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January 29, 2010

Chaos, Turbulence, Fragilities: Defining the New Normal, Blueprinting Business Performance

A few interesting things happened in this last week that define the things we want to address here. In an exchange with a friend on business performance in the new normal, despite several months of back and forth, most of what we'd been saying about the next decade hadn't really sunk home but we finally managed to get the other shoe to drop. His reaction was somewhere between Wow and OMG! What that exchange makes clear to us is that, in line with our expectations, most businesses haven't a clue as to what's coming at them. So those issues (defining the New Normal benchmark and assessing business preparation and performance outlook) define our endpoints. At the same time we had an amazing, in many senses State of the Union and Davos 2010 kicked off. This environment has moved from Chaos to Turbulence and is still very Fragile - and will remain both Turbulent and Fragile for the decade as deep structural adjustments in the global economy, governance (corporate and public) and geo-politics that will radically alter the deep foundations we've taken for granted for the last three decades are changed in response to the crisis and governance and performance failures. Those changes are a central theme of this year's conference.

Taken all together the economic outlook, the implications for investment and asset performance and business governance define the touchpoints of our highly selected readings section after the break, including several critical vidclips from Davos as some from the FT on emerging markets. There's nothing there that we're putting up just for fun. But the central questions are what will the New Normal look like and how are businesses prepared for it? And how will public authorities deal with restoring a fragile world economy. To set the stage you might want to listen to this brief round table from McKinsey. But we'll let a much wiser man define the situation in words we hope you recognize and take to heart:

"The dogmas of the quiet past, are inadequate to the stormy present. The occasion is piled high with difficulty, and we must rise with the occasion. As our case is new, so we must think anew, and act anew. We must disenthrall our selves, and then we shall save our country. Fellow-citizens, we cannot escape history. We of this Congress and this administration, will be remembered in spite of ourselves. No personal significance, or insignificance, can spare one or another of us. The fiery trial through which we pass, will light us down, in honor or dishonor, to the latest generation."

Annual Message to Congress (1 December 1862) – A. Lincoln


 

The New Normal Political Economy

Despite all the political posturing that went with it it was government intervention that saved us from a second Great Depression. The good news is that a recovery has begun but that bad is that it's policy-dependent, still far from self-sustaining (meaning interest rates are going to say low), will weaken as stimulus fades and be below potential for a long time. Which means weak job growth when almost all industries are already over-capacity. Just on these factors alone would mean we'd be facing a weak decade with, let us emphasis, no clear back to long-term potential growth and prosperity without fundamental changes in the deep structure of the Economy. In the chart in other words that upward sloping curve is out of reach without major public investments. NB: since we've covered all these points are trying to provide a compressed blueprint our charts will be composites and we'll leave the interpretations up to you.

Debt and De-leveraging

At this point we hope it's clear that what sustained the economy for the last three decades was decreasing savings, under-investment and over-consumption, fueled by financial de-regulation, leverage and debt which hurt long-term investment and growth. Dealing with the consequences of deleveraging and balance sheet reconstruction for consumers and businesses will take the rest of the decade, presuming growth is adequate if not good, but is primary reason why it'll be lackluster and unlikely on current course and speed to reach the upward sloping curve. Building off Reinhardt and Rogoff's work the McKinsey Global Institute did a detailed study of the outlook by country and sector for deleveraging over the next decade (links in the reading - you really need to read it).

Debt, Savings, Investment and Growth

O.K. - so far we've got a weak recovery with challenges reaching takeoff speed, a sustained period of low, below potential growth that will keep job growth limited to breakeven or below and deleveraging that will further reduce consumer demand in the developed world. We previously dug into how the high growth eras in the US economy were the result of high savings, which led to high investment and created a virtous cycle. Now we're on the wrong side of a vicious cycle. The l.h. side of this composite illustrates the technical side of that argument while the r.h. side illustrates the conceptual side. There are two bottomlines here. Consumers, as they are already doing, will be forced to do and are likely to choose to do, will need to change their fundamental behaviors. And collectively we need to rebase the economy and find new sources of growth while reducing or eliminating major structural weaknesses that have been drags on economic performance: deteroriating infrastructure, exponentiating healthcare, poor education and a shortage of high-quality laborforces and a dearth of new innovation. To get back to long-term potential we need to fix all that (and it's a great puzzlement to us why businessess, investors and financial advisors don't see that but on the evidence to date they really....really....really don't get it).

Re-Balancing the World

The rapidly emerging world grew on the developed world's consumer bubble and the recycling of their savings into our debt. Well in this brave new world that equation is going away. The major exporting countries are going to have shift to more domestically based economies instead of relying on exporting commodities or manufactured goods. In fact despite the BRIC acronym lumping very disparate countries together we're going to see a great seperation driven by these factors. Brazil is well positioned by a balanced economy, India somewhat less so, China's basic model probably needs to adjust faster than it's capable off and Russia's in the deep dodo. All of this governed as much by geo-political factors as much as anything else. In some ways this chart set almost speaks for itself - consumer debt is dropping dramatically in the US because of huge hits to net worth while China built its growth on exports and investment and has a very unbalanced economy where forced savings have subsidized manufacturing and infrastructure. The Chinese have an immense challenge that could take the rest of the decade to deal with but have a sharply limited horizon because of demographic problems, unlike Brazil and India plus constant and on-going risks of social instability. They know all this but the various factions are debating how, when, where and even why. May we all live in interesting times indeed!

Business Performance and the Multi-factor Dashboard

We won't go back over the business performance problems in any depth since we've just spent the last several years going into it in excruciating detail over the last few weeks. But what we hope is clear from the benchmarks we've summarized above is that businesses need to be constantly monitoring and adapting to the multi-dimensional factors of a very fragile, turbulent and complex New Normal. They need to understand the social, political and international factors, the structural disruptions in their industries and economies and the business cycle and long-term economic trends.

But all those things are largely beyond their control (the Supreme Court notwithstanding). What is in their control is how they respond - and the fundamental conclusion of all our previous analysis is that they need to perform well now and innovate for the future - and put in place the proper sets of metrics, incentives and management systems to turn strategies into delivered realities. One of the themes that comes up over and over again in the Davos vidclips is that the public's trust in business has gone from bad to abysmal in the last few years - and we're not talking about just Finance but all business. As you'll find out from the last set of readings it would appear that business is doing NONE of the things it should be doing to cope with these realities.

On that note we'll give you a quote from another wise and brilliant man:

"The costs of maintenance of an existing order are inversely related to the perceived legitimacy of the existing system. ... it is the successes and failures in human organization that account for the progress and retrogression of societies".

Prof. Douglas North, "Structure and Change in Economic History", 1981.

In other words either companies fix their performance and governance problems and start meeting their private and public obligations effectively or they will be fixed for them (fix is used here the same way the vet talks about "fixing" your cat!).

Davos Sessions

What Is the "New Normal" for Global Growth? Despite an upward revision of the International Monetary Fund's most recent World Economic Outlook, average real GDP growth of the global economy over the next five years is expected to be less than that of the five years (2003-2007) before the crisis. Speakers: Dennis Nally, Arif M. Naqvi, Raghuram G. Rajan, Nouriel Roubini, David M. Rubenstein, Heizo Takenaka, Michael J. Elliott.

Rethinking Market Capitalism A sudden global recession, massive government bail-outs and a steep loss of public trust in corporations have forced a re-examination of the spirit and structure of capitalism. What elements of market capitalism should be rethought? Speakers: HRH Prince Salman Bin Hamad Al Khalifa, Herman Gref, Guy Ryder, Ben J. Verwaayen, Jacob Wallenberg, Tony Tan Keng-Yam, Willam W. George.

  • Business Leadership for the 21st Century "Management is doing things right; leadership is doing the right things." -- Peter F. Drucker (1909-2005) What are the pressing global, industry and societal issues that business leaders must address in the wake of the "Great Recession"? Speakers: Stephen Green, Rosabeth Moss Kanter, Indra Nooyi, Eric Schmidt, Wang Jianzhou, Robert Greenhill
  • Rebuilding Trust in Business Leadership A global survey in 2009 revealed that only 29% of respondents trust information communicated by CEOs, down from 36% in 2008.What steps should business leaders take to rebuild trust among their stakeholders?
  • Rethinking Compensation Models A 2009 study revealed that 70% of the 200 largest companies (by market capitalization) in the S&P 500 Stock Index reported changes to their executive pensation programmes. How should compensation systems be redesigned in the wake of the "Great Recession"? Speakers: Shumeet Banerji, Mark Mactas, Stephen G. Pagliuca, Guy Ryder, Peter A. Weinberg, Adi Ignatius
  • Rethinking Systemic Financial Risk In 2009, the G20 tasked the Financial Stability Board (FSB) and the Basel Committee onBanking Supervision to develop "macro-prudential tools" to combat systemic risk. What structural deficiencies still persist in the regulation of systemic financial risk and how will they be addressed in 2010? Speakers: Jaime Caruana, Ibrahim Dabdoub, Robert E. Diamond Jr, Stefan Lippe, Jonathan M. Nelson, Guillermo Ortiz, Suzanne Nora Johnson.

Economic News & Information

If M Does Not Pickup, Will V Save Us? Before we get started, let’s get the forecast update out of the way. With the release of November business inventories data, we have revised up significantly our real GDP annualized growth rate for Q4:2009 – from last month’s projection of 3.5% to 4.5%. Again, it is a sharp slowing in the rate of inventory liquidation that is driving this upward revision. Our projection of the annualized growth rate for final sales in Q4:2009 is 1.6%, just one tick above Q3’s reported growth. So, the anticipated surge in top-line fourth-quarter growth is largely an inventory story. Unless, however, final demand begins to grow faster, the inventory story of the last year’s fourth quarter will be a one-off event. And this is where the “M” and the “V” referenced in this month’s commentary come into play. After surging right after Lehman’s failure in September 2008, growth in the M2 money supply (predominantly physical currency, checkable deposits, saving deposits, small time deposits and household money market mutual fund shares) has been trending lower. As shown in Chart 1, in the 6 months and 12 months ended December 2009, the annualized growth in M2 was 1.9% and 3.4%, respectively. In the past 20 years, only the early 1990s experienced similarly weak M2 growth for any length of time (see Chart 2). So, should we expect a similar surge in M2 velocity in 2010 as was experienced in the early 1990s? Perhaps not. This past economic recession and financial crisis resulted in the largest household capital losses, excluding real estate, in the post-war era (see Chart 6). By an order of magnitude, the recent losses surpassed those experienced in 1990. Including real estate, the recent capital losses were even more severe. Moreover, the capital losses experienced in the past several years occurred across a wide spectrum of asset classes. It would be reasonable to expect that household investors today are more risk averse than they were in the early 1990s.

The looming deleveraging challenge The specter of deleveraging has been haunting the global economy since the credit crunch reached crisis proportions in 2008. The fear: an unwinding of unsustainable debt burdens will drag down growth rates for years to come. So far, reality has been more benign, with economic growth recovering sooner than expected in some countries, even though the financial sector is still cleaning up its balance sheets and consumer demand remains weak. New research from the McKinsey Global Institute (MGI), though, suggests that the deleveraging process may just be getting under way and is likely to exert a significant drag on GDP growth. Our study of debt and leverage in ten mature and four emerging economies indicates that some sectors of the economies of five countries—Canada, South Korea, Spain, the United Kingdom, and the United States—will very probably experience deleveraging. What’s more, our analysis of deleveraging episodes since 1930 shows that virtually every major financial crisis after World War II was followed by a prolonged period in which the ratio of total debt to GDP declined significantly. The one exception was Japan, whose bursting asset bubbles in the early 1990s touched off a financial crisis followed by many years when rising government debt offset deleveraging by the private sector. The “lost decade” of sluggish GDP growth that followed is a cautionary tale for policy makers hoping to somehow avoid the painful process of deleveraging. Business executives too will face challenges: they may have to adapt to an environment in which credit is tighter and costlier and consumer spending could be slower than trend over the medium term in countries where household debt has built up. Our findings underscore the likelihood that growth will be stronger in emerging markets, which are far less leveraged, than in mature ones. To cope, companies should build the potential impact of “pockets” of deleveraging into their market outlooks.

A budget freeze? Let me start with a statement of what I see as the core challenge facing monetary and fiscal policy at the moment. How can we successfully stimulate the economy in the short run and still maintain confidence in the longer-run reliability of the dollar and solvency of the U.S. government? In terms of monetary policy, the task is to persuade the public that the Fed will achieve 3% inflation over the next two years and yet subsequently contract its balance sheet sufficiently to prevent inflation from getting out of control afterwards. In terms of fiscal policy, the task is to support demand at the moment but then be able to phase out the fiscal stimulus over time as investment and net exports rise to take the place of government spending. Obviously this is not so easy to accomplish, but I feel that Carlo Cottarelli has been thinking along the right lines:

The myth of China’s blithe consensus The point of all this is to suggest the richness and even ferocity of the internal debate taking place within China.  There is a tendency I think, especially among the foreign cheerleading fraternity, to ascribe a unanimity of opinion within China and to see this both as a good thing and as a confirmation of the views of the cheerleaders. I would argue that this is wrong on all three counts.  First, there is most certainly no consensus.  The debate in China is as fierce and as well-informed as it is anywhere in the world.  Second, unanimity, or even strong consensus, would not be a good thing for China.  Given how complex matters are, any strong consensus would simply represent a failure to debate the issues, and a corresponding increase in the probability of making horrible policy mistakes.  In fact if there is a rapidly growing consensus about anything it is that policymakers seriously flubbed the chance to force through adjustment measures, such as a revaluation of the RMB, earlier when conditions were much more propitious and when the cost of adjusting would have been much lower.  Third, cheerleading tends to occur far more enthusiastically among foreigners than within China.  That is clearly a good thing.

  • G-7 Consumption Behavior and Global Rebalancing U.S. consumption growth, which as noted has been in the 2-1/2 to 4 percent range for almost two decades, will remain weak. After a shrinking of consumption in 2009, consumption growth is projected at 1-3/4 percent in 2010. Elsewhere also, consumption growth will remain below precrisis levels through 2010.
  • The rout in global stocks is a tempest in the teapot of China’s command economy The current turmoil sweeping China’s financial markets is a result of exactly this command economy. And the ripples that have spread out from China to produce declines in stock markets in Brazil, India, and other emerging countries are so powerful because so many investors outside China don’t understand how China’s command economy actually works to produce extraordinary short-term volatility that really doesn’t signify much of anything in the long run.

Oil up to around $75 ahead of US inventory report Oil prices rose to around $75 a barrel Wednesday in a wavering market as investors played down concerns that energy demand isn't recovering as quickly as expected. By early afternoon in Europe, benchmark crude for March delivery was up 36 cents to $75.07 a barrel in electronic trading on the New York Mercantile Exchange. Earlier in the session, when the dollar was stronger, it fell as low as $74.44. The contract dropped 55 cents to settle at $74.71 on Tuesday.Trading was lackluster ahead of a weekly oil inventory report by the Energy Department's Energy Information Administration that is expected to show demand remains weak despite another cold snap in the U.S. "Both refinery utilization and crude oil imports are at figures only seen previously after hurricanes, going back over the last two decades or more," said a report from U.S. energy consultancy Cameron Hanover. "They reflect extremely weak demand for refined products right now." Clarence Chu, a trader with Hudson Capital Energy in Singapore, said the American Petroleum Institute has forecast a 2.2 million barrel decline in oil inventories, compared with market expectations for an increase in supplies of 1.5 million barrels. Cold and snow from before Christmas into the first part of January helped drive oil prices to a 15-month high earlier this month. Below-average temperatures were forecast again for much of the eastern half of the U.S., the world's largest oil consumer, through at least the end of the week. But oil prices have been clouded by falls in stock markets amid anxiety over President Barack Obama's plan to regulate banks. China is also moving ahead with measures to curb bank lending, sparking concerns that a slowdown in China's big economy could destabilize a worldwide recovery and dampen global appetite for oil.

Markets News & Information

The Ring of Fire: Investment Outlook By Bill Gross (Feb10) There have been numerous changeups and curveballs in the financial markets over the past 15 months or so. Liquidation, reliquification, and the substituting of the government wallet for the invisible hand of the private sector describe the events from 30,000 feet. Now that a semblance of stability has been imparted to the economy and its markets, the attempted detoxification and deleveraging of the private sector is underway. Having survived due to a steady two-trillion-dollar-plus dose of government “Red Bull,” Adderall, or simply strong black coffee, the global private sector is now expected by some to detox and resume a normal cyclical schedule where animal spirits and the willingness to take risk move front and center. But there is a problem. While corporations may be heading in that direction due to steep yield curves and government check writing that have partially repaired their balance sheets, their consumer customers remain fully levered and undercapitalized with little hope of escaping rehab as long as unemployment and underemployment remain at 10-20% levels worldwide. In this New Normal environment it is instructive to observe that the operative word is “new” and that the use of historical models and econometric forecasting based on the experience of the past several decades may not only be useless, but counterproductive. When leveraging and deregulating not only slow down, but move into reverse gear encompassing deleveraging and reregulating, then it pays to look at historical examples where those conditions have prevailed. Two excellent studies provide assistance in that regard – the first, a study of eight centuries of financial crisis by Carmen Reinhart and Kenneth Rogoff titled This Time is Different, and the second, a study by the McKinsey Global Institute speaking to “Debt and deleveraging: The global credit bubble and its economic consequences.”

Jeremy Grantham: Lessons learned from the past decade “What a Decade!” follows, providing Grantham’s thoughts on the past decade including the following list of lessons learned: • The Fed wields even more financial influence than we thought. • Low rates have a more powerful effect on driving financial assets than on driving the economy. • The Fed is capable of being extremely out of touch with the real world - “What housing bubble?” - plus more doctrinaire - “No, the low rates had no effect on housing” - than anyone could have imagined. • Congress is nearly dysfunctional, primarily controlled by large corporations, and hamstrung by the supermajority now routinely required in the Senate. • Government administrations can be incompetent for long periods. • Poor leadership can really damage a country’s hard-won reputation in a mere 10 years. • Obama is not a miracle worker! • The leadership of major corporations can be very lacking in insight and competence on a fairly routine basis. • The two time-tested investment tools, value (P/E ratios and P/B ratios) and price momentum, are now much more heavily used and not so reliable as they once were, say from 1977 to 1997.• Asset classes really are more inefficiently priced than individual stocks on average, and therefore offer greater opportunities for adding value and reducing risk. • Developed countries, including the US, are past their prime compared with developing countries: it is indeed a new world order. • Education and training are the keys to increasing wealth on a sustainable basis and the US is in danger of losing its once large edge here. • We all live on an island, which can be overexploited and turned into a barren Easter Island if we are not careful. Resources are finite and biodiversity is fragile, and both must be protected. Carbon emissions are the single greatest threat. • Being a global policeman is expensive, and somewhere between difficult and impossible. • The Fed learns no lessons! The Appendix to the report is a summary of Grantham’s part in a debate entitled “Financial Innovation Boosts Economic Growth”, sponsored by The Economist.

Stock market leadership points to risk aversion As far as leadership since the start of the nascent US stock market correction on January 20 is concerned, it is interesting that cyclical sectors such as the Materials SPDR (XLB), Financial SPDR (XLF), Energy SPDR (XLE) and Technology SPDR (XLI) have been leading the market lower. Traditionally defensive sectors such as Consumer Staples SPDR (XLP), Utilities SPDR (XLU) and Health Care SPDR (XLV) also declined, but to a lesser extent than the S&P 500 Index as a whole (-5.1%) and the cyclical sectors. This is the type of pattern one would expect typically to emerge during a correction phase. The final words go to David Fuller (Fullermoney) commenting as follows from across the pond: “Why might this be no more than another correction rather than the beginning of a new bear trend? Unless the modest global economic recovery is about to slide back into another slump, which I doubt, I do not see the catalysts for another stock market collapse. Instead, and despite the current uncertainty, I think this could still be an economic sweet spot for stock markets characterized by modest global GDP growth, reasonably accommodative monetary policy and generally low inflationary pressures.

Doing the "Safety Dance": What Are Traders So Afraid Of? But if the bond market were really worried about the Fed being politicized, prices would likely be falling and yields rising. Instead, Greenhaus says yields are falling for a fairly simple reason: The economic recovery is "very fragile."

FT Video clips on Emerging Markets

Jing Ulrich, JPM Chairman of China equities and commodities on why earnings growth and not easy credit from band lending and monetary policy will drive the Chinese markets in 2010. And discusses risks of asset bubbles, particularly in the property markets.

  • Part Two on changes in the markets plus renminbi policy changes. Part Three on banking capital raising, IPOs and commodities demands, including over-supply in steel (as the exemplar of over-capacity and over-supply in manufacturing in general).

Stephen Roach of Morgan Stanley discussing whether BRIC consumers can replace the US consumer as engines of world growth and finding that it’s not possible unless they re-balance their domestic economies to shift from export-lead to consumer-driven economies. And that in the long-term the center of gravity will not shift their way unless they re-balance and succeed to transitioning to domestically driven growth.

Business

Volcker on Re-thinking Finance With the “Volcker Rule” regarding US financial regulation taking center stage, Paul Volcker’s response to questions on financial innovation at the “Future of Finance Initiative” six weeks ago makes for interesting viewing material.

Toyota US sales halt deals blow to image, earnings Toyota's suspension of U.S. sales on an unprecedented scale to fix faulty gas pedals deals a blow to the automaker's reputation for quality and endangers its fledgling earnings recovery. The suspect parts are made by a U.S. supplier, but they are also found in its European-made vehicles, an official with the automaker said Wednesday. Toyota said it hasn't decided what to do there. Japan's Toyota Motor Corp. announced late Tuesday it would halt sales of some of its top-selling models to fix gas pedals that could stick and cause unintended acceleration. Last week, Toyota issued a recall for the same eight models affecting 2.3 million vehicles. Toyota is also suspending production at six North American car-assembly plants beginning the week of Feb. 1. It gave no date on when production could restart. The timing could not be worse for Toyota. Two years ago, the company beat out General Motors Co. to become the world's largest automaker. Now just weeks into 2010, it is stopping sales in its biggest market, the U.S., at a time when it desperately needs to sell cars here after reporting its first-ever annual loss last year. The sales and production halt involves several best-selling U.S. models, including the Camry and Corolla sedans and the RAV 4 crossover, a blend of SUV and car whose sales surged last month.

 

Management lessons from the financial crisis The Quarterly: What management lessons do you think we should be learning, so far, from the financial crisis? Richard Rumelt: There’s been a dramatic failure in management governance. And so our basic doctrines of how we manage things are in question and need revision. At the heart of this failure is what I call the “smooth sailing” fallacy. Back in the 1930s, the Graf Zeppelin and the Hindenburg were the largest aircraft that had ever flown. The Hindenburg was as big as the Titanic. Together these vehicles had made 620-odd successful flights when one evening the Hindenburg suddenly burst into flames and fell to the ground in New Jersey. That was May 1937.The history of bumps and wiggles—and of GDP and prices—didn’t predict economic disaster. When people talk about Six Sigma events or tail risk or Black Swan, they’re showing that they don’t really get it. What happened to the Hindenburg that night was not a surprisingly large bump. It was a design flaw. The Quarterly: You’ve used two similar terms: Richard, you called it a “design flaw”; Lowell, “flawed assumptions.” Either way, could you describe in a bit more detail what you think some of those flaws were? Richard Rumelt: The idea that these risks were independent is a central part of the design flaw. The independence assumption shows up in the collapse of various financial institutions and in derivatives, where people designed them, thinking that various risks were diversifiable—and they’re not. And it shows up in the management of the whole economy, as Lowell mentioned.This focus on meter readings rather than on a deeper understanding of the forces at work is what gets you into trouble. And what I see in the companies that I work with is that while they don’t have a solution to the problem, there’s an increasing distrust of the meter readings and of the pronouncements from on high. There’s a sense of, “Something is wrong with the system.”The Quarterly: Are you referring primarily to nonfinancial companies? Richard Rumelt: Yes. Financial companies would just like to get the game going again, mostly. Lowell Bryan: Building on what Richard was saying, I would use a slightly different set of words, as opposed to meter reading. I think that underlying a lot of the problems are hubris and a belief that you can actually predict the future, plus or minus 10 percent. It’s earnings forecasts and expecting that you ought to be able to manage your delivery against them.It’s basically this presumption that, of course you’re going to have smooth sailing.

  • Setting strategy in the new era Someone in the introduction of their book wrote that if you don’t have a clear vision of the future ten years hence, you’re not managing. I couldn’t disagree more. I think if you have a clear vision of the future ten years hence, you’re a psychotic.

Strategy in a ‘structural break There is nothing like a crisis to clarify the mind. In suddenly volatile and different times, you must have a strategy. I don’t mean most of the things people call strategy—mission statements, audacious goals, three- to five-year budget plans. I mean a real strategy. For many managers, the word has become a verbal tic. Business lingo has transformed marketing into marketing strategy, data processing into IT strategy, acquisitions into growth strategy. Cut prices and you have a low-price strategy. Equating strategy with success, audacity, or ambition creates still more confusion. A lot of people label anything that bears the CEO’s signature as strategic—a definition based on the decider’s pay grade, not the decision. By strategy, I mean a cohesive response to a challenge. A real strategy is neither a document nor a forecast but rather an overall approach based on a diagnosis of a challenge. The most important element of a strategy is a coherent viewpoint about the forces at work, not a plan. Discerning the significance of these events is harder than recounting them. I think we are looking at a structural break with the past—a phrase from econometrics, where it denotes the moment in time-series data when trends and the patterns of associations among variables change. A corporate crisis is often a sign that the company’s business model has petered out—that the industry’s underlying structure has changed dramatically, so old ways of doing business no longer work. The same principle applies to the economy as a whole. In most of the recessions of the past 40 years, demand caught up with capacity and growth returned in 10 to 18 months. This recession feels different because it is hard to imagine the full-steam reexpansion of financial services or a rapid turnaround in housing. Beyond these two hot spots, there seem to be unsustainable trends in commodity prices, oil imports, the nation’s trade balance, the state of our schools, and large entitlement promises. Already, the idea that the United States can grow by borrowing money from China to finance consumption at home has begun to seem implausible. We know in our bones that the future will be different. When the business model of part or all of the economy shifts in this way, we can speak of a structural break.

How managers should approach a fragile economy A powerful tension is at work today in global economic sentiment. The financial markets, pundits, and policy makers think the global economy is out of the woods, but executives aren’t so sure. Our research suggests that the executives are right—and that to thrive, companies must adopt some new approaches to management. Simply put, the daily experience of business leaders suggests that a full recovery of economic activity to pre-crisis levels is further off than expected. Moreover, the distribution of responses suggests that, as a group, executives simply don’t know what will happen. An improving global economy is not the same as a recovering one. We see three main underlying reasons for this confusion and skepticism. Each of them presents tough management challenges. Let’s start with public policy. Yes, the unprecedented monetary stimulus, government guarantees, and injections of capital seem largely to have ended the short-term crisis that landed the capital and credit markets in the hospital. But it remains unclear what will happen when the patient is taken off its meds—less risk taking and lower returns in the global financial system seem inevitable—or what will be the unintended consequences of the recent massive growth in public balance sheets and of rising regulatory costs. A second reason for the uncertainty is the difficulty of comprehending the information available on unfolding economic events—information often delivered in the form of sound bites with little explanation of what various indicators really mean. The third reason is the very nature of the economic shift under way. This crisis wasn’t and still isn’t a singular breakdown. Rather it consists of many smaller crises, each with its own pace and impact, that are interrelated and still under way.

Business Executives Expect Difficult Times to Continue in 2010 -- but Are Failing to Plan Tough, Defensive ActionsToo few companies have taken or plan to take the long-term, defensive measures necessary to survive and thrive in the wake of the Great Recession. Although businesses around the world are entering 2010 with an appropriately sober view of the business climate, only 28 percent say that reducing labor costs is a priority for 2010, only 26 percent have made managing cash flow a priority, only 16 percent say that balance sheets and debt restructuring are a priority, and only 13 percent have put exiting noncore businesses on the list of priorities. "The slow-growth world that we're in, and should expect to be in for some time, fundamentally changes the nature of competition. Life is going to be harder," said Rhodes. "From now on, every day should be treated as if it were a World Series game -- because there will be no more regular season games. What will distinguish long-term winners from also-rans is the resolve to fundamentally rethink and rework business models and, at the same time, be courageous enough to invest in the future of the business." Observed Stelter, "According to our survey, leaders recognize the need both to be defensive and to attack. But when it comes to action, they are poised to attack and invest but seem only to be playing around the edges of cost-cutting. We're concerned that they're skirting true, long-term defensive actions." In the face of these trends, executives have taken, or intend to take, short-term defensive actions. Between 50 and 70 percent of surveyed executives have made the easier, more obvious moves such as increasing their focus on key customers; reducing administrative and travel spending; renegotiating supplier contracts; and reducing inventory levels, marketing budgets, and wages. But far fewer have made, or plan to make, more wrenching, longer-term moves. Only 44 percent plan selective exits from product lines, only 39 percent plan selective exits from customer segments, and only 43 percent have taken or plan to take actions that involve divesting businesses and exiting sales channels. "Smart companies will have acted quickly and restructured around profit centers and projects," said Rhodes. The reluctance to take more definitive defensive steps is particularly evident in the comparison between executives' plans for expansionary, or "attack," measures and their plans for more core-strengthening activities aimed at cost structures. For 2010, 37 percent of executives have made prioritizing expanding capacity, building sales presence, and making acquisitions a priority. In addition, 32 percent said that R&D and innovation investing are priorities, and 30 percent are focusing on retaining and hiring talent. One reason that companies are not going to the lengths they should to rethink cost structures and core strengths seems to be a view that the new economic order -- characterized by slower growth, lower profits, more protectionism, and greater consumer savings rates and price sensitivity -- will not be long-lived. Fewer than 50 percent of the surveyed executives said that these new realities will still be relevant in the medium term -- in other words, the next two to three years. Rhodes and Stelter believe that this perception of the potential duration of the recovery is too optimistic. The underlying dynamics of the financial crisis remain in place; it's a very-best-case scenario that U.S. unemployment will return to 5 percent by 2014; and China's capacity to save the global economy is overstated.

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January 26, 2010

Alternative Investments, Strategic Futures of PE and Lessons?

We're going to tunnel down on the Private Equity business, its past performance, reactions to the crisis and its strategic outlook. This is important for its own sake because the PE Industry heavily influence prices, values and capital allocations - furthermore, it will remain a major force into the future. But not as it was - the Industry needs to go thru a major re-think and shift from a financial engineering driven approach to an integration of financial plus operational engineering. Widespread studies indicate that something like 20-40% of the Industry might be shaken out in the aftermath of the crisis, let alone adapting to the turubulences of the "New Normal". Who survives and prospers will be those firms which make this transition.

But the Industry is important not just for its own sake (it is), its role and influence on Finance as a whole (that too) but also for what it tells us as investors about the likely evolution of alternative investments. Even without direct access to PE investing everybody has been influenced by the big deals, the leverage used and the prices paid. That world is gone and isn't coming back in anything like its old form. A good way to put this in context is this recent debate at the Economist's Buttonwood forum on Financial Innovation where the Cons were Jeremy Grantham and Richard Bookstaber. There's a very extensive readings section after the break that reviews how deals have (not) performed, how the firms and the investors are reacting, what the trends are for the future and changes in the external environment. Perhaps one of the most telling readings is the Business Week lead story on how KKR, one of the founders, is completely re-doing its business model - and the other firm they want to emulate is Buffett and Berkshire! Now there's a fundamental SEE change for you.



Strategic Theory and Outlook

The basic theory behind PE investing is that a firm combines equity from limited partners with leverage borrowed from commercial source, buys out existing companies, changes the capital structure, improves the performance of the company and then harvests the returns by either taking the revamped company public or selling it to a strategic buyer. On that theory McKinsey is anticipating that funds will begin flowing back into alternative investments but that outlook was developed before the full force of the downturn and the fallout was clear - which means it was originally optimistic but is now probably wildly so. Normally the best time for investment is during the downturns when multiples are low but because of the uncertainties, the crippled M&A and Debt markets and the troubles at portfolio companies that's not happening. And as a result of the systemic shocks limited partners are re-evaluating the terms, funding and control relationships. All in all this next decade will partly follow the old cyclic patterns but they will be more severe and call for more fundamental rethinkings than previous ones.

After-shocks of the Crisis

The impacts on PE activity and situation get a little clearer when we look at this next chart set which shows the situation with portfolio companies and the PE firms. Portfolio company debt is largely trading as distressed debt, which means it's in danger of defaulting, so that the estimate is that some 50% will go into bankruptcy. The not surprising consequence of very high multiples and excessive leverage. At the same time the PE firms have a lot of "dry powder" to invest - that is they should be well positioned to take advantage of these circumstances but in fact are struggling to do so. One implicit implication here though is that equity funding resources should be available. The question is what to do with them - what about debt funding, what new leverage ratios, how will the limited partners react and where will the returns come from? Both from damaged portfolio companies and in the future?

It's clear that Private Equity will remain a force but that force will be forced to change :). The interesting question is how, when and where.

Current State of the Deal-making Environment

We've got two chartsets to look at and the one that provides an overview of the level of activity and the impacts of the crisis is here. This next set tells a complementary story as well as telling us what the evolving structure of investments and the environment looks like. First off, in both developed and emerging markets, there was a huge falloff in deal activity and it doesn't look like it's repairing itself despite a lot of anecdotal discussion that things are "picking up". Perhaps but in the new normal we're going to see an extended period of sub-part deal-making, just as we did in past aftershocks. As the comments note the environment remains very challenging.

When you look at Investment types there's a strong emphasis on smaller opportunities, distressed debt and swapping investments around (secondaries) though there is a trickle of a return of investor money. Meanwhile, as we said earlier, the supply of dry powder is pretty large. It's jus that the financing and the deals aren't there.

Restructurings of Deal Engineering

This all has consequences not only for the rate and volume of deals but for their terms and structure, as this next chartset hopefully makes clear. The supply of loanable funding for leverage has dropped precipitously and will likely take a long time to recover and never come back to the levels it was at during the PE bubble of the 2005-2007 period. Whether it stays at these abysmal levels and how long is another question.

Meanwhile PE firms are having to put higher proportions of equity into the deals, lowering the potential returns significantly. They are also big drops in leverage (debt:equity) and pricing multiples. Those are changes we anticipate will become the new normal.

Considering everything that happened the fact that limited partners are planning to maintain PE investments in their portfolios is significant. Again, at the old levels? Not likely. But the biggest changes will be in the terms and conditions - fees will be reduced, reporting and transparency requirements will become much more stringent, sympathy for financial engineering pure plays will drop significantly and investors will become much...much choosier in which firms they invest in. As usual when a rising tide lifted all boats and then drained away it will be the good swimmers who will survive. And the good swimmers will be the operattionally capable firms!

Strategic Changes in the Business Model

This next chartset brings home that critical point. The structure of deals and the sources of future returns are going to shift, and have to, in very fundamental ways. PE Investment will remain an attractive option but if, and only, if the various firms look to new sources of return. Which in turn means new capabilities that haven't traditionally been part of their capabilities.

