Things That Go Bump in the Night
From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!
-Traditional Scottish Prayer
It's been a long time since we have looked in my worry closet, but there are definitely bumping sounds coming from behind the door. While largely over-looked, Bank of America closed down an "enhanced cash" fund and did the unthinkable and broke the buck. But the real story is even worse. I make the suggestion that you look at your cash funds and see what is in its portfolio. You may want to redeem ahead of the crowd.
The Fed comes in for some very deserved criticism for its ham-handed handling of the rate cut. Inflation? As I predicted last summer, we are now seeing inflation over 4%. And the Producer Price Index is even worse. An increasing number of mainstream economists are suggesting that we will soon be in a recession, and some make my thoughts that it will be a mild one seem, well, rather Pollyannish. There is a lot to cover, in what I think will make for a very interesting letter.
Foolish Investor of the Year? Really?
But first, I want to send out a big thank you to the team at the Motley Fool, one of the more respected and larger educational investment web sites. You know when someone gets nominated for an Oscar, they always say that they are just happy with the nomination and really don't care if they win? Do you believe them? Well, that is exactly how I feel. It seems Motley Fool nominates five individuals or companies for everything from Best CEO to Best Marketing Campaign or Best Innovator.
And they also have a category for Investor of the Year. You might recognize the names of Warren Buffett and Carl Icahn. There are also two all-star fund managers, Mohnish Pabrai and Bruce Berkowitz. And included in this group is your humble analyst. I have to admit to being very surprised. And honored. To whomever at Motley Fool thought I should be in that group, thank you very, very much.
You can read the story at http://www.fool.com/investing/value/2007/12/11/fool-awards-2007-investor-of-the-year.aspx. And if you want to see (and vote on) what the other categories and nominees are, you can click on the following link: http://vovici.com/wsb.dll/s/cadg2f403. And now, let's jump into this week's letter.
Breaking the Buck at Bank of America
Columbia Management, which is a unit of Bank of America, is shutting down its Strategic Cash Portfolio, which is an "enhanced cash fund." That means it moves out the risk curve to try and earn a little more than your average money market fund. This is a fund for institutional investors with a $25 million dollar minimum. The fund had roughly $34 billion, but it seems that some $21 billion wanted to redeem. Typically, such redemptions would be at $1 per share, just like a money market fund. But enhanced cash funds are not required to maintain a $1 per share valuation, which is why they are allowed to invest in riskier paper, like short term commercial paper from SIVs (Structured Investment Vehicles) backed by asset backed securities. So, technically B of A did not break the buck, as they were not required to maintain the value of the fund at $1.
However, the assets of the fund had fallen to less than $1. If Columbia/B of A allowed the larger investors to go at $1, then that means more losses for those who did not redeem. So, they decided to close the fund. Not an easy decision, as my guess is that the fund was generating close to $60 million in annual fees, assuming a 20 basis point management fee.
And since GE Asset Management had closed a similar fund a few weeks ago at $.94, B of A decided to follow the precedent. Sort of. The large investors in the $21 billion pool will not actually get the 99.4 cents the smaller investors will get. They are actually going to be given their share of the actual assets of the funds, called a "distribution in kind." So some state pension fund is going to be given a collection of SIV commercial paper and who knows what else and wished best of luck in getting your money. If I was an investor, I would not be very happy. Exactly what trading desk at a pension fund is going to sell those assets? And to whom and for what price? Isn't that the reason you gave the money to B of A in the first place? To let them do the management?
Giving investors their assets back "in kind" is a huge black eye for B of A. Why would they do it? My guess is that there is simply no way to value or cash out some of the portfolio, as clearly much of the portfolio is illiquid in the short term, and would have to be sold at a loss if they had to go to the market in size.
Now, maybe that's what the investors wanted to do. I don't know. But as Michael Lewitt wrote this week:
"All in all, this is nothing less than a disaster for Bank of America and Columbia Management from a reputational standpoint even if investor losses turn out to be relatively minor. It is also a sign of just how severely strained short-term money markets have become in the current credit market meltdown."
