Friday, January 25, 2008

Bill Gates' Stupid New Charity Idea

Bill Gates made big news this week with his charity pitch at the Davos World Economic Summit. Called 'kinder capitalism,' Bill wants his corporate friends to assign their best minds to charity projects, and to donate some of their net income, as well.

Give me a break!

There's Bill, looking appropriately nerdy, sitting with Michael Dell and.....Bono!

Now we get it!

Here's the five-year price chart for Bill's company, Microsoft, Dell, and the S&P500 Index.

Notice how neither Bill nor Michael have managed to do for their shareholders in the past five years what a cheap, passive S&P500 Index fund could have done?

Dell ends up flat- his shareholders basically finished dead even over five years. Bill returned 1/3 less to his shareholders than the index- and most of that occurred in just the past six months.

Gates has it all wrong. But, hey, if it gets you face time with a real rock star, who cares how you treat your shareholders? And looking at Gates and Dell, you can just see these guys as the nerdy college-age kids they were, busily building businesses in their dorm room or buying MS-DOS on the cheap from the original owner/developer, rather than develop normal social networks.

According to the plan, companies assign bright personnel to figure out what they can do to alleviate some global poverty ill, and levy a mandatory tax on their shareholders out of net income with a donation.

Bono had a great big, silly grin while telling CNBC viewers,

'You don't have to donate anything. You buy these guys' products, and make them donate.'

Well, uh, not quite Bono. Make that,

'..and make their shareholders donate, whether they want to, or not.'

Here's another idea, Bill. How's about you and Michael Dell learn how to outperform the market again. Then, ask shareholders if they will vote, individually, for their shares, to donate a portion of any dividend you pay, out of equity gains above those of the S&P, to the charity you choose?

That way, you have an incentive to actually do your job. And Mike, too, for that matter.

Honestly, if this wasn't so pathetic, it'd be funny. Gates makes his billions, and people still don't like him.

So he establishes a foundation, perhaps in hopes that this will make people like him. Then he suddenly gets religion, like Ebenezer Scrooge, and declares that now he'll be a kind and nice guy.

Perhaps Gates has it backwards. Allowing for his last five years of drought in performing for his shareholders, Gates at least once was good at making money from software. What if Bill concentrated on using his unique talents for that, and using some of the excess profits to do good.

Anyone can give (someone else's) money away. Or exhort others to do so. It seems to me that corporations should focus on enriching their shareholders, preferably in a consistently superior manner, and let the shareholders decide whether or not to support charities.

Gates' idea would sound a lot better had he discovered it when he was leading Microsoft to consistently superior total returns. Now, he just looks desperate to get attention and hang with the Davos "in" crowd.

Not content to merely underperform for his shareholders, now he wants to take their profits, too, so he can be popular with the international set.

Meg Whitman's Decade At eBay

eBay's CEO Meg Whitman announced her retirement this week, effective later in the year.
How good a job did she do in her decade of leadership at the online auction house?
From the nearby Yahoo-sourced chart stretching back to 1999, pretty well, it would appear.
The slope of the blue curve depicting eBay's stock price easily has outstripped the S&P500. More than that, however, it also handily outperformed those of Dell, Microsoft and Yahoo.
Yes, Meg Whitman did a very capable job creating superior amounts of shareholder wealth over more than half of her tenure.
But this chart shows something else, too. I think it provides a snapshot of the reality of Schumpeterian dynamics.
First, look how eBay flattened almost exactly when Google took off as a public offering. eBay has not outperformed the market for the past three years. Google has taken off like a rocket.
But look more closely down near the S&P500's price curve. Yahoo had a brief, sharp rise in value creation from 1999-2001, then crumpled. It ended the time period about even with the S&P.
Microsoft and Dell actually fell below the S&P500, since 1999, in terms of stock price growth.
To me, this picture documents the natural comings and goings of technology companies. Microsoft was a giant in an earlier era, but declined as other computer-related and -based product categories became more important.
Dell led box manufacturing and distribution for a time. But it, too, fell behind as the source of technology-based shareholder value creation.
Instead, the source moved onto the web, driving Yahoo, the internet's first general-purpose information provider.
But, as I've written in many posts (see label 'Yahoo') concerning the firm, it was a mile wide and an inch deep, with no driving central objective.
While eBay was not a direct competitor, per se, the auction site tapped into a new, advanced form of value creation while Yahoo's became less unique.
Finally, as eBay's business model began to reach saturation, Google's search engine model ramped up and, through judicious inclusion of online advertising, shot up above all the one-time technology stars from a shareholder value creation perspective.
Seen in this tableaux, it's much easier to understand why I don't ever expect the older technology names to regain their prior abilities to consistently outperform the market.
Even Meg Whitman, capable as she was at eBay, only managed that feat for a few years.
Of course, the most interesting question isn't what Whitman's replacement will do for eBay- he's actually been dealt a fairly weak hand.
No, it's what and who might wrest technological sizzle, excitement and shareholder value creation capability from the search-ad-tied in online product space now dominated by Google.

