that the US has entered a depression, where real earnings will decline and not recover for several years. If the Fed prints enough money and creates substantial inflation, earnings could bottom in nominal terms in 2010 at the earliest at which point I expect treasuries to yield more than stocks.
Until then I expect the depression to be disinflationary, rather than a deflationary because the government is preventing any significant bank failures which is a necessary condition for deflation. Although asset and consumer prices are declining, this is not deflation; instead it is a reflection of a drop in the velocity of money as individuals and businesses hoard cash. So if indeed this is a disinflationary depression, I expect the difference in yields between treasuries and stocks to diminish over the next year.
Japan offers a recent example of a disinflationary depression and as can be seen in the chart below the yield on Japanese stocks exceeded the yield on long-term government bonds during a significant part of the past two decades.
I am expecting similar results in US markets and would not be an aggressive buyer of equities until they yield more than treasuries.
Buying November ‘09 Fed Funds Futures
Published on November 3, 2008
Last Friday I purchased fed funds futures contracts for November 2009 at 98.25. I went long fed funds futures earlier this year and closed the position in September with a huge gain. In retrospect, I could have made even more if I held on to the position, but I didn’t anticipate the Federal Reserve slashing the overnight rate by 100 basis points in October.
If I would have known in advance that October would be the ninth worst month in stock market history, the CRB index would register its largest monthly decline on record, and the US dollar would attain its biggest monthly gain against a basket of currencies in more than 17 years then, of course, I would have predicted the Fed’s policy decisions. But October was an unusual month to say the least.
What I find strange is that the market is pricing in only another 25 basis points cut by the next FOMC meeting on December 16th, after which the Fed is expected to embark on a tightening campaign next year by such an extent that the overnight rate would reach 1.75% by November.
I think only two conditions would necessitate such a policy response: (1) the US economy soon begins to stage a rapid recovery or (2) confidence in the US dollar is shaken and its value plummets. The first condition is highly unlikely, in my opinion, given that the US consumer is early in the process of decreasing consumption and increasing savings in order to repair his balance sheet from the damage done by declining real estate and equity values.
As for the possibility of a dollar crisis, I certainly expect one at some point in the future, but not in the next 12 months. The US dollar is the world’s reserve currency and in a period of de-leveraging, it will be in great demand. Only if the Fed prints money in a far more rapid fashion would confidence in the US dollar be shaken, and even then the Fed would have first resorted to a zero interest rate policy (ZIRP) for a period of time before attempting such a risky action.
During the last recession, the Fed began easing in January 2001 and didn’t raise rates until June 2004 or 41 months later. In the current cycle, the Fed first cut rates in September of last year or 14 months ago. If the Fed emulates its policy actions from the previous downturn then rates won’t increase until February 2011. I don’t know if the Fed will wait that long before it begins to hike rates, but given that the current recession will be far more severe than the previous recession, I am confident that there won’t be a hike in 2009.
Lowering of the fed funds rate helps the two groups most affected by the current crisis: banks and consumers. Banks benefit because their business is based on borrowing short and lending long, so their net interest margin will expand. Consumers benefit because many adjustable rate mortgages and loans are based on the banks’ prime rate which is influenced by the overnight rate. Therefore, there is a lot of incentive for the Fed to implement ZIRP.
However, I don’t think it will be enough to offer much of a stimulus for the economy because banks are barely solvent and don’t want to lend in order to preserve capital. And consumers have too much debt relative to the total value of their assets to want to borrow more. Therefore, credit growth, which factored in each time in the past as the Fed cut rates to pull the economy out of a recession has disappeared. Once the Fed cuts rates close to zero, it will realize that additional actions will be required.
Japan held rates at zero for nearly six years in its decade-long struggle against deflation. When that was not enough it resorted to “quantitative easing”, a technical term for what amounts to printing money on huge scale. I expect the Fed to follow the same game plan. Though it has already started to print money via its normal open market operations, I expect more aggressive money printing through unconventional means when it realizes ZIRP is not making much a difference.
The following table lists the profits or losses I would incur under various fed funds rates for each November 2009 contract that I buy at a price of 98.25:
My intention is to hold the contracts until they rise to at least 99.50 (i.e. the market prices in a 0.50% fed funds rate or lower) so that I can make a profit of more than $5,000 per contract. This would be a spectacular return since the Chicago Board of Trade requires a maintenance margin of only $1,200 per contract.
