Not Quite a Correction

A market correction is defined as a 10% drop. We haven't had a correction in any of the major indices for quite some time, but we are close right now.


At a decline of 8.31% we are 1 or 2 down days away from a correction. As a point of reference, a 20% decline is a bear market. Naturally along with the correction comes enhanced volatility. I've got a running bet with 3 to 1 odds that we'll hit 35 before the year is out. What do you think?


I think I told someone the other day that as sick as it sounds, buying Google now, even at $700 would probably look smart in 5 years. I won't back down from that statement, but I will say that buying Google on the dips is probably the best way to scoop up shares. If you look at the graph below I think you can make a strong argument that buying Google when it is within 5% of its 200 day exponential moving average is a safe bet. Even after the after market action today that left google at 627 the shares are still 16.5% above their 200 day EMA. In other words, you may want to wait another 50-60 points or so before you dive in.

Bill Miller's Market Commentary

Bill Miller's market commentary is a must read for investors looking for perspective on market events. You can read his commentary at the lmcm website. Bill gives a great synopsis of the current market environment and then follows it with his value equity commentary:

One of the enduring features of the findings in behavioral psychology as it applies to finance, a subject I have discussed many times over the years, is the almost complete inability of those who are aware of them to actually apply them. You can attend Richard Zeckhauser’s seminars at Harvard, read lots of articles and case studies, be reminded of how recency bias, or anchoring, or the representative fallacy, or myopic loss aversion impair clear thinking and skew decision making, and still fall prey to them and others of their ilk the moment you are confronted with real world situations.

The recent precipitous decline in financial stocks, especially those related to housing, which sent Countrywide Financial (CFC) to $12 last week, and led to 20 to 30% drops in financial guarantors in a day or so—after they had already dropped between 25 and 50% this year—is a case in point. After falling 20% in only a few days on no news, and this after being down 50% for the year, CFC rallied over 30% in one day once they reported their results and indicated they would be profitable for the 4th quarter and expect to earn a reasonable return on equity of 10-15% for all of 2008. The price action on both sides was driven by emotion – first fear, then relief – and was hardly the result of a careful analysis of Countrywide’s long term business value. That, by the way, we think is in the $40’s compared to its current price of about $14-15.

This is not unusual. Warren Buffett has often noted how any knowledgeable analyst would have pegged the value of the Washington Post at about 5x what it traded at in the 1974 bear market, yet no one wanted it at that price. The 2002 bear market saw some similarly amazing prices. AES traded under $1. It will generate over $1 of free cash flow this year and is up 20 times from the lows of 2002. Yet fear set its price, as it did those of Nextel, Tyco, Corning, Amazon, and a host of other companies at that time.

Today fear dominates the pricing of housing stocks, of mortgage related securities, of financials, and of many consumer stocks. Confidence and optimism underlay the pricing of energy, materials, industrials, and non-US stocks, especially those of emerging markets, and China in particular.

I am reminded once again of the quote that sits in the front of Ben Graham’s Security Analysis, from Horace’s Ars Poetica: “Many shall be restored that now are fallen and many shall fall that now are in honor.” (The quote does not say “all” by the way, just “many”).

So what do you think, is it time to start buying Citigroup and housing stocks?

Level 3 Asset Writedowns

Some market analysts are now expecting bank and brokerage writedowns to increase to between $100 and $500 billion, mostly due to the decline in value of Level 3 assets. Most of these writedowns will come as a result of a new FASB rule limiting the ability of companies to avoid valuing hard to value assets. According to the FASB terminology:

Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs and used when there aren't any quoted prices available. Level 3 values are based on ``unobservable'' inputs reflecting companies' ``own assumptions'' about the way assets would be priced.

Considering the sheer volume of Level 3 assets that most of the major US banks hold on their balance sheets and in off balance sheet entities, it seems shareholders would be very concerned about the degree to which banks can manipulate the value of those assets by changing their own assumptions. When banks finally reveal that those assets are truly as worthless as many of us assume, they will take even larger write-downs:

U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc.