There is never just one cockroach. There are a lot of these enhanced cash funds. I called one of the smarter bond managers I know, John Woolway, and asked him for his thoughts on these funds. While he manages bond portfolios for individuals, he has had the cash portion of their portfolios in treasury funds since the summer, as he could see the problems were going to develop. And he thinks it could get worse. (I will be happy to send you John's email if you like. Just drop me a note.)
There are a lot of mutual funds which are essentially enhanced cash funds. You should check out what kind of cash fund you are in. If you are in one of these enhanced funds which has exposure to asset backed commercial paper, my suggestion would be to get out now. Maybe the fund you are in will not have problems, but you can bet the guys running the B of A fund were smart guys who thought they understood the risks. It is just not worth the risk for an extra 1%.
The risk is that there is a "run on the bank" in these funds, and that the funds sell the most liquid assets to meet redemptions, leaving the problematic assets in the fund. In theory, they are marked to market, but if there is not a market price, how do you know what the price is? Maybe those assets eventually get marked higher. Maybe not. Do you really want to be in a fund that is under pressure?
Please note that I am not suggesting that you redeem from ordinary money market funds! There is a big difference. Just the funds with exposure to asset backed commercial paper. There is a simple rule. If you want higher returns, you are going to take more risk, and I think the lengthy period of stability that we have seen lulled investors into forgetting that principle. This is a market that is re-pricing risk.
Inflation Rears it Ugly Head
As I predicted in August, inflation is now running over 4%, or to be precise at 4.3% for the last 12 months. Core inflation, without those pesky food and energy prices, is at 2.3%. Energy costs have risen by 21.4% in the last 12 months, and 5.7% in November alone. Since energy is 8.7% of the total inflation index that means energy costs have contributed 1.6% of the total rise.
Notice in the table below from the Bureau of Labor Statistics the index did rose from 201.5 in April of 2006 to 203.9 in August, before going back down to 201.5 - basically suggesting there was no inflation for those 8 months. And then by August of this year we were up to just under 208. As I noted this summer, the comparisons for the fourth quarter of this year, with even modest inflation, were going to give us an ugly inflation number for November. It is likely to be even worse next month.
And the data from the Producer Price Index which came out Thursday was even grimmer. The PPI measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services. (Thanks to Greg Weldon of www.weldononline.com for slicing and dicing the stats.)
Finished Goods showed a 7.2% year over year rise, which is a record high. November showed the largest one month increase since 1973. Finished Consumer Goods have risen 5.7% since August while we are in the middle of a credit crunch.
And as Greg noted, there is pressure in the "pipeline." They track the rise in prices of materials that will be used in making products. Depending on which area you look, those prices have been rising rapidly the last three months, which will show up in the prices of finished goods at a later date. For instance, the index for "Materials for Manufacturing" spiked 8.7% in November and 42% year over year. Other indexes are showing growth over the last three months of 4-5%.
I remember a few years ago that many writers were saying that a falling dollar would not bring about inflation, as producers would simply lower their prices in order to sell to US consumers. Import prices have risen 11.4% in the last 12 months. Even if you take out petroleum, prices rose 3% for the second straight month.
Inflation is starting to spread out. In the ISM services survey, every industry surveyed showed a majority of responders reporting higher prices. Last month the Services Price Index jumped from 63.5 in October to 76.5 in November, which is a huge jump.
With the release of the data Friday morning, the dollar strengthened as it appears to the currency and bond markets the Fed will have to stop cutting rates as inflation will stay their hand. Let's examine that assumption as we turn to the Fed and its actions this week.
Academics at the Fed
I wrote (tongue in cheek) in 2004 (in Bull's Eye Investing) that since speaking in sentences that were incomprehensible, as Alan Greenspan did, seemed to be a requirement to be the Fed Chiarman, Ben Bernanke was therefore not qualified because he wrote and spoke quite clearly. I thought his appointment was a good one, as he promised a more transparent Fed. That is not what we got last this week.
One can argue whether the rate cut should have been 25 or 50 basis points. I thought 50, for reasons I will touch on later. There were reports that Fed governors were surprised by the negative market reaction. Clearly, there was no one in the room that had been on a trading desk, as it was clear that the market would react violently if it did not get the larger cut.