Copper Prices Return to Earth
Published on October 26, 2008
Base metals prices have collapsed this year with losses particularly steep in just the past few weeks. For the last two years, I have been writing bearish posts on base metals with the viewpoint that when the global economy slumps, demand for industrial metals will decline significantly, and prices will fall. I even put my money where my mouth is and shorted base metals stocks last year. Now that prices of industrial metals have substantially declined, it is worthwhile to examine whether they have fallen too much. Here is a price chart of copper dating back to 1980.
I prefer to view the prices of commodities in terms of a stable monetary unit such as gold rather than a depreciating one such as the US dollar. This ignores the effect of monetary inflation and more precisely shows the real value of the commodity. Here is a long term chart of the price of copper in terms of ounces of gold per 100 pounds of copper dating back to 1840.
Here is a chart of the real price of copper in terms of gold since 1980.
The ratio peaked at 0.579 in September 2006 and is currently 0.239 which is slightly below its average since 1980 of 0.277. A glance at this chart suggests copper is significantly undervalued when its price is less than one-fifth of the gold price.
The real price of copper has been declining over the past 170 years. This should be expected given that technological advancement and accumulating savings has reduced the real cost of production over time and will continue to do so in the future. In the long run, the price of any commodity is equal to its cost of production plus a reasonable profit for the producer. However, in the short run there could be wild price swings as there is a time lag to when supply can increase or decrease to meet demand.
The speculator can make profits by betting on commodities when the market price is well below the cost of production as the market is signaling to producers that supply needs to be reduced. Eventually, the price will have to rise otherwise the commodity won’t be produced. On the other hand, money can be made shorting a commodity when its price is significantly above the cost of production because it will encourage greater supply until demand is met, at which point the price will fall.
To get a sense of what the current cost of production of copper is I took a look at the financial statements of copper producers Southern Peru Copper (NYSE:PCU) and First Quantum Minerals (TSX:FM). A summary of their quarterly results are provided below using both recent and current base metals prices.
As can be seen, the projected earnings for PCU and FM using current metals prices are still quite healthy, though they have declined substantially. Only if the copper price were to fall another 50% to $0.85/lb. would either be at risk of losing money. These companies operate some of the higher margin mines in the world. A copper price below $1/lb. would cause many miners to lose money. However, it is also important to keep in mind that if the decline in the copper price is accompanied with a drop in other commodity prices, then a mining operation’s energy costs (which account for approximately 50% of total costs) and labor costs would fall as well. So the cost of production would be lower.
In recent years there has been a lot of money spent on investment and development to expand production from current copper mines and to bring online new greenfield projects. This will add to supply. As the previous analysis shows, miners can still make money at current metals prices so there still exists an incentive to increase production. However, the global economy is beginning to contract which will cause a reduction in copper demand. Together, these factors will put downward pressure on the copper price. The best time to be bullish on copper is when the world economy is about to expand. I don’t see this occurring for the next few quarters, at least.
So what would get me to bet on copper? First, I want to be confident that the global economy is on the verge of emerging from the current downturn. Second, the copper price should be below most mining operations’ cost of production, which I estimate to be around $1/lb. And third, the real price of copper, as measured in term of gold, should be well below its long time average of the past; I think an attractive ratio would be around 0.2 ounces of gold per 100 pounds of copper.
I will concede that these are very strict conditions that are rarely met. But they were satisfied in as recently as 2002 and 2003 which, in retrospect, were terrific years to buy copper. If the market continues to value copper above where I think it is very cheap, then I will simply look elsewhere to speculate where the risk/reward ratio is more favorable.
Closing Short Position in MBIA Calls
Published on October 17, 2008
Today I closed my short position in MBIA’s January ‘09 call options with a strike price of $10 for 85 cents compared to my selling price of $4. I also closed a short position in the January ‘09 calls with a strike price of $15 for 35 cents compared to my $3.30 selling price. As I previously outlined, the bond insurers are going to be hit by an avalanche of claims and insurers like MBIA have under reserved. After a spectacular rally in August that took MBIA’s share price from $4 to $19, the market has come to accept my view as the stock has collapsed to as low as $5 last week.
However, last night CNBC was reporting a rumor that the Treasury was considering including the monoline insurers among the financial institutions that it wanted to recapitalize. At this point in time no official is confirming this rumor, but given that the lack of confidence in the insurance provided by the monolines is one of the main reasons municipalities are having trouble raising money, I think it’s quite likely that the government will do everything in its powers help keep firms like MBIA solvent.
