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I read the book Street Fighters to get a real sense of history about the collapse of Bear Stearns. I truly felt that only an industry professional could understand the actual cause of the collapse. A lack of liquidity speculatively fueled by rumor mongering caused Bear Stearns to essentially beg the Federal Reserve for a bailout that fueled a large run on the bank.

There are several key bits of information leading to Bear Stearns collapse, some more obvious than others. I read this from the point of view as an analyst trying to figure out if in hindsight there was any hint that there could be a leading indicator into the failure of Bear Stearns. I have only identified leverage at 30:1 as the smoking gun. There is, however, buried in the footnotes talk of the actual corporate culture of Bear Stearns. The quote “Criticism is not welcome” was given to a higher up subordinate directly out of the mouth of Schwartz. Only an insider would have been privvy to this type of inside information. Though non-public, it would seem that to probe this question with regard to any company’s financial analysis a qualitative assessment of corporate governance would have revealed this fatal flaw.

We all know that leading to the Bear Stearns collapse was a shotgun wedding in which Paulson did not approve of what would have been an initial $10 bid by JP Morgan for Bear Stearns. Upon further review of the balance sheet there was $30 billion of unmarketable collateralized mortgage obligations that would normally be sold to obtain more CDO’s to sell. This process froze during the Credit Crisis, particularly around March 16th, 2008 and caused the liquidity crunch that stopped Bear Stearns from functioning in the market. Coupled with a run on the bank it appears to me that one particular facet could have spared Bear Stearns. Nearly 15 minutes after the acuisition was announced at 7:05 pm on the following Sunday around 7:18 the Federal Reserve announced that they would accept the CDO’s with AAA ratings as collateral for overnight funds. It is my assesment that this would have saved Bear Stearns. Around this time, I issued a statement last year calling these Corporate Liar Loans, which is what they are. Far from worthless, yet without a functioning secondary market to price theses assets, banks would mark to model these securities. The deal with JP Morgan would never have been completed without Geithner and Paulson lobbying for the acceptance of AAA paper as collateral for immediate overnight funding.

As an analyst, what struck me most was the absolute arrogance of Schwartz in all this. By the end of the book everyone was yelling at other saying “You should have sold” (our CDO’s) three months ago, but they refused to take the loss and ended up losing everything. This is surely hindsight, but a point of fact was the former corporate governance mentality of Ace Greenberg that essentially would never hold slightly losing positions. The losing positions, particularly the CDO’s, that caused the liquidity crunch would have been alleviated if these positions were not on the balance and cash was in hand.

During a conference call the prior weekend to BSC’s sale, an analyst had a buy rating on BSC. Understandably so, as the book value was $80, and BSC had closed at $30. JP Morgan made a fortune instantly on this deal. The original deal was announced at $2 with a crown jewel clause of the $1 billion headquarters of BSC. The later deal was upped to $10, which still was astronomically low from the book value of $80 per share.

As an analyst, I would say a much greater analysis of qualitative corporate governance documents as well as higher level interviews would have been a signal that something was amiss. Me personally I’ve long advocated for low debt to equity rations, no more than 20% of net worth should be debt. Just by Modigliani and Miller the company was nearly completely debt, and the costs of financial distress especially for BSC’s debt mispriced.

It has long been accepted that high debt to equity ratios are acceptable in the case of financial companies because of there ease and lower cost of issuing debt obligations. BSC did not have a capitalization problem. They had a liquidity problem. I cannot see the data anymore with any companies after BSC was sold, but I would bet that the current ratio was greatly below 1, meaning their short term obligation far exceeded their short term liquid assets.

I thought the book laid out in an understandable chronological fashion the events of the last 72 hours of Bear Stearns very clearly. I do think that the tangents to explaining the backgrounds of the players involved would have made a much better introduction than jumping straight into the liquidity panic at the beginning of the book.

In the end, the epilogue written with hindsight drew a parallel with the debt leverage ratios and overall economic conditions as the cause of not only BSC’s collapse, but Lehman’s, and AIG’s. I would posit that a combination of greed and hubris caused all of these firms essential demise. There’s no short straw that these were competitive cultures, but somewhere higher up there has got to be some form of humility. If I learned anything from this book, it’s that a good financial analyst explore qualitative somewhat nonpublic sources before making their assessment of a company’s long term prospects. Mainly I read this book to see if there was any way to at least know what was coming. In the end, there was only the smoking gun of intense leverage that caused operations to cease when large institutional clients began to pull money out of the accounts. Know that any company receiving Federal Funds is on the government’s time. What this means as investors is that all TARP receivers are failed companies, and are now controlled by the Treasury and Federal Reserve with quite a few strings attached. Normalcy will only return when the Treasury and the Federal Reserve are satisfied that the funds not only were repaid but that they are sure they will never have to re-issue bailout money again.

