bizzXceleration: Performance, Value and Profit

Once more into the breech dear friends and shorted be he who ignores to much stuff. Terrible poetry but perfectly in line with the realities of this morning, the week, the month and the last several. My perfect example is this headline from CNBC,Housing Recovery Is Looking a Lot Shakier These Days, which my friend Bill over at CalcRisk responded ROFLOL! Why - because he's been analyzing this for something like nine months. But as the stimulus fades it would appear the underlying weakness in Housing, which ain't all that underlying, is becoming visible enough to the commentariat and analtocracy to notice. The problem is that it's only one among several major data sets which have been visible for months, equally widely ignored, from which the lessons everybody should have learned haven't been because they were never taken, and which are increasingly likely to bite everybody in the arse tout suite'. Others include the Fed beginning to end QE and their purchase of MBS(the source of 80% of the housing demand), a surge in delinquencies in housing and credit cards, a previously mentioned cliff-dive in bank credit, a good GDP number entirely based on Inventory effects and the outlook for fiscal stimulus to start fading long before we reach self-sustaining takeoff velocity (the real point in Bernanke's recent testimony that was almost completely ignored). We ignore all those at our mutual peril but ignore them everybody is. Another blogging buddy (Prieur du Pleiss) was kind enough to call attention to Montier: Was it all just a bad dream? Or, ten lessons not learnt from which we take the following two quote:

"At its simplest, value investing tells us to buy when assets are cheap and to avoid purchasing expensive assets. This simple statement seems so self-evident that it is hardly worth saying. Yet repeatedly I’ve come across investors willing to undergo mental contortions to avoid the valuation reality."

"In his book on value investing, Marty Whitman says, “Graham and Dodd view macrofactors … as crucial to the analysis of a corporate security. Value investors, however, believe that such macrofactors are irrelevant.” If this is the case, then I am very happy to say that I am a Graham and Dodd investor. Ignoring the top-down can be extraordinarily expensive. The credit bust has been a perfect example of why understanding the top-down can benefit and inform the bottom-up. "

The chart is taken from that same white paper which is well worth your time along with a discussion of Shiller's CAPE without the cycle (What is the Cyclically Adjusted S&P500 P/E Ratio ? ), which finds that stocks have been tremendously over-valued for a long-time. Which is, as are the other points, entirely consistent with things we've been saying for years. The basic points we want to focus on is that you need to understand the macro-environment AND business performance, along with the notion that at current valuation levels the chances of a decent return for the next ten years are nil. The critical questions are what do you do about that?

 

Once More Into the Confusion: the Real Macro-environment

So, especially given that today saw revised GDP numbers come out, plus Housing (abysmal) and the week saw Durable Good, et.al., let's take yet another pass at benchmarking where we're at in the business cycle. In this graphic we combine both the data (YoY changes in GDP, Consumption and Employment) along with conceptual models of where we're at in cycle and what we're looking at going forward.

First off it should be clear that we've crossed the cusp of a recovery but, as expected, Employment is lagging and will be weak for years. If you want this week's high-frequency data to confirm that the Durable Goods Orders chart gives it to you. Second off all we've done is arrest the collapse and begun to move into the early stages of growth. We're a very long way from self-sustaining growth and the chances of serious growth are poor to non-existent. Any questions? 

The Answer Ain't 42: What's the Question Again?

As many of us know the answer to the ultimate question was 42, at least in Douglas Adams' world. In our world the question is what should we be looking for - and our answer is those businesses that can creat sustainble value over the long-term (and that we have opportunities to buy into at less than a full price). Since we're facing at least another decade of a volatile and fragile market that means there will be buying opportunities, as long as you don't get in when the PEs are over the top of course. It also means that you need to be building up a target list of potential candidates with good long term potential. That potential will not come from growth because this decade will ALSO see most industries facing worldwide excess capacity. Instead it'll come from those businesses that create value for their customers, establish and maintain a clear market position (call it branding if you like), build hard-to-duplicate operational capabilities (especially in supply chain management, customer service and core operations) and leverage technology in business-driven ways. 

Now we've put up several examples of very deep dives on various enterprises (Citi, Dell, WMT, Cisco, et.al.) to illustrate how to go about it but we want to revist one of our early favorites and on-going targets, Home Depot. In fact our strategic assessment for things to work on is in this graphic., first suggest in April07, re-visited in Oct07 and then again in Sep08. In that last post we found that HD was not only moving in the right direction, perfectly in line with our earlier suggestions, but had made substantial progress for as early in the game as it was. It seems like time to briefly re-visit them because they are "walking the talk" in multiple ways. In fact we're thrilled at the level of execution and operationality being shown and carried thru. They're strategically focused on customer value and carrying that down to the key operating areas of Merchandising and Store Operations, which is where a Retailer realizes that value in tangible form.

Value Focus, Store Operations and Customer Service

Under Nardelli's regime HD destroyed a decade's worth of accumulated good will and developed a terrible reputation for service, in contrast to the outstanding one they had. To get it back takes changes in the way they treat their employees, in floor operations, in the way they stock their stores, the way they replenish them and the IT support they provide. All of which seems to be in train and well along - and they are reporting honestly on their status as well as telling a darn good story.

In fact one of the most impressive things we see is that each major operating function tells the same story but taken down from the corporate level to the specific concerns of each key function. Now that's progress. In particular they seem to be changing from an inside-out, financial engineering approach (Nardelli) to an outside-in value delivery focus driven by enabling the store clerks to take care of the customers. And backing it up with training, process re-engineering and policy and procedure changes. Outstanding!

Integrated Measurement and Performance

What's even more, or equally, impressive, is that they developed their strategy based on value, translated that into effective capital investment decisions and are putting ROIC at the center of the enterprise results. But not at the center of their metrics. Instead each operating function is building it's own bottom-up metrics based on the things they need to do.

What we really like about this chart is two things. First, it starts with the overall enterprise guidelines, emphasizing discipline on an integrated set of value measures. Second, each function has its own metrics based on what they need to do to be in line. Here, reading clockwise, you see how process improvement in store operations puts more emphasis on time spent with customers, how transforming the Merchanising operations with regard to product strategy, mix and marketing impacts gross margin (a critical retail metric) and then how SCM operations contributes constructively. All based on metrics derived from the nature of each function. That is CRITICALLY important because the two biggest problems facing all businesses in this environment are short-termism and the tendency for each function to be run in isolation. These metrics tell us that "local" decisions are being made that integrate and balance short- vs. long-term and function vs. enterprise issues. NB: though not quite yet - a historical stock price composite,with PEs and earnings, chart is in the readings and HD is fully valued just now. But if we get the kind of correction we should get then...

Ultimate Question

The ultimate question is who will perform in this environment and it'll be folks who make these kinds of long-lasting strategic improvements and execute them. In other words as investor, stakeholder or other involved party what you need to be doing is finding those enterprises who can in fact not succumb to sclerosis but actually adapt to the "New Normal" and adopt the innovations they need to more than survive. We're going to suggest that HD appears to be one of those and somebody that goes on your long-term watch list.

In some alternate Universe the Earth was designed and built by a race of superior multi-dimensional beings as the most amazing super-computer designed to answer the Ultimate Question. The final piece, once those beings had the answer but having lost the question, was contained in one of the organic components - Arthur Dent's brain. All they had to do was remove and bring to a close almost 15 million years of research.

Well the conditions of the New Normal are going to go looking for the Ultimate Answer to the question of business performance in every nook and cranny. When the brains of the company are opened up what will be found? We've got even less choice than Arthur about all this - that saw is coming (actually it's here) and so far not many are turning out to have the right answers. (Complacency, Hubris and Sclerosis: Beyond GS to Real Performance). Herein lies you "ultimate answer"!

So long for now, and thanks for all the fish.

READINGS

Market Lessons, Economy & Policy

Montier: Was it all just a bad dream? Or, ten lessons not learnt James Montier, a member of GMO’s Asset Allocation Team, examines whether we learned anything from the market declines of 2008 and early 2009. In this paper - his first since joining GMO from Société Générale - he outlines ten of the lessons he believes not to have been learned. Here is the opening paragraph: “It appears as if the market declines of 2008 and early 2009 are being treated as nothing more than a bad dream, as if the investment industry has gone right back to business as usual. This extreme brevity of financial memory is breathtaking. Surely, we should attempt to look back and learn something from the mistakes that gave rise to the worst period in markets since the Great Depression. In an effort to engage in exactly this kind of learning experience, I have put together my list of the top ten lessons we seem to have failed to learn. So let’s dive in!” Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt (the GMO Whitepaper).

• What is the Cyclically Adjusted S&P500 P/E Ratio ? 

