Shaking the Mesquite Tree
The Investment section of your favorite bookstore is certain to have many titles to entice you. Such was the case a few years ago with a book titled, Shaking the Money Tree. This guy’s writing was fun, colorful and had good current suggestions. In one passage he tells about a guy lamenting to his friend that the country is in the throes of a heroin epidemic. The friend asks, “Who sells the needles?”
The paragraphs that follow are my own and probably bear no resemblance to the book. The truth is that I have completely forgotten the book’s message, but the question about the needles carries a message that all research directors know. A good analyst’s or money manager’s instincts can pave the way to investment success.
Now, think about where the question above was leading. Lesson 1: Go where the money is. Willie Sutton said he robbed banks “. . . because that’s where the money is.” If the economy is in a growth mode and the demand for technology seems insatiable, buy technology stocks. Utilities may be great for some reasons, but they do not project growth. Tech stocks do. Likewise, energy and health care will face growing demand for years. Take advantage of demographic, technologic and societal changes.
The next step in your effort to get the low hanging fruit from any tree is to look for the second derivative players. That field includes suppliers and facilitators. Lesson 2: Pick the companies that make money from the companies making the money. For example, Exxon is a major oil company. Who helps Exxon get the oil? Companies like Schlumberger and Halliburton. There are hundreds of others. Use your imagination in picking your stocks.
Now take that a step further. Some of the suppliers might be the big boys. Both SLB and HAL are industry leaders. SLB has 1.33 billion shares, and HAL has 923 million shares. Lesson 3: Look for companies that offer the investor leverage through a more significant ownership position. Who else participates in the exploration and production effort? There will be hundreds of companies in the process that takes the product from the ground to the consumer. Maybe one or more of these will be the goose that has your golden egg.
There are likely to be some undiscovered jewels among the market choices. Many people have been enamored by Wal-Mart’s success. We can easily see the reasons. Their growth, their delivery methods and their inventory control have been extraordinary. But history has shown us that there seldom is just one solution to the market’s challenge. Maybe Target’s numbers and market acceptance offer similar growth opportunities at a better price. WAL is also one of the leading grocers in America. But what about Kroger? It has been equally competitive. Maybe other stocks in this business also offer growth opportunities. Lesson 4: Find the overlooked alternatives. You can run the same drill in the pharmaceutical business, in telecom, consumer discretionary and throughout the market. There are winners everywhere, and weak stock markets like todays offer an opportunity to look beyond the obvious.
Finally, good quarterbacks complete passes by throwing the ball where the receiver is going to be, not where he is when the play starts. Lesson 5: Invest where the market is likely to evolve. Example. If energy independence is a valid goal, and if oil shale holds enough energy for U.S. needs for the next 1,000 years, maybe we can find examples of lessons 1 through 4 in shale production and delivery.
The answers are out there. Your challenge is to be like the winning quarterback. Make your investment where the action is going to be.
My disclaimer is that I am writing this from the Llano River Ranch in Kimble County, Texas, two hours west of San Antonio and surrounded by mesquite trees. Shale activity in South Central Texas has been rampant for well over a year, and my bias is to the companies that are likely to be where the action is heading.
Tom Mongan, CFA
May 26, 2012
Tom Mongan is a financial analyst in Houston, Texas
Europe's Lesson for U.S. Taxpayers
You can usually count on the Sunday morning TV talk shows to ignite the passions of political junkies, and today’s were no exception. One brief comment on high taxes for the wealthiest 1% caught my attention because I had just finished reading an interesting comment by economist Scott Grannis in a Seeking Alpha.com article titled “Some Additional Perspective on Europe.” Grannis, who was the chief economist for Western Asset Management for years and who was an economist under John Rutledge at the Clairmont Institute, writes regularly as the Calafia Beach Pundit. His work is always insightful and thought provoking.
This article looked at the disparity in industrial production between the U.S. and Europe. The industrial production of both groups had sharp declines following the recession in 2008. Both then turned to gains in 2009, but the paths separated last year, and one obvious reason is the serious financial strain that Europe is facing.
Nothing too surprising up to this point. Then Grannis shows the path of industrial production for several major EU players: Germany, France, UK, Italy, Spain and Greece. This is where the record gets more interesting. His chart follows.
