A True Outsider’s Perspective Revisited

Good Evening: After yesterday’s launch into space, U.S. stock prices spent Tuesday settling into a comfortable, if slightly lower, orbit. The economic data out today continued to portray a slowing rate of economic decay in the U.S., enough so that some bulls are proclaiming the recession might be over and some bears are rethinking their positions. I will quickly cover today’s rather uneventful activity before reviewing the telemetry of the recent equity rally with a fictional character I introduced back in February. Perhaps this “Warren Buffett of Mars” can give us some perspective on what has and hasn’t changed since his last visit.

U.S. Economy: Services Shrank at Slower Pace in April

The swine flu scare continues to recede, but it didn’t have much impact on overseas bourses. Markets in Asia and Europe were confined to gentle ranges overnight, and our stock index futures were off a bit prior to this morning’s open. The averages opened anywhere from down a fraction to 1% lower, as some speculation about bank capital needs was offset by some conditional optimism from Chairman Bernanke. Stocks received a short-lived boost when the ISM services data came in at 43.7 versus expectations for a reading of 42 (see above). Any figure below 50 is contractionary, but this data point joins many others during the last six weeks that have been less awful than feared.

Here Comes the Sun: The Recession May Be Over

The arrival of spring has brought with it a lot of chatter about green shoots and a turn in the U.S. economy. As you can read in the above article, Charles Schwab’s Liz Ann Sonders is telling Schwab’s client base that these improving data points might mean the “Great Recession” is now over. With stock prices and bullish sentiment figures rising in tandem, I doubt she is alone in holding this view. I remain skeptical, but there are fewer disbelievers every day.

Closing the book with an open mind

The 30% rally in equities since the March lows and all of the less bad economic data has caused even the grizzliest of bears to reconsider their views. BAC-MER economist, David Rosenberg, has been among the earliest and most accurate practitioners of the dismal science since housing started to roll over back in 2006. As should all investors, Mr. Rosenberg has decided to question his own arguments, and the piece you see above has him playing devil’s advocate (in this case, Angel’s advocate) with himself. Trying to argue the other side’s case is always a fruitful exercise, lest one become too wedded to certain opinions. Though Mr. Rosenberg ultimately decides to remain skeptical, he is now open to the possibility that the rally under way may continue. I will only say that when bulls are proclaiming to see the sun and bears are questioning their own shadows, a decent top is probably not far off.

U.S. Stocks Retreat on Concern Over Government Stress Tests

Neither of these articles seemed to have much of an impact on the major averages, though, and the indexes bounced around below unchanged for most of the session. They all closed with losses of less than 1%, and even the volatile KBW bank index could only muster a decline of 1.6%. Treasury yields rose only slightly in the wake of yet more supply. A decent 3 year note auction saw yields rise 1 to 2 bps. The dollar was mixed but noticeably higher against the euro, and commodity prices drifted in the opposite direction. A modest decline in energy prices and crosscurrents in the other sectors left the CRB index down 0.2% today.

A True Outsider’s Perspective — Jack McHugh, February 12, 2009

Back in February of this year, I used a thought experiment to show why the constantly changing plans out of Washington and the ever shifting rules that governed them would present a significant barrier to entry for fresh private capital seeking to exploit a growing number of bargains. The full piece is above, but here is an excerpt of it for any new readers:

“Imagine you run a sovereign wealth fund on Mars, say the “Retired Employees Secure Capital Umbrella Entity”, or R.E.S.C.U.E. fund, for short, and you’ve been sent to Earth by your forward-thinking leadership. Earth is your preferred investment destination because word is starting to get around the galaxy that there is a credit crisis on the Blue Planet that will yield a patient investor a healthy rate of return over the long term. Upon educating yourself about the Earth’s markets and securities, what would you buy? Since you are known as the “Warren Buffett of Mars”, you might shift your gaze to the markets in the home country of the original “Oracle”. The U.S. has the largest and deepest markets, too, which should give an extraterrestrial buyer plenty of choices from which to pick securities with a built-in margin of safety for your investors back on the Red Planet.

“After learning the ins and outs of EDGAR, and after boning up on U.S. financial history by reading the books of exceptional authors like Jim Grant, you might be tempted to have a peek at the latest analytical research from Wall Street…Before asking a kindly U.S. broker to help you identify and then buy the best values, you have one final question for him or her: ‘How is the U.S. government responding to this crisis, and how will these policies impact the values of financial stocks and mortgage-backed securities?’ Momentarily stumped, your broker then takes your question as a cue to launch into a description of the various alphabet soup lending programs put in place by the Federal Reserve, as well as the stimulus package before Congress and the different possible plans recently outlined by Treasury Secretary, Tim Geithner.

