Spring Training - My Ray Of Hope

Well sitting up doing some research tonight. I think I have officially exceeded my self-imposed 7 cups of coffee daily limit. There has been some great research on coffee released in the past couple of months including one study claiming that you were 30% more likely to hallucinate if you exceeded 7 cups of java per day. Hence my 7 cup limit. I would encourage readers to hop over to http://www.7cupsofcoffee.blogspot.com/ to get more insight not only on coffee, random facts but also the economy and specifically technology.

After all the market crap we are dealing with I am glad to have spring training started. I have to give Apple and MLB.com credit. They have a great app for the iPhone where I can watch clips of every game (almost in real time). This year they have added the feature to be able to listen to any MLB game from the voice of either the home or away announcer. This will certainly make it easier to keep up with the Red Sox.

Speaking of the Sox there have been a few good things going on this week. First of all Jon Lester appears to be continuing his development. He is working on a straight change or circle change. If he is able to master this by the 2nd half of the year he will almost be unhittable. This would take him to 4 pitches – fastball, cutter, curve and change. More importantly it would really be a great complement to his cutter against right handed hitters. The importance of power pitching cannot be underestimated. I am looking forward to hearing how John Smoltz is fitting in. Hopefully Lester, Matsuzaka, Buchholz and Beckett will all benefit from being around this consummate professional.

The real surprise so far clearly has to be Takashi Saito. The 39 year old has come in and appears healthy. The Boston staff has tried to slow him down to make sure he is healthy for the season but Saito looks ready to claim a roster spot. He hit 93 on the gun the other day and displayed a couple of speeds on his curve ball. This will be a welcome addition to the pen. No offense to Mike Timlin but he was just a body last year and not an effective pitcher. The pen looks solid for 2009 with Papelbon, Okajima, Delcarman, Saito and Ramirez. Not entirely sure who will round out the staff but Javier Lopez will probably be there to see spot duty and situational roles against lefties before the 8th inning.

I like what the Red Sox did in the offseason. Look reality is that the world has changed in the past 9 months (well at least to anyone except the Steinbrenners). Taking a chance on Smoltz, Baldelli and Saito seem reasonable from a risk / reward perspective. There isn't alot of money tied up. This is a win-win situation. Certainly looking forward to the season.

On a side note I officially picked up a ball last Wednesday to prepare for my season. This being season 2 since coming out of 'retirement' (I laugh because since no one knew I was gone it is hard to call it retirement). The shoulder felt the best it has in 12 years. I think my velocity will be better this year (hard to be worse than last year) and hopefully my command follows. Each at bat feels more relaxed. All in all not a bad first outing.

Tax The Rich What New York Can Learn From California

Did anyone catch New York mayor Michael Bloomberg this week as he blasted proposed tax increases to the top 1% of his states earners?

“One percent of the households that file in this city pay something like 50 percent of the taxes. In the city, that’s something like 40,000 people. If a handful left, any raise would make it revenue neutral,” the billionaire mayor said on his weekly radio show.

So it does raise the question will people leave? Here are a couple of articles supporting Bloomberg's assertion:

“California’s Gold Rush Has Been Reversed: Entrepreneurs are fleeing heavy taxes in the state.”
Wall Street Journal

“Exodus From California.”
National Review Online

For years we have kept hearing from the "sell side" and "buy side" alike how California continued to have positive demographics which supported home building and housing valuations. Needless to say "things were not different this time". From bank failures to foreclosures to ghost towns - California continues to crumble. The state has a $42 billion deficit (this estimate has grown from the mid teens estimate a few months ago), sports the 4th highest unemployment rate in the union and illigal immigrants are leaving in record numbers. Does anyone think this will lead to a strong housing market or banking system? Where are all those "great franchises". It would seem to me that the sheer number of banks within California has to be reduced. As with the overcapacity in housing we also have an overcapacity in banks. Either we will have too many banks fighting for too few loans and earnings will be dismal for years to come or we purge the system and get it healthy again.

Here are a few salient points on the demise of California. The bullet points presented are from a California Business Roundtable.

1. The cost of doing business in California is 30 percent higher than the western-state average.

2. Almost 40 percent of the California decision-makers participating in the Roundtable survey plan to “outsource” jobs from California to other western states, preferably Texas.

3. Half of the companies have “explicit policies to halt employment growth in California while less than five percent of companies have retention policies in place to keep jobs in California.”

