Where the science of investing becomes an art of living
- Name: David M Gordon
- Location: Summerlin, Nevada, United States
A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!
26 February 2009
Money as Debt
23 February 2009
Apple to end AT&T's exclusivity agreement?
This rumour, if true, would make the iPhone a more compelling purchase, as Verizon/VZ (and Vodafone's Verizon Wireless) offers, arguably, the best 3G network, and, again arguably, the best cell network, period. Which all could, should, and would result in a goosing of sales of the iPhone.
-- David M Gordon / The Deipnosophist
Labels: Company analyses
22 February 2009
When numbers deceive
"The first example cited by the author failed to illustrate his point. There was only a 37.5% survival rate of those who were on the raft, and we can infer that more than a third of those staying on the boat got off. The difference isn't worth talking about..."Although the article, about which Richard remarks, discusses a state of mind in processing a crisis situation rather than statistics, Richard nonetheless makes an excellent point. A point worth investigating further...
Read on to learn more.
-- David M Gordon / The Deipnosophist
When numbers deceive
Our understanding of the world around us is profoundly influenced by statistics. Unfortunately, say authors Michael Blastland and Andrew Dilnot, we often have no idea what they really mean.
Counting is easy when you don't have to count anything with it: 1, 2, 3 … it could go on forever, precise, regular, and blissfully abstract. This is how children learn to count in kindergarten.
But for grown-ups hopeful of putting counting to practical use, it has to lose that innocence. The difference is between counting, which is easy, and counting something, which is anything but.
How many centenarians are there in the United States? Someone must know, don't they? They just go out and count 'em.
"How old are you?"
"One hundred and one, if I'm a day."
"Thank you." And they tick the box.
We often talk of social statistics, especially those that seem as straightforward as age, as if a bureaucrat were poised with a clipboard, peering through every window, counting; or, better still, had some machine to do it for them. The unsurprising truth is that, for many of the statistics we take for granted, there is no such bureaucrat, no machine, no easy count. What is out there, more often than not, is thick strawberry jam, through which someone with a bad back on a tight schedule has to wade—and then try to tell us how many strawberries are in it.
When the U.S. Census Bureau distributed forms asking people how old they were, the answer that came back in 1970 was that there were about 106,000 centenarians in the United States.
Job done? The bureau believes there probably were, in truth, not 106,000 but a little fewer than 5,000. That is, the count was roughly 22 times the estimated reality. And though the 1970 Census produced a particularly inaccurate tally, persistent overcounting of centenarians remains a problem.
What happened? The Census Bureau describes the count of people at older ages as "hounded" by problems, including: "Lack of birth records … low literacy levels … functional and/or cognitive disability … individuals who deliberately misreport their age for a variety of reasons, as well as those who mistakenly report an incorrect age in surveys."
The raw data shows, in short, a mess. And this is at the relatively simple end of counting, where definitions are clear and everyone knows what they are looking for. If the simple, well-defined facts are not always easy to come by, what happens when the task becomes just a little more complicated?
When mammograms cry wolf
Percentages confuse even the experts. The accuracy of a typical medical test, for instance, is usually expressed as a percentage: "The test is 90 percent reliable." But it has been found that doctors, no less than patients, are often hopelessly confused when it comes to interpreting what this means in human terms.
Gerd Gigerenzer, a German psychologist, asked two-dozen physicians to tell him the chance of a patient truly having breast cancer when a mammogram that was 90 percent accurate at spotting those who had it, and 93 percent accurate at spotting those who did not, came back positive.
Of the 24 doctors, just two worked out correctly the chance of the patient really having the condition. Most were hopelessly wrong.
Gigerenzer had added one other important piece of information: that the condition affected about 0.8 percent of the population for the group of 40- to 50-year-old women being tested. Quite a few of the physicians assumed that, since the test was 90 percent accurate, a positive result meant a 90 percent chance of having the condition. In fact, more than nine out of 10 positive tests under these assumptions are false positives, and those nine patients are in the clear.
To see why, look at the question again, this time expressed in terms that make more human sense: natural frequencies.
Imagine 1,000 women. Typically, eight have cancer, for whom the test, a fairly but not perfectly accurate test, comes back positive in seven cases. The remaining 992 do not have cancer, but remember that the test can be inaccurate for them, too. Nearly 70 percent of them will also have a positive result. These are the false positives, people with positive results that are wrong.
Now we can see that there will be about 77 positive results in total (the true positives and the false positives combined), but that only about seven of them will be accurate. This means that for any one woman with a positive test, the chance that it is accurate is low (one in about 11) and not, as most physicians thought, high.
Taming those gazillions
Numbers, when they're large enough, simply blow our mental fuses. People often find anything with an "-illion" on the end incomprehensible. They make a useless mental shortcut: "lots of zeros = big."
But any time a reporter or a politician tells of millions or billions spent, cut, lost, added, saved, it is worth asking, in all innocence: "Is that a big number?"
Millions, billions … if they all sound like the same thing, one useful trick is to imagine those numbers as seconds. A million seconds is about 11.5 days. A billion seconds is nearly 32 years.
What you usually need, though, is a way to think about a number on a human scale. Often, if you divide a big number by all the people it is supposed to affect, it becomes strangely humble and manageable.
A convenient number to help in this sort of calculation is 15.6 billion (15,600,000,000), which is the U.S. population (300 million) multiplied by 52, the number of weeks in a year. This is about how much the U.S. government needs to spend annually on any program for the program to cost $1 per American citizen per week. Divide any public spending announcement by 15.6 billion to gauge its real size.
In defense of bacon
Numbers have an amazing power to put life's anxieties into proportion: We actually have the ability to measure uncertainty. Yet this power is squandered through an often-needless misalignment of the way people habitually think, and the way risks and uncertainties are typically reported. The news says, "Risk up 42 percent." All you want to know is, "Does that mean me?"
"Don't eat bacon," for instance. That bit of advice comes from the American Institute for Cancer Research. Not "cut down," or "limit your intake." The AICR says "avoid" processed meat.
The AICR also says, "Research on processed meat shows cancer risk starts to increase with any portion." And the institute is right; this is what the research shows. A massive joint report in 2007 by the AICR and the World Cancer Research Fund found that an extra ounce of bacon a day increased the risk of colorectal cancer by 21 percent. A single sausage is just as dangerous.
You will sense there is a "but" coming. The but is that nothing we have said so far gives you the single most essential piece of information: namely, what the risk actually is.
First, let's look at the way the AICR report does it. On Page 23, the authors acknowledge that the incidence of colorectal cancer in the United States is about 45 per 100,000 for men and about 40 per 100,000 for women. A hundred pages later, readers find the 21 percent increase owing to bacon. None of this is conveniently presented, and media coverage was by and large even worse, usually ignoring the baseline risk altogether.
Fortunately, there is another way to present the report's featured finding. Here it is:
"About five men in a hundred typically get colorectal cancer in a lifetime. If each of the 100 ate an extra couple slices of bacon every day, about six would."