The Financial Accounting Standards Board's rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank's chief credit strategist Bob Janjuah in London wrote in a note today. The new rule is effective Nov. 15.

``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' Janjuah said. ``The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ``mark- to-make believe.''

Wall Street's biggest firms have written down at least $40 billion as prices of mortgage-related assets dwindle because of record foreclosures. Morgan Stanley, the second-biggest U.S. securities firm, has 251 percent of its equity in Level 3 assets, making it the most vulnerable to writedowns, followed by Goldman Sachs Group Inc. at 185 percent, according to Janjuah.

The credit crunch is not over yet, and the worst may still be in front of us. If Wall Street is hurting this bad you have to imagine that we should see some more hedge fund blowups in the coming weeks. Hedge funds can hold off on valuing their assets longer, but eventually they will have to pay the piper.

Hat Tip: Bloomberg

Only Funny Because its True

Hat Tip: Barry Ritholtz

What Makes a Great Investor?

Greg Mankiw writes: "Hedge fund manager Mark Sellers tells Harvard business students the secrets to success as an investor. An excerpt:

As an investor, you need to perform calculations and have a logical investment thesis. This is your left brain working. But you also need to be able to do things such as judging a management team from subtle cues they give off. You need to be able to step back and take a big picture view of certain situations rather than analyzing them to death. You need to have a sense of humor and humility and common sense. And most important, I believe you need to be a good writer. Look at Buffett; he's one of the best writers ever in the business world. It's not a coincidence that he's also one of the best investors of all time. If you can't write clearly, it is my opinion that you don't think very clearly."

Google Telephony

Okay, so today's news about Google's entrance into the telecommunications world has been rumored for months if not years. But, today's announcement was still real news and represented what for many was a significant departure from the announcement they were expecting. Many thought Google would announce a GPhone, not unlike what you see to the right. What they got was an alliance of 33 companies attempting to rewrite the rules of the cell phone world. I won't get you my first impression here. Rather, I will shower you with links. It is a cop out, but I really can't do this story justice. If you read this in order it is better:

1) Andy Rubin: The Man Behind the Google Phone

The Google Phone — which, according to several reports, will be made by Google partners and will be available by the middle of 2008 — is likely to provide a stark contrast to the approaches of both Apple and Microsoft to the growing market for smartphones. Google, according to several people with direct knowledge of its efforts, will give away its software to hand-set makers and then use the Google Phone’s openness as an invitation for software developers and content distributors to design applications for it.

If the effort succeeds, it will be the most drastic challenge to date of the assertion by Microsoft — the godfather of the desktop PC — that Google and other members of the so-called open-source world can imitate but not innovate.

2) Google Phone Crunched

Reports started trickling out last week that Google is ready to announce its Gphone, or rather Gphones. It is more a reference design, than a single phone. Android-based phones will start to come out on the market in the latter half of 2008 (from HTC at minimum). One mobile startup CEO I know says he was contacted on Friday by Google and given the final go-ahead to port his app onto Android, which his company has not even started to work on yet. The software development kit will be available on November 12. Today’s announcement is just that. There is nothing concrete here in terms of products or services, but going mobile represents a major growth opportunity for Google, which wants to bring the Internet (along with search and contextual ads) to your phone.

3) Bloomberged

Spending on mobile-phone ads may jump to $11.4 billion worldwide by 2011 from $2.17 billion today, according to Informa Plc, a London-based research firm. Google, in Mountain View, California, gets 99 percent of its more than $10 billion in annual sales from advertising, mostly by selling text links next to search results on its own pages and partner sites.

Google shares passed $700 last week, gaining $100 in less than a month, on speculation the company would extend its lead in Internet advertising into wireless devices. Gene Munster, an analyst at Minneapolis-based Piper Jaffray & Co., predicted as early as August that Google was developing software to run mobile phones.

4) WSJ

Android is a bid to change how the wireless industry operates. Carriers traditionally have decided what applications most consumers see on their cellphones, setting rules and negotiating fees for software developers to gain access. Google has struggled at times in recent years to get its products -- including Google Maps, Gmail email and its search engine -- onto mobile phones in a way that's easy for people to use. With Android, software makers can theoretically write applications that run on any user's phone -- and consumers can freely browse the Web.

