Sunday, November 23, 2008

Fixing the Housing Crisis

From the Desk of Joe Rollins

Everyone probably realizes that one of the major factors leading to the real estate boom and subsequent bubble was low interest rates – they were too low for too long. In the aftermath of September 11th, interest rates fell to extremely low levels and were kept there for almost three years by the Federal Reserve System.

Over the past several years, many homes were being sold in this country with variable interest rates. Even though interest rates were too low, they were just not low enough to satisfy the housing appetite by people who could not afford them. The general presumption was that in a few years, the house would appreciate in value and when the adjustable rate was due to change, the buyer could refinance to a fixed rate. I vividly remember seeing adjustable mortgages in the 3% interest range jump up to market rates after the three-year expiration. Of course, this is not the only reason for the real estate bubble, but it was certainly a major contributing factor.

Today, we have low interest rates again. It is hard to imagine that we basically have interest rates today that are equal to or lower than the interest rates that were available to the general public after September 11th. These low interest rates provide a window of opportunity to turn a good portion of the unsold residential real estate inventory and make housing affordable to many while also helping to put a lot of Americans back to work. In this particular scenario, these mortgage interest rates would not only apply to short-term variable rates, but also to standard 30-year fixed mortgages.

On Thursday, due to the fear gripping Wall Street, a 30-year Treasury bond ended the day with a yield of 3.48%. This is the lowest rate on a 30-year Treasury bond in over 50 years. It also was the largest yield drop for the long-term bond since the day after the 1987 stock market crash. Since the market dropped more in November of this year than it did in October 1987, I believe this drop was an appropriate response.

The government could facilitate a real estate recovery by entering the open market and selling $100 billion in 30-year Treasury bonds at 3.48%. Since there is such a gigantic demand for these bonds at the current time, I feel there would be no problem at all in issuing these bonds to willing buyers. After the government gets the $100 billion from selling 30-year Treasury bonds, they could turn it over to their wholly-owned subsidiaries, Fannie Mae and Freddie Mac. At that point, these quasi-governmental agencies could start extending mortgages at 4% to all qualified buyers. At an average mortgage of $200,000, that would be 500,000 new mortgages for Americans.

A standard 30-year fixed mortgage at 4% will create an immediate housing demand across the United States. Additionally, the agencies could use some of the $100 billion to refinance a great many of the home mortgages that are currently in foreclosure. If in the next six months the government issued $100 billion in new mortgages, we could see a stabilization of the real estate market by the middle of 2009. The combination of low interest rates and low payments will offer many Americans an excellent housing opportunity. Coupling low interest rates with the decline in values that the homes have suffered over the last two years will provide for a buying frenzy unparalleled in American real estate history.

I do not pretend to know more on the subject of real estate than the average person, but I do understand that if the government can issue Treasury bonds at 3.48% and lenders can collect the mortgages at 4%, this would be a win-win for the government, the agencies, the homeowners and ultimately for America.

A government program that actually makes money? What a novel concept!

Saturday, November 22, 2008

Did We All Wake Up and Find Ourselves Stupid in July?

From the Desk of Joe Rollins

There’s no way to sugarcoat the stock market’s poor performance during October and November. As I write this post, all three of the major market indices are down roughly 50% year-to-date. The Dow Industrial Average, the S&P Index of 500 Stocks and the NASDAQ Composite all have virtually the same returns year-to-date – all are down around 50%. Indisputably, that fact is hard to swallow. This has been the worst year for stock market investing since 1937.

I’m not exactly sure anyone can properly explain what is going on in the stock market right now, but I certainly don’t think it has anything to do with economics. One of my clients pointed out in frustration with me that we are living in a different world now, but I take exception to that statement. I truly don’t feel that the fundamentals of economics and the valuation of stocks are any different today than they have been throughout history, which I hope to illustrate below.

Around July 1st of this year, something drastic happened. The markets were undoubtedly bad for the first six months of 2008, but since then, the losses have gone to incomprehensible level. As of this writing, 99% of all publicly traded mutual funds have suffered losses for 2008. The very best fund managers in the world have accumulated losses of 50% or more in 2008. Bond funds and conservatively-balanced funds also have losses approaching 30%. The destruction of wealth over such a relatively short period of time has been nothing short of mind-boggling.

In spite of the market’s terrible performance, I just don’t believe that we all woke up in July to find ourselves completely unable to understand the basic fundamentals of stock market valuation. Perhaps some people are generalizing the facts instead of reading detailed information for a complete and proper analysis of the current situation. This makes me wonder if the traditional approach to market analysis has become unfashionable. Current analysis tools tend to deal strictly with market momentum – up is up and down is down, and never shall the two meet.

As I often hear exclaimed on the daily financial news, the “buy and hold” philosophy is dead. I don’t concur with that exclamation, and I have some evidence to indicate how the market has so mispriced securities that there is incredibly high hope for our investments.

It’s apparently become chic to criticize the world’s most well-known investor, as evidenced by a lot of posts I read by other financial bloggers. Lately, Warren Buffett has become the favorite whipping boy, in spite of him taking Berkshire Hathaway, a little-known shirt manufacturer, from nothing to a current market capitalization of $120 billion. In fact, Berkshire Hathaway, as early as one year ago, was valued at one-quarter of a trillion dollars. There aren’t many investors who can proclaim to be as successful as Warren Buffett, but according to some bloggers, he woke up stupid at some point in 2008.

In October of 2008, Warren Buffett invested $3 billion in one of the world’s largest conglomerates, General Electric. In addition, he was given warrants to purchase GE’s common stock into the future at a price of $22 per share. Based on today’s valuation, that agreement appears to have been a mistake. However, I wouldn’t discount Warren Buffett’s prowess too quickly.

