No Home Price Stabilization

The November Case Shiller home price index data was released today and the numbers confirmed the acceleration in home price declines we first witnessed in the median price indexes. While I think its safe to say that no one thought these numbers would be pretty, I imagine few thought we would see 2% declines across the board:

According to my calculations San Diego is now down 16.3% from its peak in November of 2005. The 10 City Composite is down 9.4% since its peak in June 2006 and the 20 City Composite is down 8.6% since its peak in July 2006. Trillions of dollars of home equity have already been lost and price declines are not showing any signs of slowing.

When you break this data down into tiers and you adjust the numbers for inflation the data gets even more depressing. In San Diego the real price of "low-priced" homes (its all relative because for San Diego a $446,000 home is considered low-priced) has fallen by nearly 30% since its peak:


Because this post has been fairly depressing up to this point I figured I would take the first graph and invert it so that it "looks" like home prices are actually going up. I have found that charts that show prices going up and to the right generally make people very happy. So here goes:


Okay maybe that didn't work for anyone else, but it brought a smile to my face . . . .

Hat Tip: S&P Case Shiller, Piggington

Changes

This is what happens when polls ask voters what they want from Washington:



Hat Tip: Mebane Faber

Fed Cuts Rates Again

On the back of news that GDP growth in the 4th Quarter of 2007 was a less than expected 0.6%, the Federal Open Market Committee (FOMC) cut rates for the second time in as many weeks this afternoon, lowering the benchmark federal funds rate to 3% and the discount rate to 3.5%. The Fed has now lowered rates 125 basis points over a two week period, the fastest drop in 17 years.

Many on Wall Street think that cheap money is the cure for our country's credit problems. However the tide is turning and cheap money is no longer the consensus solution. Many of the top economic thinkers and investors are starting to ask whether the "cheap money" era needs to come to an end. One prominent investor who is calling for an alternative approach is Bill Gross. He believes that it is time for a paradigm shift. He argues that U.S. and global demand has been driven for years by financially engineered lower interest rates and cheap credit. He believes our economy needs government help, and probably in the form of "a well constructed, more than temporary fiscal/monetary stimulus plan." I think Gross argues this point effectively, though I am always wary of government intervention: "because demand in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck, there is a legitimate question as to whether its black hole imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages."

Mr. Gross' ultimate point:

My point is that Chairman Bernanke must recognize the reduced benefits and obvious dangers of a déjà vu trek to 1% short rates. Those yields produced 5% 30-year mortgage rates to the homeowner for a 2-3 month period in 2003 and they could do so again, but bubble creating, inflation inducing damage to the U.S. dollar would be the likely result now. Best to stop far short of 1% and at the same time encourage reforms in FHA government assisted programs that would permit subsidized mortgage rates with minimal down payments.

An artificially low, 1% short-term interest rate was an elixir during the days of a burgeoning shadow banking system. It cannot be the solution now.

Well it looks like Bernanke has failed to heed Gross' advice just yet and continues to use up a lot of his dry powder to prop up the weakening US economy. We'll have to wait and see how much lower he'll take rates before he realizes that another shot of liquidity won't help the economy much.

Note: In our quarterly newsletter sent out to clients I had predicted 3% short interest rates by the 4th quarter of 2008, but never thought we'd hit 3% in January!

Hat Tip: Bill Gross

How Will You Spend Your Stimulus Check?

I have been asking friends and neighbors how they plan to use their $500 (est.) "stimulus" checks and I have gotten some interesting feedback:

1. What's a stimulus check?
2. 1 Share of Google.
   
3. An unlocked iPhone.
4. Use it as seed capital to open my own hedge fund.
   
5. A Wii and a couple extra Wii controllers.
6. Wait isn't this just the government giving me back my own tax dollars?
   
7. Can I get that in Euros?
8. A thank you card for Alan Greenspan.
9. A Nouriel Roubini bobble head doll.
10. Start my own Web 2.0 startup.
11. 1 tank of gas.
12. Donate it to Obama's campaign.
13. Buy a marijuana vending machine (only in California!)
    
14. Pay off my student loans.

I hope this is what the government had in mind when they agreed on the fiscal stimulus package. If you have plans for your stimulus check please let me know in the comments section!

Okay gotta go run and watch Bush's State of the Union Address. I'm sure this will be enlightening . . .

Only Funny Because it's True

Sadly, fiscal stimulus is a lot like handing out money on the street -- it is well intentioned, but rarely cuts to the root of the problem:


Hat Tip: Ritholtz

Interesting Insights from Mercer

This is a quick writeup about the book 2020 Vision by Mercer. You can read more here:

According to a new book published by Mercer’s investment consulting business, investment managers will need to adapt and innovate to avoid falling into a two-tier industry of outperforming alpha fund managers and those left behind to chase scarce market returns.

The book, 2020 Vision: Investment Wisdom for Tomorrow, captures the views of some of the most influential investment figures from around the world and presents seven key themes that will influence the investment industry during the next decade.