As it relates to Bear Stearns, the overnight receipt of funds from the collateralized mortgage obligations if they could be used by an investment bank to tap the discount window would have absolutely prevented BSC from being acquired at brutally heinous levels. This ability to tap the discount window ended a whole culture of investment banking, as more companies then turned into bank holding companies or financial supermarkets.

It’s a quick read, but an essential read if you truly want to understand the credit crisis and what is being done to correct it.

All right, I know what I remember from the internships with brokerage houses the old adage that “If it goes up too fast, then you should sell.”  The general rule of thumb was if it goes up 20% in less than 6 months sell.  by that logic you should be selling, but the antithesis is far more accurate than the old adage.

The market went down too fast, it hasn’t gone up that fast.  The point I’m making is that the market should never have reached around 666 on the S&P500 Index.  It was pure panic selling that caused the market to go down to that level where negative annualized rates of growth were being priced in.  The talking heads that are now short and have been since July of 2007 are merely talking their book to try and get the market to go irrationally lower once more.  They are using the old adage that the market came up too far, too fast as justification for why we are going lower.  This has no applicability in the current market because the fact is the market went down too fast. That means that it is all right to be buying for the long term even at today’s levels, and I warn you that if you wait for us to drift back to 666 on the S&P, I don’t think you’ll ever get your opportunity to buy in, and will be left either in appreciating short positions or in cash if you haven’t taken a position yet with current money market rates lagging the rate of inflation.

There’s very reasonable fundamental value in the market right now, and certainly there’s no reason for it to be going down.  I did post on elitetrader.com under the name bwolinsky that I thought we’d see a little pullback possibly to 87 on the SPY ETF, but I happen to think that will be one of  the last pullbacks you’ll see before we go to around 1000 on the S&P index.

To summarize, while I can appreciate the wisdom of taking profits because of the old adage “it went up too far, too fast”, you have to put in context.  This measure of profit taking strategy I believe was first brought up because brokers had to make money by churning client accounts.  Of course anyone who is short is going to provide reasons why we should head lower, but don’t be fooled by this one, as it does not apply in today’s market, because we went down too far, too fast, not up.

There’s always two sides to economic news.  It can either be net positive or net negative.  The way these stress tests will be net positive is if we find out that the larger banks don’t have to raise capital.  If we find that the larger commercial banks have to go out and raise tens of billions of dollars, what do you think will happen to our markets?

It’s obviously going to be a negative and the market will most likely turn down off this news.  If we can avoid the situation where the larger banks do not have to raise billions, then we will go higher, because the smaller regional banks aren’t large enough to raise billions by themselves or even collectively as much as might be required by the larger banks.  We can stand to have smaller financial entities in positions to have to raise capital, but if the “too big to fail banks” are found to be undercapitalized, we will go lower.  As long as our larger banks, including bank holding companies, do not have to raise capital, this will be perceived as a positive.

The market is positioned anticipating a minimal amount of capital will need to be raised, but if it gets caught off guard when we find out the news, we’re going lower, and could be until the banks raise their capital.

It’s simple supply and demand.  The money that the banks might have to raise will induce selling in order to create an attractive enough price to get stakeholders in these banks to purchase ownership stakes that replenish the underfunded banks.  I wish I could give a definitive answer, but you’ll get it immediately basically when the methodology and the statements in the stress test results are released.

I can guarantee some will be underfunded, and some will be insolvent.  The real question is whether the larger banks that pose systemic risk to our entire financial system are deemed to be solvent.  On that question, I was asked to calculate capitalization ratios for several of our large banks, and most were sufficiently capitalized.

What it all comes down to is exactly how much money is needed in order to get banks back to solvency.  I happen to think that there will be at least one larger bank, that shall remain nameless, that might have to raise tens of billions.  As long as the supermajority of large commercial banks don’t have to raise capital, the market will rally off the news.

I don’t see any price action that would make me say there have been any leaks as to the results of these stress tests.  I would be ready and vigilant to observe any unusual price action the day before in any particular bank, as it would be an indication of whether that bank was capitalized sufficiently or not.

It is a historic time for the market, having rallied so much off of the lows.  I still hold my S&P target of 1000 by the year end to cap off one of the largest intra-annual swings the market has ever been witness to.

Good luck, and happy trading.