The geography of cancer
Chance is a concept we tend to believe we do understand. But chance has a genius for disguise. Frequently it appears in numbers that seem to form a pattern. People feel an overwhelming temptation to deduce that there is more to the events they witness than chance alone. Sometimes we are right. Often, though, we are suckered, and the apparent order merely resembles one.
To see why, take a bag of rice and chuck the contents straight into the air.
Observe the way the rice is scattered on the carpet at your feet. What you have done is create a chance distribution of rice grains. There will be thin patches here, thicker ones there, and every so often a much larger and distinct pile of rice. It has clustered.
Now imagine each grain of rice as a cancer case falling across a map of the United States. Wherever cases of cancer bunch, people demand an explanation. The rice patterns, however, don't need an explanation. The rice shows that clustering, as the result of chance alone, is to be expected. The truly weird result would be if the rice had spread itself in a smooth, regular layer. Similarly, the genuinely odd pattern of illness would be an even spread of cases across the population.
This analogy draws no moral equivalence between cancer and rice patterns. Sometimes, certainly, a cancer cluster will point to a shared local cause. Often, though, the explanation lies in the complicated and myriad causes of disease, mingled with the complicated and myriad influences on where we choose to live, combined with accidents of timing, all in a collision of endless possibilities that, just like the endless collisions of those flying rice grains, come together to produce a cluster.
Why numbers matter
Asked about basic facts and figures of American life, individuals are often terribly wrong.
Michael Ranney likes asking questions. Being a professor of education at UCLA, he has plenty of young people around who can act as guinea pigs. For example: For every 1,000 U.S. residents, how many legal immigrants are there each year? How many people, per thousand residents, are incarcerated? For every thousand people, how many computers are there? How many abortions?
Few of us spend our leisure hours looking up and memorizing data. But many of us flatter ourselves that we know about these issues. And yet …
On abortion and immigration, says Ranney, about 80 percent of those questioned base their opinions on inaccurate information. For example, students at one college typically estimated annual legal immigration at about 10 percent of the U.S. population (implying 30 million legal immigrants every year). Nonstudents guessed even higher. The actual rate in 2006 was about 0.3 percent. That is, even the lower estimates were more than 30 times too high.
The students' estimates for the number of abortions varied widely, but the middle of the range was about 5,000 for every million live births. The actual figure in the United States in 2006 was 335,000 per million live births—67 times higher than the typical estimate.
If anyone conversing with you made the numerically equivalent mistake of telling you they were at least 370 feet tall, it's unlikely you'd take seriously their views on any subject.
The good news: Many respondents found the correct answers so surprising that they adjusted their political views on the spot.
From The Numbers Game by Michael Blastland and Andrew Dilnot. ©2009 by Michael Blastland and Andrew Dilnot.
Published by arrangement with Gotham Books, a member of Penguin Group (USA), Inc.
21 February 2009
They lived to tell the tale
In any emergency, people essentially divide into three categories. John Leach, one of the world's leading experts in survival psychology, has developed what might be called the Theory of 10-80-10 to explain the phenomenon. First, around 10 percent of us will handle a crisis in a relatively calm and rational state of mind. Another 10 percent—the ones you definitely want to avoid in an emergency—lose control of themselves. They freak out and can't pull themselves together. The vast majority of us, though, fall into the broad middle band. Around 80 percent of us, Leach says, will "quite simply be stunned and bewildered." We'll find that our "reasoning is significantly impaired and that thinking is difficult." In short, most of us will turn into statues in the first moments of a crisis. That's okay—the response is not necessarily fatal and it doesn't last forever. The key is...Perhaps that is not a sudden case of tinnitus you hear, but a shared resonance.
-- David M Gordon / The Deipnosophist
They lived to tell the tale
Escaping from a plane crash or shipwreck, says author Ben Sherwood, requires skill as well as luck. What can we learn about survival from those who made it out alive?
On Sept. 28, 1994, Paul Barney was making an overnight trip from Estonia to Sweden by car ferry. To save around $40, the 35-year-old British landscape architect had decided against taking a cabin below deck and instead planned to camp out in one of the open spaces of the sprawling 15,000-ton ship. Around 11 p.m., as the ship, christened the Estonia, pushed into a storm, he settled down with his sleeping bag in a perfect spot inside the cafe on Deck 5, at the vessel's stern. He awoke around 1 a.m. to a sudden bang.
The ship was listing dramatically to its right. Tables and chairs began to slide. At first, Barney wondered if the vessel had run aground. Then he realized that the ferry wasn't swaying and that the tilt of the deck was steadily increasing. "So I thought, We've got to do something about that," he says.
Barney was always pretty good at what he calls "orienting" himself. He decided the best place to get more solid footing and figure out an escape plan was the doorway between the cafe and the promenade deck. As the ship tipped even more, he maneuvered around the door frame to stay standing. From this precarious perch, he attempted to redraw a mental map of the ship, but his brain struggled to keep up with so much confusing information. With dishes and glasses crashing everywhere, he knew one thing for sure: The boat wasn't suddenly going to right itself. There wasn't any lifesaving equipment around, and the captain and crew weren't providing any emergency instructions. "I realized that this was quite a desperate situation," Barney says, "and I was quite likely to die."
Barney expected to see passengers scrambling for their lives. He imagined scenes of bedlam, with people clawing for life preservers and fighting for the lifeboats. Instead, he encountered something truly strange: Many fellow passengers seemed unable to do anything at all. "People were just not moving," he says. "They were frozen to the spot, almost waiting to be told what to do." As the lights flicked on and off, they looked like marble statues, pale and immovable.
"Why don't they do something?" he asked an Estonian man who was sharing the door frame with him as the ship listed ever more steeply.
"Just don't think about it," the man replied.
That man didn't make it to a lifeboat, but Barney did. After pulling some warm clothes from his backpack and taking off his boots—(he didn't want to end up wearing them in the water), he clambered upward on a latticework of ceiling pipes and vents and found himself standing alone atop the massive hull of the side-turned Estonia. A half-moon cast some light on his surreal surroundings. Despite gale-force winds and waves crashing from every direction, he was able to creep 500 feet across the porthole-pocked surface of the ship to join a group of passengers who were launching an inflatable life raft.
Of the 16 who boarded the raft, 10 died of hypothermia that night. Of the 989 people who had been aboard the Estonia, nearly two-thirds didn't even make it off the ship.
Why do some people survive a life-threatening situation and others die unnecessarily?
In any emergency, people essentially divide into three categories. John Leach, one of the world's leading experts in survival psychology, has developed what might be called the Theory of 10-80-10 to explain the phenomenon. First, around 10 percent of us will handle a crisis in a relatively calm and rational state of mind. Another 10 percent—the ones you definitely want to avoid in an emergency—lose control of themselves. They freak out and can't pull themselves together. The vast majority of us, though, fall into the broad middle band. Around 80 percent of us, Leach says, will "quite simply be stunned and bewildered." We'll find that our "reasoning is significantly impaired and that thinking is difficult." In short, most of us will turn into statues in the first moments of a crisis.