A government purchase of preferred shares, if done at the same terms as was put forth to the major banks, would be very favorable to MBIA shareholders. The capital would help the company pay out its claims and the 5% interest rate is very cheap. And most importantly, the government backing would mean that there would be no further ratings downgrades. The government would get warrants equal to 15% of the value of the preferreds, which would dilute existing shareholders only modestly.
It is sad that the government is considering a bailout of a company that reaped enormous profits for many years at the expense of taking on a huge amount of risk without firing the management, wiping out the shareholders, and giving the creditors control of whatever is left of the company after the government is paid back. However, without a bankruptcy filing the government has no legal authority to takeover the company and if it waited for a bankruptcy, problems would worsen in the municipal bond market.
So I decided to take profits in my short position before the government steps in and the market reacts favorably, as it started to do late Thursday.
Covered Short Position in US Treasury Bonds
Published on October 15, 2008
Today I covered my short position in the December contract of 30 year US Treasury bonds futures at $113.89. I initially sold the contract last Thursday for $118.29. This was only a small short term trade to play some lessening of fear after the US and Europe announced they would recapitalize the banking system. Although today’s stock market plunge seems to indicate that the market remains as fearful as last Friday, Treasury bonds have taken the hit that I expected. This may be due to concern about the huge supply of bonds that the US government will have to issue to finance all these bailouts. In any case, for the first time I am sitting almost entirely in cash and awaiting new opportunities. In volatile markets like these, I don’t expect to wait long.
I’m Now Neutral on Equities
Published on October 13, 2008
The recent stock market rout has left equities no longer trading at the expensive valuations that I had been concerned about. They aren’t cheap either, so I don’t plan to do any buying at current levels. But I have closed virtually all of my short positions leaving my portfolio with lots of cash. My reasoning for believing that stocks have become more fairly priced is based on my outlook for earnings and the multiple the market will assign to those earnings.
S&P 500 four-quarter rolling operating earnings peaked at $90 during the 2nd quarter of last year. After the second quarter of this year earnings have declined to $70. Given that the only driver of earnings growth, energy and materials companies, will now suffer declining earnings, I expect at some point over the next year S&P 500 earnings will bottom within the $50-$60 range and will remain there for several more quarters.
Typically PE ratios are in the single digits during both deflationary periods because of worries of plummeting earnings and highly inflationary periods when investors demand a greater earnings yield to compensate for a rising cost of living. While inflation has been uncomfortably high recently, I believe we are entering a disinflationary period where the market will assign a multiple close to the historical average which is 15.
So if we get earnings of $50-$60 and multiply it by 15, I get a fair value for the S&P 500 of around 750 to 900. I felt very comfortable taking a big short position when the S&P 500 was trading at over 1300 earlier this year. But last week it dipped below 900 and I had no reason to remain short. If the market rallies to around 1100 I will re-establish a big short position. If the market continues to drop and falls to below 600, I will probably go aggressively long. But within 600 and 1100 I’m not going to make any big bets.
Currently, I’m almost entirely in cash. I own Altius Minerals (TSX:ALS), a handful of tiny positions in micro-cap resource stocks, a short position in MBIA (NYSE: MBI) calls, and a short position in 30 year Treasury bonds. Because I don’t see any significant mispricings in the equities, commodities, credit, and currency markets, I’m going to wait patiently for opportunities to present themselves which they always do with high frequency.
Shorting US Treasury Bonds
Published on October 13, 2008
Last Thursday I shorted 30 year US Treasury bonds futures which trade on the Chicago Board of Trade. I sold the December contract for $118.28. This is only a short-term trade based on my belief that the plan for governments around the world to directly recapitalize banks, guarantee interbank lending, and provide a blanket guarantee on all deposits would be enough to prevent a total financial system meltdown and restore confidence in banks.
There are several ways to play this from going long equities to buying Euros. The trade I feel most comfortable with is to bet on rising interest rates on government debt securities which have plummeted due to a flight quality. The 30 year treasury bond looks the most overvalued because the government will have to print a lot of money in the future to pay for all these bailouts. However, other than a short term correction in Treasury bonds I expect its price to remain firm as headline inflation begins to drop dramatically over the next year leading the market to fear deflation. I will probably close out the position at around $112.