Author and Senior Associate within Mercer’s investment consulting business, Harry Liem, believes the ability to sustain future superior performance will define the funds management industry in the coming years and that only those players who can adapt themselves faster than their competitors will maintain their leading edge.

Harry says that institutional investment is based on the search for alpha or outperformance, however, active investment managers have long battled against the erosion of alpha as their ideas and processes are taken up by competitors. The best of them are constantly searching for new ideas and new sources of information to maintain their competitive advantage.

The book reveals the insights gained from conversations with 12 professional and academic figures in the global investment industry, including, Dr Stan Beckers, Head of Alpha Management at BGI, Ray Dalio, Chairman and CEO at Bridgewater and Professor Stephen Brown, Professor of Finance at NYU.

It is set against the background of 12 ‘mega trends’ including a more difficult monetary environment, global economic imbalances, increased competition, the separation of reward for skill (alpha) and market exposure (beta), increased interest in the ‘alternatives space’, and growth in socially responsible investing (SRI).

Seven common themes emerged from the interviews, providing investors an insight into what they may expect from the industry in the coming years:

1. Active versus passive - the moving frontier

As more and more of what was once deemed ‘insight’ becomes systemised, pure alpha may become rare.

“However investment technology is changing with great speed, led by cutting-edge hedge funds. There will always be an important role for human judgement. The most successful funds will be those which learn to integrate these machine-based systems with seat-of-the-pants checks and balances that can effectively introduce common sense into the process.” – Stephen Brown, Professor of Finance at NYU.

2. The future of the investment industry - the dual world

While some fund management firms are positioning themselves for the coming decade with a firm focus on alpha returns, others will fall behind.

“The investment business will consist of alpha generators and beta replicators (and firms that do both), and the alpha generators will have very smart people who understand financial engineering and are equipped with fabulous information technology. In other words, the quality of play will increase dramatically.” – Ray Dalio, CEO of Bridgewater.

3. Generalist versus specialist - a place for both

Traditional debate has now moved into hedge fund space with many investors comparing the merits of the ‘fund of fund’ versus the multi-strategy approach.

“One could mount a reasonable case for either the fund of funds or multi-strategy approach to thrive going forward, depending on the marginal cost of acquiring alpha externally or developing it internally.” – Harry Liem.

4. The current environment - concern and hope

As the sub-prime mortgage fallout continues, attitudes to risk are being re-assessed.

On the one hand there is concern.

“The most striking thing about today’s environment is that practically every risky asset looks overpriced. At current levels we believe all of the major sectors of the global equity markets are overpriced, credit spreads are universally too narrow, yield curves give too little premium for duration risk.” – Ben Inker, CEO of Grantham Mayo Van Otterloo.

“Taking risk within specific opportunities while being generally defensive appears the prudent strategy this late in the cycle.” – Jae Park, CEO of Loomis Sayles and Co.

On the other hand there is hope that emerging markets will be able to take over as the engine of the world, at a time when economic growth in the US is slowing down. Economic leadership may pass back to the East.

“The pendulum of history which swung so visibly and decisively towards the West in the past 200 years is now beginning to return at an accelerating pace towards a twenty-first century world dominated by the East, in wealth, population, technology and economic dynamism.” – Robert Lloyd George, Chairman of Lloyd George Management.

5. The hedge fund industry - expecting a shakeout

There is increasing concern among interviewees about the fast growing hedge fund industry.

“As a client recently said: there are about 8,000 planes in the air and 100 good pilots.” – Ray Dalio, CEO of Bridgewater.

“The alpha can in fact be leveraged up, so in that sense, there is unlimited alpha. Many hedge funds operate by using leverage and assuming tail risk which is not captured in the traditional ratios.” – Professor Stephen Brown

6. Ethical Investing - the jury is still out

A common theme is that socially responsible investing is going mainstream. During the past decade investors have mainly been focused on governance, and in recent years the attention is expanding to take in environmental and social aspects. The body of research on whether ethical investing adds value will continue to grow.

“In essence, there are three competing hypotheses. The extra-financial information may be found to be relevant (eco-efficiency and corporate governance matter), irrelevant (have no material impact on performance) or relevant in a negative manner (i.e. there may be a risk premium for investing in sin sectors such as defence and tobacco). To make things confusing, you can actually find academic evidence for all three hypotheses.” – Rob Bauer, SRI expert and Professor of Finance at Maastricht University.

7. Investing: art, science or skill?

Despite all the emphasis on quantitative techniques, at the heart of superior performance lies human insight.

“There is a scientific method to it all, but it is the art that makes us humans indispensable, as we need to process information and be one step ahead of our opponents.” – Jae Park, CEO of Loomis Sayles and Co.

