Friday, October 30, 2009

3Q GDP Results

This morning's Wall Street Journal has a good, short piece by Liam Denning under the Heard On The Street column.

Before you join yesterday's exuberant equity investors who bid up the market by 2%, consider Denning's remarks about the quality of the initial 3Q GDP number of +3.5% annualized growth.

He writes,

"Fully 2.2 percentage points of the third quarter's 3.5% growth figure related to vehicle purchases and residential construction, both juiced by government support. Federal spending added 0.6%

If these GDP data were company earnings, they would be what analysts euphemistically call "low quality." Investors buying into the market off the back of them are ignoring weekly unemployment-claims data that came in above 500,000 again on the same day."

Count me in Denning's camp, rather than those optimistic equity managers and analysts flocking to praise the recently-arrived US economic recovery.

Even this morning on CNBC, senior economic idiot Steve Liesman verbally assaulted former New Hampshire Senator John Sununu about supply-side economics, claiming that currently-low inventories and strong inventory liquidation of the past few quarters virtually guarantees a robust US economic recovery. Grinning as only a self-deluded moron can, Liesman insisted that Sununu quoted Say's Law to him last year in a sort of economic debate. Sununu denied it, although admitting to favoring supply-side economics.

Sununu then went on to note that, while cheering a possible rebuilding of inventories, observers should also acknowledge the several trillion dollars of debt recently printed in the form of dollars or dollar-denominated obligations to fund this juicing of GDP growth.

Beyond the near term effects of this corruption of the GDP number, Denning also suggested,

"The danger is that all these short-term fixes leave the economy dangerously addicted to taxpayer-funded steroids. The circularity in the housing market, whereby Washington provides tax breaks to first-time buyers, guarantees most of the mortgages written, and then buys most of those, beggars belief, and suggests a worrying case of amnesia following the bursting of the housing bubble."

This, I agree, is a genuine concern. Along with teaching car buyers to wait for a government subsidy, we've added teaching home buyers to expect government aid for that, too. No matter that many quickly use the government-supplied cash to leverage up their debt even further.

What this all means, in the larger sense, as Denning so effectively highlights, is that we can't even trust GDP numbers now. The 3.5% was already somewhat expected, given the depth of decline since late-2007. But knowing that, after government-subsidized activity and spending growth are removed, the remaining 3Q GDP annualized growth was only an anemic +0.7% is no cause for celebration.

This doesn't mean one cannot take advantage of misplaced enthusiasm on the part of many equity investors. But I don't think the 3Q GDP number should be a basis for declaring the US economy healthy and in full recovery.

Thursday, October 29, 2009

Sandy Weill's Regulatory Suggestions

Monday's edition of the Wall Street Journal featured an editorial by Sandy Weill, ex-CEO of Citigroup, and Judah Kraushaar. In it, Weill articulated six steps which he believes will "revitalize" the US financial system.

I was a little surprised to find that I actually agreed with several of Weill's ideas, given that he is responsible for assembling the failed mess that is today's Citigroup.

Weill starts out on the wrong foot by, as you'd expect, defending the concept of "too big to fail" as moot and irrelevant. By choosing to see the recent financial mess as caused by Lehman's failure, which isn't, strictly speaking, true, he feels he can simply declare bank size of no practical importance.

I would beg to differ. What got the ball rolling on this crisis was the mid-2007 failure of two Bear Stearns mortgage-related mutual funds. By year end, Citigroup, Merrill Lynch and others were hastily writing off a combined hundreds of billions of dollars of marked-to-market mortgage-backed holdings.

Lehman marked the end of the valuation-based failures of private sector, publicly-held firms, not the beginning.

However, despite Weill's very biased view on this point, which might be expected to color his entire analysis, several of his other points actually make sense.

