Mr. Arnold’s phrase is not an entirely new idea, but it is a particularly timely idea. In the current investment climate, no prudent investor can afford to ignore what’s happening to a company’s balance sheet. A company’s financial position will often weaken first. Then, the market will crush the stock. Therefore, if you keep a close eye on the financial health of your investments, you have an early warning system about danger for the stock price.

Credit has become a more important investment influence than at any time since 1998, when the Asian crisis hit. In the summer of 2007, the subprime crisis finally unsheathed its sword. A number of subprime investors suffered mortal wounds, leading to massive losses. Since then, the crisis has only widened and deepened, spilling over into other areas of the economy. It looks certain to toss the U.S. economy into recession, if we aren’t there already.

With these thoughts in mind, I put in a call to Egan-Jones last weekend. Mr. Arnold called me back and we chatted as snow flurries swirled just outside the window of my study, dancing around the old dogwood tree. Arnold emphasized the imperative of analyzing company-specific credit trends, not only to avoid risk, but also to recognize opportunities that the equity market may be missing.

So credit analysis can sometimes provide a treasure map, instead of warning buoy, you might say. What are the credit markets telling us today? Where are the risks and where are the opportunities?

With Egan-Jones as our guide, let’s take a look at today’s unstable stock markets and see what signals the credit markets are sending our way. We’ll look first at the sunny side of the omelet…

The credit markets are still in lockdown mode. Before August 2007, money was easy. If you wanted to finance a leveraged buyout, people would throw money at you. Not any longer. Now, finding that easy money is like getting a drink during Prohibition. It will cost you.

As such, the list of improving industries is really short. It’s basically energy and energy service companies. But especially, Egan-Jones reports, the domestic producers. They are unaffected by geopolitical troubles and have more natural gas exposure. Egan-Jones views the latter as a positive given the wide swings and uncertainty in oil prices.

In the energy service sector, credit quality is strong across the board, Egan-Jones notes. The risk here is that companies might squander their credit on expensive acquisitions. Overall, though, the financial strength in the energy sector is improving. If credit precedes common, then you’d expect the stock prices of the group to stay strong, or at least to weather the turbulence better than the rest.

Outside of the oil patch, however, most industries rate neutral, such as the pharmaceutical, retail, chemical, and auto part industries. These neutrally-ranked industries have a swirl of good and bad things going on. Investors will have to pick carefully to be among the “good” names. One example of the dispersion of results from the auto supplier sector: BorgWarner had great results recently, pushing its stock to all-time highs. ArvinMeritor, on the other hand, swung from a profit to a loss. Its stock hovers near 10-year lows.

Let’s look at the declining industries…

Many of these you’d expect. Insurance is a bad one right now. The mortgage crisis has hit most insurers with losses in their investment portfolios. Many of them now face a wave of mortgage-related claims and writedowns. Egan-Jones is very bearish on insurers.

The banks aren’t any better off. As the recent wave of mega-billion dollar writedowns illustrates, most of the large U.S. banks possess a very thin shield of capital to protect them against insolvency. Leverage is the biggest part of the problem. Many financial intuitions use titanic amounts of leverage. Consider that Fannie Mae has only $40 billion of equity supporting $840 billion in assets and another $640 billion off balance sheet, hidden in the folds of the footnotes. This whole sector is a disaster.

Egan-Jones also warns against broker and finance companies. Companies such as Morgan Stanley and Bear Stearns reported their first quarterly losses in company history. Many of these companies will need capital infusions, probably from Asian Sovereign Wealth Funds or from deep-pocketed Arab funds. Auto manufacturing, homebuilders and cable television/media companies round out the declining industries.

Interesting note on the homebuilders: In 2007, write-downs overwhelmed profits for the industry as land values fell. Egan-Jones points out the specific case of Lennar Corp., which sold a property portfolio for 40% less than the value of the property on Lennar’s balance sheet. The company had to book a $475 million loss as a result. Bad stuff still brews in the land of homebuilders.

