Monday, February 16, 2009

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Saturday, February 07, 2009

Fixing a Deflation: A Most Intelligent Analysis

I have reprinted in total an interview between fund manager Ray Dalio and Barrons. This is the most detailed and well-thought-out description of what is a deflation and how it is repaired that I have seen. It echoes my thoughts and commentary almost verbatim, but with a lot more detail and credibility. Read on to understand what is happening and how we get out. I will put my commentary in brackets[]:

http://online.barrons.com/article/SB123396545910358867.html?page=2&page=sp

SATURDAY, FEBRUARY 7, 2009 INTERVIEW

Recession? No, It's a D-process, and It Will Be Long

Ray Dalio, Chief Investment Officer,
Bridgewater Associates

By SANDRA WARD

AN INTERVIEW WITH RAY DALIO: This pro sees a long and painful depression.

NOBODY WAS BETTER PREPARED FOR THE GLOBAL market crash than clients of Ray Dalio's Bridgewater Associates and subscribers to its Daily Observations. Dalio, the chief investment officer and all-around guiding light of the global money-management company he founded more than 30 years ago, began sounding alarms in Barron's in the spring of 2007 about the dangers of excessive financial leverage. He counts among his clients world governments and central banks, as well as pension funds and endowments.

"The regulators have to decide how banks will operate. That means they are going to have to nationalize some in some form." No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%.


In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%. Here's what's on his mind now.


Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.


Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.


Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?


Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.


You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.


You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?


The D-process is a disease of sorts that is going to run its course. When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?


The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s. Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt.

Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.


As goes GM, so goes the nation?


The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.


This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.


We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money [Exactly, but keep reading, the story gets even better].


It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.


Isn't the process of restructuring under way in households
and at corporations?


They are cutting costs to service the debt. But they haven't yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.


What are you suggesting?


An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.

So where do things stand in the process of restructuring?


What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.


The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.


However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth.

There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.


Is a restructuring of the banks a starting point?


If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.


On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something. But the future of banking is going to be very, very different. The regulators have to decide how banks will operate.

That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?


Nationalization is the most likely outcome?

There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?


Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down.

Does this give you comfort?


Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.


To the extent we are going to have nationalized banks [Citi, BAC for sure, as I have maintained; they are already Fed controlled, if not completely nationalized], we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending.

So whose money is it, and who is protecting that money?

The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.

Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower.

If you shouldn't have lent to them before, how can you possibly lend to them now?


I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them. Those examples exist, but they aren't, by and large, the big picture. There are too many non-viable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.


By the way, in the bear market from 1929 to the bottom, stocks declined 89%, [note: in 1929 the DJI stocks were very extended and had the same kind of PEs as 2000. When stocks tanked in 2008, the PEs were much lower because the air was already let out of the stock market, so we will not need to see a DJI of 1400 before this is over. We probably already has seen the DJI low] with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.


At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.


In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933. [The timing of the change in Presidents is remarkable in its similarity. The market decline and recession started in 1930 and two years later, there was an election. This time, the housing market peaked in 2006 and two years later, there was an election. I think we are in early 1933 if we use the Great Depression as our reference. That was a great time to get long the stock market]


Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?


The Federal Reserve is going to have to print money [my blog friends who fear the printing press need to pay attention here. This point is why I discount what I hear from Marc Faber, Jim Rogers and Peter Schiff. They don't know their history]. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression [this answers the question about who will lend us the money to back the printing press]. We are in a position where that will eventually create a problem for currencies and drive assets to gold [which, in this context, is okay. I am long gold, but I am also long our economy].


Are you a fan of gold?

Yes.

Have you always been?

No. Gold is horrible sometimes and great other times [because its only value is as an alternate currency or jewelry. Gold has NO inherent value. It is an unproductive asset]. But like any other asset class, everybody always should have a piece of it in their portfolio.


What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.

Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity [this is a point that changes my thinking a bit. I think in terms of either / or; but Dalio makes the case for an overlap of the appreciation of both asset classes].

While the dollar is bad, it doesn't mean necessarily that the bond market is bad. I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.

Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive.


Other currencies will decline in relationship to the yen and in relationship to gold [hmmmm, I don't know if "less bad" is good enough for me. I think Japan is in this with the rest of us; though recent currency action supports Dalio's case here].


And China?


Now we have the delicate China question. That is a complicated, touchy question. The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus.


China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.


From the U.S. point of view, we want a devaluation [YES!! this is the point I always make: we must create inflation to get out of this problem, thereby devaluing the dollar]. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.


