Phil’s Favorites

Borrowing from Mish’s Global Economic Trend Analysis blog again, here are a couple articles on walking away from your mortgage.

Borrowers Abandon Mortgages as Prices Drop,
in the Wall Street Journal, by Ruth Simon and Scott Patterson.

“As home prices plummet, growing numbers of borrowers are winding up owing more on their homes than the homes are worth, raising concerns that a new group of homeowners — those who can afford to pay their mortgages but have decided not to — are starting to walk away from their homes…”

Another article in the New York Times is Facing Default, Some Walk Out on New Homes, by John Leland.

And, Mish’s suggested tune, e.g. to whistle while packing:

50 Ways To Leave Your Mortgage

You just slip out the back, Jack
Make a new plan, Stan
You don’t need to be coy, Roy
Just get yourself free
Hop on the bus, Gus
You don’t need to discuss much
Just drop off the key, Lee
And get yourself free

This article is from Trader Mark, on his Fund my Mutual Fund blog.

$2 Trillion of Petrodollars Needs a Home This Year

A staggering figure in this article from the UK Telegraph…. “reverse colonization” looks to continue, and this is the type of money that *WILL* put a floor beneath equity market as Sovereign Wealth Funds go hunting for prey. Even if only 20% ever makes it into equity markets that an astounding $400 Billion. Even in this day and age of $8 billion write offs, that is some serious change. Think US stimulus plan x 2.5. Yet another reason I could see a “decoupling” in equity markets vs real economy later this year.

And just think… this tax on the world…will continue next year… and the next… and the next… and the next… all while we dither away, not willing to even fathom a Manhattan Project for Alternative Energy. Maybe crude $120 will wake us up? $150? $3.75 gas at Memorial Day 2008? I don’t know what it will take, but nothing for this current administration I suppose.

• The surge in the price of oil is set to unleash a tsunami of petrodollars onto financial markets, according to Morgan Stanley.
• With the price of crude oil skirting the $100-a-barrel mark, strategists at the investment bank reckon as much as $2 trillion of petrodollars earned by the world’s oil exporters will need to be invested this year.
• Petrodollars are “big, and getting bigger,” according to Morgan Stanley’s Stephen Jen.
• While Mr Jen estimates that oil exporters, particularly the Gulf states, will choose to spend about 10pc of the petrodollars upgrading their infrastructure, “a tsunami is coming.”
• At $100 a barrel, Morgan Stanley estimates that the value of the world’s proven oil reserves stands at $121 trillion. That compares with Russia’s gross domestic product of $1.2 trillion, Britain at $2.7 trillion and the US at $14 trillion.
• Mr Jen writes “The financial arguments for transforming underground oil wealth into above-ground financial wealth are quite compelling.”

Again this was part of my 13 Outlier 2008 Predictions; that equity markets would confound bloggers (like myself!) and finish relatively flat for the year based on a 2nd half liquidity surge, combining Fed induced printing of dollars shoved into the system, along with foreign infusions. However, at the time I did not expect 125 basis point to happen within 9 days, so maybe my time line needs to be moved up… these numbers are simply staggering.

This also makes yet another case for global inflation - this world is awash in petrodollars and they will drive up the costs of finite assets the world over. Oh what a conundrum!

From the Big Picture, Barry Ritholtz on
Why the Fed is Compelled to Lie to Congress

Beginning: “I had an interesting conversation yesterday about Ben Bernanke’s testimony with a person upset over the obvious understatements, spin, and happy talk — even as the Fed Chair quite soberly discussed the US slowdown.

If the Fed were to come clean about the present circumstances, it would cause a market panic. That’s why we get this very gradual shift in assessments, all designed to be somewhat reassuring as it slowly feeds measured dollops of reality into the marketplace.”

“Why? Imagine if the Fed Chair told the unvarnished truth: The Dow would see a 1,000 point intra-day drop, and that won’t help the Fed steer the ship.”

The more I read, the more I’m worried. In fact, last night, I had my first nightmare with bears, brown ones, in groups.

Mish Shedlock writes about the Fallacy of Inflation Targeting.

Ben Bernanke is in favor of inflation targeting at 2% a year. Considering he means prices, he sure is a long ways off, at least as measured by the CPI or PPI.

But let’s assume the Fed could magically meet that target. Inquiring minds might be wondering how that would look graphically. Let’s take a look.

Inflation Targeting at 2% a Year

click on chart for sharper image.

The above chart is thanks to Minyan Charles who writes:

Hey Mish,

I have been pondering this whole “inflation-targeting” approach by the Fed. Their stated goal is around 2.0% year over year, correct? So, I did the graph I included which confirmed my suspicion that a constant percentage increase is indeed an exponential growth curve (who says bacterial growth is irrelevant for finances!). If the mandate is price stability, why would you shoot for an exponential growth situation? (And that is if you’re doing your job well and hitting the target!)

Does stability really mean ever more increasing prices?!? When you combine this with the stagnant growth in wages over the last 30 years, it is easy to see why the middle class has been so squeezed. Why would deflation be so horrible, besides dispersing some wealth back to the have-nots? And did the Fed really kill inflation in the 1980s? Or did they just change the statistical reporting mechanisms?

Thanks,

Minyan Charles

Charles, thanks for that chart.
Let’s see how the model actually stands the test of time.

CPI In Actual Practice

click on chart for sharper image
The above chart courtesy of the St. Louis Fed.

Note what happened once Nixon closed the gold window. Greenspan has maintained the Fed has approximated the gold standard in practice. The above chart proves otherwise.

Inflationistas Need Not Apply

No doubt inflationistas will be crowing about the above chart. Why shouldn’t they? Then again Inquiring minds may wish to consider this progression.

• Inflation: What the heck is it?
• An Interview with Paul Kasriel
• Things That “Can’t” Happen
• Deflationistas Do It For Less

Fallacy of Inflation Targeting

The reason banks (and government) want inflation targets is that inflation is beneficial to those with first access to money: banks, government, and the wealthy. By the time access to credit filters down to everyone, the economy is poised to reverse. This happens time and time again in every cycle. The current housing bust is the latest example.

Inflation Targeting and Price Stability Questions

• Why should inflation be targeted at 2% and not 1% or 3%?
• Why should any inflation be targeted at all?
• Even if it was smart to target prices, can prices really be measured it accurately?
• What do central banks do to overcome lag effects of monetary tightening and loosening?
• Is this just blind faith “we know neutral when we see it”?

I addressed the above questions in Inflation Monster Captured. Inquiring minds may wish to take a look. If you have not yet seen it, there is a cute video from the ECB in the above link.

What it all boils down to however, is inflation targeting is nothing more than Fed sponsored theft to the detriment of those who obtain access to credit late in the cycle.

More importantly, the Fed can only succeed when attitudes allow the Fed to succeed. For more on attitudes please see Credit Lines Dry Up, Homeowners In Withdrawal.

Here is the pertinent snip:

Attitudes are like pendulums. Momentum carries both pendulums and attitudes to extremes. The pendulum of consumer recklessness has now reversed, having recently reached a secular peak. It will not stop at equilibrium on the way down. Instead, momentum will progress to a point of complete exhaustion marked by cautious saving instead of reckless spending.

For still more on attitudes please see “Social Mood Darkens”, point 5 of Professor Depew’s “Five Things” on How It’s Gonna End.

According to Professor Depew, “Social mood drives social action, not the other way around. Cautious people cause home prices to plunge. Cautious businessmen cause credit to tighten. Fearful people suddenly view debt as harmful, not helpful.”

In the final analysis the Fed undershoots, overshoots, and blows serial bubbles. It matters not whether this is by accident or design. The end result is the same: wealth concentration in the hands of the banks and the wealthy, fear sponsored government fascism, and the impoverishment of the middle class. For these reasons the Fed should be abolished.

Note that the inflation cycle ends when consumers are no longer willing or able to borrow, and banks are no longer willing or able to lend. The preponderance of data suggests that is precisely where we are now. The last time this happened the US was facing the great depression. There are now safety nets that may prevent a similar occurrence now, then again perhaps not. The real question is whether or not one is prepared.

