The self-proclaimed "anti-Cramer," Doug Kass, anchors
"The Edge," a diary about stocks and investing. As a dedicated short-seller, Kass can seek out the bear market in any environment.
This week, he discussed
lies in inflation data
great profit expectations
the spreading subprime fungus
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Not-So-Little Lies in Inflation Data
Originally published on 2/12/2007 8:44 a.m. EST
On Wednesday at his semiannual
Board Chairman Ben Bernanke will discuss the state of the economy. More specifically, he will likely comment on whether the economy can sustain itself free of inflationary pressures that are typically associated with the current trajectory of economic growth.
The level of inflation affects the term structure of
. And the general level of interest rates determines, in part, the value of
Most readers know that I believe that the government's inflation figures are bunk, and that the current benign inflationary readings (low) have misrepresented the true rate of inflation (higher).
For some time I have expected a period of "blahflation" (blah economic growth and stubbornly high inflation), and nothing I see through my first-hand observations or through serious quantitative exercises is consistent with the government's currently low inflation readings. (See the discussion of the Cleveland Federal Reserve's inflation calculations below.)
Evidence Contradicts the Readings
For example, this week George Washington University became the first major college to charge over $50,000 per year for room, board and tuition in 2007. The cost of home insurance around the country (particularly in coastal areas) has risen exponentially -- and in certain cases this is actually forcing homeowners to sell their homes. Rental prices of apartments are rising at annualized rates over 3%-5% (office rents at nearly twice that rate!), and food prices are soaring (just look at the higher prices of commodities such as wheat, corn, sugar, etc.).
Then there is the owners equivalent rent calculation within the CPI, which has dramatically understated and misrepresented the historical cost of housing. And how about the devastating impact that mortgage-rate resets (from the teaser loans of the last three years) will have on homeowners? It, too, is nowhere to be found in the government's measures of inflation, which, in the main, represent a true work of fiction. Even New York Mets baseball tickets for the 2007 season have been goosed by as much as 20%.
Measuring the general level of prices has become a controversial exercise. Often, nonmonetary events -- such as geopolitical crises, weather and financial accidents (particularly of a hedge fund king) -- interfere with and distort the trend-line rate of inflation. The solution, adopted by monetary and government authorities, has been to look at CPI by taking out two volatile or high-noise components (food and energy).
By contrast, I have encouraged readers to look at the measure of inflation calculated by either the Federal Reserve Bank of Dallas (
trimmed mean PCE rate
) or the Cleveland Fed (
Of the two, it is my belief that the Cleveland Federal Reserve Bank's model (created by economist Dr. Michael Bryan) appears to present the most accurate picture and forecast of the general level of inflation, and it has a higher correlation with past monetary growth than other inflation measures. As such, it is far superior to either the CPI, excluding food and energy, or the all-items CPI.
Bryan's weighted median CPI, like the trimmed mean PCE rate, takes away monthly outlier inputs. Arguably, moves in the commodity markets are growing ever more violent (in either direction), stimulated by the proliferation of large capital pools that manage commodities as well as increased mandates by institutional investors to increase their commodity exposure.
The level of inflation over the last 12 months was +3.7%, according to the Cleveland Fed -- considerably higher than the other inflation gauges that are dished out to investors by the government. (CPI was 2.5%; CPI less food and energy was 2.6%.) Here is the
If Chairman Bernanke and the Federal Reserve increasingly focus on the Cleveland Federal Reserve measures of inflation, look for Bernanke to be more hawkish on Wednesday than is generally expected. And look for the capital markets to feel the pain.
One Stock Rocked
This morning, India's aluminum and copper producer Hindalco Industries announced its plan to acquire Canada's rolled-aluminum products maker
for $6 billion. Hindalco will pay $44.93 per share vs. Friday's close of $38.54 per share. I wrote last Monday that
I had heard Novelis was a candidate for acquisition.
Great Profit Expectations Can't Be Met
Originally published on 2/13/2007 8:56 a.m. EST
"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly."
-- Jeremy Grantham
Yesterday we argued that a key tenet to the
rosy view of the markets -- the government's release of relatively low inflation rates -- is bunk, and that the rate of inflation has been systematically understated.
By contrast, I wrote that I prefer to look at the Cleveland Federal Reserve Bank's weighted median CPI to get a better gauge on the real level of inflation.
Today we argue that the generally accepted observation that forward P/E multiples are relatively low -- another essential argument underlying the bullish market view -- is also likely to be proven incorrect.
Corporate profits are booming. In fact, U.S. corporate profits in 2006 rose to their highest as a portion of GDP in over 75 years.
The chart below, prepared by ContrarianEdge.com's Vitaliy Katsenelson, graphically depicts how high current corporate profit margins are above trend line.