But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.


And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive. [this is a major thesis of mine, and I own FXI, the China equity index fund and will buy more. This is a long term phenomena that will last my lifetime. China will be the major source of commodity demand for decades, so commodities are a great investment here]


You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?


A wave of currency devaluations and strong gold will serve to negate deflationary pressures [YES!! another of my points: inflation cancels deflation], bringing inflation to a low, positive number rather than producing unacceptably high inflation [this is the point where Faber, Rogers and Schiff are most wrong because they do not acknowledge the role of cancellation of deflation] -- and that will last for as far as I can see out, roughly about two years.


Given this outlook, what is your view on stocks?

Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.


Thanks, Ray

.

Sunday, February 01, 2009

Refuting the Arguments of Gold Bugs

Today, I answer the blogposts of a couple of gold bugs who are a little overwrought with the idea of a new age where gold is king:

"Another Case for Gold": http://livingoffdividends.com/2009/01/31/another-case-for-gold/comment-page-1/#comment-32504


"Boy, Nirav, is the author of this piece mixed up. There are parts of it that are correct, but the overall picture is decidedly mixed and confused.

You and I have been in agreement that gold and other precious metals and hard assets will benefit from a period of monetary expansion once the deleveraging is done. I believe that as long as dollars are printed to replace the financial assets lost in write-downs, there is no inflationary pressure created: no extra demand chasing too little supply. (and in fact, we are now entering a period of excessive inventory, whether houses, cars or clothing, which is the source of all deflations).

But once inventory (supply) is back in balance, then all the excess money supply (demand) will probably cause inflation. How much inflation will be determined by how fast the Fed and Treasury can remove the dollars from circulation. One way is as the author described: by selling Treasuries. But this also is the source of one of his misdirections. Here are the errors I saw in his arguments:

  1. “if the Fed floods the market with Treasuries, it will achieve exactly the opposite effect it’s looking for — it will cause rates to rise” - POINT: when the Fed uses this policy of selling Treasuries to reduce monetary supply, it is INTENTIONALLY trying to raise interest rates (see Paul Volcker in 1980). Interest rates must go up to attract buyers to Treasuries. That is the whole point, which addresses another of his confused arguments:
  2. “Do you really think the Chinese and the Japanese are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to buy dollars to stop an inflationary price explosion?” POINT - NO, of course not. The Fed already knows it will need to raise interest rates to attract capital to Treasuries once de-leveraging (fear) is out of the market. The very low rates of today are a product of global fear of economic failure. I find it very interesting that global wealth is flowing to the US dollar through Treasuries and not to Gold. It really refutes the Gold Bug argument, doesn’t it?
  3. “They’re not going to fund an inflationary dollar at 2%. Ever.” POINT - DUH!! Come on, the author of this piece seems smart and well-educated, but this statement makes me wonder. First, the mechanism for issuing debt of any kind, government or corporate, is through auction. The 2% rate is a product of what the market will bear, not some Federal fiat. Interest rates of all types are set by the market, not be some pre-ordained decision. The Fed officials (really, any one educated in economics) understand that when we enter a period of excess money supply (we can only wish for that right now), then interest rates will be bid higher.
  4. The reason for this is also Economics 101: investors are only concerned with the REAL return of an investment, not the NOMINAL return. The real return is the investment return minus inflation. So, the market will ALWAYS require a return that is positive or in excess of inflation. 2-2.5% is the normal expected REAL return for a riskless investment (Treasury). How do we know this? It is quoted every day in the Treasury Inflation Protected Securities (TIPS). When inflation is negative, as it is right now with a contracting GDP, very low interest rates still generate positive Real Returns.
  5. “[In the past] the U.S. money supply was much smaller, and our ability to borrow was much stronger. But those days are gone.” POINT - many younger writers, or those not solid students of economic history, forget the context of “the past”. In the 1950s and early 60s, America’s economic nexus, America was the only country with its economic infrastructure left intact after World War 2. America was never bombed or invaded and its manufacturing infrastructure had been built to the sky in support of the Western World’s war machine. Because hard assets were plentiful, soft assets (currency) were not widely needed. People miss this very important point. Currency is just a substitue for real or hard assets. Those assets can be buildings, machinery, coal, oil or gold. American then, like China now, had lots of assets and against those assets, loaned the rest of the world money so they could rebuild theirs. When you loan money, money supply contracts, just as when you borrow money in expands.
  6. The author (and most goldbugs) forget that currencies are comparative. If the entire world prints more money in concert, how can any harm be done? The dollar is just a unit of measure that represents economic exchange. Each dollar represents a fractional claim on the national aggregate assets of America. When I was a small boy, $1 meant a lot (could buy 3 loaves of bread). Today, $1 is probably represented by $10 in making purchases (still buys 3 loaves of bread). Does that change my life in any way? NO. Does it change my buying power in any way? NO. As long as my income is 10 times what it was before (and on average for Americans, it is), it is a wash. No one cares. And as long as the rest of the world follows the same path, it matters not. But, if you hold Real Assets over that time period (gold or real estate, among others), they will hopefully be worth 10 times as much, but probably no more (at least not for long). So, does that ounce of gold today buy any more than it did in 1972? NO. Money is symbolic and comparative, and to try to make some case for a new paradigm for Gold is as hopeless and mindless as those who tried to dismiss it entirely 10 years ago.

