Thursday, September 23, 2010

How To Spot A Bubble? (So you think you're a contrarian? Part Deux)

In re-hashing my for-profit education stance, I came across another element of being a contrarian: spotting bubbles

Case in point: Netflix- $165/share. Yes, the stock has risen 800% Year-over-year. Yes, I am a subscriber and love the service ( I would cancel cable before I would cancel netflix). The reason I am comfortable calling Netflix a bubble is based upon the level of hubris displayed by Netflix CEO Reed Hastings in a recent interview. Here is an excerpt from the interview with "The Hollywood Reporter",

"THR: American services when they enter the Canadian market typically charge the locals more than they charge stateside. Why the discount for Canadians?

Hastings: We want to provide an incredible value for Canadians, and it's the lowest price we have anywhere in the world for unlimited screenings. And anyone can try it for free for a month. It's pretty addictive.

THR: Are you concerned that American Netflix subscribers will look north and ask for the same discount Canadians get at $7.99?

Hastings: How much has it been your experience that Americans follow what happens in the world? It's something we'll monitor, but Americans are somewhat self-absorbed.

THR: How will you will measure success for Netflix Canada?

Hastings: I'm certain we'll succeed, so it's kind of a matter of degree. We're not quantifying that in terms of subscriber numbers or profitability. What we're focused on is getting out there. We've got to get out on all of the devices, get the word out, and we need to be such a good service that people not only stay with us but rave to their friends about it. "

I'm not so appalled by the fact that he views Americans as ignorant and self-absorbed, as the fact that he does not measure success in terms of subscribers and profitability. It should be no-big-secret that Netflix was cashflow negative under its traditional 3-out-at-a-time plan for $19 (due to high postage and DVD replacement costs) and only turned free-cashflow positive due to its streaming business (subscriber growth exploded under its $9, one-at-a-time, unlimited streaming plan- due largely to lower shipping and dvd replacement costs).

Netflix's existing streaming agreements were priced opportunistically as content-owners failed to envision the subscriber growth that Netflix would generate from being able to stream through newer DVD players/TVs/gaming systems. Unfortunately, those contracts do not run forever and Netflix will find itself in the same difficult position as cable companies in a few years (forced to pay much higher rates for streaming). The difference is, Netflix posesses no major barrier-to-entry or competitive advantage like the cable companies do.....

I am not short NFLX yet, but at $8.3Bln market capitalization (4.4x sales/16x Ebitda) I firmly believe that NFLX shareholders will have a "coming-to-Jesus" moment at some point over the next two years.

COCO a Go-Go....

Since my recommendation to buy COCO (Corinthian Colleges) and WAPO (Washington Post) on 08/16/2010, both stocks have increased in value by a substantial amount (+25%, vs +5% for the S&P 500). At its peak today, COCO was up more than 36% over the past month.

As it turns out, the Education Secretary Arne Duncan announced they were "keeping their options open" and that final DOE regulations could be delayed. This should lead to significantly more upside in both COCO and WAPO.

Previously, I laid out a number of potential problems with the bear-case, which included skepticism that: 1)Racially-divisive gainful-employment rules go into effect on schedule without any changes 2) Belief that upcoming Congressional elections might create uncertainty about final rule adoption (Republicans want to extend oversight of not-for-profits, not just for-profits) 3)Current valuations imply that COCO/WAPO shutter their entire programs overnight, giving zero credit to ancillary programs (Heald College) or foreign programs (17% of assets in Canada)

Essentially, if you priced a business at liquidation value (i.e- 2-3 earnings and below tangible book value then suddenly decide suddenly that the business will live a little bit longer... you will have made a huge mistake selling-out and materially underpriced the value of the franchise. There is uncertainty in all human endeavors and perhaps an above-average level of uncertainty in federal funding, but with 30% of the company's shares shorted and the forward business value priced near zero.... I believe the pessimists are over-confident in their analysis to the point of arrogance.

Remain long COCO ($6.50) and WAPO ($375), in spite of my disgust of for-profit education stocks.

