The Blues - Dr. Dr. Tell Me The News ...

The Blues - Dr. Dr. tell me the news... Is the $700 billion Bailout Plan necessary? - There is a future and it's good!

Kendall J. Anderson, CFA October 5, 2008     Printer Friendly Version

The Blues

Last year while on the road heading from New Orleans to Memphis, I passed through the Mississippi Delta Valley and stopped in Greenville, Mississippi to experience a steak at Doe's Eat Place, recognized by Bon Appétit Magazine as one of the top restaurants in America.  You'd be shocked upon arrival if you were anticipating a five-star location.  Doe's Eat Place is in one of the poorest parts of one of the poorest regions in the country.  The building, close to 100 years old, has whiteboard siding and a cement block building attached, and when I pulled up on my motorcycle, the bike looked right at home.  The local kids came over in droves to check out the strange looking and mighty dirty bike with a South Carolina license plate. When I walked inside, I noticed the floors sagging beneath my steps, and the tables looked as if they came from the local flea market. But the smell was intoxicating, and I was treated like royalty even though I must have looked like I had just been through the gauntlet. Also, I'd have to admit that I had one of the best steaks I have ever eaten in any restaurant in the world.  If you ever get a chance, stop in and enjoy a meal at Doe's, and remember, there's no need to get dressed up for dinner.

My route to Memphis was via US Highway 61, the "Blues Highway" where this fully American form of music, the Blues, was created. During the depths of the Great Depression most little towns along the route to Leland, where the road intersects with US 10, were alive on Saturday nights with musicians playing on the street corners for tips.  With Robert Johnson's music playing in my helmet I could truly feel the blues surrounding me.

I know that all of you, including stock holders, bond holders, small business owners, bank employees, home owners, and our clients, felt a bit of the blues this past month, and it's fitting that Rock Hill just finished its 4^th annual Blues Festival.  I can only hope that these blues are only temporary and will become just memories quickly.

Bridgewater Associates

Most of you know how I feel about hedge funds.  I have said many times that there is no hedging in hedge funds.  Hedge funds do not share in any losses, the definition of a moral hazard. While believing that most individuals have no reason to understand or even explore the world of hedge funds, we still have to admit that they do have a tremendous amount of influence on the daily volatility in the markets.  They also, due to the typical fee structure of 2% annual fee and 20% of any profits beyond a benchmark, have been on the leading edge of new approaches to investment management. Bridgewater Associates presented a picture that was both enlightening and encouraging.  The discussion covered de-leveraging, economic/market cycle, and the balance of payment imbalances.

The meeting was held early in the month and prior to the crisis that recently exploded on all front pages.  Bridgewater's research on the current debt picture was and is extremely helpful for the split of those who believe we need to do something now and those who believe "those lousy bums on Wall Street need to pay." Here it is:

Aggregate "Risky" Debt Assets Held by All Entities

Since 1/1/2007 (US$ billions)

Aggregate "Risky" Debt Assets Held by All Entities

Since 1/1/2007 (US$ billions)

Bridgewater Research (September 2008)

What is important to take from this is that the real losses currently in the system but not recognized or accounted for are, by Bridgewater's estimate, over $1 trillion ($2,016 billon total losses, less $483 billion losses recognized and $352 billion new capital). Half of these are losses of commercial banks, and there are only two ways for banks to cover these. The first is by new capital, either through new investments or retention of earnings.  The second is through bankruptcy, and some have taken this route, including IndyMac and WaMu, while many more are on the edge of making this decision. No matter what side of the Bailout debate you were or are on, the only source capable of slowing or minimizing this bankruptcy option is our federal government, and we will take a further look at the Bailout plan shortly.

Bridgewater also offered encouraging thoughts regarding the recovery potential of the markets once this crisis passes, which it surely will. In the past 10 economic cycles, when the Federal Reserve cut interest rates and infused cash into the system, the markets averaged a positive 22% gain over the following twelve months.

Mark Vitner - Director and Senior Economist Wachovia Corporation

The event with Mark Vitner was jointly sponsored by Wachovia and Winthrop University and was held in downtown Rock Hill on September 12^th.  If any of you are unfamiliar with Mark, you can turn on CNBC, CNN, NPR, or Jim Lehrer NewsHour, or take a look at the Journal, Business Week, or USA Today, and sooner or later Mark will be interviewed or quoted regarding his views of the economy.