4.California’s “regulatory environment is the most costly, complex and uncertain in the nation.” Regulatory costs are 105 percent higher in California than in other western states.

It appears the slippery slope to social unrest has begun. Both at the Federal and State level governments are looking to increase revenue any way possible. It is hard to see how this situation ends well. As the economy continues to unwind this year (both equity and house prices moving lower) look for business and taxpayers alike to do whatever possible to preserve their balance sheets.

Be careful New York.

Recent Economic Data ... UGLY

It's been about a week since a real post. Far too long for my millions and millions of my readers. Sometimes it is good to poke fun at oneself as it pulls you away from the desperate times we are all facing.

Homes Sales

US data for January certainly dashed all hopes that housing activity had found a bottom. I spoke to a couple of people (unnamed for their own good) who were challenging my collegue JJ's questioning the bottom that they were touting. From my recallection these are the same people that use 9 recessions (all post WWII) to establish trends such as duration and magnitude of this recession. Anyway existing home sales fell, the application for purchase index fell, new home sale fell and as such month of inventory rose. All this means prices have much further to drop. This will not be good for growth as it will continue to drive savings rates back to trend levels to compensate for the drop in net worth. I expect we will see US savings rates above 10% before we are done this deleveraging process.

Mortgage Rates

The 30 year mortgage has moved back to around 5% (4.99% last week). Even though mortgage applications have been volatile it appears that approximately 70% of new apps are to refinance at lower rates or lock in a variable rate product at an attractive rate. The remaining 30% are primarily bargain hunters looking for distressed / foreclosed situations. It would appear that prices have to fall to a point where the buyer can purchase a property, rent it and make a profit. In asset bubbles the "make a profit" point is lost as the mania has investors believing that "it is different this time" and that prices will rise for ever. We forget Finance 101 which taught us Cash is King.

This buy or rent scenario leads me to an interesting point. In overbuilt areas with foreclosures rising there would appear to be a flood of rental properties hitting the market. Wouldn't this push down rental prices (simple supply and demand) and therefore lowering what an investor would be willing to pay? Therefore the bottom in housing prices in these areas may be lower than we think. Be wary of the stress tests!!!!!

Bond Holders

Is anyone else entirely tired of Bill Gross at Pimco crying about his financial holdings? Why shouldn't the bond holder take a haircut just like the equity holder? The assertion that this can't happen is ridiculous. Of the "bondies" that I know I would argue they are more technical than the majority of my equity friends. They know exactly what they were doing here. About half of the liabilities of of Citi, B of A and JPM are funded out of the bond market. Why should the US taxpayer subsidize $1.5 trillion of debt if the deposits at these institutions are to be protected? The burden on the US citizen clearly continues to escalate.

The problem for governments across the world isn't necessarily Mr. Gross's voice but it is the voice of all the pension funds, insurers and money market funds heavily invested in financial service bonds. To wipe out equity holders is one thing but to wipe out pensions via bond default is another. It equates to systemic risk to the system. I guess we should not lose sight of the Great September Debaucle that was Lehman Brother and that the US relies on foreign institutions both public and private as a source of funding. Who says this isn't political???

As far a pension funds go, I look forward to how actuarial assumptions are about to change in our low interest rate environment. Won't pensions have to take more risk in order to meet future obligations? I read this as equity investments. Yikes. Have fun at those investment committee meetings.

Durable Goods

Just plain aweful. The main point to take out of the data is the weakness in both imports and exports. Global it is. Here is a look across the world:

Imports Exports

Germany -3.6% -7.3%
U.K. -5.9% -5.5%
Japan -31.7% -45.7%
Taiwan -56.5% -44.1%

I could go on but you get the point. This leads me to GDP revisions as I cannot see this trend ending any time soon.

GDP Revision

I'll say sorry in advance for the rant you are about to witness. Government statisitical data is a complete joke. If you, the investor, do not take the time to look into what inputs they have used and how they are calculated it is your own fault for not understanding the magnitude and seriousness of the mess we are in. While GDP has its problems my prime target is the Birth/Death Ratio in the employment numbers. One just has to look up what this plug figure is to "get" while at economic turns (either positive to negative or vice versa) or when the rate of change or slope gets steeper it either understates (going from negative to positive) or in our case has overstated (both steep slope and positive to negative change) the strength of US employment.