At the same time Warren Buffett invested in General Electric, he also invested in Goldman Sachs. Both of the stocks are suspect at the current time, but based on fundamental analysis, they continue to be brilliant purchases. General Electric isn’t your typical corner store investment, and over the last three years, it has made the following in net profits: 2007 - $22 billion; 2006 - $20 billion, and; 2005 - $16 billion. General Electric has had gross sales in the same years as follows: 2007 - $172 billion; 2006 - $163 billion, and; 2005 - $150 billion. This is one of the most successful companies, not only in the world today, but also in the history of American finance. However, it’s priced almost like a penny stock today.

At Thursday’s close, General Electric stock was valued on the market at $12.84 per share. General Electric has now confirmed that their Board of Directors has approved their dividends at $1.24 per share annually, through the end of 2009. Therefore, if you invested in their common stock at $12.84 and you received the $1.24 dividends per year, you would have a return on your investments in dividends alone of 9.66%. That’s a fairly stunning return on one of the top capital titans in American history.

Based on Thursday’s market price, the entire enterprise value of General Electric was $127 billion. During 2007, General Electric generated cash flow from operations of $46 billion. Therefore, on a cash flow valuation basis, General Electric could be purchased in its entirety from its cash flow in only 2.8 years. Valuations currently defy any level of imagination.

As of the General Electric’s third quarter, they have a book value – meaning the sum of their total assets less their liabilities – of $11.28 per share. Since that time, they have raised in the open market and through Warren Buffett an additional $15 billion in capital. Therefore, even if the company made no profits in the fourth quarter of 2008, they would have a book value of close to $14 per share.

In summary, you can basically purchase one of the greatest manufacturing conglomerates of all-time for less than book value and earn a return of close to 10% assuming the stock never actually goes up. I would argue that Warren Buffett’s purchase price is more closely correct than the market at this point.

This is even more compelling when you take current interest rates into account. Yesterday the one-month Treasury bond was yielding 0.1% annually. I am not saying 1%, I am saying one-tenth of 1%. Interestingly, a three-month Treasury on Thursday was yielding 0.2% annually, which means that you could purchase a Treasury bond for no return only to guarantee that you would get your money back.

The yield payable on the two-year U.S. Treasury bond, which reflects trends in interest rates, is below 1% for the first time ever. The yield on 30-year Treasuries, led by expectations of inflation, is below 4%, at an all-time low.

Even more stunning is the long-term interest rate on Treasury bonds. Today, a 10-year Treasury bond was yielding 3.03% annualized. This is the lowest rate recorded on Treasury bonds in over 50 years. Basically, if given the choice, you could buy Treasury bonds yielding 3.03% or General Electric stock generating close to 10%. Of course, in the case of Treasury bonds, they would not increase in value and General Electric just might.

To further inspire you to invest, the U.S. Treasury’s low yield would be taxed to you at a stunning 35%, while the 10% return from General Electric would be taxed at a preferential rate of 15%. For these reasons, I argue that we have not entered a new investing world. Rather, our current investing world is misguided.

At about the same time as Warren Buffett’s General Electric investment, he also invested $5 billion in Goldman Sachs Group, Inc. Once again, this is not a run-of-the-mill company – it’s a worldwide respected investment house. Goldman Sachs is considered by all to employ the best and the brightest business managers in America. Its net income over the last three years are as follows: 2007 - $11 billion; 2006 - $9 billion, and; 2005 - $5.6 billion. Its sales in those same years are as follows: 2007 - $88 billion; 2006 - $69 billion, and; 2005 - $43 billion. Not exactly a mom and pop shop, right?

Along with Warren Buffett’s $5 billion investment in Goldman Sachs, he received warrants to purchase Goldman Sachs’ common stock at $115 per share. As of Thursday’s close of business, the stock was trading at $52 per share, or a stunning 65% less than the price that Warren Buffett agreed to purchase it at only two months ago. I know it seems like the fourth quarter of 2008 has gone on for decades, but on October 1st, the greatest investor of our lifetime agreed to buy the stock at $115 per share and less than two months later, it is selling on the open market at $52 per share. Did Warren Buffett wake up in July and become stupid? I don’t think so!

As of Friday, Goldman Sachs has a book value of $130 per share. Assuming that the company just broke even in the fourth quarter of 2008, the stock is now trading at only 40% of the value of Goldman Sachs’ assets less its liabilities. I am still not a believer that fundamental stock market valuation is this far removed from reality.

Let me give you an example of why Warren Buffett hasn’t lost his touch: He has the patience and understanding to know that in the end, stock market fundamentals are more important than short-term fear or momentum. In 1973, Warren Buffett bought shares in the newspaper, The Washington Post. Shortly after his purchase, the stock plummeted 20% and stayed there for not just a few months, but for three years. It was a full three years later, in 1976, before Buffett’s investment had finally made it back to break-even. In fact, Warren Buffett later reported that it took until 1981 before it got to a value that he thought it was worth when he first purchased it.

Warren Buffett is the ultimate example of “buy and hold.” He has said on numerous occasions that he does not purchase for a few months, but rather, for a lifetime. How successful has he become? Today, he is the richest man in the U.S., recently surpassing his good friend Bill Gates’ wealth.

It’s also interesting to understand how his Washington Post investment turned out. At the end of 2007, Warren Buffett’s investment was worth a cool $1.4 billion. Given that he had purchased it for only $11 million in 1973, the stock had increased 127 times the purchase price in the 34 intervening years. All of us could stand to be as stupid as Warren Buffett. For a man of modest means, he has become an incredible success due to his long-term investing philosophy, which has made him the richest man in America. I don’t think the definition of “stupid” applies to Warren Buffett.