Saturday, January 24, 2009

Looking Up for Energy and Resource Stocks

Swiss investor, Marc Faber, still hates America, but he has a good track record for market prediction. So, I paid attention when I read this in Barrons today, in the Investor Roundtable Part 3:

Faber: When volatility diminishes (in the next few months), you want to be in cyclical industries. Among the most cyclical stocks are resource producers. They were driven up by incremental demand from China, and then collapsed. In the next six months they could have significant upside. I like Rio Tinto, BHP Billiton and CVRD [Companhia Vale do Rio Doce].

The financial crisis and collapse in commodities will keep supplies out of the market. Nobody is exploring now. There is no money, and projects are being postponed. Whenever the recovery comes, in five or 10 years, resources stocks will go ballistic from today's low levels. If you're optimistic about the next six months, too, when the news may be slightly better than today, you should own them. Freeport McMoRan Copper & Gold fell from 127 to 15 and is now 26. Xstrata, in Switzerland, is another one. A lot of these stocks are more attractive than gold, because gold is at a 20-year high relative to industrial commodities.

Scott Black: Rio Tinto's balance sheet isn't in good shape. They have a refinancing issue.

Faber: Worst-case, the Chinese government could buy them out. China has taken a big stake in the company. Meryl recommended Kaiser Aluminum [KALU] earlier today. I would add Alcoa.

Felix Zulauf: You're not saying this is the beginning of a big bull market, but of a base-building process from low levels.

Faber: Correct, but when stocks decline by the magnitude seen in resources shares, or the Nasdaq after 2000, a base-building period follows that can extend for several years. When you print money, you can get an artificial bull market (in cyclical and resource stocks) that exceeds everyone's expectations.


And this is a quote from Scott Black, another on the Barrons Roundtable of great investors (and a disciple of Benjamin Graham and value investing). He makes the case for XTO. But the arguments and metrics can be applied just as well to the Canroys (though it appears XTO did a much better job of hedging than PWE or PGH):


BLACK : My next pick is an old favorite, XTO Energy, in Fort Worth. The stock is 37.58, there are 577 million fully diluted shares, and the market cap is $21.6 billion. The company did a smart thing by hedging approximately 77% of its natural-gas production in 2009. They have locked in 1.6 Bcf [billion cubic feet] of gas at $8.94 per Mcf [thousand cubic feet], and 62,500 barrels a day at $118.85 per barrel. Production has been growing dramatically, and should average about 2.67 Bcf per day in 2009, up 18% year over year. About half the increase is from drill-bit growth, the rest from acquisitions. XTO bought Hunt Petroleum last year for $4.2 billion, figuring it could triple reserves, which are now 80% gas, 20% oil. It has 12 Tcfe [trillion cubic feet-equivalent] of gas and 500 million barrels of oil.

BARRONS: What are you pricing reserves at?

Black: I value the gas reserves at $3 per Mcf and the oil at $8 per barrel. Breakup value is about $44 a share, so the stock is selling at 85% of breakup value. My 2009 revenue estimate is $9.86 billion -- slightly higher than the Street's -- which converts to $4.50 a share in earnings. Return on equity is 15.5%, return on total capital 10.3%. Free cash flow is $2.28 billion. XTO has cut its capital-spending budget this year, to $3.8 billion from more than $5.3 billion. They are wed to the notion of knocking $1 billion to $2 billion of debt off the balance sheet.