Back to the GDP revision. As seen above the global consumer is retrenching. It should be no surprise that the consumer spending component of GDP was revised lower and inventories were revised higher. This should lead to lower prices going forward as inventory levels are too high and need to be reduced. The price reductions we have seen should get more aggressive. It will be interesting to see at what price the consumer steps in?

Unemployment

Weekly claims continue to trend higher. News of layoffs continue - read any paper around the world to get a flavor. Not a good trend. This should push the official unemployment number. Lets not forget how interconnected this number is. Higher inventory levels will lead to more layoffs. Psychologically if a consumer is concerned of losing a job they will be less inclined to purchase anything (house, car, clothes etc) and dramatically increase their savings rate and pay down debt. The trend is not our friend.

To quote Dave Rosenberg from Merrill "...any rally is to be rented and not bought".

Quotes Of The Day

The ultimate result of shielding man from the effects of folly is to people with world with fools.

Herbert Spencer, 1891

... any propping up of shaky positions postpones liquidation and aggravates unsound conditions.

Murray Rothbard, 1975

Hey maybe someone should send these to governments around the world. We are walking very close to the edge of the cliff.

More On The Fiscal Stimulus Bill

I have read a great deal of analysis on the $787 billion package. However I continue getting stuck on one number. The tax cut contained within the package is for the middle class and amounts to $400 per individual or $800 per couple. This is per year! So really individuals are saving about $8 per week. Wow thanks for the help. Do you think this will help if your salary get cut or you are behind on some credit card debt say at 19%? Not sure how relavent it really is. I would have rather seen the money spent on increased "shovel ready" infrastructure projects and education. This would address both the short and long term needs for the U.S. economy. Building schools in Milwaukee ($87 million) when they already have 15 empty schools due to shrinking demographics is not my idea of spending on eduction.

D Is For Deflation

Just a quick post to get people focusing on Fridays CPI number in the US. Whether we call it negative inflation or deflation (for the record I am clearly confused what the hell the difference is) we should see the first of many negative numbers. Remember the run crude went on in the first half of the year? The year over year changes will look staggering.

I am currently very long gold in this environment and am debating taking some off the table as historical gold does not perform well in deflationary environments. If it were only so simple. We were right in characterizing this move in gold to coordinate with USD strength. Since it appears every currency is in a race to devalue there currency (to increase competitiveness and boost exports) and to cut rates to zero (clearly there are more rate cuts in store of the UK, Euroland, Canada etc) I am less inclined to exit my trade. Since gold is essentially a zero interest rate investment what would I rather own? A currency about to be devauled or a "store of value". I'll keep you posted.....

Industrial Production As A Leading Indicator

January Industrial Production was aweful falling 1.8% month over month. Leading the charge was a 2.5% drop in manufacturing output. Since auto companies shuttered in production and cut capacity in the month I guess we should not be too surprised. In fact auto assembly units fell to 3.9 million units (this is an annualized figure). This in turn drove manufacturing capacity utilization to 68%. This an all time low for this 61 year old data series.

Unfortunately this isn't where the pain ends. We know that inventories are at decade highs. My guess is that sales will remain weak for a prolonged period of time due to consumer balance sheet repair and the fact that we pre-bought too many vehicles in the last few years of our debt-fuelled comsumption binge. The underlying trend of owning a vehicle for 10 years or more is going to come back in vogue.

In the mean time as auto production continues to be curtailed (until inventories can be worked through) all associated industries should suffer as well. These include plastics, textiles and everything else involved in the auto industry. These numbers have not come through in the industrial production as of yet. Industrial production as a leading indicator is not turning any time soon. This is true of every country globally.

The ISM (I prefer using NAPM but should use the current acronym) increase we saw last month looks to be a small positive blip in a very negative trend. Global industrial demand is in absolute freefall, the Empire State manufacturing survey and todays IP point to a sharp decline in ISM.

I would not like to be a long only fund manager at this point. There would few places to hide. I wonder how investors will feel when they see that there mutual fund beat the index by 30 basis points but was still down 30% this year. Its going to be messy. I would move into long / short fund (make sure there is no long bias please and little leverage) or opportunistic hedge funds that can capitalize without the market moving higher.

I Love Numbers BUT The Truth May Not Be In The Headline

Just spent the past hour getting caught up with all the economic data hitting the market over the past few hours. Attention is clearly on the Obama "save the homeowner" plan but I wanted to discuss the headline 46% surge in Mortgage Applications.

