 |
|
|
|
|
|
|
|
|
|
||||||||||||||||
 |
 |
 |
|||||||||||||||||||||||
|
|
|||||||||||||||||||||||||
 |
 |
||||||||||||||||||||||||
|
|||||||||||||||||||||||||
Prevaricators' MarketDraughn PartnersCliff W. DraughnApril 14, 2009
|
||||||||||
15 Lake Street, Suite 100 Savannah, Georgia 31411 912-598-4032
Second Quarter 2009:
Prevaricators’ Market
“I sincerely believe … that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale.” Thomas Jefferson
“We’re in a government dependent financial system; I never thought I’d see the day.” Paul Volcker
The United States Department of Treasury has become the defacto Private Equity Firm of our financial markets. In less than three months, the Obama Administration has moved our regulators from a role of referee to that of player. No longer viewing their role as supervisory, our Departments of Treasury and Federal Reserve have taken it upon themselves to re-engineer the financial system as we have known it for the past 75 years. In the process, they are risking huge sums of taxpayer dollars and becoming “investors” in distressed mortgage-backed securities in an attempt to recreate the shadow banking system and open the door to inflation. Two critical questions to ask:
Is it Necessary?
The short answer, in my opinion, is yes. Whenever a country experiences the types of credit freezes and market meltdowns that our financial system has been through in the trailing 12 months, it is appropriate for the government to assume the role of lender of last resort. The reasons are complicated, but it is worth understanding how we got into the mess we are in.
The famous economist Herb Stein once remarked, “If something cannot go on forever, then it will stop.” When one compares the prior bubbles of housing, stocks, etc., there is always one common denominator at the base of all bubbles: excess leverage. The massive explosion of private sector debt as a percentage of GDP over the last ten years was unprecedented in our economic history. Greenspan presided over the formation of not one but two of the largest bubbles ever in the history of the US economy: tech stocks in the late ’ 90s and real estate from 2001 to 2007. Greenspan did so by promoting policies of deregulating the securities markets and allowing the banking sector’s leverage ratios to skyrocket from historical levels of 10 to 1 to the over-the-top insane 30 to 1 (or more). The Maestro was in reality more like a Hans Christian Anderson emperor without clothes – not a pretty sight.
With the expansion of more and more credit since 2001, the US consumer went on a borrowing spree, which was good for the economy but in reality a cancer that grew in the financial system. As Herb Stein accurately predicted, one day the lending stopped. Over the past year the US consumer hit the wall harder than Dale Earnhardt Jr. on turn three at Daytona. We have reached the end of the private sector’s debt supercycle. I explained in detail the consumer’s reasons for the sudden reversal from spend/consume to save/avoid in my first quarter letter. As a brief summary, the urgency of consumers to repair their balance sheets from the double whammy of falling house prices and falling equity markets has abated all but the most needed of expenditures in American households. And as a consequence of this newfound thrift, you are witnessing for the first time in years an upward surge in the US savings rate. On the surface one would think that this is a good thing. However, economies are much like a Rubik’s cube in that every time you make a change to one side of the cube it invariably changes the look of the other sides. The paradox we face is that one person’s spending is another person’s income. If we all stop spending at the same time and you no longer buy my “stuff,” then I have no job from which I can produce income and savings. No jobs and no income leads to a depression – no ifs, ands or buts.
Therefore, if the private sector is now deleveraging and doing it on a much faster scale than most thought possible, then who is left to spend/consume in order to keep the economy going? Who will give some form of stability to the job market in order to avoid a depression? Answer: the government, with my and your tax dollar. In my opinion, if the government does not take an active role and replace some of the consumer spending, then our story ends in insolvency. The traditional forms of monetary policy are ineffective during periods of insolvency, and therefore we now require a higher level of intervention. For those of you who object to putting the taxpayer “at risk,” I would beg to differ with you. Although I despise that is was the government’s lack of monetary constraint and lax regulatory enforcement that put us in this mess, we will not soon get out without the government’s participation.
What I can and will debate are the tactics being employed on how the government implements all the spending and bailouts. Which brings us to the second question: will the current programs work?
Bureaucrats Gone Wild!
“Americans eventually get it right but not until they have exhausted all possible alternatives.” Winston Churchill
Will the combination of existing intervention programs work? In my opinion the short answer is: not yet. The current programs are ill-advised because they attempt to support and reward those that have failed, thereby protecting the bond holders of failing institutions at the expense of taxpayers. The TARP ($800 billion), TALF ($1 trillion), stimulus package ($789 billion), and the PPIP ($1 trillion) are all targeted towards a banking system that broadly participated in the mortgage-backed securitization markets. By design, the TARP, TALF, and PPIP programs are punishing those banks that remained solvent and avoided the greedy securitization/CDS practices, and are rewarding those banks that chose to be involved in risky lending and investment practices and that overleveraged their balance sheets. What’s more infuriating is that the Treasury and Federal Reserve are implementing these programs for spending/investing with monies not even approved by Congress. They are doing so by abusing the FDIC’s balance sheet and potentially putting at risk the solvency of the FDIC, and could endanger the FDIC’s ability to protect ordinary depositors. I do not think the average American realizes that the government’s actions are socializing losses while at the same letting the fat cats get away with the profits. By the way, why is Obama allowed to fire Wagoner at GM and yet Ken Lewis retains his job at Bank of America?