Mike “Mish” Shedlock

From Econbrowser, James Hamilton asks

Did somebody say stagflation?

Five weeks ago I asked, Will inflation fears restrain the Fed?, and my answer was that they would not. Certainly inflation fears did not prevent the Fed from lowering its target for the fed funds rate by 125 basis points since I offered that assessment. But I believe that this week’s data will force the Fed to be more cautious about the magnitude and pace of subsequent rate cuts.

Let’s get this out of the way first: Wednesday’s report from the Bureau of Labor Statistics on the consumer price index would I believe be described in Fedspeak as an “unwelcome development”. The seasonally adjusted CPI increased at a 4.7% annual rate between December and January, a pace not far from the average over the last six months or year. The Fed tends to pay more attention to core CPI, which excludes food and energy. But even this was up at a 3.1% annual rate over the last three months and 2.7% over the last six.

Even if the Fed continues to ignore the broader CPI itself, has inflation as recorded by the core CPI crept up high enough to get its attention? I’m reminded of these words expressed by Fed Chair Ben Bernanke in June of 2006:

While monthly inflation data are volatile, core inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth. For example, at annual rates, core inflation as measured by the consumer price index excluding food and energy prices was 3.2 percent over the past three months and 2.8 percent over the past six months.

Now, the 3.1 core CPI inflation we’ve seen over the past three months is technically shy of the nasty 3.2% Bernanke said he could not tolerate, and the 2.7 for the past six months is also not quite the 2.8 he declared to be too high, but gee, they seem pretty darn close. For visual amusement I’ve plotted below the historical 3-month and 6-month core CPI annual inflation rates compared with the 3.2 and 2.8 thresholds previously articulated by the Fed Chair. Either we’ve basically reached the limit of what the Fed has been willing to tolerate in recent years, or else they’ve moved the bar.

There also has to be growing discomfort within the Federal Reserve about ignoring the continuing high inflation recorded by the CPI itself, as reflected, for example, in this speech from Federal Reserve Bank of Philadelphia President Charles Plosser:

While the Fed’s goal is to achieve stable prices for all goods and services, economists and policymakers sometimes focus on core inflation, as it has been thought to give a better indication of underlying inflation pressures since it excludes food and energy prices, which can be quite volatile. The idea is that over time, core and headline inflation rates should, on average, be similar, as increases in the volatile components are offset by later decreases and vice versa. I am concerned, however, that over the past 10 years headline inflation has exceeded core inflation by about 40 to 50 basis points. This has been true of both the consumer price index (CPI) and the broader personal consumption expenditure (PCE) price index. Indeed, headline inflation rates have exceeded core inflation rates in 8 of the last 10 years for both the CPI and the PCE price measures on an annual average basis. While I would like to believe that, over time, these two rates should be converging on average, I am concerned that the data are suggesting that core inflation rates may not be as indicative of underlying or trend inflation as we might have thought. My conclusion is that we need to look at both measures of inflation– headline and core– since it is not clear which one is telling us the most about underlying inflationary pressures. As a consequence, I was very much in favor of the FOMC’s beginning to include forecasts of both core and headline inflation in our quarterly forecasts.

Here’s a graph illustrating Plosser’s concern. Historically, the CPI and CPI ex food and energy recorded a similar average long-run trend, with the latter having the benefit of not being kicked around by strictly short-run crop failures or oil supply disruptions. But the changes in energy prices over the last five years have not come from temporary supply disruptions, but instead reflect longer run developments. Likewise, rising food prices are due not so much to poor harvests as to our misguided ethanol policy, which unfortunately again I see no sign of going away.

Tim Duy also notes that the Fed could not be cheered by the modest trend upward in the rate of inflation that consumers tell University of Michigan surveyors they are expecting for the next 12 months, now up to 3.7%.

Then there’s the little item of those raging commodity prices over the last 30 days.

[pictures courtesy of Kitco]

The one remaining key indicator that is yet to become unmoored is the expected inflation rate implied by the gap between the yield on 10-year nominal Treasury bonds and that on bonds whose coupon and principal are indexed to rise with the CPI. This gap has remained quite stable over the last year.

Greg Ip, Felix Salmon and Greg Mankiw are concerned that the 5-year TIPS-nominal spread has fallen relative to the 10 year, implying that the 5-year forward inflation rate (the so-called 5-year, 5-year break-even rate) has gone up. But I agree with the analysis by knzn and particularly Francisco Torralba that the facts are much less alarming than Ip’s graph might have seemed to suggest, and that the basic impression of stability of longer term expectations that one brings away from the graph I’ve plotted above is the correct one.

Notwithstanding, I doubt the Fed will feel free to continue charging ahead with rate cuts on the basis of the comfort provided by this one remaining favorable indicator. Yes, the Fed will still cut another 25 basis points at its March 18 meeting. And more likely 50, if we get a dreadful employment report for February or more scares like today’s Philadelphia Fed survey. But I have to believe the Fed will be following that path down with great reluctance from this point on.

Excerpt from Barron’s Article on MRVL:

Simply Marvell-ous

By Bill Alpert

“SEHAT SUTARDJA, HIS WIFE, and his brother started Marvell Technology Group a decade ago with the crazy idea of entering a semiconductor niche already crowded by two dozen competitors. Big ones, in fact, like Texas Instruments (ticker: TXN), STMicroelectronics (STM) and National Semiconductor (NSM).

“We were engineers, very focused, very optimistic about coming out with the best product, so we never thought for a minute about the challenges in the market,” says Chief Executive Sutardja. “The thought never crossed our minds.”

Commenting on MRVL and Barron’s article, Eli Hoffmann, editor at Seeking Alpha:

New Chips Could Double Marvell’s Stock - Barron’s:

“Shares of chip-maker Marvell (MRVL) have fallen by two-thirds to a recent $11 amid an options backdating scandal that played with shareholder confidence and decimated its executive staff. Barron’s Bill Alpert says Marvell’s outlook is pretty darn good: it is working to stop its management gaps, and recently depressed margins are due to rise as its expenses level off.

Marvell’s disk-drive chips — already a mainstay of almost every hard-drive product, and which generate almost half of its revenues — are about to get a major upgrade called “iterative decoding” that will allow hard-drive makers to exceed the technology’s current size limitations. It has also begun producing similar drive enhancers for Blu-ray DVD drives.”

Here’s an excerpt from article in the NY Times, by Edmund L. Andrews, followed by comments from Mish’s Global Economic Trend Analysis, by Mish Shedlock.

A ‘Moral Hazard’ for a Housing Bailout: Sorting the Victims From Those Who Volunteered

“WASHINGTON — Over the last two decades, few industries have lobbied more ferociously or effectively than banks to get the government out of its business and to obtain freer rein for “financial innovation.”

But as losses from bad mortgages and mortgage-backed securities climb past $200 billion, talk among banking executives for an epic government rescue plan is suddenly coming into fashion.

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

“We believe that any intervention by the federal government will be acceptable only if it is not perceived as a bailout of the bond market,” the financial institution noted…”

Mish’s comments posted at his Global Economic Trend Analysis:

Bank of America Asks Congress for a $739 Billion Bank Bailout

The New York Times is writing A ‘Moral Hazard’ for a Housing Bailout: Sorting the Victims From Those Who Volunteered.

Over the last two decades, few industries have lobbied more ferociously or effectively than banks to get the government out of its business and to obtain freer rein for “financial innovation.”

But as losses from bad mortgages and mortgage-backed securities climb past $200 billion, talk among banking executives for an epic government rescue plan is suddenly coming into fashion.

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

My Comment: The attempt to blame the free market for this mess is galling. The blame lies with Congress, the Fed, and the SEC. If the Fed had not reduced interest rates to 1% and held them there, the bubble would never has gotten as big.

Tax breaks by Congress and things like “the ownership society” helped drive up prices. GSEs were created to promote affordable housing and now the limit on “affordable” has been pushed to $730,000.

