Federal subsidies are never free. One way or another, their costs are extracted out of the private sector. Yet policymakers are acting in a manner that assumes the private sector is working its way back to the economy we saw in 2006-07. The idea goes as follows: Stimulus spending is supposed to kick-start household spending. Zero interest rates are supposed to kick-start another wave of bank lending.

But this isn’t happening because many have misdiagnosed the reality we’re facing: Too many balance sheets need to de-lever, and if policy tries to stop this process, it will fail. And in the end, the public-sector balance sheet will be strained to the breaking point, which will have its own disastrous consequences for the private sector. The consequences of the attempt to “keep consumer spending up” to unsustainable levels will ultimately be disastrous.

The most-glaring recent example of the market drawing conclusions from misleading economic data is in the recent surge of stocks tied to the U.S. housing market. Investors are all of a sudden convinced that a recent blip up in seasonally adjusted housing starts will last. Mark Hanson, a widely cited expert whose opinion I’ve respected since first reading his work in 2007, summarized his view on housing in an early February note to clients:

“In the past several months (the slow season), the housing sector has no doubt benefited from a major stimulus of sorts…record-low rates; artificially low inventory; the most-favorable weather conditions in recent history; an epic backlog in foreclosure completions; [year-over-year] comps against the 2010 tax-credit hangover period; and a near-record volume of stale MLS listings being pulled off the market in order to ‘refresh’ them for the spring — right when seasonal adjustments are at their peak. In order words, a confluence of transitory factors has, in fact, caused some incremental and significant pulled-forward demand — and increased general housing- and consumer-related activity — during a time of the year when this type of activity is generally slow. But many of these factors have a high probability of reversing into the spring, meaning the payback will be much slower activity when conditions are generally busy… never lose sight of the fact that U.S. housing suffers from a narrow and finite demand foundation, which we continually focus on.

“When this housing recovery theme falls apart, the bull cases across a number of sectors will have their legs cut off over a three-month period, just like last year. And the gap between the consensus (further improvement into springtime) and the more-than-likely realization that the double dip continues is extremely large.”

In many areas of the U.S., low-end home prices are competitive with rentals. Mortgage rates are near all-time lows, and prices have already crashed. But high-end home prices will continue to drop for years to come. One’s primary residence is increasingly being viewed as a slowly consumed durable good, rather than an “investment.” Financing for more-expensive houses is also scarce. Banks aren’t interested in writing jumbo mortgages; even if they were, the traditional “move up” buyer is hard to find. If he can’t sell his existing house, he likely won’t have the down payment for a larger, more-expensive house.

This disappearance of the move-up buyer is important, especially because Wall Street is now under the mistaken belief that in early 2012, housing is in the early stages of a strong recovery.

“The next phase to the U.S. housing crisis is house price compression,” Hanson writes, “the upper price bands [will compress] on the lower. It’s already happening. The data we watch closely every day are clear. This adds an entirely new dimension to the U.S. housing crisis, one that pushes out an ultimate “recovery” a lot further into the future than anybody is forecasting, or can model.”

The excess supply of housing — especially at the middle and higher end of the market — will take several more years to clear. Prices will fall as this unfolds. After slowing foreclosure activity in 2011, most banks are set to accelerate sales of repossessed houses in 2012.

Regards,

Dan Amoss

The Future of Higher End Housing Prices was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The idea goes: If the S&P falls below 1,040, then we’re likely to revisit the lows below 700. Who knows if this widely cited “if, then” conditional probability is valid? We may find out soon enough. When universally accepted technical support levels are breached, we tend to see heavy bouts of “self-fulfilling prophecy”-based selling.

Regardless of how the technical conditions play out, there’s still a big difference between current stock prices and the prices that most value investors are willing to pay to assume the risks of owning stocks. The word “risk” is key. In periods of heightened economic and political risk, investors demand higher risk premiums to hold stocks. A simpler way of stating “higher risk premiums” is “lower stock prices.”

These risks include the speed at which politicians are driving national economies down Friedrich Hayek’s proverbial “road to serfdom.”

Austrian theory acknowledges both the “seen” and the “unseen” effects of government policy, while Keynesian theory ignores the unseen in the pursuit of managing this thing we call “GDP” at all costs. The conceit that GDP can be managed by enlightened bureaucrats usually undermines vital capital foundation. Too many people confuse economic activity (measured by GDP) with economic progress (which usually involves rising living standards driven by rising productivity and falling consumer prices; see the U.S. industrialization in the late 19th century).

The road to serfdom, originally outlined by Hayek, is now taking the global economy down one of two paths:

Painful austerity plans and deflation that salvage what’s left of today’s currency system by promoting savings and encouraging new capital formation;

OR

Endless stimulus injections into economies with the promise of austerity “once the economy recovers.” Unfortunately, most Western economies are now thoroughly addicted to government spending. Each fiscal and monetary injection into zombie banks will likely have to be larger in order to offset the withdrawal symptoms of losing the last stimulus plan. Entrepreneurs figure this game out and gradually withdraw from participating in the economy in a healthy, productive manner. This loss of entrepreneur confidence in the system will ultimately accelerate the demise of all paper currencies.

The second path one is more likely in my view, because it’s more politically popular – especially once the European “pro-austerity” camp discovers just how addicted their economies are to the welfare state. Hopefully, a critical mass of people who value freedom over the illusion of economic security can move to wean us off today’s frighteningly powerful roles for governments and central banks. But based on the decisions we’ve seen in recent years – decisions driven mostly by political considerations – I’m not holding out much hope at this point.

After this weekend’s G-20 meeting in Toronto, we’ll know more about the direction in which the “world improvers” seek to drag their constituents. Ideologues are lining up on either side of the political debate between a) austerity and b) “endless stimulus and money printing.” Where one stands in this debate will depend on one’s view of the proper role for government.

Based on polling data, I probably don’t need to convince you that confidence in Washington, D.C., is near an all-time low. This normally shouldn’t be a concern for the stock market or the economy. But it is becoming a growing concern, because politicians keep pushing unpopular big-government agendas in a truly tone-deaf manner – agendas that will further dampen the entrepreneurial spirit that made the U.S. economy the envy of the world (while other countries were sabotaging their own progress with various flavors of Marxism during the 20th century).

Threats from Washington, D.C., include everything from raising tax rates, to bailing out cronies at zombie corporations, to a debased dollar, to an energy policy that – regardless of how it’s sold – will, in practice, have the effect of dramatically raising prices and worsening the U.S. dependence on oil imports. Case in point: The answer to the BP oil spill is to take away the right for Gulf Coast oil workers to work on statistically safe drilling projects for the next six months, and then put them on BP-funded welfare checks.

No price was too high to bail out the financial terrorists at the “too big to fail” banks. There’s not much desire for the current Congress and the Fed to end embarrassingly large subsidies and guarantees for the big banks. Apparently, in the wee hours of this morning, bank lobbyists succeeded in watering down the “Dodd/Frank” financial reform bill enough to render it almost meaningless. This bill serves to ultimately transfer even more wealth from the middle class to Wall Street kleptocrats (mostly via the hidden inflation tax, engineered by a politicized Federal Reserve).

