Recent Observations from "The Hog Blog"

Week Ending: May 7, 2010

Wow, what a week!  Rather than re-type my thoughts, I'm sharing with you some correspondence to clients (with the really good parts omitted) and to some investor friends of mine.

(5/6/10) TO CLIENTS

Just wanted to take a minute to address the deterioration of capital markets over the last few days, including today's stunning drop.

For starters, yes, this is precisely the kind of thing I've been concerned about. The question was never, "Will stocks fall?" it was always, "What will the catalyst be?" I think we have our answer: European sovereign debt, or more broadly, the structural financial arrangement of the European Union. As the US was quietly moving upwards of late, European stocks have been falling. Did you know that, as of this writing, European stocks are in a full-fledged bear market (down 26%)?

The Market opened on the downside because of the continued unrest in Greece, and more importantly for what it might portend in other debt-addled European countries (Spain, Portugal, etc.). Stocks traded down throughout the day, picking up momentum. This makes complete sense to me and I think we're just beginning another global sell-off of risk assets. Investors remain skittish and the nostalgia today's dive was not lost on those that were invested in 2008.

The REAL story (that's still not out en masse) is the US Stock Exchange briefly melted down today. The Dow went from -400 to -998 in a matter of minutes between 11:30 and 11:45 a.m. Pacific. In the process, many stocks traded down 50% or more. Essentially, the bids disappeared and automated trades were executed at levels that will astound those on the buying and selling end, to the extent that they're not canceled . Think of it as a "ghost in the machine." The notion that the US exchanges have this problem should be of great concern. This may play out to the downside tomorrow.

WHAT WE'VE DONE

(OMITTED!  Sorry...)

BOTTOM LINE(s)

The goal is not to prevent any losses-there's no way to do that without being in 100% cash, and that's the single worst mistake investors make (market timing into cash). The goal is to limit the losses...and so far so good!

This hedging strategy has a multi-month approach to it, so if the markets snap back on any given day (and they will) don't be too quick to judge.

If we're wrong, we'll forgo more upside participation. But I'd rather incur opportunity cost than real declines given the risks that exist.

Finally, your bonds and your Financial Plan are your true salvation (If you don't own bonds, you don't need to, because you have plenty of time).

If we can answer any questions, let us know.

 (5/6/10)  EMAIL RE:

I don’t think the nostalgia of seeing the Dow plunge a few hundred points intraday was lost on anyone that suffered emotionally in late ‘08/early ’09. I think a lot of them wish they would have exited sooner. It’s certainly not contrarian, but I think it could describe a scenario where over the next couple of weeks, retail investors act with a hair trigger, and we could get some days like we had in October of ’08.

The other thing I took from today is that it reminded me of April 4, 2000. The Naz lost 14% intraday, but closed just 3.2% down for the day. (Today, the Naz lost 9.2% intraday, closed down 3.2%). It freaked me out back in 2000…I cut my tech exposure in half. The next few days everyone said, “It was a fluke” and the market rose a bit. A week later, the market was down 22% from the closing level on April 4th.

CHART OF THE WEEK

This chart is from the Financial Times (it accompanied a great story).  It shows the growing perceived counter party risk among European banks.  (It's one of the reasons we gotten defensive).  Remember the TED spread?  This is the equivalent for Euro banks.  Implies that there's more going on than Greek debt problems.  Reminiscent of our financial crisis, European banks are starting to get leery about who to deal with among their brethren, lest they engage in a transaction with bank that turns out to own the bonds of Greece, and it's over-levered peers (Spain, Portugal, etc.). 

THE RICH LIFE:  My hat is off to the Oregon Department of Fish and Wildlife.  Their Hunter's Safety course is outstanding. My two oldest are taking the class. It's very rigorous, but goes to detailed lengths to teach not only the relevant law but also the ethos of the sport. 

Week Ending: April 30, 2010

I've been asked about my opinion of the Goldman lawsuit.  That's an easy one.  It's a witch hunt and a miscarriage of justice, as best I can tell, as will be proven over time.  And wrong as it may be, it's really easy to understand how it happens.  It diverts attention to just one culpable party, so we don't have to look too hard at the more protected or sympathetic others: the Government, the Real Estate industry (lenders, appraisers, agents, etc.) and the Mortgagee (ourselves).  And of course, Wall Street is an easy target, those greedy people whose only real objective is to screw the little guy and enrich themselves in the process. 