Thursday, January 24, 2008

More on Bond Insurers, Insurance, and Swaps

Back on the last day of 2007, I wrote this post on AMBAC and MBIA. In that post, I concluded with,

"But mortgage insurance is far riskier. Compared to a municipality's ability to tax and raise fees, a mortgage is typically repaid from the borrower's far more risky and volatile personal income stream.

One has to wonder at the wisdom of AMBAC and MBIA jumping into the mushrooming world of mortgage-backed instrument guarantees. I'd be willing to bet that, compared with the sleepier, slower-growing world of municipal obligations, the burgeoning volumes of CDOs with mortgages underpinning them became too tempting for the two municipal bond insurance firms.

It probably seemed relatively simple to them to hire some experienced mortgage bond analysts, leverage their existing operations into the new sector, and watch the new income invigorate their stock prices.

Instead, both AMBAC and MBIA are ending the year down more than 60%.

It seems that financial excess wasn't limited to just the borrowers and lenders. Even the insurers got into the act. No wonder Warren Buffett has chosen this opportune time to enter the municipal bond insurance business- while the two major competitors are reeling from losses in unrelated market segments."

Now, after the weekend's downgrading of the fixed income insurers by rating agencies, and the Monday US financial markets holiday, investors panicked.

I recall when I first learned the mechanics of fixed-variable rate interest-bearing loan swaps. If I'm not mistaken, it was early in my tenure at Chase Manhattan Bank. Those were simple enough. One party wanted a floating-rate loan, and another wanted fixed. Obviously, they differed on outlook on the rate environment going forward. Essentially, each paid the other party's interest obligation each period.

Even here, it occurred to me that there were conditions under which a party might find their counterparty, who had opted for the variable rate payment, unable to make payments if rates rose too high.

When I learned about credit derivative swaps, I recall being very sceptical that these were reliable. The Wall Street Journal featured an article detailing the mechanics of such swaps last Friday in an article entitled, "Default Fears Unnerve Markets."

The piece describes credit swaps as,

"At the center of these concerns is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn't like life insurance or homeowners' insurance, which states regulate closely. It consists of financial contracts called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast: about $45 trillion, a number comparable to all of the deposits in banks around the world.

Not everyone who buys one of these contracts has bonds to insure; because the value of an insurance contract rises or falls with perceptions of risk, some players buy them just to speculate. In much the way gamblers make side bets on football games, a financial institution, hedge fund or other player can make unlimited bets on whether corporate loans or mortgage-backed securities will either strengthen or go sour.

If they default, everyone is supposed to settle up with each other, the way gamblers settle up with their bookies after a game. Even if there isn't a default, if the market value of the debt changes, parties in a swap may be required to make large payments to each other.

This being Wall Street, the investors often use heavy borrowing to magnify their wagers."

This is clear enough, but poses the risk I immediately noticed- counterparty risk. In the world of financial instrument trading, there's a bright line dividing exchanges and over-the-counter, or 'bespoke' instruments. The latter require members to have collateral and/or credit sufficient to settle their outstanding obligations. This is policed by the exchange, resulting in low counterparty risk. When Wall Street brokers trade with each other, for their customers, everyone feels comfortable that the brokers are able to settle their trades. This works backward, in that the brokers require similar asset levels from their customers, because the former aren't in the business of taking that type of risk, although they will lend on margin, at rapacious rates.

In the over-the-counter market, of which credit swaps are one, there's no central location or crossing point for the instruments. In olden days, before computer screens, it was also called a 'telephone' market. POSIT and other "crossing networks" are modern-day equivalents. Bids and quotes are posted, but it's just a very efficient way of presenting, in one 'place,' a myriad of independent bids and asks on various custom instruments. As such, there's no guarantee of counterparty viability.

So, as long as nobody actually defaults, the game seems reasonably benign. Prices vary with risk assessments of the borrowers, but no contractual payoffs are involved, which might tax an issuer of a swap.

However, as the summer's credit crunch continued into the fall, according to the Journal piece,

"With many bond values falling and defaults rising, especially in the mortgage arena, some institutions involved in these trades are weakened. This has investors and regulators worried that, through such swaps, some market players could spread their own problems to the wider financial system.

"You are essentially counting on the reliability of strangers" to pay up on their contracts, notes Warren Buffett, the Omaha billionaire. In some cases, he says, market players can't determine whether their trading partners have the ability to pay in times of severe market stress.