This bill also did nothing to reform the monstrosities most directly responsible for inflating the housing market with underpriced mortgage credit: Fannie Mae and Freddie Mac.

Bottom line: This environment is dangerous for the stock market. Bull markets require healthy risk appetites among those with capital to invest.

Regards,
Dan Amoss
Whiskey & Gunpowder

July 6, 2010

How to Profit on the Road to National Serfdom was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

As for the S&P 500, the lowest-cost way to short it would be to sell short SPY, the S&P 500 ETF. If you’d rather use options to short the S&P, you can buy “at the money” or slightly out of the money puts on SPY. I’d stick to further expiration dates.
 
The S&P 500 is overvalued. It would take a resumption of investor fear to drive it down to, or below intrinsic value. Despite recent weakness, we’re not yet seeing much fear — at least not as much fear as we should be seeing, considering the horrible economic and regulatory environment. The vast majority of investors still think we’re in a new bull market.
 
The best estimates I’ve seen put the S&P 500’s intrinsic value somewhere in the range of 800 to 900. This range should go up over time assuming economic growth, and the “survivorship bias” of the index (i.e., companies like GM and Citigroup, whose market caps get obliterated, get lower weights, while successful companies like Apple get higher weights as they rally).
 
But for now, considering valuations, profit margins, and risk premiums, the S&P is likely overvalued by 25%. The S&P could easily fall to that range by 2010, 2011, or 2012 but there’s no way of knowing when.
 
2. Can I buy and sell put options from my online brokerage account, or do I need to use a broker?
 
Dan: Every good online brokerage offers options trading. You’ll just need to open a margin account. Your online broker should have all of the available educational tools. E*TRADE has worthwhile links to free educational resources on options trading here. The basics of the simplest options trades are not complicated. I like to keep recommendations simple.
 
3. Is there a minimum amount of money a person needs to short stocks?
 
Dan: From my experience, there is no minimum amount. Most likely, the minimum amount would be your broker’s minimum for opening a margin account. You need a margin account to sell short. Another way to limit the amount of money you commit to shorting would be to buy put options instead. You can get the same exposure as shorting, but with much less money involved. Each put contract gives you exposure to a short sale of 100 shares of stock.
 
For example, if you shorted 100 shares of a $20 stock, you’d have to borrow $2,000 from your broker in your margin account (the amount borrowed depends on your level of equity in your margin account), sell the stock at $20, and have the obligation to buy it back in the future. Your profit is the difference in the stock price between when you sell it short and buy it back, multiplied by the amount of shares you sold short.
 
If you used a put option with an asking price of $2 per contract, you can short the same value of shares ($2,000), but only risk $200 ($2 per contract times the right to sell 100 shares of the underlying stock). Profit potential is much higher, but so is the risk of loss. The way we deal with this in Strategic Short Report is to find stocks that we’re highly confident are overvalued, and look for put options with high strike prices and distant expiration dates. If the thesis isn’t developing as we expected after a few months, we cut our losses.

4. Is there still opportunity to short BP, what do you think is the best way to do this?
 
Dan: I would not recommend shorting BP at today’s price, because it’s likely undervalued. The only thing powerful enough to drive it much lower would be endless class action lawsuits, without any sort of negotiated cap on damages.
 
That’s not an outcome I would bet on. It’s certainly possible, but not likely. The U.S. government has an interest in keeping BP alive and functioning normally, so it can fund cleanup costs damage claims out of its future cash flow. The value of BP’s future cash flows — after adjusting for spill-related costs — is likely much higher than the current stock price (especially if over the next decade, average oil prices are north of $100 per barrel, which is very possible).
 
That being said, if you want to bet on the government and lawyers tearing the company apart in a foolhardy manner (which wouldn’t necessarily surprise me), it would be much smarter to buy puts rather than sell the stock short, because with puts, you can limit your risk of losses.

Regards,
Dan Amoss
Whiskey & Gunpowder

June 17, 2010

How to Short the Market Right Now was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Dan Amoss: Okay, well I start from the assumption that most economists and analysts are ignoring the importance of balance sheets. There’s way too much bad debt in the global economy, and governments and central banks are trying to paper over these bad debts.

And the consequence of this is that governments will eventually reach the limits of what the market will allow in terms of debt to GDP ratios. At that point, it will be hard for the economy to both grow and service the incredible burden of debt that it has.

Overindebted balance sheets at all levels of society tells me that this is not a typical economic cycle. Yet the stock market is priced for a typical economic cycle, and factoring in record earnings and profit margins in 2011 and 2012.

Stocks are expensive right now, based on my favorite method of valuing the broad stock indices, which is the Shiller PE ratio, the work of Yale economist Robert Shiller. This PE ratio is defined as the price of the S&P 500 divided by the average, inflation-adjusted earnings over the past 10 years. This ratio is about 20 right now, far above the historical average of about 15.

At the end of long bear markets, the Shiller PE shrinks to between five and ten. So over the next few years, the broad market could go down another 50% through some combination of falling prices and rising corporate earnings.

Most stocks are likely to fall this summer, simply because efforts of governments and central banks to paper over bad debts will hit some serious roadblocks, particularly in Europe and in the U.S. mortgage market. Any company that needs to constantly tap the corporate bond market or its line of credit could see much more weakness this summer.

I’m always looking for stocks that can fall faster than the market. Typically, I like to drill down to specific sectors and stocks to find the ones that are the weakest and/or the most expensive.

Gary: Could you give a couple examples of that?

Dan: Sure, an example of an area that I’ve been focusing on is companies exposed to commercial real estate — that includes most REITs. REITs trade like stocks, and they own portfolios of commercial real estate. They typically pay out 90% of their earnings as cash dividends. REITs reached an extraordinarily high valuation in 2007. They were priced for for continued increases in rents as far as the eye could see. And people were using extraordinary amounts of leverage to buy these properties.

And then when the 2008 crisis hit and financing dried up, you saw affordability collapse, in terms of what types of properties investors could buy on a leveraged basis.

Since the 2008 panic, the Fed pulling rates down to zero percent has helped REITs out a lot, but now you have a big overhang of what I call zombie properties that will restrain the appraised value of the overall index of commercial real estate.

Gary: Now, in terms of the feds holding down interest rates, you expect this will result in bigger problems?

Dan: Well, it delays the ultimate resolution of the commercial real estate bubble that peaked in 2007. What the market needs to restore health to commercial real estate is fresh equity. Which means you need liquidations of the old owners’ interest in kicking hte can down the road with serial refinancings, have their equity wiped out, and bring in new buyers with the capacity to inject sustainable levels of equity into these properties.

For most commerical properties purchased with high leverage between 2005 and 2007, the debt to asset ratios — if they haven’t been foreclosed on — are now well over a hundred percent. In other words, the investors are underwater, like a homeowner with negative equity. Owners with negative equity have little incentive to properly maintain their properties. Properties that aren’t maintained, lose many tenants as leases roll off, which accelerates a liquidity crisis. In this type of situation, which is rampant, if the banks don’t foreclose early on, and just roll over loans to insolvent borrowers, the ultimate loan charge-offs when forclosure becomes inevitable will be even larger.

