Financial Methods

Are We In A Recession Already?

It's been a rough few months for economic indicators.  There have been recent low readings from productivity, durable goods, GDP, ISM, and of course, housing.

First, productivity - nonfarm output per hour  - took a hit last quarter.  It was the lowest year-over-year reading since 1997. 

Thus, Greenspan's 'productivity miracle' of high growth and low inflation may be coming to an end. 

 

Durable goods ex-defense ex-aircraft fell by 5.1% in October.  Normally, I wouldn't put a lot of emphasis on a one-off event, but this one caught most by surprise.   We could see a rebound in the next report, but time will tell.

Fed Chairman Bernanke gave us a small indication about the outlook for current-quarter GDP this week:

the indicators in hand suggest that real GDP growth this quarter is likely to be in the same general range that it was in the second and third quarters. ¹

Annualized third quarter GDP was just revised from 1.6% to 2.2%.  Yet this remains below the 2.6% rate in Q2 and the 3.5% average growth over the last two years.  Based on the most recent durable goods report, fourth quarter GDP may be below 2%.  There is no question that the slowdown is on.  The open questions are how long? and how low?

The ISM Manufacturing index has dropped every month since August.  The November reading showed contraction.  This ends 42 consecutive months of expansion.  New orders, production, and employment were down; prices were up.  The ISM index for services is still showing expansion. 

The Truck Tonnage Index from the American Trucking Association has suffered the largest year-over-year drop since 2001 [see the excellent blog The Big Picture].  Year-to-date through October the index is down 2.1% versus 2005.   It's true that rail volumes have been up and that one can argue that the gift-card phenomenon has pushed the traditional Christmas inventory build-up deeper into Q4.  Yet it is hardly good news for the holiday shopping season - if the economy were firing on all cylinders, there would be plenty of freight for trucks, trains, and gift cards.   

The housing sector is undergoing a meltdown.  The national median home price for existing home sales has hit the largest year-over-year drop on record.  The inventory of unsold homes, currently over a 7-months supply, continues to rise.  Don't expect prices to stabilize until inventories do.²

The yield curve remains inverted with short rates higher than long rates.  This inversion has been with us for most of this year.  It is only one indicator, but it is flashing - 'Recession Coming'.   For more on this indicator, see this article on the New York Fed web site.

Chart courtesy of Bloomberg.

It's unlikely that we are in a recession at the moment, but slowing growth, declining productivity, the inverted yield curve, and an imploding housing market make a 2007 recession a very real scenario.

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Source:

1. Ben Bernanke. The Economic Outlook.
Speech before the National Italian American Foundation. November 28, 2006.
http://www.federalreserve.gov/boarddocs/speeches/2006/20061128/default.htm

2. National Association of Realtors. Existing Home Sales Rise in October, Market Stabilizing.
Press Release. November 28, 2006.
http://www.realtor.org/press_room/news_releases/2006/ehs_oct06_existing_home_sales_stabilizing.html

© 2006 Michael Cale

Schwab's Quant Advantage

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The Schwab Equity Rating (SER) model rates over 3,000 companies each week and assigns them a letter grade.

Chart courtesy of Barron's

Wall Street's army of sell-side analysts, who create the more traditional focus lists, are good at picking great companies, but aren't necessarily consistent at picking great stocks over time, says Forsythe, who works in Chicago. In its quest for stocks with sustainable high earnings growth, the Street focuses on profits. "The payoff from accurate earnings forecasting is extremely high," he says, but the accuracy is typically too low to pay off. Just 15% of quarterly EPS forecasts are within 1% of actual reported EPS, according to a Schwab study.