Germany’s success versus the plight of the other nations is making the news daily. Many of the countries are facing a serious collapse of confidence among investors, and in some cases the solvency of their major banks is in question. The main reasons are austerity, tax policies and work ethics. Higher taxes alone will not solve the problems and neither will austerity. Countries must produce their way out of decline, and high taxes can be an impediment.
Grannis then notes that Ireland’s industrial production has fallen only 7% since 2007, and that is after rising 300% in the past two decades. Their strength has stemmed from the sharp cut in their corporate tax rate. On a drive through southern Ireland a few years ago, I had to think whether I was in County Cork, Silicon Valley or Austin, Texas. The tech companies apparently liked the environment.
In contrast, the U.S. has the highest corporate tax rate in the world, and many see a solution to our huge deficits as a tax increase. One of the most perilous examples currently is California. If anyone would like to read a genuine horror story, look at Michael Lewis’ book, Boomerang. His discussion of Vallejos’ disasterous situation should be a must-read for anyone planning to vote in the upcoming election.
Neither author is maing an overt political statement. Their perspectives are economic and financial. You can draw your own conclusion from the numbers.
Tom Mongan
May 20, 2012
Tom is a financial analyst in Houston, Texas
Obama's Selective Tax Plan
The president is going to great lengths to sell his tax plan to the voting public. The argument resonates with many people because it appeals to their sense that a privileged group is taking something that should be theirs. The plan’s popularity developed momentum when mega-billionaire Warren Buffet said that he paid less in taxes than his secretary. The tax code seems biased when big earners can use various deductions to dramatically reduce their taxes.
Obama’s plan hopes to implement the Buffet Rule, which says that those earning more than $1 million per year should pay 30% in taxes. Very few people earn more than $1 million, so this is bound to sound like a reasonable way to attack our exploding deficit. Conservatives have been quick to say that there just isn’t enough potential tax revenue from this idea to make a difference in the deficit. The total take will only be about $5 billion, a pittance compared to our $1.3 trillion deficit. They say further that any increase will likely create an investment disincentive in the group most likely to put funds and people to work.
The president acknowledges that the plan will not eliminate the deficit, but in the interest of fairness this new tax source will matter. This sounds a lot like Al Gore’s complaint several years ago about “those who take so much and give so little.” You can imagine that this plan will raise the ire of many people who struggle each month to stay afloat. Let’s look for a moment at just how little the top earners actually give, keeping in mind that many top earners pay big tax bills. They all basically are in the top tax bracket of 35%. The chart below comes from the Heritage Foundation’s Fact Sheet #85 entitled, “Taxes Are Not Too Low: It’s the Spending, Stupid.”
This was taken from IRS data, and while the numbers are several years old, we have little doubt that they are still relevant. One number that should jump out is that the top 1% pays 38% of all Federal income tax. The top 10% of earners are carrying 70% of the load. If you are having trouble connecting this information to the fairness appeal, you are not alone. But fairness, or unfairness depending on your political stance, has yet another dimension. In 2010, the latest year that the Heritage Foundation included in its calculations, 49% of our population were not included in the tax rolls. That means more than 150 million Americans paid no taxes at all. In 2000 only 34% paid no taxes, and in 1980 the number was 15%, a disturbing trend. So where does it end, and what are the limits to fairness?
Try to put this issue into perspective. The president is proposing what amounts to a new bracket for the much derided alternate minimum tax. He is inciting his base with an argument that is tantamount to class warfare. If the Buffet Rule becomes law, there will be relatively little economic impact. There may be a much greater impact at the polls in November. We expect tactics like this from the rival parties. But when the person leading the charge is the president, a leader whom we hope will make decisions based on the good of the country, the result for many is disappointment.
T R Mongan
4/13/2012
Know When to Hold 'Em
The investment results for the first quarter of 2012 were excellent. They helped rebuild both capital and confidence for investors who have seen their net worth decline over the last four years. The S&P 500 increased 12.1% before considering dividends. If we look back to the lows of October, 2011, the gain is 29%. In the wake of last year’s flat line, investors who stayed with the market have every right to feel vindicated.