The first one, unfortunately, does not. Weill wants the Fed to be the financial super-cop. There's so much wrong with this idea that I couldn't deal with it, and Weill's other remarks, in one post. Suffice to say, you don't give more power to the guy who just misused the considerable power he already had. Also, I'd note that Weill was, for nearly his entire career, a securities industry operator. I'm not entirely sure he really understands Fed regulation.

His second point is worthwhile. He, like me, believes that "complex instruments," by which I assume he includes derivatives, should have regular market pricing and be traded through exchanges. The much-feared daisy chain effect of AIG's financial products unit failing would have been eliminated, had its derivatives positions been held via an exchange which required posted collateral. Exchanges remove counterparty failure risk, and would have removed most of the concern over an AIG or Lehman failure in the first place.

Another point Weill makes, which echoes my own prior posts, is to force underwriters of structured financial instruments to retain a healthy portion of the issues, and regularly sell portions to affirm their pricing.

His desire for regulators to somehow oversee the ratings agencies isn't really sensible at all. Just from stories I've heard from senior rating agency employees, it's clear to me that they face undue pressure from their clients, as well as intellectual and technical intimidation. It's unlikely that a bunch of mid-level civil servants at regulatory agencies will ever be capable of going toe to toe with Wall Street financial engineers and produce a useful result. Bank regulators are used to simply counting things and comparing existing reserves to required ratios, reviewing loan documents, and generally checking accounting and paperwork. They aren't securities valuation experts.

Perhaps the best of Weill's suggestions is that regulators stop messing with bank loan loss reserves. According to Weill, the regulators have been pressuring financial institutions to lower reserves in the healthy portion of the lending cycle, then take larger reserves as losses mount. He's correct to note that classical banking does the reverse- fund the loss provisions in good times, both to match losses to when the loans were made, and to smooth out the effects of loss recognition.

Finally, again, reinforcing published work of mine going back to the mid-1990s, he endorses making more senior executive compensation dependent upon and only vested after longer time periods. While he advocates the wrong metric, ROE, his basic instinct is correct. Long term vesting, lagged average total-return based compensation will put a stop to executives reaping quick cash bonuses while avoiding longer term consequences of risky strategies.

Overall, I was pleasantly surprised with Weill's ideas. For a guy whose best years in the financial service industry were spent hoovering up ailing wire houses and rationalizing their back offices, he actually seems to understand more about risky front office behavior than you'd guess from his failure in creating the monstrosity called Citigroup.

Wednesday, October 28, 2009

Today's Housing Price Data & An Old Post

Back a few weeks ago, I wrote this post concerning the effects of government-directed rewriting of mortgage contracts. Of particular interest that day were the comments of former Lehman economist, now Barclays Capital chief economist, Michelle Meyer.

Coincidentally, I noticed an explosion of hits on this blog today due to searches on Miss Meyer.

How propitious. Because this morning, new housing data was released.

Listening to CNBC's reporting of the breaking data this morning, it was clear that various measures of housing activity failed to meet expectations, helping to send the S&P500 Index, my and most institutional money managers' preferred measure, skidding nearly 2% as of 3:30PM, as I write this.

On the subject of housing prices, the Wall Street Journal noted in today's edition,

"Real-estate prices increased for the fourth consecutive month, but consumers are feeling more glum, a disconnect that shows how rising unemployment continues to weigh on households even as the economy improves.

Analysts warn that prices are being propped up by the government and may resume falling in the coming months as that support fades away. The first-time home-buyer tax credit has sparked demand, in the process pulling sales that might have happened in late 2009 and early 2010 and jammed them into the past few months. The supply of foreclosed homes on the market, meantime, has temporarily decreased as a result of rules that require banks to consider more people for loan modifications."

Perhaps Ms. Meyer spoke too soon earlier this month? We'll soon see.

CNBC's Celebrity "Business Journalism"

This morning, as I was reading and writing before breakfast, I listened, as usual, to the audio of CNBC, to which my television was tuned.