  Chris Turner took a look at Yale’s Bob Shiller “cyclically adjusted price to earnings ratio” (CAPE). Shiller uses an inflation adjusted S&P 500 Index (using simple monthly CPI data). The professor then divides that a 10 year average of trailing earnings (similarly CPI adjusted) earnings.Chris wanted to know what happens if we pull the Cycle out of the CAPE? (Chris’ paper is here).Short answer: You end up with a long term chart of inflation adjusted SPX valuation that implies the market, by Shiller’s metrics, has been overvalued (i.e, “Not Cheap”) for a long time.

  • CAPE Removed
• Technical talk: Expect more volatility for equities

Brisk 5.9 Percent Growth in Q4 Will Likely Fade The economy rocketed ahead at a 5.9 percent pace in the final quarter of 2009, stronger than initially estimated. But the growth spurt isn't expected to carry over into this year. The fresh reading on the nation's economic standing, released by the Commerce Department on Friday, was better than the government's initial estimate a month ago of 5.7 percent growth. It would mark the strongest showing in six years. Even so, it didn't change the expectation of much slower economic activity in the current January-to-March quarter. Roughly two-thirds of last quarter's growth came from a burst of manufacturing -- but not because consumer demand was especially strong. In fact, consumer spending weakened at the end of the year, even more than the government first thought. Instead, factories were churning out goods for businesses that had let their stockpiles dwindle to save cash. If consumer spending remains lackluster as expected, that burst of manufacturing -- and its contribution to economic activity -- will fade. The signs aren't hopeful. Consumer confidence took an unexpected dive in February. Unemployment stands at 9.7 percent. Home foreclosures are at record highs. And many Americans are still having trouble getting loans. Forecasters at the National Association for Business Economics predict the economy will expand at only a 3 percent pace in the first quarter of this year. The next two quarters should log similar growth, they predict.Unlike past rebounds driven by the spending of shoppers, this one is hinging more on spending by businesses and foreigners.

• 'Average GDP' in 2009 Worst Since 1946, Q4 GDP Revised to 5.9%
  

Housing Recovery Is Looking a Lot Shakier These Days The recent slump in housing is making some analysts uneasy about a recovery that many thought sustainable just a couple months ago and comes at a time when the Federal Reserve is nearing the end of a critical, year-long program to support the mortgage market."Housing is at a pivotal, ambiguous point," says Ted Gayer, co-director of Economic Studies at the Brookings Institution.A spate of recent reports from home sales to mortgage activity has been starkly negative. And, even if some of it can be written off to seasonal patterns, namely weather, the weakness is not what what people expected with the extension and expansion of the government's homebuyer tax credit that jacked sales for several months last summer and fall.New homes sales fell to a record low in January, extending a two-month slide; pending and existing home sales were down in December; homebuilder sentiment in January fell back to where it was last June, and mortgage applications have fallen three of the past four weeks. Even the optimists never expected a traditional housing recovery with unemployment stubbornly high, the consumer balance sheet still in repair mode and credit conditions stingy, but right now there's palpable worry about momentum-especially given a string of solid months in mid- to late-2009.

• Existing Home Sales... "Uh Oh" Edition,Existing Home Sales Decline Sharply in January, More on Existing Home Sales, Existing Home Sales losing the little mo it had
•  Freddie Mac: Delinquencies Increase Sharply in January, FDIC to Test Principal Reduction ,Underwater Home-Owers: Demand Principal Reductions

Govt. Interference Makes It "Almost Impossible" to Forecast Stocks, Strategist Admits There's no shortage of hubris and declarative statements on Wall Street, especially among the pundits and strategist types. Thus, it was refreshing to hear Miller Tabak equity strategist Peter Boockvar say "it's almost impossible to say where the market is going to go" in the short term. There's a very specific reason for Boockvar's apparent modesty: The overwhelming influence of policymakers worldwide, which he says has forced market players to become political scientists. "If I came into work every day focused on fundamentals, return on equity, economic data...company behavior, then I'd be able to tell you where I think the market is going to go," he says. "But we're all sitting around waiting to see how the market responds to...what the governments are trying to do to supposedly make things better."

China is misread by bulls and bears alike China specialists have known for a long time what the world suddenly seems to be discovering: that China’s national balance sheet contains much more debt, especially in the way of unstable contingent liabilities, than had been assumed. The first reaction is to conclude that China is on the verge of collapse. But this is based on only a partial understanding of the balance sheet. Yes, there is a lot more debt than many supposed, much of it collateralised by non-viable, illiquid assets, but liabilities are also a lot less liquid than we might think. Capital controls, a high savings rate and limited alternative investments will allow China to defend the domestic balance sheet while it works through the adjustment. Will China collapse? No. It may have a painful financial contraction, but this will not necessarily lead to a collapse in growth. Instead it will grind away at its overinvestment and excess capacity, which, with a reversal of the favourable demographics enjoyed since the mid-1970s, will slow growth sharply, but this will coincide with three more favourable circumstances.First, China will continue to urbanise rapidly, which will raise household income and create new sources of growth. Second, even as the workforce declines, increased education and infrastructure spending will raise worker productivity. Third, a sharp contraction will force Beijing finally to liberalise the financial system and transfer resources from the inefficient state sector to small and medium enterprises, increasing productivity. Chinese growth will almost certainly slow dramatically, but the country will nonetheless continue to grow faster than the rest of the world. Its share of global GDP will rise.

• The myth of China’s blithe consensus
• Never short a country with $2 trillion in reserves?
• Rising wages in China are a good thing

What the PBoC cannot do with its reserves If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit.  And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets.  Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.This was not a discretionary lending decision.  It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar.  Why?  Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price.  What it does is far simpler.  It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price. China’s reserves are often thought of as if they were a treasure trove available for spending.  They are not.  They are simply the asset side of the mismatched balance sheet.  If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100.  To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes.  Reserves are effectively borrowed money.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one.  It does not “realize” the loss, however, until it revalues the RMB to its “correct” value. In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation.  It occurred the very day the trade took place.  When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB.  This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB. This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter).  Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that.  The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take. Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country.  Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption.  This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

Value & Business Performance

Get your portfolio ready for the profitless global economic recovery So what should investors do about it? What’s “it”? The global crisis in profits caused by excess supply over demand. Take a look at how “it” is at work across the global economy. The aluminum industry—awash in excess global capacity with more scheduled to come on line.The auto industry—awash in excess global capacity with more scheduled to come on line. The steel industry—awash in excess global capacity with more scheduled to come on line.The memory chip industry—awash in excess global capacity with more scheduled to come on line. As I’ve written about repeatedly in the last week or two, because the world hasn’t begun to address the problems of excess capital and the excess production capacity that it creates under current economic rules, the global economic recovery is going to turn out to be extraordinarily profitless in industry after industry as producers with excess capacity cut prices in an effort to buy market share. This isn’t a short term problem. With the short-term success of the Chinese economy in recovering more quickly from the depths of the downturn than any other global economy, China’s “solution” of flooding the economy with cash, building new plants, and then exporting the excess has become a model to emulate. The mis-match between global supply and demand in many areas of the global economy will go on for years, and in some sectors the excess of supply over demand will get worse before it gets better. To avoid the trap of excess capacity killing even modest profits I think you have to look for sectors that have barriers that prevent excess capacity from driving down all prices as companies slit each other’s throats to acquire profitless market share. I can think of three big barriers like that. First, brands. In markets and for products where consumers are willing to pay for a brand, the brand provides protection from excess capacity running prices so low that the producer can’t make a profit. Second, distribution and service networks. Building new production capacity is relatively fast and easy these days. But distribution and service? That’s tough.

• Ford’s dilemma: It has to sell more cars in places like India to survive but can it make a profit there?
• Alcoa delivers bad news for global profits

Can CEOs destroy shareholder value in an acquisition? Just watch them I call it destruction by acquisition. Forget the synergies, the cost-savings, the cross-selling that CEOs tout when they announce one of these deals. Too many of the huge merger and acquisition (M&A) deals struck in the second half of 2009 and that are still being struck will take money out of shareholder pockets this year and for years to come. But some CEOs are so desperate for growth and so pessimistic that their company can produce growth internally–you know by doing things like developing new drugs, marketing new products in new markets or finding new reserves of oil or natural gas, for example—that they’re willing to mortgage the future for a deal that makes them look good now. Or that allows them to disguise how bad things actually are with accounting tricks for long enough to walk out door and cash out those options. Not every deal in 2009 and 2010 will destroy shareholder value. I’d give you a few at the end of this post that might actually work out well for shareholders and discuss how to tell the difference between the good and the bad. But a high percentage of the deals that have earned the headlines and moved the stock market in the last year or so need to be seen for what they are: admissions of weakness in sectors desperate for growth. ExxonMobil (XOM) buys XTO Energy (XTO) for $41 billion. Kraft Foods (KFT) buys Cadbury (CBY) for $20 billion. Xerox (XRX) buys Affiliated Computer Services for $5.6 billion. Comcast ($37 billion) buys NBC Universal for $37 billion. Merck (MRK) buys Schering-Plough for $41 billion.What’s striking about each one of these deals? They’re in sectors that are desperately seeking growth.Let’s just take the most obvious growth problem child, the biotech and pharmaceuticals sector. 2009 started off with Pfizer (PFE) buying Wyeth in January. And it culminated in the fourth quarter of 2009 with 78 deals.