That's okay—the response is not necessarily fatal and it doesn't last forever. The key is to recover quickly from this brainlock, shake off the shock and figure out what to do. And I do mean quickly. If you're ever trapped in a burning plane, for instance, you typically have only 90 seconds before the cabin temperature will soar to 2,000 degrees and a flashover fire will consume everything.
David Koch remembers the familiar screech of the airliner's wheels touching down in Los Angeles and, a few seconds later, "a sudden sickening crunch." A spray of sparks and a ball of fire lit up the window beside his seat on the 737 that he and 82 other passengers had boarded back in Columbus, Ohio. He was sure they had struck another plane.
The cabin echoed with screams as a flight attendant shouted: "Stay down! Stay down!" Koch quickly unbuckled his seat belt and got ready to run for the exit, but the plane kept skidding. Around 20 seconds later—what seemed like forever—it finally slammed to a stop, and another explosion shook the plane. Koch was thrown forward into a first-row seat and then against the bulkhead.
Fear swept the plane as the cabin lights went out. Koch, who had been riding in first class, watched passengers run down the aisles toward the rear of the plane. Thick, choking smoke filled the cabin. The intercom shut off. The flight attendants offered no more evacuation instructions. The passengers were on their own.
Koch immediately got on his hands and knees and started crawling toward the back of the plane, searching for an exit. But after moving a few rows, he encountered "a fighting, frenzied mob jamming the aisle." The congestion, he says, "suddenly made me realize that escape was probably impossible because I was last in line to get out of the rear exit. I concluded that I was probably going to die. At that point, I stood up and, choking heavily on the smoke, walked back toward the first-class section.
In the midst of the chaos, Koch's thoughts were clear and calm. "For a few long moments, I stood there, immobilized, not knowing what else to do," he says. Then Koch experienced an amazing sensation. He says he felt his mind separate from his body and rise up toward a white light. He remembers looking back at his body dying on the airplane while his mind successfully escaped. Suddenly, his mind snapped back to his body and he realized that there had to be a way out. If smoke was pouring into the front of the plane, there had to be an opening in the fuselage.
He stumbled forward. Every breath of black smoke was tremendously painful, and he was feeling faint. Then he saw a crack in the fuselage. He pried his fingers into it and, realizing it was the galley door, pulled hard. He shoved his head outside and gulped down a few breaths of air. "A tremendous sense of strength came over me," he says.
Below him he could see fire burning under the plane. Oh, what the hell, he thought, jumping past the flames onto the asphalt 10 feet below. He landed hard, and crawled away from the plane. When he looked back, "the sight was a nightmare." He watched passengers struggling and squeezing to get through the exits.
The date was Feb. 1, 1991. Koch's plane, USAir 1493, had indeed collided with a second aircraft, a twin-propeller commuter plane that an air traffic controller had mistakenly directed to the runway that the larger plane was coming in on. Everyone on the smaller plane was killed. Twenty-two people on the USAir jet were killed, including 18 who couldn't get off the plane.
Safety investigators found a number of disturbing facts about the evacuation. A woman seated in 10F, the emergency row, admitted that she froze and was unable to leave her seat or open the window exit next to her. A male passenger climbed over the seat, opened the hatch, and pushed the woman out onto the wing. A few moments later, two male passengers "had an altercation" about who would evacuate first. The fight lasted several seconds. Those two events "significantly hampered the evacuation," investigators concluded.
When the fires on the plane were put out, the charred bodies of the first-class flight attendant and 10 passengers were discovered lined up in the aisle less than eight feet from the exit in Row 10. This was the pileup that David Koch had encountered. If he had not turned around, he surely would have been the 12th person to perish in that aisle.
What lessons can be drawn from the experiences of Paul Barney, David Koch, and other survivors like them? Christian Hart, a psychology professor and veteran skydiver who has analyzed skydiving accidents, may have an answer.
Hart has interviewed numerous skydivers who failed, for one reason or another, to pull their chutes and yet were saved just seconds before impact by automatic activation devices. He has also reviewed many reports that skydivers have filed about these harrowing incidents.
His conclusion is that two kinds of personalities emerge under extreme pressure. The first keeps trying to solve problems no matter what happens. They refuse to quit and sometimes die trying to save themselves. The second type gives up quickly. They resign themselves and surrender.
Hart believes that parachuting offers three survival lessons for the rest of us who don't jump out of airplanes. First, in the event of an emergency, try to relax. Some skydiving instructors have a special signal when they're free-falling with anxious students: They pat the top of their heads. It's a sign to stay clam. The simple act of remembering to loosen up can break you out of brainlock. Second, remember where you are. It may seem obvious, but "situational awareness" can mean the difference between life and death, whether you're hurtling toward earth at terminal velocity or driving 75 miles an hour on the interstate. Third, never give up. Many parachuting deaths could have been prevented, Hart says, if skydivers had kept working on their problems. Human and mechanical errors are fixable, but you never find out if you give up.
From the book The Survivors Club by Ben Sherwood ©2008 by Ben Sherwood.
Reprinted with permission of Grand Central Publishing, New York, N.Y. All rights reserved.
US Airways 1549 touches down
The markets should have such a soft landing!
-- David M Gordon / The Deipnosophist
20 February 2009
A geography quiz
19 February 2009
Back in November 2007, in a post entitled "As the World Burns," Tom wondered why the mainstream media wasn't connecting the dots on the subject of global drought. In modest frustration, he returns to that subject -- more pressing than ever -- today.
I do not always agree with Tom, but in this instance I do. Because of this essay's importance, I requested Tom's permission to share it with you. Please share your thoughts in reply.
-- David M Gordon / The Deipnosophist
What Does Economic "Recovery" Mean on an Extreme Weather Planet?
By Tom Engelhardt
It turns out that you don't want to be a former city dweller in rural parts of southernmost Australia, a stalk of wheat in China or Iraq, a soybean in Argentina, an almond or grape in northern California, a cow in Texas, or almost anything in parts of east Africa right now. Let me explain.
As anyone who has turned on the prime-time TV news these last weeks knows, southeastern Australia has been burning up. It's already dry climate has been growing ever hotter. "The great drying," Australian environmental scientist Tim Flannery calls it. At its epicenter, Melbourne recorded its hottest day ever this month at a sweltering 115.5 degrees, while temperatures soared even higher in the surrounding countryside. After more than a decade of drought, followed by the lowest rainfall on record, the eucalyptus forests are now burning. To be exact, they are now pouring vast quantities of stored carbon dioxide, the greenhouse gas considered largely responsible for global warming, into the atmosphere.
In fact, everything's been burning there. Huge sheets of flame, possibly aided and abetted by arsonists, tore through whole towns. More than 180 people are dead and thousands homeless. Flannery, who has written eloquently about global warming, drove through the fire belt, and reported:
"It was as if a great cremation had taken place… I was born in Victoria, and over five decades I've watched as the state has changed. The long, wet and cold winters that seemed insufferable to me as a boy vanished decades ago, and for the past 12 years a new, drier climate has established itself… I had not appreciated the difference a degree or two of extra heat and a dry soil can make to the ferocity of a fire. This fire was different from anything seen before."Australia, by the way, is a wheat-growing breadbasket for the world and its wheat crops have been hurt in recent years by continued drought.