Hat Tip: Mebane Faber

Qualcomm Conference Call

I was impressed with Qualcomm's Q4 results announced today. As expected, most of the questions on the earnings call related to Qualcomm's ongoing legal struggles with Broadcom and Nokia. It is important to keep in mind that Qualcomm will have work-arounds for the Broadcom injunction by the end of the quarter and that the Nokia revenue has already been removed from the reported GAAP revenue. While I don't think these legal struggles will be over anytime soon, I do think that Qualcomm is a great company and that the overwhelming focus on the legal issues is temporarily depressing the stock price.

Conference Call Comic Relief: At the end of the call CEO Paul Jacobs (who was calling in from Davos) said somewhat sarcastically that he was glad to hear "so many questions based solely on the business instead of on the legal troubles." I'm sure that one got more than a few chuckles.

Disclosure: Long shares of Qualcomm at time of writing.

Update: Fed Cuts Rates to 3.5%

Well, apparently Ben Bernanke is an avid reader of this blog because he read my post last night calling for an emergency rate cut and promptly cut rates 75 bps before the open of the market this morning. The move was welcomed by the street and the market reacted positively, rebounding from a miserable open that saw the Nasdaq down almost 5%.

When I step back and look at all this fear about a recession I can't help but smile. Whether or not we really end up having two consecutive quarters of negative GDP growth doesn't really matter. The point is that we had excesses during the up-cycle and a healthy down-cycle to remove those excesses is necessary and useful. With the Fed Funds rates at 3.5% a fiscal stimulus package on the way and an ongoing "pricing in" of the impending recession, one could make a reasonable argument that the second half of 2008 might not be as bad as we had originally thought. The best news for the market this year would be signs that the housing market is stabilizing. If we don't get that we are still not bullish.

*For growth oriented investors there was a sale on Google shares at the open this morning. After trading above $700 three times in 2007 and briefly touching $747 a share Google hit a low today around $561. This is the first time we have seen Google dip below its 200 day exponential moving average in 10 months. For long term buyers of Google today was a great accumulation day. Again, we are not saying that Google's shares won't trade lower. We actually wouldn't be surprised to see them dip back into the $400's as advertising budgets are slashed, but the fundamentals of Google's story are still strong.

Emergency Rate Cut Time?

After global markets were routed on Monday and Tuesday it appears as if the US markets will follow when they lead out Tuesday morning. S&P 500 futures are off almost 500 points at the time of this writing. Commodities are also down broadly led by declines in wheat, soybeans, oil, corn and copper.This is the broadest "risk asset" unraveling we have seen since 9/11 and picks up the momentum that has been building since the year started. Such tight coupling of "risk asset" declines is not good news for the equity side of endowment style portfolios, but allocations to TIPS, bonds and cash will all hold up well in this scenario. If there was ever a day that the Fed should take action to stem further declines it appears today will be that day.

In hindsight last week may mark the low point for the dollar. Believe it or not, although the US has caused the crisis it is still the truth that the US may well be in the best position to ride it out. Investors have snapped up the dollar as fears of a more general global slowdown spread.

For most investors however these headlines mean little. Warren Buffett would probably call all of this "noise." The truth of the matter is that for long term investors the share price declines represent nothing more than an opportunity to find great values. But, we do urge caution. Value traps abound, and a savvy investor will not buy companies indiscriminately just due to a share price decline.

By the way, for those of you who enjoy Nouriel Roubini's analysis his subscription website is free to all for a short period of time. Check out the RGE Monitor here.

A Brief History of the Credit Crisis

Here's a short history of the "Credit Crisis":

Its hard to say where it all began, but one of the first places it reared its ugly head was in the private equity market. It was in that market that we were introduced to "Pik-Toggle" and "convenant lite" loans as well as bridge loans that slowly transformed themselves into "pier loans." After setting all kinds of LBO records and seeing 6 of the top 10 LBO deals in history in a year-long period between 2006 and 2007 many industry types saw the writing on the wall. But, in the infinite wisdom of now unemployed Citigroup CEO Chuck Prince "as long as the music is playing you've got to get up and dance." Was his risk control officer sleeping?

Around the same time the LBO market was imploding, Main Street was getting introduced to what was alternatingly referred to as the "mortgage meltdown" and the "subprime crisis." For a while we couldn't go to a cocktail party without discussing the intricacies of "subprime", "alt-a","no doc", "pay option", "neg am" and all sorts of ridiculous loan programs. Then we watched and laughed as the mono-line mortgage companies like New Century Financial and Accredited Home Loans went under even though Tom Brown assured us these were solid companies. Once those guys failed we realized that a lot of their mortgages weren't worth anything and we tried to trace them. At that point we stumbled across a veritable alphabet soup of structured vehicles apparently dreamed up by someone who clearly thought that securitization was fun and that acronyms were clever: SIV's, SIV-lite, CDO's, CDO squared, CDO cubed, CLO's, Conduits, CPDO's and all other kinds of "toxic soup." To monitor this mix of letters we visited Markit.com daily to watch the cliff diving in the ABX Index and tuned in to WSJ for our daily update on the fluctuations in the ABCP market. When we looked deeper we noticed that much of this "toxic waste" was rated AAA by the ratings agencies and was held all over the place. Some of it was hiding in our money market funds, some was in Europe and China and some was in our hedge funds.