I should add that there are good reasons to pay attention to Egan-Jones. For one thing, unlike competitors Moody’s and Standard & Poor’s, Egan-Jones does not receive money from the companies it rates. Egan-Jones is simply a subscription service, like my investment letter, Capital & Crisis. Therefore, it is truly independent.

Not surprisingly, independence is an extremely valuable attribute in the world of credit analysis. A recent study relates: “Credit ratings from Egan-Jones more accurately reflect information in the marketplace and are frequently up to 237 days ahead of actions taken by Moody’s and S&P.”

In short, if you buy the notion that “credit precedes common,” you’ll want to hang onto your energy stocks and tread carefully in the mortgage-lending, insurance and brokerage sectors.

The message from Egan-Jones is quite clear: If you invest in the stock market, you cannot afford to ignore the credit market.

Regards,
Chris Mayer
February 26, 2008

How Credit Effects the Market was originally featured on Whiskey and Gunpowder

Why is this happening now? Here’s my theory: Dec. 31 is a major day on the financial calendar. If you take a sample of bonds, you’ll find that a disproportionate number of them are due for interest and/or redemption on Dec. 31. Redeeming bonds is very cash intensive, and cash is not freely available in the banking system right now.

So it seems likely that some frantic finance directors will be working long hours to find the cash that will enable them to avoid a default next week.

If that’s right, the festive season could see the announcement of some nasty shocks. June 30 won’t be much fun, either, for the same reasons. The credit crunch is deepening, and will continue doing so until at least next summer.

For those of us who like to take responsibility for ourselves (it’s called freedom, by the way), it’s getting just a little tiresome that money creation is diluting our savings and making us pay — again — for the excesses of the buy-now-think-later generation. Some of us would prefer to see the government react with a shrug and a sympathetic “bad luck” to the losers in the next financial train wreck. But it’s not the mood of the nation. Politicians have begun one of their competitive caring phases, and they’re rescuing victims everywhere. Every clapped-out bank, every busted pension scheme, every industrial zombie, and absolutely every government department will be nurtured in the warm embrace of the public purse.

This causes a natural backlash. Issuing new money reduces depositors’ returns, prompting savers to switch to better stores of wealth. This capital flight should be easy to spot, but modern economic statistics can obscure it. You see, the main way economists measure economic health is by counting the money spent in the economy, and now that savers are dumping currency (and buying better wealth stores), the effect is tough to distinguish from the economist’s beloved GDP growth. Our healthy GDP figures are a distortion, and the economy is not making a steady booming noise, but an ominous hissing — the noise of savers abandoning the currency.

You can see this at the key entry points to the real economy:

1. Oil is multiplying in price.
2. All the grains are multiplying in price.
3. All the base metals are multiplying in price.
4. Gold is multiplying in price.
5. Producer prices are through the roof.

In spite of this, the monetary authorities are racing to issue more money, and economists are clamouring for cuts in interest rates. They’re caught ‘twixt the devil and the deep blue sea, because although they could address these serious inflationary indicators, doing so risks the revenge of a giant economic threat — a rout in the housing market. And that would mean depression.

So it looks increasingly likely that low rates are staying, and the hot global investment money, sucked in by Britain’s recent and comparatively high interest rates, is about to quit Britain and send the currency into a tailspin. This produces higher prices for imported goods. At the same time, our public finances are in a serious mess, and the biggest contributor to our service-based economy — London — is the main victim of current turbulence. And please don’t ask about the trade figures, because they’re just ugly.

It is becoming genuinely possible that people will refuse to hold sterling for more than a fleeting moment. Inflation could turn so severe that the “hyper” prefix is justified.

I know — it’s too far-fetched to be believable. Or is it? For 150 years, the values of Western currencies have stayed way above purchasing power parity levels with Asia. Being a developed country is what drove this premium, as money flowed down a one-way street to our advanced economies. These were the only places where sophisticated products could be built or bought.