It was an act of the SEC that created the nightmare at the rating agencies. See Time To Break Up The Credit Rating Cartel for more on the rating agencies.

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

My Comment: The reason they are at “high risk” is twofold. Prices are too high and Congress and this administration is spending too much money weakening the dollar. Home prices need to come down, the war in Iraq needs to be stopped cold turkey, and Congress needs to stop bailing out banks and homeowners when they do something stupid. While we are at it, we need to abolish the Fed.

“We believe that any intervention by the federal government will be acceptable only if it is not perceived as a bailout of the bond market,” the financial institution noted.

In practice, taxpayers would almost certainly view such a move as a bailout. If lawmakers and the Bush administration agreed to this step, it could be on a scale similar to the government’s $200 billion bailout of the savings and loan industry in the 1990s.

My Comment: Everyone would view it as a bailout of banks and Wall Street for one simple reason: It would be a bailout of banks and Wall Street.

The arguments against a bailout are powerful. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers.

A rescue would also create a “moral hazard,” many experts contend, by encouraging banks and home buyers to take outsize risks in the future, in the expectation of another government bailout if things go wrong again.

My Comment: Precisely.

If the government pays too much for the mortgages or the market declines even more than it has already, Washington — read, taxpayers — could be stuck with hundreds of billions of dollars in defaulted loans.

My Comment: Taxpayers could be stuck or would be stuck? I think the latter. No one entity or agency can value these things, certainly not Moody’s, Fitch, and the S&P. For recent evidence, please see Evidence of “Walking Away” In WaMu Mortgage Pool.

The only proper way of establishing the worth of these securities is by the free market, not guesstimates by bureaucrats who cannot find their asses with both hands at one time, nor by banks willing to sell the government a bill of goods at taxpayer expense.

But a growing number of policy makers and community advocacy activists argue that a government rescue may nonetheless be the most sensible way to avoid a broader disruption of the entire economy.

The House Financial Services Committee is working on various options, including a government buyout. The Bush administration may be softening its hostility to a rescue as well. Top officials at the Treasury Department are hoping to meet with industry executives next week to discuss options, according to two executives.

“There are a lot of ideas out there,” said Scott Stanzel, a spokesman for President Bush, when asked at a White House press briefing on Friday about a possible buyout program. “There are many different ways in which we can address this problem and we continue to look at ways in which we can do that.”

My Comment: There are indeed a lot of ideas out there and every one of them but one is a horrid idea. The only good idea is to let this play out naturally over time without the government making matters worse.

Supporters contend that a government rescue could be the fastest and cleanest way to force banks and investors to book their losses from bad mortgages — a painful but essential first step toward stabilizing the housing market.

My comment: Those supporters are socialist fools.

The government would buy the mortgages at their true current value, perhaps through an auction, at what would probably be a big discount from the original loan amount. The mortgage lenders, or the investors who bought mortgage-backed securities, would be free of the bad loans but would still have to book their losses.

My Comment: This just gets sillier and sillier. If the Government buys them at “True Value” then why don’t the banks just hold them at “True Value”, or sell them to someone else at “True Value”? Clearly the idea is to dump them on the government at a price far above “True Value”.

If the government took control of the bad mortgages, supporters of a rescue contend, it could restructure the loans on terms that borrowers could meet, keep most of them from losing their homes and avoid an even more catastrophic plunge in housing prices.

My Comment: A plunge in home prices should not be catastrophic. It should be welcome. Property taxes would drop and housing prices would be more affordable. Where are all the affordable housing clowns hiding out now anyway?

“Every citizen has a dog in this hunt,” said John Taylor, president of the National Community Reinvestment Coalition, a community advocacy group that has developed its own mortgage buyout plan. “The cost of spending our way out of a recession is something that everybody would have to bear for a very long time.”

Mr. Taylor estimated the government might end up buying $80 billion to $100 billion in mortgages. But he said the government could recoup its money if it was able to buy the mortgages at a proper discount, repackage them and sell them on the open market.

My Comment: Mr.Taylor is clearly a complete buffoon. How the hell is the government supposed to be able to package this garbage and sell it on the free market if the banks can’t?

Surprisingly, the normally free-market Bush administration has expressed interest. Treasury officials confirmed that several senior officials invited Mr. Taylor to present his ideas to them on Feb. 15. Mr. Taylor said he had also received calls from officials at the Office of Thrift Supervision and the Office of the Comptroller of the Currency, which is part of the Treasury Department.

My Comment: Bush knows Republicans are going to get slaughtered in the upcoming election so he is vote pandering like everyone else.

But even supporters acknowledge that a government rescue poses risks to taxpayers, who could be left holding a very expensive bag.

Ellen Seidman, a former director of the Office of Thrift Supervision and now a senior fellow at the moderate-to-liberal New America Foundation, said the government’s first challenge is to buy mortgages at their true current value. If the government overpaid or became caught by an even further decline in the market value of its mortgages, taxpayers would indeed be bailing out both the industry and imprudent home buyers.

My Comment: The first and only challenge is to do nothing.

“It’s not easy, but it’s not impossible,” Ms. Seidman said. “There are various auction mechanisms, both inside and outside government.”

My Comment: With that Ms. Seidman proved she is a complete buffoon too.

A second challenge would be to start a program quickly enough to prevent the housing and credit markets from spiraling further downward. Industry executives and policy analysts said it would take too long to create an entirely new agency, as Bank of America suggested. But they expressed hope that the government could begin a program from inside an existing agency.

My Comment: We are in deep trouble if we start addressing the second challenge. The first and only challenge should have been to do nothing.

But even if the government did buy up millions of mortgages and force mortgage holders to take losses, the biggest problem could still lie ahead: deciding which struggling homeowners should receive breaks on their mortgages.

My Comment: See how this has already morphed into a third challenge. And they did not even say so. There will be 88 challenges, all of them butchered, if we go beyond the first challenge of doing nothing.

Administration officials have long insisted that they do not want to rescue speculators who took out no-money-down loans to buy and flip condominiums in Miami or Phoenix. And even Democrats like Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee, have said the government should not help those who borrowed more than they could ever hope to repay.

My Comment: Instead they want to rescue the banks who were equally stupid, if not more so.

But identifying innocent victims has already proved complicated. The Bush administration’s Hope Now program offers to freeze interest rates for certain borrowers whose subprime mortgages were about to jump to much higher rates. But the eligibility rules are so narrow that some analysts estimate only 3 percent of subprime borrowers will benefit.

My Comment: Innocent victims are easy to spot. Those who stayed out of the mess but saw property taxes soar to the moon anyway. The second set of innocent victims were those on fixed incomes who got paid a lousy 1% in their money market accounts while the Fed blew the biggest credit bubble the world has ever seen.

Bank executives, meanwhile, warn that the mortgage mess is much broader than people with subprime loans. Problems are mounting almost as rapidly in so-called Alt-A mortgages, made to people with good credit scores who did not document their incomes and borrowed far more than normal underwriting standards would allow.

My Comment: Finally a true statement. The mortgage mess is indeed very broad. But notice how the blame was shifted to those who did not document their incomes, from banks who knowingly looked the other way while it happened.

Borrowers who overstated their incomes are not likely to get much sympathy. But industry executives and consumer advocates warn that foreclosed homes push down prices in surrounding neighborhoods, and a wave of foreclosures could lead to another, deeper plunge in home prices.

My Comment: Most of those who overstated their incomes are not looking for sympathy. They are simply walking away. It is banks who are looking both for sympathy and handouts.

Right or wrong, the arguments for rescuing homeowners are likely to be blurred with arguments for rescuing home prices. At that point, industry executives are likely to argue that what is good for Bank of America is good for the rest of America.

My Comment: There is no blur here. The arguments for rescuing homeowners and rescuing home prices are both equally stupid.

What’s good for Bank of America is to learn a very painful lesson. What’s good for America is Ron Paul.