The issue is raising broader concern among regulators and investors over what Wall Street calls "counterparty risk," the danger that one party in a trade can't pay its losses. A recent survey by Greenwich Associates found that 26% of investors were worried about counterparty risk, nearly double those who said so in a poll last March."

This side-bet casino ran with minimal supervision. But, in truth, even better regulation couldn't have mitigated the worries when a few thinly-capitalized insurance firms whose main business had been stable, solid municipal bond insurance, levered their balance sheets with these bets.

As I wrote in my prior linked post, it's a vastly different world to insure payment of mortgages from insuring a taxing authority's ability to repay its bonds.

That credit swap buyers ignored the difference, and the lack of balance sheet muscle of AMBAC, MBIA and ACA to actually absorb the full extent of their obligations was simply stupid business. Legal, but unwise.

And, of course, just like "portfolio insurance" in 1987, what seems fine in the abstract, isolated case of loss, works far differently when everyone defaults at once. Or seems to. The fallacy of composition comes into play, guarantors/counterparties, a/k/a the insurers, become overstretched, and the whole mess descends into default.

As the Journal noted, it's much more complex than an exchange,

"Sometimes it isn't clear who owes what. A tiny hedge fund sold a swap to a unit of Wachovia Corp. this spring and faced repeated demands for more collateral as the subprime market slid. The fund, CDO Plus Master Fund Ltd., says in a suit in New York federal court that it insured a $10 million security, but Wachovia eventually demanded more than $10 million of collateral -- even as the security's value dwindled. Wachovia called the suit "without merit."

Last fall, with the market for low-end subprime mortgages collapsing, investors worried about firms with exposure to them. Analysts zeroed in on ACA and other bond insurers that had assumed the risk on many such securities.

ACA appeared to be in the most precarious position, because its capital of $425 million seemed minuscule compared with the $69 billion of credit protection it had provided on corporate and mortgage debt. ACA had added about $20 billion of that exposure between April and September."

Now the state of New York is reputedly organizing some sort of private capital rescue of the swaps/bonds insurers. Even Jack Welch noted on CNBC the other morning that Warren Buffett's entry into the basic muni insurance business demonstrates it is a private, capital market solution, not a government bailout.

And Rick Santelli noted earlier this week that the one thing that will totally unglue financial markets is if those swaps insurers are allowed to fail.

All true. But they miss the fundamental point of the whole morass. MBIA, AMBAC and ACA launched themselves into unwise businesses with inadequate capital. Their counterparties blithely assumed obligations would simply be paid when due.

It reminds me of a story about auto insurance. I used to play squash with a guy from AIG. A few years back, AIG began underwriting auto insurance in my state. I asked Joe, the AIG guy, what he thought of it. The AIG price quotes for comparable insurance were much lower than the limited options available.

Joe laughed and said that neither he, nor any AIG employee whom he know, would touch an AIG auto policy. When I asked why, he explained that AIG makes much of its money by being stingy on payouts for claims. This tendency, he further explained, extends to auto insurance, too.

Since AIG employees were intimately familiar with the firm's culture regarding payment of claims, they all steered clear of the firm's auto insurance, at any price.

Usually, when something seems too good to be true, it is. The easy availability of credit swap insurance from the three firms must have seemed 'too good to be true.'

It was. The firms aren't properly capitalized to underwrite the huge risks related to subprime mortgage securities. When those securities stop paying, the premiums which the insurers have collected, and invested, aren't going to be sufficient to fulfill their policy obligations.

What I have to wonder is, what in God's name were the buyers of this 'insurance' thinking? Weren't they typically middle- to senior-level managers at well-regarded investment, commercial banks and asset management firms? Didn't they realize that insurance is only as good as the ability of the insurer to actually pay?

Evidently not. Or perhaps everyone simply assumed the worst case would never occur. Much like those using portfolio insurance.

I accept that a lot of inept fixed-income investment, via subprime mortgages, CDOs and swaps, have finally affected equity markets. I'm reasonably confident that, given some time, the larger effects of these problems on the equity markets will recede, leaving fixed-income investors with the large, enduring losses.

The question is, what would be a fair and effective manner in which to contain the damage to, and avoid the insolvency of the insurers?

Some have argued for a variant of the old, 1980s "good bank, bad bank" mortgage loan solution. The municipal businesses of AMBAC, MBIA and, if there is any, ACA, would be packaged up with sufficient capital, and spun out. The remainder would exist to handle non-municipal claims.

That seems reasonable and appropriate. After that, anyone who loses insurance protection due to their counterparty, the insurer's, inability to pay deserves what happens.