Once in a lifetime This is perhaps the greatest marketing strategy struggle of our time:Should your product or service be very good, meet spec and be beyond reproach or...    should it be a remarkable, memorable, over the top, a tell-your-friends event?The answer isn't obvious, and many organizations are really conflicted about this.Delta Airlines isn't trying to make your day. They're trying to get you from Atlanta to Salt Lake City, close to on time, less expensive the other guy and hopefully without hassle. That's a win for them.Most of the consumer businesses (restaurants, services, etc.) and virtually all of the business to business ventures I encounter shoot for the first (meeting spec). They define spec and they work to achieve it. A few, from event organizers to investment advisors, work every single day to create over-the-top remarkable experiences. It's a lot of work, and it requires passion. If you ran a spa at a ski resort, which would you shoot for? Most of the people who come aren't regulars, and most of them just want a massage, a good one, one that makes the trip a little special. I don't think most people coming by expect anything more than that.On the other hand, you could invest in staff and training and services that would be so connected to each other and the guests, so willing to engage and to change people that it might become the sort of transcendent experience that people talk about for months.

• It's easier to teach compliance than initiativeCompliance is simple to measure, simple to test for and simple to teach. Punish non-compliance, reward obedience and repeat.Initiative is very difficult to teach to 28 students in a quiet classroom. It's difficult to brag about in a school board meeting. And it's a huge pain in the neck to do reliably.Schools like teaching compliance. They're pretty good at it.To top it off, until recently the customers of a school or training program (the companies that hire workers) were buying compliance by the bushel. Initiative was a red flag, not an asset.Of course, now that's all changed. The economy has rewritten the rules, and smart organizations seek out intelligent problem solvers. Everything is different now. Except the part about how much easier it is to teach compliance. 

Home Depot

Cheap at the Price: Nardelli, Home Depot and Performance This has been an interesting year so far for major corporate announcements with the number of name-brand enterprises making suprising changes from Home Depot to Dell, not to mention MSFT's Vista launch. Not to pile on too much but there are several lessons and mysteries worth exploring in Mr. Nadelli's departure. The obvious one is the severence package valued at $210M which has predictably created outrage in many quarters. Not to mention the widespread comments in the business press and the blogosphere - including the well-founded reports of spontaneous celebrations in the halls of corporate offices and stores alike that were all over the news.Despite the outrage let me suggest that his departure was cheap at the price. And that the real question was why it took the Board so long to reach the necessary conclusions. Perhaps the short-term lesson is that dissing the Board, as he did by not inviting them to last year's annual meeting, is not in any CEO's interest. On the other hand after six years he walks away with at least $20M in cash and the rest of the package.

Home Depot: a Little History Well let me try and get back to discussing Home Depot and the lessons therein for corporate performance. While my primary purpose and focus here is on enterprise performance I keep letting economic and market events seduce my attention away - largely because it's hard to sail the boat well if you don't know where the wind and the currents will take you. That said I'm liable to succumb in the future somewhat often to build up my collection of tools and observations. In the prior HD post we talked about Nardelli's short-term focus doing tremendous damage to the soft-assets of customer value and employee morale; and that enormous asset depreciation being reflected in a long-term decline of PE Ratios and the associated drop in enterprise value. With a couple of toolkit posts on PE trends and valuations in the market we can turn around and dig a little deeper now into HD's history. Unfortunately the Nardelli experiment in excessive cost control for apparent short-term earnings not only spent soft-assets but squandered a major market opportunity. Now that housing is slowing dramatically the new management must not only re-build the company that was but face severe down-pressures in demand. It won't be easy but perhaps a look back may help.

 Picking on HD Some More After some sidetrips to explore performance vs. valuation and the impacts of sacrificing employee morale on long-term performance it's time to revist our friends at Home Depot. Not that we're above just plain old picking on HD, probably the sign of jilted expectations for us as well as the many folks who innundated message boards around the Net and the Blogosphere expressing their deepest disappointments with value and customer service at HD. But it's also more than that - and we hope - much...much more. HD was, perhaps is and certainly can be a great company again but it faces many challenges.

• Six Steps to Prosperity: HD Initiatives to Consider So here's our preliminary shopping list - things to focus on now and things to do to set the table for the future. In other words while emergency repair and recovery needs to be pusued with all due haste and effort those short-term focused efforts need to seque into longer-term and deeper changes or they will be unsupportable.

 Performance Re-visited: Another Trip to HD's Woodshed For some time now it's been the intention to revisit prior dissections of HD - where we ran a nice little series but also with the intent of using HD as an example of we outsiders taking a look at company performance. It seems like it might be time to re-visit that and for several very good reasons. As the set of postings on profits and earnings show company performance is a critical factor in many things. And, the point in yesterday's post on the Weekly Reader, there's a lot of examples of folks who deserve poking at. Just to review the bidding the last HD posting id'd six major factors in digging into HD's performance and then worked thru them in some detail. The six are: 1) Economic environment and whether or not it was going to be worse, 2) Employee Morale and it's linkages to HD performance (an analysis thread we dug into in several postings, and here), 3) Customer Service - a major area of old competitive advantage, current major breakage and bad image and one requiring major investments but not too major, 4) Operations - major changes in procurement, logistics and store operations to improve service and lower long-term operating costs, 5) Product Development - continue and expand the development of new products with higher value propositions and new services to support them ala Target and 6) revisions and extensions of the historical Business Model because the US market is pretty well saturated and new market niches will need to be developed to restore growth.So the key questions are how're they doing, what's likely to happen and what can we do about it ? Below we present a summary table of the six factor

 Value Delivered: Revisting HD as Retail Exemplar The last post (Value at Risk: Business Performance, Issues, News) laid out the high level concerns with understanding and improving general business performance. Here we're going to both build on that and take it down to a specific enterprise by re-visiting our prior posts on Home Depot. (Performance Re-visited: Another Trip to HD's Woodshed) As well as try to kill several birds with one boulder, so bear with us. And there are several things that thread thru here perfectly illustrated by the past posts on Citigroup and Dell Computer. In all three cases careful attention to the details of what the companies are doing indicates that they are all well along with putting in place the kind of re-engineering transformation required to turn poor performers into good ones. And in each case there are macro-considerations that also need to be weighed, as Dell's recent results and the resultant analyst outcry about non-delivery indicate. The bottomline here is that HD is putting in place all the right kinds of carefully crafted strategic initiatives that promise to turn it into a high performer once we all come out the other side of the worsening economic downturn and the Housing crisis. Now is the time to learn about, follow and monitor that performance. Not, if you believe our economic analysis and earnings/valuations outlooks put money into a bet on an immediate return.So before we dive deeply into the thing we've been looking forward to for months, a analysis of HD's turn-around, let's set the stage.

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Well we've had a few weeks chock-a-block with a few years worth of news, and none of it good. The Fed has started moving to reduce quantitative easing (emergency) programs, sovereign credit crisis appear to be metastasizing from Dubai to Greece to the PIIGS and China further tightened it's monetary policy. There was even a frisson of fear that China was beginning to walk away from the dollar! The last is NOT true though though the former are but, as we keep reminding everyone, we're in a policy-driven and fragile environment where deep structural changes that normally occur gradually over decades are occurring in months or worse, in weeks. The end result is that we have a turbulent situation that's beyond hard to read because no clear patterns emerge that sustain themselves for long. There's a whole slew, and we mean slew, of readings after the break that surveys the landscape that confirms all this and covers ground we've covered a lot in the last nine months. The really interesting, and truly dangerous thing, is that so many folks are so surprised at things that have been visible for months. It was almost exactly at this time last year that we were warning that the economic data was going to be much worse than the markets were expecting - the end result was last year's March Market Madness when the sky truly fell.

Will it happen again? NASA flies what's called the Vomit Comet, a padded airliner, that flies a parabolic arc at the top of which the astronauts get a few minutes of weightlessness to get some experience. But everyone knows that it will end and starts preparing for the return of reality by getting back on the deck. Or risks serious injury. Are we in a similar situation? Meanwhile the WealthTrack video clip will give you a professional view of the state of things, an accurate one we think, and this YouTube clip will give you the popular attitude. Both are important.