So going back to the zero percent effect: for banks, the lower interest rates are, the lower they can justify on their income statements how long they can hold these non-cash flowing properties.

Gary: I see, and another example if you have one handy?

Dan: Yeah, another area I’m focusing on is the consumer electronics companies that produce in the U.S. and export to Europe. One in particular generated most of its 2009 operating earnings in Europe.

This company is heavily exposed to the Euro/dollar exchange rate. Its stock doubled off the lows in 2009, yet the company is facing massive long-term head winds in their core product. Technological shifts will make it obsolete in a decade.

Yet the market is pricing this stock like we’re in a typical economic recovery and it won’t be hit by competitive pricing pressures and a weak European economy.

Gary: This is not your garden variety contraction; it’s not just a regular recession. But before I move on, two things I figure would be hit a lot by the lack of credit were things homes and like electronic toys seem to be the biggest beneficiaries of cheap credit when it was available for the past, I don’t know how many years. Does that sound right to you?

Dan: Yeah, that sounds right. Easy credit can impact the economy in a lot of destructive ways by sending all sorts of false signals about what sustainable demand really is to producers.

Producers gear up equipment to service that demand, and then when the credit’s gone, the pain, the adjustment is wrenching. We see this now, not only in the U.S. consumer economy.

There’s risk of German factories selling into Southern Europe. There’s risk of a big adjustment there, loss of sales and margins. And same thing with China and the U.S. relationship, balances in the global economy will take a long time to work out.

There will be a lot of wealth destroyed in the process.

Gary: Speaking of wealth being destroyed, what effects do you see coming out of the deepwater drilling moratorium for the Gulf of Mexico? The people in government who are instituting it, they probably don’t think about these things at all — about perverse and unintended outcomes.

Dan: Yeah, there’s no doubt that this is a huge environmental catastrophe, but it seems like government regulators are trying to make this even worse.

Whereas the fishing and tourism industry was hurt by the first order effects of the spill, by imposing this six month blanket moratorium on the rest of the off shore drilling industry, we’re going to start seeing rapid production decline rates kick in on a lot of these off shore wells.

We get in excess of one million barrels of oil per day of oil production in the U.S. from deep water wells. The nature of these wells, the decline rates of these wells, dictates that you’ve got to keep drilling new prospects very actively to avoid a scenario of contracting oil production in the Gulf.

A report from Morgan Stanley that came out last week claimed that in an extreme worst case scenario — if deepwater drilling is permanently banned in the Gulf of Mexico, it will drive today’s 1.2 million barrels of oil per day of deep water oil production down to zero over a four to five year period.

And considering the state of big oil projects around the world and the ever growing demand from emerging economies, we simply can’t afford that level of decline in production. You can have a situation a couple of years from now where high oil prices will continue to crowd out any discretionary spending among U.S. consumers, which would be very bad for a lot of stocks.

Gary: So it’s going to pinch the consumer’s wallet and we’re talking everything being affected.

Dan: Exactly. The average American household spends anywhere between five to ten percent of their income on gasoline and transportation. That can easily go much higher. In developing nations, the cost of transporatation is a much higher percentage of the household budget, yet demand’s still growing.

Gary: That sounds like a recipe for disaster. So you have the government claiming it’s going to stimulate the economy, which is probably not a good idea in the first place; and then they’re doing this, which will create a huge drag on the economy. For stocks, it’s just sounding pretty bad.

Dan: Exactly.

Gary: Speaking of government intervention — I want to talk about short selling, which government tries to portray as evil, as this destructive, unpatriotic act, but don’t short sellers serve an important function, especially now they’re going to have as you mentioned this summer coming up, looks like they’re going to have just a field day? They do something important for the market.

Dan: The most important thing that short sellers do is they communicate, especially during the midst of bubbles, when the emperor has no clothes. They point out inefficiencies in pricing. Famous short sellers were among the first to warn about credit excess a few years ago and housing bubble.

Short sellers basically sell into the peaks of bubbles and provide liquidity to panicky sellers near market bottoms when they buy to cover short positions. When people are panicked and wanted to get out, and there are few providers of liquidity, they’re one of the few consistent providers of liquidity in really weak markets.

And secondly I would say based upon history, mostly because the tide tends to go against short sellers over the long term, they have to be twice as rigorous in their analysis. You can’t afford to be wrong as often when you’re a short seller, especially when you’re betting against a company using accounting shenanigans to inflate their earnings.

So those are two main reasons that short selling benefits the market. There are several more, but those are the first two that come to mind.

Gary: Sounds like short sellers have to be very smart. So what kinds of things would happen — there was a ban on it for a little while, kind of a populist thing to demonize short selling.

What happens when there aren’t short sellers? They provide this important function; say they’re stopped from doing it, which I guess could happen, again.

Dan: The last few instances where they’ve banned short selling led to a period when markets typically went into free fall, and we saw that in the fall of 2008 in the U.S. with the ban on shorting financial stocks.

The biggest period of decline occurred after the bans. And the reason that is, is because so many market participants, everyone from long/short hedge funds to convertible bond investors, use short selling as a key component of their investment strategy.

So when you take that component away, those investors typically just withdraw from the market. And when you have a mass amount of investors who tend to be very active traders withdrawing from the market, liquidity evaporates. And the last time you want liquidity to evaporate is during a panicked period.

It tends to make things much worse and has never resulted in the outcomes that the bureaucrats and regulators are seeking by banning short selling.

Gary: Imagine that.

Dan: They think it will end selling, but what really causes markets to crash is no bidding. Banning short selling often results in a market with no bids.

Gary: Would you say that’s fair to say that markets tend not to get so out of whack when they are allowed to correct themselves automatically as opposed to having things but in their way that are very un-market like…basically politics and political decisions?

Dan: Yes.

Gary: Okay, so the short sellers fit right in the Whiskey Bar really easily. Do you have any famous stories or examples of short selling?

Dan: The best example in my mind of how short sellers provide value to investors and society at large is the story of Jim Chanos and Enron. Enron was a darling stock in the late 90s and up until the year 2000. Every analyst on Wall Street loved it; brokers were pushing it to their clients.

You have this hedge fund maanger dedicated soloey to short selling, Jim Chanos, who’s known for his skill in forensic accounting. He looked into all the off-balance sheet entities, figures out what’s really going on, and concluded that the company was basically a big Ponzi basically. So his hedge fund sold short the stock.

Chanos was selling near the peak as the public was buying; if Chanos’ fund hadn’t shorted it so aggressively, the stock likely would have kept going up because it had the nature of a Ponzi where because it was going up, it was drawing in more capital, which in turn cause it to go up even further. And because Chanos was selling short , he stopped a lot of investors from losing even more money by prompting them to dig deeper and ask harder questions in order to really understand a company that was ‘all hat and no cattle.’

Gary: He corrected an imbalance. He was the market that worked, essentially. Regulators say they need to be there to prevent Ponzi schmes and things that’s rob the investor, but he was doing their job.

Dan: If regulators want better enforcement of the security laws, they should do everything to listen to, rather than hamper short sellers, especially in situations where ridiculously promotional companies are constantly in the market raising capital from gullible new investors.