Placing The Blame

I enjoy listening to classical music. The most convenient radio station for me is, sadly, WQXR, one owned by the parent of the People's Daily- The New York Times Corporation.

Thus, I awake to ultra-liberal radio news. This morning, it was the 'news' that a recent public opinion poll found Americans looking more darkly at the country's current situation, and blaming Ben Bernanke and the Fed for moving too slowly to cut interest rates.

This left me incredulous. Yesterday's post discussed the long, complex set of events that have led the US economy and financial markets to their current condition.

The varied and long-running consumer behaviors which led us to this point could hardly have been regulated, much less prevented, without stifling behavior more familiar in, say, the failed, discredited Soviet economy of old.

As I wrote here, in November, in response to a Henry Kaufman hand-wringing editorial in the Wall Street Journal, our financial system has endured many failures over the past decades, as innovation has delivered ever more convenience and value to consumers.

The current financial market troubles are fairly simple, not totally unexpected outcomes of greedy, supervised behaviors by firms themselves. That is, the regulators aren't the only parties who may have missed some of the behaviors.

Merrill Lynch, Citigroup, Morgan Stanley and Bear Stearns all possessed well-paid, intelligent, experienced and educated senior and middle managers. They knowingly took risks, and/or looked the other way at their own organizations' and employees' excesses.

This isn't just, or even, really, a failure of regulation.

Similarly, it's not a failure at the Fed, either.

As Neil Cavuto said the other night on Fox Business News, paraphrasing him,

'If we think we need this kind of Fed rate activity and Congressional stimulus when we're not in real economic trouble, decline or recession, what will we want if we really get into trouble?'

I think he's right. We're not in a dire economic recession. And, should we slip into one soon, it will likely be mild.

As I'm writing this, I hear Nancy Pelosi blathering about the stimulus package being patched together in Washington. It's probably a mistake, as Alan Reynolds noted recently in his Journal editorial.

Permanently lower tax rates and similar, lasting fiscal policies would have much more impact, now and longer term, than sprinkling a few hundred dollars each across lower-income voters.

It seems that our country, as investors and consumers, just whine a lot more, over less, than we used to. We're not even near the pain and difficulties of the mid-1970s. Remember wage and price controls, 'whip inflation now' buttons, and Jimmah's cardigan-clad fireside talks urging us to cut up our credit cards and turn down our thermostats?

We're not anywhere near that point now. Plus, we have much better tools- analytics, information, etc.- with which to assess the situation at the market, firm and governmental level.

If too much 'help' is doled out now, by Congress and the Fed, all we'll do is remove the moral hazard of excessively risky behavior on the part of financial firms, industrial companies, investors and consumers. That won't be a good thing.

To paraphrase the title of a movie in current release,

"There will be pain."

And there should be.

Wednesday, January 23, 2008

Samuelson's Economic Insight

Are we in a recession? Are we truly experiencing two consecutive quarters of decline in real GDP?

Is fiscal action by the Federal government useful or even necessary?

What may have caused the softening growth that many now swear is a recession?

The more I reflect on what I learned about economics in college and graduate school, and since, the more I come back to one simple insight.

Paul Samuelson's 'accelerator-multiplier' theory.

Stunningly simple, it seems to square, for me, at least, with human behavior. As many great economic insights do. Such as fellow Nobel Laureate Milton Friedman's concept of income as a steady, long-term expected value.

Samuelson noted that when growth slows from a higher rate, to a lower one, the mere slackening of growth is transmitted back through what we now would call the supply chain, as a series of demand reductions.

Instead of 10% more materials each year to make my products, this year, I need only 5% more.

My supplier will see a decrease in expected sales. Growth will be half of what it was, and, thus, sales fall below expectations.

While real output is still higher, the gradual cutback in production from expectations results in a contraction, as workers work to produce less. The cycle continues, and the multiplier effect, which, in forward gear, causes economic expansion, is responsible for its contraction when run in reverse.

Seen in this light, recessions which are attributable to simple changes in economic outlook can't really be affected very effectively by one-time fiscal monetary transfers.

Plus, as noted by Alan Reynolds in his recent Wall Street Journal editorial, writing checks to one group of US citizens by the Federal Government simply means borrowing from someone else, in some way, and paying interest in the bargain. But nothing is really created. Either other spending is curtailed, or debt is assumed, crowding out someone else's potential spending, and making the stimulus really a function of differential marginal propensities to consume, to be technical.

Samuelson's genius seems to lie in his identification of a fundamental tendency of humans to view the lack of attainment of growth objectives to feel like a cutback in business. If this is what is happening, even as a result of the wealth effect of the many tens of billions of dollars of recent equity losses in US markets, it remains a phenomenon which is unlikely to be fully and successfully addressed by one-off fiscal spending by the Federal Treasury.