Is That All There Is: Market Madness V2.0

 It looks like the "risks" of a real 10% correction are fast fading, despite all the gyrations in the world markets. Of course that's what they were saying in 2007 when we had the Shanghai Surprise (the canary) or the BSC Collapse (the first collapse). Now that's not to say that we're expecting anything like that, but as you'll see in the readings, none of the economic data is particularly good and the outlook is what we've been saying it is - another long jobless recovery and a decade of doldrums.

So, when you look at the chart, we see a downtrend that's still intact, a market that tried to rally over it and couldn't, a bear market rally after surviving last year's March Madness and seem real questions. Are we for example at the top of that NASA vomit arc? Given how badly the markets have misread the economic data this year, and for the last several, we can envision a couple of scenarios. In the short-run this complacent dynamics keeps playing out and the market turbulates sideways for a couple of quarters. Then the real economic data starts to show up, sans the Inventory boost, with stimulus fading, policy beginning to move away from emergency measures and earnings getting away from easy YoY gimme comps. That's a recipe in the last half of the year for a real correction. The question you have to ask is do you want to play that game (which has been going on since September after all)? Or is it time to start thinking about preserving capital. Unless you're prepared to get into the trading game the risks factors are mounting, the return outlooks are deteriorating (where are PEs for example, cf. the readings) and the chances of decent returns over the next several years are fading if not gone.

 

The Wallet Insert Version of "Be Your Own Economist"

Here's our little contribution to analyzing and understanding the economic situation. In the readings you'll find two longish excerpts from recent posts on the Economic Report of the President (History, Baselines, & Your Future: the Economic Report of the President ) and a discussion of the situation and outlook on Deficits and Debt for the US (Real State of the Deficits/Debts, Politics and Governance Changes). We strongly suggest you take a look at both and set aside any ideological blinders you might have in place. Sadly most folks can't do that and look for data to support their preexisting conclusions. Which most of the Investment and Business communities are guilty of. Also in the readings, just to step away from any potential political biases, you'll also find a recent speech by Janet Yellen and the latest Outlook from Northern. In addition to our own work OMB, Yellen and Kasriel see the same world we see.

So, rather than repeating ourselves and covering ground with the same charts and analysis we've been covering for months now, we've provided a cheat sheet that cuts some corners but lets you do your own outlooking. What it shows is the regressions relationships between key variables on a Year-over-Year basis. Which really translates into average annual real growth rates. So, for example, a YoY increase in real retail sales translates into a 2.9% increase in Consumption, a 2.7% increase in real GDP and a 1.6% increase in Employment. It also implies a 2.2% increase, note that's an increase, in Unemployment. That's because the economy's got to grow at 2.5% to get breakeven, or 0.0%, "growth" in Unemployment. We've highlighted the critical juncture where Unemployment starts getting pulled down but to get a real improvement in Unemployment we need GDP to grow for a sustained period at at least 3.6%. And by sustained we mean years! How likely is that - well skim the readings. But the short answer is not very.

Gimme Some LUV: World Economic Outlook

Sir Martin Sorrel a few weeks back called it exactly right when he called the world outlook a LUVest. An L-shaped recovery in Europe, though just this morning the head of the BOE said Europe was stalling out (and the sovereign credit crisis won't help), a drawn-out U-shaped recovery in the US and a V-shaped recovery in Asia, especially in China.

We've tried to capture all that and the linkages and feedbacks with this graphic. In the US the economy is "recovering" but very weak (implying both a need for more stimulus which is problematic AND a likelihood of ZIRP into 2011 by the Fed), credit markets have moved away from near-death and Housing is still facing life-threatening challenges. And if you think the Credit Markets are "fixed" take a look at Bank Credit Collapse.

Meanwhile the economies of the rest of the Developed world are facing serious problems. In the rapidly emerging world India and Brazil survived fairly well and China apparantly even better. But there's three major catches that everybody's not factoring in: 1) they pumped a lot of funny money into funnier loans and created another bubble, 2) there's a trade backlash building and 3) a significant drop in US consumption means that the old export-pulled model is broken beyond recovery. China's real problem is that it needs 8% growth to move ahead, 6% to breakeven and will get that only if everything works. Meanwhile they need to re-structure their economy. It's highly unlikely they'll be able to do that before the reaping machines catch up. Only in their case you end up with a major exposure to political instabilities.

Mental Models and Cognitive Breakdowns: Minds, Money and the Lizard Wars

The Markets were of course closed Monday before last and PBS's Newshour took advantage of that to do most of the hour on one of the best presentations of the last decade's work on the psychology of decision-making. Now they couched all this in terms of Markets and Investing but in actual point of fact it applies to any decision processes in conditions of uncertainty, risk and doubt. We can't recommend it highly enough.

Where the chickens come home to roost however is that the common theme running thru every section of our writings, is that folks are not taking the best information available and positioning themselves properly. Instead they're either freezing up and falling back on what they know, while telling themselves it'll work, or denying reality entirely. That's true of even business as we discussed in detail in a previous post (Complacency, Hubris and Sclerosis: Beyond GS to Real Performance).Or, with respect to valuations as this chart on PE Ratios shows.

There are, at the end of the readings, some more exceprts on earnings, valuations and business outlooks that pick up those themes. Needless to say we think they all confirm 'em! Now there's always the danger of course that we're guilty of our own sins, so-to-speak, and screened the readings to support our biases. We could say that's the risk you take, or that we've looked at a LOT of stuff and screened for credability, track record and logic. what we will say though is that we did screen base on our own analysis, picked those readings that were consistent with them and that our track record for over four years ain't too shabby. That being the case you can assume some biases and presume what we hope is more accuracy (we're fantasizing maybe a 10:90 split but you judge).

The really important points are that things are fragile, policy-dependent, we're on the cusp point of major transitions and most of what you read is not well grounded. Or is even plain wrong. In other words a lot of the inputs floating around start with the biases and confirm them while we try to start with the analysis and prove or disprove it.

UPDATES:

Well just in case this morning's market gyrations doesn't pretty confirm everything we're trying to say in this post some recent TechTicker commentary and interviews are dead on point and we recommend you invest the time in listening to them. Starting with this overview of a skittish and uncertain situation where no one knows which end is up:

Markets Freaking Out Again -- So It's a Great Time to Stay Diversified

Where we'd strongly, and we do mean strongly, differe with Blodgett and Task is in their strategic advice. They suggest diversification where we're suggesting heading for the sidelines, as we've essentially done since September, in the name of capital preservation and waiting out at at least the next couple of quarters. Other than that their take on the outlook, issues and valuations (especially valuations) exactly aligns with ours. To that clip we's suggest you listen to the 3-part interview(s) with Barry Ritholz, particularly this one:Something's Gotta Give: Rising Retail Profits Meet Falling Consumer Confidence

READINGS & CLIPS

Mental Models and Breakdowns

Your Mind and Your Money- Feeling vs. Thinking GRECH: Standard economics assumes that people are cool, calm and collected. They make logical decisions to maximize their wealth. Princeton psychologist Daniel Kahneman turned that idea on its head. He found that in matters involving risk, people are anything but rational. His work won him a Nobel prize. DANIEL KAHNEMAN, PROFESSOR EMERITUS, PRINCETON UNIV.: People hate losing much more than they like winning. We actually have a pretty good idea of the ratio, the factor, how much people hate losing more than they like winning. And it's about between two and three. If you ask, let's say, Princeton students, how about a gamble where if it shows tails you lose $10, if it shows heads you win 'X' dollars? What would "X" have to be before you like the gamble, before you're willing to take it. They'll want $25. So that's a very fundamental fact about people that they're loss averse. GRECH: That trait, loss aversion, leads people to shy away from good bets. Susan Abrams says that happens to her. After the market crash, her emotions said hunker down. She chose to stay out of the market. ABRAMS: I still was nervous, you know. GRECH: MRI brain scans have taken Dr. Kahneman's insights one step further. Dr. Jonathan Cohen is a brain scientist at Princeton University. He and others have found evidence that emotional mechanisms like loss aversion are hard-wired in our brains.DR. JONATHAN COHEN, PRINCETON UNIVERSITY: Our brains have different kinds of mechanisms, some of which are sort of holdovers from prior times and may still be very useful. With those different mechanisms that serve different sorts of needs, you have the potential for conflict. And it's that conflict between these different mechanisms that may explain our erratic and sometimes seemingly irrational behavior.