Meanwhile, central China is experiencing the worst drought in half a century. Temperatures have been unseasonably high and rainfall, in some areas, 80% below normal; more than half the country's provinces have been affected by drought, leaving millions of Chinese and their livestock without adequate access to water. In the region which raises 95% of the country's winter wheat, crop production has already been impaired and is in further danger without imminent rain. All of this represents a potential financial catastrophe for Chinese farmers at a moment when about 20 million migrant workers are estimated to have lost their jobs in the global economic meltdown. Many of those workers, who left the countryside for China's booming cities (and remitted parts of their paychecks to rural areas), may now be headed home jobless to potential disaster. A Wall Street Journal report concludes, "Some scientists warn China could face more frequent droughts as a result of global warming and changes in farming patterns."
Globe-jumping to the Middle East, Iraq, which makes the news these days mainly for spectacular suicide bombings or the politics of American withdrawal, turns out to be another country in severe drought. Americans may think of Iraq as largely desert, but (as we were all taught in high school) the lands between the Tigris and Euphrates Rivers, the "fertile crescent," are considered the homeland of agriculture, not to speak of human civilization.
Well, not so fertile these days, it seems. The worst drought in at least a decade and possibly a farming lifetime is expected to reduce wheat production by at least half; while the country's vast marshlands, once believed to be the location of the Garden of Eden, have been turned into endless expanses of baked mud. That region, purposely drained by dictator Saddam Hussein to tame rebellious "Marsh Arabs," is now experiencing the draining power of nature.
Nor is Iraq's drought a localized event. Serious drought conditions extend across the Middle East, threatening to exacerbate local conflicts from Cyprus and Lebanon to Gaza, the West Bank, and Israel where this January was reported to have been the hottest and driest in 60 years. "With less than 2 months of winter left," Daniel Pedersen has written at the environmental website Green Prophet, "the region has received only 6%-50% of the annual average rainfall, with the desert areas getting 30% or less."
Leaping continents, in Latin America, Argentina is experiencing "the most intense, prolonged and expensive drought in the past 50 years," according to Hugo Luis Biolcati, the president of the Argentine Rural Society. One of the world's largest grain exporters, it has already lost five billion dollars to the drought. Its soybeans -- the country is the third largest producer of them -- are wilting in the fields; its corn -- Argentina is the world's second largest producer -- and wheat crops are in trouble; and its famed grass-fed herds of cattle are dying -- 1.5 million head of them since October with no end in sight.
Dust Bowl Economics
In our own backyard, much of the state of Texas -- 97.4% to be exact -- is now gripped by drought, and parts of it by the worst drought in almost a century. According to the New York Times, "Winter wheat crops have failed. Ponds have dried up. Ranchers are spending heavily on hay and feed pellets to get their cattle through the winter. Some wonder if they will have to slaughter their herds come summer. Farmers say the soil is too dry for seeds to germinate and are considering not planting." Since 2004, in fact, the state has yoyo-ed between the extremities of flood and drought.
Meanwhile, scientists predict that, as global warming strengthens, the American southwest, parts of which have struggled with varying levels of drought conditions for years, could fall into "a possibly permanent state of drought." We're talking potential future "dust bowl" here. A December 2008 U.S. Geological Survey report warns: "In the Southwest, for example, the models project a permanent drying by the mid-21st century that reaches the level of aridity seen in historical droughts, and a quarter of the projections may reach this level of aridity much earlier."
And talking about drought gripping breadbasket regions, don't forget northern California which "produces 50 percent of the nation's fruits, nuts and vegetables, and a majority of [U.S.] salad, strawberries and premium wine grapes." Its agriculturally vital Central Valley, in particular, is in the third year of an already monumental drought in which the state has been forced to cut water deliveries to farms by up to 85%.
Observers are predicting that it may prove to be the worst drought in the history of a region "already reeling from housing foreclosures, the credit crisis, and a plunge in construction and manufacturing jobs." January, normally California's wettest month, has been wretchedly dry and the snowpack in the northern Sierra Mountains, crucial to the state's water supplies and its agricultural health, is at less than half normal levels.
Northern California, in fact, offers a glimpse of the havoc that the extreme weather conditions scientists associate with climate change could cause, especially when combined with other crises. In a Los Angeles Times interview, new Secretary of Energy Steven Chu offered an eye-popping warning (of a sort top government officials simply don't give) about what a global-warming future might hold in store for California, his home state. Interviewer Jim Tankersley summed up Chu's thoughts this way:
"California's farms and vineyards could vanish by the end of the century, and its major cities could be in jeopardy, if Americans do not act to slow the advance of global warming... In a worst case... up to 90% of the Sierra snowpack could disappear, all but eliminating a natural storage system for water vital to agriculture. 'I don't think the American public has gripped in its gut what could happen,' [Chu] said. 'We're looking at a scenario where there's no more agriculture in California.' And, he added, 'I don't actually see how they can keep their cities going' either."As for East Africa and the Horn of Africa, under the pressure of rising temperatures, drought has become a tenacious long-term visitor. For East Africa, the drought years of 2005-2006 were particularly horrific and now Kenya, with the region's biggest economy, a country recently wracked by political disorder and ethnic violence, is experiencing crop failures. An estimated 10 million Kenyans may face hunger, even starvation, this year in the wake of a poor harvest, lack of rainfall, and rising food prices; if you include the drought-plagued Horn of Africa, 20 million people may be endangered, according to the International Federation of Red Cross and Red Crescent Societies.
Recently, climatologist David Battisti and Rosamond Naylor, director of Stanford University's Program on Food Security and the Environment, published a study in Science magazine on the effect of extreme heat on crops. They concluded, based on recent climate models and a study of past extreme heat waves, that there was "a 90% chance that, by the end of the century, the coolest temperatures in the tropics during the crop growing season would exceed the hottest temperatures recorded between 1900 and 2006." According to the British Guardian, under such circumstances Battisti and Naylor believe "[h]alf of the world's population could face severe food shortages by the end of the century as rising temperatures take their toll on farmers' crops... Harvests of staple food crops such as rice and maize could fall by between 20% and 40% as a result of higher temperatures during the growing season in the tropics and subtropics."
Not surprisingly, it's hard to imagine -- perhaps I mean swallow -- such an extreme world, and so most of us, the mainstream media included, don't bother to. That means certain potentially burning questions go not just unanswered but unasked.
The Grapes of Wrath (Updated)
Mind you, what you've read thus far represents an amateur's eye view of drought on our planet at this moment. It's hardly comprehensive. To give but one example, Afghanistan has only recently begun to emerge from an eight-year drought involving severe food shortages -- and, as journalist Christian Parenti writes, it would need another "five years worth of regular snowfall just to replenish its aquifers." Parenti adds: "As snow packs in the Himalayan and Hindu Kush ranges continue to recede, the rivers flowing from them will diminish and the economic situation in all of Central Asia will deteriorate badly."