Now at 1400 the S&P has essentially doubled since the March 2009 lows and is nearing the highs set in October 2007 when the economy began its collapse. Not surprisingly, many commentators are beginning to caution us of a pullback. Their reasoning has merit. U.S. fiscal problems are huge, and the Obama administration, as well as Congress, seems more concerned with a social agenda than economics. The European debt issues are far from resolved and geopolitical unrest is likely to intensify.
If this were the complete story, we would agree to protect our investment gains. But there is another side to the coin. Despite unimpressive numbers, the U.S. economy is growing and inflation is in check. The Federal Reserve and the Treasury are committed to supporting growth. Corporate balance sheets are very strong, and corporate profits are at all-time highs as the following chart shows. Even with the recent gains in stock prices, price-earnings ratios are below the average of 15 times trailing earnings, and market strategists expect future corporate profits to rise by 3% to 5% per year.
Skeptics may question this market’s sustainability, but there is reason to think otherwise. As the economic decline progressed over the last four years, investors made a mass exodus from equity mutual funds. Data from the Investment Company Institute show that investors withdrew more than $ 400 billion from these funds. No wonder prices fell. But that trend is beginning to change, and ICI data show that investors now hold $2.6 trillion in money market mutual funds. That’s a lot of buying power.
We know from many studies that the equity market is heavily influenced by economic issues that affect all companies. Next in line is the impact on industry groups and subgroups. Analysts consider ten basic categories: consumer staples, consumer discretionary, finance, energy, health care, technology, utilities, materials, industrial and telecommunications. They do not all move at the same pace or even in the same direction, and in each group there can be multiple winners.
Finally, according to some theories, these issues also affect individual companies. This is why index funds can work and why beta is an important measurement for many investors. But we also know that individual stock selection can be effective in isolating those companies that have proprietary advantages. The direction of the U.S. and the global economies may be the overriding force, but that does not mean that stock performance is predestined. Half are above average, half below.
The case for investing in equities rests in part on the potential of individual companies. Try to forget for the moment the endless Washington criticisms of corporate America and focus on what individual companies are accomplishing. Their earnings gains are partly from the tight expense control that companies initiated over the last few years to protect their margins. The gains are also from their many new products, services and markets, both domestic and foreign.
With the recent market strength and the losses over the last four years, a market decline of 5% or more is possible. But keep in mind that every sell decision also carries a decision about what to do with the money. Bonds are offering low returns, and their prices will fall if interest rates rise. They are not a good short-term alternative, especially in a rising economy. Cash is safe, but only a temporary solution.
Active investors can take advantage of any pullback to reinvest at lower prices. But history shows that most investors, even the pros, have poor records at market timing. If you consider yourself in the latter category, you will be in good company if you stay in equities.
T R Mongan, CFA
04/04/2002
Dividends and Buybacks Are Sending an Important Signal to Investors
We are in the period when most companies report last year’s earnings. They also declare dividends and in some cases announce plans to repurchase shares of their own stock. The list is long, but this week two announcements are worth our attention. Apple declared its first dividend, and Target announced a dividend increase, citing its record of 40 years of continuous dividend increases. Both companies also announced stock buyback programs.
Common stock repurchase programs have become common, but these are noteworthy because of the scale. Apple plans to repurchase $10 billion of its common stock over the next three years. Target recently announced that it has completed its $10 billion program that started in 2007, and the company’s directors approved a new three-year repurchase program of $5 billion. The program that they just completed amounted to 197.5 million shares. That was 23% of the stock outstanding when the program began.
The standard comment from corporate management is that dividends and buybacks are a way of sharing their profits with shareholders. Financial analysts also talk about buybacks being part of the 2% dilution strategy to offset stock awards used as compensation. Maybe so, but $10 billion programs and 23% buybacks make a much larger statement. Target’s press release tells us the real message. “[The company] continues to generate more cash than we need to fund appropriate reinvestment in our core businesses.” After considering their choices, management has decided that their stock is the best investment that they can make in today’s market.
Now look at what they are buying and what they are paying for it. In Apple’s case, they are buying an investment in a company that generates a 45% return on net worth, a number far above the national average. And they have almost $100 billion in cash and investments. Given the choice to invest in a government security earning 2% or an established company earning 45%, most people would not need to study the issue very long. Target’s internal returns are lower, but for a leader in the consumer staples business, they do very well. Both companies also have strong balance sheets.