My friend Dave sent me this note from Deutsche Bank last week:

"...it was revealed late yesterday that the vote at the SEC to sue Goldman was 3-2, strictly along party lines with the 3 Democrats voting to sue while the Republicans were opposed. So clearly there were politics at play and what was even more surprising was the timing of the release - it was released during market hours and it was clearly a market-moving piece of news - it would have been more prudent to release it after the close to allow the markets to digest it properly. Also as everyone knows the US Senate is currently working on a financial services reform bill and the timing of this releases was coincidental (at best) - making it that much harder for Republicans to maintain a filibuster. Nevertheless the news that the vote was along party lines and was very political helped to push markets up higher yesterday.

The animosity towards Wall Street is universal and crosses party lines. Almost everyone is lining up to punish the investment banks and that is why politicians are all over this issue. At this point, this is resembling a witch-hunt. Yes Wall Street should take its share of the responsibility for this crisis. But lets not forget that without insatiable demand from the people out there to purchase homes, cars, flat-screen televisions and myriad other things that they could not afford, there would be securitization market to speak of. It was their greed as much as Wall Street's mistakes that led to this crisis (and of course with able help from the ratings agencies, the government and the predatory lenders). The point is that everyone was to blame but if you open a news-paper these days, you would be forgiven for thinking this mess was created solely by investments bankers. This is wrong and it is a travesty that this witch-hunt is taking place. And what is more troubling is that the government needs not only the tax money that Wall Street bonuses generate but the economy needs the money that is injected from these pay-outs. Just ask the cab-drivers and restaurant owners in New York how much the recession and the cut in Wall Street bonuses hurt their businesses. By going after Wall Street, the government and public are inadvertently going after themselves! "

And then the other day, I get a taste of the "victimization" that's out there in the form of a Letter to the Editor of my local paper.  Check this out:

MY LOST HOMES

I’ve lost three homes under the Federal Reserve policies, Wall Street scandals and loan freezing done by our banks since 2009. Where were our congressmen protecting “we the people?” Was owning a home and making an investment based on an economy that was a lending credit-based economy an error on my part? Apparently so. Who is responsible for making sure that our money comes back to us in the form of staying in our homes or getting our credit restored?"

Wow, really?!

CHART OF THE WEEK

Not a chart, but funny and poignant.  God help this Country through the next several years!

THE RICH LIFE:  Was watching the Hornby Eagles online the other morning with my 8-year-old, Tate, and was reminded that I need to ramp down my hunting zeitgeist with the V-tine boys, and balance it with a little ecology.  To wit:

Tate: “Can you shoot those?”

Me: “No. You can’t. They’re protected.”

Tate: “Because they’re our state mascot, right?”

Me: “Our national bird. Right…but you can’t shoot them in any country.”

Tate: “Why? They look tasty.”

Me: “Tate, you don’t even like chicken…whatchoo talkin’ bout?!”

Tate: “I’m just sayin…”

Need to lay some Theodore Roosevelt on him…

Week Ending: April 23, 2010

Note to prospective Investment Managers: If you’re thinking of starting a firm, and want a stable of happy clients, with minimal departures, don’t do what we do.

I’ve often said that it’s not easy to be a client of Valentine Ventures. While EVERYTHING we do is in our clients’ best interest, it’s not always easy to understand our techniques and objectives. That’s part of why we communicate frequently—in the hopes of assisting folks in understanding what we’re doing—especially when it may fly in the face of convention, or run counter to lessons-learned from prior relationships with inept, lazy and self-serving financial practitioners. The standards for Financial Services have been too low, too long.

Sometimes, difficult as it is, we have to do what we think is in our clients best interest, even if it’s not what they want at the moment. We did not let any clients bail from their investments in March of last year when the stock market was down 55%, despite their pleading. And now, we’re not going to recklessly accumulate risk assets in a desperate undertaking to bring the asset levels back to the 2007 peak, just because stocks are flying.

Further, we’ve agreed to adopt the “tough love” approach to steering clients towards the financial decisions that they must make. Whether it’s dropping the price to move a piece of real estate or modifying a budget to bring it in line with the risks and realities of the day, it’s never easy, and rarely pleasant.

The easy things to do would be to create a portfolio that “hugs” the stock benchmarks (like the Dow or the S&P 500), and never tell anyone anything they don’t want to hear if their financial plans are out of line with reality.