Today, things are different. You could measure circuit board production in two factories in Indonesia and in Britain and get the output per worker priced in local currency. Multiply both by their conversion rate into U.S. dollars and the British factory seems to have produced five-seven times more U.S. dollar-denominated output. So our GDP looks good, but only through the distorting lens of a Western currency conversion. There’s another way to measure that same output: Simply count the circuit boards. Do that and you’ll see there’s no material difference in productivity between a British and an Indonesian worker. Perhaps the root cause of Western currency premium has evaporated, and the anomaly is now that sterling really is five-seven times overvalued against Asian money.

You could switch to euros. But looking at the EU’s policy, it’s creating as much money as the Bank of England. And the U.S. Federal Reserve is doing it too, while all of Asia is battling to hold down its currencies so that its exports can continue apace. It’s a bizarre race to the bottom for the world’s currencies.

It’s time to sidestep the financial consequences of this largesse. What can we savers do?

If you’re as bothered as I am, currency should be struck off your Christmas list and replaced with something more reliably rare. I think gold could soon look so highly priced in sterling that many of us will be too frightened to buy it. But it isn’t there yet, so perhaps buy just a little now, and if it makes you a small profit, it will be easier to buy a little more next month. If that makes you a profit too, allow yourself to build a proper stash. I’m not sure we’ll ever again be able to buy it for much under £400 per ounce.

I have just instructed my bank to transfer all my remaining cash deposits to BullionVault to buy gold, and I look forward to spending 2008 long gold and completely sterling free.

Regards,
Paul Tustain

December 27, 2007

An Imminent Collision was originally featured on Whiskey and Gunpowder

Last month, All-Star third baseman Alex Rodriguez opted out of his contract with the New York Yankees. The 32-year-old slugger, already the highest-paid player in the majors, is coming off a very productive year in which he is sure to win his third American League MVP award, and is in line for a huge payday. The same week, Merrill Lynch’s CEO Stanley O’Neal stepped down from his position with the wealth management giant and left with $160 million for his trouble.

As teams around baseball will scurry to try to come up with enough money to entice Rodriguez to join their team, Merrill Lynch will also be competing to woo a financial rising star to play for them. In both cases, there’s a lot of money at stake, and it may be hard to prove whether or not that money will ultimately buy success.

Laurence Fink, the CEO of BlackRock, a major American investment firm, is the No. 1 candidate. This is not the first time that Fink’s name has come up as a possible CEO candidate, and the financial star is having to deal with the same kind of rumor and innuendo that is usually saved for the sports section. So far, Fink claims that he is happy with his position at BlackRock, but Merrill has reportedly given him two weeks to make up his mind.

Fink has been the CEO of BlackRock since 1998 and has successfully led the company for the past decade. Regarded as a whiz kid early in his career, Fink has been largely lauded for his early success with mortgage-backed securities in the 1980s. The irony of Fink possibly succeeding O’Neal is twofold: his success with mortgage-backed securities — seen as O’Neal’s biggest failure — and the fact that Merrill Lynch purchased 49.9% of BlackRock under the management of O’Neal. Before this summer’s credit crunch brought everything crashing down around Merrill and O’Neal, his investment in BlackRock was thought of as the former Merrill CEO’s greatest success.

While Rodriguez flirts with the idea of playing for different teams next year, Fink also has his options open. Buckling under the same pressure experienced by Merrill Lynch, last week Citigroup Inc. parted ways with its CEO, Charles Prince. Citi, the largest bank in the United States, also seems to be in the market for Fink. This isn’t new for Fink, as he was rumored to be in the running for the top position at Morgan Stanley in the past.

While there is no doubt about Fink’s impressive track record as head of BlackRock, one can’t help but wonder whether or not his talents are being overvalued by Merrill Lynch and Citigroup. Can someone who has never managed an institution as large as Merrill be the savior that they are looking for? Could someone from inside be more appropriate to take over? During O’Neal’s tenure with Merrill, he was known to get rid of executives that did not perform up to his standards. O’Neal periodically got rid of many high-ranking executives, many of whom would probably be considered as possible successors to O’Neal himself. This has led to a dearth of executive talent at Merrill and a blemish on the resume of many executives who worked under O’Neal.