I certainly do not want to diminish the losses that we have all incurred; they have been major and excruciating. There’s no way for me argue that I was right and the market was wrong when losses incurred are approximately 50% on all the major indices for 2008. Even though I do believe the market was wrong, I still understand that the losses incurred have been devastating. My intention is only to explain stock market valuation, and that the fear factor encompassing the market today has nothing to do with fundamentals. I have written extensively on the subject of the Federal Reserve’s method for valuing the stock market. This valuation method creates a relationship between anticipated earnings and the yield on the 10-year Treasury.

I recently received my Standard & Poor’s valuation of 2009 earnings, dated November 19, 2008. Their anticipated earnings for 2009 on the S&P 500 is $91.85. The expected P/E ratio is a little over nine. The historic multiple for the S&P 500 is approximately 16. By any standards, these rates are incredibly cheap. If you divide the estimated earnings for 2009 by the aforementioned return on the 10-year Treasury ($91.85/0.303), you get an implied valuation of the S&P 500 of 3,031. As of Thursday’s close of business, the S&P 500 has a valuation of 752. Therefore, to reach fair value, the market would have to go up 300%. I recognize that 2009 earnings are probably too high and the 10-year Treasury rate is probably too low, and assuming that both of those are wrong by a factor of 50%, then fair value on the S&P 500 would be approximately 1,500, or a 100% return from where we are today.

Admittedly, I have never seen market valuations as cheap as they are presently. In fact, I haven’t even read any historic valuations that approach this level of undervaluation. Stocks were definitely cheap during the Great Depression, but at that time, there were no earnings. While some corporations have high profile lack of earnings in 2008, anticipated earnings for 2009 are expected to be at record levels.

Even more stunning than these numbers is how ridiculous valuations have become. Currently, the indicated dividend payout on the S&P 500 is $27.47. Based on Thursday’s close, the dividend yield on the 500 stocks making up the index would be 3.65%. In summary, that means you could purchase the entire index of 500 stocks and have an implied dividend yield greater than a 10-year Treasury and double what money market accounts are paying in interest. This is the first time in over 50 years that the dividend rate exceeded the 10-year bond. I assure you that there have never been valuations that give you this type of future profit opportunity.

As of Thursday, over 100 individual stocks making up the S&P Index of 500 Stocks were selling below $10 per share. These are the 500 largest and most successful corporations in the greatest economy in the world, yet the stocks are selling in the single digits.

My intention in this post is not to explain the Wall Street carnage – there is no explanation for fear. Stock market investing as a profession for 2008 has been thrown out the window. As I have said before, current valuations have nothing to do with fundamental analysis, only fear. I am not trying to make light of the losses that have occurred; I only want to make sure that you are aware of the opportunity going forward. Now is not the time to get out of the market, it is the time to get in. At some point, valuations will overwhelm fear and the potential for gains will be absolutely spectacular in magnitude.

I am often asked how I can be so optimistic in times like these. Believe me, I’m not blind to the problems in the market, but I also understand its potential. If someone offered me the opportunity to go to Las Vegas and gave me the same odds as we have today in the stock market, I would take them. With a risk of going 10% down or 100% up based on current valuations, would you take it? I would in a heartbeat. That’s where we stand today, with enormous potential in front of us once fear has finally lessened.

I did not wake up to find I had become stupid in July – just poorer.

Saturday, November 15, 2008

TARP - Bait and Switch?

From the Desk of Joe Rollins

Some of you may know that when I was a freshman in college, I played on the University of Tennessee’s basketball team. The year was 1967 and coming from rural Tennessee, I had never before had an opportunity to play in front of more than the 400 people that could fit into the cracker-box gym at my high school.

The first significant freshman game that I played as a Tennessee Volunteer was against Vanderbilt University at Adelphia Coliseum. Our game was just prior to the nationally televised varsity game, which started at 3:00 p.m. In all the other junior varsity games I had played, the janitors were still getting the auditorium ready for the varsity game when we were on the court, but this particular game was different.

In 1967, the University of Tennessee was intensely hated by Vanderbilt University. In fact, since the Vols had gone to the Orange Bowl the previous year, it wasn’t unusual for Vanderbilt students to throw oranges from the upper balcony onto the court, causing them to explode with great force. Additionally, Adelphia Coliseum was unique in that the first three rows were actually situated below court level. For this reason, the players’ benches were placed on the ends of the court rather than on the sides.

When we first entered the court at 11:30 a.m. to practice for our noon tip-off, there were 15,000 Vanderbilt fans already seated in the bleachers – double the amount of people than in the two towns in which I grew up combined. We had brought only one ball onto the court to practice that day, and almost immediately, one of my teammates mistakenly dribbled it off the end of the court into the first three rows filled with Vanderbilt fans. They seized the ball and wouldn’t give it back, leaving us all looking stupefied while standing at mid-court without a ball to continue our pre-game warm-up. But that was only the beginning of the shenanigans we would face during that game…

The game became really intense sometime during the second half, making all of us somewhat fatigued from running up and down the court. At one point, we were on the far end of the court from our bench. I went up for a rebound, got hit by a player’s elbow, and knew immediately that I was injured. I reached for my mouth, and my hand was promptly covered in blood, leaving me to wonder if I had any teeth or not. By that time, all of the players had made their way to the other side of the court, leaving me by myself in the middle of the court with blood streaming down my face and onto my uniform. The hit left me dazed and disoriented, until I finally realized that the bench was on the far end of the court and started making my way to it. As I walked towards it with blood soaking my big orange jersey, I was greeted in a most interesting manner from the fans.