On the surface this is an impressive number. The "CNBC talking heads" get all fired up that is a sign that the economy is starting to bottom and that the supply of homes on the market is going to get sopped up, prices will stop declining and that banks will survive (assuming defaults stop). Okay so lets scratch the surface a little deeper.

First of all about 75% of the increase in Mortgage Applications was due to refinancing. This is solely a function of government purchases at the long end of the bond curve to bring yields down. This has worked as 30 year fixed rates dropped below 5% last week. When people are unsure about the future then tend to reduce risk. This is one way to do this. Fixing your payment for 30 years under 5% is compelling. To me this has nothing to do with reducing the supply of homes in the system (like the headline would like you to believe). On a side note in the past decade refinancing activity increasing has usually led to increased spending. I don't believe it will be the case this time. As personal net worth erodes (via house values and portfolios) consumers are forced to retrench. If we overlay this statement with low savings rates, high household debt burdens and rising unemployment it paints a very different picture. It is the reason why the saving due to lower gas prices over the past 8 months hasn't been spent and retail sales are dismal and getting worse.

The truth is in the trend. Actual purchase applications rose about 9% week over week but this follows steep declines the previous 2 weeks of 10% and 11% respectively. Lets do some quick simple math (my CFA designation allows me to do this). If we do a quick purchase application index it would look something close to this. If we start the index at 100 and reduce the 1st week by 10% it is at 90 now. Take another 11% off the index for week 2 now we are at 80.1. This doesn't look very healthy to me. Remember the headline about a 46% increase in Mortgage Apps. Well in reality is was only a 9% increase in purchase apps so this make the index now 87.3. Reality is that purchase appls are down 12.7% in just 3 weeks (100 - 87.3).

The above math gives a very different outlook than the headline. In fact YoY activity is off 28%. Now ask yourself how is this taking supply away. Truth is it isn't. When we look at the "real trend" in conjunction with, unemployment (the US has lost about 2 million jobs in just 3 months), New Home Sales and Housing Start data it is even worse. This in no way should be viewed as a positive data point.

What should be talked about (and it is by a few such as Roubini, Rosenberg, Krugman, Case) is that bubbles create overcapacity. The US built roughly 2 million too many homes over the past 6 years. In order to work though this overcapacity prices will continue to fall. Truth is I have no idea how far ... no one does. All we do know is that overcapacity is deflationary and time is the only cure. Don't bet on the consumer (via the baby boomers) to come to the rescue this time! Rallies are still to be sold.

Swedish "Super" Models

Well the blog post won't be as exciting as the title. There will be no photos of Elin Nordegren (Mrs. Tiger Woods) or her twin sister here. We'll save that for another site.

I thought today may be a good day to publish and old internal piece I did briefly illustrating the "Swedish Model" for handling their housing crisis in the early 1990's. It was done in October of last year and illustrates some interesting points. Take a read. I have comments below....


ROAD MAP FOR THE GLOBAL STOCK MARKETS

Swedish Crisis of the Early 90’s Provides Guidance

Background

Probably the best model to look for parallels
Swedish government implemented a blanked guarantee for all bank liabilities (ex-equity) in 1992
Government injected government capital into most troubled banks (some still failed)
Loan losses were 12% of GDP (this compares to IMF estimates of US loan losses at 10% of GDP)

Swedish government intervened after GDP had been declining for 7 consecutive quarters YoY
US government / FED and central bank are taking a much more proactive approach (this is most likely due to the inter-connectedness of the global financial system)

Key Points

Recession lasted 3 years
Output declined sharply immediately after government intervention (we are seeing this right now)
The economy began to grow again 3 quarters after intervention
Credit growth to the private sector was negative for 2.5 years following intervention
Household savings rate rose dramatically (this is beginning as we speak)

Stock Market Implications

Stock market fell 45% from peak to trough (it took 27 months)
Global markets are all in this range
The bottom in Sweden was made approximately 1 month after government intervention
The following 12 months the market rallied 43% and was followed by another 20% the ensuing year and yet another 24% in year 3
Appears that government intervention provided the floor even though the economy weakened for some time

What can still be done …..?

Governments can guarantee inter-bank lending which will allow the global financial system to begin moving again (look for LIBOR to fall)
Purchase equity stakes directly in distressed financial institutions – so far equity holders have been left holding the bag allowing relentless selling and financial sector short selling (the ban was removed this week) – this would cease
Continued reducing interest rates where possible – a steep yield curve is necessary for the banks to be able to repair their own balance sheets – the ultimate goal would be to pass these reductions on to the end consumer (this has not happened yet)

What is needed ….?