In traditional analysis, there also seems to be an under-appreciation of the forces of creative destruction. "Analysts study the company, the industry, the management and forecast earnings," he says. The implicit assumption is "if I find a great company, I'll find a great stock....But if a company is great today, it doesn't necessarily mean it's going to be great in the future, and that's where this fails," Forsythe continues." Great companies get big and hard to operate; saturate their markets. Success attracts competition."¹

As a result of Forsythe's model, Schwab has a consistent series of impressive returns.  Since 2003, Schwab's model portfolios have been first in either the three or five-year time frame with the exception of one year, when it took second place.¹

This quantitative approach emphasizes many variables, but a few emphasized in the article are:

• Valuation
• Free cash flow
• Cash level
• Low capex to assets ratio

An important point the article overlooks is the fact that a quantitative model for stock selection is likely to outperform over the long term, in my opinion.  Even professional decision-makers (like portfolio managers) are ocassionally overcome by emotional factors such as trend following, peer pressure, groupthink, etc. and make bad portfolio decisions.  Mathematical models, while not perfect, do not make these errors.  However, remember that models are subject to changes by the model-makers (and their bosses).   

A quick stock screen on some of these criteria (plus a few of my own) yields a short list of only 16 stocks.  They are listed below, ranked by the Entity Value / Free Cash Flow ratio (from lowest to highest).  So, in theory, the best values are at the top of the list.

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1.	HIG	Hartford Financial	$85.49
2.	SCHW	Charles Schwab	$18.38
3.	C	Citigroup	$49.89
4.	CLMS	Calamos Asset Mgmt	$27.11
5.	PL	Protective Life	$46.90
6.	LION	Fidelity Southern	$18.27
7.	ENH	Endurance Specialty	$37.00
8.	BK	Bank of New York	$35.32
9.	AHL	Aspen Insurance	$26.46
10.	LFG	LandAmerica Financial	$60.25
11.	MNT	The Mentor Corp.	$50.99
12.	OKSB	Southwest Bankcorp	$26.50
13.	AFG	American Financial Group	$51.49
14.	AHM	American Home Mortgage	$34.49
15.	OPY	Oppenheimer Holdings	$33.73
16.	WM	Washington Mutual	$42.60

The full criteria for the screen is:  Entitiy Value/Free Cash Flow <=5, Free Cash Flow >=$100m, Yield >= 0.75%, Cash per share >= $1.00, P/E ratio (trailing 12 mo. earnings) <=50.

It is interesting that the results are largely in the financial sector - insurance, banking, investments - with Schwab coming in at number two. 

It would seem that the requirement for at least a 0.75% dividend yield likely excluded a lot of non-financial companies.  Yet running the screen without the dividend requirement results in only 13 additions to the list.  They are: PJC, CNA, CFNL, RNWK, ACGL, Y, ASPV, RAIL, USU, NAVG, BER, IDCC, CBI.

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At the time of publication, Mr. Cale did not own any interest in stocks mentioned in this article.

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Source:

1. Vito Racanelli. The Schwab Advantage.
Barron's. November 27, 2006.
http://online.barrons.com/article/SB116441935011032447.html (subscription).

© 2006 Michael Cale

10 Things Your 401k Provider Won't Tell You

Nicole Bullock  at Smart Money posts a good Top 10 list - 10 Things Your 401k Provider Won't Tell You.

A quick summary is included below.  Make sure to read the full article for more detail on each point.

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1.  We're making a mint on your 401(k) — even if you're not.
2.  You're buying wholesale, but we're charging you retail.
3.  No one in his right mind would buy these funds — given a choice.
4.  Our 'target-date funds' may miss the target.
5.  We offer tons of investment options. Too many, in fact...
6.  ...but you still aren't diversified.
7.  If you quit your job, you'll have to pay to keep your 401(k) here.
8.  You'd be better off in a Roth 401(k) — too bad your plan doesn't offer it.
9.  You want to see some outrageous fees? Try a variable annuity 401(k).
10. Your nest egg could be a whole lot bigger.¹

This is why Individual Investors Have The Edge - they have the ability to counteract many of these disadvantages through a rollover IRA. 

See also - The Revolution In Index Investing.

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Source:

1. Nicole Bullock. 10 Things Your 401k Provider Won't Tell You.
Smart Money. November 14, 2006.
http://www.smartmoney.com/10things/index.cfm?story=december2006

© 2006 Michael Cale

Milton Friedman On Hong Kong

A popular explanation for the economic success of many western nations is the presence of natural resources.  Don't believe it.  Hong Kong is the unexplainable success story.  Hong Kong has very little natural resources and had many impediments to overcome.