The Credit Market Panic Will Soon Subside
Published on October 12, 2008
The credit markets have come to a standstill as evidenced by the skyrocketing TED spread. This is the difference in rates between three-month LIBOR and three-month T-bills and is a gauge of how fearful banks are to lend to one another.
The reason LIBOR has exploded is that the value of the assets on the balance sheets of banks have been declining leading to widespread worry that they could could be worth less than the value of the liabilities resulting in failure. No bank will lend out funds when it has doubts of being repaid.
This is a very serious problem in our credit dependent economy because it can cause economic activity to come to a virtual standstill. For example, naked capitalism examines how letters of credit are not being honored by banks causing global trade to seize up.
Up to this point government responses have not directly addressed this solvency issue, but have tried to cure the symptoms by lending boatloads of money to provide liquidity. This has been ineffective because banks have been taking these funds and using them to shore up reserves rather than lending them out because they question the survivability of other firms as well as themselves. Thus, the credit markets remain arrested.
The Paulson plan recognized that the capital levels of banks needed to be increased and planned to address this by buying up distressed CDOs and subprime loans for a small fraction of par value. The hope was that this would make the balance sheets of banks more attractive for private sources of capital to invest in. Meanwhile, the government, with its low borrowing costs, would hold the assets to maturity for a profit. But the plan is faulty because it requires a lot of time to implement and the $700 billion allocated to it is insufficient. And there is no guarantee that banks will receive sufficient capital from the private sector.
In the meantime the financial system is melting down which has finally made officials realize that the best way to tackle the problem is to directly inject capital into troubled firms. In addition, they plan to guarantee all interbank lending and provide a blanket guarantee on all bank deposits. This should restore confidence in the banks and credit should start flowing again to where it is needed.
In the long-run these policy decisions could lead to big losses for taxpayers and prevent the economy from correcting its many years of malinvestment in the financial sector. I am opposed to any government interference in markets and would much rather see the entire financial system collapse followed by a return to a true gold standard with no fractional reserve banking. After an initial depression, the economy will grow at its full potential. But no one wants to suffer any near term pain. The result is that the government bailout of banks will lead to a less severe downturn in the economy, but no strong recovery for many years, i.e. we get a softer, but longer depression.
But for the time being the credit markets will begin to function more normally. Businesses and individuals who are low risk borrowers will soon be able to get the funds they need and a complete meltdown in the financial system will be averted. However, we will still have to deal with the fact that banks will restrict loans to only the most creditworthy borrowers and demand for loans will drop off as individuals reduce their debts. Consumer spending is going to disappoint for several years and business investment will be sluggish.
But the panic caused by the turmoil in the credit markets will soon subside and the TED spread should moderate.
Covering Short Position in American Axle & Manufacturing
Published on October 10, 2008
Today I covered my short position in American Axle & Manufacturing (NYSE: AXL) at an average price of $3.12 for a profit of 59% from where I initiated the position just two weeks ago. The stock has collapsed along with the general stock market and I am hoping that there could be a decent short-term bounce that will allow me to short the stock again. I don’t think the company or any of the major auto manufacturers can survive much longer.
Covering Short Position in SunTrust Banks (NYSE: STI)
Published on October 10, 2008
I have covered my short position in SunTrust Banks (NYSE:STI) at an average price of $33.22 for a profit of 26% in four weeks. As I have explained, SunTrust is worth significantly less than my covering price because the bank has still not taken the necessary write downs which will force it to raise capital. However, the stock market is incredibly oversold and due for a sharp counter trend rally. If that rally takes SunTrust back up to the low- to mid-forties than I might short the stock again.
Shorting American Axle & Manufacturing
Published on September 30, 2008
I am of the opinion that the US economy has just slipped into the worst consumer spending slump in decades. This will lead to a sharp pullback in big ticket purchases. Automobile sales, which tend to be financed, are especially vulnerable given the current problems in the credit markets. Moreover, the average US household owns almost two vehicles meaning that the market is saturated. Most new demand will come from replacement and this need, too, is declining as cars released in recent years are lasting longer. Another consideration is the rise in energy prices which is leading to a shift in demand from SUVs and light trucks to more fuel efficient cars.
The US auto companies are already in trouble due to their significantly greater cost of labor compared to their Asian competitors. European manufacturers also face this challenge, but their efficiency and technological superiority have allowed them to carve out a niche in the luxury market where they can more easily pass on their costs to their customers. GM, Ford, and Chrysler have been losing market share for years and are burning cash at an alarming rate. Bankruptcy is only a question of time.