Mike “Mish” Shedlock

It’s been hard to remain optimistic for this market, even though many stocks are now looking priced very low from the perspective of past valuations and future prospects.   Ockham Research had some encouraging words to say in their article, Don’t Give Up on the Stock Market.

As yet another down week for the stock market comes to a close, it may be time for a pep talk. There’s a lot of pessimism in the financial markets right now and that sentiment only worsened with the release of inflation data this week. Consumer prices jumped 4.3% in January, which may limit the Fed’s options regarding further monetary easing in the months ahead. Also this week, oil crossed back over $100 a barrel for only the second time in history. There is fear that crude prices will push even higher into record territory when OPEC ministers meet in early March, as some analysts speculate that the organization may agree to production cuts at that meeting. Rising commodity prices combined with mounting evidence of a slowing economy have stoked the fears of some pessimistic market watchers that the economy may be facing a period of “stagflation”, that dreaded financial phenomenon not seen since the late seventies.

In times like these, it is worth remembering the adage “this too shall pass”. Bear markets do come to an end and rising stock prices will return. When times are tough, it is easy to be a pessimist (and a majority of investors currently are). However, successful investors are those who see opportunity in all market environments and who take appropriate steps to capitalize. The only way to guarantee a loss in a in a bear market is to sell in the midst of the carnage. On a positive note, stock market valuations are just now reaching more reasonable levels. For example, the market’s price-to-peak earnings ratio is now hovering at around 15x, which has historically been a great level at which to increase equity exposure.

Back in late 2006 through 2007, we had predicted that the market was due for a pullback as valuations could not persist at such high levels indefinitely. Well sure enough, this has happened and now the “experts” have changed their tune from touting the “Goldilocks” economy to bewailing various doom and gloom scenarios. Logically, everyone knows that the stock market cannot always go up. But now, almost six months after reaching its all-time high, the Dow is down 14% and many act as if they believe the roof is caving in.

Do not be swayed by the pundits and experts telling you that the U.S. financial system is fragile and weak. While the difficult housing market is a concern in many important regions, it represents a relatively small (4.5%) sector of the economy. The economy grew last year in the midst of a burgeoning credit crisis. The U.S. economy will remain strong as long as American consumers and businesses continue to spend as consumption is the source of nearly 70% of our GDP. Be wary of falling into the pessimistic mindset that the news outlets are using to drive ratings and readers, because if you do, you could miss a terrific buying opportunity.

From Global Economic Trend Analysis, Mish Shedlock’s take on the Ambac bailout.

Ambac Bailout Hopes Excite Bulls

Bloomberg is reporting Ambac Soars on Reports Bailout May Happen Next Week.

Ambac Financial Group Inc., the bond insurer in rescue talks with banks, soared in New York Stock Exchange trading on optimism the company may soon reach an agreement that would save its AAA credit rating and avoid losses on $556 billion of securities it guarantees.

The New York-based company rose 16 percent after CNBC Television said a deal between Ambac and its banks may be announced Feb. 25 or Feb. 26. A group of banks is preparing to inject $2 billion to $3 billion into Ambac, the Financial Times said. The money would be part of plan to split Ambac, the newspaper said.

A rescue that enabled Ambac to retain its AAA rating for the municipal and asset-backed securities guaranty units would help banks, the insurance company and municipal debt investors avoid losses. Banks stood to lose as much as $70 billion if the top rated bond insurers, which include MBIA Inc. and FGIC Corp., lose their credit ratings, Oppenheimer & Co. analysts estimated.

Eight banks including Citigroup Inc. and UBS AG formed a group to consider providing financing, a person familiar with the matter said earlier this month. Royal Bank of Scotland Group Plc, Wachovia Corp., Barclays Plc, Societe Generale SA, BNP Paribas SA and Dresdner Bank AG, were also involved, said the person, who declined to be named because details hadn’t been set.

FGIC, which lost its top rating at Moody’s Investors Service last week, asked to be split in two to protect the ratings on municipal bonds it guarantees. MBIA yesterday said all bond insurers must eventually divide their businesses.

S&P Futures Soar On The News

Volume surged way ahead of the news stories hitting mass media, spurring silly talk on message boards of the PPT. Here are a couple of charts I was watching real time.

S&P 500 3 Minute Chart

S&P 500 15 minute chart

click on chart for sharper image

More Details Emerge After Hours

After hours, additional details are emerging, mainly in the form of what the bailout might look like. MarketWatch is reporting Banks may recapitalize Ambac to save AAA rating.

A group of eight banks that are major counterparties to Ambac Financial Group may recapitalize the struggling bond insurer in a bid to save its crucial AAA rating, two people familiar with the situation said Friday.

“We have a lot of alternatives. A capital raise has always been an option to stabilize the rating,” said Vandana Sharma, a spokeswoman for Ambac. “We’re trying to do the best by all constituents, including policy-holders, shareholders and counterparties.”

Splitting up bond insurers would be difficult, pitting policyholders against shareholders of the bond insurer holding companies. “The lawyers have already begun gearing up on that one,” said Josh Rosner, a managing director at research firm Graham Fisher & Co.

One proposal involves banks injecting roughly $5 billion of capital into specific bond insurers and also providing a $10 billion line of credit.

Another idea involves commuting, or effectively tearing up, CDS contracts between banks and bond insurers. In return for dropping their claims, the banks would get a preferred equity stake in the bond insurer.

“Putting capital into an insurer is more of a contract issue between the companies involved, rather than a regulatory issue,” said James Gkonos, vice chairman of the Insurance Practice Group at law firm Saul Ewing. “That would be the simplest and most efficient way to do this.”

A forced splitting up of a bond insurer by a regulator such as the New York State Insurance Department would be an “extreme scenario” that would involve public hearings and litigation and take a long time to complete, he explained.

Still, any re-capitalization of Ambac by bank counterparties would present its own problems too, because it could dilute existing investors in the company. Such a plan would also use up capital that banks may need to help them through other problems thrown up by the global credit crunch.

“Sometimes there are problems that just can’t be solved,” Rosner said. “At some point, the market is going to realize that there is not always a best solution. There is often just a least worse solution.”

Who’s Holding The Bag?

If you want to know who’s holding the bag if the monolines fail, simply look at the who’s who list of sponsors.

Who’s Who Bagholder List

• Citigroup (C)
• UBS AG (UBS)
• Royal Bank of Scotland (RBS)
• Wachovia Corp (WB)
• Barclays (BCS)
• Societe Generale SA
• BNP Paribas SA
• Dresdner Bank AG

The two key sponsors (Citigroup and UBS) were on the list of recommended shorts by Meredith Whitney. See Analyst Meredith Whitney Asks Banks “Where’s Waldo?” for more on expected bank writedowns and dividend cuts.

Some Problems Can’t Be Solved

A $2-$3 billion infusion simply cannot fix a gaping long term $70-$150 billion problem (depending on who you believe) in the monolines. Should an attempt to do so be made, I confidently predict the banks will have to go back to the well again and again to provide additional capital.

If instead the banks agree to an upfront writeoff of the entire amount of worthless CDOs in return for an equity stake, exactly where are the banks going to come up with the necessary cash? Even if they do manage to pull that off, they will have accomplished nothing but buying a business model that is slowly dying and facing competition from Buffett as well.

“Sometimes there are problems that just can’t be solved”, and this is likely one of them. Oh sure, the market may rally a bit, especially if Moody’s, Fitch, and the S&P keep their collective heads buried in the sand and reaffirm the AAA ratings on a mere $2 billion infusion, but long term the problem cannot go away until the entire package of CDOs guaranteed by the monolines is properly marked to market at a value close to zero.

Mike “Mish” Shedlock

Wow, what a end to the day! Maybe fortunately, I lost my internet connection half an hour before the close and couldn’t sell everything uncovered, which was my inclination prior to losing comcast.

Here’s an article on Stagflation and Mark Perry not buying it. Thanks Mark!