Around 8am, Mario Gabelli joined the program, along with Pimco's Bill Gross. The two traded views on various topics as economist David Malpass made an appearance to discuss his recent Journal article on the effects of currency depreciation on trade flows versus investment flows.

The adoration with which the CNBC co-anchors treated Gabelli was sort of stomach-turning.

Remember back in 2007, when Gabelli was being investigated by the SEC for defrauding the government in a frequency spectrum auction? As I recall, Gabelli recruited the wife of some colleague to front for him and take advantage of some minority set-aside benefits in the auction process. There was apparently some evidence that Gabelli funded the whole effort, and the woman was just a figurehead.

News reports which I found by Googling this subject only note that Gabelli's firm settled with the SEC to vacate the charges.

Here's what occurred to me this morning as I listened to Gabelli hold forth on various topics.

In the two years since Gabelli's fraud incident, why hasn't CNBC's on-air staff ever had a proper interview with him over those charges? Why haven't they grilled him on exactly what really happened?

Here's a leading business channel deliberately ducking the opportunity to behave like a real news organization. They have a guy on as guest-host who was caught up in the sort of business behavior that sickens everyone.

Yet they never have laid a glove on his even once. Instead, Gabelli gets the celebrity treatment on every visit.

This sort of incident, more than most, cements my view that CNBC is all about business entertainment, and not at all about reporting.

Sure, they announce news and breaking development. But because essentially all of their 'in depth' reporting consists of recruiting industry figures to debate and argue points, the channel is entirely dependent upon those guests.

They have no real analytical staff of their own to serve up in-depth reporting. So they have to make nice to all of their guests, or else they have nothing but headlines to read.

You have to wonder why Murdoch's gang, with Roger Ailes at the helm, can't figure out how to combine the now-unused Wall Street Journal investigative reporting capabilities with Fox Business News and blow CNBC off the air.

Tuesday, October 27, 2009

Allan Meltzer On Excessive US Deficits & The Weakening Dollar

I've written quite a few posts recently regarding what I believe is the arrival of the US at a new tipping point involving the weakening dollar, excessive deficits and externally-held US debt, taxation, additional social spending programs, and coming inflation. As I explained in an email to a friend recently, for the first time in thirty years, I'm genuinely concerned that the predictions of the dollar's and US's economic and, eventually, military superiority's decline, are now within view of coming true.

In fact, with all the government intervention of the past year, posts focused on cases of firms chalking up consistently superior total return performance have declined. Instead, the most interesting topics seem to be the economics of the dollar and deficit spending, and massive government intervention in the private sector of the US economy.

In last Friday's Wall Street Journal, respected Carnegie Mellon political economy professor Allan Meltzer weighed in with a reinforcing editorial entitled "Preventing the Next Financial Crisis."

The crisis to which he refers is not a private sector banking crisis like last year. Instead, he begins his editorial,

"The United States is headed toward a new financial crisis. History gives many examples of countries with high actual and expected money growth, unsustainable budget deficits, and a currency expected to depreciate. Unless these countries made massive policy changes, they ended in crisis. We will escape only if we act forcefully and soon."

Echoing others, and my own concerns, Meltzer then observes,

"Massive purchases of dollar debt by foreigners can of course delay the crisis, but today most countries have their own deficits to finance. It is unwise to expect them, mainly China, to continue financing up to half of ours for the next 10 or more years. Our current and projected deficits are too large relative to current and prospective world saving to rely on that outcome.

Worse, banks' idle reserves that are available for lending reached $1 trillion last week. Federal Reserve Chairman Ben Bernanke said repeatedly in the past that excess reserves would run down when banks and other financial companies repaid their heavy short-term borrowing to the Fed. The borrowing has been repaid but idle reserves have increased. Once banks begin to expand loans or finance even more of the massive deficits, money growth will rise rapidly and the dollar will sink to new lows.