If any fiscal actions were to have longer-term consequences, they would seem to be the act of making soon-to-expire tax rate cuts permanent. And perhaps going further and lowering rates, permanently, once more.

Anything less would seem unlikely to provide a sufficient, long term change in demand to alleviate any potential recession. Instead, simple spending programs like that now contemplated by Congress might just feed inflation and aggravate the dollar's price.

More On Cramer, Santelli & Financial Markets Turmoil & Excesses

Yesterday's post involving Jim Cramer's attempts to bully and intimidate other CNBC on-air participants- notably Rick Santelli and Brian Wesbury- attracted what I believe to be a record number of readers. The number of visitors who simply Googled something like,

"rick santelli jim cramer cnbc"

was astonishing. And that my blog post ranked among the first results for that Google search. I'm still getting hits this morning, as I write this piece.

Even Jack Welch, this morning's CNBC SquawkBox guest host, took time to specifically and explicitly give Santelli an on-air 'well done' for shutting Cramer up.

Carlos whats-his-name seconded, safely, declaring that the incident was "good television."

But back to the main topic- the financial markets.

Somewhere yesterday afternoon or this morning on CNBC, a few very calm, sane, well-reasoned guests offered the following recap of the current situation, and the path to it. I've summarized their joint specific wording, but the thrust of my synopsis is faithful to their points and, for what it's worth, also reflect my own thinking:

"We have a free market economy and free financial markets. There's regulation, to be sure, but, mostly, participants are free to take risks and make money as they choose.

The past few years saw excesses involving, but probably not limited to:

-people buying houses that they could not, in the long run, actually afford
-financial institutions creating opaque structured financial instruments whose ultimate value and trading patterns were actually unknown and, thus, very risky
-some homebuilders (over) built in markets known to be overheating

Beginning last summer, this all came to a boil. As a result, private investors, large and institutional, and small and retail, lost money due to these financial excesses.

The smaller investors lost on housing and rising mortgage payments. The larger, institutional investors lost on opaque credit instruments which, in the event, turned out not to actually have continuous markets in which to trade them.

With this background, many institutional financial market participants and related pundits, such as Jim Cramer and Steve Liesman, both of CNBC, regularly began to excoriate Fed Chairman Ben Bernanke.

Two commentators noted that this is grossly unfair. How, they asked, can one man and the rest of the Fed be expected to correct, at a stroke, with just interest rate cuts, what an entire financial market and one economic sector took years to screw up?

Alan Reynolds, in his superb editorial in yesterday's Wall Street Journal, noted, similarly, that President Bush and Congress can't just wave a fiscal stimulus wand and prevent a recession, either. If it was that easy, we'd never suffer recessions.

No, we have recessions as the natural counter-cycle to financial market and/or economic excesses.

But we aren't in a recession yet. And we don't seem to actually be headed for one. It's just a financial market panic reaction to a slowing, but still growing, economy.

One commentator opined that what we have is

'A bunch of Wall Street investors whining because they aren't making money this week. Grow up!' "

This Fed-bashing, which even as I write this, is being continued by CNBC's on-airhead Mark Haines, misses the point. The Fed can't magically undo in weeks or months what a host of investors and economic players took years to do.

If you want that type of centralized financial and economic control, maybe you should climb in Professor Peabody's WayBack machine and return to the Soviet Union of 1965.

In our economy, you have to take the bad with the good. Someone else's excess can affect you. It's just part of the world of free economic and financial markets.

In fact, another reason that magical elixirs evade us is that there are so few genuine recessions and financial meltdowns.

In a falling market, everybody is working in unfamiliar territory. My partner noted that, while my long-oriented equity, and derived options strategy, work superbly 90% of the time, we really are in uncharted waters when my market allocation signal indicates the need to take short or put positions. There are just so few, recent, relevant market samples on which to do research and base strategies that bear market equity-related strategies are inherently riskier. There's less data and, thus, far more volatility in any particular approach to profiting, or limiting losses, during such inflection points and subsequent bear markets, followed, usually pretty soon, by the inevitable second inflection point on the way back up.

Guess what? It's the same for the Fed and most market participants.

If you carefully consider the origin of the Fed, and its most unique role, it has to be fighting inflation through the provision of stable monetary policy. It's not actually supposed to cure recessions.

Financial panics? Yes. Financial liquidity shortages? Yes.

In the final, summary analysis, here's what I think is going on now.

The past few years saw an excessive buildup of investment in housing-related sectors. Too many houses were built, too many people bought homes they couldn't really pay for, and too many financial services firms churned out structured, mortgage-based securities to fund them.