Almost in unison, 15,000 people jumped to their feet and gave a roaring standing ovation. I was struck by the good sportsmanship exhibited by the fans at that moment, but once I reached the bench, I realized they weren’t cheering for me but for the player that had elbowed me. Regardless, I must admit that it was the only standing ovation I’ve ever received – directly or indirectly – by 15,000 people.

This memory came flooding back to me when watching the news outlets discuss Treasury Secretary Hank Paulson’s announced changes to the $700 billion financial plan to more consumer assistance rather than bank assistance. It seemed that the entire world responded with a standing disapproval of jeers and sneers.

As I write this post, the stock market is actually about flat for this week. I know it feels worse than that due to the incredible volatility we have witnessed, but even with the first three down days of the week, Thursday’s significant gains left us with flat performance for the week. If you’re like me, then your head is likely spinning from trying to keep up with the extreme volatility in the market as of late.

I decided when I went home on Wednesday night that I would perform as much research as possible regarding the TARP to determine whether this program has worked to our benefit or our detriment. There is an enormous amount of information available on the Internet on the subject, but most of it is extraordinarily biased.

It’s nearly impossible to watch the news without hearing the commentators criticize the TARP, and likewise, it’s nearly impossible to find any pundits who are satisfied with what has taken place thus far. However, it’s important to keep in mind that virtually all of these analysts are biased in some way or another as it pertains to how the money from the TARP should be used. My only bias is that I want the economy to improve. In order to understand how that is possible, I wanted to find out exactly how the TARP will be used to improve the economy.

Treasury Secretary Paulson was on Bloomberg on Wednesday night, and for about two hours he discussed the progress of the financial plan and his goals for the TARP. Paulson is a brilliant man, and the fact that he is donating his time to deal with this political nightmare in Washington shows that he is a true patriot in every respect of the term. It should not be forgotten that two years ago, Henry Paulson was the highest paid executive on Wall Street, making in excess of $50 million in compensation alone (although many have said that he made closer to $1 billion in his final year as chairman of Goldman Sachs). For a man of this stature and intellect to go to Washington and take the grief and incredibly uninformed triviality of Representative Barney Frank and Senator Christopher Dodd reflects that he did it as an act of patriotism. I can honestly think of no other reason for him to do it considering what he’s being put through.

I want to give you some information that isn’t being provided by the media: THE TARP IS WORKING AND THE ECONOMY IS ALREADY GETTING BETTER. You may be wondering how I could make such a statement when it seems that everyone else is so negative on the TARP. My statement isn’t based on public opinion, but rather, on actual facts. The evidence is overwhelming that the TARP is working and those who argue otherwise are clearly uninformed.

The program was designed to purchase troubled assets from the banks. All of us originally wondered how that was going to work given the incredible complexity of purchasing the individual assets from public companies. While it would have benefited the original banks from which the assets were purchased, the effect would only be a benefit of $1 for every $1 of assets purchased. The multiplier effect simply would not have accomplished the goals as quickly as we need them to happen.

It was quickly realized that the original plan needed to be revised to give the greatest bang for the buck. By virtue of purchasing preferred stock in the banks, they were basically able to receive a positive benefit of 10 to one. Since banks can loan about 10 times their equity, rather than $250 billion of money being injected into the economy, they have injected $2.5 trillion with the leveraged effect of the banks.

As of Friday morning, $290 billion of the original money is committed. Approximately $180 billion of that $290 billion has already been funded. The remaining $60 billion on the first appropriation will probably not be used, except in emergency cases. Given that only approximately one-half of the original $350 billion has now been funded, and that is for only three weeks, the positive benefits are already being reflected in the economy.

Four major banks that received some of this money have already announced major mortgage refinancing programs. Bank of America, JP Morgan Chase, CitiBank and Wells Fargo have announced that they will be refinancing mortgages for consumers and taking losses up to $100 billion. These plans are already in motion and helping the public. Under no circumstances could the government have moved this quickly to benefit the consumers. In fact, Fannie Mae and Freddie Mac announced an inept plan to help refinance mortgages, but it has not been agreed upon or implemented. The private sector was the answer to this issue, and the TARP has been a success thus far.

As I have mentioned in prior posts, the three-month Libor has dropped by over 50% in a period of only three weeks. For the first time in months, major investment-grade debt is being issued at reasonable prices. Bonds issued during October have climbed as much as 10% in one month, reflecting the improved environment for debt.

The Federal Reserve, jointly with the Department of Treasury, has issued over $2 trillion in commercial paper instruments for major corporations. The actions by the Federal Reserve have freed-up the commercial debt market to allow for corporations to fund their short-term debt. Interest rates have fallen dramatically on this commercial paper, making the corporations more profitable and therefore, able to provide jobs for their employees. The commercial paper market has freed-up and is now working to the benefit of American corporations, and all of this is as a result of the TARP.

Also on Thursday, The Wall Street Journal printed a forecast by well-known economists, a majority of whom indicated that the U.S. is now in the midst of the worst part of a recession - Economists See No Growth Until 2nd Half of 2009. The overwhelming consensus was that economic growth would probably return by the second half of 2009. Even more interesting is that two-thirds of these economists indicated that the TARP was helping the economy and that the actions by the Department of Treasury had done much to free-up the debt markets for the use of corporations and stabilize the financial markets which were previously frozen.

On Wednesday, Treasury Secretary Paulson announced a major change in the direction of the TARP. There was an enormous negative outcry by the public, the journalists, and of course, the stock market. This is a complicated matter, and I believe that people are reacting before they really look into the positives associated with the changes Paulson is making to the TARP.