Many market participants reassure themselves that inflation won't come by noting the decline in yields on longer-term Treasury bonds and the spread between nominal Treasury yields and index-linked TIPS that protect against inflation. They measure expectations of higher inflation by the difference between these two rates, and imply long-term investors aren't demanding higher interest rates to protect themselves against it. But those traditional inflation-warning indicators are distorted because the Fed lends money at about a zero rate and the banks buy Treasury securities, reducing their yield and thus the size of the inflation premium.

Further, the Fed is buying massive amounts of mortgages to depress and distort the mortgage rate. This way of subsidizing bank profits and increasing their capital bails out these institutions but avoids going to Congress for more money to do so. It follows the Fed's usual practice of protecting big banks instead of the public.

The administration admits to about $1 trillion budget deficits per year, on average, for the next 10 years. That's clearly an underestimate, because it counts on the projected $200 billion to $300 billion of projected reductions in Medicare spending that will not be realized. And who can believe that the projected increase in state spending for Medicaid can be paid by the states, or that payments to doctors will be reduced by about 25%?"

There you have it. Meltzer does a great job of ticking off the sources of unease many, including me, feel about the current monetary and fiscal situation. It truly feels like a nearby bomb, the timer on which is finally, after some 60+ post-WWII years, nearing zero.

On the matter of who owns this mess, Meltzer, in a genuinely bi-partisan vein, writes,

"The Obama administration chooses to blame outsize deficits on its predecessor. That's a mistake, because it hides a structural flaw: We no longer have any way of imposing fiscal restraint and financial prudence. Federal, state and local governments understate future spending and run budget deficits in good times and bad. Budgets do not report these future obligations.

Except for a few years in the 1990s, both parties have been at fault for decades, and the Obama administration is one of the worst offenders. Its $780 billion stimulus bill, enacted earlier this year, has been wasteful and ineffective. The Council of Economic Advisers was so pressed to justify the spending spree that it shamefully invented a number called "jobs saved" that has never been seen before, has no agreed meaning, and no academic standing."

And there's the rub. Anyone with a brain who has been watching federal government behavior since Reagan's exit from office knows that both parties have allowed our society to rack up huge debts to finance promises which are simply unable to be kept.

Having come of age in business during the Reagan years, with Volcker at the Fed, I never really thought that the lessons of the Carter, and post-Carter years could be forgotten, or simply denied. But, as Meltzer concludes,

"One reason for the great inflation of the 1970s was that the Federal Reserve gave primacy to reducing unemployment. But attempts to tame inflation later didn't last, and the result was a decade of high and rising unemployment and prices. It did not end until the public accepted temporarily higher unemployment—more than 10.5% in the fall of 1982—to reduce inflation.

Another error of the 1970s was the assumption there was a necessary trade-off along a stable Phillips Curve between unemployment and inflation—in other words, that more inflation was supposed to lower unemployment. Instead, both rose. The Fed under Paul Volcker stopped making those errors, and inflation fell permanently for the first time since the 1950s.

Both errors are back. The Fed and most others do not see inflation in the near term. Neither do I. High inflation is unlikely in 2010. That's why a program beginning now should start to lower excess reserves gradually so that the Fed will not have to make its usual big shift from excessive ease to severe contraction that causes a major downturn in the economy.

A steady, committed policy to reduce future inflation and lower future budget deficits will avoid the crisis that current policies will surely bring. Low inflation and fiscal prudence is the right way to strengthen the dollar and increase economic well being."

I feel like I'm economically much older than my years, because I recall arguments concerning Arthur Burns' ineffective reign at the Fed. His inability to pre-empt inflation during the LBJ "guns and butter" years of the Vietnam war and the Great Society program spending.

Even this morning, as I write this, I have listened to CNBC's senior economic moron, Steve Liesman, argue that commodity price inflation has no information value for the coming storm of CPI inflation.

Milton Friedman reminded us that

"Inflation is always and everywhere a monetary phenomenon."