Nor is this piece meant to be authoritative, exactly because I know so relatively little. Think of it as a reflection of my own frustration with work not done elsewhere -- and, by the way, thank heavens for Google University. Yes, Googling leaves you on your own, can be time-consuming, and tends to lead to cul-de-sacs ("Nuggets end 17-year drought in Orlando"), but what would we do without it? Thanks to good ol' G.U., anyone can, for instance, check out the National Oceanic and Atmospheric Administration's Drought Information Center or its U.S. Drought Monitor, or the National Weather Service's Climate Prediction Center and begin a self-education.
Now let me explain why I even bothered to write this piece. It's true that, if you're reading the mainstream press, each of the droughts mentioned above has gotten at least some attention, several of them a fair amount of attention (as well as some fine reporting), and the Australian firestorms have been headlines globally for weeks. The problem is that (the professional literature, the science magazines, and a few environmental websites and blogs aside) no one in the mainstream media seems to have thought to connect these dots or blots of aridity in any way. And yet it seems a no-brainer that mainstream reporters should be doing just that.
After all, cumulatively these drought hotspots, places now experiencing record or near-record aridity, could be thought of as representing so many burning questions for our planet. And yet you can search far and wide without stumbling across a mainstream American overview of drought in our world at this moment. This seems, politely put, puzzling, especially at a time when University College London's Global Drought Monitor claims that 104 million people are now living under "exceptional drought conditions."
Scientists generally agree that, as climate change accelerates throughout this century (and no matter what happens from here on in, nothing will evidently stop some form of acceleration), extreme weather of every sort, including drought, will become ever more the planetary norm. In fact, experts are suggesting that, as the Washington Post reported recently, "The pace of global warming is likely to be much faster than recent predictions, because industrial greenhouse gas emissions have increased more quickly than expected and higher temperatures are triggering self-reinforcing feedback mechanisms in global ecosystems."
Now, no one can claim beyond all doubt that global warming is the cause of any specific drought, or certainly the only cause anyway. As with the Texas drought, a La Niña weather pattern in the Pacific is often mentioned as a key causal factor right now. But the crucial point is what the present can tell us about the impact of a global pattern of extreme weather, especially extreme drought, on what will surely be a more extreme planet in the relatively near future.
If global temperatures are on the rise and more heat means lower crop yields, then you're talking about more Kenyas, and not just in Africa either. You're probably also talking about desperation, upheaval, resource conflicts, and mass out-migrations of populations, even -- if scientists are right -- from the American Southwest. (And in case you don't think such a thing can happen here, remember Steinbeck's The Grapes of Wrath or think of any of Dorothea Lange's iconic photos of the "Okies" fleeing the American dustbowl of the 1930s.)
Right now, the global economic meltdown has massively depressed fuel prices (key to farming, processing, and transporting most crops to market) and commodity prices have generally fallen as well, including food prices. Whatever the future economic weather, however, that is not likely to last.
So here's a burning question on my mind:
We're now experiencing the extreme effects of economic bad "weather" in the wake of the near collapse of the global financial system. Nonetheless, from the White House to the media, speculation about "the road to recovery" is already underway. The stimulus package, for instance, had been dubbed the "recovery bill," aka the American Recovery and Reinvestment Act, and the question of when we'll hit bottom and when -- 2010, 2011, 2012 -- a real recovery will begin is certainly in the air.
Recently, in a speech in Singapore, Dominique Strauss-Kahn, head of the International Monetary Fund, suggested that the "world's advanced economies" -- the U.S., Western Europe, and Japan -- were "already in depression," and the "worst cannot be ruled out." This got little attention here, but President Obama's comment at his first press conference that delay on his stimulus package could lead to a "lost decade," as in Japan in the 1990s (or, though it went unmentioned, the U.S. in the 1930s), made the headlines.
If, indeed, this is "the big one," and does result in a "lost decade" or more, here's what I wonder: Could the sort of "recovery" that everyone assumes lies just over a recessive or depressive horizon not be there? What if our lost decade lasts long enough to meet an environmental crisis involving extreme weather -- drought and flood, hurricanes, typhoons, and firestorms of unprecedented magnitude -- possibly in some of the breadbasket regions of the planet? What will happen if the rising fuel prices likely to come with the beginning of any economic "recovery" were to meet the soaring food prices of environmental disaster? What kind of human tsunami might that result in?
Once we start connecting some of today's drought dots, wouldn't it make sense to try to connect a few of the prospective dots as well? After all, if you begin to imagine what the worst might look like, you can also begin to think about what might be done to mitigate it. Isn't that more sensible than looking the other way?
If the kinds of hits regional agriculture is now taking from record-setting drought became the future norm, wouldn't we then be bereft of our most reassuring formulations in bad times? For example, the president spoke at that press conference of our present moment as "the worst economic crisis since the Great Depression." On an extreme planet, no such comforting "since the..." would be available, nor would there be any historical road map for what was coming at us, not if we had already run out of history.
Maybe the world we knew but scarce months ago is already, in some sense, long gone. What if, after a lost decade, we were to find ourselves living on another planet?
Feel free, of course, to ignore my burning questions. After all, I'm only an amateur with the flimsiest of credentials from Google U. Still, I do keep wondering when the media pros will finally pitch in, and what they'll tell us is on that distant horizon, the one with the red glow.
Copyright (c) 2009 Tom Engelhardt
18 February 2009
The graphic below should at least take some of the mysticism out of the markets. The markets are not an enigma and are not always shrouded with uncertainty, but they do historically spend large chunks of time in a structural phase that isn't bullish (or bearish). This is why we began talking about the concept of a "structural fair" market back in 2001, and explore other asset classes. 2008 was tough because very few asset classes worked, so an investor that was diversified may not have lost an arm, but had deep cuts all over their body. We have to continue to look for areas that are providing leadership, and currently that leads us into assets such as
. There are some areas of the stock market that continue to hold up relatively well, but equities as an asset class continue to operate within a negative trend for now. If history is a guide, structural markets can last much longer than we have seen since the Dow Industrials began to plateau back in December 1999; on average the market phases for the Dow shown below have lasted about 14 years. (Sound familiar? -- dmg)
Really, you should consider a subscription to obtain the total value of what Dorsey Wright offers, not limited to the snippets I share.
-- David M Gordon / The Deipnosophist
More re iPhone applications
17 February 2009
Meltdown - a guest review
I first 'met' Tom online ~10 years ago, when he and I participated on the old George Gilder forum (GTF); Tom and I finally met in person 2-3 years later, when he traveled to Los Angeles to attend my trading seminar. Over the past 10 years, I have come to know Tom to be a fine man; intelligent, successful, and a serious student of economics -- an interest he pursues as a hobby, and yet the passage of time has proved him correct on so many items...
Tom wrote the review below for another venue, but re-wrote and shares it with you at my behest. Enjoy!
-- David M Gordon / The Deipnosophist
Thomas E. Woods has published a new book entitled, Meltdown. Woods wrote this book to explain the causes of the current economic crisis and, in particular, to combat a number of fallacies that are being disseminated by government, media pundits, and many economists.