Speaking of hedge funds, Bear Stearns had some good ones (or at least ones with good names): the High Grade Structured Credit Strategies Enhanced Leverage Fund and the High Grade Structured Credit Strategies Fund. It turns out these funds leveraged themselves to the hilt to buy CDO's full of loans that were extended to people with no credit history and no income -- in order to buy overpriced homes with no money down. Needless to say things ended badly. But Bear wasn't the only firm to take a hit. Goldman Sachs had to pump billions into one of its hedge funds and veteran investors from Paul Tudor Jones to Jim Simons to the guys at Sowood all took their lumps. It was around this time that Goldman's CFO David Viniar declared that the problem was that 25-standard deviation events were happening "several days in a row." Berkeley economist Brad DeLong helped bring Viniar's comments into perspective: "the universe isn't old enough for even one 16-standard deviation to have ever happened." Hmm . . one might get concerned if a large Wall Street Firm had a CFO that didn't understand standard deviation . . . or maybe not. After all, Goldman has come to this point in the credit crisis looking better than just about every other bank on the street.

To deal with the ongoing crisis in the alphabet soup mentioned above some brilliant people at SIV City (aka Citigroup) decided to fight fire with fire and came up with a nice little acronym of their own: the Master Liquidity Enhancement Conduit (MLEC). This quickly became known affectionately as the "Super SIV." Then someone woke up and realized that hiding things didn't make them go away and out went the Super SIV. It's a shame to because that would have been a fun experiment.

But we ultimately did find a "solution." In the interest of full disclosure and supposedly to simplify this situation all we had to do was familiarize ourselves with FASB 157 and start referring to assets as Level 1, Level 2 or Level 3 Assets. Level 1 assets are fairly familiar to us, these are friendly things like stocks, bonds and other exchange traded securities. You know, the boring stuff that we actually have prices for. Then there are the Level 2 assets. These are assets that don't have a quotable price but apparently you can "derive" the price from inputs or from other similar assets that actually have prices. These are usually fairly innocuous things like restricted stock, muni bonds and currency swaps. Level 3 Assets are really where all the action is. These are assets that trade so infrequently you can't actually say that there is a legitimate market for them. Not surprisingly most of the acronyms above fall into Level 3. These are the assets that banks and hedge funds "mark to model" according to their own assumptions in order to come up with pricing. I don't even want to start into discussing all the flaws associated with "marking to model." But, I do sincerely hope these are different models than the one's David Viniar builds over at Goldman Sachs to analyze standard deviation . . .

So what's next? Well today we added "Counterparty Risk" to the ever expanding lexicon of the credit crisis. Counterparty risk isn't news to those around Wall Street but like the rest of the alphabet soup it will probably be news to those on Main Street. Counterparty risk basically describes the risk that one party in a trade can't cover its losses. The major problems are probably going to come in the Credit Default Swap (CDS) market. This is the market where one party assumes the risk, for a price, that a bond or loan will go bad. Many investors use this market to remove credit risk from their portfolios or to hedge a balance sheet exposure. Other investors speculate in this market and oftentimes don't have the capital to pay their liabilities in the event of a credit event. We know the speculators are out there because the market is a $45 trillion market. It is a market bigger than the credit market that it aims to protect and is roughly equal to the total amount of bank deposits in the world. It is also a popular market with hedge funds looking for ways to amplify their returns.

Just yesterday, ACA Financial Guaranty Corp. revealed that it is trying to unwind the roughly $69 billion of credit protection it sold to investors. If you ask me that's a lot of credit protection for a firm with less than $500 million of liquid assets. The problem started when S&P downgraded ACA Financial to junk status and now the firm is clawing to stave off bankruptcy. Something tells me that they aren't alone. As firms scramble to determine their exposure to counterparties like ACA Financial we could see some sort of seize-up in the CDS marketplace. In the meantime we'll probably see some sort of bailout or massive liquidity injection for ACA. Remember when you hear about a liquidity injection think about adding 60 seconds to a ticking time bomb: the goal is to add just enough time to run away before the whole thing blows up.

The next shoe to fall? . . . . could be in the commercial real estate world. Just look at the rising spreads in the CMBX market or follow the continuing saga of Harry Macklowe in New York or Ian Eichner out in Las Vegas. It is clear that many of the loans granted to buy or build commercial properties were based more on the ability to refinance rather than the ability to actually pay the loan. The result will probably be similar to the lending problems in the residential market. Rising defaults will lead to a decline in the desire of investors to purchase more packaged debt and the market will begin to unravel. And since commercial real estate cycles typically trail residential real estate cycles by 6-8 quarters we are just now entering the danger zone for CRE. The other area to watch are all those heavily over-leveraged companies that recently went private during the private equity boom. Many will struggle in the event of a recession and when they are unable to refinance their heavy debt loads will be forced to pursue bankruptcy and/or restructuring. Finally, some of our favorite hedge fund managers will reveal that they are not immune to this crisis. They too will take their versions of the "write-downs" that public banks are taking right now. After all they own the same alphabet soup and have exposure to the same counterparties as the big money center banks. I think it is safe to assume that there will be a few more "Amaranth/LTCM/Sowood" blow-ups before all said and done.