• Your Mind and Your Money-Risk Roulette
• Your Mind and Your Money-Herd Mentality

 

Deconstructing the House  Note: Two different stories with a theme ...First, from an article in the Arizona Daily Star: Chandler man arrested for gutting foreclosed home (ht Mellanie) Police say 35-year-old Daniel I. Clark was booked on suspicion of defrauding a secured creditor and criminal damage. Police say a neighbor of Clark's stopped an officer on patrol and reported that Clark was "deconstructing" his house.And here is the video of the bulldozer guy in Cincinnati featured on WKRP, uh, WLWT.com:

Markets

8 reasons for investors to worry  In October, the worry was that the stock market had gone up too far, too fast and was ready for a fall. Now the worry is that the long-feared decline has finally arrived and that it will be much worse than the correction that investors have been waiting for. Or at least that's the fear. All this history tells you something about how tough the past four to five months have been on investors, who have been through two bear markets in less than 10 years and are justifiably inclined to jump at every bit of news, good or bad. Jumping at every bit of news is actually not bad behavior. The lesson of the past decade is that investors can easily get too complacent. Remember the saying: You're not paranoid if they really are out to get you. The goal is to put together a list that tells you 1) what the chances are that something will go wrong, 2) how bad it might be if something does go wrong and 3) when things might go wrong. Worry No. 8. Slowing economic growth remains the big worry in 2010. It's the one worry that, if turned into reality, could make all of the seven other worries in this list much, much worse. And it's the only one that could work to combine some of these discrete worries into a much bigger crisis -- again. Unfortunately, I can't discount the possibility that the world's developed economies, including the U.S., will lead the globe back into a painful slowdown at the end of 2010 and into early 2011. Investors certainly can't relax in the first half of 2010. But it's the second half of the year that I'm really worried about.

• What a Difference a Day Makes (2/16/10) While my explanation may or may not be correct, it looks like things "bounced" vs. "got crushed" for the time being (I am officially out of my short-term rebound trade, though I am continuing to hold some strategic long positions in gold, commodities, and non-USD currencies).
• Emerging-Market Stock Funds Post Biggest Outflows in 19 Months on Greece
• Are Cracks Forming in the BRICs?
• Oil, Copper Pace Commodity Drop as China Seeks to Cool Growth

Why stocks, worries are both rising  Is this still a bear market? Even though stocks, measured by the Standard & Poor's 500 Index ($INX), were up 70% from their March 9, 2009, low to their recent high on Jan. 19?  Yep. Yes indeed. Absolutely. If by bear market you're talking about what's called a secular bear market. Strong market rallies -- even three- to four-year cyclical bull markets -- can take place inside a longer bear market trend. And despite a bull rally, the long-term trend can still point very strongly down.I think that's exactly where we are now: in the midst of a strong cyclical bull rally that's taking place in a long-term bear market downtrend that began in March 2000 and could have five to 10 more years to run. I raise this question and answer it this way not to scare you out of the market. Remember that even if this is just a cyclical bull market rally inside a larger downtrend, such a rally can go on for as long as three or four years (although a cyclical bull is by no means guaranteed to go on for that long). I don't want you to jump ship just yet. But I think understanding that we're in a cyclical bull inside a secular bear market is the best way to explain why this stock market feels the way it does, why so many investors still doubt this rally even after a 70% gain and why it has been so hard to go along for the ride. And that feeling you have that it's all going to end badly? It's perfectly normal and likely as not to be correct in the longer term, if this is still a secular bear market.

So is the correction over already? I’m not willing to call this correction over until China’s financial markets have been back in business for a week or so. If the return of news flow from China hasn’t sent prices back to where they were on February 8, then I think this correction is probably over. And it will have ended short of that 10% pain level for the same reason that all the other corrections in the bull market that began in March 2009 have petered out after just a 4% to 5% drop: There’s still an awful lot of money on the sidelines that missed out on the 70% rally off the March bottom and is just waiting for a dip to buy in. The more times that dip is just 5% instead of 10%, the more investors will say “Buy” after a 5% drop, figuring that’s all they’re going to get in the way of an opportunity. That sets a limit to how bad a correction will be. On the other hand, if you can remember back just a few days to how nervous everybody was when the S&P 500 was down just 8%, you’ll recognize just how jittery investors are.I’d call bullish sentiment a mile wide but an inch deep.

• My thin reeds say the first half of 2010 will be surprisingly strong in the U.S.

The Value of Corporate Bonds WSJ (hat tip Abnormal Returns) details: “Since peaking in mid-January, corporate-bond prices have had their biggest decline since a breakneck rally that began last March. That climb had made it cheaper for companies to finance  operations, greasing the skids of the economy. This past week, though, the cost of protecting against corporate defaults rose to the highest level in three months. Returns on high-yield debt turned negative for the year. And companies, after raising record amounts of new debt earlier this year, abruptly trimmed the amount of new debt they brought to market. Some were forced to cancel sales. Even after the market's recent declines, many analysts aren't expecting much, if any, of a rebound.” …. While not exactly a sell-off, after the one direction bet we've seen with corporate bonds over the last 12 months ( that has narrowed the spread on the broader corporate bond benchmark from 600+ bps to less than 200 bps), the value of corporate bonds becomes as dependent on expectations of interest rates as on future spread compression.

• Where to Hide? Since the remarkable comeback across all risk sectors following 2008's collapse (the illiquidity in TIPS during the crisis made them trade among credit risk sectors), corporate bonds (both investment grade and high yield), agency mortgages, and even TIPS have been under pressure.
• TIPS Drive Away Biggest Bulls Foreseeing Inflation That Economists Don't
• Pimco’s Bill Gross Boosts Non-Dollar Developed Debt

China Sells Treasuries... or Did They? So Japan has passed China in total Treasury holdgings.... or have they? Looking at the above chart we see that the United Kingdom is listed as the third largest holder of Treasury bonds after the MASSIVE 12 month change seen below. This is where I miss Brad Setser and his blog Follow the Money (he left blogging when he went to work for the White House). As he detailed back in the summer:

China tends to account for a very large share of purchases through the UK. From mid-2006 to mid-2007, about 2/3s of the UK’s purchases of Treasuries were ultimately reassigned to China. I would expect the something similar is happening now — all of China’s bill holdings tend to appear in the US data in real time, but only a fraction of China’s long-term purchases tend to show up directly in the US data.

So (most of / some of?) these purchases by the United Kingdom were likely on behalf of China. Below is the last jump / reset cycle, though it is important to note that this cycle has happened on six occasions since 2002.

• Dollar Up as Europe Reels A dramatic turn in sentiment in favor of the dollar and against the euro continued Monday, with lingering fears of a possible European debt crisis pushing the greenback to its highest point in nine months.
• Chinese Whispers in Treasury Market In fact, it isn't clear that China is shifting out of Treasurys at all, while firm conclusions over its preference for short- or long-term U.S. debt are hard to reach. How so? The key is to look at U.S. Treasury holdings in the U.K. and Hong Kong. Both have at least doubled in the past year. At the end of December, the U.K.'s holdings totaled $302.5 billion, and Hong Kong's were $152.9 billion.
• China's Treasury Sales Don't Mean a Major Dollar Shift

As Fed Raises Rate, an End to Big Bank Profits Is Expected ... The days of easy money — and, just maybe, easy profits — are numbered. News on Thursday that the Fed would raise the interest rate that it charges banks for temporary loans was seen by lenders as a sign that their long, profitable period of ultralow rates was coming to an end. The move suggested that policy makers believed the nation’s banks had healed enough to withdraw some of the extraordinary support that Washington put in place during the financial crisis. And, while all those bailouts stabilized the banking industry, it was low rates from the Fed that helped propel banks’ rapid recovery. Even though the Fed had telegraphed its intention to raise the largely symbolic discount rate, the timing of the move, coming between scheduled policy meetings, caught some economists by surprise. Stocks and bonds sank in after-hours trading, suggesting Friday could be an anxious day for the markets.

Donald Coxe – Investment Recommendations  The February edition of Donald Coxe’s Basic Points research report (subtitled “Hard Rocks and Hard Shocks”) has just been published. His investment recommendations, as summarized in this document, are listed in the paragraphs below, but I do recommend you also read the full report at the bottom of the post.