Plain and simple and one word – TIME
Credit bubbles all have two things in common first is the excessive liquidity that gets us into this mess and the second is that TIME is ultimately needed to restore the financial system to equilibrium


Today is the day as the S&P looks to retest its low made in November 2008. Lots has happened in the past 3 months. It is clear that the leverage in the financial system was certainly more than anyone anticipated. For example leverage at Europe's largest financial institutions make Lehman look conservative - remember even though the for sale sign was out no one would buy them in September. This leads to the point that nationalisation in one form or another is inevitable. The sooner the Roubini coined term "zombie banks" are eliminated from the system the sooner the system can begin to get healthy. Don't mistake my words here. Eliminating the insolvent banks isn't the panacea to our problems but is a step in the right direction of a very long unwinding process.

Think of this example: lets say healthy bank A (this in itself seems like an oxymoron right now) has the ability to lend on its balance sheet through a combination of prudent lending and strong capital ratios but insolvent bank B keeps getting bailed out by the government with it unclear if there is more taxpayer money to come (lets refer to this as TARP1, TARP2, TARP3 etc.). Why would healthy bank A begin to lend? Bank A will continue to hoard money and clog up the system. We already know that unless mandated bank B will use the capital infusion to strengthen its balance sheet (they will also argue that they are too big to fail and should such receive more capital in the next TARP rounds). So nobody lends. This is part of our problem today.

The returns in Sweden post government intervention were tremendous. After falling 45% (peak to trough) they rallied 43%, 20% and 24% in the 3 years following intervention. I think we will differ from Sweden on one key point. That being the relative strength of the consumer. Clearly in the years 17 years after the Swedish crisis saving rates in the Western world collapsed (remember when they went negative for a quarter in 2006) while debt expanded. This is what sets this apart. My view is that consensus earnings targets for the S&P are too high (really pick any western world stock market it will be the same if I am correct) and the multiples applied to the earnings are also too high. Markets must go lower to find equilibrium. This is not going to be fun.

U.S. Fiscal Stimulus - Devil in the Details

Looks as if the House and Senate have finally agreed on the stimulus package and it should be signed into law tomorrow. However, it appears the headline numbers (and the ones being reported by all the talking heads) is much more impressive than should be reported. I continue to hear how the $787 billion is equivalent to 5.5% of 2009 GDP. One is left to believe that all the stimulus is actually going to be spent in 2009. It leads to hope (on a side note I have to put that hope is not an investment style) which both the sell side and the long only buy side are banking on. Reality is that only $184 billion will be spend in this fiscal year (ending September 2009). Now it is only 2% of GDP. Lets put that against Q4 GDP of -3.8%. First of all the revision will most likely take this to -5%. Q1 doesn't look any better. How will earnings meet current expectations? They won't! Not as massive an injection as one might believe.

Here is what should be being reported:
1) the $787 billion is the estimated cost over 11 (yes eleven) years
2) $184 billion will be spend in fiscal 2009 - maybe adding 1% to 2009 GDP
3) the spending is NOT cohesive and is a complete free for all of projects
4) spending will be dispersed as follows: $115 billion on tax cuts (my guess is that these will be added to savings), $54 billion on education, $46 billion on transportation infrastructure (wasn't this suppose to be the rebuilding of America - not for $46 billion) etc...

The reality is that this is only the initial spend and is no where near what is needed to add or save the jobs that Mr. Obama targets. What you have not heard yet is that there is an Omnibus bill planned for this summer. Look for this to be Fiscal Stimulus 2. My guess is that when the economy continues to perform poorly through Q2 and the Omnibus bill comes to the forefront the USD will begin to fall. In the mean time look for the USD to hold in as both the EURO and POUND look much weaker in the near term. My guess is that markets will rally off the news that this stimulus plan has actually been passed (looking passed the reality of the spending) and that Mr. Geithner will actually have some concrete solutions with TARP 2. I continue to believe in selling this rally and protecting yourself for the back half of the year - earnings are not coming back anytime soon.