The old model saw those returns, at least in theory, result from multiples expansion, operational improvements and leverage. In the new normal without the impact of leveraged bubbles multiples expansion will be a thing of the past. And the amount of leverage will decrease while the cost will go up. This chart (from Credit Suisse's Alternate Asset group) suggests that operatonal improvement will become the dominant foundation of future returns. We think that's true and should always have been. If we have one quibble it's the argument that operational improvements were effective in the old model - perhaps in previous generations but not recently, given the levels of debt that were use in the bubble. Which of course also leaves two hangovers - the aforementioned bankruptcy risks, reducing portfolio returns, and a legacy of excessively high prices that will reduce future returns as well. In the various scenarios played out here the argument is boiled down to IRR's being reduced from 36% to 23%. Perhaps, again! But those 36percenters were, if they ever existed, anomalies. And 23% may still be optimistic.

The bottomline bottomline will be for that minority of firms that can meet the new challenges, grow revenue and improve operational performance there will be a decade of significant opportunities. That may be just the top decile of firms however. In which case there will be a lot of sadder and wiser investors as well as ex-PE folks wondering around the landscape.

And you need to think of Private Equity as being the exemplar for Alternative Investments in general. After the Tech Bubble burst Venture Capital, then the "golden child" of alternative investing went with it and has never come back. Earlier this decade there was a lot of talk about the possible death of Hedge Funds but the financial bubbles led to a lot of new entries - and subsequent failure of hundreds of funds. Across the spectrum of alternative investments there are real nuggets but none of them that rely solely on financial engineering and the quick flip will enjoy the same level of easy money and success that they've had. Whether those days are gone forever or just this decade thing will change. And the broader markets will reflect that - something that doesn't seem to have sunk in any part of the Finance Sector or in Investors minds, either.

Deals, History and Consequences

Buyout Firms Profited as a Company’s Debt Soared How so many people could make so much money on a company that has been driven into bankruptcy is a tale of these financial times and an example of a growing phenomenon in corporate America. Every step along the way, the buyers put Simmons deeper into debt. The financiers borrowed more and more money to pay ever higher prices for the company, enabling each previous owner to cash out profitably. But the load weighed down an otherwise healthy company. Today, Simmons owes $1.3 billion, compared with just $164 million in 1991, when it began to become a Wall Street version of “Flip This House.” Simmons is one of hundreds of companies swept up by private equity firms in the early part of this decade, during the greatest burst of corporate takeovers the world has ever seen. Many of these deals, cut in good times, left little or no margin for error — let alone for the Great Recession. A disproportionate number of the companies that were acquired during that frenzy are now struggling with the enormous debts. More than half the roughly 220 companies that have defaulted on their debt in some form this year were either owned at one time or are still controlled by private equity firms, according to analysts at Standard & Poor’s. Among them are household names like Harrah’s Entertainment and Six Flags, the theme park operator. Executives at THL counter that Simmons was the victim of hard economic times, not mismanagement or too much debt. For now, the Golden Age of private equity is over, the financiers say. In a speech to an industry gathering last spring. Mr. Schoen said that bankers and bondholders were reluctant to lend more money to the buyout kings. “We’re in a brave new world,” he said. “We can’t go back to where we were, at least not in this investment cycle, and probably not in my career.”

Debt Trips Up Hinckley, Venerable Yacht Maker Like other yacht makers, Hinckley lost substantial business when the economy turned sour. But Hinckley’s problems can also be traced to its sale to one, and then another, private equity firm over the last dozen years. With each sale, it took on more debt, which became onerous when business slowed. And the culture also shifted from a family-owned business to one controlled by outsiders. Beginning early this decade, near the peak of demand, private equity buyers poured money into yachting, convinced — wrongly, it turned out — that the business could weather any economic storms because its wealthy clients would continue to buy. Several other boat makers have run into problems, including Ferretti of Italy and the MasterCraft Boat Company of Vonore, Tenn. Hinckley may well survive this downturn, thanks to a strong brand name nurtured over decades of Hinckley family ownership and a loyal clientele, some of whom spend their summers near Bar Harbor.

Serious Money, Vanity Fair (May 2007)But, in my adult life, the event of the bubble bursting, taking us back, for better or worse, to the way we were, never happens. From the 80s on, when finance became the secret code of modern life, from hostile takeovers through leveraged buyouts, junk bonds, venture capital, the I.P.O. craze, and hedge funds, bubbles have only burst so the next can get even bigger. Private equity might be a dangerous rage, but what that promises, in addition to inevitable vulgarity, is that there will be more things that are private and there will be more equity. The outsize success of private equity, the tsunami of private money, the pure giddiness, not to mention faddishness, of P.E. deals, are the result, as most success is, of a market anomaly. When the stock market crashed in 2000, it left lots of businesses stranded and undervalued—unable to go public or raise new money. What’s more, with a lackluster stock market, pension funds and rich people had to find more promising places to put their dough. Hence, private equity got lots of money to buy these cheap companies. Then, with business improving, and the market rising, and valuations going up, they got to refinance these companies—taking money out and buying more companies. Which is where we are now—with private equity remaking the world financial order. Except that the outlandish success of private equity also means that nothing is cheap anymore—everything is overvalued. So what to do? Which all sounds a lot like a bubble—a sense of growing hyperbole. (“When it ends,” says Blackstone’s Schwarzman, he of the birthday party for 1,500 and a personal fortune of $15 billion or so, “it always ends badly. One of the signs is when the dummies can get money and that’s where we are now.”) Still, bubbles can go on for rather a long time. And the biggest money is made at the crest of the bubble. True, you don’t want to find yourself the only one standing when the music stops, but you don’t want to get out of the game too early, either. That’s the other message at the conference: bubbles come and go, but nothing short of a cataclysm can derail the ever expanding power and reach of modern finance. And, even here, speaking of cataclysms, neither 9/11 nor the last meltdown of the stock market has much interfered with business. So, barring a collapse of the entire international monetary system, the world will continue to be remade by ever smarter financial strategies—the line between equity holder and employee ever finer and harsher, the world of owners and renters ever more binary.

Trends, Issues & Problems

Mixed Signals For Private Deal Market The Alliance of Merger & Acquisition Advisors released the results of a survey Tuesday showing that the volume of deals among mid- and small-cap private companies has fallen off precipitously in the first half of the year. The survey, which polled AM&AA member deal brokers, advisers and acquirers, showed a 58% decline in the total number of transactions among private companies compared to the first half of 2008 and a 44% falloff from 2007. The news wasn’t all bad, as the total dollar volume of transactions was off by only 12% from last year and 22% from 2007. The average deal size grew to $13.5 million, almost doubling the $7.8 million average a year earlier, suggesting that smaller transactions are having a harder time crossing the finish line. Meanwhile, the average acquisition multiple across all industries was 4.69x Ebitda, according to the survey. The poll is largely in line with data from the broader M&A market, which has seen the number of transactions fall almost 28% year to date, according to Thomson Reuters. However, the data provider also tallied a 36% falloff in the dollar volume, which -- in contrast to the AM&AA survey -- implies that dealmaking at the top end of the broader M&A market has slowed. Perry Campbell, chair of the AM&AA market research committee, pointed to the difficult financing environment for the slowdown, but added that that performance issues also played a role. He told Mergers & Acquisitions that smaller targets, in the absence of compelling offers, “will pull a company off of the market, wait for things to recover, and then do it all over again” when the conditions improve.

Get Ready for the Private-Equity Shakeout For decades the world’s top private-equity firms have sustained above-average returns in the long run by focusing on fundamental value creation and, in particular, operational improvements… However, from 2003 through 2007, nearly all private-equity firms wee able to grow exponentially thanks to an unusually favorable financial and economic climate and, in particular, four major drivers of growth: massive amounts of cheap debt, rising profitability across all industries, escalating asset prices, and the allocation of significant assets from institutional investors to private-equity funds. The recent financial and economic crisis has sent all these drivers racing rapidly in the opposite direction. The biggest impact of the perfect storm will be on the private-equity firms themselves. We estimate that around 20-40 percent of these firms will disappear; on the other hand at least 30 percent will survive. The fate of the remaining will hang in the balance. There are three main steps that private-equity firms should take: First, they should prepared all their portfolio companies for a long and deep recession, focusing on operational improvements. As the top-performing private-equity firms have shown, operational value creation holds the key to success. This will be the most critical differentiator in today’s recession, especially for the 50 percent of private-equity firms that are hovering between survival and extinction.

Driving the Shakeout in Private Equity The balance of power has shifted toward limited partners, and we expect that limited partners will exercise this power and guide major changes in how the industry operates. The topics under discussion are….transparency, fees, the use of dry powder for bailouts and the implementation of true active ownership. The clearest drive of success …is the capability to create operational value (true active ownership). Limited partners seek a deeper understanding of that capability…. [and] will base their future commitment decisions on that capability dimension – therefore it becomes a table stake for firms to survive.

Wealth Matters: Big Investors Grow Wary of Hedge Funds and Private Equity LESS than two years ago, anything considered an alternative investment seemed to have an automatic cachet. Investors were shoving one another aside to get into the top hedge funds and private equity offerings. Venture capitalists were raising money with ease to invest in companies, even if their ideas were merely interesting, not tested. But the collapse of the financial markets last fall showed the investments’ limits. Investors suddenly realized that they could not get access to the money they had put in or sell their investments for anywhere close to what they were worth on paper. Seemingly overnight, investors began to reassess the tradeoff between the promise of high returns that did not always materialize and limited access to their money. “Clients are concerned about liquidity, lock-up periods and fees,” said Rob Francais, chief executive of Aspiriant, a high-net-worth advisory firm. In other words, the very things that had made hedge funds, private equity and venture capital so exclusive are now a cause for concern. This new caution has led, at best, to greater discernment among the wealthy. But at worst, it has fostered an ostrich mentality. “If they can’t understand it, they’ll pass,” said Joe Curtin, head of portfolio analytics and consulting at U.S. Trust Bank of America Private Wealth Management. “That’s a significant departure. If the strategy can’t be explained in conversational terms, they’re not going to do it.” Like so many other things this year, learning such a seemingly simple lesson has been costly. And the wealthy have not been the only ones to find it out the hard way. Two of the biggest buyers of private equity in 2008, for example, were public pension funds, which bought 26.6 percent of all private equity, and corporate pension funds (14.2 percent), according to Dow Jones Private Equity Analyst. This means the retirement plans of many workers had exposure to the same securities that have so frightened sophisticated individual investors.

Private Equity Investors Grow More Cautious Investor sentiment toward the private equity industry has dropped sharply over the past year following its poor performance during the financial crisis and frustrations about a lack of transparency at private equity firms, according to a study released late Wednesday. While investors in private equity have become more cautious in the last year, investors still do not seem to be pulling their money out of the asset class, according to the survey from Coller Capital, which buys and sells interests in private equity funds. But investors have increased their due diligence of private equity firms before committing new capital, and some are pushing for more investor-friendly terms, the study found. (Read the full report after the jump.) Coller found that 70 percent of private equity investors, known as limited partners, plan to maintain their target allocations to the asset class over the next 12 months and nearly all of the limited partners surveyed said they believed 2010 would be a “good” or “excellent” year. “There is a clear indication from investors that they perceive the P.E. market is bottoming out and that we’ve been through the worst,” said Luca Salvato, a principal at Coller. “While there is caution going forward, there is a view that we are on an upward track.” The survey also found that investors’ expectations for returns over the next three to five years had fallen sharply, with 71 percent of respondents saying they expected net annual returns of less than 16 percent. Two-thirds of limited partners have also changed the way they manage private equity as a result of the downturn, according to Coller’s study. Roughly 60 percent of all respondents said they had changed their risk appetite and investment criteria and half of all respondents have demanded improved reporting from the firm they invest with.

Private equity investors get more wary over where to put cash Investors in private equity hit the brakes this year amid economic uncertainty, pushing fundraising to its lowest level since 2004. However, commitments continued to flow to the top funds. Capital raised in the industry globally slumped 65% year-on-year to $225.6bn in 2009, according to data provider Preqin. The average fund size fell 13% from $592m last year to $513m this year, Preqin said. The drought came as investment committees paused to come to terms with the changing global economy, and capital became more constrained. Meanwhile, demand for new funds was held back by the $1 trillion of uninvested commitments, or dry powder, as private equity firms struggled to allocate existing capital, according to Preqin. Fundraising took much longer this year, as investors and general partners spent longer on due diligence. The 25 largest funds took an average 14.5 months to raise funds in 2009 compared with 12.2 months last year and eight months in 2007. Cathleen Ellsworth, a managing director at buyout firm First Reserve, said: “Investors are demanding, they have a right to be demanding and will continue to be demanding – they’re tying up their capital and have a fiduciary responsibility and managers are put through a rigorous review.”

Coller Predicts LPs Will Shun Re-Ups Private-equity firms looking to make deals this year have had a tough time amassing debt for transactions. Coller Capital says they ought not bother looking to their LPs for any extra capital, either. The global investor in PE secondaries reports that almost 80% of limited partners will deny PE firms’ attempts to re-up funds next year. Coller Capital said growing sentiment that PE firms’ re-up terms are not substantial, lack transparency and may contain conflicts of interest is contributing to what looks to be an LP backlash. In North America, 28% of investors think the perception of the asset class has been damaged through the course of the recession; that number almost doubles in Europe and Asia. The Coller Capital report noted that two-thirds of LPs have changed the way they manage private equity as a result of the recession. “When we look back in a few years, I think we’ll see today’s upheavals as a significant moment in the maturing of an industry,” said Jeremy Coller, chief investment officer of Coller Capital. An Institutional Limited Partners Association report released in September called for better practices involving governance, transparency and partnerships. LPs and PE firms have increasingly clashed with the onset and gradual recovery from the recession; Norwind Capital was pushed away from one potential deal, Pensions & Investments reported earlier this year, after LPs objected to its planned platform launch in the fertility space. TA Associates, wrapping up its $4 billion fund, made concessions in the way of lower carried interest and a provision that redirects transaction fees to offset limited partner management fees. PAI Partners was forced to redeem nearly half of its most recent fund after a very public (and ugly) power struggle resulted in the firm tripping its key-man provision when heads of the investment firm departed.

Private Equity Fund-Raising Hit a Five-Year Bottom in 2009, Down 68% Last year was just miserable for private equity fund-raising in the U.S. Hitting its lowest point since 2003, it fell 68 percent to $95.8 billion across 331 funds, down from $300 billion across 508 funds in 2008, according to Dow Jones LP Source. No category of funds escaped the slowdown, except for secondary funds — a major outlier that saw a more than 50 percent increase in fund-raising. Here’s a summary of the other findings:…. What’s also interesting about the data is how it broke down by quarter. Going into the fourth quarter, there were definite signs that the economy was rebounding. Investors were clearly feeling more secure, and liquidity was starting to return to many markets. But, despite glimmers of hope, the downward trend in private equity persisted to the last. The fourth quarter actually saw the lowest amount of fund-raising all year long — even lower than the first quarter when everyone was still spooked by the downturn. Only $35 billion was raised by 75 funds in Q4 of 2009. It looks like limited partners are taking a bit longer to recover from the blow delivered by the downturn, having become more choosey about where to put their money. It’s unclear whether growth in 2010 will be enough to change their minds.

  • U.S. Buyout Fund-Raising Falls 73% In 2009 “The theme of 2009 was not fund-raising but rather fund size reductions, LP amendments and annex funds,” said Nicolas von der Schulenburg, a managing director of Portfolio Advisors.

Corporate Debt Exploding? It's Hopeless As we have witnessed several times over the last three decades, today’s corporate financial crisis was born of excessive leverage, itself born of excessive optimism, what was called “irrational exuberance” during the last downturn. The current down cycle, like the cycles of 1990-1991 and 2001-2003, is defined by rapid corporate leveraging followed by a tumultuous crash made manifest by high corporate debt default rates, a shortage of liquidity and cratering financial markets. In past downturns, corporate defaults and a dearth of liquidity forced periods of deleveraging that sowed the seeds for the next expansion. Deleveraging was forced upon corporations via debt defaults; those defaults led to a restructuring of balance sheets, often times with the assistance of the bankruptcy courts. These restructuring plans greatly reduced the debt on struggling companies and reallocated the equity away from the original equity holders and into the hands of creditors. What makes this cycle different is that people are betting on blind hope. Struggling companies crippled by debt are not beginning the cycle of bankruptcies and deleveraging that is so badly needed to restore our economy to health. Rapid as it has been, the rise in corporate default rates has been slowed in this cycle by the debt holders who are coming up with admittedly creative and optimistic ways to avoid deleveraging. We have seen an increasing number of cases where lenders convert their entire loans to payment-in-kind paper on the hope that some day the struggling borrower will “grow into” its oversized liabilities and actually pay interest on its debt. We call these “hope notes” and we don’t use the term in a positive way. In the last 12 months, more than $160 billion of institutional leveraged loans (27 percent of the outstanding) has been amended. Right now, the most popular recipe for a troubled company is one part covenant loosening, one part “amend and extend,” and one part hope notes. This is not a recipe for success. I believe companies need to abandon hope and deleverage. It can happen in one of two ways and creditors and corporate issuers must step up to make this happen.

PE Industry Responses and ReThinkings

Don't dabble in distressed With the alarming rise in the number of business restructurings, plummeting stock prices and substantially squeezed margins, many investors are considering whether now is the right time to invest in distressed. Adding to the appeal is that private equity firms are actively raising new funds focused on distressed investing. According to Private Equity International, in the first six months of 2008, distressed funds raised an aggregate of $37.7 billion globally. When dealing with distressed investing, one cannot dabble. You are either in or out. Experienced players know the stakes are high and the level of return may hinge upon resolving a multitude of the target's operational and strategic issues. Funding and liquidity constraints, financial reporting issues, high turnover and the lack of formal controls are often associated with distressed companies. Therefore, interested players must have the proper turnaround talent, process and infrastructure to evaluate, plan and manage such investments.

Dealmaking Strategies for Middle-Market PE Firms -- How PE Investors Are Beating The Recession Enough with the doom and gloom. No question middle-market PE dealmaking has taken a nosedive.  No question it’ll be a long long time before we see again the pace of the past few years.  And no question the credit markets are in for a painful cold spell.  The pressures on many companies and their capital providers are the most severe as many have ever experienced. So if you prefer to spend the next year huddling under a rock, you’re going to have lots of company.  On the other hand, remember this -- that year you’re off the field means there’ll be more opportunities for those of us who forge ahead.  The fact is there are more PE investors actively working on deals than you may realize.  And of course, everyone knows that historical data shows that the most profitable portfolios are the ones built in bad times.  What distinguishes us contrarians is that we’re open to changing direction.  Some of us are looking at new sectors.  Some are focusing on distressed companies.  Some are turning to alternative financing sources to get deals done.  And some are working with portfolio companies on M&A opportunities. I promise -- if you join me at the MasterClass I’m chairing for The Capital Roundtable on April 23, I will show you creative and opportunistic strategies for snatching victory from the jaws of recession. At this full-day MasterClass you’ll learn all this and more --

  • Where and how investment bankers and investors are looking for new deals.
  • What are the best practices in structuring deals when credit is tight.
  • Who’s lending at regional and community banks, insurance companies, and non-bank sources.
  • When to consider asset-based lending, sale-leasebacks, and other ready alternatives.
  • How you can successfully renegotiate and/or restructure terms with your existing lenders.
  • Steps you can use to enhance the value of your portfolio companies.

Looking For The Positive Spin Even for a glass half full guy like me, it’s been tough lately to find something good to say about this market. What seems like the Neverending List of Negative News seems to grow on a daily basis. Just yesterday, the NY Times Dealbook referenced a report from Bernstein Research concluding that M&A activity is going to drop 25% next year and even more in 2010 before it bottoms out. Yes, the report said there are select industries that will continue to see healthy deal flow, but for investment banks and others whose business is linked to transactions, the general outlook for the next 18 months is about doing less with less. On a relative scale, the mid market continues to be a safer place to play than the large market, and that’s unlikely to change even as 2009 gets worse. And since we’re comparing, I would argue that versus their public counterparts, the story is arguably a bit more hopeful for private equity-backed companies. For one, PE-owned companies don’t face the risk of a stock-market dive that erodes investor confidence and buying capital overnight. Moreover, the fact that financial sponsors can’t realize ROI until they exit their investment—dividend recaps are pure fantasy at this point—means they’re more likely to think through the impact of layoffs and other cost-saving moves on the future value of the business. On the flip side, however, many PE-backed companies are highly levered at a time when cash is disappearing. Buyers who invested at the peak of the market—sometimes at double-digit multiples—could end up making ugly, short-sided decisions to recoup what is now a bad investment. So perhaps we're just dealing with varying degrees of pain.  But while that pain is unavoidable, the obstacles we're facing now will undoubtedly lead to some good. For those PE firms who pride themselves on operational expertise—and actually have it—this is their time to shine. Some of those hard decisions that we put off when things were going well will finally be made, and who knows? Maybe they’ll prove to be the ones we should've made all along.  As the old saying goes, success is often born of adversity. 

PE Portfolios Take Center Stage Private equity firms are taking strong measures to improve the operations and performance of their portfolio companies, according to McGladrey Capital Markets. The results of a private equity survey, announced on Friday, found that a large number of buyout firms -- 88% of respondents -- executed layoffs at their portfolio companies. In addition, 75% ordered salary freezes, while 71% were focused on improving business processes and 68% sought to reduce capital spending. Choppy debt capital markets and the economic downturn are driving private equity firms to focus on improving the bottom line of portfolio companies. As a result, many aren't seeking to take their businesses public or sell them. "If the performance isn’t there you’re not going to be selling any portfolio companies," said Hector Cuellar, president of McGladrey Capital Markets. "Given the overall economic environment, private equity firms are trying to focus on operations."  Indeed. Less than 20% of roughly 100 respondents polled expected to sell a portfolio company, division or product line in 2009.  In the meantime, financial buyers are also focused on working capital issues at portfolio companies. Investors, for example, are concerned about bill collections, credit monitoring and inventory management, among other areas.

Adapting to Market Transformation  Knowledge@Wharton: To begin with, I wonder if you could tell us a little bit about the 16-year career that you have had in private equity and some of the opportunities that you see today because of the crisis in private equity as well as some of the government funding coming in through the bailouts? Roberts: Private equity, like most alternative investment strategies, is cyclical. It is perhaps too simple to say -- but I think it's accurate -- that it is a good time to buy when valuations and multiples are low, and there is not a lot of available debt. In hindsight, it wasn't a very good time to buy when the opposite was the case, when lenders were throwing debt at everybody and when multiples were high. You now have a situation where it's very hard to borrow. That is forcing acquisition multiples down. There aren't a lot of sellers yet, but we believe there will be because of the necessity to de-leverage. So we think the next few years will be a very good time to be putting money to work in private equity and finding very good values. Knowledge@Wharton: What are some of the other trends that you are seeing, in a nascent form, in private equity these days? Roberts: I think everyone is having to adjust to at least two major trends. One trend is that most people have legacy portfolios, where they have companies they need to deal with and decide: Is this company worth nursing back to health? Is there a way of restructuring the balance sheet? How do I preserve value? Does it make sense to put capital in? A lot of private equity talent and energy is being devoted to that. I think the second trend is that the traditional leverage buyout is off the table, for now and for the foreseeable future. So when we're looking at transactions, by and large, we're looking at transactions that have no leverage, where you're buying all equity. And therefore, you have to come up with prices and returns that make sense in that context. We're finding some situations, but they're few and far between. Knowledge@Wharton: Do you plan to change your strategy at all in this environment? And if so, how? Roberts: You need to take two things into account in private equity, when you're pricing a deal. One is, you cannot count on leverage very much, if it all. And so you have to structure and price a deal with that in mind. Number two, you have to price in a continued downturn. It depends on the industry and the company, but you can't count on this turning around very quickly and all of a sudden there being a great economic recovery in 2010, for example. That leads you to price very conservatively and to be patient. But we are out there very aggressively looking, because in order to find the right situations, you have to look at a lot until you find the right ones.

Granahan: PE's Power Play I was thinking about this after seeing some data this week regarding private-equity overhang -- the difference between what PE funds have been able to raise over the past couple of years and what has actually been invested. It's now at $400 billion, an all-time high, and pros in the M&A world point to this as a sign that a PE-led buying binge may be around the corner. Some even boldly cite the fourth quarter as when the shopping spree will start. But try to rein in your optimism. While it's nice that there appears to be a handful of arrows in the quiver, there is also a compelling, if not groundbreaking, explanation as to why all that money is sitting on the sidelines: Not much looks attractive at the moment. Remember, even at a time when we already knew the economy and the debt markets were in the tank, there was no shortage of optimists saying that the deals, particular for strategics, would be too good to pass up. But the reality has been far different, whether it be the result of unrealistic seller expectations, lack of financing or simply the business of the target company falling off a cliff. "Dealmakers have to put down their pencils and dispense with historical spreadsheet analysis," said David Cohn, a managing director at Mosaic Capital and a member of the Alliance of Merger and Acquisition Advisors, which helped author a study on the overhang issue. "History now tells private equity little about the future." True enough, but one thing we can say about the future is that it has the potential to be starkly different from what the PE industry had grown accustomed to in the early part of this decade. More regulation, dicey tactical allocation decisions and the possibility that the commercial real estate market is teetering are just some of the issues that will need to be grappled with. Hopes run high, but reality may get in the way.

Pension Funds' Private-Equity Cash Depleted 59% While Paper Profits Shrink  U.S. pension funds contributed to the record $1.2 trillion that private-equity firms raised this decade. Three of the biggest investors, state pensions in California, Oregon and Washington, plunked down at least $53.8 billion. So far, they only have dwindling paper profits and a lot less cash to show the millions of policemen, teachers and other civil servants in their retirement plans. The California Public Employees’ Retirement System, the Washington State Investment Board and the Oregon Public Employees’ Retirement Fund -- among the few pension managers to disclose details of their investments -- had recouped just $22.1 billion in cash by the end of 2008 from buyout funds started since 2000, according to data compiled by Bloomberg. That amounts to a shortfall of 59 percent. In total, they haven’t reaped a paper gain from funds formed in the past seven years. The wisdom of those investment decisions hangs on the remaining value private-equity firms assign to companies they snapped up in 2006 and 2007, during the peak of the buyout boom. For the California, Oregon and Washington plans, that figure totaled $15.8 billion at the beginning of the year. While some investors say they’re confident the private- equity industry’s traditional practice of taking over companies will pay off, others have been shaken by a credit contraction that froze deal-making, eroded the value of the assets on private-equity firms’ books and prevented them from cashing out in public share sales. Now pension managers on both ends of the spectrum are looking skeptically at the so-called internal rate of return buyout firms calculate to gauge their results.

Harvard Endowment Fell 30% Harvard University, disclosing investment returns that trailed well behind the performance of the average college, said its endowment over the last year shrank by 30%, or $10.9 billion. The dismal returns at Harvard and other wealthy schools in the year ended June 30 have exposed weaknesses in their exotic and--as it turns out--high-risk approach to investing. The school's positions in such illiquid assets as private equity partnerships were pummeled in the past year, after stellar results over the previous decade. In the category Harvard calls "real assets," including timber, commodities and real estate, annual losses approached 40%. In a report released Thursday, Harvard showed it had trimmed its risk profile by raising cash, cutting by $3 billion its future commitments to invest in private equity and other investment funds, and reducing its real asset category to 23% from 26% of its model portfolio. It also said it had "clawed back" previous bonuses to its portfolio managers who performed poorly, and planned to bring more assets under internal management, which would give it the ability to move faster to sell assets and raise cash in tumultuous markets. Other wealthy schools, including Yale, Stanford, Princeton and MIT, have predicted losses similar to Harvard's. They all follow an investment model that deemphasizes traditional stocks and bonds and instead loads up on alternatives unavailable to the average investor. Yale and Harvard, pioneers in the method, had said that they could afford to take big risks because they were investing for decades, even centuries. Many lauded and copied the schools, saying they had found a high-return, low-risk strategy. But Eric Bailey, managing principal of CapTrust Financial Advisors LLC, a Tampa, Fla., firm that advises college endowments, says, "If it looks too good to be true it probably is." Mr. Bailey says typical colleges outperformed Harvard last year because they stuck to a plain-vanilla approach -- often 60% stocks and 40% bonds. That strategy would have generated a roughly 13% loss in the year ended June 30. Harvard currently aims to have only 4% in U.S. bonds -- one of the few safe havens over the last year. Harvard cut by more than half the percentage it aimed to hold in U.S. bonds since 2005.

Investment Indigestion at Stanford Stanford University is holding a garage sale. Not the desks-and-chairs kind. Instead, Stanford is selling stakes in funds run by the biggest names in private equity at deeply discounted prices. While no one will confirm the names aloud, they are of the caliber of Henry R. Kravis, Stephen A. Schwarzman and Leon D. Black. During the boom times, Stanford Management, joined other endowments in a rush to plow increasingly large percentages of their funds into private equity, real estate and other illiquid investments — committing some $12.6 billion of the university’s endowment. But then the market soured, and Stanford’s endowment lost $4.6 billion in value in its last fiscal year, a decline of 27 percent. So it now seems to be suffering from investor’s remorse. Its plan to sell part of its stakes in private equity firms — a bid to raise $1 billion or more — appears to be an attempt to cut losses on current investments and a way to get out of committing more money to future deals. One executive involved in the auction process, first reported last week by LBO Wire, a news service of Dow Jones, called it “the biggest fire sale in private equity, ever.” A potential buyer said, “For someone in our business, it’s a rare chance to get a portfolio of this quality and of this size.” Even so, Stanford’s decision will send a chill through the halls of endowment offices at other universities. By trying to sell such a large position all at once, Stanford will invariably depress prices for any institution considering a similar move. Virtually nobody in the industry would talk on the record about Stanford’s planned sale. Everyone contacted was a buyer, adviser or consultant — or wanted to be — and considered this deal to be the third rail of the endowment industry. One question that has vexed the endowment industry is how to determine the value of portfolios. At the end of every quarter, private equity firms typically send out current valuations of their portfolios and the endowments accept them at face value. But what happens if Stanford is able to sell its stake at only 50 cents on the dollar, for example, when K.K.R. is listing it at 80 cents? If other endowments hold similar stakes, what happens to their value?This is still a hypothetical, because unlike investment banks, endowments don’t have to mark to market. Instead, they value their assets on a hold-to-maturity basis, which means they should not have to reduce the value of those portfolios in the short term. But if things get worse, will they have to?

Can KKR Make Like Berkshire Hathaway? Kravis thinks Berkshire, with its piles of cash and trove of publicly traded shares with which to make acquisitions, is nothing less than "the perfect private equity model." That the storied dealmakers at KKR are acknowledging their shortcomings says much about the state of the leveraged buyout business. Kravis and Roberts could try to wait out the rough patch, nursing their wounds and promising investors they'll do better once the deal environment improves. Instead they're reshaping KKR's three-decade-old playbook. The financial crisis has taught the granddaddies of private equity many things. They must be nimbler and quicker. They must move beyond the audacious leveraged buyouts that have come to define private equity in the popular imagination—most famously, their 1989 acquisition of RJR Nabisco. They can't rely solely on debt to pay for their deals. They need, as Kravis puts it, "more control over our destiny." The two have cooked up a four-part plan to make it happen. First, they're building an in-house investment bank to serve KKR's portfolio companies. Second, they're taking KKR public, with shares expected to be on the New York Stock Exchange (NYX) in early 2010, in hopes of one day using the newly minted stock to make acquisitions and invest in the firm. (It listed 30% of KKR in Amsterdam in October.) Third, while Kravis and Roberts certainly aren't abandoning buyouts, they're placing more emphasis on minority stakes and joint ventures with companies in a broader array of sectors. Finally, they're adopting new management techniques to preserve KKR's tight-knit culture as the company expands. Other private equity firms see the value in KKR's emulating Buffett. "This makes sense for them," says John Canning, chairman of buyout shop Madison Dearborn Partners. "A firm that big can't rely [solely] on historical methods of capital raising anymore. Things change." If Kravis and Roberts get this experiment right, their strategy could point the way for other buyout firms. Even bankers acknowledge the need for firms to move beyond leveraged deals. "Private equity will become broader and broader," predicts Morgan Stanley CEO John J. Mack. "Instead of buying companies and restructuring them, they will have a whole panoply of investments."

External Responses

Towards A Common Regulatory Regime? After the G-20 Summit, it seemed that the world was in some agreement that hedge funds, and probably private equity funds too, need regulating. But as various governments start taking concrete steps towards new regulation, it’s clear that there’s still lots of room to disagree. The European Commission, which has so far proved to be the most in favor of regulating private equity, is expected to unveil a report on regulating hedge funds and PE firms on April 28. According to our colleagues at Private Equity News and others who have reviewed a draft of the report, it is expected to include provisions on minimum capital requirements, how much leverage a fund can have, and disclosure of some information on portfolio companies. A spokeswoman for the European Commission declined to comment. The U.K., however, seems to be taking a different approach. An official at the U.K. Treasury Ministry said the ministry doesn’t believe private equity has presented any systemic risk so far. He added that since it is outside of the euro zone, the U.K. has some leeway in adopting European Union laws. “Because London is a financial center, we’d like to maintain that independence,” he said. A paper submitted by U.K.’s Financial Services Authority last month named hedge funds among systemically significant entities, but didn’t mention private equity firms. The largest private equity firms already disclose some details about their own organization and their portfolio companies in the U.K. In the U.S., there are still few details. Congress is expected to come up with two pieces of legislation in the next few weeks, including one on a single systemic risk regulator, said Steven Adamske, a spokesman for the House of Representatives’ Financial Services Committee. He declined to elaborate on whether private equity firms will be included in the legislation. “There will be more hearings” on the issue, Adamske said. In prepared testimony before the committee last month, Treasury Secretary Timothy Geithner said hedge funds, private equity firms and venture capital funds over a certain size should register with the Securities and Exchange Commission and be subject to certain disclosure obligations.

The Private Equity Meltdown Myth Michael Gross, a founding partner of the private equity firm Apollo Management LP who is now at a hedge fund, recently asked a group of business students at Northwestern University this question: In three years’ time, what might the private equity and airline industries have in common? His answer: From day one, neither will have ever made a return for its investors. It’s hard to imagine another industry that has suffered quite the unmasking that private equity has. Hedge funds underwent a calamity, but their basic business of buying and selling stock still works in a leaner world. The business of providing investment advice and making trades—the meat and potatoes of investment banking—will exist even if no independent investment bank does. But private equity firms are another matter. Once, they purported to be in the business of buying troubled companies and turning them around. They contended that they could manage the companies better away from the public glare of shareholders. When money was loose and leverage was king, private equity firms thrived. No more. In the wreckage of the bust, they have been revealed as hapless corporate stewards and gullible investors. The competition for the highest-profile debacle is stiff. Add to that the reality that private equity firms generally don’t make their money by choosing good investments. They make it on an amazing Technicolor array of fees: management fees, deal completion fees, consulting fees, performance fees, special events fees, fees of every kind and stripe. Chalk it up to yet another racket of the bubble years. So it would be natural to assume that private equity is in trouble. Yet, in one of the richer ironies of the Great Recession, private equity firms are poised to flourish. They’ve raised money for new funds and locked it in before investors have had a chance to fully realize how disappointing the returns will be on the last ones. Capital is king now, and many private equity firms have enough money for 10 years. The private equity industry is shaping up to be a great example of why it can be rewarding to do irrational things in a bubble.