1970s Style Stagflation? I Don’t Buy It

The topic of stagflation was discussed tonight on CNBC’s “Kudlow and Company,” and guest John Browne, former member of British Parliament and ultra-stagflationist, argued that we are facing a “far, far worse situation than the 1970s,” and further predicted that we are “facing a massive recession.”

Larry Kudlow disagreed, and said “Stagflation is a total canard.”

The money supply data support Larry Kudlow, not John Browne. The chart above compares the growth of M1 during the peak of the stagflation period of the 1970s (the 85 month period from December 1974 to December of 1981) to the growth of M1 over the last 85 months, from January 2001 to January 2008. (M1 is set to equal an index value of 100 in the beginning month of each sample period.)

Notice that there is a significant difference between the two periods: During the 1970s, M1 grew by almost 60%, compared to a 24% growth during the last 7 years. And for the last 3.5 years, M1 has been flat, with almost 0% growth!

Like Larry Kudlow, when it comes to staflation, “I don’t buy it for a nanosecond.” Not gonna happen.

UPDATE:

The chart above compares the growth of M2 during the peak of the stagflation period of the 1970s (the 85 month period from December 1974 to December of 1981) to the growth of M2 over the last 85 months, from January 2001 to January 2008. (M2 is set to equal an index value of 100 in the beginning month of each sample period.)

Notice that there is a significant difference between the two periods: During the 1970s, M2 grew by almost 95%, compared to a 50% growth during the last 7 years.

Bottom Line: The money supply data (M1 and M2) don’t support the position that we are entering a period of 1970s-like stagflation.

The chart above compares the growth of the monetary base during the peak of the stagflation period of the 1970s (the 85 month period from December 1974 to December of 1981) to the growth of the monteary base over the last 85 months, from January 2001 to January 2008. (The monetary base is set to equal an index value of 100 in the beginning month of each sample period.)

Notice that there is a significant difference between the two periods: During the 1970s, the monetary base grew by more than 70%, compared to less than a 40% growth during the last 7 years.

Bottom Line: The money supply data (M1, M2 and monetary base) don’t support the position that we are entering a period of 1970s-like stagflation.

The Washington Post had an important article on drugs and disease which is at least tangentally related to stocks, especially if you’re in a company selling drugs for lowering cholesterol.

Medication Under a Microscope
Studies Raise Questions About Drugs’ Efficacy Against Disease

Excerpts (Lots):

A series of surprising findings about some of the most widely accepted assumptions in medicine has renewed debate about how aggressively doctors use drugs to prevent and treat some of the nation’s leading health problems.

In addition to casting doubt on notions such as lowering cholesterol to prevent heart disease and normalizing blood sugar to protect diabetics, the studies involving well-known drugs such as Avandia and Vytorin have also rekindled concern about whether new medications are being tested adequately before being allowed on the market.

“We definitely need to pause and reassess our assumptions about what is best for patients,” said Harlan M. Krumholz, a professor of medicine at Yale University. “Clearly we have more to learn.”

No one is arguing that common strategies such as lowering cholesterol and blood sugar are unnecessary for many patients. But a number of researchers question whether too many Americans are being prescribed drugs, or combinations of drugs, including medications that have not been clearly shown to extend or improve life.

“There is a wake-up call in all of this,” said Steven E. Nissen, a Cleveland Clinic cardiologist who often advises the government about new drugs. “We can’t rely on assumptions. We don’t always understand the biology of how drugs work as well as we think.”…

The first of the unexpected findings came in December 2006, when Pfizer abruptly terminated the development of a promising cholesterol drug. The drug, torcetrapib, was designed to cut the risk for heart disease by boosting “good” HDL cholesterol, a new strategy that was considered one of the most promising for fighting the nation’s leading killer. But patients taking the compound in a large international study appeared to be at increased risk of dying.

About six months later, Nissen and his colleagues reported that the drug Avandia, which was widely used to lower diabetics’ blood sugar levels, appeared to increase the risk of heart attacks.

Then, last month, Merck-Schering Plough Pharmaceuticals, a joint venture between the two companies, disclosed the results of a long-awaited study that suggested that its popular cholesterol-lowering drug Vytorin did not slow the progression of heart disease. That stirred uncertainty about whether driving cholesterol levels ever downward always helps and whether approving cholesterol-lowering drugs without showing that they reduce the risk for disease is appropriate…

Evaluating ‘Surrogates’

Part of the problem, Krumholz, Nissen and others say, is how the government sometimes evaluates drugs, relying on “surrogate endpoints” instead of medications’ ability to treat or prevent illnesses. Cholesterol-lowering drugs, for example, can be approved based on their power to cut cholesterol and not on whether they protect against heart attacks or strokes. Diabetes drugs can be approved based on whether they reduce a protein known as hemoglobin A1C — a measure of blood sugar — and not on their effect on complications caused by high blood sugar.

“There are a lot of things we do in this country where we treat these surrogate measures with very little evidence that we are actually treating the patient,” said Nortin M. Hadler, a professor of medicine at the University of North Carolina.

If one drug prevents heart attacks by lowering cholesterol, that does not guarantee that another will do the same if it works differently, critics argue. And drugs may have unforeseen hazards that outweigh any benefits, or they may not produce secondary effects, such as lowering inflammation, that add to their usefulness….

Pharmaceutical industry representatives argue that the use of surrogate endpoints has been shown to be reliable and helps speed valuable drugs to patients. It would take much longer and cost much more to conduct studies that measure the effect on diseases….

Pushing Prescriptions?

Some critics go even further than questioning the use of surrogate measures to approve drugs. They argue that the evidence supporting the widespread use of many cholesterol-lowering and blood-sugar-lowering drugs is weak, except for select patients. The popularity of these drugs has been driven by industry-funded studies that overstate their value for preventing disease, they argue, exposing far too many people to the potential risks of the medications themselves.

“What’s going on here is our research enterprise is almost completely controlled by the pharmaceutical industry,” said John Abramson, a clinical instructor at Harvard Medical School and author of the book “Overdosed America.” “It’s their job to create a need for their products. Their job is not to maximize public health.”

Abramson, Hadler and others argue that more emphasis should be placed on improving cholesterol, blood pressure, blood sugar and other risk factors through lifestyle changes, such as eating better, maintaining a healthy weight and exercising more.

“People are making a ton of money by selling the drugs and the monitoring equipment,” said Howard Brody, director of the Institute for the Medical Humanities at the University of Texas Medical Branch at Galveston. “It distracts our patients from what really matters more, which may be getting more exercise or making lifestyle changes that ultimately may be more beneficial than obsessing about their blood sugar or playing with their little monitor device.”

Several experts cited examples of situations in which they believe doctors may be pushing drug therapy too hard, such as a new condition called “pre-hypertension” that calls for patients with moderately elevated blood pressure to take medication. Some doctors have also started diagnosing “pre-osteoporosis” or “pre-diabetes,” and prescribing drugs to prevent bones from thinning or to lower blood sugar before patients have either disease.

“It feeds on the American psyche of ‘Just don’t stand there, do something,’ ” said Mark Ebell of the University of Georgia, deputy editor of American Family Physician. “We want to do everything possible. Sometimes pushing too hard to make a number look better can have unexpected collateral effects that do harm a patient.”…

[Grundy] and others agreed that more research is needed to validate the effectiveness of individual drugs, adding that the increasing propensity of patients to take multiple drugs that may produce unforeseen side effects in combination is a growing concern.

“Drugs can be great, but they can have side effects,” Grundy said. “If you start piling on one drug after another, you can get into trouble.”

This article is written by a long-time friend, David M Gordon, who writes on stocks, the process of investing, and a variety of other subjects at his site, The Deipnosophist, where the science of investing becomes an art of living.

Is it safe?

One reader chides me for purchasing stocks with high PEs, as though successful investing requires nothing more than a snapshot (frozen moments in time) of the opportunity rather than recognize that investing is a process and not an event.

Companies and their products have life cycles; so do stocks. Value stocks are nothing other than growth companies whose (rapid) growth is a thing of the past. Thus, value stocks represent opportunities largely for that class of investor fearful of the markets’ continuing processes and trend — its continuum — and who prefer to hide under the covers of snapshot measures of a company’s value and worth.