Their finding and development costs were $1.45 to $1.50 per Mcfe in 2007, and $1.65 in 2008. This year they could fall to $1.50. XTO is one of the few energy companies with rising earnings, because of hedging. They will earn about $3.75 to $3.80 a share for 2008, and $4.50 for '09. The stock sells for 8.3 times earnings and 3.6 times discretionary cash flow. It is extremely cheap. You've got asset and earnings protection. And they are in every major field in the U.S. -- the Barnett Shale, Fayetteville and so forth. Energy is a controversial investment today, but XTO is the cream of the crop.

Schafer: If they hedged this year, does that mean next year's earnings will be down?

Black: No, because they hedged 2010, too.

Friday, January 23, 2009

Goodbye, President Bush; We Will Miss You

I do not name this post sarcastically. I know I am in the minority, but I will miss President Bush. Yes, he was hard to watch and listen to at times, with his less than perfect execution of the English language (and won't the liberal comedians miss him for this?!). And yes, he was bullheaded and stubborn and overly loyal to his friends; and he could stick too long to his conservative principles when pragmatism suggested otherwise. But that is also why I liked President Bush. Like every human, he was fallible. But unlike most politicians, he was humble and able to laugh at himself. He knew he was not very polished and he reveled in his imperfections.

I just read a great piece on President Bush's retirement from the Presidency by Karl Rove. Yes, it is biased as Rove was Bush's right hand man for many years. But it is also honest and true. Read the article below. I think regardless of your political orientation, you will appreciate the great human being that is George W. Bush. And note his accomplishments. Did anyone besides me and Karl Rove get the irony of President Barak Obama warning terrorists that "you cannot outlast us"? This statement was only made possible by the unpopular policies of President George W. Bush. In the unvarnished re-examination of historians, he will be remembered for protecting us at one of our darkest times.


OPINION
JANUARY 21, 2009, 10:48 P.M. ET

Bush Was Right When It Mattered Most

http://online.wsj.com/article/SB123258532378704477.html

By KARL ROVE

Its call sign has always been Air Force One. But on Tuesday, it was Special Air Mission 28000, as former President George W. Bush and his wife Laura returned home to Texas on a plane full of family, friends, former staff and memories of eight years in the White House.

The former president and his wife thanked each passenger, showing the thoughtfulness and grace so characteristic of this wonderful American family.

A video tribute produced warm laughter and inevitable tears. There was no bitterness, but rather a sense of gratitude -- gratitude for the opportunity to serve, for able and loyal colleagues, and above all for our country and its people.

Yet, as Mr. Bush left Washington, in a last angry frenzy his critics again distorted his record, maligned his character and repeated untruths about his years in the Oval
Office. Nothing they wrote or said changes the essential facts.

To start with, Mr. Bush was right about Iraq. The world is safer without Saddam Hussein in power. And the former president was right to change strategy and surge more U.S. troops.

A legion of critics (including President Barack Obama) claimed it couldn't work. They were wrong. Iraq is now on the mend, the war is on the path to victory, al Qaeda has been dealt a humiliating defeat, and a democracy in the heart of the Arab world is emerging. The success of Mr. Bush's surge made it possible for President Obama to warn terrorists on Tuesday "you cannot outlast us."

Mr. Bush was right to establish a doctrine that holds those who harbor, train and support terrorists as responsible as the terrorists themselves. He was right to take the war on terror abroad instead of waiting until dangers fully materialize here at home. He was right to strengthen the military and intelligence and to create the new tools to monitor the communications of terrorists, freeze their assets, foil their plots, and kill and capture their operators.

These tough decisions -- which became unpopular in certain quarters only when memories of 9/11 began to fade -- kept America safe for seven years and made it possible for Mr. Obama to tell the terrorists on Tuesday "we will defeat you."

Mr. Bush was right to be a unilateralist when it came to combating AIDS in Africa. While world leaders dithered, his President's Emergency Plan for AIDS Relief initiative brought lifesaving antiretroviral drugs to millions of Africans.

At home, Mr. Bush cut income taxes for every American who pays taxes. He also cut taxes on capital, investment and savings. The result was 52 months of growth and the strongest economy of any developed country.

Mr. Bush was right to match tax cuts with spending restraint. This is a source of dispute, especially among conservatives, but the record is there to see. Bill Clinton's last budget increased domestic nonsecurity discretionary spending by 16%. Mr. Bush cut that to 6.2% growth in his first budget, 5.5% in his second, 4.3% in his third, 2.2% in his fourth, and then below inflation, on average, since. That isn't the sum total of the fiscal record, of course -- but it's a key part of it.