Aside from that, the other sectors of the US economy were firing on all cylinders, energy price increases due to legitimate global demand increases notwithstanding.

Eventually, beginning last summer, the financial house of cards built upon suspect mortgages began to collapse.

Private investors lost a lot of money. Perhaps something like 15% of the $1.5Trillion subprime mortgages outstanding could default. That's about $200Billion.

However, associated with these are many over the counter interest rate and credit swaps that now carry much counterparty risk.

When these risks and losses began to become apparent, large US commercial and investment banks wrote off nearly $100B in losses, prompting a corresponding loss in equity values in the sector, and then some.

Now, the credit market losses have hit the equity markets, resulting in trillions of dollars of US equity market losses in January, 2008, already.

Eventually, these levels of losses will affect consumer financial behavior in a more slowly-growing, but not recessionary, US economy.

In the meantime, a lot of less-skilled, mediocre institutional investors, analysts, pundits, traders, etc., are panicking. Thus, what would have been a softening economy with a loss of some credit instrument investments due to the mortgage sector mess, seems to have amplified into a near-term financial panic that assess the US economy as already in recession.

As my longtime friend and sometimes business partner, B, emailed me a few months ago,

'We're not in a recession yet. But if enough people keep saying we are, we will be soon.'

So true.

Even so, because the basic economic signals remain non-recessionary, most investors are likely to be surprised that, later in the year, the economy will appear to be healthier. And the equity market downdraft will seem to have been overdone.

It's likely that the particulars of how long the equity markets turmoil and bear market will last, as well as how long the economy will remain soft, have to do with the degree to which the recent events become central determinants of longer term consumer behavior. And right now, nobody knows how that will develop.

Tuesday, January 22, 2008

On The Recent Equity Markets Turmoil

Today's Fed rate cut of 3/4 of a point indicated that the Governors believe they need to reassure financial markets that the end of the world is not nigh.

More specifically, due to the US markets being closed yesterday for a holiday, other equity markets around the globe delivered a sell-off overhang of at least 7%, waiting to hit the US financial markets at the open.

Now, if you were listening to/watching Jim Cramer on CNBC this morning, you'd think the Fed board is addled, asleep, and full of idiots. He was all bugged-eyed and self-righteous about having called this market drop way in advance.

Cramer alleged that it was impossible to understand the Fed's actions, or anticipate them. He expressed a lack of awareness of what triggered this morning's surprise rate cut.

But this is so simple.

First, the Fed doesn't exist to satisfy the raving maniac Cramer's desires for easy money and money manager bailouts.

Second, Bernanke has always said that evolving data will inform and influence his Fed's actions.

Third, Monday's global equities markets sell off constituted new, important information about investor sentiments that had gotten way ahead of economic realities. Thus, the Fed eased in order to avoid what anyone who remotely watches financial markets knew would be a crushing open in New York this morning.

Now, CNBC is chiefly a business entertainment network. That's why they had Jim Cramer hanging around on camera almost all this morning, posturing, bulging his eyes out and screaming.

But they also had three adults on the morning programs, too.

Rick Santelli directly took on Cramer regarding the latter's own market calls. Santelli reiterated his enduring, consistent view that the financial markets will behave according to their own animal spirits. The Fed can cut, and that's fine, but it doesn't mean the markets will magically believe that fixed income losses, and consequent equity damage at financial institutions, are at an end.

Santelli rebuked Cramer for having been giving bullish advice all summer and fall, to which Cramer screamed back,

"Have you watched my show?"

Santelli smirked, dismissively waved his hand and turned sideways, pointedly facing away from the camera. Cramer fell silent.

Santelli is right. Cramer's "Mad Money" show begins with a disclaimer absolving CNBC and anyone else except, well, Jim Cramer, from blame for following his financial advice. On the rare occasions I've been in a room with Cramer screaming from the television, I recall that he explicitly conditions his advice as being for viewers' own "mad money," i.e., spare money they can lose without serious financial injury.

Thus, Cramer plays a disingenuous little game. If he happens to get a short-term call right, he trumpets his great wisdom. If not, he reminds you that you were supposed to: do your own homework; only use spare funds not really intended to be saved, and; bought and sold according to some unspoken timing approach to which Cramer vaguely refers, but never clearly describes or defines.

Santelli knows this, and effectively called Cramer on it, chiding him for wailing about the Fed and fixed income markets in August and the fall, while simultaneously issuing 'buy' recommendations to his viewers.

Then we come to the second adult who made an appearance on CNBC this morning- Brian Wesbury.

As I have written several times, found under the label 'Brian Wesbury,' the noted economist has consistently forecast a 'not recession' for the US economy this year. Wesbury has warned of slowing growth, but not a recession. His observations of jobs, payroll numbers, and the Fed's easing, all combined to cause Wesbury to caution against betting on a recession.