Gary: We talk a lot about economic Armageddon. Is this it?

Dan: I wouldn’t go as far as saying that quite yet because what we have basically what I talked about earlier regarding the unaffordable debt problem. The U.S. can get away with effectively socializing the losses from all of the bad debts in the banking system for a while, but it’s going to eventually show up in disappointing economic performance, especially amongst small businesses.

And when jobs and tax receipts don’t pick back up as expected, deficits are going to surprise on the down side. We have not seen the last of the Federal Reserve’s quantitative easing.

I think we’ll see more of what I call the ‘deflation trade’ for the next few months, which means Treasury bonds will probably keep rising (yields falling) and most stocks will keep falling; the Federal Reserve is saving its ammunition until everyone’s afraid of deflation and they’ll start another big round of Treasury bond and mortgage buying, at which point depending upon how savers and global providers of capital react, it could be very, very troubling.

In a scenario where the bond market loses confidence in the integrity of the currency, we could see rising yields on every type of bond despite a weak economy; for most investors, this would qualify as economic Armageddon. Stocks and bonds would both fall in value under this scenario.

This ultimately to me adds up to why you should own gold because the confidence in the monetary system will eventually collapse if governments and central banks remain on their current paths.

Gary: They’re going to do it again.

Dan: Exactly, the key point is central banks want to maintain this low inflation outlook as long as they can. As long as the market believes that, they can keep expanding their balance sheet and supporting asset prices as much as they can get away with — , until the market says no. And we’re a long way from that, I think; we’re at least a few years from that.

Gary: Wow, but in the mean time, this summer seems to be a very good environment for falling stocks. We’re not at the end of the world quite yet, or the end of the monetary system. So there’s still a lot to be done with the falling market, which is what you do; right?

Dan: Right.

Gary: So what is the one thing that we just can do right now to make sure that we won’t be wiped out by this market that’s going to be falling a lot in this very short term, but we’re not at the point where we have to get your golden bullets quite yet, but in the near term, what should they do?

Dan: I think number one is making sure your portfolio has a heavy cash component. Number two for the stocks that you do own, be very confident in their prospects, that they’re companies that are going to benefit from the likely trends in the global economy that are sustainable, like energy and food and water and basic materials, basic necessities. The stuff that emerging economies are working hard to afford, and that most Westerners take for granted.

And number three I think if you want to hedge the market risk in those stocks, the opportunities are great to selectively short sell certain companies that will be victims of this economic scenario.

Gary: Yeah, I hear that you’re very good at that last part. Thanks, Dan. See you around the Whiskey Bar.

Gary Gibson and Dan Amoss
Whiskey & Gunpowder

June 9, 2010

Why You Need to Short Stocks Right Now was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Shorting stock is probably one of the most unusual ways to make money on Wall Street. And I think the best way to explain it is with a story.

Say a friend lets you borrow his brand-new car for an extended time. So for all intents and purposes, the car is yours.

One day, a complete stranger sees you with the car and says, “I’ll give you $52,000 to sell this car to me.”  Unsure of what to say, you take his phone number and say you’ll think about it.

You’re very curious, so when you go home, you do some research and discover that $52,000 is a very fair price for the car. But you also learn that the local car dealership is having a big sale in two weeks, so there’s a good chance the car will sell for a lot less than it sells for today.

You call up the man who wants the car and agree to the sale. You meet him, and he hands you a check for $52,000. That’s a nice chunk of change…but now your friend is out a car. Luckily, you know what you’re doing.

Two weeks later, the car sale starts, and you’re able to buy the exact same model of car — from its color to its option features — for $42,000. You’ve now replaced your friend’s car and kept a nice $10,000 for yourself at the same time.

What you’ve done is known as short selling. And short selling a stock works pretty much the same way.

Make Money Selling Something You Don’t Own

When you want to short a stock, you simply call your broker and say how many shares of a company you want to short.

The broker then “borrows” the stock shares, either from his firm’s account or from other investors. He then immediately sells those shares on the open market. The money from the sale is yours to keep.

So if you short 100 shares of stock at $50, your broker will borrow 100 shares of the stock, sell them, and then deposit the $5,000 into your account.

But don’t make the mistake of thinking this is free money. Always remember that you will need to return the borrowed shares at some point. This is called “covering the short,” or “buying to close” your position.

The goal is to cover your short for a lower price than what you borrowed it for. For instance, if the stock you shorted falls to $40, you can instruct your broker to buy shares to close your position. Your broker buys 100 shares at $40, taking $4,000 from your account to pay for the transaction. The shares he bought are then returned to whom he borrowed them from.

Meanwhile, you’re left with $1,000 of pure profits.  But notice that the lowest a stock can go is to zero. So your maximum gains will never be higher than what you earned when you initially sold the stock. In the example above, you’ll never make more than the $5,000 you got for shorting the stock.

Now, the downside to this strategy should be clear.

If the stock rises, you could be in trouble. You might have to buy back the stock at a higher price than you sold it for. For instance, if you cover your short at $60 per share, your broker will need to spend $6,000.  Since you got only $5,000 when you originally shorted the stock, you’ll need an extra $1,000 in your account to pay to close the position.  If the stock goes to $70…$80…$100…you’ll have to pay that much to cover the short. In other words, your risk is theoretically unlimited.

But it probably won’t come to that. Since you’ll need enough money in your account to cover the short, your broker may ask you to deposit more money.  (This is sort of like a margin call.)

Short traders know this. So when a stock seems to be on a run, they’ll often race to limit their losses by covering their short positions. Unfortunately, their buying can run up demand for the stock. And as you know from basic economics, increased demand leads to higher prices.

This is called a short squeeze — traders covering their shorts artificially boost a stock’s price. (In my newsletter Strategic Short Report,  we want to avoid short squeezes at all costs).

Another thing to keep in mind is that when you sell someone else’s stock, they are still eligible to receive the stock’s dividends. Since you borrowed their stock, you must pay any dividends the stock pays out.

So as you can see, shorting the stock itself is a good idea only in very certain situations (situations that will be coming up this very summer, by the way). You are forgoing the biggest gains, but your trade will tend to be less volatile. Often, this is our best route if we are confident that a stock will fall, but less confident about when.

Also, some good short-selling targets are so small that they have no exchange-listed options.

Strategic Short Report will recommend short sales in situations in which it’s the only way to profit on the downside. More often, however, we will use another option which we’ll discuss in the next issue of Whiskey & Gunpowder.

See you then.

Regards,
Dan Amoss

Getting Prepared for the Best Short Market in Years was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

First, let me make this perfectly clear:

Shorting a stock is NOT taking money out of someone else’s pocket.

You are NOT doing anything to make the stock fall in value.

And you are NOT profiting from someone else’s misfortune.

Instead, short selling is about taking a stand against unbridled greed.

Think about it — you buy puts or short a stock only if you think the price will go down. And the only reason the stock price will go down is if the stock price doesn’t reflect the company’s value. If a stock is overvalued, it’s because investors believe the company’s hype.