How Private Equity Could Rev Up the U.S. Economy It's been a rough two years for private equity firms, those freewheeling and much-vilified financiers who buy companies only to sell them later for a profit. The buyout boom that ended in 2007 wasn't pretty; many of the deals made at the height of the frenzy have been disasters. Bankruptcy courts are littered with private equity blunders, including household names Chrysler, Tribune (TXA), and Linens 'n Things. Such high-profile blowups heightened private equity's reputation as a group of fast-buck artists who are better at destroying companies than running them. But a strange thing has happened. While the experts were proclaiming—and maybe even celebrating—their death, private equity firms were quietly bulking up their war chests and readying themselves for a new wave of deals. By some measures they're stronger than ever: Firms are sitting on a record $1 trillion with which to make new purchases, according to research firm Preqin. "They are showing up at the party with a wheelbarrow full of cash," says Donna Hitscherich, a professor at Columbia Business School. Slowly and deliberately, firms are mobilizing their forces to exploit huge opportunities being created by the recession. Some big buyout firms, filling the void created by the financial crisis, are acting like traditional investment banks, providing loans to troubled companies and even advising executives on mergers. Some firms are aggressively hiring and firing buyout specialists, turning the cold eye they usually train on companies onto themselves. Other firms are prowling bankruptcy courts in search of cheap assets or are capitalizing on government stimulus spending. The next few years will be dismal for many firms, no question. Buyout shops may be sitting on piles of cash for new purchases, but their portfolios also are stuffed with companies at risk of folding unless they can refinance their debt. Boston Consulting Group estimates that 20% to 40% of private equity firms will disappear altogether in the next few years. But the wiliest players have inoculated themselves from the worst of the pain. During the boom years, firms used a number of slick tricks to extract money from companies right away and ease potential losses. First they loaded the companies they bought with debt and kept the proceeds for themselves. Then they collected ongoing management fees from those same companies. Often they did both.

ILPA Issues PE Guidelines The Institutional Limited Partners Association unveiled a set of guidelines for the private equity industry, billing the effort as a drive to better align the interests of LPs, sponsors and portfolio companies. The ILPA, in the 15-page document, focused on best practices involving governance, transparency, and the partnerships. Taken in the context of the current environment, the effort would also seem to underscore the push by limiteds to be more vocal in pressing their rights with sponsors. In July, for instance, Norwind Capital was reportedly forced to backtrack from an investment after its LPs, according to a story in Pension & Investments, blocked efforts to launch a platform in the fertility space. The publication identified Harvard and Yale as the limiteds in question and noted that style drift was the reason cited. Even the outperformers are dealing with more vocal LPs. TA Associates wrapped up its latest fund at $4 billion in August, well ahead of its target, but the firm made some concessions in the way of lower carried interest (20%) and a provision that redirects transaction fees to offset limited partner management fees. The ILPA, meanwhile, listed a number of principles designed to guide limited partner and sponsor discussions. Many of the items reflect current issues facing both GPs and their investors. For instance, the ILPA noted that changes to the tax law that personally impact members of the general partnership “should not be passed on to limited partners in the fund.” This, ostensibly, looks out to potential changes to the tax treatment of carried interest. Also, another suggestion targeted clawbacks, stating that these provisions “must be strengthened so that when they are required they are fully and timely repaid.” Moreover, the ILPA guides GPs to maintain a “substantial equity interest” in the funds, taking the form of cash, and suggests that all transaction and monitoring fees should “accrue to the benefit of the fund,” which is in line with the modification made by TA Associates. The ILPA also discussed governance and transparency best practices, which hearken on past efforts from the association and other similar organizations to create a boilerplate approach for reporting performance and calculating fees.

Posted by dblwyo at 09:09 AM | | Comments (0)

January 22, 2010

Comes 'round, Goes 'round: Hastening Forward Slowly to Finance Reform

The Markets have been tanking most of this week and have given up most of mini-bubble beyond 1100, which if you recall was our upper resistance limit in previous posts. It's doing so because a bunch of things have come together, though semi-predictably there's a chorus of voices blaming the President's announcements of a major reform to restructure the Finance Industry and change what it's allowed to do and how it functions. Given the poor quality of earnings since last March, recent reports showing how weak the core businesses are and Industry behavior over the year with regard to reform that announcement was, at best, a trigger that crystallized an already saturated solution. What really saturated things and put them on the cusp point of teetering over an edge was a slew of disappointing earnings, an improved grasp on the real economic outlook and China's major changes in policy. ALL of which we've been discussing for months.

Rather than reviewing all that it's collected in the readings but we're going to use it as our fulcrum to focus on the salvo across the bow fired on reform, and ask you to start with investing eight minutes in listening the President's announcement. This is not just political theater, though there's some of that, it's to the point, substantive, grounded and a sensible reaction to being stone-walled by the industry for one year (bear in mind the Administration reached out to the Industry within days of taking office and has been trying to reach out for months).

Starting at the Top: Long-term Economic Performance vs. the Industry

Let's start at the top by looking at how the economy has performed when it's fueled by debt to encourage consumer spending and that's built on dissavings, leverage and the sacrifice of investment. An effective and efficient financial sector is necessary for economic growth and prosperity so the Industry argues that they are socially positive allocators of capital. The question is how have we done - not how they've done - as a result. Starting in the UL and working around clockwise we find that Industry profits grew cumulatively at rates that dwarf economic growth, wage growth and other industry profits. Further that the recent debacle destroyed almost a decade's worth of Industry profits but were better than half recovered this last year. Meanwhile (UR) we've experienced the worst economic crisis in many generations that will take a at least a decade to recover from and (LR) been dug into a hole where we're at least 12.2 million jobs in the hole. Worse we face a decade of poor job creation which means we're likely to stay in that hole for a very long time - so much for middle class dreams, eh? Then (LL) there's the long-term structural damage where a secular decline in Investment reduced Growth because of a drop in Savings, induced by un-regulated Finance and the growth of debt financing for consumer spending. We'd have to say the theory of effective capital allocation justifying the Industry as it is doesn't seem to have a very good business case behind it, based on simple, staight-forward data.

Earnings and Performance Outlook

In our post on the Pecora II hearings we borrowed some charts from one of the witnesses where he reviewed the structural shifts in the industry, the impacts on debt and the compensation comparisons which you might want to review. Here we'll take a complementary view on the same subjects and look at the nature of earnings and the implications going forward.

The President talked about reducing internal hedge and private equity investing AND eliminating proprietary trading for the Banks own accounts (bearing in mind that GS admitted last week that it trades against its clients and their interests - we'll be surprised if that doesn't result in some lawsuits). Some of the Financial Press heard part of the message and suggests (UR corner) that an elimination of proprietary trading will have a minor impact. If you'll look at what actually drove earnings this last year at the big banks it wasn't banking or client services (LL corner), it was trading. A few months ago McKinsey took a pass at projecting the future recovery of some of these alternative investment enterprises worldwide but, even with their optimistic estimates, the recovery was weak. Now that's dedicated firms not the big banks but nonetheless the impacts on alternative investment vehicles are likely to be significant (though there's a case to be made that eliminating it as a line of business from the big banks will help those who do it using their own money and take their own risks).

What's not being discussed is "Yield Curve" trading - which is where the banks made their money. With monetary policy keeping short-term rates near zero (ZIRP) and supporting Treasuries banks have been able to borrow at zero and then turn around and buy risk-free government assets. That's not a bad strategy for re-building capital bases and building up a cushion to fund the continuing losses from bad debt as well as re-structure the banks. Instead those profits went into bonuses - and guess who's money they're playing with? Bank profits in 2009 were entirely funded with OPM (other people's money) and you are the "Other People". In a hard-headed business world the folks who's capital is at risk should get the profits, not the folks who manage it. On their own terms, processes, business models and philosophies there's a very strong case to apply a windfall profit tax to the banks - on the order of 80-90% all things considered. After all, we want to be fair and compensate them for their management services at a fair rate, even 2 and 20! :)!!

Banks as Businesses and the Strategic Outlook

We want to finish up by revisiting a point we've been making off and on for over a year now by looking at banks as businesses. Now we've spent a bunch of time talking about how to assess business performance and even applied it to the Finance Industry as a whole. The result, by line of business vs. key operating functions, is encapsulated here.

If you map the last year, the charts above and the President's statements here they all match up perfectly. The Industry isn't making it's money by running effective businesses in the traditional areas but is doing it on trading and related activities, using public risk capital - not their own. (sorry for the teeny size but click to enlarge - we wanted to cover a bunch of ground here so...).

Aside from running good businesses the executive leadership of any firm is ALSO responsible for running their enterprises in a socially responsible manner which is measured by three criteria - earn a profit (which pays for jobs, investment, growth and cycle risks), do no harm and cooperate in fixing societies problems. Again, based on the evidence collected and presented above - not some arm-waving rabble-rousing,and judging the Industry's own standards by which it judges business performance - we end up with this assessment of performance as measured by these broader principles (and at the time we built this chart we were feeling generous - before a year of stonewalling). The Industry has a fundamental fiduciary responsibility to itself, its stakeholders and its investors to contribute constructively and positively to fixing the problems that nearly collapse the world economy. A responsibility that they don't appear, on the available evidence, appear to have met.

A third major line of criticism is that any business must add value, which in the case of an industry like Finance where the traditional lines of business have been subsisting on charges and maneuvers for years, means re-thinking value propositions, strategies, critical objectives and business models. If that were in fact going on and we were going to see a return of the value-creating innovation that benefited the economy in the 1980s in the early years of deregulation then the yield curve subsidy would have some justification. Instead we get this assessment.

Where's the Plan Wall Street?

Sadly, if you go back and listen to the President's announcement or read the prepared text, it seems to use that every single statement he made is not an allegation. It is in fact a simple statement of fact. But we've tried to provide sufficient evidence to let you judge for yourselves.

In the readings, just so we don't get to isolated but keep the bigger picture in mind, you'll find refreshed updates on the economy and markets as well as links to major previous posts and a complete set of links to our entire two years of work analyzing the industry and its performances. Finally you'll find some links and excerpts relating to the tornado that may have just appeared but has been building up since this time last year.

We'd also urge you to listen to the President's last several sentences - it may be political theatre but we think it's far more than that! And the Industry is about to reap the results of what it's been sowing - the results of which will be forced fundamental changes for which they are not prepared and are not preparing!

And one final point but perhaps the most important one - the Industry seems to be a terminal victim of self-inflicted organosclerosis yet the opportunity to innovate, create value and make money by providng the right kinds of products and services has never been better. Where are the real businesspeople and bankers?

Economy & Markets

Dealing With the New Normal: Economic Situation, Market Outlook and Business Performance We barely survived a very difficult downturn but are now facing a sustained period of sub-par growth, poor job creation, major changes in consumer demand and related challenges. Meanwhile Markets are over-valued and anticipating a return to the old normal - raising the risks of poor returns. At the same time businesses are struggling to catchup to the surprises of the downturn, improve performance and re-position themselves. Any stakeholder needs to under the relationships between the economy, markets and business performance and assess which ones are likely to well in this new environment compares to the many who will not. Whether your an investor, employee, executive, customer or business partner you will have to cope with these challenges and should consider adjusting your decisions in line with the situation we see emerging.

Smooth sailing now; icebergs ahead The odds that the U.S. stock market will win its current bet look daunting.Investors who've been pushing up stocks are betting that the U.S. economy will produce a big enough increase in earnings to keep stock prices headed higher and at the same time show enough signs of weakness to prevent the Federal Reserve from raising interest rates in 2010. Seems like trying to get a camel through the eye of a needle? Well, I think the odds are better than you might think -- for the first half of 2010. Then they get progressively worse until, by 2011, the chances that the stock market will get the precise balance it needs are almost nil. (This column is an update of my how to worry/when to worry post at JubakPicks.com.) The key to my relatively optimistic view for the first half of 2010? Timing. As stocks move further from the bottom in earnings at the end of 2008, year-to-year earnings growth slows because the year-earlier quarter was progressively less horrible. That makes spectacular earnings growth pretty easy to come by in the first half of 2010 while making earnings growth in the second half of the year look increasingly ordinary (especially if stocks have kept moving up in price quarter by quarter). So the odds that stocks will deliver the earnings needed to justify higher share prices look pretty good in the first half of 2010 and then decline as the second half progresses.

The coming economic crisis in China I think investors are worried about the wrong kind of crisis in China. Worry seems to focus on the possibility of an asset bubble and the chance that it will burst sometime in the next two to three months. I'm more concerned about a slide into a crisis that will be an extension of the Great Recession. That slide could begin, I estimate, sometime in the next 12 to 18 months. I understand the worry about the possibility of an asset bubble in China. After all, we've just been through two horrible asset bubbles -- and busts -- in the U.S. and global financial markets. And a Chinese bubble is a distinct possibility, one that should certainly figure into your investing strategy. But China's economy and political system are so different from ours in the U.S. and those in the rest of the developed world -- and its relationship to the global financial market so unique -- that I don't think we're headed toward any kind of replay of March 2000 or October 2007. A bigger worry is a long-term slide into a lower-growth or no-growth world in which nations strive to beggar their neighbors and all portfolios slump. As crises go, it's very different but ultimately just as painful for investors as the asset bubbles that draw all our attention now.

Business

The secrets of J.Crew's success This shouldn't come as a shock -- it's a bleak time for retailers. Stores have gone out of business, 70%-off sales are de rigueur and women are shopping in their closets rather than whipping out credits cards to spend on something new. But while most retailers have been suffering through the Great Recession, J.Crew is having its golden era. First lady Michelle Obama wore J.Crew while gabbing on Jay Leno's "Tonight Show" couch in 2008, and the first daughters wore clothes from Crewcuts, the company's children's line, to their father's inauguration. J.Crew's creative director, Jenna Lyons, has taken on fashion icon status, joining the likes of superstar designers Donna Karan and Miuccia Prada. The company's recent success is more than hype. J.Crew Group (JCG, news, msgs) reported 14% revenue growth in the third quarter and had strong holiday sales. The retailer has managed to provide fashion retailers with a glimmer of hope that women will shop, recession be damned. "J.Crew has become an expert in recasting timeless classics into current fashion must-haves," says Eric Beder, a retail analyst at Brean Murray Carret. Reflecting on J.Crew's success, Drexler told investors and analysts during a recent conference call: "It's about product, it's about quality, it's about design, it's about service, it's about creativity." Corporate speak, sure, but Drexler knows that his company's success doesn't depend on celebrity endorsements or the latest wash of jeans. It has to do with consistency. And therein lies the not-so-secret reason for J.Crew's success -- make clothes women want to buy and they will buy them

GE Earnings Drop 19% General Electric Co. posted a 19% slump in fourth-quarter profit as it was again dinged by a big drop in earnings at its finance arm and substantial weakness at its NBC Universal media unit. But the overall results topped Wall Street expectations, and the conglomerate heralded "encouraging signs" at its infrastructure divisions. New orders for big-ticket equipment and services came in at $22.1 billion in the fourth quarter. The figure was off 3% from about $22.8 billion in the year-ago period, but up from $18.4 billion in the third quarter and from $18 billion in the second quarter. Chief Executive Jeff Immelt previously has called the second quarter the potential low point for new orders amid the economic downturn. "GE's environment has improved, and we saw some encouraging signs at year-end," Mr. Immelt said in a prepared statement Friday. He said the Fairfield, Conn., conglomerate is on track to achieve the broad financial forecast it unveiled at its annual outlook meeting last month, which essentially called for flat overall 2010 results followed by "solid growth" in 2011.

Banking Business vs. Reform and Social Responsibilities

The Corporation vs. Society: Performance, Social Responsibility and the Win-Win The focus of the Finance Industry on short-term financial reform and bonuses led us all to the brink of disaster in 2008 and has caused a wave of anger in the citizenry, most business folk and even much of the industry itself. At least those portions that were badly damaged by the mis-behaviors the caused them to almost be driven out of business themselves. While that anger is obviously justified much of the discussion has centered on emotional judgments. Here we would like to consider the case for reform from two more hard-headed, analytical if you like, perspectives. One is from the point of view of Society and the Industry as members of that society. The other from a “business case” perspective. Either alone justifies significant regulatory reform. Taken together we consider the case to be overwhelming. No business or other organization exists solely for the sake of existence. It exists to create a value for society, whether that’s measured in profit terms or not. Overall then a business, as a business, has three strategic goals. First, it must deliver value. In this case profits. But those profits should be based on contribution and not financial engineering. Second, in its own long-term interest, it needs to be a productive workplace where the worker is made effective. People are social animals and the more comfortable they are in their environment then the more they will contribute to the health and performance of the organization. Third, an organization or business must be socially responsible.

Banks As Businesses: Performance, Reform and Blindsidedness Now that the smoldering re-regulation fires are beginning to burst back into flames the Finance Industry seems to be doing just the opposite. Despite repeated attempts on the part of the Administration since the beginning to reach out and work with them constructively they have been lobbying behind the scenes as hard as they can to limit and reduce the various reform legislation packages. Along the way they have repeatedly treated the political establishment, the Administration and the various regulatory agencies and the President with disdain and disrespect. Worse, they have treated the Public with disdain and disrespect by announcing record bonuses, arguing that those bonuses were the result of their own performance instead of government funding and support and reacted in a tone-deaf and disdainful fashion to the widespread distress in the economy that most people are suffering thru. The core of their argument is that what they do is good for the economy and the country and their bonuses are earned and necessary to the efficient and effective functioning of their businesses. Sadly all the evidence is against them on that score.

Pecora 2 Hearings, Malfeasances, Your Future & Cusp Points The Financial Crisis Inquiry Commission (FCIC), or Pecora 2, kicked off its hearings this morning with quick statements from the chair and vice, testimony from the heads of 4 of 5 of the big banks, a second panel from several investment banker/analysts with strong criticisms and an afternoon panel from four banking/economic/housing experts. Frankly the hearings so far are stunning - intelligent, polite, informed, limited axe-grinding by the commissioners (with some exceptions), almost no ideology and a strong bi-partisan spirit of inquiry, digging into the data and understanding.

Renewing the Enterprise 2: Governance, Measurement & Performance The fundamental messages we've been trying to drive home are that the next decade will be one of the most challenging in at least four, if not since the Great Depression, that the new realities have not sunk into investors, management and stakeholder consciousness and the single biggest challenge will be to improve enterprise performance. Performance improvement will either be led by the enterprises or imposed from the outside, less effectively, by a high level of distrust and justified anger at near-disasters brought on by malfeasance. And this is not just restricted to the Finance Industry. It is in enterprises own best interests to improve their governance, management systems and performance to make sure it's done well, adapted to their needs and, most importantly, they actually improve their performance

Banks, Finance Industry and Reform

Prudence Pays Off for Jefferies—and Its Workers While employees at the likes of Goldman Sachs Group Inc. and J.P. Morgan Chase & Co. quiver at pronouncements from Washington, the bankers and traders of Jefferies Group Inc. are happily avoiding the fray.Complicated stock clawbacks? Not at Jefferies. The New York securities firm has no plans to take back shares from rank-and-file employees. Chief Executive Richard Handler also isn't giving up a potential $12 million bonus this year. His target compensation for 2010 is $26 million depending on whether he can achieve certain performance goals and whether the board signs off on it. Jefferies, which specializes in trading debt and stocks, didn't take government rescue funds. Nor does it handle consumer bank deposits. During the crisis, it kept a clean balance sheet and relatively low leverage. Its size—revenue about one-tenth that of Morgan Stanley—has also helped it fly below the radar. Jefferies has a reputation as a scrapper, willing to take on difficult clients such as financier Carl Icahn. The firm is sensitive about its reputation, asking via email that certain terms not be used to describe it, such as "small" and "boutique." Mr. Handler declined to be photographed for this article. But now its perch outside the Wall Street pecking order is something of an advantage in the market for financial-industry talent. The question for the 47-year-old firm is whether that is just short term, or can be used to build something more lasting. "We can pay our people what they deserve to be paid," Mr. Handler said in an interview from his sparse New York office overlooking Jefferies's trading floor. "We are only beholden to our shareholders." Such a notion sounds almost quaint these days on Wall Street, where large firms have been trying to douse a political firestorm over bonuses

Obama hits Wall Street, pushes for bank limits Embracing Depression-era policy and populist politics, a combative President Barack Obama chastised big Wall Street banks Thursday and urgently called for limits on their size and investments to stave off a new economic meltdown. Investors responded by dumping bank stock. Obama's rhetoric covered the whole financial industry, but the key changes will affect only a few high-profile players, including JPMorgan Chase & Co., while sparing investment banks like Goldman Sachs Group Inc. The move could undercut Treasury Secretary Timothy Geithner's strategy of maintaining close ties with the financial industry as part of the administration's overhaul efforts. Obama's announcement included changes that have been advocated for over a year by former Federal Reserve Chairman Paul Volcker -- who appeared with the president at the White House -- particularly by endorsing Volcker's proposal to ban banks that take deposits from also trading stocks for their own profit. The change would separate commercial banks from investment banks, a line that was blurred a decade ago by the repeal of the Depression-era Glass-Steagall Act.

Proposal to Rein In Banks Sinks Stocks President Barack Obama proposed new limits on the size and activities of the nation's largest banks, pushing a more muscular approach toward regulation that yanked down bank stocks and raised the stakes in his campaign to show he's tough on Wall Street. With former Federal Reserve Chairman Paul Volcker at his side, Mr. Obama said he wanted to toughen existing limits on the size of financial firms and force them to choose between the protection of the government's safety net and the often-lucrative business of trading for their own accounts or owning hedge funds or private-equity funds. Mr. Volcker has been an outspoken advocate of such rules; until recently Mr. Obama's top economic advisers, including Treasury Secretary Timothy Geithner and Lawrence Summers, were less than enthusiastic. Big banks and their trade groups attacked the Obama proposals as unnecessary and unwise. "If people are focused on things that caused or were real contributors to the financial crisis, it wasn't trading," said David Viniar, chief financial officer at Goldman Sachs. Over the past several years, banks have bulked up their profits in areas far beyond taking deposits, making loans and trading stocks and bonds on behalf of customers. Some have bought or sponsored hedge funds. Others have moved to invest their own money in the markets. After the collapse of Lehman Brothers and the rescue of American International Group in the fall of 2008, investment banks Goldman Sachs and Morgan Stanley formally became banks—giving them access to Fed loans and federal guarantees of their borrowing in financial markets. When the crisis ebbed, Goldman and some other banks were able to borrow at low rates and turn profits trading for their own accounts. This gave Mr. Volcker and his allies, who include Vice President Joe Biden, new fuel for their argument that government-backed banks should be prevented from taking big trading risks.

Policy Pivot Followed Months of Wrangling For nearly a year, President Barack Obama's economic team resisted measures to restrict the size and activities of the biggest U.S. banks. Two days after Democrats suffered a devastating election loss in Massachusetts, the White House rolled out a proposal to do just that. The policy's evolution took months, according to congressional and administration officials. Prompted by the cajoling of former Federal Reserve Chairman Paul Volcker and other respected voices, dissenters in the administration—notably Treasury Secretary Timothy Geithner and White House economics chief Lawrence Summers—gradually dropped their opposition. On Jan. 13, Messrs. Geithner and Summers locked down the final regulatory proposals into a memo to the president that they said was unanimous.

They Brought it Upon Themselves U.S. investors spent a second consecutive day reacquainting themselves with the term “risk”. Since the past few months have mostly been tranquil, this renewed volatility might require an adjustment period, with most of the adjusting taking the form of lower securities prices. And while yesterday’s big concern was a potential cooling of the Chinese economy, today’s culprit was political heat on our nation’s largest financial institutions. President Obama proposed sweeping new regulations for the banking sector, including caps on deposit size, and bans on activities like proprietary trading and owning alternative asset managers. Financial shares slumped in response to this latest salvo directed at Wall Street, the timing and ferocity of which may not entirely be coincidental to Tuesday’s election results in Massachusetts. Predictably, there was considerable gnashing of teeth in the executive suites up and down Wall Street, but I believe top management brought these latest proposals upon themselves. Executives at our nation’s largest financial firms reacted with shock and dismay this afternoon, but they brought these policy proposals on themselves. They’ve successfully gamed the legislative and regulatory systems so well and for so long that they literally cannot understand why so many people are angry enough to side with the President on this issue. Maybe their memories are a little foggy, so let me try to list just some of the change Wall Street firms themselves were able to effect during the past 15 years. It’s a Top 10 checklist of memorable achievements only a bank executive could love:

Posted by dblwyo at 10:15 AM | | Comments (0)

January 18, 2010

Renewing the Enterprise 2: Governance, Measurement & Performance

The fundamental messages we've been trying to drive home are that the next decade will be one of the most challenging in at least four, if not since the Great Depression, that the new realities have not sunk into investors, management and stakeholder consciousness and the single biggest challenge will be to improve enterprise performance. Performance improvement will either be led by the enterprises or imposed from the outside, less effectively, by a high level of distrust and justified anger at near-disasters brought on by malfeasance. And this is not just restricted to the Finance Industry. It is in enterprises own best interests to improve their governance, management systems and performance to make sure it's done well, adapted to their needs and, most importantly, they actually improve their performance.

Backing up those assertions you'll find an extensive readings collection on each of the major issues involved after the break; here we want to review the evidence and explore the core concepts of performance improvement and management systems. But start with the BNN clip of Don Coxe both laying out the situation and the level of reality denial currently prevalent in the markets. A reality, judging by the week's reactions to earnings in the markets, that might just be sinking in the general consciousness.

The Value Equation: Balancing Short vs. Long-term

If you look at the general cases, the industries or the specific companies there is one redcurrant symptom of failure. The sacrifice of long-term value creation for the appearance of short-term performance.

That difference, often thought to be mere words and arm-waving, actually makes a substantive difference in enterprise performance and in long-term stock values. In other words it makes a difference to every stakeholder.

And it actually turns out to be measurable using market data - though only after performance has resulted in changes in market valuation. The graphic lays it out nicely, both in general terms and using the specific example of MickeyD's. In their case the fundamental strategy was add more stores without changing the old value proposition and just grow, grow, grow. Well that kept up reported operating profits and earnings but the saturation led to a deterioration in total enterprise value because long-term value tanked.

Then they slowed growth, reinvented the menu and the stores and created both a new core proposition and translated that into execution. The result was a surge in future enterprise value driving a surge in total value. The trick is to spot the change in the value equation early but clearly you can also spot it while it's well underway and hop on the gravy train as it plays out.

To spot it early and to know whether or not it is sustainable you have to analyze the business as a business - think like an owner. Is the value creation sustainable, what is the strategy, can it be executed and, most importantly, are they walking the talk? That is, is what they say they intend to do what's built into plans, capabilities and compensation? If so value will be created.

Compensation vs. Performance Breakdowns

It's not just the Finance Industry but all enterprises that have lost trust thru, at best, non-performance or, at worst, malfesant behaviors.

The argument for exhorbitant executive compensation has been that it results in outperformance. As the result of the Financial crisis there have been several major studies of that proposition and the "startling" result confirms what common wisdom would suspect. Not only has it NOT resulted in out-performance but just the opposite. In fact the performance deficit is large and signficant.

This ought to cause major pressures from stockholders and stakeholders for performance-based compensation tied to long-term value creation. But, with all the sturm und drang in Washington the fundamental regulatory change has already happened. The SEC has put forth new regulations requiring executive compensation to be tied to long-term objectives. The saddest thing about this is that a regulatory agency is having to put controls in place that should have been common business practice and taken for granted. That it felt it had to act, on the basis of good evidence that it is not, is a major indictment of corporate governance. When the Auto Task Force went into Detroit what it found was not the bad situations it anticipated but abysmal conditions; Wagner should have been removed, years ago. When the government is forced by your private and social failures to re-engineer executives and the Board have let everyone down, including themselves.

Governance Breakdowns: As-Is vs. Should-Be

The question becomes what's broken and what should be done to fix it. Let's start with the way things are and go to the way things should be, and must be to cope with the New Normal, not to mention the SEC!

At best what you here from most companies is some rather vague strategic assessments of the state of the enterprise (and if you listen to conference calls, all the questions that get asked). For that strategy to be deliverable it must translate into operational capabilities that support each other and are aligned with the overall enterprise goals. What you get is a set of functional fiefdoms that grew up by accident and are defended politically on internal agendii, with the result that the realities of strategic implementation are dictated by inadvertent operational strategies. Thereby making what you hear all fantasy. And it's easy to judge - when Bartiromo interviewed Sue Decker at Davos a while back the answers were beyond vague. Immediately telling you that Yahoo hadn't a clue. The contrast with Bartz is astounding. Which is one early and easy tell!

What you want and need is a clear, simple, straight-forward and crisp definition of current strategy and objectives and evidence that it is operationally deliverable. WMT would be our example of best practices while Citi is a perfect example of an organization that, finally, articulated a clear strategy but doesn't have the management system or operational capabilities to make it happen. BAC and Dell may be suffering similar breakdowns in performance management. Ideally what you'd hear, less granularly and with more give in the boundaries, would be a clear articulation of future value and strategy as well as deep changes in operational capability. Again these are things you can dig into into in the analyst presentations.

Re-thinking Performance Management

 A favorite story is the Citi branch manager who confessed that the 30 corporate memos from HQ he saw a month went into the round file cabinet and he focused on montly branch performance. That's sad but telling because it tells you how broke the management system is, that any notion of long-term value was non-existent and that incentives were on the appearance of short-term performance. People will do what you incent them to do, period, though that takes more than money.

What you need is set of operational measurements and metrics that link the performance of the individual functions and organizations to the broader corporate goals. Fedex has been doing this for years and the heart of WMT's re-engineering was setting performance goals for return and operational performance at the store and department level.

Performance results from Efficiency (using what you've got given a level of economic activity), Utilization (using what you've got effectively as demand rises and falls in the cycle) and Capacity (increasing capabilities in line with the strategy). But what business units do is activities - they don't return profits per se. In other words the necessary, and now mandated, revolution in management systems requires decisions about the principal activities for each unit, the appropriate metrics, and what should they be in three time frames (matched against the Efficiency, Utilization and Capacity adjustments). For a Fedex station manager it might be packages per stop, for a WMT store manager it might be sales and profits per square foot, preferably by department.

Most importantly compensation of all sorts, including who gets promoted, should be based on these sorts of adjustmenable activity indicators. And you'll be able to tell that it's happening when you hear the executives talk about it (see UTX's analyst reports for example) and it starts showing up in results.

Speaking of Results: the New Normal Tsunami

To return to our point about the coming challenging decade take a look at this chart (PBS just put out an interactive graphic looking at job creation from BLS stats for the decade, anticipating 10% job growth over the decade. Less than breakeven - this is going to be a VERY tough decade indeed). This chart give us a start on the long-term market performance of four exemplary firms, all of whom are on our list of very well-run organizations.

Recently they've had major runups following the market but, on the whole, nobody has returned to '04 peaks. You can see the Enterprise Value pressures at work on WMT in the middle of the decade as their business model aged and withered, and the impacts of their re-invention, then and now. But INTC and BAC are indeed challenged (meant to include CSCO but...fat fingers).

If we're right about the decade profits and earnings will be challenged (not to mention the artificiality and poor quality of finance profits) and we're looking at a sideways market where PE's will compress. The bottomline of bottomlines here is that long-term performance, and therefore management systems, performance, governance and compensation practices, are really going to matter. More than ever! And it will be incumbent to find the enterprises walking the talk now and for the future.

The Adaptive Organization: Petraeus on Marines

One organization with astounding espirt de corp that manages to do more with less again and again, maintain discipline but always be resilient under extreme stress while also, simultaneously, adaptive to long-term requirements is the USMC. And nobody summarized it better than Gen. David Petraeus (in a Marine birthday speech where he took a lot of heat for his USAF jokes while everybody missed or ignored the substance).

If you find this overall topic of organizational performance interesting we strongly suggest that you listen to the address, though it admittedly runs about 30 min. or so. But in that time there's a lot of ground covered, besides the inside jokes of course.

Petraeus' fundamental theme is that what distinguishes Marines is their adherence to bedrock principles in the face of all opposition combined with a constant willingness to innovate and adapt. Examples in history include the invention of amphibious warfare and Counter-Insurgency but more recently the application of COIN to supporting the Anwar Awakening in Iraq.

We'd add that within the context of strategy, doctrine and operations every Marine corporal is empowered to make local decisions. Applied to business the lessons are that value is created on the frontline, not in the Boardroom. And what happens on the frontline needs to be decided based on the overall good of the enterprise, not on merely local conditions, narrow incentives or short-term gains. To get from where we're at to where we need to be will challenging but necessary and the heart of it lies in governance and performance.

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READINGS

 This is a rather large collection of readings that tries to set the stage for the challenges of the next decade, translate those into value-creation opportunities and challenges for business and look at the major governance and performance management issues. Including using GM as a perfect exemplar of a failure of management, measurement, leadership and governance. Each of those issues gets its own special section as well, including extensive discussions on executive compensation. The bottom line conclusion is that Boards, Executives and Companies are facing very challenging times, the lowest trust level in decades and major challenges to their management systems. They will either implement new approaches or have them implemented for them.

Facing the New Realities

Why Many Investors Keep Fooling Themselves What are we smoking, and when will we stop? A nationwide survey last year found that investors expect the U.S. stock market to return an annual average of 13.7% over the next 10 years. Robert Veres, editor of the Inside Information financial-planning newsletter, recently asked his subscribers to estimate long-term future stock returns after inflation, expenses and taxes, what I call a "net-net-net" return. Several dozen leading financial advisers responded. Although some didn't subtract taxes, the average answer was 6%. A few went as high as 9%. We all should be so lucky. Historically, inflation has eaten away three percentage points of return a year. Investment expenses and taxes each have cut returns by roughly one to two percentage points a year. All told, those costs reduce annual returns by five to seven points. So, in order to earn 6% for clients after inflation, fees and taxes, these financial planners will somehow have to pick investments that generate 11% or 13% a year before costs. Where will they find such huge gains? Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%. All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.