In a collection of Milton Friedman's writing published in the WSJ, the renowned economist explains the financial success of Hong Kong.

By some accident of officialdom, the colonial office assigned John Cowperthwaite, a Scotsman and a disciple of Adam Smith, to serve as financial secretary of Hong Kong. Cowperthwaite's free market policies are widely credited with producing the subsequent economic miracle that led to a phenomenal rise in the average level of living despite a nearly 10-fold rise in population.

It is hard to conceive of a more severe test of free market policies. Hong Kong is an island devoid of any significant natural resources other than a great harbor. When the Communists took over China, refugees came streaming over the borders with only the possessions they could carry. They and their successors produced a rapid rise in population. Hong Kong received negligible if any foreign aid to assist the assimilation of the refugees.

Under these adverse circumstances, the salvation of Hong Kong has been its complete free trade and free market policy. No tariffs on imports, no subsidies or other privileges to exports. (The only restrictions are those that Hong Kong has been forced to impose by pressure from other countries, including the U.S., as under the multifiber agreement.) There is no fixing of prices or wages; few if any restrictions on entry into business or trade; and government spending and taxes have been kept low. The top tax rate on personal income is 25%, with a maximum average rate of 15%. . . .

What a contrast to the experience of most of the colonies to which Britain gave their freedom after the war. And what a striking demonstration of how much better free trade and free markets are for the ordinary citizen than the protectionism of Mr. Buchanan and the "fair trade" of President Clinton. "Fair" is in the eye of the beholder; free is the verdict of the market. (The word "free" is used three times in the Declaration of Independence and once in the First Amendment to the Constitution, along with "freedom." The word "fair" is not used in either of our founding documents.) ¹

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Source:

1. Milton Friedman. Friedman's Sampler .
Wall Street Journal. November 18, 2006.
http://www.opinionjournal.com/extra/?id=110009267

© 2006 Michael Cale

Happy Thanksgiving

Unfortunately, some elementary school teachers with a political agenda cannot enjoy Thanksgiving for its current meaning - grace, sharing, appreciation, humility, and family.

Long Beach, CA teacher Bill Morgan has drawn national attention for his Thanksgiving "lesson" by stealing his student's backpacks and school supplies in an attempt to illustrate how settlers stole from the natives.

Regardless of your opinion of our nation's history - like every other nation, it contains both good and bad elements - students (older than Mr. Morgan's) should be presented with the facts, and with many different political perspectives, and should develop the skills of critical thinking and logic.  Mr. Morgan's lesson, aimed at such a young audience, is clearly an attempt to indoctrinate, not to educate.

If you are above elementary-school age, you can review last year's entry - The Thanksgiving Lesson You Should Have Learned in School.   It seems that it is not taught in Long Beach.

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Source:

Associated Press. Teaching Thanksgiving From A Different Perspective.
CNN. November 22, 2006.
http://www.cnn.com/2006/EDUCATION/11/22/teaching.thanksgiving.ap/index.html

© 2006 Michael Cale

Another Innocent Drug War Victim

Kathryn Johnston, a 92-year old woman living in a high crime neighborhood in northwest Atlanta, fired a pistol at 3 men breaking down her door around 7PM.  Unfortunately, the men were police officers in civilian clothes serving a narcotics warrant.   The three officers were all hit by gunfire.  Fortunately all three officers survived. 

Ms. Johnston was killed by police when they returned fire.  Ms. Johnston was the only resident of the house and had lived there for 17 years.  Ms. Johnston's niece maintains that the police had the wrong address.  If so, it wouldn't be the first time.  See a map of botched police raids.

Assistant Chief Alan Dreher said the officers "knocked and announced" [see Wilson v. Arkansas (1995)] their presence before they forced entry into the elderly woman's home. ¹

There are conflicting news reports as to whether the Ms. Johnston opened fire as the officers were approaching the house or when they were attempting to enter the house.