There were scathing comments being made in the news regarding Paulson’s proposed changes, and in fact, I saw many references to a supposed “bait and switch.” I have heard an inordinate number of uninformed Congressmen express the same opinion. However, none of us should sell Treasury Secretary Paulson short.

In reviewing the information about the TARP along with the data and analyses, it appears to me that Treasury Secretary Paulson has been absolutely correct in his decisions. Rather than criticize him and his colleagues, they should be praised. They quickly realized that the program in its original form would not be as effective as the one that was ultimately implemented. The one they did implement has worked well thus far, and will work even better once it is fully funded. In Paulson’s words, “I will never apologize for changing a strategy or an approach if the facts change.”

Paulson’s proposal mentioned on Thursday was even more intriguing to me. He indicated that for the second half of the TARP, the money would be used to fund loans for automobile purchases, student loans and credit card receivables. The public, the press and the financial networks missed the entire point: THE FIRST HALF OF THE TARP WAS FOR WALL STREET, AND THE SECOND HALF OF THE TARP IS FOR MAIN STREET!

By furnishing funding for consumer-type receivables, the Treasury will free-up the lack of credit extension to consumers. Who could argue that making more college loans available to kids is not beneficial? Who could argue that the extension of credit on credit cards is not beneficial to consumers who are literally frozen from fright? Certainly, we all need to be able to secure a loan to purchase a vehicle. Both of these actions were brilliantly conceived and planned.

It is highly unlikely that Treasury Secretary Paulson will be working for the government when the second half of the TARP is approved, but I can only hope that whoever is put in charge avoids political influence and does what’s right for the economy, as Paulson has done. Those who argue that Paulson did a “bait and switch” with the U.S. economy are clearly as uninformed as the Congressmen who are also making that assertion.

Many of my clients have expressed outrage regarding the proposed bail-out of the Detroit auto industry. Let’s not forget that the automobile industry in the United States is incredibly successful, but unfortunately, none of the successful companies have plants in Michigan. Secretary Treasurer Paulson and President Bush have acknowledged that the original TARP was not designed for the auto industry and should not be used for such. Having read the bill myself, I concur. If Congress wants to provide assistance to Michigan’s auto industry, then they should do so by separate legislation.

I am a diehard capitalist, but I do recognize that if Detroit’s auto industry is forced into bankruptcy, it would be seriously detrimental to the economy as a whole over the short-term. For the long-term, it would be fine and the economy would adapt, but over the short-term it would be devastating. The answer to this issue is short-term loans until Detroit’s auto industry turns profitable again. Then, they can compete with Toyota, Honda, BMW and Mercedes, and if they’re unable to compete on a fair and equal playing field, then they should cease to exist.

I find it incredibly interesting that the majority party, which will control all departments of government, is pushing an outrageous bill that supports the very unions that helped them get elected. Make no mistake; the reason that GM, Ford and Chrysler cannot compete with the other car companies manufacturing in the United States is because of the work restrictions the unions place upon those companies. Due to outdated work rules, excessive pay and extraordinary benefits, these car companies no longer have any ability to compete with the non-unionized car companies located in the South that don’t carry the legacy costs of the Michigan companies.

Congress now wants to force these companies to be unionized and make them as inefficient and incompetent as the ones in Detroit. I suppose the theory is that since Detroit cannot compete due to the unions’ control of their labor, we will just the force the other non-union companies to be as inefficient and incompetent so Detroit can compete. Obviously, the end result is that we will have overpriced cars that will not be as well-made or as inexpensive as we have today.

Again, the economy is on the mend. You may not hear that on TV or read it in your local paper, but it is definitely happening. If you spend time reviewing the facts, clearly the economy is improving and things are getting better. I urge those who are criticizing Treasury Secretary Paulson to take the time to review the data.

Sources: Bloomberg, The Wall Street Journal

Saturday, November 8, 2008


From the Desk of Joe Rollins

Winter is just around the corner, as evidenced by the chill in the air when I went outside to get my newspaper this Friday morning. I am not a fan of freezing cold weather, so I get a little melancholy when I see the trees turning bare and the plants and flowers going dormant for winter. But, there is something to look forward to…

One of the great joys of living in Atlanta is witnessing our spectacular spring begin. I look forward to the transitional period from winter in early March to the glory of our colorful spring in early April; I’m ever-amazed to see the 250 rose bushes planted at my home change from brown sticks to beautiful blooms and the many azaleas turn from ugly twigs to beautiful flowering hedges. The incredible metamorphosis from winter to spring is nothing short of spectacular.

It may be a stretch to analogize the change in seasons to the economy, but I truly believe we will see some spectacular changes in the financial world over the coming months. As brutal, complex and depressing as the news on the economy is today, a financial metamorphosis will occur in the spring of 2009. I know that skeptics cannot see how we will get from the current state of despair to a stabilization of the economy in only six short months, but I believe that the extraordinary efforts of our government and the coordinated efforts of the governments around the world to solve the economic issues will cause our markets to bloom again.

This past Thursday, there were coordinated worldwide rate cuts, as evidenced first by the Bank of England’s lowering of its key lending rate by 1.5% to a 54-year low of 3%. To understand the magnitude of this rate cut, the last time the rate was this low in England was in 1954. The last time the Bank of England cut rates this drastically was in 1992, but that was from a much higher level. A 33% cut in the key rate in one day was inconceivable before the unimaginable events that have occurred in 2008.

Moreover, the European Central Bank, which controls much of the European economies, cut their key lending rate by one-half of a percentage point to a two-year low of 3.25%. Even though Switzerland is not part of the European Central Bank, it likewise immediately cut its rate in a similar fashion. The 3.25% European Central Bank rate is still too high, but at least they’re moving in the right direction.