Markets Not Facing 'Reality' Of Slow Economy: El-Erian Financial markets have failed to price in the remaining problems that bedevil a long-term economic recovery, Pimco's Mohamed El-Erian told CNBC. Inconsistencies that the market faces include the tax on bailed out banks that President Obama announced Thursday and its effects on their ability to lend; long-term unemployment issues and the difficulty in fixing them due to the federal budget deficit, and weaknesses with sovereign balance sheets, Pimco co-CEO El-Erian said in an interview. Despite these issues, stocks continue to climb, with the market about 60 percent above the March 2009 lows and posting mild gains so far in 2010. "You come to the conclusion that the market simply hasn't priced in the reality of what we talk about every single day," said El-Erian, who helps run the world's largest bond fund. El-Erian said the "serious, sequential contamination" of world balance sheets will be a larger issue in 2010 and require corrective measures. Yet he also said US gross domestic product gains are likely to be in the 4 to 5 percent range and will present the illusion that the economy is recovering more strongly than fundamentals would indicate. "What you're getting is a recovery phase, a healing phase that was artificially created," he said. "The history of crises is very clear. They expose structural problems and when you look at the structural problems you need a structural response, and so far we've only had a cyclical response." El-Erian's comments echoed those he made July 29, 2009 on CNBC in which he said the market was on a "sugar high" that was not reflective of economic slowness. Stocks have gained about 15 percent since those comments.A lasting recovery will only be built on real growth and not that which is stimulated by government, he said. "We want it to happen," he said. "But navigating our clients' assets through this very fluid market is not about what we want to happen but what is likely to happen."

  • Don Coxe  BNN's Pat Bolland and Jacquie McNish are joined by Don Coxe, chairman, Coxe Advisors LLC.

When the Fed Stops the Music The Federal Reserve has been very clear about the fact that they intend to stop the quantitative easing program at the end of March. What that means in practice is that they are going to stop buying mortgage securities. That does two things. As Bill Gross so aptly points out, those mortgage purchases helped keep mortgage rates low. But they also financed the US government fiscal deficit, albeit indirectly. It seems that funds and banks that sold the mortgage securities turned around and bought US government debt or put the cash right back at the Fed. But the currency I want the most if I am a central banker is that barbaric yellow relic, gold. Just as India has recently bought 200 tons of gold, I think central banks in other emerging nations will want to buy more, too. They all have relatively little gold as a percentage of their reserves. Look for that to change. I also like gold in terms of the euro, the pound, and the yen - more than I like it in terms of the US dollar, but even there I like gold long-term, at least until we get some fiscal sanity. The reason this recession is different is that it is a deleveraging recession. We borrowed too much (all over the developed world) and now are having to repair our balance sheets as the assets we bought have fallen in value (housing, bonds, securities, etc.). A new and very interesting (if somewhat long) study by the McKinsey Global Institute found that periods of overleveraging are often followed by 6-7 years of slow growth as the deleveraging process plays out. No quick fixes.

Mark Mobius on emerging market valuations “Nevertheless, on a relative basis, emerging market economies seem to have done much better than those in the developed world. I believe the kind of premium that the market is currently placing on these emerging market valuations is justified, to some extent. Unless there is certain monetary tightening in these emerging market economies, I think current valuation levels are sustainable.

Deleveraging out of the debt mire will be an unsavoury task Moreover, alongside the (limited) rise in broker borrowing in the past decade, there was also a far more startling increase in "real economy" debt, particularly in the household and real estate sector. Since the crisis started, this "real economy" debt has declined a tiny bit, while financial sector leverage has fallen considerably. But since public debt has spiralled, gross leverage levels for most large nations have not fallen. And that, in turn, has a crucial implication: namely that, insofar as deleveraging is inevitable, much of it is still to come. From a historical perspective, this challenge is not entirely unprecedented. The UK and US have, after all, slashed vast debt burdens before during the last two centuries, and McKinsey has identified four dozen smaller deleveraging episodes around the world since 1950. But while governments have sometimes softened this task before by creating rapid growth, often due to exports (via devaluation), or a peace dividend (after a war), those routes do not offer an easy escape this time. Growth, in other words, could be tough to achieve. So that leaves three unpalatable options, McKinsey suggests: outright default, inflation or belt-tightening. McKinsey's best guess - or hope - is that belt-tightening will predominate, and it consequently forecasts a grim climate of austerity for the next decade. It may be right. But to my mind, at least, it remains a very open bet whether western voters will accept austerity without a backlash; personally, I would thus put a higher emphasis on the other options too. Either way, the real moral is that the task now facing the western governments is monumental.

The lesson from two lemonade stands The first stand is run by two kids. They use Countrytime lemonade, paper cups and a bridge table. It's a decent lemonade stand, one in the long tradition of standard lemonade stands. It costs a dollar to buy a cup, which is a pretty good price, considering you get both the lemonade and the satisfaction of knowing you supported two kids. The other stand is different. The lemonade is free, but there's a big tip jar. When you pull up, the owner of the stand beams as only a proud eleven year old girl can beam. She takes her time and reaches into a pail filled with ice and lemons. She pulls out a lemon. Slices it. Then she squeezes it with a clever little hand juicer. The whole time that's she's squeezing, she's also talking to you, sharing her insights (and yes, her joy) about the power of lemonade to change your day. It's a beautiful day and she's in no real hurry. Lemonade doesn't hurry, she says. It gets made the right way or not at all. Then she urges you to take a bit less sugar, because it tastes better that way. While you're talking, a dozen people who might have become customers drive on by because it appears to take too long. You don't mind, though, because you're engaged, almost entranced. A few people pull over and wait in line behind you. Finally, once she's done, you put $5 in the jar, because your free lemonade was worth at least twice that. Well, maybe the lemonade itself was worth $3, but you'd happily pay again for the transaction. It touched you. In fact, it changed you. Which entrepreneur do you think has a brighter future?

  • Why you, why now? The goal is to create an offering that can answer these two questions. Why from you and why right now...Most businesses that struggle are unable to answer these two questions in a compelling fashion. They act as though they deserve that sale, or that they need to aggressively close so you'll buy today, instead of working to build in these very elements to the product itself.
  • What the industry wants If the industry can't make money selling what you're selling, why will they help you? You can view these things as ridiculous peccadilloes. Or you can see them as parts of the system as permanent and as important as the gatekeepers who rely on them. On the other hand, fall in love with the system and you might forget the end user. And we know how poorly that works.
  • Maneuverability We often talk about speed when describing certain kinds of businesses. Some companies are bureaucratic, slow, dysfunctional... others are fast... fast to market, fast to ship you something. Just like a car, though, there's an alternative to raw speed. Call it maneuverability.

New World of Business

In the aftermath of the Great Recession One insistent question at the start of a new decade involves the lingering effects of the old: What scars will the Great Recession leave? So the Great Recession's nastiest scar could be an era of economic frustration, characterized by slower growth and contentious competition for scarce resources. Stunned by huge wealth losses in stocks and real estate, Americans save more and spend less. Businesses suffer from weak demand. Hiring remains sluggish. Worse, the slowdown coincides with an aging population, which could compound the effect. The answer may hinge on two things: trade and entrepreneurship. Most economists see stronger exports as a substitute for weaker consumer spending. Unfortunately, that depends heavily on economic growth and trade policies abroad. By contrast, entrepreneurship is a sleeper issue that depends on what Americans do. If you doubt its importance, consider this: All net job creation from 1980 to 2005 came from firms that were five years old or less, according to a study by economists John Haltiwanger of the University of Maryland and Ron Jarmin and Javier Miranda of the Census Bureau. In any one year, that may not be true; but over time, mature firms lose more jobs than they create. "It's not small firms but young firms that count," says economist Robert Litan of the Kauffman Foundation, which sponsored the study. If Americans don't continue to create firms -- not just high-tech start-ups such as Facebook but construction companies, florists, restaurants, dry cleaners, engineering firms -- the economy may languish. Beginning a business is a risky, exhausting, chaotic process. Every year, there are roughly 500,000 to 600,000 company "births" and almost as many "deaths." Half of new firms don't make it to year five, says Litan.

Layoffs: Profits Now, Questions Later The millions of layoffs in the past year have been bad news for almost everyone—except, that is, for investors. Companies turned smaller payrolls and other expense cuts into better-than-expected profits, fueling a 31% advance in the Standard & Poor's 500-stock index in the past year. "It's been a cost-cutting rally," says Terry Morris, senior equity manager at National Penn Investors Trust Co. There are now more questions on Wall Street about the long-term impact of all this job-shedding. But, for a year, aggressive job cuts have improved investor perceptions of many stocks.

CEOs see light after a dismal 2009  It was a year many chief executives would like to forget. Sales plummeted, consumers disappeared and profits evaporated. But some corporate chiefs found a silver lining—or at least a new impetus to try things differently. Below, CEOs tell how they managed during the worst downturn in memory—and talk about signs of hope for 2010. One thing Jim Owens learned managing through a "horrific" 2009 is that the Boy Scouts are right. "Being prepared" was crucial to weathering the storm, said the Caterpillar Inc. CEO, echoing the scouts' motto. In 2005, Mr. Owens ordered each of his construction- and mining-equipment company's 28 business units to devise a detailed plan for what they would do if their individual markets hit a 25-year low. Mr. Owens, a 63-year-old Ph.D economist, knew the good times had to end eventually. And indeed, sales for 2009 are expected to fall almost 40% to between $32 billion and $33 billion. During the boom, Caterpillar expanded aggressively by hiring workers and enlarging factories—but it also built in greater flexibility by relying more on temporary and contract workers. As business slid, the Peoria, Ill., company slashed 37,000 workers—but only about half those were full-timers. In 2009, the machinery that powered Condé Nast's fabled magazine empire broke down, forcing Chief Executive Chuck Townsend to rethink some of the principles that had long helped distinguish the publisher of Vogue, GQ, Vanity Fair and other upscale titles. In the spring, Mr. Townsend directed his marketing executives to start listening more to advertisers and—within reason—give a little ground on rates. For decades, Condé Nast, a unit of closely held Advance Publications Inc., had thrived by pumping huge sums of money into creating the shiniest magazines on the rack and an aura of prosperity that justified the high ad rates paying for it all. But by about April it had become clear to Mr. Townsend that this recession was different from any he had seen. The conspicuous consumers who had fueled his core advertisers had gone into hibernation. Next year holds a huge market-share opportunity for publishers who didn't cheapen their products and opted for flexibility and collaboration with advertisers, Mr. Townsend said.The biggest risk, Mr. Townsend said, is a fragile recovery that fails to instill confidence in consumers. "If that occurs," he said, "we're going to be swept back in."

As the economy tentatively recovers, chief executives are trying to ramp up growth, but not hiring. The economy grew 2.2% in the third quarter and layoffs have slowed, but companies continue to shed jobs. And employers are hiring at their slowest pace since the Bureau of Labor Statistics began tracking in 2000. Managers can't rely on the traditional carrots of raises or promotions. Employers plan meager 2.8% raises in 2010, after 2% bumps in 2009, according to consulting firm Towers Watson. And the static job market, which includes Baby Boomers who have delayed retirement as well as younger employers unable to find better opportunities elsewhere, hasn't created many openings for managers to award promotions. At companies from Rockwell Collins to Ford Motor Co. and Sanofi-Aventis SA, managers are reaching deep into their toolbox to coax more productivity from salaried, nonovertime staffers. They're unleashing a bevy of cheap rewards, such as praise, thank-you notes and $25 gift cards. They're also scrutinizing employees' duties to nix unnecessary tasks, freeing staffers for higher-impact work.

Special Report: America’s route to recovery Youngstown is an extreme but by no means unique case in America. On a basic level, it represents some of the challenges facing the country today in the wake of the longest and deepest downturn since the 1930s. After two economic expansions based not on sustainable growth but on asset bubbles -- the dotcom boom of the 1990s then the far more damaging housing mania this decade -- longstanding problems have been brought into sharper focus. Even during the recent good times, the U.S. manufacturing sector, the muscle behind U.S. post-war economic might, was buffeted as corporations shipped low-cost production overseas. "The easy, blue-collar shot to the middle class is gone," said Mike Rollins, president of the Austin Chamber of Commerce. "It's going to take a lot more work to get there now." In short, the world's largest economy is at a crossroads. With a smaller manufacturing sector and a consumer base less able to keep leveraging future earnings, where will sustainable, long-term prosperity come from? And more immediately, where will jobs come from? This is a debate that is taking place at the local level around the country, from Youngstown to El Centro, California, and many places in between. But it is also a discussion that few see taking place at the national political level. "Washington just doesn't get it," said Shane Savage, a real estate agent in Pensacola, Florida, smoking a cigarette outside the home of a client who needs to sell fast in a down market. "It's going to take a long time to fix the mess that we're in and our politicians don't have a clue how bad it really is out here."

The Best Is Yet to Come The big idea behind "Sonic Boom" is that globalization—celebrated, reviled and analyzed for at least a decade now—has hardly begun. The world, Mr. Easterbrook believes, is on the verge of a period of pell-mell integration that will dwarf anything before now, and a good thing too: The coming age of global integration, he argues, will produce riches that none of us can imagine and scatter them more widely than ever before. But Mr. Easterbrook is not offering just another account of the shift in economic opportunity from the West to the East. Instead, he wants to show how a rapid reconfiguration of resources is benefiting all sorts of unexpected people and places. Erie may not be booming, but it is doing better than it has for decades, thanks to General Electric's willingness to ignore Wall Street analysts (who said that manufacturing was dead and the future lay in finance) and make a bet on renovating its locomotive plant. Today the plant is an important profit center, and trains are the apple of everybody's eye, including Warren Buffett's, while GE's financial-services division was the source of almost all the company's recent losses. But he is at his most interesting on a subject that he seems slightly reluctant to embrace—the creativity of the manufacturing sector. Manufacturing companies have done a much better job of improving their productivity than sexier service companies. The average car bought today costs 6% less than the average car bought a decade ago and is stuffed full of clever gadgets. America produces more steel today than it did 30 years ago, despite the shuttered plants and slimmed-down work force. Manufacturers have also been much better at responding to the pressures of globalization. Haier, a Chinese domestic-appliance maker that had such a bad record for quality a generation ago that the Chinese used its washing machines to store coal, is now a world-class company with its American headquarters in Camden, S.C. General Electric sells 40% of the locomotives that it makes in Erie to China.

Cheapest reliable alternative For most products and services, most of the time, people sign up for the Cheapest Reliable Alternative Plan. If everything appears to be the same, then of course they're going to pick the cheapest one that's good enough. In the face of this understandable strategy, you have a few choices: You can be cheapest (difficult to sustain). You can be more reliable (great if you can figure this out). You can redefine the playing the field to be the only one (most preferred). Buying a new microphone or lights for your DJ business doesn't do any of these three to your competitive status, it merely makes you feel good. Same with re-organizing your office, painting the parking spaces or buying a new laptop. They merely keep you where you were. The scalable, profitable strategy is to change the game, not to become the most average.

Governance Failures: GM as Exemplar

 

After Bankruptcy, G.M. Struggles to Shed a Legendary Bureaucracy When G.M. collapsed last year and turned to the government for an emergency bailout, its century-old way of conducting business was laid bare, with all its flaws in plain sight. Decisions were made, if at all, at a glacial pace, bogged down by endless committees, reports and reviews that astonished members of President Obama’s auto task force. “Everyone knew Detroit’s reputation for insular, slow-moving cultures,” Steven Rattner, head of the task force, wrote recently in Fortune magazine. “Even by that low standard, I was shocked by the stunningly poor management that we found.” G.M. will present its first postbankruptcy scorecard on Monday, when the company reports third-quarter earnings and its cash reserves. The company said on Nov. 3 that its financial health had “improved significantly” in recent months. Even as it labors to change its culture, G.M. must convince consumers that it is building better cars. One sign of its challenge: Fewer than a dozen of the company’s models were recommended in a recent Consumer Reports survey. But instead of playing down the survey, as G.M. might have in the past, its chief executive, Fritz Henderson, ordered it sent to every employee in the company.

Auto task force shocked by state of GM, Chrysler The shockingly poor financial management of General Motors and Chrysler weakened their case for a government bailout, but officials feared letting the automakers collapse would severely harm the U.S. economy, the former head of the Obama administration's auto task force says. In a first-person account posted on Fortune's Web site Wednesday, Steven Rattner said he was alarmed by the "stunningly poor management" at the Detroit companies and said GM had "perhaps the weakest finance operation any of us had ever seen in a major company." GM's board of directors was "utterly docile in the face of mounting evidence of a looming disaster" and former GM chairman and chief executive Rick Wagoner set a tone of "friendly arrogance" that permeated the company, Rattner wrote. "Certainly Rick and his team seemed to believe that virtually all of their problems could be laid at the feet of some combination of the financial crisis, oil prices, the yen-dollar exchange rate and the UAW," Rattner wrote. Rattner said the task force was divided on whether to save Chrysler. Chrysler was poorly run during its alignment with Daimler AG, and "larded up with debt, hollowed out by years of mismanagement, Chrysler under (private equity firm) Cerberus never had a chance."

A Lament for Saab, Quirky but Loved The ignition was in the floor. It had a rear hatchback, not a trunk. The hood was hinged at the front, so it opened away from the windshield. And many of its owners — including Jerry Seinfeld’s character on his long-running sitcom — were intensely loyal. Auto enthusiasts across the country were dismayed by the news Friday that General Motors was planning to shut down Saab, the Swedish carmaker it bought two decades ago, after a deal to sell it fell apart. Even with its modest and steadily declining sales, Saab long stood out as a powerful brand in spite of itself. “It wasn’t designed to be a fashion statement,” said Ron Pinelli, president of Autodata, which tracks industry statistics. “It was designed to provide transportation under miserable weather conditions.” But in the process, Saab became a statement of its own. The American competition had floaty rides and Japanese cars were tight on space. By contrast, a Saab had taut steering, requiring drivers to actively guide the car as it powered through ice and snow. Priced several thousand dollars above Japanese rivals, Saabs featured front-wheel drive and turbo-charged engines, and many were sold with manual transmissions. Saab sales were always strongest in the Northeast, home for a time to the company’s American headquarters in Connecticut. Many Saab owners consider the brand’s glory days to be the 1980s, when Americans began buying cars again after a recession and energy crisis. Mr. Pinelli, who was selling Volvos at the time, said he admired his Swedish rival. “The cars were communicative,” he said. “They didn’t try to numb the experience like cars do today.”

What GM Can Learn From Toyota's Humility Andy Grove, one of the founders of Intel, is famous for saying that "only the paranoid survive." The long-term success of his company suggests he's right. These days, Toyota is looking like one of the most paranoid companies on the planet. It's the world's biggest carmaker but certainly isn't coasting. The global recession has hammered sales and profitability, with Toyota losing $8.4 billion in the fiscal year that ended in March. Sales are likely to be down 18 percent more this year, with a turnaround next year looking modest at best. That weak performance isn't surprising to anybody who has followed the woes of the U.S. auto industry. But here's something that is surprising: Toyota's CEO, Akio Toyoda, said at a recent news conference that his company is "grasping for salvation" and is deep in the grip of long-term decline. "Toyota has become too big and distant from its customers," Toyoda said grimly. Then he apologized for losing money and letting down the motoring public. American car buyers have believed for a while that their homegrown automakers—especially the recently bankrupt Chrysler and General Motors—got too big and lost touch with their customers. But Toyota? Its products consistently rank near the top in quality and reliability. Sales in the United States are down about 29 percent so far this year, but that's roughly the same as the industry average; GM and Chrysler are down more, and BMW nearly as much. But Toyota is far more contrite than its rivals. Public apologies are traditional in Japan when a business loses its way, and for Toyota, losing billions in the Detroit tradition is a dramatic comedown. Besides, Toyota is very likely to get its act together, return to profitability, and continue its ascent. Projections by forecasting firm CSM Worldwide show Toyota gaining U.S. market share over the next several years and battling neck and neck with Ford and GM to be the top seller of cars. That would make Toyota the only foreign-based automaker ever to come close to the No. 1 spot in the world's biggest auto market. Apologizing for missteps helps explain Toyota's success—and Detroit's decline.

Short-termism vs. Performance

Wall Street's Mania for Short-Term Results Hurts Economy It's been a year since the onset of a financial crisis that wiped out $15 trillion of wealth from the balance sheet of American households, and more than two years since serious cracks in the financial system became apparent. Yet while the system has been stabilized and the worst of the crisis has passed, little has been done to keep another meltdown from happening. All of which makes it particularly disappointing that so little attention was paid this week to a report by a panel convened by the Aspen Institute on the "short-termism" that has now become hard-wired into the culture of Wall Street and corporate America. Their complaint is that the focus on short-term financial performance by investors, money managers and corporate executives has systematically robbed the economy of the patient capital it needs to produce sustained and vigorous economic growth.

SEC backs broader disclosure on executive pay Federal regulators voted Wednesday to require companies to reveal more information about how they pay their executives amid a public outcry over compensation. The Securities and Exchange Commission voted 4-to-1 to expand the disclosure requirements for public companies. Company policies that encouraged excessive risk-taking and rewarded executives for delivering short-term profits were blamed for fueling the financial crisis.

Put a name on it Here's a positive step to avoid the faceless bureaucracy that wants to take over your organization: Every new rule needs to be associated with one and only one person who is willing to stand up for it and explain it (to your people and to the public). "No swimming until 45 minutes after eating." Really? Why? Who made this rule up? Why? I think most international travelers would like to know who made the rule that bans wifi from international flights. Or the name of the other person who made the rule that you can't have a blanket covering your legs during the last hour of a flight. If we knew the bureaucrat's name, could we lobby to have them fired for being ridiculous actors in security theater? Organizations thrive on their ability to allow individuals to remain faceless. It permits them to act badly, not in the interest of their customers. One of the reasons I so enjoy buying from small companies is that you know exactly who has their name on each and every policy. It builds a more responsive organization and it's good marketing.

 

Leadership, Psychology and Social Performance

The Neuroscience of Leadership Success isn’t possible without changing the day-to-day behavior of people throughout the company. But changing behavior is hard, even for individuals, and even when new habits can mean the difference between life and death. In many studies of patients who have undergone coronary bypass surgery, only one in nine people, on average, adopts healthier day-to-day habits. During the last two decades, scientists have gained a new, far more accurate view of human nature and behavior change because of the integration of psychology (the study of the human mind and human behavior) and neuroscience (the study of the anatomy and physiology of the brain). The implications of this new research are particularly relevant for organizational leaders. It is now clear that human behavior in the workplace doesn’t work the way many executives think it does. That in turn helps explain why many leadership efforts and organizational change initiatives fall flat. And it also helps explain the success of companies like Toyota and Springfield Remanufacturing Corporation, whose shop-floor or meeting-room practices resonate deeply with the innate predispositions of the human brain. Managers who understand the recent breakthroughs in cognitive science can lead and influence mindful change: organizational transformation that takes into account the physiological nature of the brain, and the ways in which it predisposes people to resist some forms of leadership and accept others.

·          Change is pain. Organizational change is unexpectedly difficult because it provokes sensations of physiological discomfort.

·          Behaviorism doesn’t work. Change efforts based on incentive and threat (the carrot and the stick) rarely succeed in the long run.

·          Humanism is overrated. In practice, the conventional empathic approach of connection and persuasion doesn’t sufficiently engage people.

·          Focus is power. The act of paying attention creates chemical and physical changes in the brain.

·          Expectation shapes reality. People’s preconceptions have a significant impact on what they perceive.

·          Attention density shapes identity. Repeated, purposeful, and focused attention can lead to long-lasting personal evolution.

 

Are You a Tigger, or an Eeyore? This interview with Mindy Grossman, chief executive of HSN Inc., was conducted and condensed by Adam Bryant. Q. Tell me about your leadership style. A. I believe in accessibility. I believe in honesty and a culture that supports that. And you can’t have that if you’re not open to receiving feedback. I find out as much from the guy in backstage TV as I do from my C.F.O. Anybody can e-mail me. I do town halls with employees at least once every eight weeks. I’m out there and it makes a huge difference. Q. How do you make sure you’re getting honest feedback? A. I think the way you start sets the tone for your leadership style. For example, my first day, I went through orientation just like everyone else, because I wanted to see what everybody else feels when they come into this company for the first time. There were 15 people — a guy who is in backstage TV, somebody in production, somebody in planning, and I just came in and sat down. A. Fear is not a motivating factor. You might be able to get a little bit more out of someone in the short term, but you will completely erode your business and your culture in the long term. You’re going to lose all your good people. You’re not going to have people tell you the truth, and it becomes the tradition.

How to Survive A Disaster When a plane crashes or the earth shakes, we tend to view the survivors as the lucky ones. Had they been in the next seat or the apartment across the street, they would have perished. We marvel at the whimsy of the devastation.But survival is not just a product of luck. We can do far more than we think to improve our odds of preventing and surviving even the most horrendous of catastrophes. It's a matter of preparation--bolting down your water heater before an earthquake or actually reading the in-flight safety card before takeoff--but also of mental conditioning. Each of us has what I call a "disaster personality," a state of being that takes over in a crisis. It is at the core of who we are. The fact is, we can refine that personality and teach our brains to work more quickly, maybe even more wisely. When disaster strikes, a troubling human response can inflate the death toll: people freeze up. They shut down, becoming suddenly limp and still. Our brains search, under extreme stress, for an appropriate survival response and sometimes choose the wrong one, like deer that freeze in the headlights of a car. But the more encouraging point is that the brain is plastic. It can be trained to respond more appropriately. Less fear makes paralysis less likely. A rat with damage to the amygdala, the primitive part of the brain that handles fear, will not freeze at all--even if it encounters a cat. If we can reduce our own fear even a little bit, we might be able to do better. All of us, but especially people in charge--of a city, a theater, a business--should recognize that people can be trusted to do their best at the worst of times. They will do even better if they are encouraged to play a significant role in their own survival before anything goes wrong.

Good Boss vs. Bad Boss

Power Plus Incompetence Equals a Mean Boss So why are workplace tyrants so common? What's the psychological dynamic underlying such dysfunction at the top? It's not simply the power; there are many powerful bosses who are good and decent—or at least tolerable. Power corrupts only some—but which ones and why? Two psychologists recently decided to explore one possible explanation: perhaps it is power, but only power mixed with incompetence, that leads to aggression and abuse. It won't surprise a lot of workers to learn that their mean-spirited supervisor has secret feelings of inadequacy. But the researchers wanted to double-check these results, so they did a laboratory simulation of the workplace dynamic. They used what are called "primes" in the jargon of the field: they had some volunteers write about a time in the past when they felt particularly powerful, an exercise which is known to activate these internal feelings. Some of these empowered workers also recalled and wrote about a time when they performed admirably at some task, while others wrote about a past experience of inadequacy. As a laboratory measure of aggression, they created a ruse in which the volunteers had to choose how much noise to blast at a stranger, ranging from completely benign to head-rattling. Again they found that it's the interaction of power and inadequacy that engenders abuse. Fast and Chen believe that this dynamic reinforces itself in the workplace, because people who gain power pressure themselves to perform at a higher level, and thus are more apt to feel inadequate in their powerful role. This threatens their ego, and they become defensive. Defensiveness often comes out in the form of insults or worse. So what can be done to stop this cycle from escalating? In still another lab experiment, the psychologists again manipulated feelings of power and competence, and again measured workers' aggression—in this case their willingness to undermine another worker's performance. But in this version of the simulation, the researchers deliberately boosted some of the volunteers' feelings of self-worth by praising them for their leadership skills. Others got no such ego booster. And guess what? Power plus inadequacy still equaled aggression, except for those who got that simple shot of self-worth. As reported online this month in the journal Psychological Science, just a little praise was enough to wipe out the aggressive tendencies of the laboratory "bosses."

The Boss's Journey: The Path to Simplicity and Competence Being a great boss is a lot tougher than it looks.  I realized this a few months back when one of my former students came back to chat.  When he took my introduction to organizational behavior class, he routinely ripped apart his former bosses and many bosses we studied in class, calling them “lazy,” “idiotic,” and “incompetent.”  He sure changed his tune after getting his first job as a boss -- heading a small product development team.   During our conversation, he admitted that he needed “a little therapy” and confessed “This is really a tough job.  I am confused and keep screwing-up.” This new boss was in the second phase of the journey required to develop true expertise in any craft. As psychologist William Schutz explained, “Understanding evolves through three phases: simplistic, complex, and profoundly simple.”  (I have written about Schutz before, see this post). This process means, as my distraught student learned, being a great boss seems deceptively easy at first blush.  But no boss can master the craft without traveling through a purgatory of uncertainty and confusion.  The best bosses also realize that, although the stretches of confusion become shorter and less frequent over time, this quest for deep understanding never ends.  There is no magic cure or shortcut that will instantly transform youy into a skilled boss.  But I do believe – following Schutz’s model – that path becomes easier if you devote yourself to the relentless pursuit of simple competence (a theme I expand on in my BusinessWeek essay published earlier in the year). My view is that great bosses realize there will always be times when they are overwhelmed and baffled, that confronting and wallowing through excessive complexity is necessary for developing useful rather than useless simplifications.   Yet no matter how bewildered great bosses might be at a given moment, they strive to develop a simple mindset and master seemingly obvious moves.  The result is that, if you talk to the best bosses about their craft, they often make it seem so simple -- P&G’s AG Lafley being exhibit one here. After all, this clear thinking and elegant expression are the fruits of their labors.  This is why, when you ask great bosses about the “secrets” of their success, they usually answer there is no mystery; they are just doing their jobs.

The Art of Leading

The C.E.O. Must Decide Who Swims Q. When did you first learn how to lead people? I feel like I’m a judge, and I use that mental image a lot, which is that my job is not to make everybody happy. My job is to chart the right course and, at the end of the day, I leave this building and if I feel like I’ve done the right thing and people respect me, I’m happy. But on any day someone is probably unhappy with a decision that I made in the day, and that’s the best I can do. Q. You mentioned all the things you learned in the downturn. Any other broad take-aways? A. I reflected a lot on this when it came around this time, and I’ve talked a lot about this with fellow C.E.O.’s. So the first thing you learn is that it’s going to end. The sky is not falling. The sense of panic that starts to overtake people is overplayed. So you chart a course, and you plot out kind of a worst-case, middle-case, best-case plan. You’re probably going to have to do some cost-cutting, and get that plan laid out, and then stay on strategy. This is your reality, and that’s how it is. The sky isn’t falling, and you have to show calm confidence every day. Your employees are watching your behavior.

Planes, Cars and Cathedrals Q. What did you learn from that? A. It was a gem, because I really thought about why it happened. I realized very early that what I was really being asked to do was to help connect a set of talented people to a bigger goal, a bigger program and help them move forward to even bigger contributions. That was a different role than what was expected of me as an engineer. That experience stayed with me forever on what it really means to manage and lead. Q. Can you talk more about that? A. The more senior your management position is, the more important it is to connect the organization or the project to the outside world. You know, how does this fit in with what we’re doing? What is the real goal, the real mission? And it makes you also think about: What business are we in? And how do we pull together to have a comprehensive plan to create whatever we decided to do together? And then, how do you get everybody included, where everybody’s contributing and everybody knows what’s going on?  Q. How do you get everybody to contribute? A. I think the most important thing is coming to a shared view about what we’re trying to accomplish — whether you’re a nonprofit or a for-profit organization. What are we? What is our real purpose? And then, how do you include everybody so you know where you are on that plan, so you can work on areas that need special attention. And then everybody gets a chance to participate and feel that accomplishment of participating and contributing. Q. What have you learned to do less of over time?

I guess I’ve moved to a place where I’m really focused on four things. I pay attention to everything, but there are some things that are very unique to what I need to do as the leader. I have to really come through on these. And one of them is this process of connecting what we’re doing to the outside world. I mean, we’re here to create a business of serving customers with the best cars and trucks in the world, so where is the world going? Where is the technology going? Where are the customers going? Where is the competition going? A second focus for me is: What business are we in? What are we going to focus on? What’s going to be our business? The third one that I really focus on is balancing the near term with the longer term. And especially in the environment like we see today, where you absolutely want to keep investing for the future, even though you could invest less and make your business performance look better in the near term. Do we have a plan that works in the near term and also creates value for the long term?  And then I really focus on the values and the standards of the organization. What are the expected behaviors? How do we want to treat each other? How do we want to act?

In Risky Year, Buffett Looked 'Into the Abyss'  Warren Buffett believes his best deals during the economy's biggest belly flop since the Crash of 1929 may well turn out to be the ones he didn't do. Mr. Buffett slammed the door on one opportunity after another during the most harrowing stretch of his storied career. That impulse, he says, left him with the financial firepower he needed last month to strike the biggest deal he has ever done -- Berkshire Hathaway Inc.'s $26.3 billion purchase of railroad Burlington Northern Santa Fe Corp. In a series of interviews with The Wall Street Journal, Mr. Buffett gave his most complete account of his epic deal negotiations, including anxious phone calls he fielded from wounded companies such as Freddie Mac, Wachovia Corp. and Morgan Stanley. "I bought my first stock in 1942, and this roller coaster surpassed anything that I've seen," says the 79-year-old investor. "We didn't do all the smartest things. We didn't do anything really dumb." Shares of giant investment banks Morgan Stanley and Goldman Sachs were spiraling lower amid worries that they would be the next firms to fail. The commercial-paper market, which helps finance the day-to-day operations of businesses around the country, was seizing up. On Sept. 16, the Reserve Primary Fund, a big money-market fund, revealed huge losses, due in part to holdings of Lehman's commercial paper. If the commercial-paper market had frozen completely, more major financial institutions and possibly even household names such as GE would have failed, Mr. Buffett says, "because their checks would have failed to clear." That would have triggered panic in the nation's money-market funds, which held about $3.5 trillion in assets, because some of them held commercial paper. The resulting chaos, Mr. Buffett concluded, could have crashed global financial markets, threatening Berkshire. "I felt that this is something like I've never seen before, and the American public and Congress don't fully understand the gravity" of the problems, he recalls. "I thought, we are really looking into the abyss." As the government swung into action, Mr. Buffett recalls, he gained confidence that the crisis would be resolved. A government guarantee of assets in money-market funds, which came days after the Reserve fund's troubles emerged, was a big step forward, he says.

Citi’s Creator, Alone With His Regrets  On that day, April 18, 2006, Citi’s share price was $48.48. After studying the photo for a few moments, Mr. Weill says quietly, “I thought the company was impregnable.” He knows now, of course, that he was wrong. Over the last two years, Mr. Weill has watched Citi — a company he built brick by brick during the final act of a 50-year career — nearly fall apart. Although every taxpayer in the country has paid for Citi’s outsize mistakes, for Mr. Weill the bank’s myriad woes are a commentary on his life’s work. “Sandy will forever be identified with Citigroup,” says Michael Armstrong, a Citi board member and a former chief of AT&T. “He put everything he had into its creation.” Mr. Weill built his wealth, status and power by creating what was once the world’s largest bank. Now, as Citi struggles to regain its footing, Mr. Weill’s legacy has taken on a darker hue. Though he was once viewed as a brilliant dealmaker, some critics now cast him as the architect of a shoddily constructed, unmanageable financial supermarket whose troubles have sideswiped investors, employees and average citizens nationwide. “The dream, the mirage has always been the global supermarket, but the reality is that it was a shopping mall,” says Chris Whalen, editor of The Institutional Risk Analyst, of Citi’s evolution over the last decade. “You can talk about synergies all day long. It never happened.” Citi’s troubles are well chronicled: a failure to integrate its disparate parts worldwide or to keep tabs on risky investments and free-wheeling operations. These lapses led to billions of dollars in losses and multiple bailouts, and the government now owns a quarter of the company.