Japan's GDP Shrinks At Annual Pace Of 12.7% in Q4 2008

Well the headline pretty much sums it up. What is becoming more frightening to me is that I have yet to see how Q1 2009 will be any better. The global economy is in free fall. I know I will hear arguments about the Baltic Freight Index, copper prices and any oil other than WTI as proof we have seen bottom and fiscal stimulus is working. My point is that the Western World consumer has shut down. Without the consumer consuming unemployment will continue to rise. I know the consensus is for around 9% unemployment by the end of 2009. This is understated in the current environment. This is where we differ. Not in direction but in magnitude.

If we dig into the GDP data from 2002 - 2006 we see that the majority of consumer spending was aided by withdrawing equity from the home. Hey I'm not here to criticize this as my family has done this as well. But reality is that when we purchase with debt we are saying I will consume now and pay later. The pay later portion takes future cash flow and applies it to paying down debt - not consuming. In other words the consumer portion of GDP is going to collapse. Again nothing new. My argument is that the magnitude will shock everyone.

I'm sure you all caught the headline on Thursday that consumer spending increased 1% in January. Both the buy and sell side "believers" continue to tought how the worst is behind us and that the back half of the year will be rosy. Don't be fooled. They all fail to mention some key facts: first is one month does not change a trend. If you look at YoY changes consumer spending is off 10.6% from January 2008. This changes ones perspective just a little. How about the 3-month change (November - January) of -9.5% (+-.5%) from the same period a year ago. Now the 1% increase doesn't look so good. But the kicker is that the rate of change appears to be accelerating. January sales are 2% below Q4 2008. This doesn't seem positive to me.

FSP - the new TRAP or TARP

Well here we go again. Looks as if the Obama team is off to a great start. I quote from Mr. Geithner "We are not going to put out details until we get it right". To me this is code for we really have no idea how this is going to work and are really hoping we get it right. I'm not the only one to think this the S&P was down 5% and the KBW Regional Bank Index down 9%. This is quite ugly. I'll have more comments on the FSP later. For now I think it prudent for investors to watch the VIX index (it moved up to 46.67) and gold (up $22). Neither moves are a good sign for equities in here.

Monthly Client Update - January 2009

Our montly returns are being audited right now. I believe our number to be accurate. That being said I will be published the official number as soon as completed - hopefully any day.

The letter is a collection of my thoughts on the outlook for 2009. The economic deterioration is moving at a break neck pace so I thought it important to outline where we stand.


February 3, 2009


Dear Investors,

This is our first communication of 2009 and it comes on the heels of our best month since inception. The fund returned 16% in January - a good start to the year. Performance was driven by our Health Care exposure. In January, the Pfizer–Wyeth mega merger illustrated that merger and acquisition activity was not dead but was just hiding in the Health Care sector. Also, one of our biotechnology companies finalized a lucrative partnership deal. This helped move the stock up 281%. We are anticipating another positive event with the company’s Phase III readout this month. Stay tuned!!!!

40,000 FOOT VIEW

In our December commentary we discussed how we are becoming constructive on the equity markets for 2009. I want to elaborate on our position. Regarding 2009, our prior view was that both interest rate cuts and pending fiscal stimulus would “…be felt in the economy in 2009 and help stabilize both the global economy and equity markets.”

This has changed somewhat. It is clear now that monetary stimulus has not worked. Central banks either have cut rates close to zero or are in the process of doing so. History tells us that recessions are inventory crises solved by monetary policy. Cutting interest rates lowers borrowing costs and induces spending, and the economy begins to recover. To be perfectly clear, we are not seeing this at all. Banks continue to tighten lending standards and hoard cash (to repair their own leveraged balance sheets) while consumers have stopped spending on anything non-essential (most likely due to the fear surrounding the ever rising unemployment rate). Our current economic situation is a balance sheet issue in which Western-world economies accumulated debt at an astounding rate over the past two decades. This is the deflationary unwinding process.

We have established three principles, not only to live by, but to invest by as well:

1) deleveraging will become the new leveraging (households really do prefer less debt)
2) in order to deleverage and pay down debt we will continue to liquidate assets
3) personal savings rates will drift upward toward the long run average of 8%

This will not happen over night. Time is the only antidote. Simply put, excess in one direction always leads to excess in the other direction.

To muddy the water, the global banking system is in the process of being nationalized (at least to some degree). Banks such as the Royal Bank of Scotland, Lloyds TSB, Bank of America and Citigroup all have varying degrees of state ownership. This process is nowhere near over. Global fiscal stimulus will certainly help. However, it will only serve as a plug figure as personal investment and consumption fall off a cliff for many years.