He was right to have modernized Medicare with prescription drug benefits provided through competition, not delivered by government. The program is costing 40% less than projected because market forces dominate and people -- not government -- are making the decisions.

Mr. Bush was right to pass No Child Left Behind (NCLB), requiring states to set up tough accountability systems that measure every child's progress at school. As a result, reading and math scores have risen more in the last five years since NCLB than in the prior 28 years.

He was right to stand for a culture of life. And he was right to appoint conservative judges who strictly interpret the Constitution.

Few presidents had as many challenges arise during their eight years, had as many tough calls to make in such a partisan-charged environment, or had to act in the face of such hostile media and elite opinion.

On board Special Air Mission 28000, I remembered the picture I carried in my pocket on my first Air Force One flight eight years ago. It was an old black-and-white snapshot with scalloped edges. It showed Lyndon Johnson in the Cabinet Room, head in hand, weeping over a Vietnam casualty report. George Christian, LBJ's press secretary, gave it to me as a reminder that the job could break anyone, no matter how big and tough.

But despite facing challenges and crises few others have, the job did not break George W. Bush. Though older and grayer, his brows more furrowed, he is the same man he was, a person of integrity who did what he believed was right. And he exits knowing he summoned all of his energy and talents to defend America and advance its ideals at home and abroad. He didn't get everything right -- no president does -- but he got the most important things right. And that is enough.

Mr. Rove is the former senior adviser and deputy chief of staff to President George W. Bush.

Sunday, January 04, 2009

Reflation Economics (or "The Minsky Solution")

As your resident amateur economist, I would like to offer up an article coming from one leg of the PIMCO triumvirate (Paul McCulley, the others being Bill Gross and Mohamend El-Erian) who rule the private sector bond world.

McCulley is the Central Bank expert of the group and his expertise is near Nobel Laureate in its quality and insight. The PIMCO group anticipated the current banking crisis and declared the cause well in advance of the blowup. The PIMCO team labeled the cause as the "Shadow Banking System" and saw the leverage that was being created by hedge funds and others using the tools like "carry trade" to create money through leverage.

Like the rest of us, this group of economists thought the outcome of "shadow banking" would be inflation, as easy money created excess demand. None of them forecast the total collapse of the system and the resultant deflation. However, McCulley suggested the possibilty through his analysis of Hyman Minsky's work as an economist 30 years ago. McCulley uses Minsky to explain money growth and contraction, and does so at times with his stuffed bunny he keeps in his office (he calls "Bun-Bun").

I thought you might find this article insightful. Here is a sample with my paraphrasing in parantheses:

(It is the explicit responsibility of the Fed to provide a “more than proportionate” response to an economic contraction). That is indeed what is needed to save capitalism from its inherent debt-deflation pathologies. The paradox of deleveraging and the paradox of thrift are beasts of burden that capitalism simply can’t bear alone (that is to say, Capitalism is not a perfect economic system, but occassionally needs help when excess greed or fear get in the way). Only the Minsky Solution can lift that load.”

Here is the entire article:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCB+December+2008+McCulley+All+In.htm

PIMCO and specifically, Paul McCulley, is the originator of the idea of “Shadow Banking”, which has come to dwarf the Federal Reserve system in the last 10 years. The amount of assets controlled by the shadow bank makes central bank policy implementation difficult, if not impossible. Shadow banking is the creation of money from nothing by private institutions, like hedge funds. Such financial institutiosn were increasingly deregulated in the 1990s and 2000s. Because they could use instruments like the “carry trade” to create money with very little invested capital, by use of massive leverage, the system effectively grew the money supply outside the control of the Central Bank. This was thought to be inflationary by the PIMCO team as late as 2007, but proved to be deflationary instead.

Now, that the shadow banking system is collapsing, it is following exactly the Minsky model. The Minsky Moment, modeled as the “Ponzi Unit” (in the McCulley chart), was achieved almost exactly at the time the biggest real-life ponzi scheme was uncovered, the Madoff Fund. Talk about life imitating art!!

So, the real central bank must transfer the leverage that is disappearing in the private sector, to the public sector, in order that the economy does not collapse into oblivion. I would like to ask Mr. McCulley what is the step to follow in the Minsky Model: how does the leverage that the public sector absorbs from the private sector get resolved? By time alone?