Sunday, September 05, 2010

Update on Washington Post

Recently, I recommended Washington Post as a good contrarian investment that was considerably undervalued near $300/share. Since that post, the stock has rallied more than 25% to +$380/share. In the interest of full disclosure, I present my full valuation breakdown of Washington Post. My original WaPo valuation was published in Barron's (March 19, 2010 edition- Letters to the Editor). The analysis below updates that work and demonstrates where I come up with my $478/share sum-of-the-parts valuation (+60% upside from entry point).

Washington Post has 4 distinct business units and a significant pile of investments that comprise its value. The business units and my best-guess at valuations are as follows (in order of relevance):

1)Cash and Investments of $1.05 Bln= $660Mln cash + $392Mln stock (mostly Berkshire Hathaway shares). WaPo does have $400Mln Long-term debt, which doesnt mature until 2019.

2) Cable Television Business worth $2.0Bln= 1.4Mln subscribers (across cable, internet, telephony) in rural markets with limited competition. This unit generates EBITDA of $300Mln per annum and is likely worth at least a 7x multiple, based on below-average capital spending needs.

3) For-Profit Education Company Kaplan-worth at least $1Bln in= Annualized EBITDA for 2010 will be $425Mln, which suggests a low valuation multiple of 2.2x pre-tax operating profit. A significant portion of Kaplan's business involves recruiting minorities and unemployed individuals to go back to school and utilize available federal grants. Recently, the Department of Education has decided to crack-down on abuses in the for-profit space. They have proposed very stringent "gainful employment" requirements, which will be certain to shut-out minorities and at-risk unemployed persons from the higher education market. Virtually no college (non-profit or for-profit) will risk losing access to federal funding by "taking a chance" on someone with a high financial risk profile (i.e- low credit score, no job, no savings, medical problems, criminal record, etc.). I do not love the for-profit education business, but the ends do not appear to justify the means.

At a 2.2x multiple, Kaplan is priced to either be out-of-business within 2 years, or be severely distressed. By pricing for the worst-case, it leaves us a free upside catalyst in the event :1) Republicans win Congress and dilute for-profit clampdown 2) Kaplan alters its business model 3) Final regulations are delayed or otherwise watered down. 4) Washington Post steps up lobbying efforts. As Bill Clinton once said, "Never pick a fight with a guy that buys ink by-the-barrel", which is certainly the case given Washington Post controls the namesake newspaper!

4) Broadcast TV stations worth at least $500Mln- This unit is clearly on the decline, but is generating an annualized $110Mln in EBITDA in spite of overall ad-market weakness. Assigning a 5x multiple with a strong political ad-spending season ahead of us seems to make sense.

5) Washington Post newspaper worth at least $250Mln?- This is a total guess. Washington Post is one of several iconic newspapers that likely has staying power, although not as much clout as the NY Times/Wall-Street Journal. The Post is still important and holds some editorial sway in the epicenter of our fast-spending federal government. The Times is set to generate $700Mln revenue this year (-30% YoY), but a distressed valuation of 1/3rd times sales appears appropriate.

Summary- In total, my estimated enterprise value for Washington Post is $4.4Bln or $478 per-share(after subtracting $400Mln debt), with a free-call option on the Kaplan for-profit schools in the event that federal student-loan regulations are not altered. If Kaplan were worth absolutely zero, Washington Post would still be worth $3.4Bln or $370 per share under our analysis.

Monday, August 16, 2010

So you think you are a contrarian?

Under-appreciated statistics on contrarians

1) 98% of contrarians at the Pamplona "running of the bulls" get run-over
2) 98% of people view themselves as having a unique and insightful opinions, when in fact it was simply derived from another commentator (i.e- Fox news, network media, blogs)

That being said, we here at are ready to boldly assert we are considering a true "contrarian" play. Namely, we are looking at several stocks in the disgusting for-profit education sector. Congress is concerned about education quality and rapid-growth of for-profit schools, which tend to leech off of federal student loan programs. In particular, our efforts are focused on the least-liked names in the least-liked sector of the market:

1. COCO- Corinthian Colleges: $5.23 last trade, valued at 1/3rd of TTM sales, 1.9x Ebitda, or 3.2x earnings . The stock is down 75% since April 2010 (past 4 months) and trades at a market capitalization of $460Mln.