• Hard Rocks and Hard Shocks-BMOCM-02-2010

Economic Outlook

Economic Report of the President President Obama took office at a time of economic crisis. The recession that began in December 2007 had accelerated following the financial crisis in September 2008. By January 2009, 11.9 million people were unemployed and real gross domestic product (GDP) was falling at a breakneck pace. The possibility of a second Great Depression was frighteningly real. In the first months of the Administration, the President and Congress took unprecedented actions to restore demand, stabilize financial markets, and put people back to work. Just 28 days after his inauguration, the President signed the American Recovery and Reinvestment Act of 2009, the boldest countercyclical fiscal stimulus in American history. The Financial Stability Plan, announced in February, included wide-ranging measures to strengthen the banking system, increase consumer and business lending, and stem foreclosures and support the housing market. These and a host of other actions stabilized the financial system, supported those most directly affected by the recession, and walked the economy back from the brink. But the Administration always knew that stabilizing the economy would not be enough. The problems that led to the crisis were years in the making. Continued action will be necessary to return the economy to full employment. In the process, an important rebalancing will need to occur. For too many years, America’s growth and prosperity were fed by a boom in consumer spending stemming from rising asset prices and easy credit. The Federal Government had likewise been living beyond its means, resulting in large and growing budget deficits. And our regulatory system had failed to keep up with financial innovation, allowing risky practices to endanger the system and the economy. For this reason, the Administration has sought to help restore the economy to health on a foundation of greater investment, fiscal responsibility, and a well-functioning and secure financial system. Even this important rebalancing would not be sufficient. In addition to the problems that had set the stage for the crisis, long-term challenges had been ignored and the U.S. economy was failing at some of its central tasks.Our health care system was beset by steadily rising costs, and millions of Americans either had no health insurance at all or were unsure whether their coverage would be there when they needed it. Middle-class families had seen their real incomes stagnate during the previous eight years, while those at the top of the income distribution had seen their incomes soar. A failure to slow the consumption of fossil fuels had contributed to global warming and continued dependence on foreign oil. And a country built on its record of innovation was failing to invest enough in research and development.

• Assessing the Stimulus, One Year In: A View from the Mainstream
• Macroeconomic Advisers: On the Stimulus Package
• Recession End Does Not Mean All Sectors Recover Equally

History, Baselines, & Your Future: the Economic Report of the President Both the proposed US Budget for 2011 and the Economic Report of the President were recently published. Both are well-written, accurate, complete, honest, skilled and inter-linked documents, though the former is probably sleep-inducing and it takes a certain amount of background to get excited about the latter. But you should, both are well worth skimming. The tables of contents if nothing else. Back at the beginning of 2008 we told our network and readers that the single most important issue facing the country would be the Economy but we didn't anticipate either how true that would be or how close to the edge of the abyss we would come. We were, by-the-way, within 24 hours of a complete collapse of world markets. An event that would have been worse than the Great Depression because of the levels of debt and financial leverage, would easily have seen base Unemployment skyrocket to 25-30% and the GDP drop by 20-25%, at least. Bad as our troubles are they could have been enormously worse, literally by orders of magnitude. Be that as it may we're still facing a decade of slow growth, difficult policy decisions and political gridlock. Let's be really, really clear about this. The world has changed more as the result of the economic crisis than it did on 911 - the arc of slow structural evolution in the US and world economies and the associated paths our societies were on are now on entirely new paths. That's why the partisan posturing in Washington is so critical and so dangerous. A major part of the problem is that for most people it really is rocket science. So to help as best we might we're going to devote this entire post to our best attempt at deconstructing the ERP to define the crisis, the impacts, the historical forces that set it up and the consequences for the future. NB: we'll also say this is the first ERP we've looked at that wasn't an apologia for an ideological position but instead a sober appraisal of the facts using the best public data and analysis. We can't emphasize that enough - the analysis in the ERP exactly mirrors that last few years of mainstream thinking, has roots in work that stretches back thirty years and lines up with our own.

Consumers spent at 2009 levels in January American consumers say they reduced their spending in January to levels similar to early 2009, when the U.S. economy was still in recession, according to a Gallup poll released on Thursday.The findings, which contradict U.S. data suggesting spending strength in January, showed consumers in all income brackets and geographic regions spending less in January vs. December in stores, restaurants, gas stations and online. In many cases, Gallup said consumers spent less in the first month of 2010 than in January 2009, a weak economic period when monthly retail sales fell nearly 10 percent and the economy headed for a 6.4 percent first-quarter contraction. "Consumer spending during the first two weeks of February shows a similar pattern. Year-over-year comparisons show consumer spending returning to the new-normal range of last year," Gallup said.

• US Economic Cycle Research Institute (LEIs), Leading Economics Positive, but Pace of Growth Slows, More on Leading Economic Indicators

Real State of the Deficits/Debts, Politics and Governance Changes That's not all it should be because if we learned anything over the last year or two it's that being right on the substance has little or nothing to do with what the politicians, punditocracy or population thinks about it. About the talking heads - we'll say this: to date we haven't seen, with some exceptions, any serious digging into what's really going nor any sense of timing, rythm or mechanics. In other words all the things that are critical for understanding what's going on and how we can go about things is largely missing from any discussion. As for the politicians and populace, well that situation seems to make the pundits beacons of reasoned enlightenment. Basically we spent the post-WW2 period paying it down until Reagan's supply side started growing it again but Clinton was able to return it to surplus (partly by drawing down defense). But the real albatross around our neck is what BushII did to us. This wouldn't even be an issue without war, tax cuts and unfunded Medicare spending increases. The first peace of good news is that the Administration is being fiscally responsible and writing down what it created and we'll be on an uncomfortable but manageable path - at least until mandatory spending metastasizes (all of which we dug into last post).

The really good news, of sorts, is in the LL corner on sources. Which are primarily the revenue shortfalls from the Great Recession and the Bush Tax Cuts. Just as a sensible business borrows to invest in future capacity by borrowing to fund the stimulus we return the economy to higher growth faster. In fact without a return to growth the deficit would be much worse. The higher the growth the better of course. Which means the current partisanship that may force a pre-mature tightening will do more damage in the intermediate- and long-runs than help. It's the long-run we need to be worried about. The really good news is that by restoring the tax rates we had under Clinton it would appear we could largely eliminate a major source of long-term structural deficits. Of course that'd still leave the Meditwins, the need to control HC costs and social security problems. The latter is also fixable as well thru some simple mechanical changes - like matching relative retirement ages to current lifespans (when it was passed benefits were very limited, and expected lifetimes were 68 or so. An equivalent would be to extend the retirement age to, say 72 or 75. Given life expectancies around 80+ that's still a major gain. Which leaves HC. Interestingly Rep. Paul Ryan has put forward a very intellectually honest Roadmap for America that proposes to shift Meditwin funding to vouchers and cap them around $5500/year. Far below where the current cost/benefit trends are taking us rapidly but more in line with world costs. It's a non-starter politically of course but does tell us that it is possible. If we could cap costs between $5-7K/year we'd really have a major leg up.

The Outlook for the Economy and Monetary Policy Unfortunately, I’m not at all convinced that a V-shaped recovery is in the cards. That fourth-quarter leap in GDP overstates the underlying momentum of the economy. Much of it was due to a slowdown in the pace at which businesses were drawing down inventory stocks compared with earlier in the year. Less than half of the fourth-quarter growth reflected higher sales to customers. Even with my moderate growth forecast, the economy will be operating well below its potential for several years. Economists think in terms of what we call the “output gap,” which measures the difference between the actual level of GDP and the level where GDP would be if the economy were operating at full employment. The output gap was around negative 6 percent in the fourth quarter of 2009, based on Congressional Budget Office estimates. That’s a very big number and it means the U.S. economy was producing 6 percent less than it could have had we been at full employment. According to this perspective, the recession has forced businesses to reexamine just about everything they do with an eye toward restraining costs and boosting efficiency. Strapped by tight credit and plummeting sales, businesses have overhauled the way they manage supply chains, inventory, production practices, and staffing. Stores don’t order merchandise unless they think they can sell it right away. Manufacturers and builders don’t produce unless they have buyers lined up. My business contacts describe this as a paradigm shift and they believe it’s permanent.

US Economic & Interest Rate Outlook (NT) Not so fast for the economy, for inflation and, therefore, for Fed tightening. The Commerce Department’s first guess at Q4:2009 real GDP growth of 5.7% is likely to be the fastest quarterly annualized growth we see for some time. Rather, sequential annualized growth rates over the first three quarters of this year are going to be on the order of less than one-half that of the last year’s fourth quarter. Although one month does not a trend make, consumer inflation in January already shows signs of abating a bit. The dollar is on the ascent against major currencies. It is good to have poor competitors. So, other than a cosmetic increase in the discount rate, which has no current policy significance, the Fed will likely find no pressing need to tighten monetary policy this year. This is the major change in our forecast from last month. We are pushing our projection of the first Fed tightening out from August of this year to January of 2011. The near-term probability of a significant acceleration in the growth of final demand is low because the banking system still is contracting credit. So, if we are correct that monetary policy is tight given the contraction in real bank credit and the very slow growth in the nominal supply of money, despite a federal funds rate of about 1/8 %, then both real and nominal economic growth will be muted this year. The 5.7% annualized growth in real GDP in Q4:2009 was largely a one-off event. Under these circumstances, there is no rush for the Fed to start tightening monetary policy.