Whispering to Rottweilers, and to C.E.O.’s That Mr. Millan keeps a straight face in these situations says less about his manners and more about where his focus lies: with the hounds. Over the years, he has learned that in a country where pet lovers treat their animals like coddled children (making them unhappy, he believes), he must delve into the human realm to put things right. He’s the first to say, however, that communicating with humans didn’t come naturally. He grew up on a farm in Mexico, where from an early age he was known as El Perrero, or “the dog man.” Dogs made sense to him. They telegraphed their anxieties in predictable ways. They loved to be led. “They accept you as who you are — one leg, two legs, no eyes, no problem,” he says. “But they won’t be around unstable energy. That’s how much integrity they have.” Not so with humans. “One of Cesar’s favorite sayings,” says Jim Milio, a partner in MPH, which produces the show out of a mini-mall in Burbank, Calif., “is that humans are the only animals who will follow unstable pack leaders.” It would take years before Mr. Millan realized that to achieve his goal of being the world’s best dog trainer, he would need to understand not just pets, but also pet owners.

Compensation vs. Performance

Wiseguys part 2 Executive compensation, the climate conference in Copenhagen and sovereign debt are just some of the topics on the table when Headline host Howard Green speaks with BNN's regular panelists of "Wise Guys": Jim Gray, former chairman of Canadian Hunter Exploration, Bill Dimma, Chairman Emeritus at Home Capital and Jim Gillies, Professor Emeritus at the Schulich School of Business.

Fund Chief Snared by Taps, Turncoats Those recordings begat a wiretap on Mr. Rajaratnam's phone, and, prosecutors say, a dizzying picture of multiple insider-trading rings began to form. Like falling dominoes, one investor suspected of trading on insider tips led to another, each with a network of sources. Some overlapped; others spun out into separate orbits pulling in additional players with no ties to the other rings. "There is reason to fear that there is a culture -- not only at hedge funds but at large firms in the financial sector -- that thinks nothing of casually exchanging material nonpublic information," said Preet Bharara, the Manhattan U.S. attorney, who declined to talk specifically about the Galleon case. For two and a half years, a team of federal agents and prosecutors coaxed witnesses to turn on their friends, recorded thousands of phone calls and plowed through reams of documents. Then, in October, they arrested Mr. Rajaratnam. Soon, 20 other people were also charged. Insider-trading charges are notoriously difficult to prove. That's because Wall Street is awash in information, and every savvy investor tries to be the first to ferret out important tidbits. To gain a conviction, prosecutors have to persuade a jury that a person traded on information that they knew was not only confidential but was also important enough to move a company's stock price. A Wall Street Journal examination -- based on nearly 1,000 pages of court documents and dozens of interviews with lawyers, traders and others involved -- shows for the first time how prosecutors built the case of a generation, one that has stilled the easy chatter in the clubby world of hedge funds and reached into the ranks of some of America's biggest corporations.

 

Get Rid of Executive Bonuses. These days, it seems, there is no shortage of recommendations for fixing the way bonuses are paid to executives at big public companies. Well, I have my own recommendation: Scrap the whole thing. Don't pay any bonuses. Nothing.This may sound extreme. But when you look at the way the compensation game is played—and the assumptions that are made by those who want to reform it—you can come to no other conclusion. The system simply can't be fixed. Executive bonuses—especially in the form of stock and option grants—represent the most prominent form of legal corruption that has been undermining our large corporations and bringing down the global economy. Get rid of them and we will all be better off for it. The failings of the current system—and the executives who live by it—are painfully obvious. Although these executives like to think of themselves as leaders, when it comes to their pay practices, many of them haven't been demonstrating leadership at all. Instead they've been acting like gamblers—except that the games they play are hopelessly rigged in their favor. First, they play with other people's money—the stockholders', not to mention the livelihoods of their employees and the sustainability of their institutions. Second, they collect not when they win so much as when it appears that they are winning—because their company's stock price has gone up and their bonuses have kicked in. In such a game, you make sure to have your best cards on the table, while you keep the rest hidden in your hand. Third, they also collect when they lose—it's called a "golden parachute." Some gamblers. Fourth, some even collect just for drawing cards—for example, receiving a special bonus when they have signed a merger, before anyone can know if it will work out. Most mergers don't.And fifth, on top of all this, there are chief executives who collect merely for not leaving the table. This little trick is called a "retention bonus"—being paid for staying in the game!

Bonus Bashers Shouldn't Stop at Goldman Sachs: David Reilly Bonuses, lavish benefits and perks subsidized by taxpayers aren’t the sole preserve of bankers. You only need look in your own backyard for examples of excessive compensation that may contribute to future crises, just as skewed rewards on Wall Street fueled the current one. That’s what I discovered reading a New Jersey Commission of Investigation report issued this month on wasteful compensation in local governments. There were plenty of sweet deals that the vast majority of bank workers -- who don’t get seven-figure compensation -- might be happy to land. These range from $200,000-plus payouts for unused days to paid time-off to go Christmas shopping. As the report put it, “Startling amounts of taxpayer- funded booty continue to be dispensed across New Jersey without regard for the common good.” Then again, most folks on Wall Street or in big banks will never see that kind of bonanza either. The vast majority toiling on Wall Street and in big banks are worker bees who receive good, but not astronomical, pay. Consider that in 2008, eight of the country’s biggest financial institutions paid 4,311 individuals more than $1 million in bonuses, according to a report by New York State Attorney General Andrew Cuomo. Yet they represent just 0.3 percent of the 1.27 million workers at those firms. And even if they’re not in the ranks of top earners, many bank workers face the threat of getting swept up in the populist outrage over banker pay.

Does Golden Pay for CEOs Sink Stocks? Why does it seem that it's always Christmas in corporate boardrooms? And how can investors tell whether those glittering pay packages are worth the cost? The answer sounds obvious: Pay the boss more for good results now, and you should get even better results later. But the evidence for that is surprisingly weak, and two new studies even suggest that when chief executive officers get paid more, shareholders end up earning less. The first study, led by corporate-governance expert Lucian Bebchuk of Harvard Law School, looked at more than 2,000 companies to see what share of the total compensation earned by the top five executives went to the CEO. The researchers call this number—which averages about 35%—the "CEO pay slice." It turns out that the bigger the CEO's slice of the pie, the lower the company's future profitability and market valuation. "These CEOs," says Prof. Bebchuk, "seem to be trying to grab more than they should."  Finance professor Raghavendra Rau of Purdue University and two colleagues looked at CEO pay and stock returns for roughly 1,500 companies per year from 1994 through 2006. They found that the 10% of firms with the highest-paid CEOs produce stock returns that lag their industry peers by more than 12 percentage points, cumulatively, over the next five years. Companies at the top of the pay pile, Prof. Rau concluded, award their CEOs an annual average of $23 million—but leave their shareholders poorer (relative to other companies in the same industry) by an average of $2.4 billion per year. Each dollar that goes into the CEO's pocket takes $100 out of shareholders' pockets.

A Window Opens on Pay for Bosses There is still one area where companies could play games to make their bosses look less well paid than they really are. That is in the area of performance-based awards, where the payout will depend on how well the executive or the company performs relative to undisclosed goals. A company that wants to do so may be able to obscure just how likely a rich reward is for an executive. Still, the information will be better than ever before. A particularly important change will make it more likely for shareholders to learn when one executive is given a huge options award. In the past, it was sometimes possible for a company to leave that out of disclosures, since the impact of the grant was spread over several years. Companies could make someone the highest-paid executive in a company for a year but not disclose that to shareholders. Perhaps the most impressive fact is that the new information will be available this year. Mary L. Schapiro, the S.E.C. chairwoman, decided to fight her way through bureaucratic delays to get the new rule out just in time for this year’s proxy season. Under normal S.E.C. procedures, there is little doubt the changes would have been effective a year from now, not this year. In less than a year, Ms. Schapiro has established a reputation for careful but determined reform, of the commission itself and of the markets it regulates.

Governance, Performance & Attitudes

Taking away directors’ rubber stamps But “Money for Nothing” casts a much wider net, blaming the financial crisis on a systemic collapse of corporate democracy caused by the failure of many if not most corporate boards to simply do their jobs. “The boards were supposed to monitor risks, provide judgment and supervise managers on behalf of shareholders,” Mr. Gillespie and Mr. Zweig write. “Boards, at the very least, should have acted in the classic sense like a governor on an engine that measures and regulates the machine’s speed and, if necessary, turns it down to keep it from blowing up. Mr. Gillespie and Mr. Zweig do not believe that the solution to board laxity lies solely in more regulations. They complain that boards tend to be focused more on avoiding legal problems than on “formulating of company strategy, identifying risks, and evaluating executive performance.” THE authors conclude with a list of more than two dozen recommendations for comprehensive reform. These include creating a new class of “public directors” appointed to corporations by a special nonprofit organization, reform of voting procedures currently subject to manipulation by management and, simply but perhaps most important, a law prohibiting people from simultaneously holding the positions of chief executive and board chairman. But no amount or manner of structural change can ensure that directors will step up and take responsibility for their fiduciary duties to shareholders, the authors assert. Boards overwhelmed by the power and glory of corporate chieftains tend to commit sins of omission, like not asking probing questions and not challenging management presentations of “fact,” rather than sins of commission like active participation in securities fraud. Mr. Gillespie and Mr. Zweig drive this point home with a bit of black humor as they recount their jailhouse interview with L. Dennis Kozlowski, the former Tyco chairman and chief executive who was convicted of grand larceny and securities fraud. Asked to articulate the highest praise he could muster for his former board, Mr. Kozlowski replied, “They didn’t slow me down.” Talk about money for nothing.

Meanness and Greed Are Out, Immelt Says The United States stands at the end of a generation when greed drove leaders and “rewards became perverted,” General Electric’s chief executive, Jeffrey Immelt, said in a speech at West Point on Wednesday. “We are at the end of a difficult generation of business leadership, and maybe leadership in general. Tough-mindedness, a good trait, was replaced by meanness and greed, both terrible traits,” the head of the largest U.S. conglomerate said in prepared remarks to be delivered at the U.S. Military Academy, according to Reuters. “Rewards became perverted. The richest people made the most mistakes with the least accountability,” Mr. Immelt said. “In too many situations, leaders divided us instead of bringing us together.” “I decided that I needed to be a better listener coming out of the crisis,” Mr. Immelt said. “I felt like I should have done more to anticipate the radical changes that occurred.” Each Saturday, Mr. Immelt now invites one of the company’s top 25 executives to chat about the future of the company, an exercise intended to give him a greater insight into what is going on across its many divisions. In a speech that focused on leadership styles, he said that executives need to be ready to move quickly in times of crisis and need to trust that their subordinates will be able to carry out their orders quickly. “In the peak of the financial crisis, it seemed like the world was going to end every weekend,” Mr. Immelt said. “I am sure that my board and investors frequently wondered what in the heck I was doing. I had to act without perfect knowledge; I had to act faster than my ability to communicate or explain my actions. I could do this because we had built trust. And we kept G.E. safe because we moved fast.”

Tending to corporate integrity becomes key in wake of huge fraud When an estimated $2.5 billion fraud at India's Satyam Computer Services Ltd. rocked the country's corporate credibility last year, the government brought in an outsider, Deepak Parekh, to clean up the mess. Mr. Parekh, 65 years old, leads HDFC Group, a financial conglomerate his uncle founded in 1977 as India's first home-mortgage company. Mr. Parekh, a U.K.-educated accountant, joined his uncle's business after its first year. He became CEO in 1993, launching India's first private bank and expanding into life insurance, asset management and real estate to build an empire with assets of $92 billion. Mr. Parekh's rise has paralleled, and helped fuel, the growth of India's middle class during the past two decades. We had to do firefighting in a number of areas. One, we needed to give support, assurance [and] encouragement to the management, because an IT company is only as good as its people. We had to talk to them, support them, encourage them and ensure they [were] paid salaries. The clients of Satyam were top Fortune 100 companies. We had to comfort them, [give] assurance that their work will not suffer. In six weeks, we practically called all the clients. We had to see that the clients didn't disappear, we had to see that the people were there to do the job, we had to ensure that the salaries were paid on time so that they didn't go

5 CEOs Who Are Worth Their Fat Paychecks The average American can be excused for thinking that CEOs raid companies rather than running them. What was once the most august job title in working America has become a synonym for greed and chutzpah. In recent years, the chief executives of Bear Stearns, Lehman Brothers, AIG, Citigroup, Fannie Mae, and Freddie Mac ran their companies into the ground while collecting pay packages that totaled eight and sometimes even nine figures. Some CEO perks sound like the trappings of royalty: car and driver, family use of private jets, personal security, lavish death benefits for family members, free tax and retirement-planning services. While CEO pay has drifted down on account of the recession, it still averages about $1.7 million, and the gap between the pay of CEOs and average workers has been widening for years. But some CEOs are worth the trouble. A new report by the Corporate Library, a corporate-governance research group, highlights 12 CEOs who get "paid for success." In response to recent corporate abuses, reformers in Congress and elsewhere are pushing hard for companies to link pay, bonuses, and other incentives to long-term performance rather than awarding bonuses based on inflated quarterly numbers or unproven pump-and-dump deals. Many companies claim that they strictly enforce pay-for-success rules, but studies by the Corporate Library and others show that it's mostly lip service; most boards of directors and compensation committees tend to be captive bodies that rubber-stamp the CEO's pay package with little scrutiny. Corporate profits from current production rose 10.6% in the third quarter, following a revised 3.7% gain in the second quarter. From a year ago, corporate profits fell 6.7%, the first single-digit decline after three straight quarters of significantly weaker profits. Corporate profits of the financial sector advanced 36.4% in the third quarter and made up the larger share of corporate profits. Corporate profits of the non-financial sector increased only 2.0%. The financial sector’s performance is artificially boosted by the support programs in place.

Posted by dblwyo at 08:18 AM | | Comments (0)

January 15, 2010

Talking Business: the Outlook vs. the Preparations

Well with the second day of FCIC hearings behind us and the agita reactions we could easily pick up on that thread and continue the conversation. Especially because we think almost all commentators are misjudging what they're hearing. Of course to better judge it you'd actually have to a) listen to the whole thing, b) know what you're hearing and c) know some of the background. We still think the three most important things we heard were 1) we really screwed up, 2) it was fundamentally bad management and leadership and we're responsible and 3) we apologize but we're not really sorry (especially Blankfein and GS!). The Street's grasp on the tsunami that will build up over the next two years is abysmal and they don't know how to deal with it, but dealing with public responsibilities is as much a part of an executive's responsibilities as is day-to-day decision making. But, God being just, JPM's lackluster earnings which are bringing down the market as we speak for all the problems we've been warning about for 18 months at least (literally) will do for now (that'll do Donkey, that'll do). Blankfein's major defense for drinking the koolaid was that nobody could have seen it coming - which is just flat not true, and is being repeated. CalculatedRisk was warning about this problems in 2005 and we were warning about a slowing economy in early 2006.

Here's where those all come together - our fundamental question. Are businesses properly preparing for the next decade of slow growth? Just to put up some new charts on that point of forewarnings this one shows monthly retail sales, quarterly back to 1960 compared to Consumption and GDP and the determinants of future demand. The sum of changes in Employment and real Wages continues to weaken. Now if you don't believe things aren't very rosy you're probably done here. If on the other hand you think business performance is a critical factor in how things will go please continue on.

 

The Auto Industry as Exemplar

In the readings you'll find another slew of stuff starting with starting with long-term fundamental changes in consumer spending habits ('ol hat here we know but it always bears repeating apparently). All the rest of the excerpts are specific company stories starting with Best Buy and Sony, which gives us consumers and the CPG's (of a sort), Alcoa (who had not so good results and tanked the markets themselves), and Exxon who's acquisition of XTO Energy (a natural gas firm) tells us an enormous amount about deep structural change in the Energy Sector. Then there's a slew of Auto articles followed by another chunk of Technomedia stories covering the outlook, Intel (who's surprisingly good results did NOT result in any significant market pop), IBM, patents and (indirectly) innovation and Comcast-NBC. Need we mention that the Jay/Conan screwup is more symptomatic of NBC's struggles with the new age than of anything else. When the world is changing under you well... march or die as they still say in La Legion Etranger!

The top chart pretty well speaks to the retail and consumer outlook - whether the necessary steps are being taken we're not sure (that's being polite btw. Actually we're highly suspicious that the overbuilt, over-stored and under-run Retail Industry is in deep dodo and about a 1 on the adaptation scale [1-5], and its suppliers along with it). Let's turn to the Auto Industry as our exemplar then. (The Self-Inflicted Collapse of the Auto Industry). The top chart shows Industry Sales and YoY changes - notice the big bubble in Sales after things were already headed south. Instead of adapting and adopting they choose to use special incentives to move stuff nobody wanted to buy. Our judgment would be that the US going out sales figure will be 13mil/year at best, probably take 2-3 years to crawl back that high, if it does and tells us the US industry is still about 40% over-capacity. Europe's in much worse shape.

Meanwhile the real growth opportunity is in Asia and Latin America but the Chinese have 117 manufacturers who need to shake out but will continue to be subsidized into more over-capacity by government spending to goose employment. And all that's before we raise the perennial but really critical issues about re-thinking and re-engineering product development, manufacturing, distribution and marketing & sales. Over this next decade the industry has merely survived so far though the jury's out. And, again, it's not like you couldn't see this coming as long as you didn't drink the koolaid and talked to somebody besides yourself.

So What About That Tech

Well, what about it? Well obviously Tech will save the day, right? Let's try that again by refreshing ourselves on how business makes capex decisions - rather like we did circa Jun08 when we said things were going to hit the rotary impeller real soon now and folks needed to prep right now. Needless to say nine months later there were lots of Tech execs wondering around with startled looks and meataxed labor forces.

The top chart compares YoY changes in GDP and Tech spending. Looks like an extraordinarily close fit to us. Which is born out in the bottom chart which shows the relationship over time - notice how tight the fit is and how high the R2 is! About as good as we've ever seen for any economic data.

Now Forrester tells us that worldwide spending will go up about 8.1% while US spending will increase about 6.6%. Who are we to argue with the guys who got it wrong the last time. Of course if you do the math and a 2.5% real GDP growth rate implies  a 4.5% growth in real tech spending. Not bad all things considered but a 1/3 under the analysts forecasts. That would required a sustained 3% GDP for the entire year - again not to far off and given how sharply the sector might rebound possible but, we think, unlikely. If you want some more background on far and fast the Industries are changing try: Technomediatainment Futures: Evolution, Barriers, Structure and Opportunities of a New Industry.

Reality Checks Indeed

So, there you have it. Reality checks from fundamental changes in Consumer behavior and weak employment to slack demand growth and the ripple effects across the spectrum of Industries from Retail to Manufacturing to Extraction to Autos to Tech and Entertainment.

In an interesting comment on the "perversity" of our times one of the best places to get your news and substantive discussion of serious issues is Stewart's Daily Show. Here's interviewing Paul Ingrassia, ex-WSJ Detroit reporter and editor. Paul's got a new book out on the history and performance of the Industry, how it dug itself into these holes and dodges the "what next" questions. Of course he's also the same guy who wrote a book in '94 about the recovery and bright future of the Industry. Here he admits they completely lost their way back then and took their fingers off the control levers.

How many other companies out there are in the same state today? We certainly know that the Finance Industry hasn't even repaired the balance sheets let alone started re-thinking its businesses. How many others are going to be the next Auto Industry?

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Business

Hello, frugality; goodbye, good life Now, with the bubble burst, we're worried about losing our jobs. We don't trust the economic rebound, and we're pretty sure taxes are going up soon. And we'll probably be worried for quite a while. As a result, say the experts who study such things, many of us are adopting much more frugal lifestyles. Oh, we're still spending, as the 3.6% increase in holiday shopping shows. We still splurge on little luxuries, as I suggested a few months ago. But if there's a cheaper alternative on the market, a lot of us will buy it. That brings us to the challenge facing many of the companies that used to post big profits and fast growth by selling us the good life -- a list of once-trendy or posh names including Starbucks (SBUX, news, msgs), Whole Foods Market (WFMI, news, msgs), Saks (SKS, news, msgs), MGM Mirage (MGM, news, msgs) and Toll Brothers (TOL, news, msgs). Sure, you've got some great products. Starbucks can perk a luscious latte. Whole Foods  has beautiful produce and a killer meat counter. But we're in a new age of frugality. We're adjusting. Can you? "We're absolutely finding that a new frugality has taken hold, one that seems to have some staying power," says Krista Faron of market research company Mintel, which tracks consumer spending patterns. It's playing out across all retail sectors, including fashion, food and home improvement, Faron says. "Yes, this is a new age," agrees Ken Perkins of Retail Metrics. "Consumers are much more focused on value now. Before, it was all about coming home with the latest handbag. Now it's about shopping your closet."

Best Buy: 'The 1,000-pound gorilla' At least for now, Best Buy stands as uncontested champ. It's the last major consumer electronics retailer in the country this holiday season, after the liquidation of Circuit City earlier this year. But Brian J. Dunn, who became Best Buy's chief executive officer in June, isn't taking success for granted, especially with rising competition from nontraditional rivals such as Wal-Mart Stores (WMT, news, msgs) and Amazon.com (AMZN, news, msgs). So Dunn has ambitious plans to take advantage of Best Buy's newfound clout: He wants to go beyond the typical big-box retailer role of selling commodity products such as televisions and personal computers and become a central player in determining which products come to market and how big-spending customers choose the latest gear. The plan is already under way. Rather than waiting for electronics makers to ship Best Buy the same products that its rivals get, Dunn's lieutenants are walking factory floors with executives from companies such as Hewlett-Packard (HPQ, news, msgs) and Toshiba (TOSBF, news, msgs), influencing product development and design. The retailer is pushing suppliers to use standardized software and digital services so consumers can listen to music or watch movies on any device. And Best Buy has set up its own venture capital fund to pour millions of dollars into startups from Silicon Valley to Asia. The goal is to shape development of new technologies in promising fields such as green vehicles, digital health and home monitoring.

Sony Pins Future on a 3-D Revival With its once-revered electronics business flagging, Sony Corp. is placing a huge bet this year that 3-D technology will vault the company back into a leadership position in the living room. In his latest effort to resuscitate the struggling Japanese behemoth, 67-year-old CEO Howard Stringer has bulled past the hesitancy of some top aides to drive every unit of the company -- from TV production to the movie studio to its videogame arm -- to advance three-dimensional viewing in the global marketplace. He has pushed executives to abandon a bias against "non-Sony" technologies and to team up with other suppliers. He has evangelized about the technology outside the company, too, persuading both the PGA Tour and ESPN to begin taping and broadcasting events in 3-D.

Alcoa delivers bad news for global profits Not because global aluminum demand and prices aren’t climbing. They are. Alcoa projects that global aluminum demand will climb 10% in 2010. Spot prices for aluminum climbed from a 2009 low of $1,500 a metric ton to the neighborhood of $2,200 a ton—a 14-month high—by the end of 2009. But because higher demand and higher prices are bringing aluminum-production capacity on line far faster than demand is growing. Take the case of China. The world’s largest consumer of aluminum is projected to consume 14 million metric tons in 2010. Huge good news, right? Well, no. China has idle aluminum production capacity of 7 million tons right now. That capacity is set to come back into the market as aluminum prices climb. China imported aluminum in 2009 but will produce a small surplus for export in 2010. The idle capacity in China is only part of the problem. Other countries have been building new capacity that is set to start coming on line in 2010. For example, Abu Dhabi, started production on December 1 at what will be the world’s largest aluminum smelter when it’s finished. Qatar and Oman are building new smelters. Alcoa itself is building what it claims will be the world’s lowest cost smelter in Saudi Arabia. By 2020, the Gulf Aluminum Council projects, the Middle East will account for 12% of global aluminum capacity. Why the Middle East? After all, the region is not exactly rich in bauxite, the rock that yields aluminum after smelting. Top bauxite producers include Australia (almost on e-third of global production), China, Brazil, Guinea, and Jamaica. Because the key to profitably producing aluminum these days isn’t sitting in proximity to a big supply of bauxite, but access to cheap electricity. Lots and lots of it. The new production capacity in the Middle East all hinges on long-term deals for cheap power. That’s easy when the region sits on such huge supplies of oil, and more importantly for electricity production, natural gas. That presents producers with existing plants with a two-fold problem. First, enough new capacity is coming on line to more than off-set in increases in global demand. And second, the new capacity will have lower energy costs that will make it tough for older plants and producers to compete.

Exxon Mobil to buy XTO Energy for $31 billion Exxon Mobil will buy XTO Energy in an all-stock deal worth $31 billion as the oil giant moved aggressively Monday to capitalize on the growing supply of natural gas at home. The deal could signal a new rush to own natural gas assets by major integrated producers, and perhaps the start of a significant consolidation in the energy industry. "Exxon is the group leader and it sets the trend. I would expect more acquisitions in the next three to six months," said Fadel Gheit, senior energy analyst for Oppenheimer. "Who that will be is the $64,000 question." Exxon is closely watched in the industry and an acquisition like XTO could prompt other companies like Royal Dutch Shell PLC, BP BLC or Chevron Corp. to move. Potential targets include big natural gas companies like Chesapeake Energy, Devon Energy and Anadarko, Gheit said. XTO shows the priority that major producers are giving to natural gas as a fuel source. New technology has unlocked trillions of cubic feet of natural gas at home, meaning energy producers do not have to navigate tricky political environments overseas. That doesn't mean that those projects are being excluded. Exxon just last week gave the go-ahead for a $15 billion natural gas project in Papua New Guinea, positioning the world's largest publicly traded oil company to provide energy to a fuel-hungry China. XTO claims about 45 trillion cubic feet of gas, much of it trapped in tight formations known as shale. Shares in the company jumped 16 percent, or $6.64, to $48.13 in early trading.Shares of Exxon fell 3.5 percent, or $2.51, to $70.32. Exxon has signaled recently that it was moving increasingly toward landing natural gas assets. Once the deal closes, Exxon said it will establish a new organization to manage global development and production of unconventional resources.

Behind Exxon Mobil’s Big Bet on Natural Gas Exxon Mobil’s acquisition of XTO Energy amounts to a $31 billion wager on natural gas becoming the fossil fuel of choice for power generation in the United States. The huge deal brings the world’s largest energy company back home to focus on what could be an expensive and time-consuming effort — something it wouldn’t have considered just a few years ago. Exxon is not a company known for making rash moves. In fact, it is viewed largely as the most conservative company in what is arguably a very conservative industry. So some analysts were surprised by its decision to acquire a company that gets a large portion of its production from somewhat unconventional sources with limited export abilities. XTO is mostly an onshore domestic natural gas company specializing in squeezing gas out of very tight and expensive reservoirs. The boom in natural gas prices in the past decade allowed it to grow and expand in areas once thought to be uneconomical to drill. At the same time, advances in technology helped lower costs and increase production. Rampant speculation from financial players sent prices skyrocketing, allowing even the most unconventional of natural gas fields to be economical. But when the speculators rushed to the exits last summer, many drillers were left unable to sell their gas for market prices. Meanwhile, demand dropped as the financial crisis curbed energy use across the board. The envisioned demand for natural gas just has not kept up with the amount of supply that was flooding the market. So even with the number of drilling rigs down to half the number operating just a year ago, there is currently a record 3.7 trillion cubic feet of natural gas in storage at the moment (equivalent to the nation’s average natural gas demand for eight weeks). All that extra supply will eventually work its way through the system, but the days of $10 gas per thousand cubic feet seems to be over for the foreseeable future. But Exxon is making a bet that demand for natural gas will rebound and continue its steady march upward, especially in the United States. Rex Tillerson, Exxon’s chief executive, said Monday in a conference call with reporters that the company expected natural gas demand to grow faster than that for both coal and oil in the coming years. He also said that all of XTO’s resource base would be commercially viable.

Auto Industry

Ford’s Bet: It’s a Small World After All HE blew into the Ford Motor Company in 2006 as an outsider from a different industry, and he was hailed as the latest in a long line of purported saviors of a faltering, century-old automotive icon. At the time, skeptics in the clubby world of auto executives whispered that the newcomer, Alan R. Mulally, would be swallowed up by the complexities of the car business, his ebullient personality smothered by the feudal infighting for which Ford had long been famous. Yet three years into his tenure as chief executive — and with a host of still nettlesome challenges awaiting him — Mr. Mulally has thus far proved to be the unifying figure that Ford has needed for decades. His vision is distilled in the laminated, wallet-size cards carried by tens of thousands of Ford employees that spell out his management principles beneath a simple heading: “One Ford ... One Team ... One Plan ... One Goal.” And on Monday, at the opening press conference of the 2010 Detroit auto show, Mr. Mulally will unveil the car that embodies his strategy for returning Ford to its status as a leader in the global auto industry. That car, the new Ford Focus, is arguably as important to Mr. Mulally as the Model T was to Henry Ford, the founder. Despite some previous efforts, the Focus is Ford’s first truly global car — a single vehicle designed and engineered for customers in every region of the world and sold under one name. It is small, fuel-efficient and packed with technology and safety features that, Mr. Mulally believes, will appeal to consumers in Europe, Asia and the Americas. The car also represents what Mr. Mulally calls the “proof point” of everything he has done since joining Ford after a 37-year career with Boeing: he hopes that the vehicle will provide a rolling blueprint for generations of Ford cars to come. “The Focus represents the first tangible evidence of a global strategy,” says Mr. Casesa. “For the first time, Ford is executing it and not just talking about it.”

GM Bets on Trucks for Recovery  General Motors Co. has freed up cash to fund a major update of its full-size pickups, a bet that consumers and businesses will resume buying trucks after a long lull in sales. GM, which had relied on full-size pickups such as the Chevrolet Silverado for a major portion of its U.S. revenue and operating profit, had put off redesigning the trucks as its finances collapsed and it underwent a government-backed bankruptcy reorganization last year. Now, unlike in the 1990s truck boom, the company plans to revitalize its pickup line at the same time it invests heavily in small, fuel-efficient cars as well as in the electric Chevrolet Volt due later this year.

Asian automakers face battle to keep US dominance Asian automakers grabbed their biggest chunk ever of the U.S. car and truck market in 2009, but they'll struggle to build on that momentum this year as rivals in Detroit offer a fleet of efficient, small cars. All automakers that sell cars and trucks in the U.S. will try to woo cautious consumers still nervous about heavy debt, high unemployment and rising gas prices. Market share held by 10 Asian automakers -- including leaders Toyota Motor Corp. and Honda Motor Co. -- rose to 47.4 percent last year, surpassing for the first time Detroit's three players, which slipped to 44.2 percent, according to Autodata Corp. Those gains will be hard to extend this year. The struggle will center on small and midsize cars, as well as alternative-fuel models that run on electric batteries, or hybrid combinations of gasoline and electric. The rivals all showed their wares this week at the Detroit auto show. The Asian manufacturers' longtime dominance in smaller and greener cars gives them a running start this year, but Ford Motor Co. has countered with a revamped compact Focus and General Motors Co. is touting an all-electric Volt and new small cars like the Aveo, which is supposed to get about 40 mpg on the highway. GM and Ford also have strong sales in midsize cars, and the 2010 Fusion hybrid grabbed the North American Car of the Year award at the Detroit show earlier this week. That's added to growing signs of strength for Detroit, even after a tough year. But that bad year was enough to shift Asian brands into the top market share spot.That's a big reversal from 1980, when the domestics owned three-quarters of all sales and the Asians held just 18 percent. Back then, Detroit still ruled a car culture that was just starting to digest the long-term implications of two gas price spikes in the 1970s.

  • Roadkill Book review: “Crash Course: The American Automobile Industry’s Road from Glory to Disaster”

Technomedia

Analysts: Tech Sector to Recover in 2010 The tech downturn is over and a recovery is on the way after a "dismal" 2009, as companies resume spending on computers and software, according to a new analysis. Forrester Research Inc. was set to report Tuesday that it expects global spending on technology products and services to grow 8.1 percent in 2010, to more than $1.6 trillion. U.S. spending is expected to rise 6.6 percent, to $568 billion. The projected increases follow sharp declines in 2009, when businesses and governments slashed their purchases of PCs, computer peripherals and communications equipment in response to the economic turmoil and credit crisis. Many large tech companies, such as Microsoft Corp., remained profitable and increased their stock prices in 2009, but often they relied on layoffs and other expense reductions to do it. Even with the expected rebound, "the level of computer equipment purchases in 2010 will still be lower than in 2008 or even 2007," said Forrester analyst Andrew Bartels. With the recession over, pent-up demand for new computers and updated software programs stands to benefit the companies that make them. The October launch of Microsoft's latest computer operating system, Windows 7, also gives companies a reason to start replacing PCs.Still, Forrester cautioned that growth will start slowly and pick up later in the year. The research firm also expects spending on communications equipment to pick up this year, partly because of demand in emerging markets that are building wireless and broadband networks. Forrester is not alone in predicting a rebound for the year. Last fall Gartner Inc. forecast 3.3 percent growth in global technology spending. Another analyst firm, IDC, said in December that worldwide tech spending would grow 3.2 percent in 2010, returning the industry to 2008 levels of about $1.5 trillion.

Intel Vulnerable as Consumers Shift to Phones to Browse the Web  Intel Corp.’s position as the gateway to the Internet will come under attack in 2010 as more consumers start going online via phones, tablets, e-readers and scaled- down laptops. Qualcomm Inc., Marvell Technology Group Ltd. and Freescale Semiconductor Inc. are among the chipmakers demonstrating new kinds of Internet devices at this week’s Consumer Electronics Show in Las Vegas. Their goal: persuade consumers to ditch their Intel-powered personal computers as the primary way of going online. “The next billion users that are going to connect to the Web aren’t going to be connected by the PC,” said Henri Richard, head of sales at Austin, Texas-based Freescale. “It’s going to be a multitude of devices.” Intel, the world’s largest chipmaker, makes more than 80 percent of PC processors -- the brains of computers. It aims to use its Atom product, which runs small laptops known as netbooks, to break into chips for wireless devices, a market IDC estimates will increase 14 percent to more than $46 billion in 2010. Its rivals are heading in the other direction: using phone chips to woo users of PCs and consumer electronics. While the PC will remain the main way for people to go online, portable devices are chipping away at that dominance -- with mobile phones leading the charge. Qualcomm, Freescale, Marvell and Texas Instruments Inc. are using chip technology developed by ARM Holdings Plc. By 2013, the number of phones regularly being used to access the Web will exceed 1 billion for the first time, a fivefold increase from 2006, according to Framingham, Massachusetts-based IDC. Over the same time period, the number of Internet-connected PCs will rise to 1.6 billion from 754 million, according to IDC.