WHERE THE RISKS LIE

Our investment approach is to focus on companies exposed to near term catalysts within five core sectors. Given current global circumstances, we are not investing in the financial sector until it is clear what role governments will play in the restructuring process. To be frank, I would have better odds in Las Vegas at the blackjack table than investing in the financial sector. TARP has indeed become a TRAP for investors. The restructuring that needs to happen will be in the form of capacity reduction. Financial institutions will either merge or fail to help reduce excess capacity. In this environment M&A premiums will be eroded and equity returns will focus on ever shrinking earnings. The competition for deposits and loans will be fierce, driving down bank earnings until the sector is rationalized. This has not happen yet and as such we wait.

We also fear that a worldwide recovery in the latter part of 2009 is priced for perfection in the markets. We see risk here - especially in China. This is an uncertain time and we feel it prudent to take a wait and see approach with the recovery. The reason for this is that if growth does not emerge, there is a high probability we will be looking at protectionism and trade wars. We have already seen the new U.S. administration making noise over currency manipulation of the Chinese renminbi. We feel this is just the beginning and we will be hearing more and more rhetoric sooner rather than later.

STRANGE BEDFELLOWS – FROM CONSOLIDATION TO PROTECTIONISM

Throughout history we note that bubbles build overcapacity and that consolidation is natural once the bubble bursts. One of the interesting points about this credit bubble is that it was global in nature, crossing borders and industries. Consolidation is not looked upon favorably in recessions. It tends to cross economics and move into politics as unemployment increases as firms merge, improve economies of scale or go bankrupt. Politicians tend to fight back via protectionist measures and support industries that should cease to exist. Decisions are not rational. The U.S. domestic auto industry is a perfect example.

For investment purposes it is important not to lose site that protectionism serves to keep excess capacity in the system, and limits corporate pricing power. In fact, I have yet to find a period in which inflation moves higher when excess capacity remains in the economy. We continue to monitor capacity utilization and the output gap as a gauge of slack in the global economy. At this point there is no reason to be excited. This is why we have cooled to the “reflationary” global growth trade. The outcome looks inevitable. Deflation is here to stay.


HEALTH CARE IS EXCITING!

To expand on our Health Care theme, there were 89 acquisitions worth $92.6 billion in 2008. It bears saying that Health Care has nothing to do with global growth, Chinese GDP or rising commodity prices. It has to do with people getting sick, which is recession-proof. However the sector is not completely immune to a major financial crisis. The lack of liquidity and limited availability of credit have become major constraints to the industry – lowering potential M&A opportunities, partnerships, and corporate financing for many biotechnology companies. Large pharmaceutical companies have become much more selective where they spend their war-chest.

After analyzing trends in Health Care M&A, we have concluded that the buyers are looking to buy companies with co-marketed products. This helps eliminate both execution risk and competitive response while potentially addressing the need to add late-stage drugs to their pipelines. The proposed acquisitions of Genentech by its partner Roche and ImClone by its partner Bristol-Myers Squibb are examples of this trend. We see this as an important theme for 2009 and have highlighted four macro factors that help support this view:

1) pharmaceutical companies have become de facto marketing companies (remember those Cialis adds where the guy is throwing the football through a moving tire – brilliant)
2) drug development has stalled in the past decade leading to insufficient pipelines
3) a large number of blockbuster drugs (> $1 billion in sales) come off patent between 2010 and 2013 – this revenue needs to be replaced
4) large pharmaceutical companies are in good financial position with approximately 8% of their market cap in cash




As a closing note on the Health Care space, we present M&A data relating premiums to deal size. Statistically 95% of all mergers between 1998 - 2009 involved companies with a market capitalization of less the $5 billion. The average premium of these deals was 45%. The remaining 5% of acquisitions were above $5 billion but captured a lower premium (25%)! We continue to build a basket of health care names that are differentiated by targeted disease, capitalization and stage of development.

INTO THE BLOGOSPHERE!

We have become much more cautious on the global economy moving forward. Deflationary headwinds continue to be felt and will be difficult to eliminate in the near to medium term. The portfolio is positioned to benefit from this environment. We continue to focus on stock-specific outcomes that are independent of the market. If we are wrong on the direction of the market our portfolio will follow the market higher as a “rising tide floats all boats”. But for now, caution is the word of the day.