Lessons Emerge as U.S. Economy Outpaces Europe Amid the cacophonous economic debate echoing in Washington, what's most striking are two numbers: 5.7% and 0.4%. Those are the economic-growth rates in the latest quarter for the U.S. and Europe, respectively. The difference is so strikingly in America's favor that it warrants a little more attention, both because of what it says about the current state of affairs and for the lessons it might offer policy makers.The gap between American and European growth can be attributed partly to economic cycles and partly to some artificial expansion in that big U.S. growth figure for the last quarter of 2009. But the disparity also suggests that, amid all the scrambling and stumbling, at least a few things were done right in the American response to the economic crisis of the past two years, and a few things less right in Europe.Such questions haven't been explored much in this weeks' economic debate in Washington, which has been a fairly sterile shouting match over whether the stimulus package signed into law by President Barack Obama precisely a year ago has accomplished much.

Key Economic Data

Labor Underutilization Rate by Household Income The following chart is based on data from a research paper by Andrew Sum and Ishwar Khatiwada at the Center for Labor Market Studies, Northeastern University (ht Ann): "At the end of calendar year 2009, as the national economy was recovering from the recession of 2007-2009, workers in different segments of the income distribution clearly found themselves in radically different labor market conditions. A true labor market depression faced those in the bottom two deciles of the income distribution, a deep labor market recession prevailed among those in the middle of the distribution, and close to a full employment environment prevailed at the top. There was no labor market recession for America’s affluent."

• Use of temps may no longer signal permanent hiring When employers hire temporary staff after a recession, it's long been seen as a sign they'll soon hire permanent workers. Not these days. Companies have hired more temps for four straight months. Yet they remain reluctant to make permanent hires because of doubts about the recovery's durability. Even companies that are boosting production seem inclined to get by with their existing workers, plus temporary staff if necessary.
• Factories Gear Up to Hire Manufacturers are seeing more signs that the U.S. economic recovery is on a solid footing, opening the way for new hiring as well as call-backs for factory workers laid off during the depths of the recession. Factories have been a relative bright spot so far in this recovery, last month adding 11,000 jobs on a seasonally adjusted basis. That's the first increase since before the downturn began more than two years ago. But manufacturers remain cautious, and some still fear a secondary slump, especially if a broader recovery—which will rely on still-elusive job creation in the wider economy and a stronger revival of consumer spending—is delayed.
• Job market improvement may be slowing, data show
• Weekly Initial Unemployment Claims Increase to 473,000 The current level of 473,000 (and 4-week average of 467,500) are very high and suggest continuing job losses in February.
• Bernanke Likely to Confront Concerns on Second Jobless Recovery in Decade

Studies: Foreclosures to Keep Pressuring House Prices  More waves of foreclosures will keep downward pressure on home prices in parts of the U.S. over the next several years, two new studies project. The studies—by John Burns Real Estate Consulting Inc. and Standard & Poor's Financial Services LLC—both conclude that most efforts to modify loans with easier terms will delay, not prevent, the loss of homes to foreclosure. The Treasury Department is expected to give its latest update this week on government efforts to avert foreclosures. The John Burns study estimates that five million houses and condominiums on which mortgages are now delinquent will go through foreclosure or related procedures that put them on the market over the next few years. That would represent the bulk of the estimated 7.7 million households behind on their mortgage payments. This "shadow inventory" of homes expected to hit the market is enough to last about 10 months, based on the average sales rate over the past decade, the Irvine, Calif., firm says.

• Double Dip In Housing Prices Seen as Risk
• Foreclosures Seen Still Hitting Prices, Housing Reports: Another Wave of Distressed Sales,
• TransUnion: Mortgage Delinquencies at All Time High, MBA: 14.05 Percent of Mortgage Loans in Foreclosure or Delinquent in Q4
• MBA Q4 National Delinquency Survey Conference Call, Mortgage Delinquencies by Period
• Nearly 25% of all mortgages are underwater, First American CoreLogic: House Prices Decline in December
• Predictions on Mortgage Rates after the Fed Stops Buying, Fed's Next Move Could Hit Housing Hard
• Capital One Credit Card Charge-Offs Increase to 10.41%

Housing Starts increase Slightly in January Total housing starts were at 591 thousand (SAAR) in January, up 2.8% from the revised December rate, and up 24% from the all time record low in April 2009 of 479 thousand (the lowest level since the Census Bureau began tracking housing starts in 1959). Starts had rebounded to 590 thousand in June, and have moved mostly sideways for eight months. It is important to note that many home builders started a few extra spec homes in January hoping to have them completed and sold before the home buyer tax credit expires. It takes about six months to build an average home, so the builders couldn't wait to start construction until the expected buying rush in April since they have to close by the end of June. As I've noted before, this low of starts is both good news and bad news. The good news is the excess housing inventory is being absorbed - a necessary step for housing (and the economy) to recover. The bad news is economic growth will probably be sluggish - and unemployment elevated - until residential investment picks up.

• MBA: Mortgage Purchase Applications Decline

NY Fed: Manufacturing Conditions Improve in February The headline number showed improvement, but two key numbers to watch are new orders and inventories. The new order index fell, and the inventory index rose sharply - and the declining gap between new orders and inventory points to a possible future slowdown in production.

• Empire Manufacturing Jumps in February
• Industrial Production, Capacity Utilization Increase in January

Disinflation So the core CPI — consumer prices excluding food and energy — fell for the first time since 1982. But that could be just a blip. Also, core CPI has been behaving erratically lately, making me doubt whether it’s still a good guide to underlying inflation (by which I mean the trend in prices that, unlike commodity prices, have a lot of inertia). What I find myself looking at these days are the Cleveland Fed “trimmed” inflation measures, which exclude outlying large price movements; the ultimate trim is the median, the rise in the price of the median category. And these indicators tell a story of dramatic disinflation in the face of a week economy: I find this a scary picture. For one thing, it suggests that deflation may not be too far in the future. But beyond that, there’s a growing belief among sensible economists that we need higher, not lower inflation. What we’re doing now is moving in the wrong direction, with real interest rates rising even as the nominal rate remains at zero.We may have to start calling the Fed chairman Bernanke-san, after all.

• Graph of Core CPI, and Cleveland Fed Measures of Inflation

Goldman Sachs Tells Fed To Start With Rate Hikes Most handicappers believe that when the Federal Reserve starts to tighten policy, it will begin by moving assets off its balance sheet and follow that with interest rate increases. Goldman Sachs‘ economists aren’t so sure after congressional testimony by Fed Chairman Ben Bernanke this week. The bank now believes the sequence of the central bank’s exit could be the opposite of the consensus view. The Federal Open Market Committee “would do its successors a great favor by making the first step of monetary tightening an interest-rate increase instead of a reserve drain,” Goldman economist Ed McKelvey told clients. He cautioned this is a very long-term call, because “we don’t expect or advocate (rate hikes) anytime soon–not in 2010 and probably not in 2011 either.” The key to Goldman’s argument is a power gained by the Fed in late 2008. Since that time the Fed has had the ability to pay banks interest on the reserves they hold at the central bank. Policymakers believe this tool gives them considerable control over financial system liquidity, as banks park reserves at the Fed in pursuit of guaranteed returns. Officials say the interest on reserves power means huge levels of bank reserves aren’t inflationary, because while banks may be flush with liquidity, it’s not being put into the broader economy. In his testimony Wednesday, Bernanke said that the interest on reserves tool stands a good chance of supplanting the overnight fed funds rate as the central bank’s focus in a coming tightening cycle. Instead of targeting the funds rate–currently close to zero percent–the Fed would state its new interest on reserves rate target. Bernanke also said the Fed may set targets for bank reserve levels as well, in another departure from the current regime.

• Fed bumps up rate banks pay for emergency loans
• The punch bowl, the party, the exit

Is the credit malaise really over? Interestingly, the Fed raised the discount rate last week as bank credit for the week contracted by a further $9 billion, According to David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates, “this brings the year-to-date decline to $115 billion, or a 14% annual rate, with every component from mortgages, to consumer credit, to business lending shrinking”. “There is no way the Fed is hiking the Fed funds rate with bank credit in secular decline and all bets are off on the sustainability of any recovery; a sustainable recovery without bank credit growth - that will be a new one. … a true tightening in monetary policy is still likely a 2011 story at this point. Those who were surprised by the early timing of the discount rate hike last Thursday should consider that perhaps the Fed wanted to have the market distinguish the move from an actual policy shift by doing it as far away from an FOMC meeting as possible,” said Rosenberg. As mentioned before, it is difficult to see a significant economic recovery without the banks coming to the party. And this begs the question: Is this what the policymakers had in mind when bailing out the banks?

