Roger Ehrenberg’s general thoughts on the market, courtesy of Roger at Information Arbitrage.
Scanning the News: Tough Times Require Decisive Action
Though I get most of my in-depth commentary on business and technology from blogs, I augment that with mainstream news headlines and alerts. I often extract the implied sentiment of headlines to get a tone of the markets and the economy, and this becomes part of the prism through which I view news, events and my activities. Lately the headlines have been pretty grim, and increasingly so as the global financial crisis bleeds into the real economy. Normally I associate depressing headlines with a contrarian opportunity to act, but at this point I believe the headlines do not yet discount the difficulties we will encounter both economically and militarily over the next 12-24 months.
Consider the top Breaking News headlines from Bloomberg.com, 2:30pm Eastern yesterday afternoon:
Breaking News
•Paulson Clashes With Congress, Warns Against Using Bailout as a `Panacea’
•U.S. Producer Prices Plunge 2.8%, Most on Record, as Global Demand Shrinks
•Home Prices Tumble in 80% of U.S. Cities as Foreclosures Drive Down Values
•Stocks in U.S. Retreat; S&P 500 Index Falls Below Lowest Close Since 2003
•Berkshire Credit Risk on AAA-Rated Debt Soars in Sign of Investor Anxiety
•Falcone’s Harbinger Capital Faces Potential $200 Million Loss on Navistar 
•Bank of America’s Lewis Says Merrill Takeover Is `On Track’ as Shares Fall
•Senate’s McConnell Calls for Expediting $25 Billion of Loans to Automakers
•Hijacked Saudi Tanker Anchored Off Somalia Coast; Rescue Attempt Unlikely
This is what I take away from these headlines:
Seeing the chinks in "Teflon Hank’s" armor. Hank has made big mistakes with TARP. He had the wrong plan, communicated it poorly and, as a result, sharply undermined his own credibility with Congress and the American people. That said, he was in a difficult position, made decisions that I believe were done with the best of intentions and changed course when he realized he was wrong. And for this he deserves credit. However, now that he is no longer Teflon Hank, he has to work extra hard to educate Congress on how and when TARP funds should be used. He is being bombarded on all sides by special interests and getting pressure from every faction in Congress. Had he done a better job of planning and communication upfront it would be much easier to manage the current situation, but this not the way it played out. What should have been a surgical strike of deploying massive funds into key areas (e.g., cleaning up busted bank balance sheets a la Good Bank/Bad Bank and developing a sensible mortgage restructuring solution, NOT opening the U.S. taxpayer’s checkbook to virtually any bank that wants a capital cushion, money that will sit idle and not be used for capital formation) will invariably turn into a free-for-all. I can feel my wallet getting lighter by the minute, which would be ok if I felt the funds were being spent in a prudent manner. Which I don’t.
The real economy shouts "No Mas." Just as Roberto Duran uttered those fateful words, the massive drop in U.S. producer prices is saying the same thing. Cratering commodity prices – metals, oil, etc. – are simply an outgrowth of the global economic slow-down. While lower prices are good, the speed and depth of the drop only exacerbated current problems: all that new production capacity that came onstream to take advantage of high prices are being mothballed only months later. Higher cost structures in the face of a precipitous drop in demand equals producer losses for a long time. And the drops were are talking about are of historic proportions, meaning that the adjustment period for demand to catch up to production capacity is likely to take years, not months.
Falling real estate prices aren’t limited to the "go-go" markets. With 80% of U.S. cities showing price declines, the real estate bust is far more pervasive than one might have imagined. And, of course, falling prices beget falling prices: vacant houses in foreclosure drive down the values of adjacent housing stock, which in turn places those houses at greater risk of foreclosure, and so on. Further, these problems are worsened by rising unemployment, falling wages and ever-rising healthcare costs. We are likely in the midst of a downward spiral that can only be braked by fixes in the real economy; restructuring mortgages is a drop in the bucket if unemployment approaches 10% and people can’t make even reduced monthly payments. We’ve just seen the beginning of the story; how the rest plays out is a function of how our new President, in conjunction with other global leaders and Congress, work to get our economic engines running again.
The equity markets have created zero value over the past five years. Sure, there have been some IPOs (value in), secondary stock issuances (value in), stock buybacks (value out), dividends (value out) and compensation paid (value out), but the bottom line is that we have basically been treading water. And if you look back, you can make the argument that we’ve made little headway over the past decade. In addition to the adverse effects on people’s savings and retirement accounts, it is very poor for consumer sentiment and people’s attitudes in general. Why did I work so hard only to be back where I started? While the issue is certainly more complex, the headline is very corrosive to peoples’ sense of worth, accomplishment and safety.