As a short seller, you’re looking past the hype — glaring at the company itself. And if you see there’s not as much value there as investors believe there is, you almost have an obligation to short the stock.

For one thing, shorting the stock may convince people to take a closer look…and see what others haven’t. Short sellers publicized accounting frauds at Enron, WorldCom, and Tyco long before anyone else noticed. They prepared for the bursting housing and mortgage bubbles while everyone else was busy refinancing and flipping property.

So short sellers are really the market’s early warning systems. And if investors refuse to pay attention, you can at least limit the stock’s damage as it falls.

Remember, stocks are not a zero-sum game. There isn’t a winner for every loser. If someone buys a stock at $20 and sells for $30, he’s made $10. Nobody has lost any money, though, and his profit gets recycled into the economy.

However, if he buys the stock at $20 and it goes to $10, the $10 he lost is gone forever. At least, it is unless someone has shorted the stock. A short seller has a chance to recover some of that money. So instead of disappearing, it can be re-injected into other investments.
Now then…how do we determine which stocks are in dire need of shorting? There are a handful of traits you have to look for…

5 Traits of an Overvalued Stocks

I’ve found that five things predict whether a stock is overvalued or not:

· An expensive stock price
· A contracting customer base
· A history of making value-destroying acquisitions
· Aggressive accounting
· A very generous stock option program.

Let’s take a little more in-depth look at these.

An expensive stock price

An accurate definition of an “expensive stock” is a stock that has increased far higher than the fundamentals justify.

Some bull markets, like the bull market in oil stocks, are justified. Earnings and cash flow have risen as fast, or faster, than the stocks.

Other bull markets are not justified. Consider the dot-com bubble. The huge runs in these stocks were not accompanied by growth in earnings and cash flow. Instead, momentum traders and psychological mania — hype, hope, and fear of missing out on the crowd’s profits — held them aloft. (We saw the same psychological top in housing finance in summer 2005.)

You did not want to be shorting these stocks as long as the psychological mania and momentum held strong. Expensive stocks can always get more expensive.  But make no mistake, the tide will eventually turn…and that’s when you strike.

During the dot-com bubble, that turnaround came in spring 2000. The psychology turned, and momentum traders started bailing out. Experienced short sellers knew that these stocks had an awful lot of room to fall — in the range of 90–100% declines. You could have made a fortune shorting and buying puts on a basket of the most egregiously overhyped dot-com stocks.  The classic examples: Pets.com, eToys, Ask Jeeves, TheGlobe.com, InfoSpace, Razorfish.

A contracting customer base

Obviously, companies need customers to survive.  Companies that are suffering a contraction in their customer base will experience declining sales, earnings, and even balance sheet erosion. But the Street may often fail to recognize it, choosing to value a particular stock by assuming past sales and earnings trends will continue indefinitely into the future.

An example is this would be USG Corp., a leading manufacturer of Sheetrock for use in new home construction.  It’s a low-cost producer and has a good management team. It’s owned partly by Warren Buffett’s Berkshire Hathaway. As a result, it has long been a favorite of value investors.

But building supply companies have suffered a huge contraction in their customer base. And the stock has fallen from $120 to $30. As new home construction has plummeted, earnings estimates for USG have, as well.

Company financial reports often discuss the customer base…but don’t expect them to highlight it if the news is bad.

A history of value-destroying acquisitions

Some executives are “serial acquirers.” They care more about building a personal empire than building shareholder value. They have the bad habit of constantly diluting shareholders with secondary stock issuances.

A classic example is Tyco Intl. in the late 1990s, when Dennis Kozlowski ran it. Kozlowski was a sweet talker who overpaid for a hodgepodge of industrial companies, yet he successfully marketed this conglomerate as “the next GE.”

That is, until early 2002. That’s when the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up. All those acquisitions destroyed value because the negative of constant stock dilution more than offset any positive gained from the acquired companies.

Of course, expansion isn’t a bad thing. Some of the warning signs to look for are acquisitions of companies unrelated to the business…paying a stiff premium for the acquisition…or acquiring a company that’s on a downward skid.

Aggressive accounting

Companies work hard to make their earnings look as good as possible. But sometimes their number boosting schemes go too far.

Take Tyco. Its rollup strategy included an accounting tactic called “bootstrapping earnings.” Here’s how it worked: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy “old economy” industries. After the books closed of these acquisitions, Tyco would automatically show higher earnings per share. Throughout the 1990s, this conglomerate consistently produced investor-pleasing earnings growth.

How was this wave of acquisitions treated on Tyco’s balance sheet? Whenever an acquiring company pays a premium above the target company’s book value, the difference usually ends up as “goodwill,” an intangible asset on the acquirer’s balance sheet. Unlike physical assets such as plants, goodwill and other intangibles are hard to value and can, in fact, be worthless. Tyco’s intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001.

This was a big red flag. How could investors possibly estimate the intrinsic value of the underlying businesses?  Tyco is not a software company in which nearly all assets are contained in the minds of programmers and in lines of code. So the explosion of intangible assets was not justified.

“Bootstrapping” (and other merger-related accounting techniques) is just one of the many accounting red flags we’ll look for in the Strategic Short Report. Others include capitalizing expenses, channel stuffing, related party transactions, and using off-balance sheet accounting to hide the true financial picture.

A very generous stock option program

Companies often offer stock options as an employment incentive — promising shares of the company in lieu of money. There’s nothing wrong with that… in fact, giving staff a stake in the company is a perfect way to make sure it acts in the company’s best interests.

But sometimes a company gets a little too generous with its options. It hands them out like candy, or backdates them to make them more attractive. Either way, it dilutes shareholder value.

Take the case of Broadcom. Back in 2000, the company issued many options when the stock was above a split-adjusted $100 per share. But when the market hit bottom in 2002–2003 and Broadcom’s shares fell sharply, those options were worthless.  So to make its employees happy, Broadcom repriced those options.

Forty-nine million options with strike prices in the range of $32 were tendered in exchange for options with strike prices in the range of $22. This ultimately amounted to $49 million less for future company operations or capital expenditures.

The result was a dilution of shareholder value and, ultimately, a lower stock price.

Figuring out if a company is playing games with its options can be tricky. But once you see the warning signs, you know you’ve found a company ripe for a fall.

Of course, a company doesn’t need to have all five of these traits to be a potential loser. But it will have several of them. And once you’ve identified a target, it’s simply a matter of choosing the best way to play it. In Strategic Short Report, we’ll use one of two methods — shorting the stock or buying puts –and which will discuss in detail in coming issues of Whiskey & Gunpowder.

Regards,
Dan Amoss

June 4, 2010

Short Selling is Good was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The forward P/E multiple on the broad stock market is not nearly as high as it was during the Internet bubble, but it’s at extreme highs if one accurately diagnoses the unsustainable stimuli currently driving global economic activity.

Just like low-quality earnings paint a misleading picture of a company’s value, this low-quality economic activity destroys wealth and promotes a dependence on sustained fiscal largesse.

Such a diagnosis would filter out how fiscal and monetary policies are distorting the efficient allocation of capital. Investors should interpret government spending as noise and interpret private sector behavior as the signal. In today’s state-sponsored economy, you cannot totally separate one from the other, but it’s still important to acknowledge the distorting influence that stimulus programs have on capital spending and hiring decisions.