But investors never stay still for long; they seek always a company with increasing earnings (Why invest in a company that does not make more money at an increasing pace?) or a rising stock price (Why invest in a stock whose share price is declining? aka, to catch a falling safe.). So, while measures of fundamental valuation such as PEs are worthy, they remain insufficient. Investors express their interest in a company’s growing fortunes via purchasing the shares of said company’s stock; a rising share price manifests as one valid measure of interest on the part of investors, if other measures ratify that rising share price.

Oddly, there come moments when investors can purchase growth at value prices; these moments typically occur during and after market sell-offs, such as the market decline of the past ~3 months. Apple/AAPL and Google/GOOG represent two opportunities that I have publicly argued in favor of for a long while. Nothing is amiss fundamentally at either company; the market’s decline merely served to lower these two companies’ share prices and valuations to startlingly fine purchase points. And, yes, while the daily bar chart of each looks scary today, at least at first glance, things change. (Farther down this post I share a third opportunity.)

Another reader, Eric Chan, writes, “With the market plummeting, are those market internals still showing a likely rebound in the near future? Perhaps that would help VMW on its breakout?”

The markets have since staged a bounce that, at this moment, appears likely to have legs, and which thus appears to be a fine opportunity for investors to buy during secondary tests. However, since Eric asked his question, VMWare/VMW broke down, and calamitously. The incessant fear regards the company’s competition, especially from Microsoft/MSFT.

I have no doubt that VMWare’s products will best whatever Microsoft offers as its solution to virtualization; Microsoft rarely offers a best of breed solution. But Microsoft is persistent and will invest for years to improve their offering, as virtualization is a key growth segment that is very close to their core markets.

More important, however, is the method by which Microsoft will compete in the near and medium term. Microsoft’s strategic objective is…
1) To protect their core operating system and office spaces, and
2) To wound VMWare and impede it’s growth, and
3) To make money in a new segment in that order.

Thus, Microsoft likely will deliver a minimalist offering that will appeal to the middle market. Almost no one in the Fortune 1000 will give it serious consideration, but mid-size companies will. Most important, they will sell it at a radically cheaper price. They do this primarily to spoil the market for the high-end, high-quality solution and slowly turn it into price-based market and could force VMWare ever farther up-market.

Simultaneously Microsoft will work to make virtualization more and more of a feature provided by their operating system. The list of stand-alone applications that became integrated into the OS is quite lengthy, and the landscape is littered with the corpses of companies who produced successful niche products that identified a segment for Microsoft and which Microsoft then destroyed by incorporating the feature into its OS.

I don’t dispute for a moment the characterization of the situation today. And while I think I have a handle on how this thing eventually plays out, I have little in the way of insight as to how long this process takes. Probably it takes long enough that VMWare will have a good earnings trajectory for many more years. That seems the key question, if one is evaluating investing in VMWare: How quickly will Microsoft spoil their market? The answer: It will take more than a first offering but it will take less than a truly superior product.

Two methods (technology company) investors utilize to manage the risk of increasing competition is to find companies that:
1) Manifest as a first-mover, and thus have an increasingly impenatrable ‘lock’ on the market, or
2) Its products have patent protection, which places a wide and deep moat and castle walls around its product.

One technology company with substantial patent protection, and which is familiar to many of this site’s readers, is Qualcomm/QCOM. Qualcomm is, quite simply, the owner of CDMA technology; although, in addition, a chip designer that sells proprietary chips incorporating CDMA technology, though it contracts the actual manufacture of those chips. The CDMA technology benefits Qualcomm primarily through the collection of royalties on the use of that technology. The chip business benefits Qualcomm by the selling of the chips and chip designs they create and manufacture.

In a (very small) nutshell that is the whole company but as you might expect there is much more to the story. To evaluate the company one must begin by understanding CDMA and its value. CDMA is one of the two basic technologies that enable the cell phone. The other is various variants of TDMA. CDMA is an acronym for Code Division Multiple Access, TDMA an acronym for Time Division Multiple Access. There are other schemes as well, but they have largely disappeared.

Let’s say you and I are both talking on our cell phones, but not to each other. We do happen to be standing very near one another, and therefore controlled by the same cell tower. Since we both share the same spectrum the cell phone must understand which incoming signal is meant for you and which for me. Likewise, should we each speak at the same time, the cell phone head-end equipment (on the tower) must be able to know which signal is coming from me so it can route it to the person to whom I’m talking. Since spectrum is an extremely scarce resource this (multiplied many times over) is the fundamental problem of all cell phone technologies.

TDMA solves the problem simply but inefficiently. Basically it “time slices” the spectrum. For a brief period, my conversation is “on”, for the next slice I am “off” and you are “on”. Since these time slices are faster than human perception we both see our conversations as happening at the same time. Of course, the more people accessing that tower on that spectrum at the same time, the more time slices are needed. At a certain point, no more conversations can take place off that tower at that time, and others trying to make or receive calls will be unable to do so until someone ends their conversation.

CDMA solves the problem in a fundamentally different way, one that, with the exception of a few diehards, is recognized universally as better and more efficient. CDMA is a variant of “spread spectrum” technology. Rather than time slice the two conversations CDMA transmits both conversations simultaneously but relies on decoder chips inside each cell phone to figure out which part of that signal is meant for you and which is meant for me. Though it requires more programming complexity it turns out that this is a huge advantage over TDMA.

Being totally digital and not having to devote complicated circuitry to handle the time slice algorithms, CDMA cell phones typically draw less power resulting in longer time between charging and/or smaller phone batteries.

There are limits to how refined TDMA time slicing can be. If sufficient time is not given to each active conversation - whether or not any actual talking is taking place at that instant or not - users will sense the delays. We are extremely sensitive to such issues once they reach the threshold of perceptibility. CDMA deals with crowding by “degrading gracefully” a technical term which basically means that every conversation may suffer slightly in terms of audio quality but no time delays will be noted. At a certain point of course, no more degradation can be tolerated and CDMA too will max out until someone hangs up.

There are few limits to how sophisticated the decoding programming can get in CDMA, resulting in innovation cycles that can pack more bits into any unit of cell phone bandwidth. New algorithms can increase the use of silence to improve carrying capacity, as can their ability to work with lower and lower signal strengths.

Similarly, these factors can drive CDMA to require fewer towers and/or more conversations off a single tower, and can do so with simpler, lower power head-end equipment.

Last, and crucially, spread spectrum provides sufficient bandwidth to support reasonable data rates for the transmission of digital data which, of course, is the driving edge of what’s happening in the cellular arena.

CDMA is a primary technology in the USA (being used primarily by Sprint and Verizon), parts of Asia, and parts of Latin America. Until recently, TDMA was used primarily in Europe under the GSM system, also by parts of Asia and Latin America. But with the adoption of 3G and the need carry increasing amounts of data, Europe and other GSM areas are increasingly moving to what’s known as WCDMA. WCMDA is bascially an amalgam of both technologies but the incorporation of CDMA algorithms has led most European courts to rule in Qualcomm’s favor regarding patent royalties on WCMDA.

On a technical level CDMA is one thing, but on a business level quite another. Qualcomm is an extremely controversial company, perceived as a newcomer and interloper by older, more established, and primarily European, companies. For years, they stubbornly refused to adopt CDMA while spending hundreds of millions trying to find ways to engineer around Qualcomm’s patents. Whether WCDMA actually is a necessary technology or just a blatant attempt to engineer around Qualcomm’s patents is a matter of much dispute. What is beyond dispute is that CDMA would have worked for 3G European networks and that - in the end - they have accomplished little in trying to engineer around paying royalties to Qualcomm. Another key market that has resisted Qualcomm is China, which - having a closed market - has both only allowed CDMA to be deployed by a relatively small provider and heavily invested in likewise circumventing Qualcomm’s patents.