Ironically, COCO paid nearly $400Mln cash to acquire a higher-quality college chain (Heald) in 2010. Had they saved their money, they would be trading at/near their cash position on the balance sheet. The entire value of COCO appears to be comprised of Heald College and the 17% of revenue derived from Canada. There appears to be little value placed on the bulk of COCO's principal business unit "Everest College". Most of COCO's revenue comes from vocational programs (auto tech, etc) or 2-year associates degrees.

Washington Post owns 9% of COCO stock and my belief is this company is likely to receive a private-equity or third-party bid for the company. It is difficult to estimate what impact government efforts to limit Federal student loans will have, but I do not believe it will destroy this company (although it could cause sales/earnings to take a hit).

2. WPO- Washington Post: $318 last trade, valued at .48x sales, 2.9x ebitda, 10x earnings. WaPo is down 44% from its April peak ($2.3Bln enterprise value), following a Barron's analysis that WaPo "is the most undervalued stock in the entire media sector". If the statement was remotely true in April, then it is even more so today!

Interestingly, WaPo generates earnings from multiple segments outside of for-profit education. It owns a number of cable-tv monopolies that generated nearly $300Mln Ebitda, which at a 7x multiple= $2.1Bln valuation. The company also owns its namesake newspaper and broadcast tv stations which are worth between $500Mln-$1Bln. On top of this, it had more than $1Bln cash on its balance sheet ($600Mln net of debt outstanding).

Essentially, WaPo is trading at a 13% discount to fair value, entirely ignoring the value of its Kaplan education division ($2.3Bln enterprise value vs. $2.6Bln estimated value of non-education businesses). So, any valuation assigned to WaPo's education segment is "gravy", as some might say. Considering that the education segment generated $377mln EBITDA over the past twelve months, it is clearly WORTH SOMETHING, even if its business activity is viewed in a low-light. If we assign a distressed EBITDA multiple of 2-3x, that segment should be valued between $750-1.1Bln.

So, combining our $2.6Bln base-line value for non-education segments of WaPo with our $750Mln base-line value for WaPo's Kaplan segment, our estimate of enterprise value increases to $3.35Bln. This valuation equates to $507 per share and represents 60% upside to the current stock price. Warren Buffett owns nearly 20% of WaPo, although its unclear if he has any interest in buying more.

Key potential catalysts that drive our "contrarian" spirit:
1) Stocks are significantly oversold within a very short time-frame

2) Both businesses have segments that are "high-quality" or immune from proposed federal legislation on "gainful employment", as it pertains to eligibility to issue Title IV student loans.

3) The value of the higher-quality, "immune" businesses exceeds the current market valuation on COCO/WPO stock

4) Federal legislation on gainful employment will not occur until AFTER upcoming 2010 congressional elections. If Democrats lose control of Congress, I believe odds of current legislation being passed decrease significantly.

5)As currently written, the new student-loan requirements are specifically designed to exclude poor, highly levered minorities. In particular, the bill will effectively shut-out those minorities with low-paying jobs and difficulty with reading/higher math. Curiously, Democrats want to spend hundreds of billions putting subprime borrowers into homes, but now want to curtail loans designed to educate those same subprime borrowers (giving them a shot at higher-paying jobs)?

6) One other potential catalyst is that for-profit schools underwrite their own loans and become a hybrid teacher/student-loan company. Interest rates would have to rise, defaults would be problematic, but in such a scenario the core business survives

7) Costs at for-profit schools rise less than non-profits. Most non-profits are focused on expanding their campuses and building giant altars to the football-gods (massive stadiums) or their own hubris. As such, for-profit schools will be better able to manage flat/negative growth in tuition rates than non-profits.

8) It is unlikely that any politician passes a bill that bankrupts the for-profit schools overnight. Take Corinthian as an example. Their student enrollment is currently 110,000 students. They have been around since 1995, which means more than 1,000,000 students would have worthless degrees thanks to a legislative effort by Congress. How will an out-of-work constituent feel to re-write their work resume' and remove their education credentials? How would that make them vote?

Tuesday, August 10, 2010

Feds yell "bomb" inside a crowded savings account...

