What do Analysts Actually Consider?

Many are pointing at Goldman Sachs this week and laughing a bit. A week ago, they suggested that the financials had hit (or were at least approaching) a bottom and that investors would be well to reinvest in the sector. A few days later, of course, they reversed their position and now recommend an underweight investment. My question has little to do with this particular recommendation or the financial sector, but rather how analysts could waiver between such extremes within such a short period of time. What is it that they look at?

It's certainly not the fundamentals! The fundamentals of a company do not change overnight and nor do they change within a week. Analysts are supposed to be the insiders who have a window into a sector, industry and a small group of companies - providing investors with greater clarity on a publicly traded company's viability as a going-concern. When I see such a respected firm reverse their position within such a short period of time, however, they come across as just another investor on the street that's watching the headlines on the ticker tape; they're just reacting to the latest news and speculation rather than actually investigating the underlying truths.

Competition & Deregulation Fight Stagflation Part 2

Sometimes it seems as though there's a counter-argument for every argument; isn't it great! I just finished writing how competition and deregulation was working to prevent inflationary pressures from spiraling out of control and then I read this article that made me rethink my position, again. I still believe that competition and deregulation are in-fact working to keep those pressures under control, but I neglected to consider the effects of rising fuel prices on the extent to which that competition can take place.

There's no doubt that communications technologies enable for a great deal of competition in the services sectors, but that's going to have a lot less of an impact on the manufacturing side of the economy. Ultimately, manufacturers have too get their goods into a market before they can sell them there and the rising cost of oil has made that far more expensive. The result is that domestically produced goods are just a little more attractive and the demand for those goods, as a consequence, is just a little higher. This higher demand for domestic manufacturing empowers laborers just a little more and makes wage-hikes just that much more likely. As I've written before, rising wages is the key influential factor driving inflation.

So where do the scales balance? Good question; it's anyone's guess really. I will say that the forces of competition and deregulation are not going away, but the oil price bubble may very well disappear. What happens then?

Oil Prices: Speculative Bubble or Not?

Yes, I know, it's not exactly an original headline, but the question does still persist. I'm certainly on the side of the argument that says it is a speculative bubble, but even I have my doubts about the extent to which the latest rise is due to speculation as opposed to real demand and supply factors. No one, for example, could argue that the supply of oil is not ultimately limited and that certainly has an effect on the price of oil. There is no doubt that the price of oil has to rise as the known sources of oil slows.

On the other side of the argument, my side, you balance the falling supply of oil with the rise in alternative fuel sources such as wind power that has received a lot of attention lately. Similarly, there's more talk about hybrids and plug-in hybrids among the automakers than ever before. As the cost of these alternatives fall, consumers will demand more of them and consequently require less oil (traditional fuel), which should drive-down the price of oil. As a result, you could argue that the force of dwindling supply is being countered by the rise in the availability of alternatives. The question then becomes, of course, which force is more powerful?

Actually, would anyone really question the suggestion that alternatives such as solar, wind and nuclear eventually outweigh the demand for oil? The cost of drilling and refining oil is only going to rise as the world's oil companies must search for less available reserves off-shore or in oil sands like those in Canada. By comparison, the improving technologies are only going to help drive-down the cost of the alternatives. The result almost certainly has to be that the demand for oil falls as the demand for the alternatives rises. The real question then becomes, of course, what is the timeline. Unfortunately, I don't have an answer for that, but I will say that I don't believe the current price of oil is sustainable and that a bet against oil will undoubtedly pay off in the long-term. I'm just not sure of my definition of 'long'.

Competition & Deregulation Fight Stagflation

I just finished reading an interesting article that has caused me to rethink my position on the state of the economy and where it may be going. I've written before on how the current slowdown resembles what we saw in the '70s and earl '80s, but after reading this article, I'm reconsidering the affects that global competition may have on the ability of the U.S. economy to ever see the sort of rocketing inflation that we say a few decades ago.

It comes down to wages. If wages don't begin to rise (accelerate, actually), then inflation will remain relatively under control. This is an important fact to remember when you consider that a global economy means that nearly every sector, industry and individual business competes with international vendors willing to cut prices and snatch-away customers. The article uses the airline industry as an example, but the same logic could be extended to almost any market. Whereas airline ticket prices rose by more than one-third in the early '80s, they've seen less than a 2% rise even with the unprecedented rise in the cost of fuel. The reason? Competition and deregulation.