I have had multiple occasions to visit with Mark over the past five years. He lives close to his office in uptown Charlotte, walks to work, and is quite well know for wearing colorful suspenders.  Mark began his education at Winthrop and went on to earn his BBA in Economics from the University of Georgia as well as an MBA from UNC.  He drives a BMW roadster with a license plate that simply says "Supply".  I asked if his other car had a license plate saying "Demand", but alas, his other car belongs to his wife and she refuses.  Oh well... at least we know that Mark is enthusiastic.

I like Mark as an economist.  He is willing to make a prediction, right or wrong.  In addition, when wrong he is not afraid to admit it and change course as needed, and he is also quite humble when he is right.

A highlight of this event was entitled "The Economy Feels Weaker on Main Street than the Real GDP Data Would Indicate." It made me take a second look at Real GDP and Nominal GDP.  Because our portfolios hold mostly large and very powerful global companies, Nominal GDP, a measure of revenue growth for the economy, tends to take the lead in our analysis.  Mark's analysis states that the Real Core GDP (private domestic final sales) has been negative in two of the last three quarters, and he estimates that it will stay negative into next year.  We see and hear the difficulties that our friends, families, employers and yes, even ourselves are going through, and this only increases our anxiety and our desires to remove risk.

Professor Dr. Davide Sola - Director UK ESCP-EAP European School of Management

The correspondence from Dr. Davide Sola was a true "black swan" event.  Being in the financial and investment business as long as I have places our firm on just about everybody and anybody's list when they're looking to market their services.  I am sure this is how Cantos found me, or at least found my electronic home address.  Cantos, based in London, pioneered the field of online business video in 2001.  Currently, they film around the world for companies large and small and deliver over 900 corporate videos and online projects a year.  I received a video interview of the Economist Intelligence Unit featuring Robin Bew of the EIU, Dr. Sola and Paul Anning, a lawyer with Osborne Clarke.  I have met and discussed economics with countless numbers of professionals over the years, but I have to admit that young Dr. Sola impressed me.  Dr. Sola is the Director of the United Kingdom branch of the ESCP-EAP European School of Management.  The school is ranked the 2^nd best business school in the UK and the 4^th best business school in Europe by Financial Times. Dr. Sola's initial comments were something like the following: "The most interesting innovations have come out of crisis. People react quite positively out of adversity. Innovation is result of creativity, and creativity is triggered during times of difficulty."  Dr. Sola also spoke about how he believes that the current crisis will actually be positive in the long run as it will help people be realistic, which will result in proper investment that is well thought out and analyzed thoroughly.

This positive spin was enough to hook me.  Also, throughout the short interview, Dr. Sola was able to take extremely complicated financial concepts and explain them in a way that anyone could understand them.   With follow up email correspondence, Dr. Sola's academic credentials came through in flying colors, and I mentioned to him my upcoming visit with Paul Volcker and in passing asked him if he would like me to ask any questions of Mr. Volcker.  He responded with the following: "It seems to me that the degree of complexity has meant that the Fed/Bank of England has almost lost track of the money supply.  In terms of the quantity theory, what's happened to V? Do we know?  Either banks have altered their reserve requirements without regulators knowing (which is basically counterfeiting), or banks are completely blameless.... a short (if not naïve) explanation from your lowly analyst is warranted."

The V Dr. Sola mentions is from the Quantity Theory of Money developed by Irving Fisher and championed by Milton Friedman. It is stated as MV=PT where M is the money supply, V is the velocity of circulations (how many times money changes hands in a given time period), P is the price level, and T is the number of transactions.  Alas Mr. Volcker did not answer the question directly; however, it surely got me to think.

Is the current situation the direct result of fraudulent bank activities?  Did they use unauthorized leverage and create so much free and unauthorized money that we were doomed to bank failures when the economy slowed?  Did the Federal Reserve, who theoretically has control of the money supply, allow this or even encourage this to happen?  Is the current infusion of "new money" necessary or will it just result in high inflation?

Economic theories are just that: theories, which are yet to be proven.  However, the questions that they propose are worthwhile in that they require us to think before we act.