As the officers approached the house about 7 p.m., a woman inside started shooting, said Officer Joe Cobb, a police spokesman. ¹

If the officers were fired upon while approaching the house, it is unlikely they were able to fulfill their legal requirement to "knock and announce" their presence.   The more likely scenario is that Ms. Johnston failed to hear the announcement and fired on the men violently breaking into her home.

Unfortunately, this is yet another innocent citizen killed by police, and three police officers unnecessarily injured.

This tragedy could have been easily avoided.  When police are legally required to announce their presence, why not send at least one uniformed officer?

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Source:

1. Associated Press. 3 narcotics officers shot, elderly woman killed.
Access North GA. November 22, 2006.
http://www.accessnorthga.com/news/ap_newfullstory.asp?ID=83581

© 2006 Michael Cale

Europeans Seek An End To Traffic Rules

In another example of  deluded pseudo-logic, several European cities are seriously considering doing away with all traffic signs. 

European traffic planners are dreaming of streets free of rules and directives. They want drivers and pedestrians to interact in a free and humane way, as brethren -- by means of friendly gestures, nods of the head and eye contact, without the harassment of prohibitions, restrictions and warning signs.¹

The German town of Bohmte (pop. ~13,500) is refurbishing their roads to eliminate the curbed sidewalks.¹

"The sidewalks are going to go, and the asphalt too. Everything will be covered in cobblestones," Klaus Goedejohann, the mayor, explains. "We're getting rid of the division between cars and pedestrians."¹

Important safety tip:  don't play (or walk) in the street.

There are many places where less (or no) regulation is a great improvement - traffic is generally not one of those areas.  Imagine no stop signs or traffic signals in metropolitan traffic.  Look for the brotherly eye contact - was that a nod of the head?

If there are no traffic rules - what is to prevent driving on the 'wrong' side of the road?  What about accidents?  If someone runs their vehicle into yours - whose insurance pays for the repairs?  There are no rules, so no one is at fault.

I've driven in many parts of the world where traffic laws are routinely ignored (and unenforced) and the results are chaotic.  It is not the simplistic utopia that the Europeans are trying to implement.  There are colorful and hateful gestures and curses exchanged and the most aggressive driver usually makes their way through the street in the least amount of time.

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Source:

1. Matthias Schulz . European Cities Do Away with Traffic Signs.
Spiegel. November 16, 2006.
http://www.spiegel.de/international/spiegel/0,1518,448747,00.html

© 2006 Michael Cale

Flaherty's Income-Trust Egg

The government of Canada threw a rotten Halloween egg at investors this year.  Canada's finance minister, Jim Flaherty, announced that Canada would begin to tax Canadian Income Trusts (with the approval of Parliament).¹

Canadian Income Trusts are similar to U.S. REITs.  They are purchased and held by investors like any other stock.  Yet the Trusts are a corporate structure that allows Canadian companies to reduce their tax payments.  Companies are then required to distribute most of their after-tax earnings to shareholders (or unit-holders as they are often called). 

Although the government does exact a withholding tax on dividend payments, the government claims that as more and more companies convert to the Income Trust structure, the loss of revenue to the government is becoming too expensive.  The government should hardly be surprised that companies are embracing this corporate structure.  Canada has extremely high corporate tax rates.

The pols talk about companies having insufficient funds for reinvestment or for research, but it's a pure money grab by politicians. I have been an Income Trust investor for years, first in Petrofund, which eventually became Penn West, and they managed to fund several acquisitions during that time period. The Income Trust corporate structure did not hamper their ability to reinvest in the business. Plus the focus of corporate managers is where it should be - on the shareholders.

For investors in Income Trusts, the initial panic sell-off has been severe.  But everything is not all gloom and doom.  The proposal may not pass, although I expect that it will in some form.  The final version may be different that proposed - perhaps energy trusts will be exempted or partially exempted.  Also, current Income Trusts will have four years before the change takes effect.  A lot can happen in four years. 