With the recent explosion of US dollar liabilities and the Fed funding our debt, Meltzer is clearly correct on the need for the Fed to begin tightening now. Burns' ineptitude was a classic example of waiting too long, then watching the inflation genie escape and run rampant for more than a decade.

Let's hope we are not going to experience that again, along with losing the dollar's reserve currency status.

Monday, October 26, 2009

Boudreaux On Insider Trading

In this weekend's Wall Street Journal, Donald Boudreaux wrote an excellent piece defending much insider trading while lampooning attempts to regulate it, over and above measures which corporations take to limit it.

Simply put, Boudreaux distinguishes between coming events which corporations will wish to keep secret, such as corporate acquisitions, and continuing situations and processes, such as accounting irregularities or incorrect investor expectations, of which anyone with full knowledge of the situation can take advantage, leading to more fully-informed market pricing.

Boudreaux makes a persuasive case that companies know better which information they want to protect, such as event-oriented acquisition information, far more so than federal regulators.

However, citing the Enron case, Boudreaux notes that insiders who would have had knowledge of Enron's fraudulent accounting and practices, and sold Enron shares on that basis, would have helped the market more correctly price the firm's shares lower.

Further, Boudreaux notes, current attempts to ferret out insider trading is biased. Regulators can only look for those who trade on generally-unknown news, not those who do not trade, but would have, absent generally-unknown news.

It's a very interesting and valid point. Insider knowledge of a failed drug certification, new product, etc., could lead someone to not buy shares. But this lack of otherwise-planned action will never be detected, leading to asymmetrical, unfair enforcement of the misguided federal notion of insider trading.

Boudreaux helpfully reminds us that markets serve to efficiently price securities by virtue of incorporating as much news as possible into their prices. The so-called 'price discovery' process.

Insider trading, he notes, contributes to this objective, rather than corrupts it. So why would we want to punish those who help make markets more efficient?

Sunday, October 25, 2009

More Bad Research On Corporate Performance From Deloitte

I read a reference in a recent Wall Street Journal column by Holman Jenkins to a recently-popular piece of research by two Deloitte consultants, Michael Raynor and Mumtaz Ahmed, along with a "researcher" from the University of Texas, Andrew Henderson.

The book they wrote is described here, and the paper from which it sprang, may be found here in a Deloitte website post, and downloaded/read.

Whenever I read of a reference to some new empirically-based work purporting to diagnose the bases of corporate performance that is desirable to emulate or duplicate, I naturally am curious to learn who did the work, the methodology employed, and their conclusions.

In this case, it appears that Raynor is the leader of the group. His bio can easily be found, as well as his own website. From what I've gathered, he is clearly an intelligent individual, but doesn't seem to be described as having any significant working experience in business, outside of his academic pursuits at Harvard (DBA) and as a consultant at Deloitte. Deloitte, it should be noted, is not exactly in the vanguard of management consulting. Neither is Harvard known as a source for the best empirical approaches to business performance analysis. And it would appear that Raynor is in a sort of 'of counsel' role at Deloitte, as he has his own speaker's bureau representative and website.

In the beginning of their article, the authors state that they believe most prior studies of excellent US businesses have, in fact, been portraits of lucky, rather than skillful firms.

It's also not all that surprising, to me, at least, to learn that Raynor's methodology has little relationship to the real world in which most businesses operate, i.e., a need to produce results that create wealth for business owners. The most easily-accessible data for this, which, conveniently, also is the business form which accounts for the bulk of US business activity, is total returns of publicly-held corporations.

Because I linked to the authors' original article, I won't duplicate their text with reposted passages here.

In their piece, the authors essentially put down total returns as too reflective of future performance, as anticipated by investors, than actual management skill.

Instead, they chose ROA as their preferred measure.

As I mentioned to a colleague, this choice, alone, virtually guarantees the uselessness of all of their efforts.