So what can we do to save ourselves? Well for starters, now that we have Bernanke's blessing we'll probably see a big fiscal stimulus package (update, $150 billion announced today!) and maybe even a surprise rate cut. All of this will be too little, too late and won't bail the US out of the solvency crisis it finds itself in. I wish I could take credit for having the foresight to predict these events, but the award for hitting the nail in the head has to go to Nouriel Roubini who was bearish far before it was popular and has nailed every twist and turn of this ongoing saga as if he can see the future.

So what will we have learned when things start to stabilize? At the root of all is this is the central premise that the whole world of "structured finance"-- which was created under the auspices of diversifying away risk -- has actually hidden and obscured risk. Now it certainly feels like risk is hidden everywhere and pops up whenever things start to get boring. In many ways the past year has been a bit like a sophisticated game of Whac-a-Mole, the carnival game in which you use a mallet to hit moles that pop out of holes at random. In a financial system that depends upon trust and liquidity, this current round of Whac-a-Mole represents a major crisis of confidence in the financial system and will likely lead to a recession and a bear market. The bottom line is that risk by any other name is still risk. You can slice it, you can dice it, you can package and re-package it, you can name it, re-name it, acronym it, and even insure against it but ultimately it doesn't go away. It is still there lurking, waiting for one of those 25 standard deviation events that comes every 3 years.

Agricultural Commodities Revisited

For the past few years our firm has been systematically overweighting commodities as a secular asset allocation decision. More recently we have trimmed our energy exposure and increased our exposure to agricultural commodities. The last time I wrote about this shift was back on December 5th. Since then our core agricultural commodity holding is up over 20% and is up 13% already in 2008, providing a great counterweight to falling equity prices:


In an environment of falling real interest rates and rising inflation owning "real assets" is absolutely critical. We feel that even after the recent run up in food prices this trend still has some legs. If you are looking for a place to park money that you've pulled out of equities this area deserves a look.

Telling a Story with Charts

We are almost in bear market territory for most of the major indices:

The Baltic Dry Freight Index is down dramatically over the past quarter. This calls into question the international decoupling story:

At present levels the markets looks very oversold. Expect a tick up in equity prices before another leg down:

Location is everything, but with surging inventory, a soft economy and rising unemployment it looks like home prices still have room to fall:


Just how far they fall is hard to tell but if you think that peak to trough will be worse than 21% you can still make money shorting the CME housing futures:


This guy has been in the news a lot recently for talking to much. This article looks at the other side of the coin:

Hat Tips: Bespoke, Ritholtz

Why Home Prices Won't Stabilize in 2008

Many economists are calling for home prices to stabilize in 2008. I think that this belief results from little more than wishful thinking. There is nothing in the fundamentals that supports the belief that home prices will reach a meaningful bottom this year. Inventory is still far too high, foreclosures don't appear to be slowing down and economic indicators are pointing towards a general economic slowdown and perhaps a recession.

The boom in home prices at the turn of the century was dramatic. From January 2000 to November 2005 the Case Shiller national home price index doubled and home prices in San Diego increased 2.5 times. Much of this increase was due to loose lending standards that resulted from global liquidity and low real interest rates. The ongoing liquidity crisis has led to a curtailment of many of the loose lending practices that defined the home price boom - 100% financing, negative amortization, no doc, "liar loans" etc. The lending led home price bubble will take a long time to unwind. I fear the unwind may end up being just as dramatic as the run up in prices. Below are the Case-Shiller home price index numbers from 1987-2007 for several cities and the 20-city composite. I am tempted to label this graph "The Anatomy of a Bubble":


At current levels all San Diego home buyers who purchased homes with no money down since April 2004 are underwater. Those who put 10% down are underwater if they bought between July 2004-December 2006. Those who put 20% down are probably not underwater unless they bought a condo downtown. Why does this type of analysis matter? Put simply, home buyers who are underwater are far more likely to walk away from their mortgage when it resets to a higher payment. Unfortunately every 1% decline in home prices pushes 1,000's more homeowners underwater and increases the probability that we will see higher foreclosure rates and more "must-sell inventory" to work off before we can establish a meaningful bottom in home prices.

If the real estate market throws the economy into a recession all the analysis gets much worse. Higher unemployment and slower wage growth along with general economic malaise will only exaggerate the correction in home prices. Until we see a stabilization in foreclosure rates, a fall in inventory, an increase in sales and an improved general economic picture our prediction remains that home prices will not stabilize in 2008.