Similarly, the Bank of Korea in Seoul cut its interest rates a quarter point this Friday. As extraordinary as it seems, this marks the third rate cut they’ve made within a month, lowering its key lending rate to 4%. All of these cuts were made in an effort to reenergize South Korea’s economy.

The U.S. banking industry now has a Federal funds interest rate of 1%. It will not be long before the Bank of England and the European Central Bank are forced to lower their rates again. There is a worldwide, coordinated effort to stimulate the global economy by lowering interest rates and instituting other economic stimuli.

Unless the lessons being taught in economic textbooks no longer apply, I truly believe a turnaround in the economy will happen. Since the beginning of time, economies have been stimulated by the lowering of interest rates and other economic incentives. I have absolutely no concerns that these global efforts will fail this time. However, we need to realize that a turnaround will not happen in one day, in one week or even in one month; it will more than likely take five or six months. My suggestion is that we all take a deep breath and watch it all unfurl.

One week ago, my blog post centered on the progress being made in the economy, but since that time we have been on the equivalent of a financial rollercoaster ride. Last week, I pointed out that on October 10, 2008, the three-month London InterBank Offered Rate (LIBOR) was at an astonishing 4.82%. While I was writing my post, the rate had fallen to 3.05%, and the rate now stands at 2.23%. This means that in less than 30 days, the rate has fallen in excess of 50%. The credit markets are quickly thawing, and with this rate coming back inline with normal percentages, interbank lending will increase, expand and help to resolve the credit crisis we have been fighting for the last several months.

As I have mentioned on several occasions, I am absolutely stunned at the naïveté of journalists who cover the economy. It is absolutely amazing that they quote history so inaccurately and without basis on such a frequent basis. For instance, I have read many times in the last week that we are facing a recession similar to the 1980 and 1981 U.S. recession. It is astonishing to me that journalists would make those types of comparisons without checking the facts.

Some of you may not recall the recession of 1980 and 1981, but when President Reagan began his term in 1981, he was on a mission to destroy inflation. Annual inflation was running at an unbelievable 14.8% in early 1980 and, at that time, it was possible to buy a risk-free, 100% guaranteed Federal Treasury bond with a rate of 15.9%. There wasn’t much need to risk investing in the stock market when you could get risk-free rates in the double-digits. As an example, on January 1, 1979, the First National Bank of Atlanta (later acquired by Wachovia), offered a one-year CD rate of 19.79%. This was, of course, a gimmick to offer a rate of return that was the same as the year, but it still reflects the type of interest rates being paid at that time.

In the early 1980’s, under then Federal Reserve Chairman Paul Volcker, the Federal Funds Rate was moved up to a staggering 20%. First mortgages on homes were routinely at 17% or higher, and the stock market suffered through three terrible years adjusting to these higher interest rates and high inflation. However, when the stock market broke in 1983, it led to unparalleled U.S. prosperity that lasted all the way up to this year.

Journalists who try to compare the economy of the early 1980’s to our economy today are not comparing apples to apples. We currently have zero inflation in the U.S. compared to the 14% inflation of 28 years ago. Our prime rate of interest is 4% compared to the 20% rate at that time. Home mortgages today have an interest rate of 6% compared to 17% back then. Unemployment today is in the mid 6% range as compared to the 9% range in the early 1980’s. Do journalists even check their facts better before writing such alarming articles? Shouldn’t readership be gained by accurate reporting rather than by sensationalism?

This past week, one of my clients wondered why the banks are hoarding money. My banking sources tell me that almost every bank is covered-up in money, which is due to a combination of the Federal Reserve’s injection of capital in the banks along with the bank’s failure to make new loans. The byproduct of this hoarding of cash will be that interest rates will continue to fall on savings accounts. Therefore, CD’s and money market accounts are doomed to get even lower rates in the coming months than they are fetching today.

I know it feels like it’s been a lifetime, but it has literally been one week and two days since the banks were funded under the Troubled Asset Relief Program (TARP). It is unreasonable to assume that any coordinated effort to loan this money could have occurred in just this one-week period.

I continue to be frustrated by the so-called “experts” regarding their perceived failure of the TARP plan. As of this writing, only $180 billion of the $700 billion appropriated has been expended and that’s happened in only the last 10 days. I do not understand the belief that the injection of capital into the economy isn’t working when the injection has yet to occur. By government standards, this injection of capital is moving at warp speed. However, it just doesn’t seem to be moving fast enough for those on Wall Street.

There is a general consensus developing among Wall Street-types that investors should trade on a daily or even hourly basis. This phenomenon is best illustrated by the hosts of the CNBC show, Fast Money. On it, traders are not concerning themselves with stock market evaluation or traditional methods of valuing stocks. Rather, they are only paying attention to the ups and downs in the market. Every single day, they recommend buys, sells and shorts and, oftentimes, they trade the same stocks within the same 24-hours. This type of trading should only be left to Wall Street professionals. It is irresponsible and not conducive to the average investor, and can be financially catastrophic.

I received a number of phone calls this week regarding the two-day decrease in the market on Wednesday and Thursday after the big run-up on Monday and Tuesday. I got the sense that the investing public felt there was no reason that the market moved up so rapidly over the last several weeks only for it to fall so hard during the two-day 10% downturn that occurred. It goes without saying that I was tremendously disappointed in this downturn; but in all honesty, it was fully explainable and should not create alarm.

Since the market bottom in mid-October of 2008, the market moved up almost 18.5% in only a two-week period (by measuring the S&P 500). That is an extraordinary move by any definition. While the move did occur from a lower base, any move of this magnitude over a short period of time will bring out major sellers.