“US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JP Morgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn plan to revive the financial system. And why not? They can put up a few percent of their own money, and swap each other’s toxic assets financed by a bewildered public suddenly bearing more than 90% of the downside risk. The ‘investors’ in this happy ‘public-private’ partnership keep half the upside while ordinary Americans take the downside off their hands. Some partnership.” John Hussman
What is doubly maddening is our government’s attempt to give massive amounts of tax monies to “troubled” homeowners while ignoring responsible homeowners who are paying their mortgages. In my first quarter letter I commented, “I fear that the US Treasury, the Federal Reserve, and the White House may decide who wins and who loses in the capital markets over the next three to five years.” There is no question in my mind that the politics of Washington will spill over into the realms of Geithner, Bernanke, and Blair. The government is now deciding whether to protect the bond holders of these bank institutions, or the depositors. Leveraging the FDIC’s balance sheet, in my opinion, is a sure recipe for disaster and will create an even bigger hardship for smaller, regional banks that pay the FDIC premiums. We have today in the US more than 50,000 banks, but we have discovered through the actions of the Federal Reserve, Treasury, and FDIC that only a fraction of those really matter, with Lord and Ruler Goldman Sachs at the top of the heap. Congress was in an uproar over the bonus payments to AIG executives and yet no one questioned the billions paid to JP Morgan, Citi, and Goldman on the counterparty claims for credit default swaps. Credit default swaps act as insurance contracts that investors can buy to insure against loss. In this case the insurance company was/is AIG and the policy holders were/are institutions such as Goldman, Citigroup, Morgan Stanley, and JP Morgan. Now, if you or I buy insurance from a company that goes bankrupt, then what happens when we have a claim? We either (a) get paid zero for not selecting a credible insurance company or (b) will get paid cents on the dollar as part of a bankruptcy settlement or state-sponsored government insurance. In the case of AIG, the tax dollars that went to them were used to pay the claims of Goldman, Citigroup, et al. at full value! No discount, no negotiated rate, no bankruptcy-type settlement; AIG simply took our tax dollars and funneled them to the counterparties. The bonuses to executives of AIG were a fraction of the credit default swap settlements. Sorry, but you place a bet in the financial markets and lose, you’re supposed to take the loss, NOT be handed a get out of jail free card from the federal government. Carol Loomis (long-time friend of Warren Buffet) recently published an article reporting that the notional value of AIG’s derivatives exposure fell from $2.7 trillion to $1.6 trillion during 2008. According to Loomis and her report on CEO Liddy’s testimony to Congress, the initial unwinds and sells were the easiest and most liquid; the remaining derivative book at AIG may take another four years to unwind. The executive compensation regalia was a smoke screen, and the American people have no clue as to what just hit them from AIG.
Within the next two years our government will eventually inflate us out of the economic recession because, in my opinion, they will be relentless in throwing more and more money at the perceived problems of the banking community. Obama and his administration are, as we say in Texas Hold ’Em, “all in.” However, the current activity of the Fed and Treasury are predicated upon the belief that the existing banking system is fine. The Fed and Treasury will continue “tinkering” with the system until something happens and they are forced to address the real problem of debt restructuring. I predict that before the end of the year we will see the “nationalization” or “programmed bankruptcy” of one of the major US banks. The Fed and FDIC will finally get it right and wipe out the stockholders of insolvent institutions, force the bond holders to swap their debt for equity at cents on the dollar, recapitalize the banks, throw out the failed management and boards, and then move forward. As Rahm Emmanuel said, never let a good crisis go to waste; and this administration will be sorely tempted not to experiment with at least one government-controlled banking entity. However long the government’s intervention efforts persist, at the end of the day you can expect inflation. Obama’s motto is inflate or die; let’s hope we inflate.
I almost hesitate writing about the Federal Reserve and Treasury’s actions, knowing the landscape will probably change tomorrow. The amount of discussion, Congressional hearings, programs, and legislation being enacted on almost a daily basis is mind-boggling. However, it is my responsibility to bring to my clients a sense of reason with regard to the economic climate we live in and to convey how to invest in this market.