Shorting GM and Ford should be profitable but even better shorting opportunities can be found among small auto parts manufacturers who are dependent on supplying the Big 3 and are focused on making parts for gas guzzling vehicles. American Axle & Manufacturing (NYSE: AXL) fits this bill and I initiated a short position last week at $7.58. AXL manufactures driveline and drivetrain systems for light trucks and SUVs. In 2007, 78% of its sales were to GM and another 12% to Chrysler. AXL’s stock price has already collapsed, but I believe the company will file for bankruptcy in the not too distant future and the stock will go to zero.
The following is AXL’s key financial data:
Sales have been trending lower for the last 5 years and have started to plummet in 2008.
AXL’s results in the first half of 2008 were severely impacted by a strike called by the International UAW. AXL estimates the reduction in sales and operating income resulting from the International UAW strike to be $414.0 million and $129.4 million ($2.57 per share), respectively. Even if this is a correct estimate and we exclude the impact from the strike, then sales would have been 13% lower year-over-year and there would still be a loss.
Since AXL is currently losing money the important question is how much cash is the company burning. Here is the 2nd quarter cash flow statement.
AXL had free cash flow (defined as cash flow provided by operating activities less capital expenditures) of negative $25 million and $115 million during the first and second quarters, respectively. This burn rate needs to improve as the company has only $196 million in cash.
AXL does have $600 million available under a revolving credit facility. However, this facility contains financial covenants which requires AXL to comply with a leverage ratio and to maintain a minimum level of net worth. A violation of either of these covenants could result in a default under this facility, which would permit the lenders to accelerate the repayment of any borrowings outstanding at that time. If AXL does not draw funds from this facility soon, there is a good chance it will eventually get pulled by banks who are trying to shrink their balance sheets.
Another problem is the rising unfunded pension and postretirement benefits valued at $524.4 million at the end of 2007.
This net liability is estimated using an expected return on plan assets of 8.50% and a discount rate of 6.45%. In my opinion, these are optimistic assumptions since I believe that equity prices are in a secular bear market and interest rates will rise. If so, then AXL’s cash outlays could be significantly greater.
AXL is currently trading for 30% less than the price I shorted at just last week. Although I believe the stock is heading to zero, if I had no short position I would short a little bit now and wait for a rally to increase the position. It’s my expectation that AXL along with many other US auto companies are going to struggle to survive.
Doubling Down Short Position in SunTrust Banks (NYSE: STI)
Published on September 17, 2008
I have shorted some more shares of SunTrust Banks. My average price is now $45.16. I believe that it’s only a matter of time before the stock retests its July low of $25.
Closing My Short Position in Washington Mutual
Published on September 16, 2008
Today I covered my shorts in Washington Mutual (NYSE: WM) at $2.25. I shorted WaMu in April at $11.94. It is my view that the nation’s largest savings and loan institution is insolvent and deserves to fail. However, Merill Lynch, too, deserved to go bankrupt but was bought out by Bank of America at a ridiculously high premium. Could Washington Mutual similarly be taken over at a big premium? According to Britain’s Daily Mail newspaper, JPMorgan Chase is in advanced talks to buy Washington Mutual. So far no other source is confirming this story, but it can happen.
WaMu’s deposits have declined over the last few months so if any other bank finds value in the company as a whole, now is the time to buy before there is a massive run on the bank. After Bank of America offered a mind boggling premium to Merill Lynch, I am now afraid that another large premium could be forthcoming for WaMu, though I would assign a small probability to this outcome.
With the value of my WaMu short position having shrunk by 81%, I don’t stand to gain a lot more even if the FDIC proceeds with a takeover causing the stock to fall to zero. Therefore, I took profits and closed my short position to look for other shorting opportunities. I’m still short calls on WaMu which have a strike price of $10 and expire in January 2009 because I just don’t see how any possible takeover by another bank will value the stock above $10 and the options should expire worthless.
What Caused the Bust?
Published on February 18, 2009
Marc Faber, who predicted the economic and financial crisis, has written an excellent piece in today’s WSJ blaming government policies rather than the free market for getting us into the current predicament. Because of the government’s ineptitude he believes that the best solution is to do nothing and allow the free market to sort out the mess.
Filed in Commentators,Economy | No replies
Tags: Commentators, Economy