One of the favorite quotes on Fast Money is that you must, “Sell the Rips.” An 18.5% move in two weeks is clearly a “rip.” The market momentum traders came out in force after the major run-up on Tuesday and sold down the markets 10% in only two days. It’s most important to understand that the net positive move was 8%.

Before the market reaches a bottom, there is a period where bottom-seeking occurs. This is when momentum traders continue to challenge the market to find the bottom, and each time there is a lower low and higher high, that is a positive. It did not surprise me to see the market sell-off; it just surprised me that it happened so quickly. Hopefully, as we move forward towards the end of the year, we will see more of these cycles of lower lows and higher highs until we get back to normal higher ranges.

Jeremy Siegel, Ph.D.’s article, “Why Stocks are Dirt Cheap,” is particularly interesting, and I urge you to read it (click on the article title to read it). Dr. Siegel is a well-known professor of finance at the Wharton School of the University of Pennsylvania, and he is a well-regarded expert on the economy and financial markets. Dr. Siegel was one of the first to forecast the economic disaster of the dot-com era. We now have accreditation by two of the most famous all-time investors – Warren Buffett and Jeremy Siegel – that the relatively low valuations in stock prices today bode well for stock market investors in the future.

As Dr. Siegel points out in his article, “The total losses in the world stock markets have been over $30 trillion over the past year. That is about ten times the entire size of subprime mortgages issued over the past five years, the purported cause of the current crisis. I believe a year from now we will be looking back on this October, kicking ourselves for not having the courage to buy stocks.”

I am not trying to diminish the fact that the current economy is frightful. It is certainly not as bad as it was three weeks ago, but it’s rocky, for sure. However, you invest looking at the future, not the past. Stocks are a forecasting vehicle, and so what happened over the last 12 months is irrelevant history to valuations in the future.

Had it not been for the extraordinary actions of the U.S. government in concert with other governments around the world, I, too, would be concerned about the prospects for our economy. However, governments around the world have taken extraordinary actions and those actions will work. It’s important that we give it time to allow these economic fixes to occur. It is unreasonable to persecute the plan when it hasn’t been fully put in place.

It was announced that the unemployment rate for the month of October moved up to 6.5%. Given the extraordinary volatility and disruption that occurred during October, this is a fairly low rate. Frankly, I am somewhat surprised it wasn’t higher. Furthermore, while it’s insensitive to disregard the devastating effects of unemployment, from a stock market investing standpoint, there are actually benefits.

When companies recognize that their profits are not holding up and prospects are diminished, lay-offs are necessary. Unlike the American automobile industry which cannot lay-off employees due to restrictions put in place by the unions, private businesses can (and do) cut their costs. While this certainly isn’t helpful to the employee that loses his or her job, it materially helps the companies. This is always a positive for stock market investing.

The world is not ending, the economy will improve, and stock prices will be higher. My suggestion is that you give yourself a break from the talking heads and start enjoying the beautiful fall season. When the ground starts to thaw at the end of winter, a beautiful metamorphosis will occur.

Saturday, November 1, 2008

"Double, Double Toil and Trouble; Fire Burn and Cauldron Bubble"

From the Desk of Joe Rollins

Here I sit writing this post on Halloween day, which is coincidentally the last day of what will undoubtedly become a legendary month in the financial world. October is now on-track to end as one of the worst performing months in the history of the financial markets.

It hardly seems likely that the market will close at break-even today, but if it does, the major market indices will have suffered through the 11th worst month in history (as measured by the Dow Jones Industrial Average). This is the worst monthly loss in 21 years (the last devastating loss occurred in October of 1987). I remember that Black Monday as if it were yesterday. In October of 1987, the Dow Industrial Average lost a whopping 22% in one day. This loss was indisputably traumatic, although it didn’t seem as bad back then as the water torture that we endured this past month. It’s remarkable that the Dow wasn’t up two straight days at any time during the month of October, 2008.

As the indexes were dramatically down during the month, the daily news managed to get worse and worse. The average daily range from the high to the low for the entire month of October was 606 points. There were even a few days where the range exceeded 1,000 points in a given day. The Dow was down 16 (inconsecutive) days during the month of October, which is the most down days in any given month since August of 1973.

During 1973, we were dealing with the Middle East oil embargo. Relatively speaking the price of gasoline was high; but worse than that was that gas was not really even available. Due to the restrictions of imported oil out of the Middle East and the gross inefficiency of our government in distributing what oil we did have, there was just very little available at the pump. The country was in a severe economic depression and corporate profits were plunging. Inflation was running at about 12% and interest rates were exceedingly high. All of the negatives that were present in 1973 are not present in 2008, yet the performance this past October was just as bad.

Each of the major market indices – the Dow, the S&P 500, and the NASDAQ Composite – will end the month down approximately 15%. Each will also be down in excess of 30% for 2008. As incredible as it may seem, there have been 10 worse monthly performances for the Dow Jones Industrial Average. Nine of the 10 occurred during the Great Depression, from 1929 through 1940. It’s confusing that the month of October, 2008 would have a performance that would rival the carnage and economic destruction that occurred during the Great Depression.

The purpose of this post is to see if we can make some sense of this performance. Last weekend, I attended an investment conference in New York City just to make sure that great city is still in existence – it is. I can further report that I had a difficult time finding a hotel reservation due to the overbooking of hotels. Moreover, all of the flights were oversold and changing a flight reservation was impossible. It was difficult to walk the streets of Times Square because there were so many tourists on the sidewalks. And forget about making a reservation at one of the famous restaurants – that was nearly impossible! Tickets to many of the Broadway plays were also sold out. So, what’s my point? There are gross inconsistencies between reality and the volatility of the financial markets.