I can’t believe Jim Cramer thinks all leveraged ETF’s are good for is knocking down stocks.  Well, by the same vein, they’re good for boosting stocks as well.

As the best pair trader in the world, I can only say that this futile attempt to get rid of perfectly priced market instruments only shows the lack of information in this country about leveraged products.  Futures on stocks and options in particular on stocks, puts or calls, are far more useful than a leveraged ETF if you did desire to manipulate securities.

I believe you will find over time that these instruments greatly improved our liquidity and efficiency.  They have their place and my place for them is in market timing.  I’m not going to say that you couldn’t manipulate prices with Leveraged ETF’s on indexes, but I would also say, even if I did want to leveraged ETF’s wouldn’t be my weapon of choice.  I’d be going straight to calls or puts.  Leveraged ETF’s are not the fundamental cause of the market decline.  These instruments only affect the speed at which markets recognize a miss-pricing.  That does not mean that if someone was so inclined they should keep buying a double leveraged inverse ETF, because, at some point, I guarantee the market will move against them, no matter how much money is out there.

It’s just the fundamental basis of all securities to be perfectly priced.  I can think of plenty of other instruments to use if I truly wanted to manipulate the market, and ETF’s would not be my choice.  Last I checked, I could buy 100 options for a fraction of the cost, but the market maker would still hedge his position by mimicing my order.  I think Jim Cramer’s crusade against leveraged ETF’s is indicative of his age.  He may have thought or even manipulated a price in his day, but all these products do is price securities better.

I have never manipulated prices, and I’m not ever going to, but with Cramer speaking against leveraged ETF’s as a broad swath of the reason the market is down shows his inexperience with such instruments.

The fundamental problem with leveraged ETF’s isn’t what they do, it’s how quickly they do it, and this is not a bad thing when you think about it, especially in this age of instantaneous market assimilation of new information.

It is my informed opinion that we are witnessing a historical reversal in domestic US equity markets.  While I tend to swing trade, my system at the badge below had it’s best week ever.  Not that the news had anything to do with it, but that we appear due for a rebound.


We have come off our lows of 666.79 on the SPX cash index to 842.5.  At one point we were down approximately 26.158%, and have rallied significantly back to only being down 6.7%.  I believe that we have another 20% of upside from here before the end of the year.  I have a feeling that the market is signaling that the Obama administration’s plan, while having its’ flaws, is enough to do the job of getting the economy back on track.

While we certainly have headwinds, the market in its rally from the lows despite horribles jobs numbers that I have posted in the past seems to be shrugging off the bad news.  I think it is presently discounting future good news.  The largest catalyst I can see is being felt through all of the increased government expenditures throughout the world.  The G20 meeting appears to have come to a conclusion that economic stimulus is necessary to promote and re-start our business cycles.

It is my opinion we are in an early stage recovery phase, and while I do expect GDP to be negative this quarter, I think the worst of what we’ve seen is over.  Note that despite the economic numbers being horrible, we are still rallying, and this is suggestive of early signs of recovery.

http://thomas.loc.gov/cgi-bin/query/z?c111:H.R.1068.IH:

This bill is the epitome of the destruction of capitalism and the free flow of capital.  These representatives do not have any idea how detrimental such a tax would be to the very foundation of modern financial markets. The 0.25% tax proposed on every securities transaction covered in the Securities Act of 1934 as well as on all futures contracts will destroy the decrease in transactions costs that have been seen since the decimalization of the stock market.  Any argument to the contrary stating that there is a benefit to this is an uninformed opinion, and would be made by only the stupidest of economically ignorant individuals.

I will add the caveat emptor in that this proposal has been attempted several times in the last decade, and has always been denied.

That, however, covers up the fact that these representatives do not have good economic advisors on their side.  Were we to do a cost benefit analysis of this bill, I would bet millions of dollars and up to the equivalent of world GDP for the next thousand years that this will be the worst disaster in the history of modern finance.

If you do not want to see equity values decline by 99% as everyone flocks towards guaranteed securities like treasury bonds, please contact these representatives and request that they remove this ill-conceived proposal.

It’s not on the senate floor, and probably will never make it there, but the fact it even made it to the house is troubling.  Every single American in particular is at risk of losing nearly all of their life savings through this bill.  Transactions costs have to be minimized in order to provide a free flow of financial information through the proper pricing of securities.  The imposition of this tax creates such a wide margin for valuation that it would be severly disruptive to the assesment of value for institutional and financial managers that are actually the main participants moving the market.