These are business issues for Qualcomm that have repeatedly affected the company. There has been extreme hostility to the very thought of cooperating with Qualcomm, with established companies feeling that their technology ought to be freely available. (The courts seemingly do not agree.) But Qualcomm is also often seen as overly “aggressive” having pushed for high royalties and refusing to allow potential partners some slack given their strong position, thus guaranteeing that potential partners would resent them and seek ways to circumvent them. The blame is difficult to establish, but there is no question that the extreme ill-will that dominates this area has and continues to have a negative impact on the company.

Nevertheless, CDMA royalties remain the crown jewels of Qualcomm’s business and a major source, of very high margin revenue.

Qualcomm however also has a second business. They manufacture various chips that incorporate CDMA capabilities and often combine them with other features. It is important at the outset to understand that they do not actually manufacture the chips. They design them and contract with fabs such as Taiwan Semiconductor/TSM to manufacture the chips. This is a quite common manufacturing technique for chip companies and leads to higher margins, lower invested capital, but also somewhat less control of the manufacturing process. It is also important to understand that Qualcomm - in its chip business - operates like any number of other companies that manufacture chips containing CDMA technologies. Companies such as Texas Instruments/TXN and dozens of others can and do produce chips containing CDMA technologies under royalty bearing agreements with Qualcomm. Wisely, Qualcomm has chosen not to be a sole provider of such chips as that would have only exacerbated their perceived problems with handset and network providers.

Therefore, in this business, they are one company among many, albeit one that has several advantages in that they do not have to pay royalties and have a more intimate knowledge of CDMA and where it might be heading.

This leads to what is probably the most important growth related issue for Qualcomm. It is a battle for the guts of the cell phone. Just as Intel/INTC - which dominates the X86 industry - has expanded for years by adding more and more to their processor chip, chip sets and eventually mother boards, in an effort to lever their control of the processor into more revenue per PC, Qualcomm whose CMDA chips are the “processors” of the cell phone has sought to garner increased revenue per handset by incorporating other technologies into their chip sets. Thus, they have added chips that include MP3 players, GPS systems, WiFi, and many other capabilities. Here, as well, the company has demonstrated something of an ability to get into spats with other companies over patents as witnessed by the long and litigious conflict with Broadcom. Their success in grabbing more of the revenue represented by cell phone handsets and headend equipment will probably drive much of Qualcomm’s growth in the future, especially considering that there may well be some market saturation issues regarding handset growth, at least in the developed and BRIC countries.

Thus limns the potential business opportunity for Qualcomm, and how it manages to make the best, or worst, of it. How about its investors…? Qualcomm remains to this day a growth company whose stock is available today at an inexpensive price and cheap valuation; its current earnings peg its PE at a startlingly low 20! Factor in a growth rate of ~20% in revenues and net income, and investors find a company whose growth rate matches or exceeds its PE, a PEG of 1 or less. (This calculation ignores the intellectual property lawsuit with Nokia/NOK, and which Qualcomm appears to have the upper hand.) The basic question re Qualcomm remains whether its executives’ always-present hubris (”Hey, we are Qualcomm, and we offer CDMA. Enough said!”) will cause the company to snatch defeat from the jaws of victory.

The company’s shares reflect this uncertainty…

[click on charts to enlarge]

Qualcomm/QCOM qualified easily as 1999’s poster child for share price momentum and extreme valuation; the investor need only view the highlighted portion of the chart to see that. The subsequent 8 years have told a different tale, although the three-fold rise since July 2002 obviously offered a profitable entry. The question becomes whether the current chart foretells whether QCOM will recapture its lost glory as a market leader; a future I believe will come to be. Consider, first, a crucial market perception by Dorsey Wright (below)…

The Basic Principle of Chart Patterns
“There is one principle that is basic to all stock charting: a stock will tend to continue in the same direction in which it is moving. Most chart reading is an attempt to determine as soon as possible what direction this is. Sometimes it is an attempt to predict the direction of a move, but this is most difficult and can be dangerous. Let us look at what actually happens before a stock rises or falls.

Typically, it will sell in a certain range for a relatively long period. We will assume that it is bouncing between 35 and 45. When it breaks out of this range, either up or down, the expectation is that it will make a considerable move. In retrospect this zone is termed an accumulation area if the price has gone up, and a distribution area if the price has gone down. These two terms are based on the assumption that the “smart-money” is accumulating a stock before it rises, and are distributing it before it falls. If the stock rises above the 35 to 45 range, it is expected to find support around the 45 level because investors who were tempted to buy the stock before its rise will recall this as being a favorable buy level. If it drops through the 35 level (violates support), the price is expected to fall substantially.

Let us suppose that the stock, after considerable fluctuation between 35 and 45, moves above this range. It is felt that the 35 level will provide support to a price decline, that 45 will be a demand area. Presumably, investors who felt they missed the stock when the price rose will be willing to buy their stock when it returns to this zone. Again, if the stock passes through the low end of this range, it should make a good downward move. Frequently, advocates of some technical method or other will get excited about a stock moving through a previous bottom or top. Such a breakthrough may be significant, but it is not necessarily so. The mere surpassing of a previous point is not important unless the breakout is from a clearly recognizable formation. Not only that but you must also note whether the stock is above or below an important trend line and also whether the relative strength is positive or negative.”

And this market perception from Trader Vic, Victor Sperandeo (excellent information at the embedded link! - dmg), who discerned a bottoming process to be as easy as 123…
1) A market stops going down,
2) A down trend line is broken, and then
3) A successful retest to confirm.

Voilà, a 123 trend reversal. Note the chart of QCOM, below, but this time with trend lines included…

Qualcomm/QCOM builds a massive (mega) bottom; from its all time high at $100 in January 2000 to its July 2002 low. (Down a whopping 85%!) Even though one key trend line is not delineated (that would be “D”), investors can see readily that which Vic Sperandeo and Dorsey Wright seek — a market in a discernible area pattern, and turning… up, into a 123 bottom, as QCOM shares slowly trade along the right (up-) side of its chart. (NB: channels AA, AB, and rising trend line C.) A price near $35 manifests as a low-risk opportunity to buy; upside breakouts lie at ~$43 and, crucially, at ~$54.

Markets, merchants, and merchandise

All measures of valuation, price, and trend are attempts to discern risk and opportunity. One item I always keep in mind is my role in the process of investing; stocks and markets do not abscond with my (portfolio) monies via some grand plan to steal from me. So as not to perceive myself a victim of random market oscillations, I perceive a set of three: markets, merchants, and merchandise. “Markets” are obvious: they provide a (continuing) venue for buyers and sellers to meet and haggle over price and value before exchanging money for goods. My role is as merchant; my merchandise the stocks I buy cheap today to sell dear later. Yes, I allow for interim oscillations between purchase and sale. The market is merely a venue, and not an intangible mechanism that sets prices; most investors allow the market to set their prices, whereas I set the prices for my wares (inflection points, or maximum points of risk and reward). The markets do not happen to me because I am the market, the market is me.

Okay, that bit of fractal analysis might seem confounding, perhaps daunting, and even foo-foo. Try this. Investors should always keep in mind timing, akin to real estate’s mantra (”Location. Location. Location.”). It is better to be in the wrong stock at the right time than the right stock at the wrong time. But for consistent success, and for the wind at your back, it is better always to be in the right stock at the right time.

And so we return full-circle to the original question, “Whether ’tis safe now to invest…?” And, although seemingly oblique, this post provides my answer. I invest in companies and their shares, not markets. While markets might create better opportunities via a combination of changing price and shifting time, they do not establish prices. We, you and I, do that.

Full Disclosure: Not long Qualcomm/QCOM, but will be soon.
— David M Gordon / The Deipnosophist

A little more cheer from Mish Shedlock; as usual, highly educational for me (having no idea what a CDS was).

Shadows of the CDS Market

I have been writing about the Credit Default Swaps (CDS) ticking time bomb for a long time. In Who’s Holding The Bag? I compared Warren Buffet’s position to Greenspan’s. Here is Greenspan’s position: “Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth.” Buffett’s take is quite different of course.