But that’s just not Valentine Ventures…

CHART OF THE WEEK

The stock market is a discounter (predictor) of the future for corporate profits, and thus the economic cycle.  But it’s not perfect, and can often give misleading cues before fine-tuning the eventual reality.  Judging by the shape of the market over the last two years (chart below), our economy should be in a rapidly improving condition.  The “V-shape” of the market suggests that’s what’s happening in the economy.   I disagree. We’re likely to learn of the true state of the economy over the coming months.  In the process, stocks will roll over and head lower—along with other risk-assets.  How low?  No idea.  I think the Market’s shape is more aptly explained by the excessive money creation by the Fed (the “sugar high”).

THE RICH LIFE:  Just got a clean bill of health.  Lowered cholesterol, low blood pressure, good fightin' weight.  Feel like a million bucks.

Week Ending: April 16, 2010

Irving Fisher's name gets dropped a lot lately.  This early-20th-century economist made many contributions, but his theory of "Debt/Deflation" is being played out, and many are taking notice.  While Fisher's theory helps explain the pervasive deflationary headwind affecting the entire economy, you can adapt it and overlay it against real estate to get a sense of where we're going.  At least that's what I'll try here.

Fundamental to understanding where we're headed in the real estate cycle is appreciating that it's market-driven, not policy-driven.  It's no surprise that despite the enormous amount of taxpayer money being thrown at propping up real estate, it hasn't worked.  The loan modification program and home buyer tax credits have done little to help, as evidenced in the new highs for foreclosures, and new lows in real estate values.  (And both numbers should continue to get worse).

Only through the natural, uncontrollable, cleansing--but painful--process of market-mean-reversion can real estate find its bottom.  The fact is that before it's over, many more will fail in their obligation to repay debt as a result of falling real estate prices and a weak economy.  When all-that-will-fail have failed because they need conditions to improve to prevent it, we'll the hit the bottom.

The Modified-Fisher for Real Estate (my term...just made up) borrows from his main theorem in suggesting that weakness begets liquidation which puts pressure on asset prices leading to further weakness as it repeats and spirals lower.  Only when all those who will fail on their loan because of the economy, or that can be convinced to walk away because of the value of the real estate, do so can we reach an equilibrium for prices and activity. 

CHART OF THE WEEK

This isn't really a chart, but rather a recent magazine cover (my thanks to Dave Floyd for sending it along).  Can you believe that nonsense?  Who's Daniel Gross and what are his economic credentials?  None...he's a journalist (trying to salvage the midterms, I suspect).  Amazing propaganda. 

THE RICH LIFE:  Three weeks into my Radio show retirement...I'm loving it.  I've used the time to catch my breath, work at a less-hectic pace, get some things done around the house, dabble in the political campaign process, spend more time with Jess and the boys, and think about investing in general.  Should have done it a year ago.

Week Ending: April 9, 2010

I'm not prone to plagiarism.  And generally, this blog is reserved for original thoughts from yours truly.  But this week, I'm lifting content from Peter Schiff's blog at www.europac.net because Schiff perfectly encapsulates my concerns...I won't try to better him with my prose.

During the 1990s, inflationary Federal Reserve policy fueled a tech stock bubble. When that bubble burst, the Fed inflated a larger one in real estate. Now that the real estate bubble has burst, the Fed is inflating the biggest bubble of them all – a bubble in government. While the earlier booms at least provided the illusion of prosperity and some fun while they lasted, the government bubble will cripple the economy and deliver widespread misery to the vast majority of Americans.

Of course, there will be winners in the government bubble, at least for a while. As was the case with the stock and real estate bubbles, plenty of money will be made by the well-connected and parasitic classes. Government employees will continue to enjoy pay raises at our expense, as will anyone benefiting from the new wave of subsidies, such as Wall Street investment bankers, financial speculators, and those working in health care or education.

These gains will come at the expense of the taxpayers who foot the bill and the consumers who face higher prices. As government grows, it deprives the private sector of the resources it needs to survive and grow. The result is a lower overall standard of living. Not only are government jobs less productive than private sector jobs, but bureaucratic interference actually makes the remaining private sector jobs less efficient as well.

Our economy is being transformed from a mostly capitalistic one to a mostly socialistic one. More decisions are being made by politicians and lawyers in Washington and fewer by entrepreneurs. The motivation behind this shift is the mistaken belief that the financial crisis of 2008 was caused by too much capitalism and a lack of proper government oversight. This conclusion is self-serving for those in power, and couldn't be more economically misguided. Through corruption or just plain ignorance, Congress and this Administration have embraced an ideology that has failed every time it has been tried.