What happens when the stimulus wears off? Why, we have even more excess capacity in sectors where stimulus was directed. Exhibit A: cash for clunkers. Exhibit B: the tax credit for homebuyers that will exacerbate the structural glut in housing supply. In the financial media, I’ve seen investor after investor defend these programs as valuable and necessary, which demonstrates their ignorance of sound economics.

We’re propping up zombie institutions, throwing good money after bad, and rewarding incompetence — all at the expense of prudent people’s savings and the capital that will be needed to fund the industries of the future. Top investors don’t tolerate low- or negative-return-on-capital decisions by the executives running their companies, so it’s puzzling to me why so many of these investors advocate the same type of economic malpractice on the part of government policymakers.

The latest sideshow for public consumption — a “paymaster” regulating pay at large banks — is another example of the government’s misdiagnosis of the problem.

Rather than regulate pay in the hopes that it discourages risky banking behavior, we should be phasing out the government guarantees of the banking system’s liabilities. That, I assure you, would discourage foolish risk-taking among bankers. Case in point: Goldman Sachs behaved in a much more responsible, sustainable manner when it was a privately owned partnership without government guarantees, rather than the high frequency trading, TLGP-hogging, heavily lobbying institution that it is today.

Like an addictive drug, today’s fiscal and monetary policies have made everyone feel better, but have further weakened the structural health and sustainability of the economy. If you doubt this, just look at the horror in most investors’ eyes when they are confronted with the prospect of a Fed Funds rate above, say, 2% — up from today’s range of zero percent. The addiction to E-Z credit and government support everywhere you look is one of the clearest reasons that this economic recovery is an elaborate illusion.

Yet we still see examples of extreme inefficiencies in the valuation of certain stocks. It feels eerily similar to the tech bubble, with investors behaving as if today is the last chance they’ll ever get to buy Amazon.com stock at less than 80 times earnings.

Whether it’s the sky-high multiple on Amazon’s maturing business, which seems to be discounting that every Chinese citizen will own a Kindle within 5 years, or the expectation that banks employing creative accounting have seen the worst of their credit losses, many investors are putting real money behind their belief in a super-bullish economic environment.

The reasons to be cautious and bearish are overwhelming. A market correction back to more normalized valuations may happen at any point.

Lastly, I attended the Value Investing Congress in New York last week, along with Addison Wiggin and Chris Mayer.

The most important takeaway for me was the audience’s apparent skepticism towards the two most bearish presenters: David Einhorn and Eric Sprott. Both hedge fund managers are bullish on gold and critical of Washington, D.C.’s wealth-diluting fiscal and monetary policies. The tone of the Q&A sessions after these presentations tells me that most investors are still very, very skeptical of investing in gold. That’s good news for gold bulls.

It’s also good news for stock market bears that so many believe in the Keynesian theories they read in their college economics textbooks. GDP growth driven by government spending is misleading, and damaging to capital formation. Much of today’s top line growth is coming at the expense of future profits — when mal-investments will be written off.

Regards,
Dan Amoss

October 28, 2009

Economic Misdiagnosis Due to Government Stimulus was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But underneath the elation over Dow 10,000 lies the palpable feeling that this rally is to be “rented,” not “owned.”

As cool weather descended upon the Northeast U.S., risk appetites started to wane. At the beginning of October traders and investors finally sobered up. Were they second-guessing whether government spending could actually kick-start a sustainable recovery? Both stocks and corporate bonds sold off sharply.

Then today I woke up to these headlines:

“Stocks Climb as New Week Starts for Wall Street.”

“Hasbro 3Q profit rises 8.8 pct on cost-cutting”

“PetMed Express 2Q earnings rise 12 percent”

Here’s why you shouldn’t believe the hype…

Cost Cutting Does Not Equal Top Line Growth

Over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are simply disconnected from reality.

Sell-Off at the First Sign of Trouble

The bulls are now enjoying their victory lap after having bid the Dow Jones industrial average above 10,000 last Wednesday. It’s puzzling to see “investors” happy about buying into a market that’s clearly overvalued. A rational, disciplined investor would be fearful about buying today, after prices have been jacked up by an unprecedented seven-month rally.

Bulls see any cautious sentiment-that “rented rally” feeling-as a source of more untapped buying power, but I see it as a reflection of weak hands being the marginal buyers; at the first sign of disappointment, they’ll look to sell. My read of the sentiment surveys is that patient value investors are skeptical and bearish, while momentum investors are bullish simply because prices have been going up.

Fund Managers Won’t Ride to the Rescue

Despite the popular sentiment that “fund managers gotta keep buying into year-end to avoid underperforming,” which would keep this market in the stratosphere, the odds heavily favor lower stock prices in the coming weeks and months.

Data from reliable sources like TrimTabs show that not only is the labor market far weaker than advertised, but net inflows into stock mutual funds have slowed to a trickle, occasionally turning into outflows. This tends to give mutual fund managers itchier trigger fingers, since cash balances in equity mutual funds are already near record lows.

Pensions aren’t going to ride to the rescue either, since they were, with 20/20 hindsight, overinvested in stocks in 2007.

Buying Momentum Could Run Out

Momentum players face the prospect of having nobody-aside from another momentum investor-willing to buy their expensive stocks at today’s prices. Patient, disciplined investors are only willing to buy at much lower prices. This could lead to an air pocket where the market could correct dramatically and quickly, without an obvious catalyst — not that there is a shortage of bearish catalysts, ranging from bank failures to home foreclosures to a crisis in fiat money.

Some pundits point to corporate mergers and acquisitions as reasons to be bullish, ignoring that fact that most deals occur closer to the peak of markets, and most deals destroy shareholder value, because the buyer overpays.

Corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is telling. In a word, the approach toward capital structure is “defensive.” Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.

Most investors, however, have permanently dialed down their risk appetites, and therefore will not chase this expensive market. Those buying stocks at today’s valuations—especially U.S.-centric finance and retail stocks—will have a very hard time finding someone to pay an even higher price in the future.

Will Government Solve the Problem? No.

The big questions back at the beginning of the month: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: As we see with “cash for clunkers,” government stimuli simply steal demand from the future.

Another big question is how will policymakers respond to a sluggish-to-nonexistent rebound in hiring?

The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs. [Count on this-Ed.]

But more importantly — because this is not yet a mainstream view — the real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.

The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not – that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it-debased by the Fed’s inflation, of course-back into your other pocket.

Where you stand on this will determine your expectations for the future performance of most stocks (ignoring special situations). I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.

I’d recommend you adjust your portfolio accordingly.

Regards,
Dan Amoss

October 19, 2009

This Stock Market Rally Is Rented, Not Owned was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Stock market bulls aren’t concerned about the inevitable acceleration in bank failures — at least for now. Even though deposits will be insured against loss, the loss of local banks will still have a depressing effect on hundreds of small communities. These communities are going to lose their only access to business credit when their local zombie banks — loaded with toxic construction or commercial real estate loans — are liquidated or merged into other weak banks.