We have seen that the free flow of capital is of paramount importance in this day of instantaneous financial digestion.  Prices move quickly in response to new information.  The imposition of this tax means that the best investment would be savings accounts, and destroy the very fabric of all traditional forms of investment.

While I acknowledge we used to have this tax, I will say that this tax was absolutely an impediment to financial progress for decades where only the richest could take advantage of the mispricing caused by this tax.  We do not want to return to these times, and this will destroy much of the progress of financial markets and pricing that we have seen over the last two decades following the lowering of marginal corporate tax rates by former President Ronald Reagan.

If you do not want to see the only source of saving be your bank accounts with a paltry, non-inflation beating rate of return, please contact the representatives responsible for this proposal of financially unenlightened legislators.

Einstein was always intrigued by the power of compounding.  This post isn’t about Einstein, but a post about how simple outperforming a benchmark is.  Consider this a case study in compounding, and we’re going to examine Berkshire Hathaway’s Book Value Growth relative to the Book Value Growth of the S&P500.  You should never go by past performance as a basis for future returns, so given that this is the only company in the world that beat the S&P500 Book Value growth rate over this long of a period, I figured that it was a superb example to expand on compounding with.

The following table shows the outperformance of Berkshire Hathaway’s Book Value Growth to S&P 500 growth with Dividends included from 1965 to the end of 2007.

Berkshire’s Corporate Performance vs. the S&P 500, Annual Percentage Change

(1) – in Per-Share Book Value of Berkshire

(2) -  in S&P 500  with Dividends Included

Year ……..                                                         (1)  (2)  (1)-(2)
1965 ……………………………………………. 23.8 10.0 13.8
1966 ……………………………………………. 20.3 (11.7) 32.0
1967 ……………………………………………. 11.0 30.9 (19.9)
1968  ……………………………………………. 19.0 11.0 8.0
1969 ……………………………………………. 16.2 (8.4) 24.6
1970 ……………………………………………. 12.0 3.9 8.1
1971 ……………………………………………. 16.4 14.6 1.8
1972 ……………………………………………. 21.7 18.9 2.8
1973 ……………………………………………. 4.7 (14.8) 19.5
1974 ……………………………………………. 5.5 (26.4) 31.9
1975 ……………………………………………. 21.9 37.2 (15.3)
1976 ……………………………………………. 59.3 23.6 35.7
1977 ……………………………………………. 31.9 (7.4) 39.3
1978 ……………………………………………. 24.0 6.4 17.6
1979 ……………………………………………. 35.7 18.2 17.5
1980 ……………………………………………. 19.3 32.3 (13.0)
1981 ……………………………………………. 31.4 (5.0) 36.4
1982 ……………………………………………. 40.0 21.4 18.6
1983 ……………………………………………. 32.3 22.4 9.9
1984 ……………………………………………. 13.6 6.1 7.5
1985 ……………………………………………. 48.2 31.6 16.6
1986 ……………………………………………. 26.1 18.6 7.5
1987 ……………………………………………. 19.5 5.1 14.4
1988 ……………………………………………. 20.1 16.6 3.5
1989 ……………………………………………. 44.4 31.7 12.7
1990 ……………………………………………. 7.4 (3.1) 10.5
1991 ……………………………………………. 39.6 30.5 9.1
1992 ……………………………………………. 20.3 7.6 12.7
1993 ……………………………………………. 14.3 10.1 4.2
1994 ……………………………………………. 13.9 1.3 12.6
1995 ……………………………………………. 43.1 37.6 5.5
1996 ……………………………………………. 31.8 23.0 8.8
1997 ……………………………………………. 34.1 33.4 .7
1998 ……………………………………………. 48.3 28.6 19.7
1999 ……………………………………………. .5 21.0 (20.5)
2000 ……………………………………………. 6.5 (9.1) 15.6
2001 ……………………………………………. (6.2) (11.9) 5.7
2002 ……………………………………………. 10.0 (22.1) 32.1
2003 ……………………………………………. 21.0 28.7 (7.7)
2004 ……………………………………………. 10.5 10.9 (.4)
2005 ……………………………………………. 6.4 4.9 1.5
2006 ……………………………………………. 18.4 15.8 2.6
2007 ……………………………………………. 11.0 5.5 5.5
Compounded Annual Gain – 1965-2007 21.1% 10.3% 10.8
Overall Gain – 1964-2007 400,863% 6,840%

Let’s think about what it means to beat the S&P500 on average 10.46% annually.  There’s taxes, as are described in the link this table came from can be seen at http://www.berkshirehathaway.com/2007ar/2007ar.pdf

Compounded Annual Gain – 1965-2007

21.1% The final compounded growth rate comes to 21.1%, or growth period on period of 400,000+%

10.3% Growth from the S&P rounded off is approximately only 6,800+%

10.8  This last number is Berkshire’s compounded outperformance, which will differ from a simple average because I was using a geometric mean.