I have just finished reading this book and would like to recommend it to anyone who is willing to consider the possibility that the US public is not getting accurate information about this crisis. Representative Ron Paul has written the introduction to Wood's book, and says "There is no better book to read on the present crisis than this one, and that is why I am delighted to endorse and introduce it."
Meltdown is a quick, 160 page read; I read it in just a few hours ... and I am a slow reader. Within that very compact space, however, Woods explains the entire broad array of causes in a style that can be easily understood by any thinking person. He builds toward a common-sense understanding of the Austrian economics business cycle theory by layering rather intuitive ideas presented in simple prose, further illuminated with straightforward examples. For nine years now I have been an informal student of Austrian economics and during that time I have read many, probably most, attempts to explain the Austrian business cycle theory. I find this book to be the very best effort I have seen. I highly recommend it.
This book is no doom and gloom affair. Woods isn't attempting to predict the stock market direction or venture any ideas about what the economy will look like in the future. In fact, he argues from both historical data and theory that, if our government would only behave differently, the necessary market adjustments would be completed quickly and our economy would rebound after a relatively brief period of recession. On the other hand, Woods demonstrates that government actions so far parallel those taken by Hoover and then Roosevelt during the Great Depression. Contemporary economists who take comfort in the idea that current monetary policy differs from the Fed's 1930s approach are fooling themselves -- on two dimensions. First of all, the 1930s Fed tried with all its then existing tools to inflate the economy during the depression. Today, it's true, we have a fiat currency and our Fed is even bolder -- but today's goal is identical to the 1930s goal. Secondly and more importantly, however, the attempt to inflate the economy in a depression is a serious policy error that prolonged the Great Depression and can only lead to tears in the present context.
In my opinion, this book and the ideas it contains are extremely important. I hope many people will read it to see for themselves.
-- Tom Burger
14 February 2009
13 February 2009
The Big Kahuna
Well, yeah, maybe. Certainly, many investors worry about Steve Jobs' health, not solely for the man and his family, but for the company... and for the stock.
Time has proved Steve Jobs to be a singular force of nature; even while deathly ill he still musters the strength to challenge other CEOs, mano a mano, to a screaming match. All in his visionary quest to get the best deal for Apple, Inc. But we investors and bystanders have the opportunity to see, real time, the mettle of Apple's bench; can the other executives rise to the occasion?
Another worry that plagues many investors is whether Apple's heyday is behind it; that the company's phenomenal cycle of innovation now is a thing of the past. Perhaps. Noone, me included, can really confirm that possibility. Apple's strategy might be best defined as evolutionary rather than revolutionary, with a focus on its three core markets. (iPhone, iPod, and the Mac.) Apple chooses to play in only a handful of businesses that manifest huge addressable markets; the company offers a narrow suite of premium products to these huge markets. Apple is most bullish about its iPhone business, where it has massive opportunity to gain market share (and has done so already); one in which software would be its principal differentiator. (Its operating system and, more importantly, the App store.)
Investing is a discounting mechanism; investors buy today to sell at a higher price tomorrow. And vice-versa. But the process of investing discounts the knowns, the perceptions, and how other investors might react to changing perceptions and changing realities. Sometimes, though, there exist some facts that are little known, if at all.
1) The Apple retail store. Apple has always bordered on a cult, if not a full-fledged religion, what with the Apple fanatics proselytizing the company's products. Someone at Apple had the bright idea to hire the nicest, friendliest, most knowledgable among them, cloak them in the appropriate priestly robes (er, white t-shirts), and have them share with you, gently, the truth, beauty, and elegance of owning an Apple. Each priest -- er, salesperson -- is knowledgable, helpful, and discreet; nary a one pesters you to distraction. God love 'em all. The sales at Apple's stores qualify as a retailer's dream, an amazing $4700/sq ft; leaps and bounds ahead of its nearest competition.
And just today, Microsoft/MSFT announced its me-too strategy, that that company also will open retail stores. Somehow, the cachet of selling goods, damaged while still in the box, does not compare to the Apple experience; i.e., Apple's successful retail sales strategy is a result of its well-designed and lovingly-engineered products and the religious devotion of its consumers. Microsoft offers nothing even remotely similar. Nor for that matter, does any company. Talk about elegance.
2) The iPhone. Everyone, me included, splashed water on the notion of Apple building and selling a cell phone. Cell phones were mostly differentiated by shape, color, service provider, and service plan -- until Apple joined the fray. With one fell and resounding swoop, Apple wrested control of the cell phone's destiny from the service provider and placed it firmly into the hands of the phone's builder. Apple dictated terms, and the service providers bullied one another for the opportunity to be the sole seller. In the US, the winner was AT&T, alas, but the iPhone is an instance where the beauty, functionality, and usefulness of the iPhone trump the ugliness of the service provider. Although barely.
But this all is well known. Less well known is Apple's ultra-conservative accounting for iPhone sales. Unlike other cell-phone manufacturers that book 100% of the revenue from each phone sold within the quarter the sale occurs, Apple amortizes the revenue over eight (8) quarters, 2 years! Apple's thesis is to match iPhone revenue with the standard 2 year service contract. This accounting is very conservative, as mentioned, but think about it: iPhone sales reported within any quarter actually represent only 1/8 (12.5%) of the total sales. This means there exists an increasing chunk of revenues yet to report. If accounted for under GAAP, Apple's revenues and earnings from the iPhone would be higher, much higher -- which makes the stock inexpensive, and downright cheap. Go figure.
3) The Applications Store, especially iPhone apps. The Apple apps store upends the entire software business model; previously, a buyer would think long and hard before spending $500 on software; licenses at $30/year also caused buyers to pause before taking the plunge. But at 99¢ -- who needs to think? You buy, and if the program satisfies you, great! And if it fails to work or inspire you, no big deal.
And, suddenly, just like that, everyone has a method to strike it rich, instantly. Write a program, like Ocarina, take advantage of the network effect and sell it to hundreds of thousands of iPhone users, and bling bling, sit back as the cash registers ring. And ring. Yes, you too can be a millionaire.
But I neglect to mention the elegance of this setup for Apple, and Apple/AAPL investors. Apple merely builds and minds the store; non-employees dream up these addictive programs, and sell them on Apple's apps store. The sharing arrangement is 70/30, which means that almost the full 30% of the revenues from the apps store drops to Apple's top and bottom line. The company's SGA for this part of the business is next to nil. Beautiful. The apps store looks only to improve. Who knew?
Oddly, two of the three items above are peripheral to the company's primary mission of making and selling electronic devices. But each also takes advantage of a unique set of circumstances that only a company such as Apple/AAPL, with a visionary leader such as Steve Jobs, can offer.
I could quantify for you even more the value of Apple/AAPL's story, but why bother? You hope to divine the market's every squiggle, a tempest in a teapot, which effort causes you not to see the big Kahuna, the wave that will carry you all the way to shore. Market cycles come, and market cycles go, but value always wins out. Sell Apple/AAPL, if you prefer, because you fear its share price will decline (farther) due to a sloppy market. The best opportunity is on sale at a ridiculously cheap price, growth at a value price. So how about a piece of (apple) pie...?