Analysts look at dividends differently than shareholders do. Dividends come from earnings after tax, and contrary to what some detractors would have you think, those tax rates can be high, 34% in Target’s case. Any money given in dividends is money that the company cannot use to finance its growth. The dividend pay-out rate therefore is an important statistic because it affects future earnings. When analysts try to determine the fair value of a company, the retention rate becomes a critical component.
In the examples here, both companies fare well. Apple, enormously successful, has just declared their very first dividend, and if stock prices are any indication, very few people think that their growth prospects are limited. With almost $100 billion in cash, they have the capacity. Target also has good prospects, and it has announced that it will soon enter Canada. The company’s dividend payout rate is less than 30%, which is conservative among large U.S. companies. Over the last ten years annual EPS growth has averaged more than 10%, and the company has said that the dividend could reach $3 if they achieve their plan for $8 earnings per share by 2017.
These are only two of many good stories in the market, and we know from experience that there are many limitations to long-term projections. But corporate strategic planners know that the stakes are high, and they devote a lot of money and talent to the forecasts. When we see corporate leaders declare dividends with conservative payouts and announce buybacks, sometimes huge buybacks of their own stocks, we are probably justified in thinking that the stocks have potential that the short-term market does not recognize.
Tom Mongan, CFA
Tom Mongan is a financial analyst in Houston, Texas
A Successful Model for Our Economic Growth
Thanks to the seemingly endless Republican debates we know that our federal finances are in shambles. Social Security seems to be going broke. Our federal deficits are large and growing, and there is no realistic way to bring receipts and expenditures into balance. Even worse, our Congress is so engaged in internecine fighting that it is only marginally functional. You can imagine that many of us are swinging between disgust and depression at our prospects.
The forecasts are generally accurate. But what we may be missing is that it does not need to be this way. An example of a working economy is alive and well . . . in Texas. A recent speech by Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas tells the story of two decades of economic success and how it happened.* Not only has the state recovered from the job losses of the 2007 recession, but it is hitting new employment highs.
The employment growth far exceeds that of the other 11 Federal Reserve Districts. The public sector added 266,000 jobs last year, led by professional and business services. Education and health services added almost as many, followed by leisure and hospitality. Manufacturing essentially tied at #4 with the oil and gas industry in new jobs added. Fisher supported his comments with charts that leave no doubt about the advantages. He shows that over the last two decades, Texas’ employment has grown faster than the Euro zone, France, Germany, and resource rich Canada and Australia. The last two countries have populations about equal to that of Texas.
Non-Texas readers will look for some “unfair” advantages, but our growth has been legitimate. Fisher offers several reasons. There has been a large and continuing flow of both workers and businesses from other states. One reason is the state’s right-to-work law. Another is the climate. Still another is the absence of a state income tax. High population density in California and New York has resulted in higher real estate and other cost of living expenses. Texas has the quality of life features that appeal to families.
The state has had governors from both political parties over the years, and its legislators have passed laws that add to the business-friendly environment. Fisher points out another interesting legislative contribution. In the late 1990s Texas eased the rules for home equity loans, but the state limited the extent of the debt to 80% of the equity value. This provided a 20% cushion when the housing market collapsed nationally. As a result home prices have been far more stable than the national average, and there have been far fewer Texas homes underwater than in the country as a whole.
Fed President Fisher then makes a critical assessment that goes beyond the statistical comparisons. His comments have important implications for our national economy. He points out that the monetary factors are the same for Texas as for all the other states. But monetary policy alone is inadequate as a stimulator. Fiscal and regulatory policies are keys supplements. Texas has been a leader in job creation and growth for over two decades, and it has happened with both democratic and republican legislatures and governors. Without a doubt this has been an important part of our success.
The final part of the Fisher speech was by far the most important for our personal planning. After showing what Texas has done under the same monetary policy that affects the entire country, he pointedly states that it has worked because of a supportive and functional state government. His speech was not meant to be a political statement, but the conclusions are inescapable. Unless we make our tax policy more accommodative and predictable, we will stifle growth. Unless we lighten the regulatory burdens of business, we cannot expect companies to make job-creating investments. The key to our growth is in the hands of the administration and Congress.