If you bought a home in San Diego at the peak of the last cycle in July of 1990 it took a full 8 years before your home price returned to its original purchase price. This time around home prices may take even longer to return to their November 2005 price level. Since the average homeowner only stays in their home for 7 years, a lot of homeowners will be literally "trapped" in their home and, unable or unwilling to buy their way out, they will likely just walk away.

I don't like making long-term predictions about home price trends, but I'm thinking another 7-8% drop in in the Case Shiller home price index in 2008 is in order. We'll look at 2009 when it comes, but something tells me we won't be much more optimistic then.

Meanwhile . . . . On Wall Street

Hat Tip: Ritholtz

Catching a Falling Knife

Anyone want to buy a house in San Diego? We could use some buyers . . .


By the time we see a meaningful recovery we could see a 40-50% correction in condo prices. We still have a year's worth of inventory on the market. I think its safe to say the blood is running in the streets . . . .

Markets, Obama Stumble

The Nasdaq is down over 17% since its peak. The S&P 500 is off over 15%. The Dow is off almost 12%. A few more rough days and we'll be treading in a bear market for US equities. As the economy cools due to the housing recession and credit crunch, and as earnings continue their slow it is inevitable that this will be priced in to equities.

The true question is the extent to which you believe that equities are overpriced at their current valuations and just how long and severe this slowdown will be. A secondary level of evaluation needs to be done to determine whether or not you think the US slowdown will be enough to lead to a general recoupling around the world that will slow growth in developed and emerging markets. If you are Nouriel Roubini these are easy questions, but if you aren't, these are questions you should be pondering.

On another note, though it is a little too early to call (13% precincts reporting) it looks as though Hillary Clinton might just mount a stunning rally to take New Hampshire and keep her hopes alive to take the Presidency in 2009. If Hillary had lost New Hampshire she would have been effectively out of the race as many in the Democratic party would have jumped ship. Those hoping for easy sailing for Obama need to take a deep breath. Republicans hoping to face a "beatable" Hillary in the general election just let out a huge sigh of relief.

On the other side of the aisle McCain secured a victory in New Hampshire by a solid 37%-28% margin over Romney. If I were a betting man I would guess that a Romney-Obama general election could be in the works.

Equity Select Portfolio Changes

I made some major changes to the Equity Select Portfolio over the weekend and am in the process of updating the trades in the system to reflect the changes.

As of this yesterday three of my positions - Goldman Sachs, BHP Billiton, Affiliated Managers Group - have been liquidated and replaced. Later this week I will write a full post about what prompted the changes and update everyone on the current performance of the ESP and the Hedged ESP.

How Many Transistors Can you Fit in Your Dot?

It may be because I don't follow Intel too closely but I was surprised that I didn't know that Intel had already rolled out a chip based on the next generation 45-nanometer manufacturing process. You can almost see the smile behind the mask of this Intel engineer holding a 45-nm wafer that has roughly 1.9 billion transistors (do you think he double checked that count just to make sure?). Intel is planning to spend $8 billion to upgrade factories to design the chips.

Just last week I wrote a blog post showing how a gig just isn't what it used to be. In that same post I wrote that it could be 15-20 years before transistors reach the size of atoms. Now Intel is saying they'll have 32-nanometer chips in production in 2009. To be sure the transistors on a 32-nm fab are not the size of atoms. But just how big are they? Stacy over at GigaOm breaks it down for us:

The different nodes measure the size of the chips, with the 32-nanometer node containing 4 million transistors in a dot the size of a period.

Okay so if the number of transistors on an integrated circuit doubles every 2 years we have the following 15 year schedule starting in 2008:

Year 1: 2009 - 4 million transistors in a dot the size of a period

Year 3: 2011 - 8 million transistors in a dot the size of a period
Year 5: 2013 - 16 million transistors in a dot the size of a period
Year 7: 2015 - 32 million transistors in a dot the size of a period
Year 9: 2017 - 64 million transistors in a dot the size of a period
Year 11: 2019 - 128 million transistors in a dot the size of a period
Year 13: 2021 - 256 million transistors in a dot the size of a period
Year 15: 2023 - 512 million transistors in a dot the size of a period

So in fifteen years Intel should be squeezing 512 million transistors into a dot the size of a period? That sounds like a lot, but is it approaching the size of an atom? I'm not all too familiar with atoms, but it seems the diameter of an atom is around 10^-8 cm. This doesn't mean much to me as I'm sure it doesn't to you, so here are some comparisons I found on to make this problem a little easier to grasp:

• "An atom is a million times smaller than the thickest human hair."
• "Take a piece of spaghetti and divided it 12 times. That comes out to be 4,096 pieces of spaghetti. If you were to divide each of those pieces 30 more times that would be about the size of an atom."
• "If an atom were the size of a period, a person would have to be over 1000 miles tall."
• "A single carat diamond with a mass of 0.2 g contains about 10 sextillion (10²²) atoms of carbon."