Now Merrill has no choice but to headhunt a star officer from outside. If it is successful in landing Fink, it will find someone who does not have the experience of leading a company the size of Merrill. Fink is also someone who is fundamentally different in his managerial style than O’Neal. O’Neal was largely praised for his ability to take on high-risk, high-reward decisions. One that paid off was his investment in BlackRock. Unfortunately, O’Neal rolled the dice again and spent $1.3 billion for First Franklin Corp. First Franklin was one of the originators of subprime mortgages, and its purchase by Merrill in January 2007 came just months before the words “subprime” and “crisis” became synonymous.

Just as in sports, you are praised for a decision that works and fired for one that doesn’t. O’Neal went from being a savvy risk-taker to an out-of-work millionaire in a matter of months. Fink, on the other hand, is known for his aversion to risk, someone who will not be praised for his aggressive decisions but will most likely not have to enter into forced retirement because of his gunslinging style. If Merrill Lynch thinks that this fundamental shift in management style will get the company to where it wants to be, then by all means, it should offer the kitchen sink for Fink. If not, then it may consider trying to rebuild its company from within, using an executive with the knowledge and experience with the firm that will surely be needed.

Fink’s cash compensation for 2007 is valued at over $34 million, and if he takes the same position at Merrill, that number is likely to rise. That kind of money is comparable with that of sports’ most talented athletes and is almost unfathomable to the average American. Where does all that money come from, and is one person really worth it? Merrill Lynch certainly must think so — these kinds of figures are nowhere near unique when it comes to highly powerful corporate CEOs.

The Boston Red Sox, Chicago Cubs or Los Angeles Angels may be willing to pay Alex Rodriguez $350 million, but that will not promise a World Series. Merrill Lynch is also trying to get back to its winning ways, but that is not guaranteed to happen by poaching the financial world’s hottest free agent. It takes more than one man to really build a winner, and a company that’s trying to build itself back up may want to try and fix things from the inside first.

Until next time,
Jamie Ellis

November 7, 2007

The Hot Stove League was originally featured on Whiskey and Gunpowder

The price of our favorite yellow metal, although it’s surely a telling commodity, isn’t the most compelling thing that I have been noticing over the past couple of weeks.

I am exposed to many different mediums of information. I read several economic journals. I keep myself aware to what the talking heads are saying on Bloomberg and CNBC. I also listen to what people are saying in order to keep a feel of what Joe Sixpack’s mentality is towards the markets.

These mediums all have one thing that has been very consistent, and very worrisome.  They are telling me that the markets are once again feeling invincible, and with that we have seen a reemergence of an appetite for risk.

It’s amazing how short some people’s memories really are. The mentality surrounding the markets today is eerily similar to what it was in July before the 10% correction in August. The rhetoric I have been hearing these past couple of weeks is also far too similar to that of 1929.

So how does something like this happen? How can so many irrational investors drive markets in the wrong direction? Is that the case, or is it that we’re in the midst of an equities bull market and I’m just missing out on all of the profits?

The Credit Market’s Effect on Equities

I’m sure you are aware of the recent record highs set by the DOW and S&P. I happen to be under the opinion that the credit market is driving equities. It is definitely the culprit of the August sell off. With that belief, I have to look forward to both housing and credit to decide on the direction of equities.

I don’t need a crystal ball to tell you that we have only seen the tip of the iceberg when it comes to turmoil in the credit markets.

This recent period of time has been a telling one for the investment bankers. Both Merrill Lynch and Zurich-based UBS, the largest U.S. brokerage house and largest European bank, respectively, posted losses for the third quarter. For UBS, this was their first quarterly loss in four and a half years. 

Bear Stearns reported its biggest earning decline in the last 10 years and Citigroup posted a 60% decline in earnings. Recently, Morgan Stanley reported that it would have an estimated third quarter loss of $.50 per share, after an initial estimate of having positive earnings of $1.25 per share.

Let’s not forget about the bank run that occurred at England based Northern Rock.  Citigroup is in the process of organizing a bailout, but this all comes after the Bank of England supplied all the liquidity needed and guaranteed all bank deposits.