There are more airlines, even with all the trouble in the sector, than ever before. Travelers have more choice than ever before. The result is that airlines are left sitting between a rock and a hard place. With the rising cost of inputs to their operations, the decision is no longer whether or not to raise prices, but rather whether or not to continue operations at all. They are no longer able to raise prices because their competition won't. One of any competitor airlines that had been fortunate enough to hedge the cost of fuel earlier will have a cost advantage and will simply assume all customers should its competitors increase their prices. In economic terms, it suggests an inelastic short-term supply curve. What's interesting about this argument is that nowhere have I mentioned wages, which is traditionally considered to be the primary driver of inflationary pressure.

There's competition for jobs too. Just like there are more airlines fighting over travelers, there are more people fighting over jobs. Workers are less able than ever before to request a wage increase. There are fewer labour unions and those that do still exist are less powerful. Moreover, the ability to outsource leaves employers not with the decision to increase wages or lose employees, but rather whether or not to keep employees or outsource operations oversees where costs could be a fraction of what they are locally. The consequence of all this is that rapidly rising inflation may really be a historical artifact.

We've Only Seen One-Third of Writedowns?

According to John Paulson, founder of the hedge fund company Paulson & Co., global writedowns stemming from the credit crisis may top $1.3 trillion, surpassing the International Monetary Fund's estimate of $945 billion. Who is Paulson, you ask? He's the guy who placed a bet on the speculative bubble in the sub-prime lending market, which has netted his fund a gain of a whopping 591% in the past year. This is the guy who saw the storm coming so you could say that he's got a fairly good insight into the breadth and depth of the sub-prime market.

$1.3 trillion in writedowns is three-times higher than the writedowns already reported. That's both a staggering total figure and worrying prediction for what the future holds for the global economy and financial markets. The U.S. economy has certainly taken the brunt of the immediate downturn, but as economic speculators are working diligently to maintain a positive attitude in the business press, the reality is that the downturn we've seen thus far is only the tip of the proverbial iceberg.

In a survey of hedge fund managers conducted at a meeting in Monaco last week, more than 80% said that the see the current credit crisis persisting for some time yet so Mr. Paulson is certainly in good company. Moreover, as much as 23% of those surveyed see the current situation worsening further before it gets better. What's interesting, is that it appears that these same hedge fund managers are watching the financial stocks like vultures circling; they waiting for the best time to buy the stocks that have been beaten-down by as much as half. If you're anything like me, then you will be watching the actions of these firms to insights into when, exactly, will be the right time to jump back into the banking waters where the opportunity appears to be astronomical.

If it's not one thing, it's inflation

I wouldn't exactly call it breaking news, but it was good to see consensus among the G8 that inflationary pressures were now the biggest threat to economic growth worldwide. The credit crisis certainly has worked to send many of the largest economies into a tailspin, the US most notably, but the persisting pressure of higher oil and commodity prices threatens to keep these same economies from any sort of near-future recovery.

Oil hit $139.12 per barrel on June 6, 2008; an all-time high. Commodity prices, like wheat, for example, have seen prices double in the past year. On a personal note, I can confirm that I've seen the price of whole wheat flour literally double in a matter of weeks at my local supermarket. While commodity prices represent a relatively small proportion of household spending (food, in general, may only see single digit-increases), the combination of these rising prices with declining home equity and accelerating unemployment figures paints a very black picture for the future.

It's a positive thing to note the G8's consensus, but worrying still is what actions will result from that consensus. To slow inflation, central banks will begin to raise interest rates. While many would tend to agree that this is long-overdue, the current state of the world economy as generally weak and slowing, will likely mean that in doing so, the higher cost of capital will only affirm the recessionary tendencies and result in a very, very slow recovery.

More Information Is Always Better

There's a lot of talk about the SEC and its persisting investigation of the ratings agencies. The good news is that, at least it appears at this point, investors will be winners now matter what the outcome.