Okay I give up, my brain just wasn't mean to understand atoms. Maybe one of my smart readers can tell me if 512 million transistors in the size of a period is getting close to the atomic level? I for one would love to know . . .

Obama and Clinton Switch Places on Intrade

Barack Obama has had a great start to 2008. He won the Iowa primary and performed well in the New Hampshire debates. To top it off investors have bid up his stock on Intrade. In fact, for the first time in the Presidential race Obama is trading above Hillary Clinton. Going into 2008 Clinton was trading around 70 and Obama around 20. As of right now Obama is trading at 55, and Clinton is around 41 (it looks like Byron Wien is off to a good start):


Obama's strong victory in Iowa surprised a lot of people. One possible explanation for Obama coming out of the gate so strong is the importance of the youth vote. If you visit Facebook's US Politics page you can track which candidates Facebook users support:


The current data does nothing to refute the notion that Barack holds a lot of weight with young voters. Once you break down the data even further it gets really interesting: Keep in mind the Facebook demographic is younger and a full two thirds of all Facebook members who have backed a candidate publicly have backed Democrats. The highest current vote getter is Barack Obama who has 39% of all votes. The second highest vote getter is Ron Paul with 13% of all vote getters. Ron Paul is followed closely by Hillary Clinton with 12% of the vote. Here is a more detailed demographic breakdown for the Democrats:

Barack Obama is strong with the youth crowd and Hillary is strong with the older crowd and with women. Nothing too surprising there.

Here's the breakdown for the Republicans:



Ron Paul is incredibly popular with males and with independents.

And finally Barack will probably fare well in New Hampshire if his sweep of the youth vote continues. Below is his Facebook support in New Hampshire (55% to Hillary's 16%):
Momentum means a lot for Presidential candidates, but we've seen in the past that winning early doesn't guarantee anything.



Hat Tip: Facebook

$100 Oil: We've Been Here Before

All this fuss about $100/barrel oil is really just a distraction. Now I can understand if you are arguing that $100/barrel oil is important from a psychological/marketing perspective, but not if you think $100/barrel oil is something new. We are actually still a few percent off of oil's all time inflation-adjusted peak of $102.81 back in 1980. But that is neither here nor there . . .


The real reason that this is an issue is not the oil hit $100, but that this time around there exists the real risk that oil could hit $150 or $200 within the next 5 years. The problem is that China is experiencing double digit GDP growth, and although they are 4 times bigger than the US in terms of population , they only use a third of the oil we use. That will change. Same goes for India . . . and Brazil, and the Middle East, and the rest of Asia . . . I think you get the picture. "Peak Oil" is an often discussed, often misunderstood theory, but the facts are fairly clear: most honest people don't expect to find some huge untapped oil field in the near future. And, as long as demand for oil doesn't decrease dramatically the story for $150/barrel oil is still intact. I'm personally of the belief that demand will soften at these prices and with a general global economic slowdown, but I do think the longer-term story is still intact.


Hat Tip: WSJ

I Never Get Sick of These!

Hat Tip: TBP

Byron Wien's 2008 Surprises

As is customary for this time of year, Byron Wien has issued his annual forecast of the biggest surprises to come.

Wien is Morgan Stanley's former chief strategist who now works for Pequot Capital. He has written his annual list of surprises since 1986. This year he is very bearish, and for good reason!

Here is his look-ahead for 2008:

1. In spite of Federal Reserve easing, and other policy measures, the United States economy suffers its first recession since 2001 as housing starts stay soft and banks are reluctant to lend to anyone where a whiff of risk is apparent. Federal funds drop below 3%. The unemployment rate moves definitively above 5% and consumer spending is lackluster.

2. Standard and Poor's 500 earnings decline year-over-year and the index drops another 10 percent. Energy and materials stocks hold up relatively well in what is viewed as a correction rather than a bear market. Market conditions start to improve during the summer.

3. The dollar strengthens in the first half reaching $1.35 against the euro and weakens in the second exceeding $1.50. The European Central Bank begins an accommodative monetary policy. Foreign investors flock in to buy cheap assets in the U.S. early in the year but the dollar declines later as several countries holding large reserves diversify into other assets.

4. Inflation rises above 5 percent on the Consumer Price Index as higher commodity prices and oil finally begin to have an impact in spite of modest wage increases. The 10-year U.S. Treasury yield rises to 5 percent. Stagflation becomes a frequent presidential campaign and Op-Ed discussion topic.

5. The price of oil goes down early in the year and up later, sinking to $80 a barrel in the first half as western economies slow and inventories are drawn down, and rising to $115 in the second. Established wells continue to decline in production while China, India and the Middle East increase their consumption.

6. Agricultural commodities remain strong. Corn rises to $6 a bushel and cotton to 85 cents a pound. Gold reaches $1,000 an ounce as disillusionment with paper currencies spreads across Asia.