Lets use an analogy: since the US Federal Reserve is the policeman for our monetary system, we will compare their actions to policing a theater. Their stated goal is to maintain stability (prices), while maximizing the number of people watching movies in the theater (full employment). Under normal circumstances, movie patrons are courteous, polite, and anxious to get inside and watch high-quality theater fare (i.e-such as "Black Dynamite").

But what happens when there is a slowdown and cinematic-poo like "Macgruber" is showing on the main screen?

People may still show up at the theater on Friday night wanting to see a movie, but would be unwilling to sit down and suffer the 90 minutes of pain called "Macgruber the Movie". While patrons may choose to wait quietly in the lobby for a better movie to start up, this is not politically or economically viable for our "theater police". The regulatory mandate is to maximize employment (people watching the movie, regardless of what is showing). As such, watching and waiting for a better movie or story to come along is not acceptable.

So, our "theater police" (Federal Reserve) spring into action... first they cut the price of movie tickets by half (lower interest rates). But what if people still choose not want to watch the current "movie" (i.e- spend money, shop, buy houses, consume)?

Well, what if the theater police used their power to scare patrons, with the following threat: "Go inside and watch the current movie, or we will make sure you can never see a movie again!".
If the threat is perceived as real, many patrons would reluctantly go watch the film, no matter how bad. Does the outcome justify the means? Are such strong-arm tactics appropriate for regulators/authority to use? Does shattering any sense of stability to to achieve full employment make any sense at all?

This is at the crux of recent economic silliness (some would mischaracterize it as "debate"). Most recently, one of the Federal Reserve Board governors (James Bullard, St Louis) noted that the massive and unprecedented expansion of US money supply (trillions, with a T) has not caused economic activity to increase significantly. Bullard goes onto suggest that an appropriate course of action would be for the Federal Reserve to scare the populace by printing even more money (under the term "quantatitive easing"). Bullard's logic is that causing individuals to panic-spend their life savings (because they are scared of their government debasing the currency) is preferential to slow economic growth.

Going back to our theater analogy, we now have someone in authority suggesting that it would be appropriate to yell "Bomb" in the lobby of a crowded theater, under the auspices that it might make some people run further into the theater (perhaps accidentally into where the movie is being shown). The problem is that some people will run out of the theater altogether and never come back (avoid US$ currency exposure), while the individuals inside the theater will be panic-stricken about when the bomb is set to go off. The inadvertent horror of watching MacGruber the Movie will become the least of their worries!. Alas, that leaves us with a careless regulator that has witnessed the carnage and tries to undo the damage by saying, "Just kidding, I was not going to blow the place up".

Such thinking is not bourne of responsible, intellectual leadership. No, not even for the purpose of "evoking a debate". If you yell bomb on an airplane, you are arrested. End of story. If our Federal Reserve Governors yell "bomb" with respect to the savings of the average American, do they expect it to generate productive, long-term investment?

Lest you think the dissertation above is hypothetical, I have attached a link to an utterly embarrassing research paper posted by an irresponsible member of the Fed Board of Governors, James Bullard.

PS- Why do central bank decisions matter?

Your savings(if denominated in US$) are directly managed by our US central bankers at the Federal Reserve. Although hypothetically controlled by our Treasury Department, the Fed which actually controls the amount of currency in circulation. For example, while it may have taken you twenty or thirty years to accrue a fixed-income pension, a small social-security-stipend, and perhaps a modest sum in your bank account..... our central bankers can conjure up a similar sum within a millisecond.

In truth, our central bankers can conjure up many multiples of our country's net worth within a few milliseconds, thanks to the wonders of computers and electronics (no more waiting for an outdated printing press to crank out all those bills by hand!).

So why does this matter? Well, your "savings" only have value to the extent that a purveyor of physical goods/services(i.e- grocery store, Best Buy, etc.) has demand for your currency. If our central bank doubles the supply of currency in circulation overnight, the value of your currency is debased (cut in half). It may take awhile for most people to recognize this. If you are earning minimum-wage working at a bowling alley, you will continue to earn your minimum wage....but that person has taken a significant pay-cut relative to his real cost of living. Unless the minimum wage worker has significant real-estate holdings or hard-assets (i.e- gold) lying around, such currency manipulation harms his interests. It harms the citizenry as a whole.