I wrote earlier about the SEC's consideration of a plan to require the ratings agencies to make their research material available to others. This, of course, would allow others (hopefully individual investors as well) will be able to assess risk-and-reward profile for a given investment - just as the credit ratings agencies do. The advantage is that investors could become less reliant on the AAA-ratings and could review the actual data that goes into such a rating. With the agencies being blamed for having rated mortgage-backed securities as tripple-A (the highest investment-grade rating) that subsequently defaulted and resulted in hundreds of billions of dollars in losses and write-downs.

Now, there's news that the SEC will offer the ratings agencies a choice between two possible outcomes. The first, will be a disclosure of the underlying information as I described above; the second will introduce a new rating scale that would help identify mortgage-backed securities and distinguish them from corporate bonds. While certainly not providing as much information, this too would work to make investors more aware of where they were placing their money and that's never a bad thing. So, no matter what happens, at least its comforting to know that we, lowly investors, will ultimately win.

Ratings Agencies & Structured Securities

The SEC's investigation of the ratings industry continues and the latest target on their hit list is the rating of structured securities. The headlines suggest that the Commission may go so far as to ban the three top ratings agencies. Moody's, the S&P and Fitch from rating such securities at all. All three of these firms help to advise investment banks on the design of such securities, so how can they be trusted (by investors) to also provide impartial evaluation of their risk-and-return profiles?

What's more interesting, and possibly valuable, to investors, however, is the SEC's suggestion that the ratings agencies be required to make available all the data that goes into the ratings so that other firm (and possibly private investors?) be able to make their own determinations based on the very same information. In my previous studies about statistics we were often presented with research papers that claimed one result or another based on some analysis. What I often found quite interesting, however, was when such papers were later refuted by further analysis of the same data by other analysts.

As is often said, statistics can be massaged to say almost anything that you want. I can't help but think that ratings agencies are simply statistical analysts with an especially bring spotlight on their research reports. Data mining, the practice of scouring through numbers to find a particular trend or pattern, is a well known practice; try it for yourself. If you use enough data, I promise you that you can find any patter or trend that you want to find if you look hard enough and make the 'appropriate' assumptions. I think that the skill to analyze data yourself is invaluable and the news that more data may be made available to the public at some time the future will only help individual investors willing to put in the time and effort to make up their own minds about an investment.

Rise in Unemployment Tops 22-year High

Last week's unemployment figures unnerved the stock market, but we know - by now - that that unnerving didn't really last. It's hard to say what the market will react to at all, let alone to what it will react positively or negatively. The fact remains, however, that unemployment is rising faster than ever and this must have real economic impact regardless of what the stock market index figures say today or next week.

I was reading an article on the subject and it's sometimes worrying to see how an author or analyst will often look for data to confirm or undermine whatever the headlines say. For example, this latest jump in unemployment, which clearly spells negativity for the economy, was discounted by a researcher who found that similar occurrences in the past were followed by significant gains in the stock markets within the following 12-months. Should we, then, be excited by the news that more companies are cutting their workforces, more people are losing their jobs and consumer spending will ultimately be forced down?

Stock analysts lose 17% for Investors

Just because it's such a powerful sentence, let me start with a quote from the article that I just finished reading...

Investors who followed the advice of analysts who say when to buy and sell shares of brokerage firms and banks lost 17 percent in the past year, twice the decline of the Standard & Poor's 500 Index.

From the perspective of someone studying toward their CFA (Charterd Financial Analyst) designation, this isn't exactly the most rosy news. What's even more worrying is the sector within which these analysts' recommendations performed the worst - their own: financials. The question is why?

I can't help but wonder what techniques are being used to analyze these companies that analysts track ...if they do use a consistent technique at all, that is. In preparing for my own career as an analyst, it is precisely on this skill that I spend most of my time working: designing my own style and set of tools used to determine what makes a good investment and what does not. The MBA Association, www.MBAAssociation.Org, just launched their Intrinsic Stock Analysis Tool on which I collaborated and I think that this is a great starting point for anyone interested in the field or anyone interested in investing their own money and having the desire to truly understand the fundamentals behind a stock's price.