Meanwhile, the latest monthly figures show that commercial bank balance sheets are shrinking at a fairly rapid rate, due to a combination of several factors: loan charge-offs, older loans are being paid back at a faster rate than new loans are being made, and regulators pressuring banks to build larger capital buffers.

So credit-fueled growth in consumption or investment is not occurring. Combine this with stagnant or declining wages and corporate profit margins and it becomes hard to imagine how GDP will rebound on a sustainable basis. GDP is the stat that every money manager fixates upon — despite the fact that GDP does not accurately measure true economic progress; it’s like evaluating a stock purely on sales growth, without thinking about what’s driving sales, and whether these sales are sustainable or accretive to wealth.

Nominal GDP is calculated as “consumption + investment + government spending + exports – imports.” Then, government statisticians subtract a highly doctored CPI figure from annualized changes in the above variables to get “real GDP growth.”

Note that all the variables in the GDP equation can be pumped up by excessive credit growth. As I mentioned in the Sept. 4 alert, if GDP is growing at the expense of degraded balance sheets, the end results are never happy. Japan’s GDP stayed higher than it otherwise would have been in the 1990s despite the incredibly wasteful spending on bridges to nowhere. Its policymakers reacted to a huge misallocation of capital into real estate in the 1980s by misallocating capital into government projects and subsidies to favored industries.

U.S. policymakers are following this playbook even faster, only without acknowledging one crucial difference: Japan had a high household savings rate to finance its government deficits, while the U.S. does not. Plus, the U.S. has already “dollarized” the rest of the world, and there are signs international demand for dollars has reached its saturation point.

The gold and commodities markets are reacting to this unpleasant reality. These markets are starting to discount the fact that the Fed will be the aggressive buyer of last resort for all types of debt securities. We’ve likely only seen the beginning of growth in the Federal Reserve’s balance sheet. As long as it can get away with it, the Fed will keep creating new money out of thin air to finance the U.S. federal deficit. Plus, via its liquidity facilities, the Fed and the megabanks will keep swapping Treasuries for legacy toxic securities marked at fantasy levels.

A few wild cards could disrupt this benign “reflationary” environment we’ve been in since the March stock market bottom, resulting in the stock market taking another nasty leg down:

1. If the “audit the Fed” bill were to pass and result in more handcuffs on the Fed, it would help to slow the reckless debasement of the U.S. dollar. But if it put an end to the Fed’s exotic lending facilities, which would force the owners of toxic securities to retain and mark them down sooner, then we could see a return to the January-early March 2009 stock market environment — only most of the damage would be contained to the financial sector as equity of insolvent institutions gets wiped out or diluted.
2. Contraction in the real economy and state governments could easily overwhelm expansion in the “federal government economy.”
3. International holders of trillions in paper U.S. assets could accelerate the rate at which they diversify into real assets. That’s how we could see a spike in “money velocity” that the deflationist camp says is a necessary condition for the CPI to rise. Most of the price pressure will be felt in oil prices, especially later in 2010 and 2011, when today’s underinvestment in new oil projects leads to tight international supplies.

I’d like to bring to your attention one more thing about today’s investing climate, because it’s being used so often lately in the media to justify today’s nosebleed stock valuations: the “money on the sidelines” fallacy. Growth or contraction in the current balance of $3.5 trillion in money market funds depends on how much companies look to borrow in the commercial paper market — not on the level of the stock market, as so many seem to believe.

Those who point to the $3.5 trillion in money market funds as if it’s a bucket that can be “poured” into the stock market bucket to keep the rally going do not understand that money does not go “into” or “out of” the market, but through the market. Trader A sells every share bought by Trader B. Once this transaction settles, cash goes one way and shares the other. The price at which the transaction takes place depends on how badly Trader B wants to own shares, not how many money market shares are in his account.

Also, money market fund balances represent very liquid short-term loans; they reflect an amount of money that’s already been spent in the economy and will be paid back over a very short time frame. John Hussman — one of the best mutual fund managers, in my view — refutes the “cash on the sidelines” fallacy best. It’s worth reading and remembering the next time you hear a talking head arguing that the rally can keep going because of liquidity.

Washington Federal Closes Offering; Now We Wait for Earnings

Yesterday, Washington Federal (WFSL) announced that its secondary stock offering would generate net proceeds of $333 million. This works out to a per share price of $13.79, including underwriting discounts and expenses and assuming full exercise of the underwriter’s overallotment. Here is an example of cash going “into” stocks, because these are newly issued, rather than existing, shares in the secondary market.

As I noted in Monday’s flash alert, I expect the offering will be necessary to absorb a mounting wave of net charge-offs in the future. It’s possible that this offering plan became a necessity after a friendly suggestion from regulators to raise more capital.

On Wednesday, WFSL stock rallied on high volume, but did not reflect organic demand for the stock. JP Morgan was the sole book-running manager for the Washington Federal offering. Knowing that it would likely receive a few million WFSL shares as a form of compensation in the underwriters’ overallotment, JPM’s trading desk probably established a short position that it plans to cover by delivering the shares it will receive upon the closing of the deal. This likely explains the bizarre trading moves in the stock this week: When institutions were more interested than expected, resulting in a higher offering price of $14.50, JPM likely covered some of their short position.

As for the analyst reaction to the offering, the two analyst notes I saw might as well be corporate press releases, because they expect this new capital to be deployed into an FDIC-assisted rollup of lots of zombie banks in the Pacific Northwest. Also, these analysts cite WFSL’s “strong” capital ratios without adjusting for future credit losses. One might suspect that these analysts have not even read the asset quality footnotes in Washington Federal’s SEC filings.

The big losses WFSL will take on construction loans are obvious, no matter how long management claims it will be able to sit on them. But what’s not obvious to the market — yet — is the rapid future loss formation in its $6.7 billion mortgage book. Management has set aside practically zero allowance for loan losses against its mortgage book. See the chart below for the allocation of WFSL’s allowance by loan type.

WFSL carries a mere $18.8 million loss allowance against its $6.7 billion book of mortgages — a ratio of just 0.28% of assets. The harsh reality of the mortgage crisis tells us that this $6.7 billion asset value is overstated, along with capital ratios (or equity); it should be marked down by far more than $18.8 million. Yet WFSL’s accounting translates as follows: Management does not expect more than $18.8 million in cumulative credit losses in mortgages (defaults, net of recoveries after foreclosure) through the rest of this credit cycle, despite the fact that the majority of these mortgages are now underwater and the job market remains weak.

As you can see in the chart, the ratio of loss allowance to nonperforming loans (by category) has shrunk dramatically. In December 2007, WFSL’s residential mortgage loss allowance was $13 million, and its nonperforming mortgages were also $13 million. As of June 30, this loss allowance had been built up to $18.8 million, but nonperforming mortgages had grown to $119 million (and will keep growing). This loss coverage ratio has shrunk from 100% to 16% over the past six quarters (as shown in the chart’s blue line) and needs to be built back up to a respectable level. And the only way for WFSL to build it up is to book large credit provision expenses in future income statements.