Overall Gain – 1964-2007 400,863% 6,840%

Folks, I know that Berkshire’s results are extraordinary, but there are people operating at collective2.com that have built systems that I believe have long run viability that will absolutely decimate the S&P500 over long periods of time.  Yes, I myself run such a system which can be visited at www.collective2.com/go/pairsqidqld .  The fall to this site is that people believe that in coming there rather than to a professional that they will achieve instant success or wealth.  The fact is, that when you understand that all investments are based relative to benchmarks, then you start to understand that it is a long run race that we’re in.

While buy and hold most likely is a succesful strategy, on a risk adjusted basis we must conclude that it is not relative to even placing money into SPY or even QQQQ or the DIA.

I’ve found over the six years of creating strategies that my biggest obstacle may have actually been myself.  This year the pairs system I run was only up 1.5% approximately.  What hit me at the end of the year was by how much the S&P 500 had fallen.  The outperformance I calculated at the end of the year was 3,980 basis points.  I’m saying that based on this, I had an outstanding breakthrough year, as I had beaten the S&P500 from March of 2007 by substantial amounts as well.  All of these figures can be seen at the link above, but what I’m trying to get across is not actually that you should subscribe to me, because there is substantial risk involved in managing a portfolio that cannot be seen by the statistics, but that the number 1 factor that is not accounted for in my results on that site is the psychology.  Your biggest enemy when you construct a long term financial plan has more to do with your psychology than about the system or plan you may have developed.

Yes, I’m an experienced trading system developer, but I don’t believe I’m that unique in the sense that most investors are of the same mind.  We expect to sell at the highs, and buy in at the lows.  We hold our financial advisors accountable for doing this, when it’s not actually the job of the advisor to buy and sell perfectly.  Mainly what your understanding should be with an advisor is that they will attempt to outperform your benchmarks.  If you’re aggressive, most likely your benchmark will be based on the S&P500 and other 100% equity benchmarks.  It is a rare advisor that can beat the S&P by even 1% annually over ten years.  For the past couple years, I can safely tell most of my clients that I have beaten the S&P 500 substantially.  Once you have this sort of understanding with your financial advisor, you become a lot less concerned about day to day fluctuations, because the simple fact is that no matter where you could have put your money this year, you would have lost, save for holding cash and bonds that will not outperform inflation over the next 5 years.

Where then do I suggest you put your money?

I strongly suggest you put your money with independent investment advisor representatives like myself that have taken the time to construct long term portfolios based on your specific needs and circumstances, with assurances that it will be re-allocated as needed on a regular basis.  Most advisors, that is, namely brokers, are loyal to the firm and not actually to their clients.  I’m sure some would dispute that, but it’s the very difference between a “BROKER” and an “INVESTMENT ADVISOR.”

Without giving too much away, every client I have is different, and are always in different situations than anybody else.  Most plans from advisors are cookie cutter and come in a box.  Having passed Level I of the CFA Curriculum, I’ve become a master of asset allocation, which is the very thing that Buffet describes himself as.  He has said he calls himself “A Professional Asset Allocator.”  That’s what I want you to think of myself and any other advisor you might work with as.  You’ll know when they present to you if they’re talking about asset allocation the way it’s meant to be thought of, which includes being relative to a benchmark as well as evolving as you pass through each life cycle.  I’ve picked up more clients than I thought possible by the simple fact that many advisors do not meet with their clients regularly to find out if circumstances have changed.  I’ve changed portfolios over 10 times with each of my clients in the past 2 years.  Mostly these were asset manager changes, but the pie was split up in the areas that were doing well and backed off from underperforming managers.

I place trust with my managers, but it isn’t really an advisor’s job to buy and sell at the right time.  Generally, we will have opinions that coincide with others that it may be time to buy or sell, but beating the benchmark is our primary focus.  I’m saying that a good advisor is absolutely like Buffet.  Buffet chooses stocks for the management and their ability to earn profits with their capital.  The reason I chose to be an advisor in the first place was that I have this ability as well, and it all comes down to picking the managers for my clients that will outperform their benchmark relative to my clients and the benchmark’s expectations.  I choose managers based on whether they hold stocks that I would be comfortable holding if the market shut down and then re-opened in 10 years.  One of my asset managers does hold Berkshire Hathaway stock, but it wasn’t the fact that he held this company more than it was about the fact that the portfolio held stocks in it that have done superbly well over the last 30 years, and were in synch with my own personal preference for purchasing domestic value stocks.  As a side note I also have a manager in International Stocks that was very bullish on Brazil for the past 8 years, and you can just see a chart of the Bovespa to see how well he did.