What I find interesting is that analysts measure their performance based on their 'Buy' recommendations alone; but what about their 'Hold' or 'Sell' recommendations. If you were to buy the stocks they suggested that you buy, you would be up by 17%, but if you were to do everything that they suggested you do, then you would be down by about the same amount. This implies that the money you would lose would be roughly double what you would gain on the up-side. That's a hell of a lot of volatility!

I find it a little frustrating to follow CNBC's latest stock market game with prize money of $1 million for the traders that generate the greatest returns within the few weeks over which the game runs. While it's great to see such games entice new people to the field of finance, it's worrying to see the style of investment that is encourage: trading, not investing. Everyone wants a quick buck, and it seems no one is willing to spend the time to analyze and develop sound investment decisions.

Ratings Agencies Screw-Up & Get Paid Anyway

With all the economic trouble that has resulted from the sub-prime debacle, a great deal of attention was paid to the ratings agencies that awarded high ratings to the debt instruments that later collapsed. In its investigation of the factors that led to this collapse, the New York Attorney General, Andrew Cuomo, also began an investigation into the credit ratings agencies themselves and a settlement in that investigation was just reached between the state and both Moody's and Standard & Poor's. That settlement, however, may leave some investors scratching their heads.

As usual, of course, no one admitted any wrongdoing. You may recall that I previously wrote that Moody's was quick to suggest that a computer bug had caused the ratings to be inflated in certain situations and it never assumed any of the blame otherwise. What is interesting about the settlement, however, is that it may mean greater revenues for these ratings agencies going-forward - yes, more money! The reason, however, actually makes sense.

It all comes down to incentives. Just as the top CEO's have a large part of their total compensation packages tied-up in stock options that align their interests with the performance of the company's earnings (that, of course, is a whole other story), the ratings agencies will be paid for initial analyses and assessments performed on new sub-prime issues. Currently, prior to the new rules, the ratings agencies were paid only if they were ultimately selected by the issuer as the final, official, ratings agency. This approach, of course, incentivized the agencies to give better ratings than they might have otherwise in order to win the business. Being able to earn some cash regardless of their ratings, therefore, should make them more willing to speak the truth ...of course, I'm not saying that they haven't been doing so in the past... you understand, right?

Marking-to-Market of Debt

I came across an interesting article that discusses the application of a new FASB rule (Statement 159) that permits the marking-to-market of debt. You will recall that marking-to-market is the practice of adjusting the balance sheet valuation of an item, previously only assets, to reflect that current market values rather than the book value or original purchase prices. Well, Statement 159, introduced last year, allows this same practice for liabilities. Considering the declining creditworthiness of the banks, you can imagine what's happened to the yields and prices of the bonds that they have on their books - it's resulted in billions of dollars in illusory revenues.

Why illusory? Good question. Just like marking-to-market of an asset, it represents the accounting adjustment of unrealized gains or losses - this does not represent actual cash flows. The investment banks, having recorded several billions of dollars in such marking-to-market gains, have been quick to offset their losses from the write-down of collateralized assets that have declined to pennies on the dollar. The write-downs, too, are unrealized losses so why then would anyone question this practice? Again, good question.

The difference is in the marketability of the assets or liabilities; put differently, it comes down to whether or not you could actually sell the assets (or buy the liabilities) at the new market price. In the case of the assets, there's no question. There is a market for the CDOs, CMOs and other three-letter depreciating assets that we've come to know over the past year; it's only a matter of price - if it's low enough, then someone will be happy to buy it. The reason is simple: they're marked-to-market based on an expectation (probability) of how much of that asset represents bad loans - the reality may be very different from what the current market dictates and the buyer of these assets could gain substantially from the even a small variance from what is currently predicted. Of course, they're assuming a great deal of risk for that potential.

In the case of marked-to-market liabilities, however, the story is very different. The debt held by investment banks such as Merrill Lynch, Lehman Brothers and other depository institutions such as Citigroup has declined in value as a result of their lower credit ratings, which has caused yields on their bonds to rise and, consequently, their prices to fall. To realize this declining liability value, however, these institutions would need to retire the debt - i.e. buy the debt back from the issuer. The question is, who wants to sell it? Moreover, to do so, these same institutions would need to raise funds, now at a far higher rate, in order to buy the debt, which would increase their actual cash flows going forward. Consequently, no bank will do this and this is why it appears as though an accounting regulation has been twisted in such a way to offer these institutions a paper-out that only leaves analysts and investors like you and me scratching their heads trying to decipher what their financial reports are actually telling them.