Discussion of Credit Default Swaps is finally hitting mainstream press, including the New York Times. Before we take a look, let’s recap exactly what a CDS is.

Credit Default Swaps (CDS)

A Credit Default Swap is a bet between two parties on whether or not a company will default on its bonds. A CDS investor is therefore making essentially the bet as the corporate bond investor. The difference being the counterparty is not a company issuing bonds but a third party willing to speculate on the outcome.

Credit Default Swaps are often used in lieu of corporate bonds when a fund manager can not find enough bonds of the right duration for a company in which they want to invest. In that case, if a hedge fund or other party wants to make a bet as to whether or not a particular company will default, all it has to do is find a suitable counterparty such as another hedge fund, a broker/dealer, or an insurance company, etc. to take the other side of the trade. In a typical CDS, the parties agree to swap cash flows so that one party gets a large payoff if the company defaults within a set period of time, while the counterparty gets periodic payments as long as the company does not default.

In theory, CDSs should trade in tandem with corporate bonds. Then again, there is theory and there is practice. One reason they may not trade in tandem is due to the fact that CDS trades are party-to-party deals that are by their very nature extremely illiquid. There is also a huge anomaly because these derivatives are not marked to market as a general rule. Book value can dramatically overstate open market value.

Credit Default Swap Tsunami

On February 11 2008 I mentioned the $45 Trillion CDS market in Credit Default Swap Tsunami Approaches. Inquiring minds may wish to take a look.

Today, the New York Times is writing Arcane Market Is Next to Face Big Credit Test.

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Since 2000, [the market for CDS securities] has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

click on chart for sharper image

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.

An inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a federal banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year “put a strain on processing systems” used by banks to handle these trades and make sure they match up.

And last week, the American International Group said that it had incorrectly valued some of the swaps it had written and that sharp declines in some of these instruments had translated to $3.6 billion more in losses than the company had previously estimated. Its stock dropped 12 percent on the news but edged up in the days after.

My Comment: I talked about AIG at length in Credit Default Swap Tsunami Approaches

In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.

But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.

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My Comment: No one knows who the ultimate guarantor of these contracts is. I have stated on many occasions that it just might be “Madame Merriweather’s Mudhut Malaysia” or some obscure hedge fund that may not be in business tomorrow.

Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. At the outset, each contract was different, volume in the market was small and participants knew whom they were dealing with.

Years of a healthy economy and few corporate defaults led many banks to write more credit insurance, finding it a low-risk way to earn income because failures were few.

My Comment: This is exactly what happened in the subprime market. Continually rising prices made it seem like there was no risk in the mortgage business. There were proclamations that housing was “A totally New Paradigm”, from economists at major firms. See Housing Bottom Nowhere in Sight.

Just as housing became a one way bet, so did bets on corporate bonds. Things got totally insane when the credit markets allowed interest on bonds to be paid not with cash but with issuance of still more debt. Debt was paid back with more debt! See Toggle Bonds - Yet Another High Wire Act.

Everyone was partying without any worries because defaults on corporate bonds were low. There was a mad rush to write insurance. Ambac and MBIA wanted in on the act too. And by guaranteeing derivatives both now appear headed for bankruptcty.

Speculators have also flooded into the credit insurance market recently because these securities make it easier to bet on the health of a company than using corporate bonds.

Both factors have resulted in a market of credit swaps that now far exceeds the face value of corporate bonds underlying it. Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter.

JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.

In 2000, $900 billion of credit insurance contracts changed hands. Since then, the face value of the contracts outstanding has doubled every year as new contracts have been written. In the first six months of 2007, the figure rose 75 percent; the market now dwarfs the value of United States Treasuries outstanding.

The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.

My Comment: There is simply no way those derivatives are marked to market. AIG told investors in December that it estimated valuation losses on its credit default swaps for October and November at just over $1bn. AIG has scrapped the adjustment because market conditions mean it cannot “reliably quantify” the figure.

One of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against.

My Comment: There is approximately $1 trillion in swaps bet on the success or failure of GM when the entire market cap of GM is a mere $15 billion.

Typically, settling the agreements has required the delivery of defaulted bonds if the insurance buyer wants to be fully covered. If the insurance contracts exceed the bonds that are available for delivery, problems arise.

For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company’s debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.

As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in.

“The insurance business is very difficult to quantify risk in,” said Mr. Farrell of Annaly Capital Management. “You have to really read the contract to make sure you are covered. That is going to be the test of the market this year. As defaults kick in and as these events unfold, you are going to find out who has managed this well.”

And who hasn’t.

$45 trillion bet on swaps with the entire treasury market is a mere $4 trillion is simply absurd. Compounding the problem is lack of knowledge abut who the guarantors are and lack of liquidity in much of the derivatives market. There’s always plenty of liquidity when times are good. However, liquidity is a coward. It runs and hides at the first sign of trouble.

Things are so illiquid now that even the municipal bond market has locked up. Insurance guarantees made by Ambac and MBIA are at the heart of it. See No Underwriter Support For Failed Muni Auctions.

Credit Default Swaps on Ambac and MBIA are trading 7 or more levels below investment grade (deep into junk) and 12-14 levels below the AAA or AA ratings assigned by Moody’s, Fitch, and the S&P. Clearly this calls into question the competency of the rating agencies.

Banks and brokerages are unwilling to commit capital and who can blame them?

• No one knows what anything is really worth because there is no market at all for some of these securities.
• Banks and brokerage houses are afraid of a downgrade of Ambac and MBIA because it might require as much as $200 Billion more in capital to be raised.
• Mark to fantasy models have too much stuff on the books at unrealistic prices.
• No one trusts the ratings put out by Moody’s, Fitch, and the S&P.
• Fears of counterparty failures are in everyone’s minds.

Credit default swaps are going to blow sky high. If 10% of credit default swaps blow up, it would wipe out $4.5 trillion in capital. A mere 1% hit would wipe out $450 billion. We don’t know when, but we do know the fuse is lit.

Mike “Mish” Shedlock

A discussion of solar energy stocks from Notable Calls.

Excerpt: “Last week I asked ‘NCN Solar’, a trader closely following and trading the solar space, to give us an overview of the current state of things. I talk to NCN Solar almost every morning, going over the most important developments - a great help to understanding this rapidly changing sector. His overview follows…“

Trader Thoughts’ Bears Take a Breather is worth reading. Trader Thoughts is a global financial market research firm providing trading ideas. Here are a few excerpts:

“We had reaffirmed last week that stocks were in a confirmed bear market. We also categorically stated that a pullback rally within the larger downtrend was overdue and should be used solely to lighten up on long-only exposures.”

“We review the major economic headline this week - a drastic shift in consumer sentiment over the past few weeks that makes a recession now appear increasingly plausible. Although the Fed has dropped is benchmark Fed funds rate by 225 basis points in six months, it has had only limited success in bringing borrowing costs down for consumers and borrowers. Nevertheless, the market believes this failure is the very reason why the Fed will further reduce rates. This negative feedback loop has the Fed pushing on a string in vain. Further, the complete freeze in the relatively obscure auction-rate bond market is the latest shoe to drop in the sub-prime contagion that has now spread world-wide. We finally wrap up with Warren Buffett’s keen sense of timing, that could potentially strike gold for Berkshire Hathaway amidst a pile of toxic waste.”

“The evidence favoring a recession is mounting. Economic growth screeched to a 0.6 percent stall in the fourth quarter. A quarterly survey issued by the Philadelphia Federal Reserve suggested a 47 percent probability of contraction in GDP this quarter and a 43 percent chance in the second quarter, levels not seen since the recession in 2001. Economists surveyed by Bloomberg and WSJ earlier this month forecast even odds of a recession.”

“History has taught us that economies do not normally slip gradually into recession; they plunge spectacularly as they turn over. This usually creates glaring discontinuities in the incoming economic data, of the sort clearly on display in the survey reports of the past few weeks. A degree of panic seems to have set in that could possibly tip the scales in a stalling economy, pushing it into a free fall.”