RMB Appreciation

As discussed last week, it appears the RMB is poised to appreciate rapidly. This is from China financial markets:

According to a Bloomberg article today, the RMB was up 0.56% last week, reaching 7.456 to the dollar. This may not sound like a lot if you trade dollar/euro, but it is easily the biggest one-week jump in the US dollar value of the currency since it was suddenly revalued by 2.1% in July, 2005. According to a Bloomberg article, RMB forward contracts imply a price of 7.38 by the end of this year and 7.25 by the end of the first quarter. The article did not list the contract expiration date or a more precise RMB value, so my calculations may be slightly off, but this implies a 6.4% annual appreciation between now and the end of the year and a 7.0% annual appreciation between now and the end of 2008’s first quarter. Implied annual appreciation during the first quarter of 2008 is 7.3%.

Two reasons are generally given for the increase in appreciation rate, and both probably are true. The first, and more cynical, reason is that there will be a meeting later this month between Chinese finance officials and their European counterparts, along with a meeting between France’s President Sarkozy and President Hu, and everyone expects the currency to be a very important topic of these meetings. As they often do before such discussions, the Chinese authorities may be allowing the currency to appreciate to help deflect some of the expected anger. One of the claims much beloved of journalists and China-watchers is that foreign pressure on Chinese authorities is almost always counterproductive, a claim about which I am extremely skeptical.

The second reason for the more rapid rise in the currency is that the inflation scare is ringing serious alarm bells in Zhongnanhai (the leadership compound), even while publicly the authorities still insist that inflation is a one-off temporary food thing. Given the anxiety, it is striking to me that fuel prices were raised by nearly 10% last week and that there are rumors that other controlled prices may also rise. This can’t help but feed into inflationary expectations. I think the only thing that can easily explain the timing of such rises must be that the costs of the subsidies must be higher than the authorities are willing to support, although perhaps there is also a sense that they should get all the bad news out of the way as quickly as possible.

If market assumptions are correct and the RMB does begin to appreciate at 7.3%, with bank deposits yielding 3.8% you can earn 11.4% in US dollars if you can smuggle money into China and deposit it in a bank. Even the most intrepid of my hedge fund friends in New York wouldn’t sniff at those kinds of returns, especially since the biggest risk is upside risk – a sudden maxi-revaluation. There’s the problem – an obvious danger of speeding up the appreciation rate is that it might set off another wave of speculative inflows, thus pushing monetary conditions even more out of whack. Poor PBoC – dammed if they do, damned if they don’t.

The "Bailout and Justify" Fed

I can't think of a Halloween in recent memory that fell on a day with such a heavy dose of economic news. Not only are we getting some of the standard fare -- ADP private payrolls, construction expenditures, the employment cost index etc. -- we are also getting some real substance with the FOMC meeting and the third quarter advance GDP figures. The end result, if this year carries on as it has thus far will probably be bad economic news followed by a great rally. Allow me to explain.


As you can see above, the market has priced in a 25 bip rate cut heading into FOMC day. I personally think the Fed could, and may try to "justify" another 50 bip cut. How would they do that? Well for starters they could point out that market conditions haven't stabilized enough to cushion the blow from an accelerating housing market decline. After all that resilient American consumer is only as resilient as the credit officer who signs off on his/her HELOC's and credit card applications.

The Fed's second "justification" option is to just point at the graph above and use dramatic works like "crisis" and "carnage" to describe the credit spreads. Surely there is something in that chart to scare the weak-hearted and spin a 50 bip cut!

The reason I emphasize the Fed's need for justification is to point out how closely Bernanke's Fed seems to be following Greenspan's basic policy, as summed up in the following Greenspan quote from September of 2004 (and pulled from Jeremy Grantham's most recent newsletter): "For the Fed to interfere in security speculation is neither desirable nor feasible," but "if a sudden correction in asset prices did occur the Fed's first responsibility is to protect . . . to provide ample liquidity until the crisis is past." In plain English, Greenspan's stance is that you can't stop speculation, but you must bail out the speculators before they hurt everybody else. The real key of course is to bail out the speculators, but justify your bailout to market participants in such a way that they don't increase their inflation expectations. While this "bailout and justify" policy seems to be the preferred option for Greenspan and Bernanke, it does have a fatal flaw; it is quite simply not the type of policy that will force market participants to accurately price risk and thus prevent future speculation (moral hazard).