IBM May Not Be the Patent King After All No one beats IBM (IBM) on patents. For 17 years running, Big Blue has been granted more U.S. patents than any other applicant, raking in an ­unprecedented 4,914 in 2009. That tally is more than the number of patents granted last year to Microsoft (MSFT), Hewlett-Packard (HPQ), Oracle (ORCL), Apple (AAPL), Accenture (ACN), and Google (GOOG) combined. IBM's worldwide portfolio now covers more than 40,000 inventions for everything from microprocessors for video games to the ­erasable read-write CD. Nonetheless, a study conducted for Bloomberg BusinessWeek by Ocean Tomo, a Chicago intellectual property consulting firm, concludes that IBM's collection of U.S. patents over the past five years ranks only eighth in value. No. 1 is Microsoft, which ranked third, with 2,906 patents issued last year. "The arms race approach doesn't pay off," says Mark Chandler, general counsel of Cisco Systems (CSCO). "It doesn't do you a lot of good just to have a lot of patents." IBM may be shortchanging itself, according to the Ocean Tomo study. To determine the firepower of companies' patent portfolios, the consulting firm analyzed five years of patents awarded to the world's 1,000-largest public companies by revenue. Among the dozens of measuring sticks Ocean Tomo used to judge the significance of a company's breakthroughs were the number of prior patents cited, patent renewal payments, and litigation. In all, Microsoft's portfolio was assessed at 3.3 times that of IBM's. "This is something that IBM people won't accept, but it's accurate nonetheless," says Steve Lee, president of Ocean Tomo's patent-rating division. He says IBM's portfolio includes a large number of service-related patents, which do not command as high a price as the video-game and software patents that heavily weigh in Microsoft's portfolio.

Comcast-NBC gives regulators a key opportunity Normally, I'm rather skeptical about mega-mergers -- more often than not, they wind up reducing competition without creating anything in the way of value for shareholders. I'm even more skeptical about mega-mergers that involve monopolists, which is how most cable companies started out in life, as holders of exclusive local franchises that, like broadcast licenses, became licenses to print money. So it is particularly strange that I now find myself rather indifferent about the news that Comcast is buying up NBC Universal. To begin with, rather than combining two companies that are head-to-head competitors, this deal combines companies that are located at different points of the value chain. NBC is primarily a producer of video content -- TV news and entertainment programming, along with movies from its Hollywood studio -- while Comcast is primarily a distributor of such content, most of which it buys from somebody else.

Posted by dblwyo at 03:24 PM | | Comments (0)

January 13, 2010

Pecora 2 Hearings, Malfeasances, Your Future & Cusp Points

The Financial Crisis Inquiry Commission (FCIC), or Pecora 2, kicked off its hearings this morning with quick statements from the chair and vice, testimony from the heads of 4 of 5 of the big banks, a second panel from several investment banker/analysts with strong criticisms and an afternoon panel from four banking/economic/housing experts.

Frankly the hearings so far are stunning - intelligent, polite, informed, limited axe-grinding by the commissioners (with some exceptions), almost no ideology and a strong bi-partisan spirit of inquiry, digging into the data and understanding. In just today's hearings (which we intended to listen to only for the kickoff but ended up getting sucked into for the whole day mostly) we heard the entire crisis reviewed, most of the major root causes id'd and the last two years of back and forth raised, reviewed and either put too bed or confirmed. By and large the preliminary indicators are that our assessments align with the Commission's and the witnesses.

Just to set the stage however we'll start you off with a recent show from Bill Moyer's Journal on PBS where an editor and a report for Mother Jones discuss their findings for why there's been such a delay in moving forward with reform and how the Industry has influenced things. If you find your blood pressure rising that was and is the intent. Perhaps the most interesting thing was that all the big bankers started off, stayed with and finished up with Mea Culpas and fairly forthright discussions of what went wrong (the most intransigent and argumentative being Blankfein of GS, who more than got into it with the Chair).

 

Where We're At: Impacts and Current Status

Let's start with some charts taken from Mark Zandi, of Economy.com, testimony. Zandi by the way is well respected on both sides of the aisle, was an advisor to McCain and has a reputation for even-handedness.  Starting in the UL corner he tell us that after a near-collapse that government intervention has stabilized the financial markets (under questioning he stated that the Stress Tests this last spring were THE major turning point). At the same time he also said that the markets are far from healthy, using (UR) the bond markets and the level of debt issuance as the critical indicator.

He then went on to point out that it was almost entirely the stimulus package that saved the economy per se from greater collapse and that many of the programs had large and beneficial effects, leading to an estimate of 4% GDP growth in Q4. Yet also worried that the as the impact fades the risks of a W-shaped outcome are serious and would recommend another $200B stimulus follow-on (again, this from a McCain advisor). He also pointed out that (LL) the labor markets were damaged and recovering poorly and would remain in trouble for a long time. Since all that lines up with everything we've been saying for months we thought it was profoundly insightful :)!

What Broke - the Analyst's Perspectives

Interestingly, despite differences in perspective (and one commissioner with an ideological axe to grind) all of the witnesses basically agreed to the same set of problems and breakdowns. Since one of them (Michael Mayo of Calyon Securities) was kind enough to provide charts to back up his diagnosis we borrowed a subset to create this composite. (all the exhibits can be downloaded from the FCIC's web site at www.fcic.gov) Starting in the UL corner he first pointed out that there was an explosion of securities in the 00's AND that the Asset/Equity ratios of the Banks and Securities firms exploded;i.e. they got themselves leveraged to a fare-thee-well (really interesting despite the roots lying in the 80s this didn't explode until this decade).

Moving down the left column that much of that issuance moved from secure instruments to structured products and that this financial engineering drove a huge surge in fees. No self-interest here of course. Moving to the righthand column we see the concentration of this new issuance in real estate trading in one form or another, in which btw, consumers, et.al. were complicit as well - since consumer debt also exploded. The real money chart is the last in the lower r.h. corner - which tells you what happened to compensation in the Finance industry vs. the rest of the economy. So there you have it - graphic testimony to malfeasant greed run amok taking the innovative technology of securitization and metastasizing it this decade to drive fees, profits and bonuses. And, oh yeah, almost collapsing the world. Again - in so many words - everybody including Blankfein, Dimon, Mack and Moynihan (BAC), basically conceded all these points (and a good thing it was the new guy and not Lewis testifying).

The Long-term Strategic Impacts

So what are the long-term consequences? Well if you read our year/decade outlook on the economy, markets and business you've got one set of answers. But we'll go back to Mr. Zandi for his take - remember this is under oath btw. 

Well Mark sees it pretty much as we see it - though if anything he's even gloomier, though he put it more simply and clearly perhaps; and talked more about long-term debt and savings. Nonetheless coming from very different directions we ended up with identical conclusions. 

First off (UL) Consumers took a huge shot to their Net Worth that they will likely never recover and which will cause fundamental long-term damage. Which you can see in the Confidence charts (UR) for businesses and consumers - which despite improvement are still worse than at any time this data shows (NB: the spokesman for regional/community banks said something similar in his own words).

The two really sad, scary and critically important factors are the long-term structural impacts. In the LR you can see the estimate of the long-term impact on GDP growth rates - we're going to be hamstrung for a long time. And in the LL you can what kind of debt financing problem we got saddled with and will take a long time to work out of.

In the readings below we have a very long accumulation of excerpts leading up to the hearings, setting out the background, some diagnosis and recommended resolutions and the impacts. The Commission is chartered to take the year to to reach its conclusions but this will indeed be the year of re-regulation in several forms or the other. 

The Hearings and the Assessment

There's been an enormous amount of criticism of the Administration and Congress for not moving faster on all this to quickly and magically fix it. Of course that's how we got into these problems and the original Pecora Commission didn't reach its end and see new legislation for almost four years. There was plenty else to do this year which should have and did preclude starting hearings on this matters. At the same time now people both have some perspectives and we've seen the Industry's true colors. All in all we don't think things could be better positioned for as good an investigation and re-think as we're ever likely to see. CSpan is carrying the hearings live and also putting them up on its web site. It's at least worth some of your time to listen to the openings (if the Chairman and Vice's statements are on this) but we felt encouraged from the get go, and more so as thing proceeded. This is as qualified a group of public servants as you're likely to get, even considering the political process that brought them there.

During the course of the hearings Zandi summarized the "root causes" in three points:

1) a worldwide excess of savings which created a sloshing surfeit of liquidity that drove down returns and caused people to go crazy looking for any advantage (something we remember saying a few times going back to '03).

2) the over-use and over-exploitation of securitization combined with absolutely terrible under-writing and diligence

3) and a failure of regulation.

He and several others added a fourth multiple times thruout today's hearings as the real root of the root - HUBRIS!

But we'll add a fifth that is the Alpha and the Omega, the ultimate AUM (OM): the failure of corporate governance and performance management. In legal doctrine there is the notion of last clear chance to avert a disaster - well the people who had the first and last chances and who had the fiduciary duty to do so were the executives in charge. And the man who stepped up to that admission was Jaime Dimon, strongly seconded by John Mack.

There were lots of factors, lots of mechanical breakdowns, a triumph of greed and some really terrible regulatory decisions. But the ultimate failure was a mangement failure - opting for malfeasant choices, in both the private and public senses, in the service of greed. Synthetic derivatives were merely the enabler, or one among many.

The results of these hearings are going to frame your life and those of you descendents for decades, just as the originals did. And just as the failures of Financial leadership already have. Like we keep trying to say - the Industry as people keep trying to analyze it ain't coming back!

======================================================================

Level-setting: Heading into the Hearings

For Top Bonuses on Wall Street, 7 Figures or 8? The bank bonus season, that annual rite of big money and bigger egos, begins in earnest this week, and it looks as if it will be one of the largest and most controversial blowouts the industry has ever seen. Bank executives are grappling with a question that exasperates, even infuriates, many recession-weary Americans: Just how big should their paydays be? Despite calls for restraint from Washington and a chafed public, resurgent banks are preparing to pay out bonuses that rival those of the boom years. The haul, in cash and stock, will run into many billions of dollars. Industry executives acknowledge that the numbers being tossed around — six-, seven- and even eight-figure sums for some chief executives and top producers — will probably stun the many Americans still hurting from the financial collapse and ensuing Great Recession.

No Seat for Wall Street at Tea Party Could all those populist pitchforks currently pointed at Washington be turned toward Wall Street instead? That's the question that ought to worry Wall Street executives as they prepare to pay themselves nice bonuses this month, hard on the heels of a government bailout of the financial system, and amid continuing job losses around the rest of the country. Financial firms know they're in for heat on bonuses; they've already been chastised on national TV by President Barack Obama's chief economist. The more searing heat, though, might come not from Washington's corridors of power but from the streets, where disjointed populist armies are starting to organize in the so-called tea-party movement. It's a movement dominated for the moment by mistrust of big government and big government health-care plans. But it's also animated by mistrust of big institutions in general, and a tendency to see those institutions secretly working in tandem to the detriment of the little guy. So it's a short leap from anger at Washington's spending of taxpayer dollars to anger at Wall Street executives saved by those same taxpayer dollars -- and then taking home big bonus checks. Right now, Mr. Phillips notes, Wall Street bonuses aren't the top item in the broad tea-party tent. Most available oxygen is being sucked out by anger over health care. But talk of more economic-stimulus measures surely would revive anger over financial bailouts, he adds. Indeed, anger over Wall Street bailouts was in many ways the spark that brought the tea-party movement to life.

The Other Plot to Wreck America What we don’t know will hurt us, and quite possibly on a more devastating scale than any Qaeda attack. Americans must be told the full story of how Wall Street gamed and inflated the housing bubble, made out like bandits, and then left millions of households in ruin. Without that reckoning, there will be no public clamor for serious reform of a financial system that was as cunningly breached as airline security at the Amsterdam airport. And without reform, another massive attack on our economic security is guaranteed. Now that it can count on government bailouts, Wall Street has more incentive than ever to pump up its risks — secure that it can keep the bonanzas while we get stuck with the losses. It’s against this backdrop that this week’s long-awaited initial public hearings of the Financial Crisis Inquiry Commission are so critical. This is the bipartisan panel that Congress mandated last spring to investigate the still murky story of what happened in the meltdown. Phil Angelides, the former California treasurer who is the inquiry’s chairman, told me in interviews late last year that he has been busy deploying a tough investigative staff and will not allow the proceedings to devolve into a typical blue-ribbon Beltway exercise in toothless bloviation. He wants to examine the financial sector’s “greed, stupidity, hubris and outright corruption” — from traders on the ground to the board room. “It’s important that we deliver new information,” he said. “We can’t just rehash what we’ve known to date.” He understands that if he fails to make news or to tell the story in a way that is comprehensible and compelling enough to arouse Americans to demand action, Wall Street and Washington will both keep moving on, unchallenged and unchastened.

Bank Profits Tripling Leaves Stocks Cheapest With 15% Discount to S&P 500  No U.S. industry has faster profit growth than banks and brokers, and no group is more hated by investors. Analysts say earnings at financial companies rose 120 percent in the fourth quarter, accounting for all of the income increase in the Standard & Poor’s 500 Index, and will triple by 2011, climbing four times as fast as the market. Should the estimates prove correct, the shares are trading at a 15 percent discount to the index, data compiled by Bloomberg show. That’s not enough for money managers burned by the 84 percent drop in the stocks from February 2007 through March and more than 160 U.S. bank failures in the past two years. Financial companies are the least-favored equities, according to a Bank of America Corp. survey of investors with $617 billion in assets that showed 38 percent of 123 money managers are holding fewer shares than are in benchmark indexes. Net interest margin, the difference between what banks earn from loans and pay to depositors, may widen to 3.54 percent in 2010, the highest level since 2003, according to forecasts for the 173 lenders followed by New York-based KBW Inc. That may not last, according to Baring Asset Management Inc.’s Hayes Miller, who recommends holding fewer shares of U.S. banks before Fed Chairman Ben S. Bernanke winds down emergency programs to damp concern inflation will accelerate as the economy picks up.

Bank CEOs: We Underestimated Crisis Wall Street executives said Wednesday they underestimated the severity of the 2008 financial crisis and apologized for risky behavior and poor decisions. They also defended their bonus and compensation practices to a skeptical commission investigating what caused the collapse. Americans are furious and "have a right to be" about the hefty bonuses banks paid out after getting billions of dollars in federal help, the commission's chairman told chief executives of four major banks, all survivors of the deepest and longest recession since the Depression. As the hearings opened before the Financial Crisis Inquiry Commission, chairman Phil Angelides pledged "a full and fair inquiry into what brought our financial system to its knees."The panel began its yearlong inquiry amid rising public fury over bailouts and bankers' pay. "We understand the anger felt by many citizens," said Brian Moynihan, chief executive and president of Bank of America. "We are grateful for the taxpayer assistance we have received."

  • Wall Street CEOs Admit Missteps  Wall Street's biggest banks acted like used-car salesmen knowingly selling lemons to consumers, the head of a commission investigating the financial crisis said Wednesday, as top bank executives came under fire on Capitol Hill. Former California State Treasurer Phil Angelides kicked off the first of two days of hearings with an aggressive exchange with Goldman Sachs Group Inc. Chairman and Chief Executive Lloyd Blankfein, suggesting the investment bank was not taking responsibility for its actions in the lead up to the crisis. Mr. Angelides said he was not trying to make Mr. Blankfein "say 'uncle,' " but the two clashed for roughly 10 minutes, frequently interrupting and speaking over one another. Mr. Blankfein at one point said, "Let me ask you a question"--a breach of etiquette in congressional hearings --before being drowned out by Mr. Angelides.

Bubbles and the Banks Why did the bankers take on so much risk? Because it was in their self-interest to do so. By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem. Of course, that conflict of interest is the reason we have bank regulation. But in the years before the crisis, the rules were relaxed — and, even more important, regulators failed to expand the rules to cover the growing “shadow” banking system, consisting of institutions like Lehman Brothers that performed banklike functions even though they didn’t offer conventional bank deposits. The test for reform, then, is whether it reduces bankers’ incentives and ability to concentrate risk going forward. Transparency is part of the answer. Before the crisis, hardly anyone realized just how much risk the banks were taking on. More disclosure, especially with regard to complex financial derivatives, would clearly help. Beyond that, an important aspect of reform should be new rules limiting bank leverage. I’ll be delving into proposed legislation in future columns, but here’s what I can say about the financial reform bill the House passed — with zero Republican votes — last month: Its limits on leverage look O.K. Not great, but O.K. It would, however, be all too easy for those rules to get weakened to the point where they wouldn’t do the job. A few tweaks in the fine print and banks would be free to play the same game all over again. And reform really should take on the financial industry’s compensation practices. If Congress can’t legislate away the financial rewards for excessive risk-taking, it can at least try to tax them.

Breakdowns, Reactions, Breakages and Consequences

Bubbles & Banks & Zero Lending Standard Loans I disagree with many of my colleagues as to where the bubble actually was. I believe we did not have a national Housing bubble; rather, what we had was a national Credit bubble. (Understanding the difference becomes important, as you shall see shortly). And while much of the country had a housing boom, only a few areas — notably, SoCal, Las Vegas, Arizona and S. Florida — were full blown housing bubbles. But that is a relatively minor quibble. Without the explosion of subprime, but with ultra low rates, we very likely would have seen a rise in housing prices, followed by a plateau. But it would not have been nearly as severe relative to historic price relationships (as an example, median income to median home price). What the newfangled lend-to-securitize subprime model did, however, was to bring millions of previous non-buyers — people otherwise known as renters — into the housing market. On top of the rise in prices caused by 1% Fed Funds rates (~6% mortgages), this added an additional level of pricing destabilization to the Real Estate market.This is evident in the charts I’ve shown again and again: Median income to median home price; cost of renting to ownership; Housing stock as a percentage of GDP — all of these showed a housing market  several standard deviations above its historic pricing mean. With that in your mind, consider how this sub-prime driven boom played into the securitization market, and eventually the Derivatives market (CDOs, CDSs, etc). Look at the 10 steps detailed here on Monday regarding the forming of the credit crisis. The inevitable conclusion is that sub-prime was a major driver of not only the Housing boom and bust, but of the entire financial crisis and credit freeze, and the subsequent bailouts . . .Could it have been prevented? Only if the Fed would have enforced traditional lending standards, i.e., the borrowers ability to service the mortgage. They should have regulated those non-bank lenders whose model was based not upon the borrowers ability to service these loans, but upon the lender’s ability to subseqeuntly sell the loan off top securetizers on Wall Street. So, the answer is yes, appropriate regulation could have prevented the entire mess . . .

The U.S.–and the rest of the developed world–is near the point where debt takes a big bite out of growth So exactly when does a lot of debt for a country such as the United States, Japan, the United Kingdom, Greece or Italy become too much debt? The threshold is when government debt rises above 90% of national GDP, economists Carmen Reinhart and Kenneth Rogoff argue in a paper headed for publication in the American Economic Review. After looking at data from 44 countries spanning 200 hundred years, they’ve concluded that at ratios of debt to GDP up to 90% there’s not much correlation between government debt and economic growth. Above 90%, however, median economic growth rates fall by one percentage point and average economic growth rates fall by about four percentage points. That makes the 90% level a kind of make-or-break point for countries that are hoping to grow their way out of debt. If the government debt load climbs above 90% of GDP, economic growth slows so much that growth is no longer a viable solution to reducing government debt. Above that 90% level, governments serious about reducing their debt load have to increasingly rely on “solutions” such as reducing wages and depreciating their currency that might over time increase global economic competitiveness enough to give a boost to national economic growth. In the short to medium term, however, these “solutions” inflict real pain on the citizens of the country since they reduce standards of living. The scary thing about Reinhart and Rogoff’s conclusion is how close the United States and other major developed world economies are to the 90% cut off thanks to the global financial and economic crisis.

So where’s the growth supposed to come from? People who don’t have jobs don’t run up their credit card balances. Not much of a surprise. But in November it added up to a record 14th straight monthly drop in credit card debt. Today, January 8, the Federal Reserve reported that credit-card debt fell by $13.7 billion in November. Total seasonally adjusted consumer debt fell $17.49 billion. That’s equal to an 8.5% annual rate of decline. The drop in total consumer debt was far larger than the $4 billion that economists had been expecting.The consumer debt numbers lag behind such economic indicators as unemployment by about a month. But the December unemployment numbers, also released today, argue that the December consumer debt numbers will continue to show that consumers are cutting back (or that banks are cutting back for them by reducing credit lines.) Nonfarm payrolls fell by 85,000 in December. Official unemployment held steady at 10%, average hourly earnings climbed by 0.2%, and average weekly hours worked held at 33.2. The “real” unemployment rate, which counts discouraged workers and those working fewer hours than they want, rose slightly to 17.3% from 17.2% in November. Most of the job loss came in the goods-producing sectors of the economy where construction employment fell by 53,000 and manufacturing jobs dropped by 27,000. Jobs in the service sector fell by just 4,000.The bad news in these two reports is obvious. The consumer sector of the economy, which makes up about two-thirds of all economic activity, isn’t showing signs that it will produce strong growth in 2010. And manufacturing activity, which had looked strong in recent surveys, suddenly seems suspect.

Shift Seen in Investment Banks' Revenue Investment banks stand to earn up to a fifth less in fixed income, currencies and commodities revenue this year than they did in 2009, as the conditions that allowed them to book record profits in the aftermath of the financial crisis dissipate and lower-margin advisory work returns to the fore. Analysts at Citigroup are predicting banks' revenues from FICC will fall by between 15% and 20% globally in 2010 from around $190 billion last year to between $150 billion and $160 billion. As a result they estimate FICC will contribute 16% of total revenue this year, compared with 21% last year. Banks with strong FICC platforms benefitted from unusually benign conditions in the aftermath of the financial crisis, but declining volatility, tightening bid/ask spreads and increased competition are forcing profitability back to 2006 levels. Among big banks, UBS AG made 13% of its revenue from FICC in 2009, Credit Suisse Group AG was at 35%, while Goldman Sachs Group Inc. was at more than half, according to the Citigroup report. Citigroup analysts predict banks' revenues from currencies business will be down by a quarter, as will revenues from interest rates, while revenues from mortgages will be down by a fifth. In credit, tighter bid/ask spreads will be largely offset by greater opportunities in high yield, distressed and structured credit, leaving income likely to remain flat or slightly down. Commodities could enjoy a 5% to 10% improvement as investor appetite for risk assets returns. On the flip side, revenues from advisory and equities work are expected to pick up as confidence creeps back to the market. Ironically, banks that came in for criticism for failing to gear up and capitalise on the FICC boom, could be among the major beneficiaries of the expected shift.

Repaying U.S. and Reaping Bounty in Fees Here comes another payday on Wall Street, just in time for the holidays. No, I’m not talking about the big bonuses you’ve been reading about already. I mean a new one, courtesy of companies like Citigroup, Wells Fargo and Bank of America returning their federal bailout money and raising new capital to replace it. And that means big fees for all the banks that will hawk these new shares for themselves and their rivals. More than $50 billion of new capital was raised as part of the effort by the biggest banks to repay the money from the Troubled Asset Relief Program and get out from under the thumb — and pay caps — of Washington. All told, December was the biggest month in history for offerings, according to Thomson Reuters. Here’s what the post-bailout bonanza means for all the banks that helped find investors for the new shares: Bank of America’s $19.3 billion offering generated $482 million in fees; Citigroup’s $17 billion offering resulted in $425 million in fees; and Wells Fargo’s $12.2 billion offering led to $275.6 million in fees.

Why Aren’t Banks Lending? They Are Being Rational  President Obama met with a dozen small banks yesterday, urging them to keep lending. He did not have to tell that to this group — about 6500 mostly AAA rated, regional and community banks — who have been happily lending away. Its how they earn their money. The larger banks, on the other hand, are the ones who have cut back lending dramatically. This is especially true of the 10 biggest banks. Why? Its the rational thing to do. These banks STILL have to much debt, too little capital. They books are festooned with bad loans, which, thanks to our corrupt Congress, they no longer have to disclose appropriately. Thanks to Mark-to-Make-Believe, they can pretend these assets are worth near what they paid for them. In reality, they cannot sell them even at 50% off. Lending money is a risky business; there is the possibility of loss. Under-capitalized banks cannot take that chance. By not lending, their capital base goes up. IT is the rational thing to do from their perspective. Rather than engage in traditional money lending, these banks have decided to simply borrow from the Fed at 0%, and make risk free loans to the Treasury at 3%. And, these banks are not lending because the way the Fed/Treasury bailouts were structured, they are encouraged NOT TO LEND. Why? They need to rebuild their capital levels after 30 years of declining safeguards and capital ratios. This is yet another unintended consequence of bailing reckless bankers from their folly. Theior oplace in the economy is so distorted, as to become nearly economically meaningless.

Banks Bundled Bad Debt, Bet Against It and Won As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits. Goldman’s own clients who bought them, however, were less fortunate. Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm. Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment. Profits in a Crisis: Graphic

A Bank Idea, With Ancient Roots, for Helping Small Businesses To this day, Bart Mitchell is not entirely sure he knows what a merchant bank is. “I guess I think of it as the old-fashioned banker who takes the time to listen to his customer’s needs and help them solve their problems,” he said. (Actually, that is not far off.) One thing he is certain about is that if not for Next Street, a four-year-old, 22-employee merchant bank with offices in Boston and New York, his development company would have been in big trouble. It is a common refrain for Next Street clients, by and large established businesses with $5 million to $50 million in annual revenue. The chief executives of these companies, which include a Boston-area moving business with as many as 400 seasonal employees, a major supplier of refurbished toner cartridges, and a manufacturer of truck batteries that meet California’s stringent new idling restrictions, report that Next Street fills a vital role for their organizations. More than one has said that its blend of Fortune-500-level advice and access to sophisticated financing could be a solution to the small-business credit squeeze threatening to derail the economic recovery. That is what makes Next Street intriguing: It may be the only small-business merchant bank in the country.

Addressing the Problem

When Greed Is Not Good When economists first heard Gekko's now-famous dictum, "Greed is good," they thought it a crude expression of Adam Smith's "Invisible Hand"—which is one of history's great ideas. But in Smith's vision, greed is socially beneficial only when properly harnessed and channeled. The necessary conditions include, among other things: appropriate incentives (for risk taking, etc.), effective competition, safeguards against exploitation of what economists call "asymmetric information" (as when a deceitful seller unloads junk on an unsuspecting buyer), regulators to enforce the rules and keep participants honest, and—when relevant—protection of taxpayers against pilferage or malfeasance by others. When these conditions fail to hold, greed is not good. Plainly, they all failed in the financial crisis. Compensation and other types of incentives for risk taking were badly skewed. Corporate boards were asleep at the switch. Opacity reduced effective competition. Financial regulation was shamefully lax. Predators roamed the financial landscape, looting both legally and illegally. And when the Treasury and Federal Reserve rushed in to contain the damage, taxpayers were forced to pay dearly for the mistakes and avarice of others. If you want to know why the public is enraged, that, in a nutshell, is why. American democracy is alleged to respond to public opinion, and incumbents are quaking in their boots. Yet we stand here in January 2010 with virtually the same legal and regulatory system we had when the crisis struck in the summer of 2007, with only minor changes in Wall Street business practices, and with greed returning big time. That's both amazing and scary. Without major financial reform, "it" can happen again.

Looking for Fairness In Wall Street Bonuses To put it mildly, it would not be a catastrophe if some of these people had to downsize, a fate they so readily inflict on companies they take private. But let's be realistic: they're not going to do it voluntarily. There are only three entities that have real power over how financial industry employees are compensated: the government, shareholders and customers. Reform proposals currently under consideration in Washington attempt to address structural issues that contributed to the recent financial crisis, but do almost nothing about Wall Street pay. I've written before about steps that, in my view, would address the worst sources of outrage (for example, banning guaranteed bonuses) while preserving incentives and competition. But now something potentially much worse might arise in Congress, which, in the wake of last year's American International Group payouts, demonstrated a willingness to impose a 90% tax on some bonuses (subsequently rescinded). With Britain and France pushing for draconian bonus taxes, pressure is building and a new fee levied on banks is under consideration. I believe such a step is heavy-handed, too simplistic and a potentially dangerous precedent for any other temporarily out-of-favor sector. Shareholders are a far more potent source of reform, since they own these companies, at least the publicly traded ones. Customers also need to exert their considerable leverage. This won't do anything about revenues from proprietary trading, where the firm is its own client. But they can certainly help rein in exorbitant fees. At the same time, reform is in everyone's interest. For bonus recipients themselves, it will quell calls for even worse sanctions. For shareholders, it should boost profits and share prices, which will also benefit all those employees being paid in stock. For the public at large it should restore some sense that people being paid large bonuses actually deserve them.

Financial Crisis Inquiry Commission set to Meet Maybe they will take suggestions and questions. My first suggestion is they start by interviewing - in private - the field examiners at the Fed, FDIC, OCC and OTS. There is no need to publicly embarrass any examiner. The various Inspector General reports on bank failures would provide a starting point (see Eric Dash's article in the NY Times: Post-Mortems Reveal Obvious Risk at Banks). Ask the examiners what they saw and when - according to the Inspector General's reports, the field examiners were warning about lending problems in 2002 and 2003. Follow the trail. Did this information generate warnings inside the organizations? If so, why wasn't action taken? Was the action blocked by political appointees? And how would the proposed regulatory reform lead to a better outcome? And a quote from Eric Dash's article: “Hindsight is a wonderful thing,” said Timothy W. Long, the chief bank examiner for the Office of the Comptroller of the Currency. “At the height of the economic boom, to take an aggressive supervisory approach and tell people to stop lending is hard to do.” If the lending was risky, telling them to stop was the regulators job. How does reform fix this? The good news is Brooksley Born is on the commission, and I think she will do an excellent job.

In 2010, Year of the Regulator If 2008 was the year an old era passed, 2010 will be the year the new one begins. In this new era, banking, insurance and trading are regarded as much as potential contagions as essential economic activities. A recently passed House bill and pending Senate proposal instruct the government to monitor the system for overall risk, essentially quarantining financial institutions that threaten others. After near-collapse and a taxpayer bailout, the financial industry has little public room to protest much of the changes designed to thwart systemic failure.

Refocus the regulatory debate on essentials There are a variety of means by which a fundamental restructuring of banking can be accomplished. The aim is to ensure, on the one hand, that institutions enjoying access to central bank windows and where deposits are governmentally insured operate in the safest manner, in the full interest of those whose deposits they take and whose businesses they provide with credit; and, on the other hand, that institutions engaged in speculative trading are subject to the vagaries and risks of the marketplace, subject of course to a precautionary range of regulations. So far, politicians and regulators have ignored the fundamental issues, pursuing quick fixes rather than challenging the status quo. However, I do not believe it is too late to reopen the debate. We must start with fundamentals and the core interests of the public if we are to ensure that we will not stand condemned in the future for failing to learn from the mistakes of the past.

How to make the bankers share the losses Bankers were paid when the risks they took paid off, but were not penalised when their bets went sour. Since it can take years to be certain that bank risks are profits or losses, it proved too easy for them to take the cash on short-term gains but to have no responsibility for the consequences of their actions years later. There has been a proliferation of plans to fix this structural weakness of the banking system. But politicians and regulators have overlooked a really simple solution. Why not design a limited-liability model, where bankers become personally liable for the cumulative amount of their bonuses? Bankers who wish to receive a bonus above a threshold (say £50,000, or twice average earnings) would become personally liable for the amount of the bonus for a period, perhaps 10 years. They would sit between equity holders and other creditors of the bank – and so would be called upon should any bank find that its equity capital is wiped out by losses. In practice, this would mean their liability would be triggered by a government or other (private sector) rescue. If there turned out to be no rescue, then they would be liable to the liquidator. If there were a rescue, the rescuer would pay over support monies, and then reclaim them from the limited-liability bankers. The bankers would be released from this liability over time, but of course with every new bonus payment they would incur a new liability. By this mechanism, all senior bankers would have a rolling portfolio of liabilities to the extent of the cash they had taken out of the bank in bonuses. The tax treatment would have to be dealt with; I suggest the liability should be the amount of the pre-tax bonus, but if called, the banker would receive tax relief on any repayment. Bankers would have to be prevented from transferring substantial assets out of their own names until the liabilities were expunged, and would also have some residency and other restrictions to prevent them escaping their liabilities.

Too Big to Jail MAYBE WALL STREET should open a casino right there on the corner of Broad, because these guys simply cannot lose. After kneecapping the global economy, costing millions their homes and livelihoods, and saddling our grandchildren with massive debt—after all that, they're cashing in their bonuses from 2008. That's right, 2008—when amid the gnashing of teeth and rending of garments over the $700 billion TARP [1] legislation (a mere 5 percent of a $14 trillion [2] bailout; see "The Real Size of the Bailout [3]"), humiliated banks rolled back executive bonuses. Or so we thought: In fact, those bonuses were simply reconfigured to have a higher proportion of company stock. Those shares weren't worth so much at the time, as the execs made a point of telling Congress, but that meant they could only go up, and by the time they did, the public (suckers!) would have forgotten the whole exercise. It worked out beautifully: The value of JPMorgan Chase [4]'s 2008 bonuses has increased 20 percent to $10.5 billion, an average of nearly $6 million for the top 200 execs. Goldman [5]'s 2008 bonuses are worth $7.8 billion. And why are bank stocks worth more now? Because of the bailout, of course. Bankers aren't being rewarded for pulling the economy out of the doldrums. Nope, they're simply skimming from the trillions we've shoveled at them. The house always wins. Indeed, 2009 bonuses are expected to be 30 to 40 percent higher than 2008's. And don't forget AIG [6], which paid the same division that helped cook up collateral debt obligations and credit default swaps "retention bonuses" worth $475 million, in some execs' cases 36 times their base salaries. As anyone who watches Dog Whisperer [7]knows, rewarding bad behavior produces more of the same—so it's no surprise that Wall Street is back to business as usual. Derivatives are still unregulated (thanks, Congress!), exotic sliced-and-diced securities are being resliced and rediced, and the biggest offenders in peddling subprime mortgages? They are raking in millions in federal grants to—wait for it—fix subprime mortgages. And the worst part? These fat-cat recidivists don't even have the decency to fake contrition. The New York Times' Andrew Ross Sorkin [8] says that whenever he asked Wall Street CEOs "Do you have any remorse? Are you sorry? The answer, almost unequivocally, was no."

FCIC (Pecora 2) Hearings and Implications

That 1930s show THE battle against the financial crisis may be ending, but the war over why it happened has barely begun. The most ambitious effort yet to settle the story begins next week with the first hearing of the Financial Crisis Inquiry Commission.Congress gave the ten-member bipartisan commission a sprawling mandate: to investigate at least 22 potential causes, from excess global savings to short-selling, and to explain why specific firms collapsed or needed bail-outs. The report, due by December 15th, is not supposed to contain recommendations but probably will. Though modelled on the body that investigated the attacks of September 11th 2001, the spiritual father of this venture is the Pecora Commission. This was named after Ferdinand Pecora, the chief lawyer on the Senate Banking Committee from 1933 to 1934. His cross-examinations brought forth revelations of widespread abuses on Wall Street: bankers selling stocks at preferred prices to powerful friends, or giving executives bonuses for dumping dud securities on the public. Within days of testifying, the head of National City Bank, the predecessor of Citibank, was forced to resign. The commission’s findings led to the creation of the Securities and Exchange Commission and the passage of the Glass-Steagall Act, which separated commercial and investment banking. Bankers could be in for another public stoning. The heads of JPMorgan Chase, Goldman Sachs, Morgan Stanley and Bank of America will appear at the commission’s first public hearings on January 13th and 14th. Regulators and independent experts will also testify. Tim Geithner, the treasury secretary, and Ben Bernanke, the Federal Reserve chairman, have already appeared before the commission privately and should do so publicly later. The commission, chaired by Phil Angelides, the Democratic former treasurer of California, is unlikely to make as big a stir as Pecora’s. Journalists, prosecutors and Congress have already produced a stream of exposés of the crisis. Most of the star witnesses have been grilled elsewhere already. The Obama administration hopes its own regulatory overhaul will be done before the commission even reports. Yet the commission seems bound to uncover some salacious wrongdoings that will shape future reforms. Mr Angelides was a perennial thorn in the side of business, using California’s state pension plan to browbeat bosses of firms he disapproved of, and he retains a dim view of Wall Street. “In 1929, people were throwing themselves out of windows; in 2009, they were lining up for bonuses,” he says. A staff of up to 50 will interview hundreds of witnesses. Reluctant ones will be subpoenaed. While national security required the 9/11 commission to keep private much of what it learned, Mr Angelides and his Republican vice-chairman, Bill Thomas, want to post their findings on the web immediately. If their final report is half as readable as the 9/11 one, it, too, should be a bestseller.