Both are doing a poor job, yet main stream media continues to focus on the Fed’s shortcomings. We have made the point repeatedly in prior Security Impression articles that there are limits to monetary policy. As Fisher says, to rebuild growth in America, our fiscal authorities must “get their act together, set aside their personal and partisan ambitions and act to right their listing fiscal and regulatory ship.”
My assessment is that the administration and Congress will not do “the right thing” on their own. Our hope must lie in the power of the electorate. The Texas model shows that it can work.
_______________
*A copy of the February 15, 2012 speech is available on the Federal Reserve Bank of Dallas website, www.dallasfed.org.
TRM
3/9/12
Show Me the Money, but Not Too Much
Dividends seem to be making the news daily, and that should come as no surprise. Who doesn’t like the increased cash flow that they provide, especially since interest rates on CDs are so low. Still, their attraction has limits. Here are three.
Dividends are a way that companies can share profits with their shareholders. The downside is that the money paid in dividends comes from the same after-tax earnings that companies use to grow their business. A second consideration is that the money paid in dividends gets taxed twice, once when the company earns it and the second time when the shareholder pays his income tax. A third factor is the negative signal that a company could generate if it needed to cut the dividend as earnings swing during the inevitable business cycle. If the dividends sometimes seem parsimonious, there are good reasons.
Company directors declare dividends based on the recommendation of management. An important consideration is the ultimate use of the money. The company can usually earn more on retained earnings than the shareholder can earn on the after-tax amount of the dividend. In this case both parties benefit from corporate reinvestment. Most corporations have strong demands for capital expenditures to expand their businesses. Their returns on new investment often exceed 20% to 25% of their pretax earnings. By the time he shareholders pay their income tax, they would need to earn substantially more on their use of the funds to equal the amount that the corporation has sacrificed.
Most companies try to balance the desires of shareholders with their own needs by choosing a dividend payout rate that is often less than 50% of earnings. The part that they retain finances growth, so the more they keep, the faster they grow and the faster future dividends can grow. In theory the growth will be reflected in the price of the stock, which ultimately benefits the shareholder.
Tax law creates exceptions. Master Limited Partnerships, MLPs, are a popular business structure, particularly in the oil and gas distribution industries. MLPs are exempt from most federal tax if they distribute the earnings that qualify as distributable cash flow. As a result, their distribution (dividend) yields are often triple the level of the normal corporation. Further, much of the distribution can be considered a return of capital to the shareholder, and as such it is not taxable, which further increases the yield.
The MLP finances its new growth by selling more shares and issuing more long-term debt. Their credit ratings are generally below the level of many corporations, but they still are investment grade credits, and their high yields make MLPs attractive investments.
REITs have similar advantages, but the yields are not as high in the current market, and the business outlook is less clear. In prior years, however, REITs enjoyed long-term growth of 5% to 7% and similar dividend yields, which gave them a good and relatively stable total return of 10% to 14%. The events of the economic downturn hit the real estate market particularly hard and investor interest in REITs has declined.
As a shareholder, I like the cash flow from dividends, and you should too. But enjoyable as it is, do not let a desire for high yields dominate your investment decisions. Not long ago the motivation was total return, the combination of dividend yield and the percentage change in the security’s price. That still is the best measure, but when the S&P 500 showed basically no growth for a decade, shareholders decided to try another approach. What makes it even worse is that bonds, bond funds and CDs have been producing very low cash flows. That makes high cash flow “the bird in the hand.”
Bonds can post high total returns for a specified period, but these figures can be misleading. Last year, for example, the bond market far outperformed the stock market. The 30-year U.S. Treasury bond had a total return of 34%. The S&P 500 returned a paltry 2%, and that was from dividends. But keep in mind that the only way to capture the bond’s total return is to sell the security. Otherwise the cash flow is very modest; the bond’s actual yield today is a mere 3.1%.
This leaves many people stretching for returns. They do this by ignoring the normal rules of diversification, by buying high risk securities and by extending the maturities of their fixed income purchases. These tactics are prescriptions for an expensive disappointment. Remember that high yield and long-term bond prices are highly vulnerable to yield change, and bond prices move in the opposite direction of interest rates. Given the tensions in the Middle East, the problems within the European Union, the huge increase in our own money supply and the Fed’s attention to inflation, I think it is a bet that I would rather avoid.