But it was not helped by the language in the statement released after the meeting. We were told that "economic growth is slowing, reflecting intensification of the housing correction and some softening in business and consumer spending..... [the rate cut] should help promote moderate growth over time.... Recent developments have increased the uncertainty surrounding the outlook for economic growth and inflation."
Growth is slowing? Only should help? Uncertainty? That was not a pretty statement when accompanied by a paltry 25 basis point cut. The fact that it is all true is beside the point. The next meeting is not until late January. The lag time for rate cuts to make a meaningful difference is generally considered to be about 18 months. The market is concerned that the Fed is getting behind the curve. The normally bullish economic survey by Bloomberg shows that economists expect that growth will only be about 1% this quarter.
And then there were rumors after the close of the market on Tuesday about actions to be taken. The next day there is an announcement that the Fed and other central banks around the world would do a $20 billion auction with more to follow to allow banks to bring a wider variety of assets to the Fed directly at lower rates, and do so anonymously! In general, I think this is a good thing. The credit markets are freezing up. Banks are not lending to each other, so the Fed is stepping in to take the place of the bank market.
Yet this was clearly something that had been worked on for at least a few weeks. Then why not at least hint in the statement released at the close of the Fed meeting that something was in the works for the very next day? A simple sentence would have sufficed. It would have calmed the markets and staved off the rather violent negative reaction. And allowing rumors to a few journalists? Is this high school? This week the Fed looked like Amateur Hour. That is not what is needed to instill confidence.
By and large, this Fed is a room full of academics that have never "run money," with the exception of Richard Fisher of Dallas who ran a hedge fund at one point in his career. We are in the middle innings of what will be seen by history as the single biggest credit crunch since the 1930's. With the exception of Fed governor Donald Kohn, they have never been in a crisis when they were in the driver's seat.
I readily acknowledge that it is not the Fed's responsibility to help prop up the stock market. But their role is to facilitate orderly markets. They did not do that this week. Given the lack of clarity in the statement about their intentions for the future, the credit markets in particular are clearly confused. And in a crisis, confusion is a very dangerous thing.
The Fed is in danger of appearing to lose what little control they have, and further in confusion as to what direction to take. Appearances do make a difference in markets where confidence is required. Bernanke promised transparency and it is now time to stand and deliver. Under what circumstances will they cut? What will force them to leave interest rates where they are? What can we expect?
From 1990 until the spring of this year, we saw the development of what Paul McCulley calls the shadow banking system. Non-depository institutions and funds created massive amounts of new money based on leverage. The Fed has lost control of the money supply, because the banks it regulates no longer are the primary movers of debt creation. Investment banks, hedge funds, SIVs, and a score of new investment vehicles have been created to finance a vast array of "stuff." Corporate loans are syndicated by banks but are then sold to non-banks (CLOs and hedge funds), who leverage the loans up beyond what a bank could do.
All that credit exploded the largest measure of the money supply (M-3, over which the Fed has no control - none - zip - nada) and lowered the risk premium for all sorts of investments and encouraged yet even more leverage in order to keep up portfolio returns.
But that changed this year and in particular in August. We are now seeing a de-leveraging that is unprecedented in the modern era. This is increasing risk premiums (which I think is good), but it is also deflating the total money supply. We are seeing two bubbles, the housing market and the credit markets, deflate before our eyes.
These are two hugely deflationary forces that if not checked could be very troublesome.
1% Growth plus 4.3% Inflation = Stagflation
I wrote three years ago that the best end result of keeping interest rates so low for so long would be a mild stagflation, and here we are. This quarter will see 4% inflation with a probability of 1% growth, so what should the Fed do? Fight inflation with rate hikes or standing pat? Or fight a recession with rate cuts?
If we are going into a recession, and I think we are, then that is by definition deflationary. When we have two asset bubbles bursting at the same time that is deflationary. Inflation will not be a problem in six months if we do not jump start the credit markets. Let's look at what Alan Greenspan said four years ago, in one of his better speeches entitled "Monetary Policy under Uncertainty." It starts with the sentence:
"Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape."