Now I want to make it clear that I don't think these moral hazard problems are necessarily Greenspan or Bernanke's fault. I think that the Fed Chairman's incentives, at least during this little slice of history, are just not in line with staying hawkish on inflation during market corrections. Indulge me on this for a moment. Back in early September Martin Feldstein suggested at the Fed's Jackson Hole Symposium that a 100-bip cut in the Fed Funds rate could be rationally justified. When reading the quote below from Feldstein's speech try to imagine yourself as the Fed Chairman listening to this speech and slowly letting your scholarly inclination to "stay hawkish on inflation and tough on speculators" slowly drift away and start thinking more about how posterity will view you if you precipitated a painful recession:

The Fed could adopt the risk-based "decision theory" approach in responding to the current economic environment. If the triple threat from the housing sector materializes with full force, the economy could suffer a very serious downturn. A sharp reduction in the interest rate – in addition to a vigorous lender of last resort policy – would attenuate that very bad outcome.

But what if the outcome in the absence of a substantial rate cut would be more benign and yet the Fed nevertheless cuts the federal funds rate? The result would be a stronger economy with higher inflation than the Fed desires, an unwelcome outcome but the lesser of two evils. If that happens, the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it would succeed in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability.

Wait a minute, hold the presses, since when did "Decision Theory" replace the Taylor Rule as the key factor in the Fed's decision making? While I don't think Marty was trying to illustrate the amazing power incentives have in encouraging moral hazard in Central Banking, he did a fairly good job of it. The acute pain of a recession is a far bigger and more salient pock mark on the track record of a central banker than that of a "longer period of slower growth." Just think, if you were Bernanke looking at the current state of the economy, and I was God and I offered you stability today followed by a "longer period of slower growth" or a 50% chance of a sharp recession that would likely be blamed on you, which option would you take? That's what I thought.

Following this line of thinking to its natural conclusion, it would also behoove an incentive-led central banker to underestimate the true inflation rate in the economy in order to provide more flexibility to cut rates in times of distress. And now we are at the truly scary part of all of this discussion. More and more scholars are starting to question whether the Fed's preferred inflation measures are truly capturing all the inflation out there in the economy. Jeremy Grantham -- a man who seems perenially worries about the market -- has not once been concerned about inflation for the past 20 years, that is until now:

For the first time in 20 years I am slightly worried about inflation. . . By the way, like many others I have an increasing distrust in the official inflation numbers.
For example, we have rising commodity prices and a very large deficit combined with a very weak currency, yet we have a decreasing inflation rate and one that is lower than that of many European countries with strong currencies. Very odd indeed.

Makes you wonder what exactly goes into the inflation calculation doesn't it? I'll tell you what. With what little I know about incentives it just seems to me that the Fed is more likely to cut big now and seek to justify than it is to rediscover its distate of inflation. I just hope all of you who have made it this far in this post have moved out of the dollar into commodities and emerging market stocks.

Sidenote: Just the other day Jim Rogers was quoted as saying: "It's the official policy of the central bank and the U.S. to debase the currency." While I think he was being a bit dramatic, I think he may have a very good point. China dropped its 'official' dollar peg 26 months ago and has allowed its currency to appreciate just 10% over that stretch. Now China is facing a serious problem: they are raising rates to fight rising inflation (6.2% in September, October numbers due in 2 weeks) and they are watching as the US lower rates (today) to fend off a recession. If the US is at 4.5% and China sees rates rise closer to 3.5 or 4% it won't be long before China's Central bank will actually be losing money if it continues to sterilize capital inflows. With the Fed in "decision theory" mode I might just follow Jim Rogers advice and start moving all of my assets into Renminbi . . .