My conclusion: show me the money, but not too much. I enjoy cash flow as much as the next guy. But I also like growth, and I want my companies to be forward looking. Some things will not change over time. A balanced allocation of asset classes, disciplined risk management and active attention to the specifics are still the way to build a winning portfolio strategy.
TRM
Investment Outlook, 2012
Regular readers know that I am on the Investment Board of Woodway Financial Advisors, a private trust and investment management company headquartered in Houston, Texas. Other members of the Board include seasoned investment professionals, business managers and an economist in addition to key company officers. In today’s meeting we discussed the economic and investment outlook for 2012, and we volunteered our forecasts ( independently ) for the Dow Jones Industrial Average and the 30-year U.S. Treasury bond on December 31, 2012. This is a good time for me to relay some of my thoughts with the caveat that these are my personal ideas, not the consensus of the Woodway Board.
Last year’s market results are a good place to start; they were disappointing. The Standard and Poor’s 500 stock index, which is the most widely cited figure among investment professionals, finished the year where it began, no gain. The only return was from the dividends that the stocks generated, slightly above 2%. The Dow was better, 8.39%, but the total return of the NASDAQ composite, which reflects many of the smaller issues and the tech issues, actually declined 0.79%. International stocks did even worse, declining 11.71%. The latter number hides a wide range of returns. France and Germany were both down 16%, China fell more than 19% and Brazil fell 27%.
Many investors looked to fixed income securities for their implied safety. Cash management accounts and 3-month U.S. Treasury bills were the biggest beneficiaries of this because they are the least volatile, but they showed almost no return. That was understandable since the Federal Reserve has conducted its policy to make funds affordable to potential borrowers through a series of quantitative easing tactics. The Treasury’s 30-year bond however did much better with a total return of 30%. The gain reflects investors’ flight to safety. Huge amounts of money, both domestic and foreign, flocked to the security of the U.S. Treasury’s guarantee, driving prices for the bonds up with a subsequent drop in yields to maturity.
The big question now is how we should invest going forward. Tepid economic growth in the U.S., election year uncertainties, struggling European economies, serious political unrest around the globe and timid consumers combine to depress many investors. The one thing we know from experience is that this year’s returns will depend on the earnings growth of the various companies, the relative valuation in current securities prices and the key economic indicators of credit, employment and inflation. Investors also need to be aware that analysts, professional investors and economists are already looking ahead to 2013 and 2014 to discern the trends that will determine the ultimate prices of securities.
Those of you who see institutional reports on the economy and on markets know that even partial answers to these issues can be book length. We will pass on the details because they are bound to change as the year progresses. Let’s cut to the chase. My personal projection is that stocks will rise between 6% and 8% for the year. Short term rates will stay close to zero as the Fed works to support economic growth, and long-term rates will rise over the 12-month period as investors become more concerned about eventual inflation. Remember that bond prices move in the opposite direction of rates and the longer maturity prices move more than the short maturity prices. Last year’s good return from long bonds is a thing of the past. With interest rates near all-time lows, long maturity bonds are a sucker’s bet.
Inflation is likely to be almost nonexistent for two reasons. The Fed will go to great lengths to prevent it from becoming a factor. There also is little demand pull from consumers to raise prices. Our system is still operating with enough excess capacity to accommodate growth, and the high number of unemployed means that wage pressures will be minimal. We also are not likely to see enough of an increase in consumer and business demand for loans to push rates higher. We are awash in cash and capacity. Corporations have huge amounts of cash and they have strengthened their balance sheets by paying down debt. The same has been true, although to a lesser extent, for consumers who have dramatically reduced their outstanding credit balances and improved their savings rate. Finally, with everything considered, deflation and hence a second stage of recession are very unlikely.
Now look at valuations. The price/earnings ratio of stocks is a popular measure of relative stock value. Even though corporate earnings are likely to grow only slightly, P/E ratios are near the bottom of their range. This means that any improvement in either valuations (higher P/Es) or earnings per share of companies is likely to translate into higher prices. Despite all the problems that network TV is happy to dump on us, there are companies with excellent growth prospects because of their products, their patents, their new markets and their efficient management. They are not going to fail. Within that vast sea of uncertainty, good companies and good industries will rise in value. Your goal (and ours) is to identify the winners and price their risks properly.