” ‘Fine’, you say, ‘but which programs have been settled upon, and what are the details describing how they’ll be implemented? Lastly, and this is important: Are these programs and/or the rules governing them subject to change?’ Upon learning that the United States has a brand new administration at the helm and that they have yet to really determine exactly how they will tackle the myriad challenges before them, our would-be investor from Mars shakes his head and takes a pass. ‘I have to wait’, he tells his distraught broker. ‘I cannot invest until the rules become clearer and the policy proposals stop changing every day. Don’t feel too bad’, he says in trying to comfort his broker. ‘I can tell by reading stories on your internet that it appears all the other nations on earth have the same problem. Call me when you have some clarity on these issues, and I’ll set about investing on behalf of our R.E.S.C.U.E. fund’ “.

Perhaps it would be instructive to update this thought experiment by pretending to listen in as the Martian Buffett (MB) discusses investment ideas with his eager broker-salesperson (BS).

BS: Hey, nice to finally catch up with you again! Things are really starting to pop here on Earth; the S&P 500 is above 900 and the economic data shows the economy is turning around. You need to get in before this market gets away from you.
MB: Really? The U.S. and global economies are growing?
BS: Well, no, but most releases are coming in better than expected and the pace of decline has definitely slowed.
MB: So, the economy is still contracting, but it’s not getting worse as fast as it used to, right?
BS: I guess so, but stocks are up. It’s a well known fact that equities are a discounting mechanism and they are now saying a rebound is on the way. The bottom is in.
MB: Is this the same discounting mechanism that rallied to new all-time highs in October of 2007 — when the credit crisis on Earth was already months old and had much pain to still dish out? And, is this the same forecasting tool that saw stock prices bottom in October of 2002 — more than a year after the 2001 recession was over?
BS: OK, forget stocks; credit spreads are coming in. You should buy some corporate bonds.
MB: Why should I buy a corporate obligation when I read stories about senior secured creditors being forced to stand behind junior creditors in the Chrysler bankruptcy? If I don’t know where I’ll stand in line when it comes time to divvy up the assets, how can I determine a fair price for the risk I’ll take holding the bonds?
BS: Chrysler was just a one-off situation.
MB: A one-off like the AIG bonus situation, which then morphed into bonus restrictions for all employees of TARP participating institutions?
BS: Hey, there’s a new sheriff in D.C. How can I predict how he and Congress will behave at any given time?
MB: Exactly — the rules are still changing
BS: Fine, but if you can’t beat ’em, join ’em.
MB: Come again?
BS: Join ’em — put the R.E.S.C.U.E. fund into the PPIP, the Public Private Investment Partnership.
MB: I agree that some of the terms I’ve read about are enticing, but why are so few firms participating? And why isn’t your government making it easy for individual taxpayers to sign up and invest alongside the big boys?
BS: Dunno — more room for you, though.
MB: Thanks, but I’m guessing that extra-terrestrial investors like me might later be portrayed as carpet-bagging opportunists. What will the tax rate be if we make a lot of money investing in the PPIP?
BS: Stay in for a year or more and I don’t see why you wouldn’t receive long term capital gains treatment, which is 15% right now.
MB: Sounds like a decent opportunity, especially for U.S. citizens if they’re allowed to participate, but I don’t think it will work for the R.E.S.C.U.E. fund. Team Obama promised during the campaign to raise capital gains tax rates. So even if the rules are the same for Martians as they are for Oracles based in Omaha, Nebraska, I still think there is a near certain chance that the rules change again in the future. Given the mood in your Capitol, I see capital gains tax rates rising as soon as next year.
BS: Oh, come on, now! What is it you want, anyway?
MB: During our last conversation, I told you the R.E.S.C.U.E. fund would pass on investing until there is more clarity. Unfortunately, the intervening months have indeed brought some clarity; it’s clear your government wants to play an active role in the economy all the way down to the corporate ownership level. It’s also clear that bondholder rights are weakening, especially in any bankruptcy where Uncle Sam feels the need to weigh in. This form of clarity requires higher risk premiums be built into securities throughout the capital structure, and those prices are higher now than when I first looked at them in February. Sorry, but I still have to pass. Unlike some managers here on Earth that I’ve been reading about, I take my fiduciary role quite seriously.
BS: But…there has to be some security somewhere that interests you.
MB: Perhaps, but only if you can structure it for me. Think your firm can handle it?
BS: Of Course! We’re the best on the Street at customizing securities for investors!
MB: So I’ve heard; some of them will no doubt wash up in the PPIP. But I’m tired and it’s time to call it a night. Why don’t we pick up our conversation tomorrow?
BS: No problem; I’ll call you tomorrow and we’ll be ready to create anything you want.
MB: I doubt it, but let’s talk tomorrow. Good night…

— Jack McHugh

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