Tuesday, August 03, 2010

Logic=Fail by Top Economists (Part Deux)

Another example of absurd reasoning by the economists that drive our monetary policy and influence our political leaders:Nobel-Prize winning economist Paul Krugman, of the New York Times and Obama confidant

Krugman has criticized both Bush and Obama for "not doing enough" to either 1) Avoid a massive depression or 2) Create a magical economic recovery filled with jobs and growth in GDP (Gross Domestic Product- a broad measure of economic activity) .

First of all, we ARE NOT IN A DEPRESSION. It seems scare tactics are a key ingredient to creating headlines and generating an unnecesary response from politicians/central bankers. GDP for 2009 was $14.2 Trillion, near an all-time high and up approximately 1% from 2007. Thus, in spite of the massive housing and credit collapse in our country, our economy continues to hum along near its all-time high. Consumer prices and company profit margins remain high and deflation is virtually non-existent outside of technology/housing.

Second, a recovery in jobs that is driven by the government increasing its own payroll does not create productivity or sustainable economic value in the long run.In spite of our "GDP data" appearing strong, many people are unemployed as a significant number of unproductive jobs were shed from the system. Many of these jobs were associated with unnecessary car production, mortgage financing, realtors, construction, leisure, gambling, etc. So if many private-sector jobs disappeared, how has our economic data remained strong?

Answer- Massive increases in government spending. Since 9/11, our government spending has increased at a rabid pace, only more-so since the housing bubble reached an unsustainable size.Currently, the government is nearly 40% of our economy.

So our economy only appears stable because of the excessive government spending (Lesson of the day- When people spend more than they earn, its called going into "hock". When governments spend more than they earn from taxes, its called "stimulus"). So our federal government is akin to someone that has lost his job, but wants to feel good about himself by pulling out the credit card and treating himself to a few fun foreign wars (Iraq/Afghanistan), unnecessary new tech(defense) gadgets, and extra perks (massive increases in transfer/social payments).

Curiously, many cities and states are reporting massive deficits, in large part because of the high pension benefits guaranteed to their many workers. The suckle of permanent government employment ensures that budgets cannot be right-sized in a downturn, to the extent that the private sector rationalizes its profit/loss. Yet, economists suggest that the correct course of action is for the government to further increase its spending role in the economy?

How much government is too much? 50% of our economy? 60%? Once the government hires workers and subsidizes poor investments (i.e- our housing bubble in the 2000's), it typically has a long and ugly end. For markets such as Detroit, which have seen a massive exodus of people, it is equally difficult to tear-down excess housing stock as it is to fire highly-paid municipal workers. In fact, one of the drivers behind Detroit's decision to bulldoze thousands of homes was the high cost of employing unionized police/fire workers to protect their communities.

Logic=Fail on part of Top Economists

A prime logic failure of many "economists" today is the circular reasoning that is employed. For many so-called Keynesians, if the economy is weak, its the responsibility of the government to "stimulate" it. It must not be left alone for a second! If the economy continues to weaken post-"stimulus", economists will confidently state the problem, " You did not use enough stimulus!" Upon firmly applying 20x the amount of "stimulus", the Keynesian economist would not second-guess the stimulus issue at all.

Although economics has claimed to be a science, it seems to rest entirely on theory and very little on empirical outcomes (see last post for other examples).

-In the real world, excessive use of antibiotics in hospital patients can lead to resistant bacterial strains ("super bacteria"). As such, if antibiotics are not having the desired effect, intelligent doctors will seek alternate treatment methods or prescriptions.

-In the real world, when you throw water on a grease fire and it simply spreads the fire further, a fireman will not tell you to throw more water on the grease. He will suggest a different course of action.

-In the real world, when a little child discovers that his square peg will not fit through a round hole, he plays around until he finds the right peg for the right hole

None of these empirical realities towards problem-solving is utilized by so-called "economists"
. Which begs the question, if economists have no benchmark to determine when their monetary experiment has failed, how will they know when to shut it down?

Economists- Argumentum Ad Absurdum

Peter Lynch is a wise man and correct about many things. One of my favorite quotes from him is that "If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes". This was never more true than today, when it seems neither amateurs or professionals are adding much value to the debate.

