Sugar High or LSD?

Years ago Charles Goodhart minted an eponymous law that is applicable today in financial markets. Last week, Pimco’s Mohammed El-Erian coined the metaphor “sugar high.” He was talking about the converse of Goodhart’s Law. We think he wasn’t harsh enough; hence, we use the metaphor “LSD.”

The 99th edition of Pears Cyclopaedia (1990-1, pp. G27, G31) restated Goodhart’s Law as follows: “As soon as the government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends.” The converse could be stated as, once markets succumb to Goodhart’s warning of this unreliability, classic standards of value will prevail again.

The recent stock market rally of certain financial stocks is an example of Goodhart’s warning at work. Barron’s Mike Santoli summed it up in his August 31 column:

“How is it possible, though, that Citigroup (ticker: C), Fannie Mae (FNM), Freddie Mac (FRE), Bank of America (BAC) and AIG (AIG) – with a combined market value near $200 billion – could ‘drive’ a stock market worth more than $10 trillion and that has added about $1 trillion in value this month, as measured by the Wilshire 5000? And how could it be that a handful of speculative stocks are muscling around the market when nearly 90% of the S&P 1500 index members were above their 200-day average price? This is an extreme also last seen in the ’03-’04 period. It says the move has been powerful, widely inclusive, that it’s probably time for a rest or a little downside shakeout, or a period when the market becomes a bit more selective.”

Let’s look at these five basket cases, which the Wall St. Journal has identified as accounting for “31% to 43% of daily NYSE share volume last week.” They lead the famous Jim Bianco list with total losses over half a trillion dollars. They have raised capital mostly from the government. They have about $100 billion less now than when the mess started. Their losses are projected to continue for some time.

BAC may be the least worst of the lot, although it is still under attack by the government. BAC is one of the 19 identified as “too big to fail.” That doesn’t mean it is going to succeed as a profitable and growing institution. It may, but time needs to pass to see that occur. C is being slowly dismantled. It, too, is one of the magic 19. We would consider these two banks as quasi-GSEs (government sponsored enterprises). How they will eventually emerge from the government bailout and what will be left for the existing shareholders is a subject of fierce debate.

AIG is in a class by itself. It would not exist were it not for the Geithner-Bernanke package of assistance. It is gradually being dismantled. It is the subject of speculation, and the legal fight with its former chairman has intensified the lawyers’ efforts. Is it worth the $50 a share market price currently trading on the reverse split stock? Maybe, but here, too, we wonder how much will be left for the shareholder after the government extracts its investment. See August 31 Barron’s column (pg.40) by Andrew Bary: after the US government’s preferred is factored in, AIG “has no tangible common equity.” We’re not sanguine. In the future, investors may wish they had seized the $50 bid when it was available.

Lastly we have the two true GSE carcasses. Fannie and Freddie stock prices have rallied without any underlying basis for increased value. Both face major additional losses. Both will need billions more in capital from the Treasury. If they were private companies, they would be insolvent. Shareholders may not realize anything of a tangible result for decades, if ever.

So let’s see. BAC and C are likely to show Goodhart’s law at work. With luck and massive stimulus on a continuing basis for many years the converse of Goodhart may ultimately lead to a profit for those who buy the shares today. Anyone who does so must think of himself as a raw speculator.

AIG may qualify for the El-Erian sugar-high metaphor. Without Geithner and Bernanke, market forces would have bankrupted AIG last September. Dismemberment may prove orderly, but restoration of value is another matter. Share buyers may want to choose “Equal” or “Splenda” and save their calories (money) for something better.

To buy Fannie or Freddie is an act in the LSD category. We wouldn’t do it with our own money. We certainly will not do it for clients. At the end of 2004 we recommended the sale of Fannie at $70 a share. At the $2 price today, it is still a sale unless the share buyer is hallucinating.

.David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com