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm

Saturday, January 03, 2009

My Projections for 2009

How bad was 2008 from an investment perspective? From Barrons issue on January 5: "The S&P 500's 37% loss of 2008 served to knock three-quarters of a percentage point off the annualized index total return since 1927, to 9.7% from 10.4%, according to Aronson+Partners. The 10-year trailing returns for large-cap stocks now appear to be at their worst level since 1827, says Morgan Keegan, and trailing returns of world equities versus bonds are at their weakest since the late 1970s, says BCA Research."

So, combined with the Tech Bust in 2001-03, we could say we are simply in the worst period for investors in 200 years. We should have "mean reversion" at some point. It has to get better!! The article goes on to say: "the lousy risk adjusted record for stocks that now dominate investors' memory is discrediting equities in the public mind as a wealth-building asset class." For those with a 20 year time horizon, this is what we want to hear. I was very worried a couple years ago when volatility had gone to less than 10 (as measured by VIX). Low market price volatility goes with a perception of low risk. When the market loses its risk, it also loses its prospects for return.

For the stock market to achieve its typical 4-6% real return (the return above inflation), there must be a perception of risk. If there is no risk, then returns will be only 1-2% over inflation (see TIPS returns as an example), and the ability to grow wealth by market investing will be lost.

Santoli goes on in his Barrons article: "This is helpful, and implies the direction of mean reversion for asset classes will favor stocks again before long, though who knows from what ultimate level? The five years following the 10 worst calendar years for stocks were always up in total -- sometimes not much, sometimes a lot, an average of about 10% annualized -- yet three times the year immediately afterward was down more than 20%."

All this is good and sounds very reasonable. But the title of this post is "Projections for 2009". I know you are looking forward to my annual amusing, but rarely insightful projections. I understand that by January 4, you have already seen more than enough forecasts. But I have been doing this since 2002 now (except last January when my crystal ball was all cloudy), so I don't want to break the string (though I just admitted I did last year). Here goes:

  • Government backed interest rates (mortgages and Treasuries) will stay low throughout 2009 (less than 1% for 2 year bonds); but sometime thereafter, maybe early 2010, they will start rising and continue going up as inflation heats up along with an economic recovery.
  • By the July 2009, the high yield and corporate bond interest rates will begin to decline, narrowing the historic spreads against risk free Treasuries
  • Crude oil will continue weak throughout 2009 in a range of $25 -$60 per barrel; as a result production and exploration will be reduced and lower production with higher demand will set the stage for a rebound to over $100 sometime in 2010 or 2011; enjoy low gasoline prices while you can;
  • Gold prices will stay under $1000 in 2009, but will not decline under $600; but gold could increase to over $1500 by 2012 because of a weaker dollar caused by inflation from excess money supply created in 2009;
  • In early 2009, GM will be forced to declare bankruptcy (or an equivalent government reorganization); same for Chrysler; this will set the stage for a revamping of the American auto industry and will usher in a new era of manufacturing competitiveness; Ford will escape bankruptcy, but will benefit from the changed labor and franchise rules;
  • At least five major mall retail brands will declare bankruptcy and will be closed; candidates: Abercrombie, Zumiez, GAP, Hot Topic, Lane Bryant, Foot Locker, Eddie Bauer, Ann Taylor; but look for the retail sector to outperform as soon as 2010;
  • General Growth may become a victim both due to the above store closings / bankruptcies, but also due to the debt it took on to acquire Rouse Companies; its survival depends on selling several of the Rouse flagship properties: Fanueil Hall (Boston), Harborplace (Baltimore) South Street Seaport (NYC) and its Las Vegas malls (Forum Shoppes, Fashion Mall, Highland Mall);
  • Official unemployment will top 8%, but will not top 10%;
  • Mortgage rates for 30 year fixed rate Fannies will be less than 4.5% with no points; but these rates will rise in 2010;
  • The stock markets will see a range and return by year end of DJI: 7000 - 10,500 (13%); S&P500: 725 - 1100 (15%); NASDAQ100: 1400 - 2200 (10%); with the lower end of the range reached in the first half of the year (there will be a retest of the November low, but that retest will be the bottom of a new 20 year secular Bull market, albeit the new Bull will be sleepy for several years while the economy and debt are repaired);
  • The best asset class return in 2009 will be in high yield bonds (junk) with a 30% total return;
  • The 2nd best asset class return in 2009 will be in energy stocks, both producers and equipement providers, though producers will have the best total return at 25%;
  • The worst asset class in 2009 will be Treasuries with 30 year bonds returning a negative 20%;