Once you accept that your investments are correlated with macroeconomic factors like domestic and global GDP, CPI, and Fed Interest Rates then you come to a realization that money will nearly always be made or lost relative to the market.  As long as you can conserve capital and keep pace with the benchmark, I know you’ll outperform nearly everybody over time.  I’m not suggesting a strictly ETF allocation, but that proper thought is given prior to investing and entrusting an advisor with your nest egg.

I am confident that even though my business started during a recession, that because most clients have lost a lot less than the S&P with some even making money (thanks, Bonds) that my clients are doing fantastic when you understand the power of compounding relative to the S&P500.

Now that 2008 has gone down in history as one of the worst years the market has ever seen, I thought I’d post about the heart of the problem.  Down to the individual, our country has a problem with debt.  Debt enables us to purchase goods and services, but also enslaves all earnings after we incur the debt to the debtor.

I posted on my blog the following quote, and I thought about it for a little bit and decided that it’s very appropriate as a summary of the market in 2008:

Would you hold overnight positions at 4 times your equity every single day of your life? I doubt it, but some companies leveraged themselves 20 times equity every day of the quarter, and it just took that one quarter to send their stocks to 0.

I believe this quote is exactly why we’re in the situation that we have right now.  It’s not mutually exclusive to financial companies, however.  It’s not even exclusive to corporations.  It seems even individuals have problems with their debt ratios, as we see in the housing market and for unsecured credit card debt.

The problem I see with Americans in particular is that we have the ability to finance substantial desires that have the potential to bankrupt us if something unexpected occurs.  Here’s an example at the individual level:  I have no debt, but I don’t have insurance.  I get into an accident and require major surgery.  Immediately you are abjectly bankrupt from the $25,000 to $50,000 expenditure that comes as a hospital bill.  This is understandable for an individual, sure, but corporations for the last decade have gorged themselves on debt.  So much so that it is equivalent to saying I make $50,000 and I have $50,000 in the bank.  I decide I’m doing well and borrow $1 million to loan to my friend at a higher rate than I was loaned the money, earning what I believe is a risk-free spread between the two.  When my friend is unable to pay, I suddenly own whatever he bought, and it becomes my obligation.  The problem is that whatever my friend bought is now worth half of what it was.  The catch is that my friend might have chosen voluntarily to walk away from his purchase and stick me with the bill.  Both parties lost everything in this situation.  You might say this is exactly the nature of a sub-prime loan, and this is primarily what has caused the market to collapse, but this ignores the fact that I should have charged substantially more for the loan in the first place.  I basically miss-priced risk, but more on that later.

When we issue debt or go to buy a bond (which is also a loan, either to governments, individuals, or corporations), we seem to have miss-priced risk.  I believe risk management is a fallacy.  Most risk managers trust “experts”, like debt rating agencies, but the catch and the gotcha really comes when you find out how risky the loan you made actually was.

The main point of this post is that as long as everybody, either corporations, individuals, or governments do not stop financing everything through debt, then essentially all we have left is a worthless IOU.  Sure there are cases where it’s collateralized, but even then, if it was not appraised correctly in the first place, we miss-priced risk and lost substantial amounts of money.

At the personal finance level I don’t believe many Americans are well behaved in this regard.  So much so, that even when the average American runs a behemoth corporation like Lehman, Bear Stearns, Ford, or GM, we pretend like debts will be magically repaid.

Work goes into paying back debt, but a lot of the work that goes into repaying the debt fails to account properly for an adequate level of return.  The Golden Rule of Corporate Finance is: Are we investing the firm’s capital in investments that our shareholders do not have the capacity to invest in as well? Corporate America in 2008 got this question dead wrong.  For that, our debt snowball finally caught up with us at the bottom of the hill and crushed our economy.

I’m not saying debt is bad, but that it has been misused for too long in our economy.  So much so that I’m extremely dubious of any company with a current ratio below 1 and would go so far as to say that any company with a debt to equity ratio above 1 actually has a negative net worth.  For the lay person, this simply means that all of your whole net worth is less than the size of your debts.  That’s not bad by itself, but the kicker is that the debt requires payments in excess of the money you bring in.  In Corporate America, this usually violates the debt covenants and triggers a technical default.