Inflation, excluding the inflation.

No one will be surprised by the fact that I, along with tens of millions of others, believe that inflation is being underreported by the government; I've written on it countless times in this blog alone, and if we've ever talked economics, then I'm sure the subject came-up. It's probably why this article really caught my attention and I'd recommend it to all of you who would like to know more on the subject.

The long and short of it is a comparison of the US economy with that of a couple dozen other countries - including many of America's trading partners. What's surprising is that US inflation rates have been a relatively consistent 3% to 4% lower than that represented by this benchmark group. Of course, economists would argue that this differential can be explained away as a result of greater productivity in the US, but do we actually believe that the US economy is more productive than India or China, for example? 

Many of you know that there are two commonly-quoted inflation rates: the headline rate and the core rate, or what the author of this reference article calls the inflation, excluding inflation. Guess which one is the official rate? What you quickly notice after glancing at a graph such as the one below is that the difference between the official 'core' rate and the more realistic headline rate is growing - the greater the separation between the two, the more unrealistic are the figures being reported by the government, and more importantly for us investors, the less reliable are the valuations used to compute a stock or bond price!

Anyone who's taken a class in finance understands the importance of the inflation rate in the calculation of the price of any asset; it's absolutely critical as a starting-point including the risk-free rate to determine a real rate of return on investment. Without an accurate measure of inflation, we have no real idea of what our real return is - i.e. what the purchasing power is of our investment upon maturity.

The thing that I like most about this article is that the author doesn't present any of this as a conspiracy theory, but rather as an alarming warning to investors - cautioning us all about keeping this discrepancy in the back of our minds when making our valuation calculations and investment decisions. Now go... read it.

Entrepreneurship: Making The Most of Any Situation

In reading an article about the latest spate of foreclosures hitting the state of New York, I came across a very interesting business - foreclosure bus tours. I realize that this isn't likely a new business, but it's new to me so I thought I'd mention it. What I find fantastic about this concept is the entrepreneurial spirit that seems to rise-up from any situation - no matter how bad it may appear to be.

The tours, that charge $75 per seat, take prospective buyers around the latest foreclosure filings. It's simply ingenious; they're fulfilling a growing need or interest and making money on it. Beyond just providing the transportation, they're also facilitating the buying process by bringing along mortgage brokers, home inspectors and even contractors to help those buyers make qualified decisions.

I can visualize the business model already. I can imagine that the bus company has brokers, independent home inspectors and contracts lining-up to come along on these rides as the resident experts on-board; moreover, I would hope, that they're paying a pretty penny for an exclusivity option. 

It really is that simple. Spot the need and figure out how to satisfy it.

Is the downgrade of the financials warranted?

In short, no. The downgrade of the investment banks just doesn't make sense. Why? Simple. With access to the Federal Reserve's credit facilities, the same facilities made available to the commercial banks, these investment banks have access to plentiful, and cheap, capital whenever they need. A credit rating downgrade, by definition, presumes that the ability of the entity being downgraded to satisfy its debt obligations has somehow worsened. The fact that these banks now have access to more, not less, capital directly contradicts this action by the ratings agencies.

So, then, why did they do it? Good question - I'm not sure I know the answer. The consensus, however, seems to be that the ratings agencies are late to the game and are now reacting to popular fears that have all but disappeared since the first fall-out from the collateralized debt obligation defaults and, more recently, swap defaults and associated insurance scandals. Furthermore, the spotlight that was placed on ratings agencies following the aforementioned collapse when they did has placed the integrity of their models and practices into question. It could very well be that they are now simply trying to follow the herd rather than lead.

Back to the Future: Stagflation

The economy growing had been growing at 5%+ prior to the continuing rise in commodity prices; the country is engaged in a wildly unpopular war, which helps to worsen the growing budget deficit and ever-expanding foreign borrowing; the Middle East is in turmoil; the American dollar is in a free-fall with no bottom in sight due to a lax monetary policy; commodity prices are surging - oil having quintupled in the past half-decade alone. That's right, it's the early 1970s all over again!