Yes, they got their article in HBR, won a prize, expanded it to a book. Fine. Tom Peters got a lot of accolades, too, at first. But his work sunk like a stone into the vast sea of strategy and management 'how to' tomes. As, I would expect, will this latest effort by Raynor, Ahmed and Henderson.

Their description of what total returns are is wrong. It's not simply a measure of future "surprises" to investors. Taken as a pattern, over time, total return measures, in a presumably reasonably efficient market of investors and analysts, the ability of a firm's performance to exceed expectations. It does involve expectations, but it also involves expectations based upon prior and evolving performance.

And, more importantly, it is the measure of wealth created by management of the firm, regardless of the exact source of that wealth. It may have been a fortuitous purchase of a patent, a discovery in the research labs, a marketing edge, the discovery of some mineral deposit, or other unpredictable competitive advantage.

In fact, the very unpredictability of the advantage is what generates surprises and wealth. If all gains or excellent performance stemmed from reproducible methods, then those methods would quickly be copied, implemented, and all competitive advantage due to them would vanish.

Such performance can't, won't, and doesn't typically last for very long. But that timeframe can be years, not days or months.

In fact, my own research began with my simple quest to learn what the distribution of company performances was on the basis of being able to consistently outperform the equity markets averages on total return. From that knowledge, I was able to discern a range which constitutes an average length of time of outperformance.
In the same research, I tested ROA's association with patterns and levels of market outperformance, and found it absent for firms which grew revenues at above-average rates. Simply put, ROA is a point estimate of little value in deducing ongoing behavior of firms that are growing at a healthy pace.

And ROA doesn't automatically or tautologically translate into shareholder wealth. So it's going to be of passing interest to both investors and CEOs.

Thus, for all their extensive, hard quantitative work, the authors of the Deloitte study have pretty much doomed it to insignificance because it doesn't generate operable conclusions which directly lead to increased wealth for shareholders or their CEOs.

Then there's the matter of choice of patterns of outperformance.

In my research, I first reviewed real corporate performance over time. From these analyses, I constructed patterning variables which grouped companies by the pattern which their performance exhibited.

By contrast, the Deloitte study authors began by arbitrarily deciding to set a threshold of occurrence of 9 out of 10 years for a variety of unspecified fundamental performance measures.

Why should 9 out of 10 be the appropriate screening value? Why impose a value on the date a priori, instead of simply letting the data describe the true situation?

Thus, the authors proceeded down a path which features their own subjectively-chosen patterns for outperformance on a measure, ROA, which has no direct relationship to the growth of shareholder value in most companies.

As I read their paper, I reflected on my own background being a curious confluence of several important streams of influence. Over many years and with different companies, as a marketing and strategy professional, internal consultant, external consultant and research director, in several different sectors, including financial services, I happened to absorb several key lessons for this type of research.

Being in consulting at Oliver, Wyman & Co., I didn't approach research on the sources of consistently superior shareholder wealth creation with the scepticism that a true believer in efficient financial markets. When I produced my financial services sector results and presented them to retiring Chairman Alex Oliver, he exclaimed, to paraphrase,

'For years we've been saying we had knowledge of what drives superior performance, but we never really did. Now, with this, we do. This is a strategy consultant's ultimate tool.'

Alex was a lot of things, including cheap and petty, but he was arguably one of the best strategy consultants of his time. In his day, he headed Booz Allen Hamilton's strategy practice, leaving to co-found Oliver, Wyman. I took his praise as justifiable proof that my research approach was unique, effective and applicable in a very pragmatic manner.

When I extended the research, on my own, to the entire S&P 500, the results were even more powerful and applicable.

What Raynor, Ahmed and Henderson have produced has no real applicability other than a sort of minor confirmation that what can be easily duplicated is of little lasting value. And that what typically creates significant shareholder wealth can't be reduced to easily-duplicated management dicta.

So, there you have it. The Deloitte study authors and I agree that unexpected innovation can't be easily duplicated as a management style.

But I already knew that, and, if you read this blog regularly, so did you.