Full Disclosure: Long Apple/AAPL. And happy.
-- David M Gordon / The Deipnosophist
More Suleman than Sully
There's a sense that everyone's digging in. President Obama has dug in on this stimulus bill: Pass it or see catastrophe. Republicans are dug in: Pass it and see catastrophe. The digging in is a way of showing certitude, and they're showing certitude because they're lost. We hire politicians to know what to do about empty stores, job loss, and "Retail Space Available." But they don't, and more than ever we know they don't. And there's something else, not only in Manhattan but throughout the country. A major reason people are blue about the future is not the stores, not the Treasury secretary, not everyone digging in. It is those things, but it's more than that, and deeper...Read her essay from today's edition of the Wall Street Journal to learn why I read voraciously everything Peggy writes.
-- David M Gordon / The Deipnosophist
12 February 2009
Basics of Sector Rotation
As always, please consider a subscription to BigTrends.
-- David M Gordon / The Deipnosophist
February 12, 2009
Basics of Sector Rotation
Investors are always looking for the next "big thing" in trading, the best way to get that specific edge, a way to turn a struggling portfolio around or augment a successful trading theory. One such strategy is the Sector Rotation strategy. This trading philosophy is based on sectors and exchange-traded funds (ETFs), which are one of the more popular trading vehicles in today's market. When utilizing the sector rotation strategy, the trader is making a long-term commitment, but also a commitment to be fluid in your management style.
Let's start with the strategy. A basic sector rotation strategy contends that the economy runs cyclically - up sometimes, lower other times. This idea was presented by Sam Stovall in his 1996 book, Sector Investing (which is why many call this the Stovall Rotational Strategy). The key is to identify the cycles, buying at the lows and selling at the highs. Success is based on timing, which is why Stovall presented four stages for the economy and for markets.
First, the economic cycle:
1. full-blown recession
2. early recovery
3. late recovery
4. early recession
Next you have the market cycle:
1. market bottom - prices drop
2. bull market - the market rallies
3. market top - the market hits a top and flattens out
4. bear market - prelude to the next market bottom, the market falls
With an economy that runs in cycles, one needs to understand that there will be sectors that lead and lag the cycles. This need leads to investors trying to anticipate the economic impact of the economic cycle. This anticipation causes the market cycle to proceed the economic cycle.
Confused? Perhaps, but don't fret. The kind folks at StockCharts.com have a widely used sector rotation model, which is included for you below.
As you can see by the model, certain sectors perform well at different stages of the economic cycle. As an example, cyclicals perform well near the beginning of a recession, tech performs well during the recession, and industrials perform well near the end. Since recession is followed by early recovery, industrials see their solid performance carry over to the beginning of the early recovery portion of the cycle.
What Does This Mean for 2009?
Really, it depends on what portion of the economic cycle you believe we are slogging our way through. If you believe we are in the early recession portion of the cycle, you will want to look at services, utilities, and cyclicals. However, if you believe we are moving through the full recession, keep an eye on the aforementioned cyclicals, technology, and industrials.
As noted in the opening of this piece, a commitment to the sector rotation is a commitment to fluid investing. Remember that the key to this strategy is timing, timing, and timing.
11 February 2009
-- David M Gordon / The Deipnosophist
ZepInvest is an aggregator of paid financial information that empowers users with access to over 80 premium investment publications in one searchable, easy-to-use Web site. It’s aimed at any investor who wants to get the best advice on how to invest money. And let’s face it, that’s all of us right now.
ZepInvest aggregates content from over 80 different publications, and offers them at a far more reasonable price than they would cost if bought yearly and individually. ZepInvest costs $600 a year as an introductory price, as opposed to over $30,000 a year if users were to buy content separately. Many of these publications were previously rarely available to consumer investors – and many cost hundreds of dollars per year. ZepInvest includes well-known publications such as The Motley Fool, Morningstar, Walter Frank’s Money Letter and CABOT.
It’s the first time that the simple Google-esque search model has been applied to premium investment publishing. Any consumer who wants advice and information that has otherwise been limited to investment professionals by price and availability can now gain access.
This is particularly critical in today’s market as people need to empower themselves with sound financial advice from multiple sources to be sure they have the best possible grasp on their investments.
Thanks to you and your contributions, the New York Times just wrote a feature on Wikinvest in their Technology section. Check out the article for the Times' review, comments from a few of our contributors, and to catch a glimpse of Wikinvest headquarters.
Special congratulations to Sr. Directors Avi Gandhi, Robyn Bergeron, and David Turetsky whose significant contributions were noticed by the NY Times staff and specifically mentioned in the article.
Keep up the great work.
The Wikinvest Team
10 February 2009
Obama's Economic Recovery Plan
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-- David M Gordon / The Deipnosophist
February 10, 2009 1826 GMT
Obama's Economic Recovery Plan
U.S. Treasury Secretary Timothy Geithner outlined the first phase of the Obama administration’s economic recovery plan Feb. 10. The plan is fairly orthodox, even though its scope is vast. It might even prove profitable for the government.
After three weeks in office, U.S. President Barack Obama’s administration outlined the first phase of its economic recovery effort Feb. 10. The plan at present requires no new actions or money from Congress. Instead, it relies purely on existing legal frameworks governing the Treasury Department and the Federal Reserve System, as well as authority and funding obtained by the Bush administration from Congress. The stimulus plan before Congress is another ball of wax completely, and if adopted, it would be the second leg of the administration’s anti-recession efforts.
While the numbers freshman Treasury Secretary Timothy Geithner provided as he sketched out the Obama administration’s plan Feb. 10 are certainly large — even mammoth — a deeper look reveals that the plan is neither creative nor new. This is not meant as a criticism of the Obama team — while the devil, of course, is in the details, the plan as announced looks quite sound. But not only does it look like a natural extension of, and a minor course correction from, the Bush administration’s bailout policies; it also is revolutionary neither in concept nor reach — only in scope.
Credit Crunches vs. Liquidity Crises
As Geithner stated, subprime mortgages lie at the heart of the crisis’ genesis, a diagnosis that is neither new nor controversial. People who should never have qualified for mortgages were encouraged to buy. The brokers who provided the mortgages in turn sold the loans to others, who packaged them together into tradable securities and sold them yet again. When the market functions normally, this secondary market allows investors to flood money into the system, dropping borrowing costs. But when home prices fall or foreclosures mount — both of which have happened in spades in recent months — it is impossible to separate the good loans from the bad in the securities. Shorn of the ability to assess how much any particular security is worth, no one wants to purchase them, so the entire housing credit system seizes up.
In September 2008, the problem broke out of housing and affected the broader financial system. Suddenly, banks were unwilling to lend not just to homebuyers, but also to each other. This proceeded on the reasoning that, lacking the ability to assess the stability of a prospective borrower’s asset sheet, lenders cannot good in conscience lend. Money thus stopped flowing completely. The accompanying graph demonstrates how the cost of lending between banks shot up during that time.