Silliness is widespread. For example, statements from our President that "we will lose 3 million jobs if we do not pass a stimulus bill". Then, after the stimulus is passed and we still lose MORE THAN 4 million+ jobs, a new study is engineered to show that the stimulus worked better than expected, even though the outcome is below the worst-case, no-stimulus forecast.

Keynesianism (a.k.a-government stimulus as savior in all circumstances) is truly a circular argument with no way of igniting any logical/factual debate. A great example of simple logic failute by the economist-elite is seen below:

Economists Tell the Masses: "It Could Have Been Worse"
Monday 02 August 2010

by: Dean Baker,

"the economists are back telling us that we should be thankful that Congress and the Fed enacted the TARP and the other programs that saved Goldman Sachs, Citigroup, and the rest from bankruptcy. A new study by Princeton University Professor Alan Blinder and Mark Zandi, the chief economist at Moody's Analytics, examined the impact of the TARP and the related Fed and FDIC bailout programs. The study found that without the bailout, GDP would have declined by another 6.5 percent and the economy would have lost another 8.5 million jobs. In other words, things might be bad now, but if we didn't shovel trillions in loans and loan guarantees to Goldman Sachs and the rest of the Wall Street gang, they would be even worse.

Before we start thanking Goldman for taking our money, it is worth taking a closer look at the study. The big story here is the counterfactual. What does the study assume the Fed and Treasury would have done if we had not passed the TARP and the Fed had not come through with its vast array of emergency loan and loan guarantee programs?
The answer is that the study assumes that they would have done nothing. In other words, the question asked by the study is "what would the world look like if the federal government had done absolutely nothing to counter the economic and financial downturn resulting from collapse of the housing bubble?"

This counterfactual seems more than a bit unrealistic. Suppose we had let the market work its magic and put Goldman, Citigroup, Bank of America, and Morgan Stanley into bankruptcy. Suppose that once these firms were in receivership and their bank units were in the hands of the FDIC, the Fed flooded the system with liquidity. How would this situation compare with the situation where trillions of taxpayer dollars were put at the discretion of Goldman and the rest through TARP and the Fed's special facilities?

The Blinder-Zandi study tells us absolutely nothing about this scenario. In other words, Blinder and Zandi have constructed an absurdly unrealistic counterfactual and told us that the TARP was much better than this absurd scenario. This is like saying that people who don't eat chicken will starve to death. Under the counterfactual that people who don't chicken don't eat anything else either, they certainly will starve to death.

But that is not a serious analysis of the benefits of eating chicken, and Blinder and Zandi have not given us a serious analysis of the benefits of the TARP. This "it could have been worse" line should be flushed down the toilet. The reality is that greed and incompetence created an entirely unnecessary disaster. Tens of millions of people are still suffering from its consequences. And the Wall Street boys and the economists who are responsible for the disaster are all doing just fine.
People should be really angry about this and a silly study that might be used to tell them otherwise should just make them angrier.

Monday, July 19, 2010

Tempted to buy BP?

Recently, Michael Santoli (Barron's, July 19 2010) posted an article suggesting that BP is clearly undervalued and citing a number of bullish hedge fund types that bought the stock "down to its low near $27 per share".

Both of the hedge funds (buying BP) cited in the Santoli article appear to be at significant losses on their initial investments. According to Mr. Santoli, DLS Capital began buying its stake within a month of the spill, during which the stock traded at an average of $47 per share (-26%). Mr. Santoli also states that T2 Partners was a buyer of BP "down to its low near $27 a share". However, Whitney Tilson (of T2 Partners) was advertising his significant stake in BP as early as June 8th, 2010. Prior to June 8th, BP stock had not traded below $36/share. Based on Mr. Tilson's statements on CNBC, he had already built a significant position at higher prices. While it is possible that Mr. Tilson "averaged his loser" on BP down to $27/share, it seems likely he is at a mark-to-market loss on a large portion of his stake.

The article seemed to imply that Tilson was a buyer largely at the low near $27/share, which does not seem to be the case (even if his opinion is still meritworthy).

Casual readers might second-guess the article if they knew that both bulls on the stock had incurred significant volatility and mark-to-market losses from their initial investment price. For many speculators after the spill-date, current prices represent a cold-eyed statement that they need BP stock price to rise back to their cost-basis.