7. The recession in the United States slows the Chinese economy modestly but its stock market declines sharply. Investors recognize that paying biotechnology stock multiples for highly cyclical companies doesn't make sense. The Chinese revalue the renminbi by another 10 percent to control inflation and as a gesture to foreign governments participating in the Olympic Games who complain that Chinese terms of trade are unfair. Several long distance runners refuse to compete in certain Olympic events because of continuing air pollution problems.

8. The new Russian President Dmitry Medvedev, under the tutelage of Vladimir Putin, becomes more assertive in world affairs. He insists that Russian oil and gas be paid for in rubles and demands a Russian seat at major world conferences. Russia and Brazil stock markets lead the BRICs. The Gulf Cooperation Council markets begin to attract interest among emerging market investors.

9. Infrastructure improvement becomes an important election theme for both parties and construction and engineering stocks rally in anticipation of huge programs beginning after the new President's inauguration. Water becomes a critical problem world-wide and desalination stocks soar.

10. Barack Obama becomes the 44th President in a landslide victory over Mitt Romney. With conditions in Iraq improving, the weak economy becomes the determining issue in voters' minds. They want to make sure that gridlock ends and Congress gets something done for a change. The Democrats end up with 60 Senate seats and a clear majority in the House of Representatives.

Wien added that he believes these surprises, which the consensus would assign only a one-in-three chance of happening, have at least a 50 percent probability of occurring at some point during the year.

Looking back to 2007 you can see that Wien was right on about half of his 10 surprises:

1. The S&P 500 exceeds 1600 surprising even optimistic strategists and investors. The combination of strong earnings, reasonable valuations and excess liquidity throughout the world drives the U.S. market higher. Market volatility increases substantially with the VIX index rising to 20.

2. Secretary of the Treasury Paulson’s trips together with the forthcoming Olympics move China to a more accommodative attitude toward the United States and the West. China revalues the yuan by 10% and eases terms for Western partnerships with Chinese companies.

3. Despite a world-wide economic slowdown, crude oil remains in short supply because of Asian demand and the price per barrel returns to $80. Development of alternative sources of energy and sales of hybrid cars remain disappointing. There is a movement in Congress to encourage the construction of nuclear powered electric utility plants and local resistance seems to be softening as the “green wave” starts to take hold.

4. As the standard of living rises around the world, agricultural commodity prices continue to soar. Corn goes to $5.00 a bushel, wheat to $7.00, soybeans to $9.00 and cotton to $.80 a pound. The volatility of cattle prices also attracts investor attention.

5. S&P 500 earnings grow by more than 10% for another year, exceeding analysts’ estimates. Profit margins hold their own as productivity continues to improve.

6. The Federal Reserve does not lower rates in the spring. The 10-year U.S. Treasury yield goes to 5.5% as higher wages cause inflationary pressures to increase and the yield curve turns positive. Real growth in the U.S. approaches 3% once again as housing begins to recover. Credit spreads widen as defaults increase in a service oriented, competitive economy that is brutal to manufacturing companies.

7. The price of gold goes to $800 and silver approaches $18. The dollar is stable against the euro because of renewed economic growth in the U.S. and higher interest rates.

8. Economic conditions in Japan continue to improve. After being one of the worst equity markets in a developed country during 2006, the Nikkei 225 rises 15%. In this market large capitalization stocks do outperform their smaller brethren.

9. The emerging markets of Asia take a rest. Attention shifts heavily to Latin America and Brazil stands out. It is a country with vast natural resources and reasonable labor costs. The country moves closer to an investment grade rating and the Bovespa rises to 55,000.

10. Neither of the current frontrunners for the 2008 presidential election in the U.S. proves to have staying power. Rudy Giuliani pulls ahead for the Republicans as fears of terrorism heat up again and Barack Obama gains momentum as he demonstrates that inexperience isn’t a terminal liability.

What's with the Adjusted Monetary Base?

Dennis Gartman is prone to getting carried away from time to time, but it is usually for a good reason. Today Gartman is bugged by what the Fed is doing with the Adjusted Monetary Base. Specifically he thinks the Fed is ridiculous to let the BASE fall in light of the credit crunch and the profound need for liquidity in the marketplace. Enough from me, here's Dennis:

The Fed needs to be very public in either explaining why the adjusted base is falling and what it intends to do to change that, or it will be the seen as provoking the most serious economic collapse of the past several decades. Perhaps the base is falling for some arcane, non-economic reason that we and other classical Monetarists are not cognisant of. If so, and if the Fed knows why this is so, then the authorities need to explain it to us and to the market in very clear terms... and quickly. We do not say that lightly, and we do indeed understand the seriousness of our comments here. What is happening to the adjusted monetary base is indefensible... and it is dangerous.

Dennis probably has a very good point, but didn't his tone remind you of Jim Cramer's infamous rant on CNBC about the Fed last year? Personally, I'm leaning toward the belief that something weird is going on with the numbers, but I'm also a little bit surprised that no one else has mentioned this yet. One caveat on the graph is that the data is only current through December 19th. It may very well be that the Fed has already corrected this problem.