The similarities between the current state of the economy and that of three-decades ago are eerie indeed; Dick Cheney is even in the white house - just as he was then under President Ford as his chief of staff and, as then, is often blamed for America's pursuit of so-called stability in the Middle East to help assure the flow of oil. Of course, with no oil actually emerging from Iraq, that's a whole other story. Thirty years ago we were in a very similar situation - it was called stagflation: slowing growth, rising unemployment and inflation. We recovered then at significant cost, which led to slow growth, high interest rates and high inflation for the better part of the following fifteen years. The question now is how will we get out of the current state of economic woes?

Fortunately, there is a growing consensus about what the solution is to get the global economy out of its current doldrums: technological advancement. Although it is an admittedly simplistic analogy, imagine if the cost of the war in Iraq had instead been invested in sustainable technologies - whether in food, energy, water or even climate change. 

Assuring the flow of energy to America need not be as expensive as it has been. The cost of the war in Iraq is estimated at nearly one-half trillion dollars; yes, trillion! The cost of a nuclear power plant is less than $10 billion per reactor - not even counting the fact that the investment wouldn't be flowing across the border and would instead create jobs both during the construction and the following operation and maintenance. Of course this is just one example, but you get the idea.

The sheer numbers involved open the doors to tremendous opportunities for technological advancement. America is currently spending on its war in Iraq the sorts of dollar sums that could quite literally solve problems and answer questions that have caused impediments to scientific progress or, at least, slowed its progress. Science and technology can improve yields per acre - resolving any concern over food shortages. Science and technology can clean not only the drinking water, but also clean-up our lakes and rivers and prevent future pollution. Imagine how much better the world would be, let alone America. Imagine further how admired America would be as a leader in technological advancement.

Timing Losses & Financial Institutional Strength

Let me tell you a story to prove a point. Assume that you loaned me $1,000 2-years ago (thanks, by the way) and I had not paid you any interest or principal ever since. Assume further that we met today to negotiate a settlement and I offered to pay you $200 as a one-time payment to satisfy the entire amount of the loan. The question: how much money did you lose and when did you lose it?

Those of you who are financial inclined are likely already doing some discounted cash flow calculations, but let's keep things simple; let's ignore the time-value of money. Many of you, then, are likely shouting a loss of $800 today, and I'm sure that many more of you would be tempted to agree, but to see why this is the wrong answer, we need to differentiate between paper-losses (accounting) and actual losses (cash flows).

From an accounting perspective, you, the lender, had created an account to represent the account loan and the expected future repayment. What is important to acknowledge, however, is that the $1,000 that you lent to me flowed out from your bank account 2-years ago - not today. Put differently, you have had $1,000 less funds for 2-years; my offer to repay you only $200 of the full amount does not represent a loss, but rather a positive cash flow today. Actually, it's as simple as:

-$1,000 :: cash flow out to me in the form of a loan

$0 :: cash flows from my repayment of principal and interest

+$200 :: cash flow from my repayment and settlement of the loan today

Now, I'm sure you're asking yourself why this revelation is important. Well, let's consider the banks that are scrambling for credit and new sources of financing in light of the so-called credit crisis spurred by the billions of dollars in write-downs. Ask yourself when those related losses actually occurred. Also, ask yourself whether the settlement of these debts at $0.20 on the dollar leaves more or less cash on the balance sheets of these banks. Notice, that I asked about whether this left more or less cash - I didn't ask about net assets. This is the difference between accounting losses and actual (cash flow) losses.

The interesting conclusion that many of you are now likely making is that the settlement of these bad debts is actually leaving these banks in a stronger, rather than weaker, financial position. So why are they scrambling to borrow from the Federal Reserves auction facilities? Good question. They certainly don't need the cash - their cash positions haven't changed! Only their accounting positions have changed. It is true that this does affect their ability to lend as it leaves them with fewer assets and collateral, but fears over bank failures is certainly unfounded. Now, as an investor watching the markets and seeing the tumbling stock prices of many, if not all, financial institutions, ask yourself if the broader market has misinterpreted the events over the past few months. Lastly, ask yourself the market's overreaction leaves you with an opportunity to profit from the rebound that is unquestionably going to happen - given enough time for the banks to restart their lending engines.