Pecora Commission

Top Risk No. 4: U.S. financial regulatory reform But the exception is in the process of financial regulatory reform. That's likely to be a tougher issue than people expect. The reform package that passed the House of Representatives is comprehensive, though it will be moderated in the Senate, where for the first time under Obama a serious bipartisan effort is being undertaken. Either way, substantial change is afoot -- more far-reaching than anything we've seen since the Great Depression. The result will be a structure put in place to monitor and address systemic risk, largely self-financed from the financial community, as well as changes on many other issues, ranging from derivatives regulation to the proper role of the Federal Reserve Bank. Unlike cap and trade or immigration reform, there's a very high likelihood that comprehensive financial regulatory reform will pass. But with mid-term elections approaching, it's likely to turn populist and lose a considerable amount of its bipartisan flavor. But while Obama's economic team will be wary of populist measures, Democrats in Congress and the president's own political advisors will see such measures as a necessary piece of "mobilizing the base" before mid-term elections. Big banks are an easy target, especially in the context of high profits and a strong recovery for the financial markets, but a weak overall economic rebound. The legislation should pass by late spring. Regulators will be given significant new discretionary powers, including some authority for breaking up institutions deemed a systemic risk. A key risk is that, depending on the political environment, the newly empowered regulators could use their capabilities to issue strict rulings that go well beyond what is specifically included in the legislation. Regulators will also likely issue proposals for revising capital requirements upward next year. Another key risk to watch will be efforts to impose further fees and taxes on the financial system. With the U.S. government running record deficits in the wake of the financial crisis, trying to recoup these costs from the financial services industry will be seen as a relatively low-cost political option. Executive compensation is one likely possibility; taxes on carried interest for hedge funds are another.

  • Not All Banks Are Created Alike Any new regulation of the financial industry must distinguish between firms engaged primarily in speculative trading and lenders linked to the real economy of Main Street. The great danger is that regulation of the former might inadvertently strangle the latter.
  • How Overhauling Derivatives Died Lobbying by Wall Street has blunted efforts to step up regulation on derivatives trading by carving out exceptions or leaving the status quo in place.
  • Agencies in a Brawl for Control Over Banks In the darkest days of the financial crisis a year ago, Sheila Bair was hailed for having predicted the housing bust. Today, the chief of the Federal Deposit Insurance Corp. is fighting for her agency's future.Connecticut Democrat Christopher Dodd, the Senate Banking Committee chairman, has proposed revoking almost all of Ms. Bair's powers to supervise banks, as part of a sweeping financial-regulation bill now under consideration in the Senate.

Posted by dblwyo at 06:21 PM | | Comments (0)

January 11, 2010

Active Allocation, Active Investing: Investing Guidelines for Lost Decade #2

Hopefully the last post was useful - in case you didn't know it we had several objectives and key points. The first thing was that we directly challenged the intellectual foundations that lies behind 95% of the investment management principles people have been recommending for three decades (the EMH), which includes much of the misused Wall St. math, much of the theory behind index funds (to a limited extent) and definitely Buy-N-Hold. We hope you took away the fundamental lesson that BnH is so much quackery. At the same time that "indictment" was also not support for much of the arm-waving that passes for "active" investment advice - it's still hard to beat the market and it takes some work and, especially some thought. What we did was lay down the foundations for two Principles and Two Guidelines.

Principle #1 - you need to actively managed your investments.

Principle #2 - you need to invest in those assets where you clearly understand the performance factors.

Guideline #1 - invest in those assets where you are pretty sure that the margin of value over price gives you a margin of safety and a good probability of a decent return.

Guideline #2 - you're going to have to spend some time working at this. Buy and forget will kill you. There's a tradeoff between the amount of risk, the amount of work. NB: we actually did a lot of the work for you by providing a strategic assessment of the Economy, Markets and Business Performance. And by updating and discussing our Four Factor Model.

So the next question is, what do we mean by active and how do you go about? Well you can start by listening to the most recent WealthTrack interview on the outlook for one thing. (WT is one of three goto information sources we're going to suggest you need to monitor frequently).


 

Active Investment Management: Allocation and Asset

Before we dive into our Four Factor Active Management approach we'll point out that this is not the first time we've tried to make some of these points. In fact we did it on this blog a couple of years ago (hence the 4Factor summaries stretching back a ways) and tried it earlier for our network, both with little effect. But we're far from the only voice. Let's quote an excerpt from a WSJ story from 2003, which along with what we think are other must-reads, is in the Readings section after the break.

 But instead of rising to the occasion, I fear Wall Street will once again go for the quick buck, flogging flaky investments and using underhanded sales tactics. Why this pessimism? Unfortunately, many brokerage houses and financial-planning firms just aren't ready for prime time.

 Let's dig into our alternative approach to relying on the paid guidance of advisors (think of it as a kindness from a stranger). Our approach is presented in this graphic, which will be a little complicated in practice. Which will also be up to you.

First off we distinguish four Investor Strategies: Conservative, Moderate, Active and Trader. The differences lie in goals (preserving capital, ability to manage/tolerate risk, and work). The more work you're willing to invest the more active you can afford to be. For each of those four we suggest a long-run portfolio allocation.

Now when we say Active Allocation what we intend is that you're adjusting the % to the four factors at any given time. And, the critical lesson, not even conservative investors can afford not to be active allocators. When we say Active Investing we're talking about digging into asset classes, specific assets and investments and understanding key themes and instruments. If we were going to do a lot more of the work we'd need to build a current allocation recommendation for each timeframe for each investor type. Timeframe is another key thing as well. If you recall each factor tends to play out over different timeframes and, here, we're suggesting that the more active you are the more you need to be adapting in shorter timeframes. At the same time, another fundamental lesson for another Lost (Turbulent) Decade is that everybody needs to be constantly monitoring their investments. Even in the last decade, where a clear trend set in from 2003 to 2007, and you could have gone in and stayed constant for five years or more you need to monitor. With no bubbles in sight, enormous uncertainty and sustained turbulence you need to monitor your investments and the Factors every month and re-validate your strategy, allocation and investments every quarter at least. In the New Normal a quarter is five years and a month could be a year.

Themes and Instruments

Themes and Instruments are key terms. A Theme, as we mean it, is an investing idea that will hold true and drive performance over one or all of the timeframes. Instruments are specific investment types, that is the tool which you use to realize and implement your decision, and you need to have some knowledge of them. Do you pick stocks directly or use a mutual fund? If a fund an index or active fund, or what about an equivalent ETF? If an ETF how about considering inverse ETFs or leveraged ETFs? In general you have to adapt the instrument to the asset - if you've done your Graham-Buffett homework then by all means buy the stock. If you haven't then you need to consider a fund. When you go foreign it's much harder to do the homework so it becomes more feasible to go the fund or ETF route. If you want to go with the big theme you might pick an ETF, for example the emerging markets EEM, or having done some work and paid attention to our earlier writings you'd focus on Brazil of the BRICs and go with EWZ. If you actually listened to the WT clip you got what we think are some excellent themes for the year, and the decade. There's a whole section of WealthTrack recent shows in the readings btw as well as a link to Bob Doll's themes for 2010 and the Decade. We don't entirely agree perfectly with all of them but think everyone make sense.

How might that all play out? Well if we look back to 2003 when at least we had the luxury of clearer trends and lower turbulence we can work an example. A standard portfolio mix is 60% equity and 40% bonds. One could even call it canonical. By late 2006 it was clear that job and GDP growth was falterring which meant, clearer in hindsight of course, that it was time to shift more toward a 40/60 split. Here's another little trick to play - you don't have to be all one investor type or another. You could keep some percent (say 50 or 90) of your investable wealth in the Conservative portfolio and pursue a more active strategy with the rest, blending the two. Anyway, in January 2008 we explicitly recommended to everybody that they get into cash or shorter-term bonds, which would have paid off very well. Especially if you'd been in Treasuries given the surge in prices for low-risk bonds. If you wanted to be more active, and accept more volatility, we strong suggest inverse ETFs, especially for the emerging markets, at the same time. Thru March of 2008 that would have paid off handsomely. Now our assessment of the markets then and since has been pretty pessimistic but one way to deal with that as they turned was to start scaling back in until you reached the appropriate allocation.

One of THE dominant themes for the next decade will be the shift in the world economy, something that Mohamed El-Erian of PIMCO noticed around 2003 when he pointed out that EM bonds were much better investments because for the first time in history the emerging markets were becoming well-run and reliable. But were under-valued and under-priced. Now right now the show is on the other foot - the EM have run to far and too fast, especially China. Which means it's time to reduce your exposure and past.

There's one other major card we've palmed here if you look at the Allocation Table closely - the percentages don't look at all like the standard canonical forms of standard practice. Cliff Asness of AQR investments (again the clip link is in the readings), one of the best hedge fund managers around, has pointed out that what you need to do is diversify but what you really need to do is diversify by risk. Bonds are 1/3 as risky as equities while commodities are 2X as risky. So, for any given situation your Bond:Equity:Commodity allocation should be 3:1:.5, or 60:20:10. We've taken his idea (btw - he has some really interesting comments on which classes have which risks) and applied it so our basic Conservative model follows it but the others accept more risk relative to the baseline. But we've also upped the proportion of offshore assets considerably once things return to normal (recognizing three different domains: US, Foreign (Europe, Jpn) and Rapidly Emerging Economies (REE)).

Timeframes, Themes and Allocations

Now we've got another WealthTrack clip for you, this time with Neill Ferguson (the historian, pundit and pontificator) who's bright, charming, has some major insights but doesn't quite know all about everything quite as he thinks. Nonetheless his sketch of the evolution of a new geo-political order and the impact of debt on long-term growth are well grounded and fairly accurate so we'd second theme.BtW - any trouble with seeing the clip and the BlipTV link for WT is after the break.

Speaking of timeframes and good advice if you put the pieces together,listened to the clips and try to boil it down here's where we end up. The market is getting tired and is due for a correction. If you're conservative now is the time to start shortening up on bonds and building cash. For any investor group now is not the time to be getting in. So as cash accumulates put it into ST Bonds. In fact we've tried to summarize where we think your overall posture ought to be, given an allocation strategy and specific investment decision. In the ST we're suggesting that you move toward cash and ST Bonds. When we say neutral we mean with respect to the target allocation, i.e. work your way back to the % you want and then actively manage your portfolio to maintain it with quarterly adjustments. That also means that we're Neutral with regard to equities in the short-term, anticipating a correction that you can hold thru, but once it turns increase your holdings with more emphasis on foreign and REE equities. But there are other changes and themes, e.g. it's not clear how inflation and rates will do but the fear is there as is the debt problem. So your choice of Investment, even as you move back longer term, should be for shorter duration bonds or TIPs. Similarly while Gold (which is almost it's own class for special reasons) and Commodities are over-priced right now we'd start moving out of them.

If you wanted to follow a more active strategy here's one rule of thumb to use: wait until the turning point is clear then adjust. If the market starts a correction you'll have more than a few days warning but you are also likely to not have a month. Be prepared and think thru ahead of time on what conditions you'll move and how and where you'll do it.

That's about as much as even one of our posts should cover. But in addition to WealthTrack we think you should monitor weekly Prieur du Pleis's Investment Postcards, particularly his weekly summary, and Jim Jubak's colum, and/or his blog. If you're looking for specific ideas, themes and suggestions it doesn't get any better. In particular his three portfolios are as good a place to start as there is.

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Refresh and Level Set

CHINA RULZ, BEARS ARE FOOLZ Perhaps it was always going to happen. After the hawkish drum beat of evidence for the prosecution going into Friday's payroll data, the employment figures were skewed well to the weak side of expectations. And while eurodollars gapped up and stayed up, the impact on other asset markets lasted, oh, at least forty-five minutes before "risk on, baby" re-asserted itself. And if that wasn't enough, Macro Man's email box was peppered with sell-side missives over the weekend trumpeting China's excellent export data. Even his equity-manager chum was talking about Chinese exports on the train this morning. To be sure, the figures were impressive. Macro Man is always somewhat bemused by the focus on Chinese exports, given that these are a) at least partially driven by the country's mercantilist policies, and b) as such, at least partially represent the vulturing of market share away from other producers. Far more interesting to Macro Man is China's import data, which was truly stunning; up 55% y/y, taking the nominal dollar amount to new highs. Unsurprisingly, this has been taken well by other markets, with developed-markets equity indices (and futures) reaching post-2008 highs. In many ways, it feels as if there is no market advantage to weighting risks and considering expected values on sundry investments. CHINA RULZ, BEARS ARE FOOLZ is looking like a manifestly superior investment methodology for the time being. In any event, whether it's "China rulz" or simply the ongoing abundance of liquidty available for certain types of investment, whatever is driving markets has spread its tentacles far and wide. Commodities have ripped higher; while oil could perhaps be explained by the cold weather gripping the entire Northern Hemisphere, gold has also made a Lazarus-like comeback after the $150/oz smackdown observed last December.

Words from the (investment) wise for the week that was (January 4–10, 2010) The declines in the Shanghai Composite Index came in the wake of investors’ concerns about a flood of initial public stock offerings (IPOs) and the authorities’ actions to slow down lending. Of all the major indices, the Shanghai Composite is the only one trading marginally below its 50-day moving average. Also, as shown by the declining green line in the bottom portion of the chart below, Chinese stocks have since July been underperforming the S&P 500 Index - a reversal of roles since China turned the bear market corner five months before most other markets in November 2008. Interestingly, Marc Faber told CNBC (via MoneyNews): “My feeling is that the US will outperform emerging economies in the first six months of 2010.” While on the topic of long-term charts, when considering S&P 500 monthly data, three momentum-type oscillators (RSI, MACD and ROC) all still signal a bullish trend. (As an aside, the long-term picture for US government bonds is in bearish mode as highlighted in a post a few days ago.) It goes without saying that the strong rally since March is bound to be followed by a correction at some stage. But rather than pre-empting (and more often than not getting it wrong as a result of short-term noise), I will be guided by the longer-term charts and the yield curve to identify a major top. Meanwhile, I am watching valuations carefully, and specifically how the Q4 earnings reports stack up. Although I am treading with caution after the 74% rally in the mature markets and 109% in emerging markets, I am not ignoring good old stock-picking, and specifically those companies with strong balance sheets that will be growing their dividends over time with a reasonable degree of certainty.

Bob Doll’s crystal ball into 2010 and the next decade BlackRock, Inc. (BLK) Vice Chairman Bob Doll has been putting out annual predictions for 15 years. Doll, who helps oversee about $3.2 trillion at BlackRock, the world’s biggest asset manager, just released his ten predictions for 2010 and for the next ten years. Eleven of the twelve predictions he made for 2009 were right. Below are highlights of his latest market forecasts. In general, Doll believes US stocks will outperform cash, Treasuries and other developed economies with S&P 500 rallying another 12% this year, reaching 1250 from its January 4 open of 1116.56. The US is on its way to recovery, but the economy will grow slower than that of a typical recovery mainly due to heavy debt load. Inflation will be a “non-issue” in the US, Europe and Japan this year even with rising prices of gold and oil. The US dollar will likely remain weak in a broad trading range with the euro and yen. Doll also noted structural issues in the economy would continue to present problems.

WealthTrack: BlipTV WT Episodes

WealthTrack 602 | 01-08-10 On this week's Consuelo Mack WealthTrack, Consuelo will ask three investment pros how they intend to make money in the New Year in stocks, bonds and foreign markets. BlackRock's Chief Equity Strategist Bob Doll runs three highly respected large cap funds; First Eagle Fund's Matthew McLennan just took over the global investment helm from legendary value investor Jean-Marie Eveillard; and veteran bond manager Marilyn Cohen just published her new book 'Bonds Now!'.

WealthTrack 525 | 12-18-09 On this week's Consuelo Mack WealthTrack, two investment champions join us for a WealthTrack exclusive from independent research firm, ISI Group. Ed Hyman, Wall Street's number one ranked economist for an unprecedented thirty years running, and top ranked portfolio strategist, Francois Trahan, will share their 2010 forecasts.

WealthTrack 523 | 12-04-09 On this week's Consuelo Mack WealthTrack, our "Great Investors" series explores the inner workings of the hedge fund world with outspoken fund manager Cliff Asness of AQR Capital Management, who will discuss his quantitative strategies as well as the investing rules that all investors should follow.

WealthTrack 534 | 12-11-09 Neil Furguson on the long-term outlook for the decade.

Re-Thinking Financial Advice

Asking for Advice Is Asking for Trouble (WSJ 2003) Wall Street has a wonderful opportunity to help millions of investors. But it probably won't. This I believe: In the years ahead, giving financial advice has the potential to be a huge growth business, for three reasons. First, we have just had a harrowing stock-market collapse, and many folks are unsure what to do next. Second, thanks to the demise of traditional company pensions and their replacement with 401(k) plans, investors are now more in need of advice than ever before. Third, that need for advice will almost certainly grow, as the baby boomers quit the work force and grapple with the complexities of managing money in retirement. But instead of rising to the occasion, I fear Wall Street will once again go for the quick buck, flogging flaky investments and using underhanded sales tactics. Why this pessimism? Unfortunately, many brokerage houses and financial-planning firms just aren't ready for prime time. Here's why: Financial advice isn't solely about selecting investments. But try telling that to most investment advisers. Far too many brokers and financial planners hold themselves out as experts who can pick winning stocks and mutual funds. Yet, in reality, outguessing the market is extraordinarily difficult. Indeed, once you figure in the costs involved, most investors earn returns that lag far behind the market average. That's why the best brokers and financial planners direct their efforts elsewhere.

Now Even Millionaires Can See the Benefits of Budgeting The Boston Consulting Group predicted this week that worldwide wealth would not return to 2007 precrisis levels until 2013. It also said it found that the number of millionaires was down 18 percent and that, across the board, clients of wealth management firms had lost trust in their advisers. “There is a shattered confidence we haven’t seen in a long time,” said Bruce Holley, senior partner at the firm. “The wealth management business is a very emotional business, and people can react in kind to that.”  This explains how someone with more than $100 million in assets can ask her adviser to put her on a budget. As far-fetched as it may sound to someone struggling to make a mortgage payment, such a request reflects the changes in attitudes about wealth in the last year. SHOW ME THE MONEY Watching where your money goes is more than just having a budget. “One of my families said, ‘If you’re worried about spending, then you’re not wealthy,’ ” Mr. Bickel said. “But across the board, there is greater discernment with use of discretionary income.” Or, as Mr. Cochran put it, “Many people thought they were gunslingers.” Now, he said, “They’re not gunslingers any more.” Mr. Holley described the sentiment as a return to “meat and potatoes” investing. Now, that group is focused more on the risk of an investment than its possible return. One result is they are poring through all the disclosures before investing, and they are not as worried about missing out if they are pressured to invest too quickly. The second group is older and held wealth longer. They exhibited almost a knee-jerk reaction to the crisis and put a lot of money into cash early on. They continued to stand on the sidelines through the initial rebound. Only now are they looking to invest in safe assets, like prerefunded bonds secured by United States government obligations. “We are very gradually working with them,” Ms. Rooney said. “For many of them, it was a loss of confidence in themselves as well as in the markets.”  Mr. Cochran said he believed many clients thought the world was coming to an end last September. That it did not end has not consoled them. They are still hesitant with new investments.

Rethinking Stocks' Starring Role For at least a generation, financial professionals have urged mutual-fund investors to put more money in stocks than in bonds. The logic: Stocks power a portfolio, while bonds provide some protection. Now some pros are questioning that conventional wisdom. After last year's stock crash, and ahead of a potentially weak economic recovery, they're arguing that bonds and alternative asset classes such as commodities deserve more weight. What's more, the classic 60-40 split between stocks and bonds—the formula that many balanced funds use to allocate investments—ignores alternative asset classes that can deliver returns with different levels of risk. "The whole 60-40 idea is almost like Betamax videotapes—it's now passé," says Andrew Silverberg, co-manager of Alger Balanced Fund. "It gained popularity while we were still in a bull market." Asset allocation should be "more dynamic," Mr. Silverberg says. "There are a lot of opportunities on the other side of the balance sheet," he adds, referring to corporate bonds. Earlier this year, Alger Balanced's stock allocation was 48%, though it has since increased to about 56%. Gibson Smith, co-chief investment officer at Janus Capital Group and co-manager of Janus Balanced Fund, doesn't stick with the 60-40 formula either. "We're not just about driving returns, but also preserving capital," he says.

Active Managers Get the Cold Shoulder A growing number of big investors are concluding that stock and bond pickers failed to add any value during the market turmoil and are shifting to index funds, a move that threatens to cut profits for asset managers. "Active managers have not given us the added performance in a down market that we hoped for," says Bill Atwood, executive director of the $9 billion Illinois State Board of Investment. Disappointing returns by some large- and small-stock managers led his fund to move about $400 million to index funds. "Now that we think we're close to the bottom, we feel we can access the upside just as well with index managers," Mr. Atwood says. The move toward more-passive investments is part of a broader reconsideration by many investors about what went wrong in 2008 and how they can reposition their portfolios to avoid a rerun of that dismal performance. Active managers promise to beat, rather than match, the market's overall returns and charge fees that can be at least 10 times higher than those of index funds. In a recent survey by Greenwich Associates, a Greenwich, Conn., consulting firm, about one in five institutional investors said they have recently shifted money away from active managers and into passive index strategies. That is up from just 4% who expected to make that shift when asked from July to October 2008. The active-versus-passive debate is shaping up as a driving force behind industry consolidation. When BlackRock Inc. agreed this month to acquire Barclays PLC's Barclays Global Investors, the giant index and exchange-traded-fund business, BlackRock CEO Laurence Fink cited investor efforts to cut costs through passive strategies as an impetus for the deal.

Wary Investors Are Seeking Out Objective Voices In the aftermath of the financial-market crisis, investors are leaving Wall Street to sign on with independent investment advisers. Last year, registered investment advisers brought in more than $108 billion of net new assets into the three largest custodians, according to Charles Schwab Corp., which holds roughly $500 billion in assets for such advisers. By contrast, the four major Wall Street brokerage firms saw an outflow of $8 billion in 2008. Investors seeking to repair their damaged nest eggs say the chief lure of independent advisers is more-objective guidance. Connie Ashline of Kankakee, Ill., decided to follow her adviser from Smith Barney, Dorie Rosenband, when the New Yorker started her own firm in March. “I feel that by my paying her as an independent adviser, she would be in a greater position to take my best interests at heart,” says Ms. Ashline, 75 years old. “The reality is that the brokerage firms are set up for the brokerage of products,” says Ms. Rosenband. And even though brokers’ titles may have changed over the years to “financial advisers and consultants,” she says the culture at the firms hasn’t. As a result, clients were often confused about what they were getting, she says, adding that she brought over about 20% of her clients, mainly those who were primarily interested in a long-term approach.

Think Like Warren Buffett 1. Think of Stocks as a Business Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions. 6. Recognize the Psychological Aspects of Investing Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking. More than anything, investors' own emotions can be their worst enemy. 8. Wait for the Fat Pitch Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player. Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.

Masterclass: Buffett on Investing and Business Analysis At the end of the last post we laid down a, perhaps the, challenge for these interesting times:

"As this sorting goes on the real winners will be the firms and industries who have an effective business model or who re-invent one. Finding them will be the interesting challenge. "

So how does one go about sorting things out. Well there's our interesting little mantra of economy - industry - firm but we thought, beyond that, we'd appeal to the words of the Master. Mr. Warren Buffett himself. Now at some point you've probably seen Warren's basic principle's in some business article or heard him on Rose or someplace else. Certainly the AAII article does a superb job of translating those principles into a screening set, within the limits. We'd summarize/paraphrase them roughly as: 1) Understand the business and be absolutely confident in it as a business for the long-haul, 2) view investments as buying a piece of the business and be comfortable not trading them for 10 years, 3) look for companies with sustainable competitive advantages that protect the core value proposition and 4) pick companies with good management. Listening to Warren takes those simple-sounding principles and fleshes them out with examples and discussions that makes them meaningfully operational. Beyond that though we got several surprises that, as long we thought we'd been following Buffett, were eye-openers: 1. Understand the business - everybody's heard that he make a decision in 5-10 mins. What's new news to us is that a) he adds develop a circle of competency, say 30+ companies, you really understand and follow and b) it takes a lot of digging and research. It turns out the Warren spent a long...long time and a lot of effort learning how businesses really work, i.e. what their business models are. Since this is our central mantra we were extremely gratified to hear it. 

Alternative Assets for the Masses Institutional investors have long used private equity and hedge funds to achieve overall returns far higher than those eked out by individuals. In the 10 years ended Dec. 31, 2008, Hedge Fund Research's Fund Weighted Composite Index gained 7% per year, on average, while the Thomson Reuters U.S. Private Equity Performance Index returned an annual average of 17%. That compares with a 13% cumulative loss for the Standard & Poor's (MHP) 500-stock index. Until recently the masses lacked easy access to these asset classes. Over the past year, however, the number of products that offer individual investors ways to invest in alternative assets has swelled. Should individuals jump in now that they have the chance? Darek Wojnar, head of product strategy and research at iShares, thinks the business of alternative assets is "in its adolescence." As retail products proliferate, the asset class will become more user-friendly compared with the hedge funds of old, he says: "Why would investors want to invest in vehicles that are expensive, have no transparency, have significant liquidity restrictions, and do not disclose exposure?" Already, JPMorgan (JPM), and Schwab (SCH) are among the big shops offering retail funds. Exchange-traded funds have also popped up, such as iShares Diversified Alternatives Trust (ALT), which has an expense ratio, or the annual cost to investors expressed as a percentage of the total amount they have invested, of 0.95%. A newer player in the fund field, IndexIQ in Rye Brook, N.Y., offers two ETFs that use hedge fund strategies, both priced at 0.75%. But don't be persuaded by the low fees alone. Lo warns that some ETFs use short positions and are "potentially misleading," because they offer short exposure on a daily basis rather than over a period of time. Check with a financial adviser or fund ratings service before buying.

Posted by dblwyo at 05:46 PM | | Comments (0)

January 09, 2010

Investing in Turbulence: EMH, Irrational Markets & Pragmatic Decisions

Not to rush everybody along but after the big overview and the detailed dissection of the turbulent markets the natural question is what now? That breaks down into two parts - framing the question and getting down to specifics. On the "teach someone to fish" theory we believe starting with the framework means reactions and decisions will be informed and, most importantly, adjustable. So that's where we're going to start. Specifically with thinking about the design, concepts and constructs for Investment Strategy. Along the way we're going to take a big pass at EMH (Efficient-markets Hypothesis), suggest where it does or doesn't work and propose some alternatives. EMH, otherwise known or translated as the Buy-N-Hold strategy in practice but usually implemented by buy-forget-regret, has a few minor "weaknesses" that got a lot of folks into trouble who didn't check the fine print. Of course it made a lot of money for those who took advantage of the first set of suckers, oops, investors and those who did read the find print.

EMH in Practice: Markets vs. the Economy

This paired composite look at YoY changes in the SPX vs. GDP. Notice a couple of things very carefully. First off the cyclic patterns mirror the GDP almost exactly. Next, the almost part comes when some piece of irrationality gets carried away. If EMH worked none of that would be true. BtW, hopefully you remember all the long-run GDP vs. Profits vs. SPX charts we keep throwing up. None of the standard shibboleths or mythologies of investing are supported by those charts. Though on some timescales in some instances the notion that the markets anticipate the economy has some merit (that weaselly enough for you?). The trick is to know what works, why and to judge how the factors are playing out.

We've got two timeframes going here so you can see how long and how well it works and then so you can actually see enough detail (1980 on) to see what's actually going on. HINT: if the EMH was entirely accurate in a pure form markets wouldn't gyrate but would look at l.t. discounted cash flow and real earnings and converge on a steady-state having nothing to do with economic cycles; adjusting only for major changes in structural factors because those changes the driving forces. Known cyclical patterns shouldn't be surprises, but of course they are since real analysts don't actually analyze reality, just what they want to look at. The difference between a known pattern and a widely ignored one, btw, should be arbitraged away by the markets if the EMH was true. Which is how Warren plays the game.

 

What's Broke in EMH and Actual Investment Choices

In the readings you'll find several key articles on EMH (in particular Six Impossible Things Before Breakfast from which these charts are drawn). Reading clockwise from the UL you see the error in market forecasts by analysts in the months leading up to an event - eventually it converges on undeniable realities. But, in the meantime, there is a disconcerting tendency looking back over behavioral driven bubbles going back to Tulips for irrationality to set in, accelerate and metastasize. That same pattern has held for 400 years! The intervening chart (UR) shows how holding periods have deteriorated - and they are not independent! If forecasts are so terrible a natural CYA response is to shorten the investing horizon - which makes the tendency on the part of institutional investors (who dominate the market) to play follow-the-heard drive various irrational collective myths and create bubbles. When you look at how the smartest guys in the room actually invest (LL) their portfolios mirror the market indices. Which is what happens when protecting your job is more important than getting it right - in other words institutions don't pay their staffs for getting it right, they pay them for not scaring the suckers, er investors.

What's Really Going On

Let's try and take a shot or four at explaining what's going on, at least conceptually. Here we've got four representative view of the theory, reading again from the UL and clockwise, starting with an interpretation of the pure theory. What it says (our interpretation and worth every penny) is that at any given moment in time market prices (markets, stocks, ..., etc.) represent the rational consensus of the best available information. Over time, given a stable (big assumption) underlying relationship and possible outcome, as more information becomes available the market's uncertainty is reduced and it converges on the right answer.

One of the first violations of the theory (which doesn't invalidate it given the restrictions) is that information is extremely costly, one way or another. Which explains Rothschild's pigeons, Poor's stock tables and why NBR just changed its format since stock prices are no longer scarce or costly. But collecting, filtering, interpreting and analyzing that data is still expensive and the range of access is, shall we say, "widely dispersed".

The third REALLY big problem is that the underlying model of Reality might not actually be REALITY - just ask all the Street folks who got blackswanned by using models that required years (a decade's worth, five, back to the last time a six sigma occurred?) of data who used models they didn't understand on very limited data that didn't span the problems they were facing. More importantly and typically we have all these arguments about what is Reality - feels like you're back in the dorm room doesn't it? Most of the time most informed, educated and unbiased observers are nothing of the sort and have and use a very narrow model instead of including all the factors and understanding their relationships. Worse, they let emotions and/or ideologies get in their ways. Subsituting rules-of-thumb for understanding and analysis at best, or tribal folk at worse and unconscious but deliberate distortion based on beliefs and emotions at worst. The cases where that's true are so numerous as to be the dominant thing we see and hear. But again real pundits don't do analysis or verification - they pontificate and publish.

As Keynes put it, "when the facts change I change my mind, sir! What do you do?". Which leads us to the LL corner. If we've got the best data we can afford, decent analytical frameworks, stick to our disciplines and not get driven by our distortions we have a pretty good chance of getting it right within the limits of our data, models, analysis and understandings. And that's why god invented hedging - and real analysis.

Speaking of Results: a Reality Test

So how does that all work? The table is the most recent update of our Four Factor analysis listing where we think we're at and incorporating that last FF update for comparison sake. Given our last two posts there ought to be little mystery (we hope none within the limits of our writing and thinking skills) about why we're saying what we're saying. Now, as a little bit of lagniappe and to be evidence-based, clicking on the file doesn't just enlarge it. It takes you to a downloadable PDF file stretching back almost four years. You judge whether or not we got it right but you can assume we wouldn't be publishing it unless we felt it held up pretty well... or more than well. Granted on line items here and there we missed some boats a tad but on the whole the accuracy is decent. You'll also find, we think, little or no mealy-mouthing or question-dodging. We lay out it as clearly as we can managed and as bluntly (given our approach, i.e. the LL corner above).

Let us suggest some stylize facts to think about:

1) This time it's different - another asset bubble not a cyclic downturn AND it was a financial breakdown, which take a long time to repair (Reinhardt & Rogoff).

2) It's going to take a long time to rebuild Employment and consumer demand will be weak.

3) Valuations are aberrational, divergent from economic reality, dependent on on policy which will be fading and nobody makes money in the long-run buying high.

4) Businesses are not preparing or prepared for the New Normal.

5) In a policy-driven world underlying structural factors gyrate more like s.t. technical ones and can be disruptive and surprising. We face several major structural risk factors that could be major surprises (China's bubble and adjustment problems, sovereign debt/deficit problems, foreclosures & credit write-offs, state & local budget shortfalls, ???) all of which could shift "structure" quickly.

6) Mental mistakes are the most dangerous. Don't let yourself get trapped in the LL corner with all the rest of the redstar roadkills.

There's a very extensive reading selection and, more than normal, we've carefully accumulated over several months a shopping list of what we think are really key things to read and think about. Consider this another little lagniappe, but only if you take advantage of it. But if you're doing any of your own investment management this ain't a bad start on your own little library.

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Assessing the Decade & Outlook

Adjusted for inflation, Dow’s gains are puny Many investors realize that stocks have been among the worst investments of the past decade. But they may not realize quite how bad the decade was, because most people forget about the effects of inflation. Despite its 2009 rebound, the Dow Jones Industrial Average today stands at just 10520.10, no higher than in 1999. And that is without counting consumer-price inflation. In 1999 dollars, the Dow is only at about 8200 and would have to rise another 28% or so to return to 1999 levels. Using today's dollars and starting at 10520.10, the Dow would have to surpass 13460 to get back to its 1999 level in real, inflation-adjusted terms. Controlling for inflation takes extra work and makes stock gains look punier, so it is easy to see why stock analysts almost never do it. The media almost never do it either. But other things do get measured in real dollars. When economists report whether the economy is growing, they account for inflation. When analysts judge long-term gains in commodities such as gold or oil, they often adjust for inflation, noting that gold hit a record this month in nominal terms but remains far from its 1980 record in real terms. Because analysts almost never do the same with stocks, it leaves investors with an exaggerated view of their portfolios' performance over time.