How about the fire sale by Lennar Homes? They unloaded a huge amount of inventory as discounts of up to $100,000. The editors here at Agora Financial warned that more of these fire sales would occur. That is exactly what has happened.

As I write on this fall day in Minnesota, St. Joe Co., Florida’s largest private landowner, has announced that they will also have a fire sale of sorts. They plan to fire 75% of their employees and sell 190 homes and approximately 1,200 sites planned for development. They threw their dividend out the window and will report a 41% decline in sales. That hurts…and you can expect more of the same to keep on coming.

The culprit of all these credit losses was tens of billions of dollars in write downs of mortgage-backed securities and other fixed income assets. In short, the reason for the write downs were bad loans made to people who couldn’t pay for them, and increased foreclosures resulting in a glut of homes on the market. It’s easy to see how this carries a snowball effect. 

More Credit Concerns Could Be on the Way

If you ask both Wall Street and Main Street, they will tell you that we have put the worst of the credit concerns behind us. In fact, there’s no need to ask, just look at how the homebuilder and financial stocks have rallied up to 20%. This seems encouraging, but I couldn’t disagree more.

There are two very important statistics I have been watching. First and foremost, we must understand that there are still $300 billion dollars of interest rates reset by the end of 2009, with a large chunk of those coming in the next six months. The implications of this cannot be denied. Remember it was the marked-to-market mortgage-backed securities that made up the majority of losses for the investment banks I just mentioned.

Those mortgage-backed securities are just sliced up mortgages packaged into bonds, and given investment grade ratings by Moody’s. Whether or not these bonds pay out is directly dependent on whether or not these mortgages get paid for by the homeowner. That is the risk in these bonds, which has been grossly under priced. 

Pimco’s Bill Gross referred to theses subprime mortgage-backed securities as “toxic waste.” There are a lot more skeletons on these investment bankers’ balance sheets. I expect there to be many more “earnings reductions” and “unforeseen circumstances” that result in some large losses. Don’t look for one of the big investment brokerage houses to go bust, but I wouldn’t be surprised to see one of these guys get bought out.

The other worrisome statistic is the $12 billion increase in credit card debt and non-mortgage loans that American consumers hold. This brings the running total to $2.47 trillion dollars. The private sector debt as a share of private sector GDP is now an astounding 340%. This is a scary thought, but the trend is even scarier.

We have seen a frightening trend that shows how truly stretched out American consumers are. There has been an exponential increase in Americans paying their mortgages with their credit cards. Homeowners do this to prevent themselves from defaulting on their mortgage payments, but in the process build up an unnerving amount of high interest debt. Even with Halloween right around the corner, what could be more terrifying?

This is exactly what Alan Greenspan has taught Americans. Bill Bonner of the Daily Reckoning had this to say on the topic: “Thanks largely to ‘Easy’ Al Greenspan down at the Fed, they could always stretch one end of their budget — the spending end. ‘Just put it on the credit card, honey…we’ll extend the equity line if we need to.’ But now the equity line is snapping back and hitting them in the face.”

So Americans are using their credit cards to postpone the inevitable foreclosures a little big longer. The amount of loans to reset at a higher interest rate is going to increase dramatically, resulting in more homes on the market, more losses on mortgage-backed securities and more losses on bank sheets.

I almost pity the dumb money that has bid up the financials and homebuilders. In fact, I almost pity the dumb money that has been purchasing any of the industrials at or near this record high…almost.

The fact of the matter is that while dumb money is at a historical record in size, it is also at a historical record in stupidity. As a result of the shear quantity of money in the wrong hands, we have seen equities boosted while the smart money notices that transports have trailed behind. We have seen dumb money buy treasury notes in huge numbers while receiving nearly a -10% real return on investment.

So have I missed out on the run to DOW 15k? Maybe. But I do understand the fundamentals of this market. So while the dumb money may have been king for the past couple of weeks, it will soon be dethroned. Ignorance can only rule for so long.

Regards,
Nick Jones

October 17, 2007

The Dumb and the Restless was originally featured on Whiskey and Gunpowder