Nostradoofus

(Contributed by Richard C Hsu)

Once again, the Fed has seemingly come to the rescue of the stock market. According to today’s New York Times, “presenting a bleak picture of a deteriorating national economy, Ben S. Bernanke, chairman of the Federal Reserve, strongly suggested on Thursday that the Fed would cut interest rates soon, perhaps by a large amount.” While Wall Street welcomed this with open arms by rising today, what people fail to realize is what worked for Greenspan after the Internet bubble burst won’t work for Bernacke after the housing bubble burst.

The reason that it worked for Greenspan is because homes had appreciated (along with the stock market) during the Internet bubble so there was plenty of equity lying around to deploy when interest rates were lowered. People could use their equity homes as an ATM in order to maintain spending and thus keep the economy going. Now it’s different: the raison d’etre for the bursting economy is precisely the DEPLETION of home equity so when the Fed lowers interest rates, there will be no equity to spend.

If the Fed tries to lower interest rates too aggressively, it will use all of its bullets and then what will be the stock market’s safety net?

Long-term real median productivity growth per capita is the perfect economic objective. It creates a simple objective function to measure all policy options.

Yes, growth should be distributed relatively evenly. Yes, there should be equality of opportunity. But all of that is contained in the above definition.

Median is used instead of average, because it makes the middle class a mathematical necessity. Equality of opportunity is similarly necessary to increase the median (though not necessarily the average).

“Long term” is a required qualification, because it prevents dumb short-term stimuli, such as fighting foreign wars to increase domestic employment.

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Much has been written about the speculation on whether the current economy is headed into a recession. Between the mortgage crisis and the inauspicious start of the market dropping 200 points on the first trading day of 2008, all signs seem to point in that direction. However, if there were any doubt, here is the nail in the coffin: this is an election year. Markets do not like uncertainty and this is the first time going back to 1952 when the Vice President of an incumbent President was not the default nominee for the outgoing party. Regardless of what the economy ultimately bears, the uncertainty of the election will cast a long shadow. Don’t look for any real legs in the market until after November.

Equity investors often feel obligated to remain fully invested, because equities have a much higher average rate of return, at least historically.

But you can think of cash as an option, conferring the right, but not the obligation, to pick up assets cheaply during panics. Unlike other forms of option, this one pays you a premium, and never expires.

This option is only useful if you can tell the difference between a cheap and an expensive equity.

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Ah, youth. How fondly I remember the endless Monopoly games of summer, in which the winner would loan ever greater sums to the loser, thereby averting bankruptcy and continuing the game.

“You landed on Park Place again? What a shame! And me with hotels there. Don’t worry, I’ll loan you the $1,500, and you just keep right on rolling.”

Evidently the scions of our federal government were similarly raised. Lenders going insolvent? No problem, we’ll loan you more, and cheaper, to keep you going. Borrowers feeling strapped? No problem, we’ll simply tear up your mortgage contract and write a new one where you pay less.

Japan tried this in the 1990s, in case you don’t remember.

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Pundits worry the mortgage collapse may push us into Japan-style deflation. That’s one possibility, but there is a more likely one.

Japan headed into its long deflationary spiral with a mostly balanced federal budget, high trade surplus, immense foreign reserves, immense personal savings, low unemployment, and high educational level. This buys an awful lot of flexibility.

The US teeters on a similar precipice, but with no net underneath: gigantic federal budget deficit, large trade deficit, high personal debt, high corporate debt, net debtor status, and uneven educational level.

The stage is thus set more for Argentina than Japan: banking crisis, hyperinflation, currency collapse. I’m not saying it will happen; only that it’s more likely than the Japan scenario.

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As the thrill of the chase has returned to Silicon Valley, every VC and hopeful entrepreneur is chasing a new version of the old dream: a winner-take-all web community.

This pursuit, now called Web 2.0, has all the things business school taught you to love: network effects, first-mover advantage, etc. And again, the signals of excess have appeared.

First is an abrupt 50% rise in professional fees among top providers in the Valley. An attorney I know there now charges more than $600 per hour — more than I paid my entire team (14 people, half programmers, all U.S.-based) in 2000, the peak of the bubble.

The second signal is that, in the effort to leave no stone unturned, VCs are examining some pretty crazy community ideas. Take, for example, the idea of community-monitored stock investment ideas.

Huh? Think about this for just two seconds. Successful stock picking means finding an idea and quietly investing ahead of the crowd. A stock picking community would collect ideas from the crowd, and let the crowd vote on them — in short, exactly what the markets already do. No edge to be gained there.