January was our second consecutive positive month. While we are pleased with these results these are only a few steps in a long journey. I will be trying to write more often and to facilitate this have started a blog: http://www.epicfailures.blogspot.com/. I’m trying to post between two and three entries per week. This will give candid insight as to my thoughts on the world in which we live and invest. Let us know if you have any questions.

Economic Data is not Pretty

Well the Initial Claims of 626,000 today were not pretty. I think the 4-week average runs around 585,000 now. My guess is we are in for another negative surprise tomorrow with the Non-Farm Payroll number. It really shows how the surveys are just guess-work. I'll talk about my thoughts on forecasting sometime but needless to say I am not a believer.

On to my point. Interest rates are going to stay lower for longer than most people believe. Inflation is dead (at least for the next couple of years) and deflation is a real concern. Data such as capacity utilization and output gap should be watched carefully. Some other points for low rates for longer include:

1. Job losses continue and will probably peak in the back half of 2010.
2. Economic growth is going no where fast. Consumer spending and private investment have fallen off a cliff.
3. The global economic system needs to purge the overcapacity. So far this hasn't happened. Consolidation should happen in manufacturing in China and financial services in the U.S. and Europe but so far nothing. Slack in the system limits pricing power.
4. A wave of protectionism is in our future (or here already) - this will prove deflationary
5. Housing prices have not bottomed (still too much supply)

The list is endless. I continue to hear talk about inflation and rising rates but have a hard time getting there with the type of environment we are in. I continue to focus on "recession proof" / defensive sectors, balance sheet strength and reducing market exposure (via pairs trades or market shorts). On the household side even with mortgage rates and borrowing costs grinding lower the trade is to use your lower interest expense to pay off debt not to incur more. Uncertain times warrant deleveraging. Be careful out there.

One Bank Two Bank Good Bank Bad Bank

Well my literary ability is not as well crafted as Dr. Seuss however you get the point. I need to vent on the proposal to take "toxic loans" off bank balance sheets. My point is very simple - what is the U.S. governement going to pay for these assets? Seems simple in theory but in reality it is anything but. Generally the assets we are talking about are collections of assets such as HELOC's, mortgages, student loans, credit card receivables etc. However the difficulty comes with valuation. The bank has all the incentive not to write down the value of the asset to the market value because it would impair (even further) their balance sheet. While a potential investor will look at the underlying assets and determine what they are willing to pay to take on such risk. Recently I was shown an example where a bank valued an asset at 97 cents on the dollars but a potential investor valued it at 38 cents on the dollar. Quite a difference. Who is right? Considering the price we are paying for risk these days the truth probably lies in the middle (but closer to 38 than 97).

Again what price does the government pay for the assets? Obama has two choices. First if he pays 97 cents the bank shareholders and management are happy but the taxpayer gets stuck with a bill as the actual value is much lower than they have just paid. Second if they pay 38 cents the bank is completely screwed and its capital base is eroded and in need of a capital injection to remain solvent while the taxpayer is made whole through its willingness to take on risk. In this situation the equity holders are either completely wiped our or are severly diluted and the bond holders are holding on for dear life.

I have a hard time supporting any plan that saves the banks without wiping out the management, equity holders and bond holders. I don't believe I am going to get my wish. It looks as if the U.S. taxpayer is going to be on the hook for this bill and only time will tell whether or not the banks have been cleansed. My feeling is they will be back to the trough a few more times before this is all over. I don't know where the "Law of Unintended Consequences" comes into play here but when I do I'll let you know.

I'm Back ....

Sorry for the length between posts. I went down pretty hard last week with a nasty cold. I've caught up with my emails and am ready to go.

Did anyone read last weeks FOMC statement? I wish they would use plain old english in these transcripts. What caught my attention was this:

"The committee sees some risk that inflation could persist for a
time below rates that best foster economic growth."

Isn't this deflation? Why can't the Fed-heads just say deflation? This may indeed may be the next shoe to drop. Currently the TIPS yields have been skyrocketing higher - signalling the markets belief that deflation is indeed dead and inflation is back in vogue. I don't buy into this at all. First global capacity utilization shows slack in the global economy and it appears no where near abating. It's hard to have inflation with excess capacity in the system. Second, debt is deflationary. The Western World pre-purchased (with debt) everything from bigger houses, more cars, tvs, computers etc. At some point we actually have to pay this back. These future payments will be made at the expense of future consumption. Demand is not coming back anytime soon. Hey maybe tomorrow we will look at the trend in household savings.