Washington Federal’s “strong” capital ratios are a function of hopeful accounting. I expect the market to come around to this view — not only for WFSL, but also for the entire banking sector. Ever since the loosening of mark-to-market accounting rules last April, the creators and users of financial statements have collectively chosen to deny reality and bury their head in the sand about the future direction of market values for collateral backing loans — and the value of the loans themselves.

Everyone is waiting and hoping for a miraculous rebound in housing prices and the labor market, when we have yet to see the bottom in either. When reality sets in, this will not end well for owners of bank stocks, REITs, and other financial stocks. These stocks are claims on assets that are marked to fantasy levels.

Mark-to-market suspension has slowed the rate at which losses are recognized, but this self-delusional accounting practice cannot make the losses disappear, and will likely make these cumulative, stretched-out losses even bigger in the future by rationing credit to the healthier parts of the economy.

Regards,
Dan Amoss

September 23, 2009

GDP’s Debt to Credit was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Drivers in the U.S. no longer determine the global price of oil. So oil prices can remain high despite a weak labor market — as we saw in the 1970s. If this winds up being the case, it’s bad news for owners of financial and consumer stocks and good news for owners of energy stocks.

Andy Xie, formerly of Morgan Stanley, is a great strategist who, while most other economists sought to justify the housing bubble, warned of the unsustainable U.S./China vendor finance trade model that grew so rapidly between 2001-2008. He recently wrote an article for Caijing magazine on the factors that might drive oil prices in the future. He writes:

Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.

Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange-traded funds individually or in baskets of commodities.

Oil is uniquely suited as an inflation-hedging device. Its supply response is very low. More than 80% of global oil reserves are held by sovereign governments that don’t respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.

Xie’s entire article is worth a read. You can find it at this link.

The Chinese government is sending strong signals to its banking system that it wants lending to slow down from its blistering pace. It remains to be seen whether this will actually result in a contraction in Chinese bank lending or whether lending may just shift from one sector to another. If I had to guess, I think oil prices will have a sharp correction this fall as Chinese stockpiling slows down and as oil and refined product inventories remain more than adequate to meet sluggish U.S. demand.

But this correction will offer trading and investing opportunities on the long side. As you see in the two charts below, the linkage between oil prices and U.S. inventories during the entire post-2002 bull market was not as close as you’d expect:

Here’s why I think a correction in oil prices will offer a buying opportunity: Inflation fears and stabilizing in global demand are not the only reasons the price of oil has doubled from its lows. Oil prices are up because the marginal cost of new supply — including from Canadian tar sands and from under thousands of feet below the ocean surface — is so high.

To Andy Xie’s important point about oil as an inflation hedge, I’d add that OPEC planners understand that they are trading a scarce, extremely energy-dense, nonrenewable, depleting asset for paper money. They also are beginning to grasp that indebted oil importers plan to ease their debt burdens by employing the heavy guns in the inflation arsenal: “quantitative easing.” So their portfolio preferences will shift away from government paper and toward retaining scarce oil in the ground for future revenues. In other words, “Why should we trade oil for dollars now if we receive higher prices five years down the road?”

This is just one of the many intricacies governing how the global oil market operates, and it helps explain why those who are perpetually bearish on oil prices waited for years and years for a rational, free-market supply response to higher prices that never arrived in force. That is, until last fall’s panic brought demand far enough below supply that prices crashed. Now, the conventional wisdom says that several million barrels per day of spare OPEC capacity will keep a lid on prices for years. We may discover by next year just how quickly this alleged spare capacity will come back online, and at what price.

The question then becomes why should national oil companies rush into the risks of making the enormous capital investments necessary to maintain production — let alone grow production. Nancy Pelosi and Ben Bernanke are not promoting policies to make energy cheaper; in fact, their playbooks virtually ensure the opposite. Privately owned exploration and production (E&P) companies that take smart risks will be the ones that deliver more supply at lower prices to help ease supply constraints.

Now, when you consider how the U.S. economy currently functions, you come to understand that rising energy prices induce enormous headaches for practically every consumer and business. Call rising energy prices a “deflationary force in the real economy” if you like. The point here is the irony of the situation: The Fed and Treasury are trying to reinflate a deleveraging private economy, and much policy could wind up accelerating the deleveraging process by adding pressure to the prices of nondiscretionary items like food and energy. After all, these are both global commodities, and capacity in these sectors is tighter than most market participants realize.

Bottom line: There is no easy, painless way out of a credit-financed asset bubble that artificially pumped up consumption. This artificial growth in consumption prompted entrepreneurs to misallocate resources into unproductive sectors that were temporarily pumped up by what looked like sustainable demand. Meanwhile, there are many sectors, including oil and gas, that have been underinvesting relative to the long-term global demand for mobile, modern lifestyles.

Sure, oil prices could correct sharply this fall as traders panic about a temporary glut in aboveground supply at storage terminals. But to use manufacturing terms, it’s the “raw material” and “work in process” inventory that really matters. That type of inventory, sitting higher up in the supply chain, is much tighter than the “finished goods” inventory sitting in storage terminals like Cushing, Okla. I expect we’ll see this tightness reflected in prices by 2010, even if demand remains stagnant.

Production capacity in oil and gas looks plentiful right now, but capacity naturally falls every year, and requires hundreds of billions in global capital expenditures just to keep supply steady. According to an exhaustive analysis published by Neil McMahon of Bernstein Research on Aug. 10, non-OPEC oil supply will keep declining in the coming years, despite healthy levels of investment. Outside of OPEC (where information regarding capacity and investment plans is murky at best) explorers are targeting smaller formations, as production from giant, decades-old fields declines. McMahon writes:

In the long term, we believe that oil prices will increase in line with the marginal cost of supply, which continues to rise as the complexity of new wells increases and production rates from established fields decline. Basically, not enough significant discoveries have been made in non-OPEC countries in recent years to help the supply situation before 2015. Additionally, flow rates from the few discoveries that have been made do not give rise to much optimism and, as in the past, the drop in absolute oil demand will be offset by rapidly declining mature field production with the recent fall in industry spending. So the continued decline in non-OPEC supply will provide an additional support for prices, as it feeds through to OPEC spare capacity. We believe that 2010 will see the next inflexion point in prices, as OPEC spare capacity begins to decline and demand shows positive growth for the first time in a number of years and we expect to see oil average $80 in 2010, $103 in 2011, $111 in 2012, and increasing to $140 in 2015.

You can imagine what this type of price trajectory will do to U.S. businesses that rely on cheap fuel, and have no ability to push through price increases. Considering how many more trillions of U.S. dollars will be floating around the global economy in 2015, and savers’ willingness hoard them declines, $140 per barrel might be conservative.

Global oil production capacity, rather than demand, will eventually drive prices. Bernstein projects 2020 oil production capacity will be about the same as it is now: 85 million barrels per day. We must consider net exports too; the global trade flows of this oil will certainly change. Over time, more tanker shipments will be diverted away from the U.S. and Europe and head to Asia. Also, in recent years, OPEC countries have been consuming more of their own product at home. Plus, the Chinese government has shown that it will beat any and all comers in the competition to secure supply under long-term contracts.

Regards,
Dan Amoss

August 28, 2009

Inflation and Oil Prices: Our Next Move was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.