For the last several years markets have struggled with excessive consumer debt, unemployment, low consumption, an absence of corporate investment, inept politics in Washington, D.C. and huge geopolitical uncertainties. Problems remain, but they are not intractable. A key issue now is timing. Those of you who are concerned about the day-to-day machinations of the markets will not find these ideas very helpful. But most of us are in it for longer periods and those prospects are promising. Depending on your age, investment wealth and your ability to live with the low yields that are likely to be with us for the next few years, your allocation to stocks should reflect the growth prospects. Keep the faith; the market will go up.
T R Mongan, CFA
January 18, 2012
Romney's Circular Firing Squad
Initially this could have served as a vetting process of the candidates. As the attacks escalated, however, the candidates built criticisms that undecided voters will use against republican candidates when the final elections take place. Recent news shows the candidates encircling their prey, Mitt Romney. That probably makes sense in some physical contests, but when you are using real bullets, the strategy is self-defeating. Circular firing squads eliminate more than just the guy in the center.
The argument against Bain Capital is specious. But even if it were true it would be a bad tactic for Gingrich and the others to use. Holman Jenkins is one of several writers who have written a far more realistic review of what happened at Bain. Jenkins’ article in today’s Wall Street Journal gives a good explanation of what went on. Knowledgeable readers would probably judge Bain’s record to be positive. But most voters have never heard of Holman Jenkins, do not read the Wall Street Journal, and will never see a clear defense of the record. They will, however, remember the conclusion, which is that capitalism can cost jobs. The fact that the process results in a far healthier economy will never rise to the surface.
By now we know that sound bites can be deadly to a political career. When supposedly objective commentators limit the candidates to 30-second answers on some of the world’s weightier issues, the odds of communicating clear explanations plummet. Listeners then must make their choice of candidate on the basis of headline-type responses that the media wants us to hear. Forget diplomatic skills, scholarship or meaningful analyses, this is just another form of show business.
Now we go to South Carolina. The tempo and the volume of the rhetoric are increasing, but we are not likely to settle the issue here. Personal ambition will keep several of the candidates in the race, even though their rankings make their eventual success all but impossible. And if Gingrich should emerge as the candidate, the vitriol of the current campaign is not likely to be lost on the huge number of independent voters who might otherwise be inclined to vote against Obama’s poor economic record.
Some will argue that there will be a coalescence of votes as candidates drop out. That’s possible, but if the candidates wait too long to leave, coalescence will become fragmented, and Obama will be the beneficiary. We are likely to see the anti-Wall Street, anti-business argument magnified when we get to the national debates. If the European economies continue to slide as many economists expect, our growth will suffer, further strengthening the movement to a greater role for the federal government. It is starting now with this week’s proposed proposed increase in the debt ceiling to $16 trillion, and it will only get worse.
There is a positive way to approach the inevitable challenge to capitalism. Maybe the candidates will show that our growth does not come from a “zero-sum” strategy that only benefits from someone else’s loss. The beauty of capitalism is its almost Darwinian consequence. Over the last several decades thousands of jobs have been lost to consolidations, yet total employment and productivity have increased. We cannot let discussions end with statistics that cite job eliminations without noting the benefits of ensuing corporate growth. Magnify the Bain criticisms and you can make the same case against technologic advances. Why not think of the Bains in our system as microcosms of capitalism? The better focus is the long-term record of U.S. growth and the many small steps that we took to get to this point.
A Mortgage Meltdown Retrospective
A friend recently sent me his critique of former Fed chairman Alan Greenspan’s inaction before the mortgage industry meltdown. My response follows. Many people were involved, leaders in the finance and banking industries and in government. Most of us hate what has happened in our economy, but my biggest fear is that it will happen again, maybe in a different form, but it will happen again. We were only a few years past the tech bubble disaster when our system collapsed from the lending debacle. Now four years later we are still limping from the second worst decline of the last century. How can we repeat the mistake? A new wave of managers and elected officials, convinced that they have a better plan, will once again override the basic rules of business.
