March 2009: The Market is Treacherous Still

The market has been rallying I think on optimism about the TALF plan and the related plan to get toxic assets off of bank balance sheets. Also, and more importantly to me, the economic numbers such as home sales and durable goods numbers have been better (and in a way too good. Given the state of the world the durable goods number seems odd. I wouldn;t be surprised to see downward revisions). For the private equity firms, buying toxic assets and asset backed paper are in essence LBOs financed by the government, providing the private equity firms with call options on the economy. But how do the private equity firms get a low enough price to make a good profit? I think the answer lies in the government owning big pieces of the major banks. The government through "stress tests" will put pressure on the banks, forcing them to either sell assets at a cheap enough price and line up private capital to cover shortfalls or merge with another bank, or the government will seize the bank. The government I think hopes that via this approach, while the government will have to pony up some capital, a lot of the capital will come from the private sector. Will this work? You cannot get water from a stone, and alot of toxic assets are terminally so--CDOs, CLOs, and many CMBS securities worth maybe $.25 on the dollar. Also as Chanos pointed out in the Wall Street Journal only a small percentage of toxic assets have been truly marked to market. I think we will see further consolidation in the banks. And Geithner's hands may be progressively tied. Congress is going to be very reluctant after AIG to ok more bailouts. If this toxic asset plan does not work the government is going to have problems, and will probably try an end run around Congress via the Fed and FDIC (as they are doing even now). Zombie banks, ala Japan, are still not out of the question, as the government hopes time, spread lending, and moving away from mark to market accounting will help the banks.

What of the "stimulus program?" Much of it is fundamentally based on taxing and and spending, rather than truly on investing. It looks like US debt is going to double to about $20 trillion within 10 years, based on what's been provided. I think in the end the present government is counting on nationalizing health care and putting price controls on doctors and drug companies and cutting back drastically on social security to the "rich", under the present government’s basically redistributioning wealth to the "poor", non-capitalist agenda. You can see the US moving very deliberately now to a European style soft socialist model. Ironic that the government is trying to use the private sector and private equity and hedge funds to bring this about. While the "stimulus" may provide a near term boost, and the Fed is trying to use the same playbook it has used for a long time of inflating us out of problems, I can't see where the framework is now being set for robust economic growth. Becker, a Noble Prize winning economist pointed out in the Wall Street Journal that the multiplier effect of government spending is less than 1. I think government efforts to prop up the housing market may have some small effect in the short run,but in the end impede price discovery, and impede a bull market in real estate. We are entering an era of increased regulation, higher taxes, government debt crowding out private sector investment, coupled with cutbacks in defense. Europe has endured chronically high unemployment and subpar GDP growth under such a regimen. The government is too cute by half, in my view. They are trying to use the private sector toward their redistributionist ends, rather than letting private enterprise flourish via low taxes and as little government intervention as possible. It's interesting to see how much the US has gotten away with. We have the privilege of being able to denominate our debt in dollars and having the world's reserve currency along with 30% of world GDP. Absent this, given our huge run up in debt our currency would share the same fate as Iceland's or Hungary's. And even so we are beginning to see strains in the Treasury market. If Treasury yields rise appreciably, which could happen as China pulls back from buying our debt and in the midst of heavy issuance, reverberating problems in the markets could arise. The government has taken a radical Kenynesian approach in what amounts only to a grand experiment, based on the view that FDR's New Deal led the US out of the Great Depression. It can easily be argued that FDR’s New Deal did not work, and instead World War II, and the world wide demand for US manufacturing is what did work to put the economy on the right path. Currently, at about 20X potential trough earnings, the S&P 500 is not cheap. In my view, this remains a treacherous market due to the global structural problems we have not witnessed since the Great Depression. Bear market rallies can be seductive. In Insight’s model portfolio, therefore, much cash is being held along with short positions as hedges against limited long positions. There will be a time to allocate heavily to long equity positions. The markets now are in much flux, and that time could come soon, depending on a variety of factors including valuation. But that time has not yet arrived, in Insight’s view.

Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net

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Four Ideas

1) The government is exchanging preferred for common re: Citigroup, and mandating that no dividends be paid to preferreds. Through its actions, the governmentt has basically compelled the other preferreds of Citi to convert to common: If you're not going to get a dividend, you might as well at least get a vote by converting to common. Govt actions have made the preferreds of other companies worry that the same fate applies to them, and in so doing upended the whole preferred market, just as happened when the govt took over Fannie Mae. Another unintended consequence of govt meddling in private business.

2) Re: banks. Where are we? The government is backing away from doing something about toxic assets , instead moving again to capital injections. The govt won't nationalize or put the banks into receivership for fear of another Lehman-like effect on the market. But this course of action leads down the path of a Japanese style lost decade. There is no easy way out of the current predicament.

3) I cracked out by macro notes from my MBA studies, and my macro textbook, co-written by Bernanke no less. What determines investment? I f(-r, -t, Af). Investment is negatively affected by higher real interest rates, negatively affected by higher taxes on investment and positively affected by the future marginal product of capital , which itself is a function of productivity. In the long run the government's massive issuance of debt will likely raise interest rates. Unless the government can repeal the laws of economics, higher taxes and issuance of govt debt should hurt investment which will in turn hurt GDP, which will in turn hurt the stock market.

4) Re: taxes--The new administration wants to eliminate the tax shield that companies get from conducting business abroad. This is a big deal. Many of the companies I model have effective tax rates in the 25% range because of this tax shield. If you move from a 25% tax rate to a 35% tax rate, EBITDA (1-t) goes down by in excess of 10%. And incorporating this into my discounted cash flow (DCF) models, DCF price values are lessened by 20% in several cases I've looked at. There is a reason the market is falling. If 600 to 700 was a price target on the S&P before, 550 to 650 is a credible price target now, and that's assuming we have a depression with a small d and not a Depression with a big D.


Philip Frank, PhD
President and Portfolio Manager,
Insight Asset Management LLC
e-mail: insight-asset@earthlink.net