Dr. Pierce, Dr. Stone and Dr. Ullrich - Winthrop University

One of the major reasons my family chose Rock Hill as our home was because it is the location of Winthrop University.  Winthrop brings to this small community a focus on education, a constant stream of cultural events, and a connection with former students around the world. It is also a true economic benefit to the community.  For us at Anderson Griggs it also provides an opportunity to receive input on various theoretical ideas that we are unable to receive from our peers.  It was with this in mind that I invited the three Doctors to ride along with me to Columbia for our meeting with Paul Volcker.

An introduction of each is warranted.  Dr. Barbara Pierce is the Chair of the Accounting, Finance and Economics Department for Winthrop's College of Business Administration.  She earned her Ph.D. from Indian University and has both academic and practical experience in most areas of accounting.

Dr. Gary Stone earned his Ph.D. in Economics from the University of North Carolina. He is a Professor of Economics and the Director of the Center for Economic Education. He also conducts Economic Education workshops for teachers of grades K-12 as well as Advanced Placement Economics teacher training courses. He is the State Coordinator of the Stock Market Game in South Carolina.

Dr. Laura Ullrich is an Assistant Professor of Economics at Winthrop.  She earned her Ph.D. in Economics from the University of Tennessee.  Dr. Ullrich worked as a business consultant for Earnst & Young prior to entering the Ph.D. program.

On the morning of our departure, Justin, our favorite analyst, reminded me to be nice.  His reasons for this are justified.  He often has had to bear the burden of listening to me rant and rave regarding the misuse of economics and accounting.  As always, it's much easier to blame the creators of the economic and accounting theories than to blame myself, a user of accounting statements and economic data. So I made sure to put on my nice hat, and we proceeded.

This trip was indeed a treat for me.  I could mention concepts and they were immediately recognized and discussed, which isn't always the case.  We spoke of the causes of our financial mess as well as the proposed (now real) rescue plan.  We of course came up with multiple sources of blame as well as various solutions for fixing the mess; however, the powers to be were not present to hear our advice.  In any event, we were in agreement that the nation is in the midst of a true credit crisis and that the government is the only entity with the ability to minimize a collapse of the credit system.

One last note - After even the short time that I spent with them, I can assure you that each of these Professors truly cares for his or her students.  I would have been proud to have had any one of them as a professor.

Paul Volcker - Former Chairman of the US Federal Reserve

If you are not familiar with Mr. Volcker, just take a moment to think back to the terrible inflation that ravaged our economy in the late 70's and early 80's. In the midst of this great financial crisis, a bear of a man stepped up to the plate and took action.  Mr. Volcker, now 81 years of age, still looks as though he could dominate any situation.  I can envision Mr. Volcker, at 6'8" tall, standing next to the parties in charge and putting the fear of Paul on them to step aside and let him do his job.  He did indeed change for a short time the direction of the Federal Reserve.  By controlling the money supply, he was able to break the back of inflation and send our economy into a period of growth in output and employment and productivity that lasted for close to twenty years.  Granted, many of you may disagree with this, and instead state that it was President Reagan and concentration on supply side economics that created this boom.  However, without Mr. Volcker's strong stance against inflation, the boom would have never started.

Today, we are in another mess. Not one of inflation, but rather of the possibility of deflation, which is a problem that has not reared its ugly head since the Great Depression.  Mr. Volcker is very aware of this and in his speech was realistic in his comments.  He stated that the plan proposed by the Treasury (it had not yet been passed) is the first step and is necessary for our country.  He also added that it would not stop a recession from happening, but would reduce the impact and shorten recovery time.

Although realistic, Mr. Volcker's presentation also had strong undertones of optimism regarding both the correction of the current economic situation and the future of the United States and its people. In closing, Mr. Volcker remarked, "It's going to be a struggle, but, out of that struggle, we can have a renewed strength and stability in the economy."

This meeting was originally set up to be a small group of Chartered Financial Analysts sitting in a room and talking.  However, because of the current crisis, our board decided to open it up to a few more people, and we ended up with a full room with many others unable to attend.  I started in the investment business during Mr. Volcker's Chairmanship, and have had the opportunity to visit with our current Federal Reserve Chairman, Ben Bernanke, and the prior Federal Reserve Chairman, Alan Greenspan, in a less formal setting.  Therefore, this was a bit disappointing for me.  Without an informal meeting with Mr. Volcker, I felt a little cheated, so I promptly took the steps to meet with him after the event along with Justin and our three guests from Winthrop. If you have ever met Justin, you know that he is as tall as Mr. Volcker.  So there he and Mr. Volcker were, talking eye-to-eye, the two tallest men in the room.  Pictures were taken by Dr. Stone who has assured me that he will send a copy.  We can't wait.