Ford, Lehman, GM, Bear Stearns were and are all in technical default.  They have negative net worths.  We know Lehman and Bear Stearns are no more, but no one saw this coming until it was too late and what little liquidity there was dried up.  In the case of F and GM their losses on a per share basis are more than double their market cap.  This implies that they are bankrupt.  F and GM shouldn’t be saved, because they behave like teenagers with their money, aside from the fact that no one wants to buy their cars.

It’s been difficult to tie personal financial behaviours with Corporate America, but on both, when you understand what it means to be in debt, neither the individual or the corporation emerged from 2008 profitably.

My hope for 2009 is that Corporate America starts to behave itself with regard to debt financing as well as executive compensation.  Any company with debt to equity ratios exceeding 5:1 I believe are violating their fiduciary duties to the company, because these are unreasonable levels of debt.

The old adage is that debt is cheaper to issue than equity because of the tax savings inherent in the interest payments.  The fact is that with debt to equity ratios at these levels, when you’re paying 5% in interest, you have to earn 25% on your assets to cover the interest.  Is there any company out there making that much on their money consistently to the point that you’d bet on your ability to make the payments for the next 30 years?  Probably not, however,  I’m not saying that there isn’t, but I’m saying the average company and individual in 2008 is engaged presently in this sort of over-leveraging.

I would want my investors to come to me with all debts paid off, and I’m of the mindset that there are only 3 things in this world worth borrowing money for because they increase your productivity capacity.  Those are 1) House, 2) Car, 3) Education.  Everything else should be paid for with cash, and all corporate growth should be financed organically.  For you high net worth individuals, jets are never to be purchased under any circumstances and neither should boats.  If you do a cost benefit analysis 99.9% of the time you’ll find that they don’t improve your productivity.  In the rare case it does there’s only a marginal benefit.  Boats and Airplanes are for renting, not owning, and that goes for corporations as well.  (Note that it’s different if you’re an Airline Company or plan to open a private Airline).

The best performing companies in 2007 were ones with squeaky clean balance sheets, and did well until mid-2008.  Most of these were technology companies, like Apple, Research in Motion, and some other tech bellwethers. I found very quickly in 2007 that companies with no debt of any kind, and high returns on equity are very well positioned to capitalize on opportunities, because their earnings accrue to the shareholder, and not to the debtor of the company.  I absolutely urge any reader to sell any stocks with long term debt.  Buffet states this as well, and while it’s true that this increases the leverage of the assets, you should see in 2008 that the debt financing is what caused our economic collapse.  So please be warned in advance.

I know it was a very long post, but in 2009, I believe we’ll see a rebirth of the proper use of debt to finance growth.  I find that companies that have to closed stores not only did so with debt, but also received negative returns on their stores.  This makes these companies as corporations to be avoided in the near future, because it suggests that management does not know how to analyze opportunities correctly.

I believe 2009 will be an up year, and I think Americans will be better behaved financially, both at the individual level as well as the corporate level.  Best of luck in 2009.

There’s plenty of blame to go around. I don’t see one convincing argument over another for the culprits: You could pick either 1)Bill Clinton 2) US Congress 3) Jimmy Carter 4) Alan Greenspan 5) Probably less convincing is the Bush Administration for lack of oversight, even though they were shouted down when they attempted to regulate this part of the market 5) Hank Paulson or Fed Chief Ben Barnanke.

It’s a comedy of errors that reads something like, well this happened, then congress did this, and Greenspan didn’t know what he was doing by putting rates so low even though we came out of the recession, and the Bush Administration didn’t regulate (hands off, you know), etc. Then pull it back to as far as Jimmy Carter and lesser so for the Clinton Administration.

It doesn’t matter what happened. I think we can stop that from continuing, so we must look forward.

I keep seeing talk of dow 5000 or dow 6000 or dow 7000. I’d be shocked to see any of them. Fundamentals say we should be a lot higher, but that’s not enough to take us back to the highs. We are now governed financially by emotions of very rich but hurting and bleeding equity management institutions. They know they shouldn’t be selling, but they have to meet their redemption orders and so must sell. It’s not their fault that their own finicky investor base is in a panic with the rest of the market.

I certainly think if we do hit either dow 7000 or dow 6000 that it will be but a fleeting moment in time before I see dow 30,000 by 2030. Don’t lose sight of the fact that we will come back from these. I don’t buy the argument that “this time it’s different.” That’s financial heresy, because something like this has always happened. I’ve heard it being compared to 1800 style recessions. I think out past 12 months from now, we’ll be at least to dow 11,000, maybe dow 12,500 to the old high of the dot com bubble.