Even Warren Buffett isn’t immune from the market’s harsh judgment. First, it was his deeply-underwater preferred stock investments, most notably in Goldman Sachs. Now, the cost of protecting against Berkshire’s credit has skyrocketed to a level more in line with BBB-rated companies, not the vaunted AAA that it currently holds. Fears are centered around the long-dated equity index put options it wrote beginning in 2005, on a notional amount of around $40 billion. In Warren’s eyes he has secured almost $5 billion in option premium that he can use for acquisitions, stock buybacks, etc. In the market’s eyes some believe Berkshire is going to have to come up with collateral for the decline in the short option position. Reality is, the only way Berkshire has to post is if its credit rating falls below a pre-determined level. As unlikely as this may seem, those in the credit derivatives markets are looking at Berkshire credit risk with a wary eye. Sentiment in this market is as volatile as the VIX: if the market continues to push against Berkshire’s credit will a downgrade become a self-fulfilling prophecy?
Even the "do no wrong" hedge funds are getting crushed. Phil Falcone’s Harbinger has been on a roll for several years, making him among the richest and most feared activist hedge fund managers on the planet. But lately things haven’t been working out so well for Harbinger, with the Navistar loss only the latest among a sea of bad news. To be fair, Harbinger is doing better than many and long-term, Mr. Falcone’s fund has been a super-performer. But like many things, people often get too much credit in good times and too much blame in bad, but hedge fund managers and their compensation models make it hard to feel bad for them when times get tough. This is the time to fix the compensation models such that payment horizon and investment horizon match. Medium and long-term investors like Mr. Falcone should secure long-term lock-up money in line with their strategies, but should only collect performance fees that match holding periods. Having activist and longer-term thematic investors getting paid quarterly makes no sense. The best-in-class like Harbinger should lead the way on a new compensation model to better align GPs and LPs. Now.
B of A and Merrill – the market says no. What once seemed like a steal now looks both pricey and risky. Mega-mergers almost ever work, especially when the cultures of the firms in question are so different. The equity markets have been properly cynical about the merger going through, even in the face of Ken Lewis’s insistence that he is committed to the deal. The market is offering him an out – he should take it. The value destruction facing BAC shareholders is monumental: bad culture fit, fleeing brokers, significant potential losses looming in its mortgage and derivative books, etc.. This is the time to protect your shareholders and to focus on execution of the core business plan. Bolting Merrill Lynch onto B of A cannot be seen as core to B of A’s business plan. It was a grasp at what seemed like a compelling opportunity. Only the equity markets didn’t believe it made sense. And I don’t, either.
Bail out the automakers – or else… This partially has to do with Mr. Paulson’s loss of control over TARP. The lobbyists and spin-masters are out in force, and all eyes are focused on the auto industry. Yes, it’s in turmoil. But the proposals on the table are perhaps worse than Mr. Paulson’s injection of $25 billion into Citigroup before they cleaned up their on- and off-balance sheet liabilities. A campaign of fear is being spread by entrenched interests, who want to see the sector bailed out and for its life to be prolonged until – who knows. The U.S. auto industry as we know it is dead. It has to die. The issue of legacy retirement and health care costs absolutely has to be dealt with before putting in dime one. That said, the industry can be restructured and the productive capacity used for other pursuits. Large chunks of the auto parts industry can be sold to more efficient foreign automakers who are already big customers. Certain factories may be able to be sold as well. Other plants can be retro-fitted for other activities, perhaps relating to core infrastructure projects to create attractive jobs, many of which can go to current auto workers. It would be far cheaper to pay workers a living wage and to give them training while plants are being re-tooled for other activities than pouring $25 billion into a sector that will need similarly-sized injections every quarter until the U.S. Treasury is bankrupt. We need radical change and creative thinking, not the same linear, predictable, pork-barrel line of thought that is the norm for legacy unionized industries.
Global instability on the rise. The recent spate of hijackings is indicative of an already unstable world in need of cooperation and order. Somalia, Yemen, Pakistan and Afghanistan will continue to be threats to the U.S. and our allies without a multilateral effort to ferret out terrorists and break their lines of funding. This will require information and intelligence sharing, jointly funded and staffed, that illustrates an unprecedented level of multilateral support that eventually serves as a deterrent to bad actors. Hopefully our new Administration can move this initiative forward – and fast.
Times are difficult and are likely to get tougher, and there is a lot of work to do. But much of the work isn’t a mystery – it just need to get done by people with brains, heart, courage and vision. This isn’t a popularity contest; it’s about serving our country. If today’s global turmoil isn’t enough of a call to action, then I don’t know what it will take.