Is the $700 Economic Bailout Plan Necessary?

Is the Bailout plan necessary? Judging from our discussion this month with these experts, the consensus is overwhelmingly yes! But the consensus is also that a recession is imminent and the plan does not provide enough to stop this progress, but rather is a way to get the wheels moving in the right direction.  As you know, our job is to take in data and make decisions based on our expectations.  According to a study completed by The Liscio Report, over the past 37 years there have been 124 banking crises, and in almost every case, the government of each country took actions to mitigate the damage.  Two that received the most reviews were Sweden's in 1991 and Japan's in 1997.  One worked, Sweden's, and one did not, Japan's.  Our politicians when debating whether to pass the Bailout plan have used both of these as examples.

Sweden gets the nod for effectively managing their country throughout the time of crisis.  Their leaders had created multiple layers of imprudent regulation and very short-term economic policies which for a number of years inflated their property markets.   In 1991 the bubble in the property markets burst, and the result was a banking system that was insolvent.  Their approach was to hold the banks and their shareholders personally responsible, and their solution was to buy all the distressed assets from the bank in exchange for ownership by the taxpayers.  The shareholders lost and the taxpayers received some recovery.  There is some disagreement over the results.  Some say it cost taxpayers 50% of the cost (estimated at 4% of GDP) while others say an actual profit was made when the distressed assets were sold.

Japan's approach was a disaster.  After their property bust, the country allowed banks to continue even though they were for all practical purposes bankrupt.  This approach extended the problem, reduced GDP and cost the taxpayers an estimated 24% of GDP.

Of all the examples given by The Liscio Report, one thing is very clear.  Doing nothing in the hopes that the problem will just go away will instead only enhance the problem and require a huge cost from taxpayers. It is important to remember that the taxpayer will pay for this crisis either directly (the Bailout) or through a severe recession with high unemployment reduced asset values, including your investment accounts, your home and businesses.

Our bill is approximately 5% of GDP.  The sad news is that this will not be enough.  More action will be needed over the coming months.  Our Federal Reserve and the Treasury have a lot of power independent of this bill, and I am sure that they will need to use these powers to infuse additional funds.

There is a future and it's good!

Our experts all agreed "this too shall pass" in regards to the crisis. Let's take a not so scientific look at the world and where we are as investors.  This past month, a Treasury Bill traded with a negative yield.   What this means is that someone, somewhere, paid the US Treasury to hold their money.  Short-term Treasury rates are less than 1%.  It's worth looking at the entire yield curve.  Here it is:

Tullet Prebon Information 2008

The amount of funds held in short-term money market funds, bank deposits, savings accounts, and short term CDs has exploded and, as of today, almost equals the total market value of the S&P 500. This pool of money will not stay long at a 0% interest rate.

Equity prices are currently priced at 11x 2009 Estimated Earnings per Share (S&P).

This means that we can buy shares at a price that returns 9.09% on our capital.

The dividend yield on the S&P 500 is 2.45%.  This speaks for itself - You would have to buy a 10 year US Treasury to have an equal amount of cash from your investment.

Price to Earnings relative to the Estimated Earnings Growth Rate is 1x.  This is a measure of value that has represented a buying opportunity.

Mutual Fund investors pulled money from both bond funds and stock funds.  This is a first. People will sell stock to buy bonds or sell bonds to buy stock and this action could be the result of panic selling.

The AAA Rated traunch of many residential mortgage backed securities are trading as if no one will ever pay back these mortgage loans.  The AAA rated traunch of an RMB receives 100 of the principal payment from the best borrowers of home loans.  The default rate on these traunches is very low, another indicator of an irrational market.

We know that during times of panic, irrationality takes hold and bottoms are formed quickly.  Are we there yet?  Probably not... but we are very close.

Until next time,

Kendall J. Anderson, CFA

P.S.  A little marketing is in order.  During September, we posted four market commentaries on our web site at www.andersongriggs.com . In addition there's a link where you can sign up for automatic delivery of these commentaries to your email account, and our monthly letters are also posted for anyone to view.  Clients and interested parties from around the globe visit our site on a regular basis.  If you know of someone who you believe would like to read these letters and commentaries, please invite them to visit our site.