It then goes on to tell us just how uncertain monetary policy is:
"Despite the extensive efforts to capture and quantify these key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and in all likelihood will always remain so. Every model, no matter how detailed or how well designed conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis. Consequently, even with large advances in computational capabilities and greater comprehension of economic linkages, our knowledge base is barely able to keep pace with the ever-increasing complexity of our global economy."
"Look, guys," he tells us (my paraphrasing), "stop looking at three different trends, running them out ad infinitum and then drawing a conclusion about the wisdom or stupidity of our decisions. The factors affecting your trends are so complex that any number of significant events could change the relationships between your trends and the desired policy."
Further, he points out that the traditional measures of money stock are becoming increasingly meaningless. The obsession with M-2 or M-3 makes for good newsletter copy, but what do such broad aggregates mean in a world where new forms of money (SWAPs, derivatives, mortgages bonds, etc) appear every day? The implication that the old linear relationships between money supply (as measured by some arbitrary and outdated statistic like M-2) and inflation may no longer be valid.
"Recent history has also reinforced the perception that the relationships underlying the economy's structure change over time in ways that are difficult to anticipate. This has been most apparent in the changing role of our standard measure of the money stock.....in the past two decades, what constitutes money has been obscured by the introduction of technologies that have facilitated the proliferation of financial products and have altered the empirical relationship between economic activity and what we define as money, and in doing so has inhibited the keying of monetary policy to the control of the measured money stock."
Not only are past relationships not always linear, but past relationships may change over time. This is the old principle of "past performance is not indicative of future results." Just because things worked in the past does not mean they will in the future, as the world is changing rapidly.
This is now more true than ever. We are in an entirely brave new world. The primary order of business is to get the credit markets back in operation and restore confidence to the markets. And this may take more than a 25 basis point cut every 6-7 weeks. If the markets get the sense that the Fed does not get it, things could get out of hand very rapidly. The Fed needs to out in front of this problem. This is not an academic issue. This is a very real world crisis.
The Fed should cut rates at a fairly aggressive pace. If things turn out not to be as bad as they look, they can take the cuts back fairly quickly. It seems to me that the risk of a recession in the midst of a credit crunch is not something to "play chicken" with.
And if they are not going to cut rates, then they need to tell the markets why and what they are going to do to help alleviate the problem. It is time for Helicopter Ben to become Transparent Ben.
If we have more than a mild recession, it will be because the Fed does not get it and did not act in time. I think they will, but this week makes me nervous.
London, Switzerland, and Barcelona
Just a quick note from our sponsor, as they say. My partners at Altegris Investments have added some very interesting new funds to their platform, and they and my international partners (Europe, Canada, South Africa) continue to look for new ideas and managers which can take advantage of today's very interesting investment environment. Basically, we are in the business of helping accredited investors find and invest in a wide variety of alternative investments including hedge funds, commodity funds and other private offerings. If you would like to see what think are some very interesting managers, you can go to www.accreditedinvestor.ws and sign up for my free Accredited Investor E-letter and someone will get back to you. For readers who are waiting for the next letter, I apologize, as my writing schedule is tight. What I am going to do is send selected chapters of my next book I am working on I lieu of the accredited investor letter until I finish the book. If you have already signed up, you should get in touch and see what's new on our investment platforms. If you want me to make sure someone calls you, feel free to drop me a note. (In this regard, I am president and a registered representative of Millennium Wave Securities LLC, member NASD.)
I will be going to Europe January 20-26. I will be in London, Zurich, Geneva and Barcelona on a whirlwind trip to see clients and meet with my partners at Absolute Return Partners in London. Drop me a note if you would like to meet.
I had a great time meeting with Todd Harrison and the people from www.minyanville.com last Friday in New York. It was a great party. I met with South African partner Prieur and Isabel Du Plessis at the Bull and Bear pub at the Waldorf to watch the new Fox Business Channel show that is broadcast live from there every day at 5-6. The producer walked over and invited me onto the show with host Cody Willard for a few minutes. Very interesting format.
It is late and time to hit the send button once again. Where has the week gone? And since I have done almost no shopping, I need to get my act in gear. Have a great week.
Your getting into the Christmas spirit analyst,