In many ways, Katsenelson's analysis reminds me of the chart of housing affordability (home prices divided by household incomes) which, when stretched into a two-sigma event in late 2004-
, served as a catalyst for a sharp downturn in the housing markets in 2005-07. It is my view that expectations of business profit margins and corporate profits over the next several years might outrun both the economy's potential to deliver, and most traders' generally bullish expectations.
Demand and productivity, price and cost levels, risk perception, credit volume and credit difficulties are all incorporated into forecasts of future profitability, and the relationships among these variables can be viewed as constituting an enduring core of the business cycle. External shocks and policy effects are more transitory and at the periphery, but they have to be considered in forecasts.
That said, I can count a number of factors that could result in a contraction and mean reversion of corporate profits: rising interest rates, a tightening labor market, a host of cost pressures in materials and/or an end to the enormous productivity gains of the past five years. As well, in a world of heightened geopolitical risks, normalcy can quickly morph into abnormalcy -- and higher prices of "stuff," like oil, to levels never imagined.
Although the U.S. economic upswing of the last several years provides a vivid example of how profits, investment, and an exuberant stock market can reinforce each other, long business expansions, as seen in the chart, have been hard to sustain over time.
The most vivid example outside the U.S. was Japan in the 1980s, when an investment-driven and speculative boom gave way to protracted stagnation. In the U.S., after deterioration in the 1970s and early 1980s, U.S. business cycles moderated again, as in the first two post-World War II decades. But globally, recessions became more frequent and more severe in the second half of the postwar era.
History teaches us that "what goes up must come down."
Subprime Fungus Will Spread
Originally published on 2/15/2007 9:27 a.m. EST
Wednesday saw another large mortgage bank, Silver State Mortgage, cease originating subprime loans. Silver State Mortgage was, according to
National Mortgage News
, one of the fastest-growing wholesale lenders in the country.
The relatively healthy subprime originators, like
Long Beach Mortgage, are
around the country faster than you can say BBB-minus.
In a related note, Standard & Poor's might have been reading
my story from last week as they downgraded ratings on 18 securities from 11 mortgage-backed bond issues and put on review a number of other bonds sold by units of
New Century Financial
Many in the media (from Jim "El Capitan" Cramer to Sir Larry Kudlow to
) have opined that the bears "don't understand the conditions under which real estate markets collapse, and these conditions (suggestive of a broadening credit problem) are not present." And, in a series of perfunctory conference calls over the last week, the leading brokerages have supported their case that there will not be a credit contagion emanating from subprime lending and that the brokerage exposure will be contained and limited, even though none of the banks disclosed their involvement in the subprime market (as agents and as principals).
It appears that the principal reason these observers are ignoring the subprime problem and
its ramifications is that the equity markets are ignoring them. Ergo, it must not be a problem. This is the definition of a Goldilocks mind-set (see no evil, hear no evil), not a Goldilocks scenario.
The subprime carnage (like HSBC's nearly $2 billion addition to subprime loan losses in the fourth quarter 2006) is ignored as is the commentary from merchant builders like
(below) and others (perhaps because their stock prices are also rising).
We began 2006 with a strong backlog that produced record deliveries. However, as the year progressed, market conditions worsened, cancellations increased, net orders declined and margins came under pressure. The result was a 2006 year-end backlog substantially below the year-earlier level. At a minimum this will likely result in a year over year decrease in our unit deliveries through the first half of 2007 and potentially longer.
-- KB Home CEO Jeffrey Mezger (Feb. 13, 2007)
Two Toxic Reagents
The credit containment argument ignores the parabolic growth and rising role of subprime lending (relative to total mortgage industry loans) -- never before have lenders relied more on the candor and integrity of borrowers, and never before have underwriting terms been so lax. These are two toxic reagents, especially within the context of the biggest housing boom in history, in which real estate mortgage receivables have mushroomed to all-time records at the major (and minor) banks.
The "dot condo" CondoFlip
that encouraged investors/speculators to day-trade condominiums (and proudly declared that "Bubbles are for Bathtubs") has been dismantled and is no longer operational, replaced by a Condo Super Center. The site now admits, in a
, that "the condo boom was driven by overly-ambitious speculators, many of whom had been successful in flipping condos in the past. As condo inventories grew and prices rose, many speculators realized that further purchasing was increasingly risky. So, buyers just stopped buying."
There is an emerging credit crisis and it will lead to rapidly rising charge-offs. Construction lending on land and condominium loans are the next area to implode (examples of exposed intermediaries are Fulton Financial, National City and Corus Bancshares).
As night follows day, the enormous securitization markets will shortly begin to demonstrate the same sort of delinquencies we have witnessed in subprime mortgage lending. Then a continued acceleration of subprime loan problems will creep into the prime market (where equally creative mortgage loans have been made to
Restrictive credit practices are just beginning to unfold as a consequence of the poor underwriting standards applied over the last decade. The more things change, the more they stay the same.
At time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."
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