Friday, July 16, 2010

Thoughts on Goldman SEC settlement

Bloomberg: Goldman Sachs Group Inc. agreed to pay $550Mln to settle a lawsuit with the US Securities and Exchange Commission, the SEC said in an emailed statement.

Wow, Goldman is going to pay less than Tiger Woods!

Friday, February 12, 2010

The Disappearing Inflation Act ( Japan Redux)

The US is unlikely to experience any funding problems similar to the rumblings from Greece, Portgual, and overseas markets.

The US shares more in common with Japan twenty years ago, versus the current EU. The US has trillions in money market accounts and liquid investments that could be used to buy up Treasuries. Just like Japan funds its deficits internally with domestic savings being recycled at lower-and-lower interest can the US. Provided that economic activity remains anemic, Treasuries may prove the most viable investment alternative for this cash (vs stocks/non-guaranteed money market funds).

For example, lets say the US has $5 Trillion in debt maturing around 48 months (4-years) at an average yield of 5% (equates to $250Bln interest per annum).

If the US runs a trillion dollar deficit for 5 years, outstanding debt will double to $10Trillion. Assuming tax revenues remain flat and assets are not sold, the total interest expense might actually so? Our Treasury could shorten the average maturity date of newly-issued debt.

Here is the math: 2-year treasury bonds yield .8%. So if our government issues $5 Trillion addtional Treasuries at .8%, total interest expense will increase only $40Bln/annum.

Since older, higher-coupon Treasuries are maturing, lets assume the Treasury refinances at least $2 Trillion of existing bonds, reducing the average coupon-rate from 5%--> .8%. This reduces interest expense by $84Bln= ([5%* $2Trln]-[.8%*$2Trln]. So, net-net, our annual interest cost falls by $44Bln ($84bln savings from low-cost, shorter maturities-$40Bln from interest on new debt)

Ultimately, our funded national debt doubles in 5 years from $5 Trillion-->$10 Trillion, but annual interest expense declines from $250Bln--> $204Bln. Since credit-worthiness is partly determined by ability to fund your debt/interest expense, the US might appear to be a better credit risk by embracing such a strategy, even though it would be more indebted . A shady sub-prime lender might suggest that since doubling of national-debt is saving the US so much money, it would present a great cash-out refi opportunity! In fact, the US should increase deficit spending even more!

The strategy outlined above (shorten debt duration, artificially lower-interest rates, closed-loop system funded by internal savings) has carried Japan for the last 15 years, but seems close to exhaustion (they are nearly 200% debt/GDP, vs the US estimated to be 60% pro-forma for current budget). The strategy will eventually fail at some point in time...and will be ugly when it does. Regrettably, any true "deadline" for sound monetary/ prudent fiscal policy in the US is likely more than a decade away. The risk of losing China/Japan as buyers of US Treasuries could easily be offset by aggressive government actions/domestic buying.

In summary, Obama/Congress has free rein to run massive deficits, avoid cutting pensions, perhaps even avoid dealing with Medicare obligations. How do you make money off any of this? not clear, but Japan-style outcome seems the most likely outcome (weak long-term equity markets next ten years, stable/rising treasury bonds).

Prime example of not learning your lesson...

Headline out today " Daimler AG to pay $200Mln to end bribery probe"

Ironically, paying money to end a probe related to illicit payments suggests they failed to learn any lesson whatsoever.

I wonder what restitution regulators would request if Daimler had been accused of prostitution? Shudder the thought.

Tuesday, January 05, 2010

Thought on gold....

Without stating a bull/bear case for gold, I simply had to comment on the horrible logic espoused by one of the "leading" gold advertisers pandering with the minds and pocketbooks of CNBC viewers.

In a recent ad, Monex (a "Cash4Gold" wannabe) states excitedly that "There has never been a better time to own gold".

Generally speaking, the best time to own an asset is when the price is low. The best time to sell an asset is when the price is high. Gold is at/near an all-time high above $1,110/oz, which indicates now is a better time to sell gold than to own it. As it turns out, 1999 was a great time to own gold, even if it didnt feel like it. Mind you, most people get excited about rising prices and tend to buy near the highs, but lets not confuse the issue of the "best time to own an asset".