The GDP data is being tainted with housing price depreciation, and we absolutely must be backing that out of the data, because it was a bubble, so it’s probably not a good predictor of future economic conditions. This goes along with the deleveraging argument that you hear thrown about on TV. I don’t buy that argument either, because we can’t really deleverage much more than this when there are a lot of financial institutions that have already gone under and don’t have much in the way of assets left to sell on their balance sheets.

I specifically see that the PE ratios are at about 10, when historically, they should be at 15 for reasonable growth rates. The argument goes, “but earnings will be lower”, sure, but if you take them lower when you’ve lowered earnings guidance by 50% or more already, what are we talking? Every company makes no profit? Not likely. New leaders that I expect to see re-emerge are Energy companies and basic materials. I happen to believe that the Chinese stimulus package will introduce a new wave of oil and commodities hoarding seen by the Chinese Communist Government prior to the Olympics. There is speculation that I deem to be accurate that the Chinese were buying Oil and other commodities to not have to pollute during their time as the Olympic epicenter. (I’m sure their gymnasts weren’t 16, but they put on a good show, anyway). This lead to that run-up, and I definitely believe this is on the horizon.

While it is true at this moment that Commodities are down, while they could stay down, the cyclical nature of these companies suggests they will be the trigger to take us higher.

We need to remember what indexes the DOW and the S&P are. Most of the S&P used to be financials at about 20%. That index has declined by about 70% so financials aren’t as big a part of the indexes as they used and single handedly account for about 14% of the market decline. The rest I stick to Commodities and Energy with Oil dropping by about 2/3’s from $147 to $60. That used to make up for 25% of the S&P 500, and has declined at least 50% from their highs, including international stocks, especially in Russia. There’s 12.5% of the market decline.

Where are the rest of the declines coming from? Wall Street’s “go-with-the-flow” pessimissim. They’ve assumed that because financial and energy companies will have declining earnings that it must be true that other consumer companies will have earnings declines. In this environment, I can see WMT gobbling up more market share from other higher cost producers such as Target or Costco. Costco will do all right because in some cases they are the lowest cost producer, but for everyday items with groceries I can see WMT gaining the lions share of the market share losses they put onto other retailers and grocery chains.

So, I guess I’m saying that I expect Oil and Energy companies to be first on the rally list. Financials will take so long to recover because of trust issues, that I can’t see them being a leader for at least 7 years. The consumer cyclicals and especially technology companies will continue to dominate in their respective fields. I don’t see CSCO losing customers, and I can’t imagine Apple will stop being the market leader in consumer electronics anytime soon. I kind of categorize retailers as different animals. I won’t touch companies closing stores, because it shows that they invested too much in capital expenditures, and got no return. This suggests their management is not only not conservative, but also has extremely imperfect information when it comes to selecting locations to sell products from. These aren’t good management tenets to look for in companies.

Once materials catch up with Energy, I think that’ll be a signal that the consumer is coming back. The political landscape I can’t see having an impact on anything but pharmaceutical and health care companies. I don’t think any problems will be seen for energy in this arena.

What’s the catalyst?

A very good question. The best analysts know their catalyst. I think I’ve picked mine as a re-emergence of commodities and oil prices from anticipated expenditures from China’s stimulus. When it is released, we should see a pickup in imports into China from China’s perspective of oil purchases.

How will International Stocks perform in this?

It all depends if they are domiciled in a free market, democratic, capitalist country. Everyone can see the writing on the wall in Russia, so I’m not even going to go into that. I think Pakistan is still ruled by a dictator, even though he is one friendly to the United States. I’d avoid any non-Western Country, because I prefer zero political risk. Though there is some, I prefer to think if it’s democratic and capitalist that it has no political risk of nationalization or royalty, rent-seeking governmental behavior. If those conditions are met, couple them with Buffet’s tenets that it be a company that has a net worth of at least $500 million and pretax earnings of $70 million. Anymore I’m beginning to wonder if Buffet has lost his touch, but probably not, and I’m certainly not a critic. So, to summarize, given the political climate is similar to the U.S. and barring a push to nationalize industries or other royalty, rent seeking behavior, I don’t mind investments in that kind of country, because it will be based more on company fundamentals allowing easier analysis.

I guess I made up for a lack of posting. But each post has a lot of information in it already, and this one is no exception, but most of the beginning I’ve already touched. The new catalyst may not only be China, but our own fiscal stimulus packages.