Is it time to read the fine print on that SIPC policy?

On August 20, the Federal Reserve tripled the amount Citibank, Bank of America and JPMorgan are permitted to lend to their brokerage subsidiaries, to a whopping 30% of bank assets. This is an unprecedented waiver of regulatory oversight, and calls the brokers’ liquidity into question.

Brokerage insolvency risk first emerged, quietly, with the Brookstreet Advisors insolvency in June. Brookstreet was buying (and advising its clients to buy) securities on margin, backed by mortgage-backed securities. When the subprime crisis hit, ensuing margin calls wiped out the firm and many of its clients.

Brookstreet’s failure, by itself, was just bad advice, not a systemic problem. The real concern was barely mentioned in the press: Brookstreet’s margin lender was a unit of Fidelity Investments. Fidelity, and presumably many other broker-dealers, have lent undisclosed sums of money against illiquid securities of dubious quality. They may repossess those securities in a margin call, but they cannot liquidate them at anything near face value.

It thus appears unlikely, but not impossible, that a major broker might fail.

Yes, investors’ assets are covered by the SIPC up to $500k, but they don’t say WHEN you get your money back. Individuals may not want to have all their eggs in one basket. Some alternatives that don’t require selling stocks:

• Move your “emergency” cash to interest-bearing checking (INGDirect pays 5% and claims no subprime exposure).
• Take physical delivery of stock certificates for long-term holdings, and put them in a safe deposit box.
• Move mutual fund shares to be administered by the mutual fund itself, not your broker.

This brings peace of mind with relatively little effort, and no taxes or trading costs.

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In the subprime meltdown, certain thought leaders are serving financial industry special interests while draping themselves in populist raiment.

Schumer and Dodd propose loosening regulation to let Fannie & Freddie buy subprime and jumbo loans. They claim to protect the working man. But who really benefits from a subprime rescue?

No benefit to subprime homeowners. They have little or no equity now — in many cases, they had none to begin with — and thus nothing to lose by defaulting.

No benefit to banks — they sold the bad loans long ago.

No, the beneficiaries of a bailout would be institutional investors holding bad mortgage-backed securities (MBS). Where are these unfortunates located? New York (investment banks and hedge funds) and Connecticut (insurance & pension funds).

Now let’s see, who are Schumer’s and Dodd’s constituencies? Why, New York and Connecticut. What a striking coincidence.

PIMCO chairman Bill Gross also appears possibly biased by self-interest. He recently suggested in his monthly letter that the federal government directly bail out defaulting homeowners. He then republished the proposal in the Washington Post.

Longtime readers of Bill Gross will remember his April 2003 issue, in which he details some of PIMCO’s income strategies. These included:

• Buying mortgages while shorting an appropriate index
• Selling out-of-the-money put and call options on Treasury bond rate swaps and futures.

The first strategy would tend to be killed by a wave of mortgage defaults (and rescued by a federal bailout). The second strategy would tend to be killed by a sudden spike in volatility of Treasury bond rates, as might occur in a monetary policy rescue — leaving a fiscal rescue as the only way to preserve the second strategy.

Again, what a coincidence that Mr. Gross appears to propose exactly the solution that would appear to most benefit himself.

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Where does all the money go in U.S. healthcare? Since 1985, costs have increased at double-digit percentages annually, yet doctors today earn only about one fourth what they did then, per hour, inflation-adjusted.

So where does the money go? Public company net profits tell an interesting story.

Big health insurance companies, often a bogeyman in these discussions, are actually not hugely profitable, earning a respectable but unexciting 10% on sales.

By contrast, nearly all major drug companies earn more than 25% on sales — almost unheard of among companies with over $10 billion in sales. 25% net margins are more appropos to small niche operations, such as a mugging or petty theft.

So are drug companies the perps? Well, not lately. Their profits have been falling dramatically for the past five years, and sales are pretty flat. Over the same period, health insurers have grown enormously, though they remain relatively unprofitable.

(As an aside, health insurers are probably worth a look for investors, because their rapid growth doesn’t seem to be priced into their stock in all cases.)

The implication is that until about 2001, drug companies were shaking people upside down to make the coins fall out. Then they stopped. (OK, what really happened is that they had high profit margins due to patent exclusivity, but then those patents began expiring.) Around the same time, insurers started taking more of the pie. But they didn’t keep much of it as profit, instead paying most of it through to employees and suppliers.

What suppliers, though? Not drug companies. Not doctors. So we must ask again: where it it all going?

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