2010 Bespoke Investment Roundtable Twelve of the most popular financial blogs/websites agreed to participate in the roundtable.  Each participant was asked to respond to the same 25 questions regarding their 2010 outlooks as well as their take on 2009.  The responses we got were incredibly insightful, and they should really help investors form their own opinions on what is to come for financial markets in the year ahead.  Below is a list of our roundtable participants.  We have created a page for each of them that has all of their responses, and we encourage you to visit their websites as well if you haven't already done so. To start off the roundtable, we've created a matrix highlighting prognostications for various asset classes in 2010.  Not all participants took part in this section of the Q&A, but the ones that did are included in the matrix below.  As shown, the consensus view is that the S&P 500 will be up in 2010, bonds will be down, oil will be up, the dollar will be up, US home prices will be up, and China's stock market will be up.  The projection for gold was split. 

Is the bull market back? There were basically four scenarios I was looking at as possibilities, all providing some important long-term context to the market. Before we get to them, let's look back and add some context to our present juncture. Below are this decade's returns for various global stock market indexes in local currencies (since January 1, 2000, and as of December 24, 2009): Annualize those and you'll see that even the outlier winner -- the Hang Seng -- was a miserable performer when accounting for the risk of owning equities. The reason to keep this in mind is because it highlights a very important point -- we've had a pretty severe global bear market in major stock indexes over the past 10 years. So the question is, what comes next? Well, that's why I'm following the long-term quarterly charts with such interest. Just as bulls were ebullient at the top, trying to squeeze every last drop of gain out of the indexes, convinced in their herd-driven certitude we have likely reached a permanently high plateau, so too will bears at the bottom over-reach, convinced that the stock market will never again recapture old highs, dogmatic in the belief that some looming crisis will forever dampen equity indexes. Neither will be correct. The answer is always somewhere in between, and since I have no idea what that in-between answer will be, I'll look to the long-term DeMark charts to be a guide.

Back in your own backyard, These funds are fast becoming the new crowded trade, if they aren't already, as institutions and individuals pile into small, overseas markets typically with less liquidity, which accelerates the rise. "For the medium term, I'd avoid emerging markets because of the froth there," says Chris Zook, chief investment officer at CAZ Investments. Long term, emerging markets do offer more growth, but international-developed markets, like Europe, hold more appeal right now, he adds. For all the profit potential of these less-developed nations, some two-thirds of their equity outperformance in recent years has come not from earnings growth but price-to-earnings multiple expansion and a weaker dollar, avers Binky Chadha, Deutsche Bank's chief U.S. equity strategist. Multiple expansion is everything except earnings growth, and includes the more mercurial attributes like sentiment, expectations, and liquidity, among other things. Moreover, this outperformance has coincided with a weaker dollar since 2002, and underperformance with a rising dollar previous to that. It's notable that in recent days, with the greenback beginning to flex its muscles and with U.S. and European stock markets making new highs, the leading emerging-country stock markets -- Brazil, Russia, India and China -- either struggled or flat-lined. With the world so taken with these far-flung marts, perhaps it's time to throttle back and move away from the herd. A very out-of-consensus idea we like is a coming bout of underperformance by these hot markets.

Stimulus timing In the table, “Rate” is the total stimulus spending within each quarter. “Change” is the change in stimulus spending from the previous quarter. And “Cumulative is the total spending to date. Now think about three questions you might ask. The first is, how much higher is GDP this quarter than it would be without the stimulus? This should depend on “Rate” — on the quantity of goods and services the government is buying right now. The second question is, how much faster is GDP growth this quarter than it would be without the stimulus? This should depend on “Change” — on the extent to which the government is buying more stuff than it did last quarter. Finally, you can ask, how much of the stimulus money has been spent? For that you want to look at “Cumulative”, and compare it with the final total for that column. Now the point is that “Rate”, in real life, follows an inverted U. The peak effect on the level of GDP comes at the top of the curve, but the peak effect on growth comes earlier, before the curve flattens out. In the table above, spending peaks in the second quarter of 2010, but the peak impact on growth is in the third quarter of 2009, i.e., it’s behind us. That’s true even though by the end of 2009 less than a third of the money has been spent. And when the spending begins to tail off, the effect on growth turns negative.

Re-Thinking Investment Strategy

This week on Consuelo Mack WealthTrack, the new realities in asset allocation. Consuelo interviews asset allocation master and bestselling author, David Darst, Chief Investment Strategist for Morgan Stanley Smith Barney who will explain how to update this essential foundation for your investment portfolio.

This week on Consuelo Mack WealthTrack with the long dominant efficient market theory under attack, what are the new guidelines for investors? We?ll ask two outstanding fund managers, Jerry Senser, a former Morningstar Fund Manager of the Year and the lead portfolio manager for all of ICAP, including their MainStay ICAP Funds, and noted contrarian Robert Kleinschmidt, who manages the top-rated Tocqueville Fund. Also joining the conversation, Justin Fox, Time magazine?s economics columnist and author of The Myth of the Rational Market.

Rydex's Schier Doubles Buffett's Returns by Finding Unloved Stock `Gems'  James Schier runs his mutual fund using the value investing principles made famous by Warren Buffett. The disciple has found enough cheap stocks to do almost twice as well as the Oracle of Omaha over the past decade. Schier’s $1.36 billion Rydex/SGI Mid Cap Value Fund averaged 12 percent gains in the 10 years ending Sept. 30, according to Morningstar Inc. Berkshire Hathaway Inc., the holding company where Buffett is chief executive officer and the largest stock owner, rose 6.3 percent a year over that stretch, Bloomberg data show. Schier’s fund ranked No. 1 in its category, which averaged 7.3 percent returns, according to Morningstar. Schier said he looks for unpopular stocks primed to exceed Wall Street’s low expectations. His approach led him to buy natural-gas companies in the late 1990s, companies whose profits were crushed by the recession last year because they depend on economic swings, and insurers rather than banks in the current climate. “The challenge is separating the deadwood from the gems,” Schier said in a telephone interview from Topeka, Kansas, 168 miles from Buffett’s base in Omaha, Nebraska.

Six Impossible Things Before Breakfast The Efficient Market Hypothesis, according to Shiller, is one of the most remarkable errors in the history of economic thought. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brainwashing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH - pretty much everyone's hand was up. Then he asked how many of them believed it. Only two hands stayed up! And we wonder why funds and banks, full of the best and brightest, have made such a mess of things. Part of the reason is that we have taught economic nonsense to two generations of students. They have come to rely upon models based on assumptions that are absurd on their face. And then they are shocked when the markets deliver them a "hundred-year flood" every 4 years. The models say this should not happen. But do they abandon their models? No, they use them to convince regulators that things should not be changed all that much. And who can argue with a model that was the basis for a Nobel Prize?

Don't Bet on Efficient-Market Model In 1974, the great financial analyst Benjamin Graham wryly described the efficient-market hypothesis as a theory that "could have great practical importance if it coincided with reality." Mr. Graham marveled at how Avon Products, which traded at $140 a share in 1973, had sunk below $20 in 1974: "I deny emphatically that because the market has all the information it needs to establish a correct price the prices it actually registers are in fact correct." Mr. Graham proposed that the price of every stock consists of two elements. One, "investment value," measures the worth of all the cash a company will generate now and in the future. The other, the "speculative element," is driven by sentiment and emotion: hope and greed and thrill-seeking in bull markets, fear and regret and revulsion in bear markets. The market is quite efficient at processing the information that determines investment value. But predicting the shifting emotions of tens of millions of people is no easy task. So the speculative element in pricing is prone to huge and rapid swings that can swamp investment value.

  • Efficient-markets Hypothesis (Wikipedia) This is first rate, clear, simple and accurate.
  • As Two Economists Debate Markets, The Tide Shifts (WSJ, 2004) For forty years, economist Eugene Fama argued that financial markets were highly efficient in reflecting the underlying value of stocks. His long-time intellectual nemesis, Richard Thaler, a member of the "behaviorist" school of economic thought, contended that markets can veer off course when individuals make stupid decisions. In May, 116 eminent economists and business executives gathered at the University of Chicago Graduate School of Business for a conference in Mr. Fama's honor. There, Mr. Fama surprised some in the audience. A paper he presented, co-authored with a colleague, made the case that poorly informed investors could theoretically lead the market astray. Stock prices, the paper said, could become "somewhat irrational."

Jobless Recovery Would Call for Nuanced Investing  The unemployed don't spend much. They do, however, brush their teeth and power their homes and seek medical care. And the companies that sell such products or services could remain attractive investments as the economy heads into what many see as a jobless recovery. The U.S.'s unemployment rate recently hit 9.5%, its highest level since the early 1980s. Many economists see it going above 10% and only slowly receding. They say an economic recovery won't inspire much hiring as companies grapple with slower economic growth, overcapacity in numerous sectors, and slack demand driven in part by a newfound saving ethic among overleveraged consumers. Investors accustomed to milder recessions in which consumer spending remained relatively strong may be in for a shock. Heavily indebted consumers are unlikely to resume spending for quite some time. That means investing in an era of high unemployment will be an exercise in nuance.

The Failure of a Fail-Safe Strategy  Asset allocation, a bedrock of investing for decades, appeared to fail miserably in 2008. The conviction shared by most investors -- that they should spread their money across myriad asset classes to minimize losses -- was shaken as nearly all markets tumbled in unison. The financial crisis has sent many financial advisers, academics and investors back to the drawing board. Mr. Mahler told the group he was rewriting the playbook he had followed for much of his 41 years in the markets. "Asset allocation did not work," he says. "Everything went into the abyss." Many investors came away from the carnage believing that last year was an anomaly -- that, in times of severe stress like that experienced in 2008, disparate markets will all tumble together as investors scramble to sell whatever they can and move into cash. But a number of influential investors and analysts, from managers of massive funds such as Pacific Investment Management Co., or Pimco, to those at small school endowments, argue that asset-allocation strategies are fundamentally flawed. This wasn't a one-off failure, they say, but one that's been long in the making."You were increasingly seeing a breakdown" of perceived relationships between asset classes, says Mohamed El-Erian, co-chief investment officer at Pimco. "And that was way before the latest phase in the markets, which accentuated the problems." Investors like Mr. El-Erian contend that the problems warrant rethinking those relationships to account for broad changes in the global economy and financial innovations that change the way people invest.

Investment Strategies: Considering Alternatives & Options

The Worst Fund Launches of the Past Decade Morningstar analysts have been having a little debate lately. When it comes to dumb fund launches, which decade was the worst: the '90s or the soon to be history '00s? We disagree along generational lines. The old guard, led by our vice president of research John Rekenthaler, contends fund companies have yet to retest the low standards for mercenary fund rollouts set in the last decade of the previous century. Analysts of more recent vintage, including me, find it hard to imagine a time of greater cupidity than the decade that's about to close out. When it comes to fund analysis, John has forgotten more about mutual funds than many industry watchers know. But he's wrong on this one. The double oughts set new records for dubious, trend-chasing new funds.

The new power brokers: How oil, Asia, hedge funds, and private equity are faring in the financial crisis The global financial crisis and recession altered the paths of four influential groups of investors: oil exporters, Asian sovereign investors, hedge funds and private equity. While Asian sovereigns and petrodollar investors emerged as more influential than ever, hedge funds and private equity saw their previously rapid growth interrupted. In a 2007 report, MGI labeled these four groups of investors the “new power brokers” because they had gained enough wealth and clout to influence global financial markets. MGI revisited the power brokers to examine how their fortunes diverged over the during the financial crisis that unfolded in 2008 and projects where they may go from here, using a scenario approach. Hedge funds and private equity buyout funds are down but not out. Hedge funds' total assets under management fell 27 percent in 2008, to $1.4 trillion, reflecting both investment losses and net asset withdrawals. However, many individual funds—nearly 40 percent in one database—delivered positive returns for the year. Moreover, MGI research shows that a significant portion of hedge funds has delivered higher and less volatile returns than investments in public equities and bonds over time. Investors will remain committed to such funds. Although their assets have declined further this year, MGI projects their growth will resume, with assets reaching $1.5 trillion by 2013 in our base-case scenario. Meanwhile, the leveraged buyout boom of 2005 through 2007 came to an abrupt end last year. It remains unclear today whether or when the “megadeals,” worth more than $3 billion each, will make a comeback, given tight credit markets and slack investor appetite for such deals. Moreover, the industry has $535 billion in capital committed by investors but not yet deployed. Therefore, buyout fund assets are projected to remain flat over the next five years at $1 trillion. However, other types of private equity funds—including distressed debt, infrastructure, real estate, and other investments—will likely continue to grow modestly.

  • Alternate Investment Strategic Outlook
  • VC investments plunge 51 pct to $3.7 billion in 2Q Venture capitalists cut their U.S. investments in half during the spring, the second-consecutive quarter to mark a more than 50 percent decline, leaving the money flowing to startups at the slowest trickle in 12 years.
  • Future of Hedge Funds There were new revelations today in the Galleon hedge fund scandal. The fund allegedly paid hundreds of millions of dollars annually to its Wall Street banks for information not disclosed to most investors. For more, BNN speaks to Monty Agarwal, managing partner, MACM LLC.
  • Hedge Funds Tell Part of ResultsTaken at face value, historic index figures suggest that even an average hedge fund manager can easily beat the stock market while taking less risk. Since 1990, a weighted index of hedge funds has returned around 12 percent annually — about four percentage points more than the returns for the Standard & Poor’s 500-stock index — with just half the volatility, according to Hedge Fund Research. On closer inspection, these claims look suspect. Research published in late 2007 by the Princeton professor Burton G. Malkiel showed that many hedge funds simply stopped reporting results after they became embarrassing. For funds that ceased reporting, the average monthly return in the six months before they did so was -0.56 percent. That contrasts with an average monthly return of 0.65 percent during their reporting lives.

The Hard Fall of Hedge Funders -- New York Magazine Rajaratnam’s downfall, and the lifting of the veil on the methods behind hedge-fund profits, signals the official close the hedge-fund era as surely as the 1986 arrest of arbitrageur Ivan Boesky signaled the end of eighties Wall Street. In retrospect, the rise of hedge funds was a hell of a bubble. There were over 9,000 hedge funds in 2008, up from just 400 in 1992. Hedge-fund assets metastasized to $1.9 trillion in 2008 from $592 billion in 2003 and $50 billion in 1993. Nowhere else in the financial industry was there money flowing that fast. A wildly successful investment banker could make perhaps $20 million a year in 2008—minor-league Hamptons-estate money. The most successful Wall Street trader, Citigroup’s Andrew Hall, made $100 million: German-castle money. Where the average investment-banking trade reads like a novel, with a beginning, middle, and end, a hedge-fund trade looks like a choose-your-own-adventure book. When one investing strategy fails, hedge funds instantly adopt another, until the biggest hedge funds regularly move in and out of trades so complicated and interlinked that they appear to be modeled on M. C. Escher staircases. Eleven years back, Long-Term Capital Management, the most famous failed hedge fund, lost money on no fewer than eight concurrent strategies all over the globe. The biggest hedge funds maintain dozens of complex strategies. Meanwhile, investors are unable to redeem their money for a year or more. The funds hold all the cards, and hold them closely. Until now. In the past eighteen months, the hedge-fund industry has nearly halved in size, falling to an estimated $1.2 trillion in assets. The end of the bubble, of course, doesn’t mean the end of hedge funds: They’ll survive in a more modest, more regulated form. Mutual funds, for instance, were at the center of a similar bubble in the sixties and now plod along unremarkably. What has died is the mythic hedge-fund identity. Managers fervently believe in the purity of their purpose—the unconstrained pursuit of profits. They tend to be Ayn Randians who play in rock bands.

Hedge funds tip-toe toward an uncertain future After the worst performance in decades, investors yanked $300 billion of cash over three quarters starting late last year. And more than 2,100 funds were liquidated since the end of 2007, according to Hedge Fund Research Inc. As if the market meltdown weren't enough, the hedge fund industry took a beating over Bernie Madoff's $65 billion Ponzi scheme one year ago, followed by the widening Galleon Group insider-trading case. The upshot is that an industry never comfortable with scrutiny and second-guessing has come under the microscope, with regulators and investors clamoring for change. So what will the post-crash, post-Madoff, post-Galleon hedge fund universe look like? One way or another, the wild west of American capitalism is expected to become just a little more civilized, humbler and almost certainly less lucrative, according to interviews with many industry sources. A return to the golden age of fat fees -- usually 2 percent of assets and 20 percent of profits, though some stars charged much more -- and practically zero oversight is considered extremely unlikely, these sources say. But will hedge funds resume their two-decades long dominance of the U.S. investment scene? That depends on just how tough the Securities and Exchange Commission, the Obama administration and their European counterparts intend to get. In March, Treasury Secretary Timothy Geithner testified about plans to tighten oversight of hedge funds. The betting is mandatory registration with the SEC is inevitable. This is a requirement the industry has long resisted, fearing it would compromise their trading strategies by forcing them to show their hand. Another proposal from U.S. President Barack Obama's administration would make the largest hedge fund advisers -- the ones that could set off a crisis of Long-Term Capital Management proportions -- subject to additional supervision by the Federal Reserve. Although most analysts agree that the era of benign neglect is over, several hedge fund executives expressed doubt that the new regulations, if they come at all, will represent much of a threat.

McKinsey’s Cracked Crystal Ball During 2007, there were several subtle signs that the global boom was peaking: Fortune crowned Blackstone Group CEO Stephen Schwartzman as the new king of Wall Street, Fox Business Channel made its debut, and we saw the first inklings of disaster in the subprime mortgage market. But in retrospect, the most obvious omen was that all too many people were assuming that the boom of the previous three years would continue for the foreseeable future. Such sentiments weren't confined to CNBC's studios. In October 2007—the precise market top—McKinsey Global Institute, a think tank nestled in the confines of the blue-chip consulting firm McKinsey & Co., issued a report documenting the stunning rise of four comparatively new pools of capital—hedge funds, private-equity firms, Asian sovereign capital (Asian central banks and sovereign wealth funds), and petroleum exporters (companies, governments, and central banks of oil producers). These new power brokers had been major beneficiaries of recent trends in the global economy. And if existing trends were to continue—and why wouldn't they?—they'd be even bigger in a few years. While highlighting the risks each of the new power brokers could pose by growing so large, the report utterly failed to sniff out the systemic risks this gang was already posing in the fall of 2007. Like virtually every professional economic-forecasting outfit, McKinsey's crew failed to see how the easy money created by the rise of Asian sovereign wealth and petroleum exporters would be put to spectacularly bad use by private-equity firms and hedge funds. It also failed to entertain the possibility that the global economy could shrink for the first time in more than 60 years. And it failed to see how the power brokers, who reinforced one another's rise, could reinforce one another's fall.

California Pension Fund Hopes Riskier Bets Will Restore Its Health  Big as California’s budget woes are today, so are the problems lurking in its biggest pension fund. The fund, known as Calpers, lost nearly $60 billion in the financial markets last year. Though it has more than enough money to make its payments to retirees for many years, it has a serious long-term shortfall. Meanwhile, local governments in the state are pleading poverty and saying they cannot make the contributions that would be needed to shore it up. Those problems now rest largely on the slim shoulders of Joseph A. Dear, the fund’s new head of investments. He is not an investment seer by training, but he thinks he has the cure for what ails Calpers, or the California Public Employees’ Retirement System, the largest in the nation with $180 billion in assets. Mr. Dear wants to embrace some potentially high-risk investments in hopes of higher returns. He aims to pour billions more into beaten-down private equity and hedge funds. Junk bonds and California real estate also ride high on his list. And then there are timber, commodities and infrastructure. That’s right, he wants to load up on many of the very assets that have been responsible for the fund’s recent plunge. Calpers’s real estate portfolio has tumbled 35 percent, and its private equity holdings are down 31 percent. What is more, under Mr. Dear’s predecessor, Calpers had to sell stocks in a falling market last year to fulfill calls for cash from its private equity and real estate partnerships. That led to bigger losses in its stock portfolio. Mr. Dear remains a believer. Private investments, he asserts, will over the long haul outperform stocks by three percentage points a year, and that is necessary to keep Calpers on track to returning its goal of 7.75 percent annual returns.

Can fund managers really pick the best stocks? Year after year it gets harder for mutual funds to beat the index. It seems like the top stock pickers hit high marks one year then fade to mediocrity the next. With the high fees associated with mutual fund management, and some of the largest funds consistently underperforming the market, you have to question whether mutual fund managers can really pick stocks. For those who invest in mutual funds, it's a very good question: If, over time, mutual fund managers can successfully pick stocks then the price of active management is worthwhile; if not, index funds are the best bet. While it is important to study the theories of efficiency and review the empirical studies that lend creditability, in reality, markets are full of inefficiencies. One reason for the inefficiencies is the fact that every investor has a unique investment style and ways of evaluating an investment. One may use technical strategies while others rely on fundamentals, and still others may resort to using a dartboard. There are also many other factors that influence the price of investments, from emotional attachment, rumors, the price of the security, and good old supply and demand. Part of the reason Sarbanes-Oxley Act of 2002 was implemented was to move the markets to greater levels of efficiency because the access to information for certain parties was not being fairly disseminated. It's hard to say how effective this was, but at least it made people aware and accountable.

Pimco's Gross Favors `Strong' Companies, Emerging Markets in Slow Recovery  Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said investors should favor debt and stocks of “strong” companies, and assets in emerging markets with improving economic growth. Investors in riskier assets will get “haircuts” because U.S. economic growth will be closer to 3 percent than the range of 5 percent to 7 percent for the past 15 years, Gross said. The U.S. economy will begin to recover in the second half of 2009, he wrote in his August investment outlook on Pimco’s Web site. U.S. corporate bonds are outperforming Treasuries in 2009, the first time in three years, as signs of improvement in the economy led investors to seek higher-yielding assets. Franklin Templeton Investments, a mutual fund company that oversees $450 billion, and JPMorgan Chase & Co., the second-largest U.S. bank, are also recommending company bonds. “There is no investment potion for this new environment other than steady income-producing bond and equity investments in companies with strong balance sheets and high dividend yields,” Gross wrote. “A journey to 3 percent nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.” Gross also favors emerging markets where growth prospects are “tilted upward,” according to the report. “Stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope,” Gross wrote. High-risk bonds, commercial real estate and lower-quality municipal bonds “may suffer,” the report said.

Analysis: Get Ready for a New Global Investment Landscape The dollar's rally and faltering U.S. stocks are a timely reminder that despite the global recovery, we still haven't shaken last year's financial crisis from our system. Truth be told, we won't shake it out for years. But the real legacy of the crisis isn't in the risk-appetite-to-risk-aversion pendulum that dominates the dollar's relationship with shares. Rather, it's in a worldwide paradigm shift that will permanently reshape the investment landscape. On the one hand, according to a survey of 225 asset managers sponsored by Citigroup Inc. and investment-management behemoth Pacific Global Investors, investors have become fundamentally more conservative. No longer striving for "alpha" returns as they were in the precrisis boom, pension funds and other savings managers are now content to match their benchmarks and maintain prudently diversified portfolios. Complexity, the survey's report says, is giving way to simplicity. Yet at the same time, the definition of risk in portfolio structures is going through a massive sea change. The giant swathe of the world that bears the increasingly outdated label "emerging markets" is graduating to the big league. Securities issued in and by these developing countries, whose economies account for 50% of global gross domestic product, have traditionally occupied the risky portion of investors' portfolios. But now they're staking a claim to a more proportionally consistent allocation, at the expense of developed markets.

Panel Set For Probe Into Crisis  A congressional panel launched to investigate the financial crisis includes a host of well-known business and consumer advocates, setting the stage for a potentially contentious inquiry. The 10-member panel appointed Wednesday will have broad authority, including the ability to investigate financial firms and issue subpoenas. Its goal will be to analyze the greatest collapse in the nation's financial system since the market crash that precipitated the Great Depression. House and Senate Democratic leaders picked former California state Treasurer Phil Angelides to head the Financial Crisis Inquiry Commission. Mr. Angelides was closely identified with efforts by state pension funds to become more active in litigating over corporate misbehavior. Other panelists include Byron Georgiou, a lawyer with a major securities litigation firm and a business owner, and Brooksley Born, a financial regulator under President Bill Clinton who was an early and vocal proponent for regulation of derivatives in the 1990s. Republican appointees include Bill Thomas, a former chairman of the House Ways and Means Committee and a conservative, pro-business lawmaker. He will become the commission's vice chairman. The commission, created as part of an anti-fraud law passed this spring, will focus on areas including failures in enforcement, policy on derivatives and the actions of mortgage giants Fannie Mae and Freddie Mac. The commission can refer any wrongdoing it uncovers to law-enforcement authorities. Some congressional aides predicted internal friction on the panel over how to proceed, pointing in part to Mr. Thomas's reputation for an aggressive style while in Congress. Mr. Angelides said he wouldn't let partisan bickering derail the commission's efforts, citing as an example the panel established in the wake of the terrorist attacks of Sept. 11, 2001. "Our job here is to do a thorough inquiry to ascertain the facts as to what brought down the nation's financial system," Mr. Angelides said in an interview. "The mission is so important that it can and must transcend" partisanship. But already Republicans and Democrats are disagreeing about whether the inquiry should delay an effort to rewrite rules governing financial markets. Mr. Angelides said he sees the efforts as "parallel" and said ultimately the goal is to provide a handbook for regulators and market players. He said the commission's investigation would encompass regulators, lawmakers and the executive branch, as well as the actions of mortgage lenders, banks, ratings agencies, securitization market players and others.

Posted by dblwyo at 12:29 PM | | Comments (0)

January 07, 2010

Chaos, Turbulence and Policy: Market Lookback, Outlook & Risks

So far it looks like a few folks are getting some benefit from our major refresh of the outlook for the economy, markets and business (our major focal points) but let's focus specifically on a slightly deeper dive on the markets.Thought we'll start with a little re-setting of the table with regard to the Economy (bearing in mind that payrolls come out tomorrow).

PBS hosted this "debate" between a think tank and a Wall St. economist on next year's outlook. Much more polite than you're used to, it being PBS of course, but here's the real test - are they really that far apart. We'll leave the answer open as an incentive to listen, and listen carefully, but a couple of hints. How strong will the recovery be and what will job creation be like? What are the downside risks and the odd of a double-dip, or at least a W? The updated outlook actually gives you all the ammo you need to both answers those questions and to know exactly why these guys are much closer than calling it a debate would imply.

Turbulent 2009 Markets

We make a distinction between chaos, where the outcomes are uncertain and very slight differences in starting points can lead to very different results, and chaos (oops - turbulence), where the behavior of things might be a tad chaotic on a small scale but there is an overall pattern. The trick is to find the pattern and figure out what describes it and how the drivers are behaving and likely to behave. If you decode the pattern you're likely to be able to figure out where things are going and how to navigate much better.

This chart is a look back, annotated, for the SPX in 2009. The annotations pretty much lay things out, at least IOHO, so we won't repeat them. But to the point of our distinction we would call this a very turbulent chart indeed, with lots of different forces causing wide and wild swings in the market. Including the threat of a chaotic breakdown as the patterns were appearing to break with  possible collapse of the banking system.

 

Uncle Ben Carries Us All

The bear rally since March has been both phenomenal and episodic and threated to derail and top out at several points. Indeed we followed Doug Kass (we found out months later so independently) and called a top in August and suggested it was time to head for the sidelines. In which case you'd have missed a bunch more rally but slept better (perhaps). The Mar-Aug rally was driven by relief but what drove the Fall upticks? We think it was largely the carry trade - because of all the liquidity injected into the system by every major Central Bank in the world (Fed, PBC, ECB, BOE, et.al.) there was a lot of slosh that didn't got into lending per se but ended up being used by banks to buy securities, loan to "investors" or, in China's case, loan to companies and consumers so they could speculate on Beijing apartments and Shanghai stocks. Which then leads to the question of what happens when the CB's back down? We got a couple of tastes of that in some SPX swings but the PBC's announcement this morning that it was going to be tightening loan standards for China sent markets down. The rule for the pattern that congealed post August was that when the $ went down EVERYTHING else went up - voila, carry trade. If all the markets are oscillating together that tells you it ain't fundamentals doing the driving, either!

The Dream's Alive

The question now is whether that euphorillusion can continue. The market spent much of Nov/Dec in a very narrow sideways trading range and has started to breakout in the new year.

One way to take a stab at that question is build a Fibonacci Box that looks at support/resistance lines based on naturally recurring changes in many different natural systems (e.g. a Nautilus shell), at 38, 50 and 62% or thereabouts. If you look back at the initial March rally to define the box it turns out each of the various stages and phase of this turbulent market has wrestled inside an F-Box at the next level. On the chart you can see how that played out thru the Relief Rally during the Spring and Summer and how the carry trade went into the Carry Box. The funds must flow indeed - thank you Reverend Father! Nov/Dec we spent wrestling with resistances at the top of that box but have recently broken out about the ~ 1110 level and into a potential whole new box, of euphorillusion. Whether it can keep on reaching depends on some big picture factors - economic recovery, job growth, housing and balance sheets and valuations.

The Real Downtrend Stands Up

An interesting thing about all this, when you pop up a couple of levels, and take a longer-term look is that the downtrend is still very much alive from the Oct07 peaks. To rally beyond this into that next box we'll need to find some different voting to bet (oops, we mean invest) on.

Even more interestingly the downtrend and a Fib graphic from the Oct07 to Mar09 market both converge around 1125 - getting above that level and staying there would seem to be a real test.

But there's another, more important thing to think about. The economy was slowing in 2007 and job growth turned very poor. So, despite the market continuing to run - though in fits and starts - we always thought (& argued) that it was way ahead of the fundamentals, which were headed in the opposite direction and would eventually catch up with the market. So setting aside, if you can, two near-death collapse experiences when King Chaos ruled, and going back to merely turbulent markets the downturn in the markets, where we're still down 30% from the peak, were the normal correction one would expect in a major recession. If not better than we' expect in fact.

Stocks for the Long Run

Yes, that's a subliminal pun on Prof. Siegal and we hope the not so hidden message hits home.  As you may recall his primary argument is that stocks are the single best performer in the long-run and what you need to do is pursue a buy-n-hold strategy. Well, that's come under a lot of legitimate challenge since returns over the last 10-12 years have been negative (was that even true in the 70s?).

Here we take two passes at the "long-term" (which it seems to us might be 50 years in theory but should be 10 in practice!). One is another Fib-limit set look at the rise in the markets from the beginning of the Tech Bubble to the tops in 2000/2007. Separately we ALSO looked for other patterns and found one around the 1130-1140 range, which started with the leveling off and topping of GDP in 98.

We find three other things extremely revealing about that. First off the two liquidity-driven asset bubbles where delusion was the key driver both get lopped off by that little exercise. Seond, the F-limits and the economically grounded reistence both hit about the same spot. And finally (for the 4th time on hugely different timescales) we find the current market heading pell-mell to that convergence point.

Mommy, Where's My Mommy?

Or to explain the pun - mommy's are safety, however illusionary that might be, say in a warzone or among certain families we know of. Setting aside the social commentary safety, following Graham and Buffett, is when the value greatly exceeds the current cost. In other words when you can buy something far less than a price you're positive you can sell it for you have a "Margin of Safety". When you do that you're Investing. The thing to remember is that buy-n-hold isn't buy-n-forget it's buy-think-review-re-think and when conditions that gave you that investible return change then you need to change your mind (hearkening to Keynes - what do you do when you're wrong?).

The high fever of the Housing Bubble was a symptom of a deeper problem - a leverage and liquidity driven market that was more than prone to create bubbles. Which always comes crashing down. When you look at reality we're in a trading range market, have been since 1998 due to the state of the economy and are going to be for at least the rest of this decade.

When you put money into markets by following trends you're Trading, or even Speculating. If you're still in this market you're doing both. Trading on the bet that you can get out when required and the changes become obvious (or are willing to ride it out for the very long-term). Speculating in that your betting that that the markets will break thru all those stacked resistance lines and continue on into the next box.

Valuations vs. Realities

The real indicator that tells us what our underlying problem is is valuations, or PE ratios. The average PE from 1936-1990 was about 14.3 or so. And over that same period as business cycle followed cycle and drove market cycles the difference between the average and the current PE always netted back out to zero. Well right now (thru the end of 98 when our data stops) we're in the highest difference from average that we've ever been. Translation - there is no margin of safety and your mommy has abandoned you on a battlefield. If you're comfortable in a shellhole (Trading) or running around dodging incoming fire (Speculating) by all means keep on. Though we suggest the odds are increasingly against you.

Oh, btw, the answer to our original question. There's no substantive difference between the two interviews. One is arguing that we're in a recovery and will get some job growth eventually, though he's optimistic about timing, and the other is arguing that it will be a weak recovery with poor job creation and many downside risks. Let's say those sum to a 20-40% shot at a W, with the median at 30%. The difference will be whether or not we reach takeoff speed to self-sustaining organic growth or we don't and need more government stimulus and continued monetary support. This "recovery" to date is entirely policy dependent and, on our take, is likely to be for some time.

NB: Economist #1 argues that we might start seeing 250K/month in new jobs next year. Bearing in mind that we need 150K for breakeven, that official figures show us down over 7 million jobs and ours show us 12.2 million in the hole when you account for labor force growth how long will it take to get back to breakeven? If the figure of merit is 7 million jobs it's 2.3 years, it the bogie is 12.2 million it's 4.1 and if you account for new labor growth it's 6.5 years. That would 2017 or thereabouts before unemployment gets back down. And this where we're expecting long-run GDP growth to be 2.5% in real terms.

Your mommy has indeed left you. The key words for the day are weak (recovery), turbulent (markets) and fragile (economy). But, based on the non-existent safety at these levels, we'd seriously think about the other part of the chart showing which asset classes perform and re-think accordingly.

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Economic News Refresh

FOMC Minutes: Expect Slow Economic Recovery In their discussion of the economic situation and

What Will Drive the Markets This Year? BNN speaks to Walter Gerasimowicz, chairman and CEO, Meditron Asset Management, about the economy and the markets, and his investment strategy.

Top Risks in 2010 part 1 In 2009 the world flirted with economic depression and financial armageddon -- both thankfully avoided. What's in store for 2010? BNN speaks with Ian Bremmer, president, Eurasia Group. Part 2

Host Chat Kim Parlee and Andrew Bell look at some cautionary tales from 2009 and warnings for 2010.
outlook, meeting participants agreed that the incoming data and information received from business contacts suggested that economic growth was strengthening in the fourth quarter, that firms were reducing payrolls at a less rapid pace, and that downside risks to the outlook for economic growth had diminished a bit further. Participants expected the economic recovery to continue, but, consistent with experience following previous financial crises, most anticipated that the pickup in output and employment growth would be rather slow relative to past recoveries from deep recessions. A moderate pace of expansion would imply slow improvement in the labor market next year, with unemployment declining only gradually. Participants agreed that underlying inflation currently was subdued and was likely to remain so for some time.

Stimulus Clouds: On his Fed Watch blog, Tim Duy wonders what will happen to the economy as monetary and fiscal stimulus fades. “The economy is gathering steam. Can’t deny it. But the clear path to sustained recovery remains clouded by government stimulus, both in the US and abroad. Few policymakers are confident that economi