This morning, while being grilled by CNBC co-anchors, and Cramer, Wesbury reiterated his stand. Cramer began to bully Wesbury, insisting that the latter 'admit he was wrong,' like Cramer alleged that he, too, admits when he 'get's it wrong.'

Wesbury pushed back- hard. He returned several times to his contention that recessions come from tight money periods, and we aren't in one. The Fed has eased plenty since the summer. Some will complain about the pace or extent, but it has not been tightening.

Wesbury noted that this alone pretty much dispels worries of recession. And he directly faced off against Cramer and retorted that he, Wesbury, has not changed his forecast that there will not be a recession in the current economic situation.

Rather, Wesbury admitted that he did not forecast a sudden equities market downdraft- but that this is not what he does for a living. He's an economist, not an equities market strategist.

Cramer was, once again, cowed by the target of his on-air bullying, and fell silent.

Finally, we come to the third adult on CNBC this morning- the venerable, solid, calm, unflappable John Bogle, once chairman of Vanguard.

Bogle behaved like he came right out of central casting to play the role of the wizened, esteemed and veteran market strategist. He warned investors/viewers not to do anything rash. That this was the time to, if anything, buy using dollar-cost-averaging approaches. He admitted that it sure is hard to 'do nothing' on a day like today. But that this is precisely what one must do.

I'm sure I'll be returning to this topic in the days and weeks ahead. This is assuredly a significant time in equities market investing. The strength and speed of this new year's market drop is truly stunning.

I've been discussing it with various friends with as much, or, in many cases, more experience than I have. And I was present, physically, on the steps of New York's Federal Hall on the day of the 1987 crash.

One thing on which my esteemed, experienced colleagues all agree, with me, is that this market event is different than others, including 2001. The concentration of assets in large hedge funds and other money management shops, with high-speed, computerized, instantaneous trading capabilities, seems to have compressed what might have been weeks worth of decline into only days.

Further, the surrounding informational environment has changed in the past seven years, as well. The availability of instantaneous, free and plentiful information online adds to the time compression of investor reactions to business news and opinion.

As I suggested to my business partner this weekend, as we discussed the situation, and our plans for the next few weeks, there are three different informational streams moving in parallel:

1. The real economy and information related thereto.
2. Investors' perceptions of the real economy and the evolving financial market situation.
3. Equity markets behavior as a function of investors' perceptions of the real economy and the markets' own behavior.

Right now, it seems that the preponderance of investors, institutional in nature, are focusing on numbers 2 and 3, rather than 1.

It's also noteworthy to recall, as I've written in some prior posts, that most institutional money is managed by mediocre investors. The broad middle of the equity markets is pushed, pulled and herded by pundits, brokers, analysts, etc.

The key to outperforming the broad equity market indices, such as the S&P500, is to be 'wrong' in the near term, but 'right' in the longer term. Specifically, the broad, mediocre middle of the investment community has to value our selections poorly at first, and, then, subsequently come around to our view, to drive the value of our portfolio holdings higher than the market.

Right now, at an inflection point, there's always the question of timing and allocation. Does one go short? Or merely not be long? For how long?

The speed of the recent equity market decline has probably caught many investors by surprise. But longer term fundamentals do not appear to be so bad. It's the near-term panic among less-skilled investors that is causing the incredible near-term volatility.

Monday, January 21, 2008

Sears (All) Shook Up

Following my recent post on Sears and its effective controlling shareholder, Ed Lampert's dismal track record with the retailer, the Wall Street Journal published another piece on the firm's shakeup in this past Saturday/Sunday's edition.

This time, Lampert and his team plan to prepare for a financial slicing and dicing approach, as evidenced by these passages from the Journal article,

"In a fresh effort to halt a long decline, Sears Holdings Corp. Chairman Edward S. Lampert plans to reorganize the 121-year-old retailer into several businesses with broad authority to shape their own future.

Mr. Lampert, a hedge-fund executive who acquired the retailer in 2005 through a merger with Kmart Corp., now sees a holding-company structure as the best way to breathe new life into Sears's slow-moving culture, said people familiar with the situation.

....Sears, with $50 billion in annual revenue, warned that its fiscal fourth-quarter profit would fall as much as 57% below the year-earlier level. Sears shares have lost half their value over the past year despite new marketing and advertising moves at Sears and Kmart.

The contemplated restructuring would create separate units to manage Sears's real-estate holdings and run brands such as Kenmore, Diehard and Craftsman. It isn't clear how the units would be divided or which unit would run the stores themselves.