In our first-quarter newsletter I highlighted what I thought were three themes to focus on for 2009:
President Obama – On the Job Training
“You cannot multiply wealth by dividing it.” Dr. Adrian Rogers
I opined in my January comments that “I caution anyone to place significant bets that Obama’s “stimulus” plan will reverse the current recession tide any time soon.” I still stand by that statement. Since taking his oath, he has done his best to restore people’s confidence by his numerous speeches and media appearances. I congratulate him for his terrific communication skills and for selecting my Tarheels to win the NCAA men’s basketball championship. However, his stimulus package was subcontracted to Pelosi and Company, which did a fine job of substituting their own self-interest in the face of the President’s intent. The debate that ensued during the passage revealed that if Obama is not going to work with the Republicans then he had better make sure to control his own party. Future legislation will only get more difficult to pass should the Democrats continue to mess around with the President by promoting pro-union, protectionist trade, beating up the bankers, and stuffing appropriations bills with pork. I referred to this in my prior letter as “drifting.” Obama cannot drift and allow Congress to control him; rather, he has to lead.
The verdict of success/failure is still out, as we have yet to make it through the first 100 days. As a plus, Obama’s approval rating, released today, has him at 64% in a Gallup Poll taken in March. I view that as a positive. I am hopeful for the best but confess that I fear the only hope we have of getting out of this mess is growth of the economy. Growth requires access to capital and incentives to take risk by the small businessmen and women of this country. Growth will not come from massive infrastructure spending and transfer payments; simply witness Japan for the last 19 years. I fear that the policies being espoused by the current administration are anti-growth and are leveraging society as a whole without admitting that the existing system is broken and in need of an overhaul. The only statement in the budget preamble I agree with is: “Part of what ails our economy is a profound disconnect between our leaders in Washington and the rest of the nation.” Prophetic statement, Mr. President.
If you want to read something scary, then read the introductory pages 5-15 of the President’s budget. You can click here:
http://www.whitehouse.gov/omb/budget/
Aging and Saving – The Face of the American Consumer
Jobs. At last count we are seeing an 8.5% unemployment rate, which is the highest in a quarter of a century. Our nation’s jobless have surpassed 13 million, and that number does not include laid-off workers who have given up looking for new jobs or have settled for part-time work because they cannot do any better. I predict unemployment to exceed 10% and probably go to 12% before the end of the current financial crisis.
Of the Americans lucky enough to maintain their jobs and incomes, the trend of increased saving and less consumption continues. As we discussed earlier, for everyone to begin cutting back and saving at the same time creates a tough economic environment. Therefore, I feel this recession is going to last longer than the consensus view because of what I believe is a directional shift of the average consumer. As an example of the retrenching consumer, consider the survey from AARP in December with this list of consumer changes:
The business environment is not improving any time soon.
A Market of Hope
This market to me has become the “Cowardly Lion” market: any investor or institution with cash is too scared to do anything. Bear markets are trickier than bull markets. Every time we see a short-term upward movement in stock prices, then the inevitable talking heads jawbone that we have seen the lows and all is finally well again. Anytime there is a rally, the news message is, hurry in and don’t miss out on the next bull market.
From the low in the S&P 500 on March 9, 2009 of 676.53 to the high on April 3rd of 842.5 we witnessed the strongest 4-week rally in the S&P since 1933. The total increase was 24% – truly remarkable but not enough to get us back to positive territory for 2009. The catalyst for the move could have been the three speeches the week of March 9, by the CEOs of Citigroup on Monday, JP Morgan Chase on Tuesday, and Bank of America on Wednesday. Each CEO stated with confidence they would make money during the first quarter of 2009. Say what? You have billions of toxic crap on your balance sheet and you can state with confidence your earnings will be positive? Bernie Ebbers is serving time for those types of misleading statements. Or, were they misleading at all? I am convinced the three CEOs, along with other insiders, knew something we did not: FASB’s pending announcement the following Monday to relax the FAS-157 “mark-to-market” accounting rule. By changing the rules of mark-to-market accounting FASB is (a) permitting the scandalous banking community to kick the can again and insert their wishful thinking versus true market prices for the securities they hold and (b) revealing a complete cave-in to political pressure. I particularly enjoyed FASB’s timing of their announcement on March 16th, which allowed for approval of the measure under their standards for discussion by March 31st … just in time for first-quarter earnings reports. The irony here is that allowing banks to play with valuations and ignore mark-to-market accounting means the banks are going to be less inclined to accept bids for their toxic assets under PPIP and TALF. Therefore, Bernanke’s basic premise for the TALF and PPIP programs of wanting to get toxic assets off the troubled banks’ balance sheets just hit a roadblock, in that no bank is going to be interested in selling an asset at a loss when they can simply price it as they please. However, for those drinking the Fed’s Kool-Aid, I am sure you are hopeful the programs will work.