Michael
I have many thoughts about the mortgage meltdown, and all are negative. I
agree that the Fed bears some of the blame. Greenspan has received
accolades from around the globe for his God-like skills managing monetary
policy. He sounded very conservative when he made his comment about the
market's "Irrational exuberance" a little over a decade ago. How could he
have missed this one? I won't let him off the hook, but he was only a cog
in the system-wide machinery that built the growth of the 2000 to 2007
economy. Also involved: Congress, the President, individuals who ignored
the basic rules of spending responsibly and thousands of loan officers who
were both pushed by their bosses and pulled by personal greed.
Over the last 10 to 15 years you could see the impact of incentive
compensation on almost all businesses. Brokers lived from their
commissions, so forget the idea that their incentive to do the right thing
for their clients was the motivating force. Each month their compensation
starts at zero. If they don't sell, they don't eat. It didn't take long
before this ethic made its way into the bank investment arena. If the
banking industry couldn't provide similar incentive, it couldn't expect to
attract the best and brightest employees. Seeing this, bank loan officers
wanted their share. At that point the camel had his nose under the tent.
The solution: bank/investment officers started getting bonuses based on
production. At XXX Bank, we had loan officers getting huge bonuses for
loan deals and financing arrangements that were exceptionally profitable to
the bank. Should anyone be surprised that officers pushed to reach new
levels of production?
The same must have been true in every mortgage production house in the U S.
Sure, we can say that many prospective homeowners were naïve (and greedy)
as they stretched for home loans. But why not? There were supposedly trained
lenders who were showing case after case where borrowers could get big
bucks for homes that would have seemed out of reach a few years earlier. The
borrowers might have been a little apprehensive, but people with a lot of
financial training were telling them that it was okay to borrow at these new
elevated levels.
So at this point we have named the Fed, the Administration, Congress, the
bank examiners, the bankers and the borrowers as culpable. And all of this
only a few years after the tech bubble burst from excessive optimism that
temporarily crippled the stock market. But one more point really bothers
me. My son-in-law is a residential real estate appraiser. Mortgage lenders
typically hire him on a case-by-case basis to appraise homes applying for
mortgage loans. The value of the home will determine the maximum size of
the loan. A high appraisal means that the lender can lend a greater amount.
In the "old days" appraisers were conservative because the bank/mortgage
lender would not want to over-extend. Similar caution led the banks to
require substantial down payments and proof of earnings or net worth that
could support the loans. The pressure on him to elevate values in the
appraisals was huge, and his refusal to do so cost him several good
accounts. Not surprisingly, one of the most egregious was Countrywide. We
know what happened next.
The conflicting objectives are obvious. Demand for growth and competitive
drive encouraged the lenders to finesse the standards. That charge applies
to the bank presidents and their department managers who set unrealistic
growth goals for their lenders. It then extended to the loan officers who
strove to build their income through commissions and bonuses based on
production. Seemingly overnight, lenders were making loans at nearly 100%
of collateral value and documentation was declining until eventually "no doc
and low doc loans" became standard. We would be unbelievably naïve to
think that a model like this could survive through a business cycle.
The prospective homeowners should have known better. But the first line of
defense was the loan officer and his or her superior who should have considered
the downside risk. The absence of responsibility was endemic, and it stretched
all the way up to Greenspan. Congress, the president and the mortgage
companies all earned a grade of “F” for their role in the collapse. Ultimately
I trace the fall to personal greed at multiple levels. The borrowers were wrong to
overextend, and regulators should have seen this coming. But as bankers and
professional investors, we are in the business of maintaining a viable system.
We failed.
XXXX won't publish this, but who cares. In four more years there
will be a new wave of lenders, managers, prospective homeowners and
politicians who will be more than willing to ignore the lessons of this
collapse, and we will be back in the soup again.
Cheers, Tom
This outcome is not inevitable. Maybe as voters we can make a difference, but to do so we must be more vocal than we have been. Any action must go a step beyond taking a strong Democratic or Republican stance. What is going on in Congress almost seems like adults rallying for the home team against the cross town rival in a high school football game. We cannot keep doing the same thing and expecting different results. Demand more of your congressional representative.
TRM