The structure would allow Mr. Lampert to spin off or close business units more easily, said a person knowledgeable about his thinking. "He warmed to the idea of a spin-off strategy," this person said. "

This would seem to be a reversal of course for the retailer which joined with KMart, and also owns Land's End. Citing a retailing consultant, the article further noted,

"Walter Loeb, a retail consultant, said the plan flies in the face of most retailers' strategy of designing a cohesive image for their business. "He's looking to turn it around by using a different approach," said Mr. Loeb. "I think it's risky."

Sears's turnaround efforts have been hurt by a revolving door of senior executives at its Sears and Kmart retail units. John C. Walden, Sears's chief customer officer, who was hired away from Best Buy less than a year ago, resigned this week, a Sears spokesman confirmed. Mr. Walden couldn't be reached for comment."

The prior article had also noted a loss of recently-hired talent at the once-dominant retailer. With this new approach, Lampert seems to be throwing in the towel on operating a single retailer, and aiming, instead, to eventually sell off the more notable brands- Die Hard, Craftsman, Kenmore- while freeing up the real estate holdings in a single, more accessible unit.

Speaking of Lampert's desire to not be seen actually running Sears, the piece concluded,

"....He (Lampert) left Sears's Hoffman Estates, Ill., headquarters Wednesday, a day before the revamping was outlined by executive vice presidents Dev Mukherjee and Corwin Yulinsky.

Messrs. Mukherjee and Yulinsky described the plan to executives Thursday morning, saying it would allow the company to unlock the value of its real estate, proprietary brands, and online units by managing each as separate entities. The executive over Kenmore, for instance, could strike sales or licensing deals with other retailers, said a person who attended the meeting.
According to the Sears spokesman, each operating unit will have a "designated leader and an advisory group comprised of senior Sears Holdings executives to provide direction and oversee the business unit's performance." "

This passage evoked several reactions for me. First, the idea that an 'advisory group' is being provided to each business executive provides a sort of ready-made firing squad for Lampert. How many of the business unit heads are going to want this group of snitches in their operations rooms or executive suites?

If you run a business, and you have this 'advisory group' that is available to you, but is not actually accountable for decisions, how readily will most managers actually be to use this group? Wouldn't they tend to want their own, hand-picked advisers?

Second, I know one of the Sears EVPs. Long ago, in my last days at Chase Manhattan, I crossed paths with Corey Yulinsky. At the time, he was in flight from a staff job at the old, pre-Weill Citigroup. Let's just say that, as a member of the new Corporate Planning staff, Corey did not distinguish himself- neither in his grasp of the bank's businesses and situation, nor the reality of dealing with then-President and CEO Tom Labrecque.

The corporate planning staff which remained in the wake of my boss Gerry Weiss' retirement, of which Corey was reputedly a key member for the new SVP of Planning, was hardly capable, in the event, of helping guide Chase along a profitable, independent road.

From there, as I recall, Yulinsky wandered over to Mercer. I can't say that I know whether it was due to ineptitude at Chase, or part of a general flight before the Chemical takeover at the point of Michael Price's gun. Apparently some time after that, Yulinsky wound up as part of Lampert's new hires at Sears Holding.

Judging by Sears' performance since Lampert's takeover, as I mentioned in the prior post, it's doubtful that his team has been adding any substantive value. Now, evidently, Yulinky's and others' best new idea is to begin stripping the firm apart into actionable entities- brands, real estate, and separate businesses.

Can you imagine a (former) customer entering a Sears store, looking for Die Hard batteries, and being told that the store management no longer had anything to do with the availability or any other aspect of the Die Hard business? It had become an arm's length supplier?

Yeah, that's going to draw in plenty of new customers, Corey. And bring the few remaining ones running back again.

The Journal piece notes, near the end,

"The restructuring is an indication that Mr. Lampert won't be making big new investments in the business. The plan is for unit presidents to craft their own budgets and set spending priorities. With the U.S. economy heading downward into what some see as a recession, this year could be troublesome because Sears's cash cushion has declined."

I think this last passage tells you the real endgame for Lampert at Sears. He's lost enough money and time spent on this nightmare. Now, he's putting everyone into their own business lifeboat, and letting them sink or float on their wits. No more money, no more top-down direction. The strong will be kept or sold, the weak, merely scuttled.

You can already imagine the business and store closings, real estate sales, and gradual contraction of the retailer's presence. In time, the few strong brands may be spun off or just sold to other retailers.

What began for Lampert, and Sears' shareholders, as an alleged attempt by a hedge fund owner to save an ailing retailer, will probably end as just more financial maneuvering, Lampert's strong suit, to squeeze some last positive value out of this failed venture by an unqualified, wealthy financier and his less-than-capable team.