…

Whether it is in education, housing, health care, automobiles, insurance, or banking, greater government involvement in the economy means higher prices, lower productivity, more bailouts, bigger deficits, increased taxes, diminished industrial capacity, fewer private sector jobs, less freedom, and a falling standard of living.

In the end, when runaway inflation and skyrocketing interest rates burst the government bubble, there will be no more bubbles to replace it – just one hell of a hangover.

Amen. 

On a different note (with ominous suggestions about the current level for stocks), I pulled the Chart of the Week from Jason Goepfert's excellent sentimentrader.com.  It show options speculation.  Specifically:

The Options Speculation Index takes data from all the U.S. options exchanges and looks at opening transactions. We total the number of transactions with a bullish bias (call buying and put selling) and also the number of those with a bearish bias (put buying and call selling).  The Index is a ratio of the total bullish transactions to the total bearish transactions.  The red and green bands on the chart are 2 standard deviations from the one-year average of the index.

CHART OF THE WEEK

Check it out!  It tends to be a pretty good contrarian indicator (and that's all we can hope for: "pretty good"...there are no reliable forecasting indicators).  What it says is that there's not only a huge amount of money speculating on continued rallies for stocks, but there's no insurance against the opposite.  One possible implication, as posited by Mr. Goepfert, and I think this makes sense, is that any sell off would likely be sharp as falling prices would drive stock sales, since there is little hedging against long stock positions.

THE RICH LIFE:  I'm a big fan of the philosophy of Jim Rohn.  Maybe you know of Mr. Rohn.  He's a lecturer on business, and life, philosophy.  One of his admonitions to ensure that your legacy entails the passage of three things to your loved ones and followers: your pictures, your journals, and your library.  I've worked for years to compile my pictures, journal and library and while the exercise has been very fulfilling, so is knowing that future generations will have something meaningful to glean a bit of a life gone by before them.

Week Ending: April 2, 2010

And the stock market rolls on...

I have no clue as to how long it can continue to rally.  For now, I am content to be only a marginal participant because my intermediate outlook for stocks is one that has them struggling, especially in the US, and I can't begin to pretend to know when that will start. I contend that we remain in a Secular Bear cycle, that began in 2000, and that's likely to continue for 5-10 more years.  In particular, the next three years look to be difficult.  So while stocks continue to ride the MSH (Monetary Sugar High for now), I caution you against seeing recent gains as permanent.

Stock returns come from two places: the dividend plus the change in price.  Stripping down to one more level, stock returns come from:

• DIVIDEND YIELD (the dividend divided by your initial investment)

• INCREASE IN DIVIDENDS AND INCOME

  • INFLATION

  • REAL GROWTH IN DIVIDENDS AND INCOME (from productivity improvement).

• MULTIPLE EXPANSION (stock price relative to dividends and earnings--e.g. P/E)

Over the last 73 years, the average annual return for stocks is about 10%, comprised of an average dividend yield of about 4%, real growth of earnings of 1.5%, inflation of 3.7%, and multiple expansion of 0.8%. 

Let's compare that with where we are today.  The dividend yield (Chart of the Week below) is 1.9%.  Inflation will likely remain below its 3.7% rate over the next few years--I expect about half that (or less), given that we're in a Debt/Deflation spiral.  So let's say 1.8%.  Add to that real growth of 1.5% and you get 5.2%

So, if we're to get a better return, it has to come from an increasing multiple.  The P/E multiple on the S&P is currently 22 The average is 17, and the market spends 75% of its time with a lower P/E than 22.  One argument is that low inflation justifies a higher multiple (the value of future earnings/dividends are worth more).  A more likely scenario is a reduction in valuation.

Also boding ill: it's entirely possible we don't have earnings growth when the other sugar high (Fiscal) runs out, and earnings weakness begets employment weakness.  The lack of real income growth would continue to retard consumption. 

I'm not abandoning stocks in the US--rather, they're underweighted to the non-US world, and to the other, alternative asset classes we use in uncertain times like this.  And that's my story, I'm sticking to it, regardless of how out of step that makes me.

CHART OF THE WEEK

THE RICH LIFE:  After six years of doing my radio show, I decided this week to hang up my headphones.  There were many factors that lead me to this decision, but the most important one was that it was no longer adding richness to my life.  It used to be a lot of fun, and a little work...but recently it's been the opposite.  I'm using my newly found time to focus on my investment firm and my family.  Surprising to me, a number of friends have asked me if there wasn't more to it.  Certainly the show brings a high profile to the firm, and a steady stream of good, new clients and so it would seem foolish to leave behind.  True, but life's too short to work too hard.  It's that simple.