At this point, a technical distinction is required for clarity. When banks stop lending to each other, the economy does not face a traditional credit crunch, but a liquidity crunch. The money is there, it is just unable to flow to where it is needed. A liquidity crunch is perhaps the most damaging thing that can happen to a modern economy. Western banking systems exist to allocate capital to entities that will use it most efficiently and effectively. When banks stop doing that, everything in the affected economy that depends upon credit at all simply stops. Most of what the Bush administration did during the final four months of its term — and nearly everything it did in September and October 2008 — was aimed at mitigating this liquidity crisis.
This liquidity crisis is pretty much over — in fact, it has been for several weeks. Interbank costs have plummeted, and interbank lending has broadly picked up again, as the graph demonstrates.
In contrast, the problem of today is a credit crunch. Liquidity is back in the system, but lending from banks to consumers and companies has yet to recover. Banks remain risk-averse not necessarily because they are worried about access to capital or the creditworthiness of their peers (the problem in a liquidity crunch), but because they are concerned about the creditworthiness of their potential customers. Credit checks have become more thorough, marginal borrowers have been declined, and loans on the whole have become harder to get.
While such circumstances are obviously recessionary, they are hardly unprecedented. In fact, what is happening now with the credit markets is the same thing that happens in every recession. Unlike the liquidity situation that the Bush administration struggled with in October and November 2008, the credit situation of 2009 is not extraordinary. Thus, the Obama plan for dealing with it is rather orthodox.
In essence, the worst is over for the United States. But we mean neither to belittle the pain of the recession, nor to wave away concerns for the future. Instead, we want to point out that the systemic danger has passed, and that the nature of the current problem lies within a more well-understood framework for which mitigation and recovery tools already exist. Some of these tools are simply part of the government’s normal tool kit; those that are not were crafted through congressional cooperation with the Bush administration within the last year.
The Obama Strategy
The Obama strategy can be broken into three pieces.
First, the Treasury Department, Federal Reserve, Federal Deposit Insurance Corp. and other government entities that touch upon the banking sector will run a “stress test” of every bank that seeks any sort of assistance. This test will focus on lending practices and balance sheets; qualifying banks can tap the Treasury for loans to help rationalize their balance sheets. The government will require banks receiving such loans to prove regularly that the government assistance is being used exclusively to extend credit to consumers. There must not be any excessive executive compensation (defined by the Treasury as an annual salary of more than $500,000), and the funds cannot be used to purchase other banks.
For funding, this program will use the final half of the $700 billion that Congress authorized to the Bush administration back in September under the Troubled Assets Relief Program (TARP). The primary difference between how the Obama and Bush administrations carried out the TARP is that the Bush administration simply wanted to shove as much cash into the system as quickly as possible to reliquify the system. As such, the Bush administration’s $350 billion simply went directly to the banks with few strings attached.
But the Obama administration does not have to deal with a liquidity crisis, so it is putting into place the safeguards, “stress tests” and lending requirements to minimize graft and maximize overall lending. The Bush team administered its half of the TARP money within a few short weeks; the Obama team’s controls mean it will take months to loan out its half. But bear in mind that the Obama team is addressing a fundamentally different issue than the Bush team was. Liquidity crises are economy killers, while credit crises are “merely” recession-causers. For the Obama team, there is not the same level of urgency the Bush team faced, so the Obama team can afford to take the time to apply its package more comprehensively.
In the second part of the Obama plan, the Treasury will set up a public/private investment fund to manage and dispose of the questionable mortgage-backed securities that touched off all of this in the first place (often referred to as a “bad bank”). The plan is to work with the private sector to set a price for the securities that is somewhere between what they were worth when they were originally formulated and their current near-worthlessness. (Remember, all of these securities are backed by actual homes with values that are far more than zero.) The Treasury will provide the initial funds to purchase the securities from banks, and the Fed will provide whatever financing is necessary. The plan is to clean the banks’ books while injecting capital, allowing the banks to make loans with more confidence. The government plans to provide $500 billion in financing immediately, and could apply $1 trillion before all is said and done.
Third, the government will participate in the secondary debt market for everything from car to college loans. Secondary debt is like the mortgage-backed securities discussed previously, e.g., loans that have been packaged together for trading. Geithner estimates that 40 percent of the capital that supports lending in the United States participates only in the secondary market. As long as banks and investors are skittish, this market does not operate smoothly. Up to $1 trillion will be applied to this via the Term Asset-Backed Securities Loan Facility (TALF), largely through Fed financing.
A Profitable Bailout?
Altogether this sounds like a lot of cash, and it is. The total price tag comes in at roughly $2.4 trillion, more than the entire government budget in a normal year. But this is not nearly as bad as it sounds. In fact, the government is likely to make money on this over time.
First of all, the TARP money is all loans. Banks that received the first batch from the Bush administration have to pay 8 percent interest annually. Additionally, under the terms of TARP, the banks had to give the government the right to veto policy decisions. So the Obama administration enters its time with TARP with all the tools in place to change bank policy to match national policy. Specific terms as to how the Obama team will rejigger TARP remain to be seen, but if anything, the terms of the TARP loans will be tightened — making it more likely that the government will come out ahead — rather than loosened.
Second, the public/private debt management effort almost certainly will produce a fat profit for the government. The government will be buying up the distressed securities at well below market prices, and then will sell them at a time and place — and most important, a price — of its choosing down the line, ostensibly after the housing market recovers. The problem is not that the money will disappear; it is instead an issue of opportunity cost and time frame. With a potential $1 trillion in assets under management, this program could well take more than a decade to flush out completely. The closest comparison in American financial history is the Resolution Trust Corp. (RTC), a federal program of the 1980s and 1990s designed to help the country recover from mass bankruptcies in the savings and loan sector. Once one adjusts for the change in the size of the economy from then to now, the RTC program was about half the size of Geithner’s public/private program , and it still took six years to complete.
Third and last, participating in the secondary debt market is a temporary measure, and the government fully intends to pull back from that market as soon as the private sector’s appetite for investment resumes. This is the only part of the program announced thus far that Stratfor anticipates will operate at a loss once all the accounting in finished. Debt trading works on the idea that private investors are better than the government at reducing costs and directing capital. So not only would government employees (albeit very knowledgeable and financially experienced employees) be playing the market, they will be doing so with the intent of keeping things moving rather than making money. That will generate losses. But even here, the price tag is not as bad as it sounds. While the Treasury will use up to $1 trillion to run this program, every asset purchased will be sold, so the cost will be largely administrative.
This does not mean that all of the Obama team’s policies will be cost-neutral. As noted in the first paragraph, this is only the first step of the Obama administration’s plans for dealing with the recession. Each of these steps deals with the financial aspects of the recession, and none actually changes anything directly related to how much trouble homeowners are having making their mortgage payments.
All of the spending and tax cuts in the stimulus package before Congress are funded with deficit spending — very real costs that will create very real debt that will definitely need to be paid back. Additionally, Geithner gave notice in his presentation that the administration will announce a fourth effort in the weeks ahead. That effort aims to provide debt relief to homeowners and small businesses, primarily to help prevent foreclosures. Stratfor does not wish to judge that effort before it is announced, but anything that uses the phrase “debt relief” normally has a lot of costs attached.