One of the biggest misconceptions of the investing public is that stock prices have something to do with a company’s performance. It’s presumed by many that when a stock price goes down, it affects the company itself. While there’s clearly a correlation between excellent performance and stock valuation, a decrease in a stock price doesn’t mean that the company is performing poorly. During this extremely volatile month, even some of the most profitable companies traded with wild, unreasonable ranges.

On Thursday, Exxon Mobil reported the highest corporate profits ever recorded by a U.S. corporation. At the beginning of October, 2008, Exxon Mobil’s stock price was $78.58. Twice during the month the stock dipped to around $56 before closing the month at approximately $75. This is just one example of how the most profitable corporation in American industrial history could trade in a market range of over 30% for one month alone.

The terrible performances of the indices during the month of October belie the actual progress that’s been made. I suppose Wall Street traders trade first and think second. The GDP was announced yesterday with a minor loss of 0.3%, which isn’t nearly as bad as the so-called experts expected. In fact, a loss this small could easily be argued to be an incredibly small rounding error in an economy that will top $14 trillion in 2008. The critics in the financial news argue that the amount could not be correct since things seem so much worse. We will know soon enough whether that number is right or wrong, but regardless, with the Fed’s actions we’re clearly closer to a turnaround than we were only a short 30 days ago.

While the U.S. indices were terrible during October, the indexes overseas were much worse. Many of the Emerging Market currencies came totally unglued during the month. It is always astonishing to me to hear the rest of the world criticize the United States for virtually every act, but when things become difficult for the rest of the world, they want to be in U.S. currency. Only the Japanese yen and the U.S. dollar receive this confidence from the world; all other currencies, including the Euro and the U.K.’s pound sterling, suffered major declines during the month. In fact, the currencies in parts of Asia and South America almost collapsed. If the U.S. Federal Reserve System hadn’t entered into currency exchange arrangements with Brazil, Mexico, South Korea and Singapore, those countries’ currencies would likely have failed. It’s a good thing the rest of the world hates us – except when they need us.

The freezing of the money funds enjoyed a spring thaw towards the end of the month. It’s true that banks decided not to lend each other money, and therefore, interbank credit seized up. On October 10, 2008, the very important three-month LIBOR interbank loan rate was an astonishing 4.82%. At this rate, virtually no bank would have been willing to borrow from another for overnight activities. Due to the intervention of the U.S. Federal Reserve and the British and European commissions, interbank lending was guaranteed. Only two and a half weeks later, this very important rate has fallen to 3.05% today. While this rate continues to be too high, it is a significant indication that bank lending is returning to normal.

It was also noted that the ability of major corporations to borrow money in normal bond refinancing had ceased. On Thursday, MGM Mirage was able to borrow $750 million in high-yield junk bonds. When speculative companies can make major bond sales, it tells you that investors’ appetite for risk has returned.

Commercial paper rose by $100 billion this past week. There is currently $1.5 trillion available in commercial paper. This is the first time in seven weeks that the amount of commercial paper has actually expanded.

Today, Ford Motor Company announced that they’re calling back 1,000 workers in order to build enough Ford 150 trucks to meet demand. For all we have heard this month regarding the incredible poor financial performance of the automobile industry, seemingly there seems to be ongoing improvement.

I’m not implying that the economy won’t be bad for a few quarters. I expect that we will see negative GDP growth in the 4th quarter of 2008 and in the 1st quarter of 2009. However, as I have written many times before, the cavalry has arrived.

All last week, I kept hearing in the financial press that whatever the government was doing to ease credit and push money into the economy just wasn’t working! I really believe a lot of the negative press being provided is from professional investors trying to influence the direction of the markets. The truth of the matter is that the major funding of the banks in the United States did not occur until Wednesday, October 29th, and the funding of the British and European banks has yet to occur. It is really hard for the actions of the Treasury to improve liquidity until something actually occurs.

Worldwide equity injections that are approximating $2 trillion have now been approved. Never in the history of U.S. and world finance has so much money been pumped into an economy over a short period of time. For those who are preaching the sermon of an upcoming Great Depression II, they will need to postpone the benediction. The U.S. economy will rebound quickly as this money makes it through the system in the coming six months.

I know these are difficult concepts for people to understand since no one has lived through it before. However, economic textbooks have long addressed these issues and the repercussions. Given the incredible influx of liquidity, this money will work its way through the system and will create jobs, construction and a better economy by spring.

As we end the earnings season for the third quarter of 2008, there was very little publicity about the earnings actually being quite good. Aside from the financial companies, the vast majority of the S&P 500 major companies beat their projected earnings. While earnings will undoubtedly come down, they certainly do not justify the incredible devaluation that has occurred in the equity markets.

It was interesting that the markets sold off last week when the U.S. consumer confidence was reported at one of the lowest all-time readings. These indexes reported to be a major destabilizing influence in the U.S. economy as well as around the world. However, I doubt few actually read the report and understood its significance.

A major component of the negative consumer confidence relates to the anticipated belief by consumers of future inflation. During the month of September, consumer outlook on future inflation was at 6.9%. I’m not implying that consumers are unaware of what’s going on, I just don’t think they’re very timely. With the price of energy falling close to 50% in the last 90 days and commodities literally falling off a cliff, you may rest assured that inflation for the next 12 months will be non-existent.

I simply wanted to provide you with a reality check regarding the ridiculous volatility and hyperbole of the financial press. While things are certainly not fabulous, they are clearly not desperate. The market should move up between now and the end of the year, but it will be volatile. Since my last post, "Let's Talk Turkey", the market has moved up, and hopefully volatility will be reduced, reality will be reintroduced and positive financial wealth will once again resume in the coming months.