There are U.S. energy trusts, which are similar to the Canadian trusts.  One important difference is that the assets placed in a U.S. trust cannot be increased through acquisition.  So watch out for depletion.  Additionally, U.S. REITs can also serve a similar function in your portfolio.  Both of these asset classes may benefit from this self-defeating move by the Canadian government.

Examples of U.S. trusts are San Juan Basin (SJT), Cross Timbers (CRT) and Sabine Royalty Trust (SBR)

Yesterday, Penn West mentioned the tax announcement in their third quarter results.

On October 31, 2006, the Canadian Federal government announced proposed changes to the taxation of income trusts. Effective in 2011, Penn West could be, in effect, subject to tax on its distributions at corporate income tax ates. The impact on Penn West's corporate structure and strategy, if any, is under review by our Management team and Board of Directors.²

No one knows how this will play out.  If you're going to lose sleep over your Income Trust holdings, trade them for something else you're comfortable with.  I'm going to hang with my modest Trust positions and see what happens.

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At the time of publication, Mr. Cale held long positions in PWE and SJT.

Source:

1. Times Columnist.  Clamping down on income trusts.
Victoria Times. November 2, 2006.
http://www.canada.com/victoriatimescolonist/news/comment/story.html?id=fea8cced-ffd1-4bf7-ac04-cb6b4fc85904

2. Penn West Energy Trust. Third Quarter Report.
Newswire. November 13, 2006.
http://www.newswire.ca/en/releases/archive/November2006/13/c3450.html

© 2006 Michael Cale

ESPN Gameday - Tennesee vs. Arkansas

About 7,000 fans showed up early Saturday morning for the broadcast of ESPN Gameday in Fayetteville, AR before the Tennesee-Arkansas football game.

© 2006 Michael Cale

Fed Caused Housing Bubble, Still Dependent On Bad Data

Dallas Fed President Richard Fisher (bio) made a couple of stunning revelations in a speech late last week. He admitted that, first, the Greenspan Fed kept rates too low, thus causing the housing bubble.

In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent "lower boundary." At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy's ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets.¹

As I emphasized earlier this year in The Fed Threatens Growth, monetary policy is difficult, especially when the decision-makers are relying on data that is subject to revision.

Economic data is erratic, subject to revision, and is always backward-looking.  So even the most recent economic data is not current.  Additionally, there is a lag between changes in economic policy and its resultant effect.  It usually takes 12 to 18 months for policy changes to work their way through the economy.

The monetary policy for 2006 has already been set. Changes made by the Fed at its March meeting will help to set monetary policy for 2007. By relying on a data-dependent 'wait-and-see' approach, when the Fed begins to see inflation slowing, it will mean that the Fed has already raised rates too high.

Additionally, by waiting until a slowdown is clearly evident in economic data, the Fed will have waited too long to begin cutting rates.  It's a difficult puzzle to solve.  Perhaps it is so complex, and humans so prone to error, that it should be left to the invisible hand.

The Wall Street Journal also picked up on Fisher's speech.

Jan Hatzius, chief U.S. economist at Goldman Sachs, called Mr. Fisher's remarks "pretty striking," while noting it is Mr. Fisher's style to be opinionated. He added that while he agrees the Fed's policy from 2002 to 2004 fueled speculative housing-bubble activity, it was still reasonable "knowing what you knew at the time. You take out some insurance against a really bad, low-probability outcome, and after the fact you regret having paid the insurance premium."

Mr. Fisher said inflation, at about 2.5% now, is still higher than his "comfort zone," but it is possible it "has peaked and is finally heading lower."²

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Source:

1. Richard W. Fisher. Confessions of a Data Dependent.
Speech before the New York Association for Business Economics.
New York, NY. Nov. 2, 2006.
http://dallasfed.org/news/speeches/fisher/2006/fs061102.cfm

2. Greg Ip. Fed Official Says Bad Data Helped Fuel Rate Cuts, Housing Speculation
Wall Street Journal. November 3, 2006. Page A6.
http://online.wsj.com/public/article/SB116252441146012283-VwY7DOfift2xMoiHn7Ojjd6KKVI_20061110.html

© 2006 Michael Cale