The current upward move in stocks is, in my opinion, a mini-bull run that will remain trapped in the longer-term bear market. The last bear market that was brought about by asset deflation and deleveraging of balance sheets was 1929 to 1939, and the market eventually declined 89%. During that timeframe, the market experienced six rallies with 20%-plus gains that renewed confidence and fueled optimism. We have gone back and not only looked at the Great Depression but also the events and aftermaths of other bubbles: the Dutch Tulip Bubble of 1636, the South Sea Bubble in 1720, the US Real Estate Bubble in the late 1800’s, the Stock Market Bubbles of 1969 and 1999, and now the Real Estate Bubble of 2008. All of these bubbles and their eventual poppings began with excessive leverage and ended with severe asset declines and bankruptcies. We are not to the end yet.
During my investment life I have experienced the recent failures of Lehman, Bear, Merrill, Wachovia, and Wamu; but I also experienced similar events with Kidder Peabody, Bank of New England, Manufacturers Hanover, First Executive Corp, MCorp, Drexel Burnham and, at the time of default, the largest, Savings and Loan Financial Corp of America. I am always leery of the statement “it’s different this time,” but in dealing with today’s market there is one thing definitely different this time: the amount of government intervention and spending of taxpayer money to “rescue” America.
The question I am asking myself is, can democracy save itself from itself? This weekend I attended a tribute dinner to Richard Russell. After the numerous accolades from his admiration society were finished, Richard took the stage. A question that struck me as the highlight of the evening was when someone asked him, if he were Czar, King, and Master of the Universe who controlled the Fed, Treasury, Congress and the Presidency, what would he do to fix today’s economy? The wise sage looked up and said, “Nothing.” And in his wisdom he was telling everyone to let capitalism be capitalism and not some bastardized experiment of the government. Yes, our pain would be great and yes it would be harsh. But in looking back at the Great Depression, it was only after bankruptcies were declared, debts extinguished, and risk repriced that we were able to move and grow once again. The actions of the government in the aftermath of the stock market crash of 1929 in reality made it more severe and prolonged the agony. History never repeats, but it does occasionally rhyme.
My point here is that with the chaos and the ever-changing rules of engagement, I will continue to play defense in this market. At the end of the day: It’s the Earnings, Stupid! Without consumption of products, without confidence in the banking system, without jobs being created, without significantly lower valuations and a willingness to take risk, then in my opinion we are still in the grasp of the bear market cycle. I opine there is more opportunity to invest in the credit markets than the equity markets, and therefore we continue to focus on the bond market as our number-one hunting ground.
Summary
In addition to attending Richard Russell’s dinner, I also attended John Mauldin’s excellent investor conference that he holds each year: a ton of smart people totally focused on the markets, all with varying opinions. If you have the opportunity to attend next year, then you should go. At the end of each day’s presentations all the speakers regathered for a panel discussion, and the one question that got everyone’s attention was, “What keeps you awake at night?” Without naming names and providing an-depth analysis, I thought a quick summary of the answers would be of interest:
If you made it to here without Prozac then you are an eternal optimist, like me. I am optimistic we will eventually work our way out of the current economic malaise and that there is another bull market on the distant horizon. Despite the government’s efforts, there is an entrepreneurial, creative, and driven spirit in this country that will not be denied. I know it is easy to say this generation of young people will never make it (our grandparents said the same thing about us), but somehow they will. The richest man in the world, Bill Gates, created a whole new industry on the heels of the 1972-1981 recession. There will be new industries, technologies, and services, and today we have no idea what they are or where they will originate. China and India are fast coming of age as competitors, but for now and the immediate future the US is still the gorilla. Let us hope our government will cease with the monkey business that’s driving the investment world ape.
My parting suggestion: a moratorium on all congressional hearings, Fed proposals, Treasury actions, and Obama appearances on the television screen for 30 days – I need a break.
Name Change: Draughn Partners to become EXCELSIA Investment Advisors
We have been fortunate to grow our business during these difficult times, and for that I am thankful to our loyal clients who remain and believe in our ability to manage money. As part of our efforts to continue the growth phase, we are rebranding the company and changing our name from Draughn Partners to EXCELSIA Investment Advisors. I assure you there has been no capital structure change nor have we been bought by anyone. The name change is a result of a market survey taken back in November of how we were perceived in the marketplace. We are in the process of implementing the change and hope to “roll out” our new look by mid-April. For the next six months, if you do type in “Draughn Partners,” know that it will automatically link to EXCELSIA. If you want a preview of our new look, type in www.excelsia.com and watch the video.
Cliff W. Draughn, Managing Principal
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Draughn Partners. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.
Please remember to contact Draughn Partners if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Please also advise us if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.
(c) Draughn Partners |
| Contact Us |