• Harvard's Rogoff Sees `Bunch' of Sovereign Defaults, U.S. Belt-Tightening

Asia Leads the Global End to Cheap Money The U.S. Federal Reserve has just kick-started its cautious exit from unprecedented emergency lending measures — but the process has been going on for months in the Asia-Pacific region, underscoring the two-speed path of the global recovery. Countries from Australia to China have been leading the global march away from easy credit as their economies rebound strongly, while Europe and the United States are still trying to find a solid footing.

World Economic Outlook

The Making of a Euromess Lately, financial news has been dominated by reports from Greece and other nations on the European periphery. And rightly so. But I’ve been troubled by reporting that focuses almost exclusively on European debts and deficits, conveying the impression that it’s all about government profligacy — and feeding into the narrative of our own deficit hawks, who want to slash spending even in the face of mass unemployment, and hold Greece up as an object lesson of what will happen if we don’t. For the truth is that lack of fiscal discipline isn’t the whole, or even the main, source of Europe’s troubles — not even in Greece, whose government was indeed irresponsible (and hid its irresponsibility with creative accounting). No, the real story behind the euromess lies not in the profligacy of politicians but in the arrogance of elites — specifically, the policy elites who pushed Europe into adopting a single currency well before the continent was ready for such an experiment. Greece, however, has a small economy, whose troubles matter mainly because they’re spilling over to much bigger economies, like Spain’s. So the inflexibility of the euro, not deficit spending, lies at the heart of the crisis. None of this should come as a big surprise. Long before the euro came into being, economists warned that Europe wasn’t ready for a single currency. But these warnings were ignored, and the crisis came. Now what? A breakup of the euro is very nearly unthinkable, as a sheer matter of practicality. As Berkeley’s Barry Eichengreen puts it, an attempt to reintroduce a national currency would trigger “the mother of all financial crises.” So the only way out is forward: to make the euro work, Europe needs to move much further toward political union, so that European nations start to function more like American states. But that’s not going to happen anytime soon. What we’ll probably see over the next few years is a painful process of muddling through: bailouts accompanied by demands for savage austerity, all against a background of very high unemployment, perpetuated by the grinding deflation I already mentioned. It’s an ugly picture. But it’s important to understand the nature of Europe’s fatal flaw. Yes, some governments were irresponsible; but the fundamental problem was hubris, the arrogant belief that Europe could make a single currency work despite strong reasons to believe that it wasn’t ready.

Rising wages in China are a good thingI met with at least 30 different institutional investors, and perhaps the fact that my trip coincided with the twelve labors of Greece, or however many they have, worry over China and the state of the world economy was deeper than on my previous trips.  For reasons I have often discussed on this blog, I have never been a believer in the survivability of the euro, and many of the people I met on this trip had heard me over the past decade express my doubts, so meetings that were ostensibly on China often became meetings on whether Greece, Italy, Portugal, Ireland or Spain will be forced to exit. This, of course, is the intra-European version of the global imbalance debate.  It is simply another way of saying that policies in major trading nations that constrain consumption and subsidize production – in effect trading off lower household income for higher domestic employment – must have the reverse impact on trading partners who implicitly made the opposite trade-off, giving up employment in exchange for higher consumption.  As long as those trading partners were able to use the recycling of surpluses to leverage up domestic demand, and so boost domestic employment through debt-fueled growth, the adverse employment effect was hidden.  Once the leverage process started to unwind, however, the deficit countries would inevitably see a surge in domestic unemployment.  The best way to deal with the problem is to have both sides unwind the mechanisms that created the mirror trade-offs.  Germany must put into place policies that trade higher consumption for lower employment, and use debt to force employment up, so that deficit Europe can gain employment, albeit at the expense of a lower share of consumption.

• Spain's Problem Is Growth, Not Deficit Spain has been getting a bad rap. It got caught up in the wave of sovereign jitters that started in Greece and moved to other high-deficit countries, but this was unfair. To underline the point, Spain successfully sold a €5 billion ($6.88 billion) 15-year bond Wednesday after swiftly drawing in €13.5 billion of orders

Japan's Economy Grows... or Does It? So how can a 4.6% increase not mean the economy actually grew? The starting point. Third quarter GDP was reported to have grown 4.8% back in November. As I noted back then, the number looked odd as nominal GDP was negative even with that 4.8% real growth due to deflation. Now it appears that 4.8% growth never happened.

Tokyo has come under increasing pressure to address wild variations in its readings of gross domestic product: In the third quarter last year, the government initially said the economy had grown a robust 4.8 percent, only to revise that rate down to reflect no growth or decline. The latest numbers, the government says, have been adjusted for more accuracy.

Subtract that 4.8% growth and add in this quarter's 4.6% growth and you get... well, no growth from the level of GDP reported back in Q3. Over the longer period, we do see a slow normalization. However, anytime nominal growth is under this much pressure in an indebted nation (a nation's debt must be paid back in nominal terms, thus with nominal growth), there is still a lot of concern going forward.

• Japan - Past the Point of No Return - By Vitaliy Katsenelson

Rising wages in China are a good thing In spite of nagging worries about inflation, most observers, as far as I can see, welcomed the possibility of higher wages.  I think they are right.  The whole concept of rebalancing the economy is completely meaningless unless it means raising household income as a share of GDP.  Chinese wage earners have struggled with a number of factors that have made it difficult to raise their wages in line with the increase in national income (GDP), and since the level of household consumption is a function of the level of household income, this has forced a rising gap between the two and has forcibly resulted in a higher savings rate. But in that sense I think many observers, who argued that raising wages was the best way to rebalance the economy because it is the most direct way to get income into the hands of workers, are missing the point.  As I see it there are four main ways to raise household income, and while each of these can have the same aggregate impact, they differ on how the costs and benefits of that impact are distributed.

• Harvard's Rogoff Says `Horrible' China Crisis May Trigger Regional Slump  China’s economic growth will plunge to as low as 2 percent following the collapse of a “debt- fueled bubble” within 10 years, sparking a regional recession, according to Harvard University Professor Kenneth Rogoff. “You’re not going to go a decade without having a bump in the business cycle,” Rogoff, former chief economist at the International Monetary Fund, said in an interview in Tokyo yesterday. “We would learn just how important China is when that happens. It would cause a recession everywhere surrounding” the country, including Japan and South Korea, and be “horrible” for Latin American commodity exporters, he said.

• China - The Mother of All Black Swans - By Vitaliy Katsenelson

 

The December Trade Release: Implications for GDP Growth, Rebalancing, Doubling Exports and the US-China Deficit The December trade release surprised some observers in terms of the rise in imports. [0] I think there are some other interesting implications. First, the implied downward revision in GDP is minimal. Second, the drop was less pronounced in the ex-oil trade balance. Third, although real trade flows are rising from their troughs, they have not re-attained pre-Lehman levels. Fourth, the US-China goods trade balance continues to improve. The ex-oil trade balance continues to decline, but at a much slower pace than the total trade balance. The sensitivity of the US trade balance to fluctuations in the oil price (see also CR Haver) reminds me that the imperative still remains to reduce America's dependence on imported oil. Real US trade flows are recovering, but have not yet "recovered". One point has struck me; not only are exports below pre-Lehman levels, in some sense they have been below below what would be expected from a traditional trade flow equation (an ECM expressing exports as a function of rest-of-world income and the real exchange rate, estimated over 1973-00, suggests that exports have been running 10% under predicted, in log terms, over 2001-07). This observation is relevant when thinking about the Administration's goal of doubling exports (presumably nominal) by end-2014 (see the discussion of the goal this post). If there is reversion to (cointegrated) trend, then the objective becomes more plausible. Finally, on a non-economically interesting but politically sensitive variable, the US-China trade balance continues to improve, despite the stabilization in the US-China exchange rate. If the conjecture of some analysts that a resumption of yuan appreciation is imminent [6], then continued reduction in the US-China trade deficit is more likely at least over the short term.

Judging Stimulus by Job Data Reveals Success Imagine if, one year ago, Congress had passed a stimulus bill that really worked. Let’s say this bill had started spending money within a matter of weeks and had rapidly helped the economy. Let’s also imagine it was large enough to have had a huge impact on jobs — employing something like two million people who would otherwise be unemployed right now. If that had happened, what would the economy look like today? Well, it would look almost exactly as it does now. Because those nice descriptions of the stimulus that I just gave aren’t hypothetical. They are descriptions of the actual bill. Just look at the outside evaluations of the stimulus. Perhaps the best-known economic research firms are IHS Global Insight, Macroeconomic Advisers and Moody’s Economy.com. They all estimate that the bill has added 1.6 million to 1.8 million jobs so far and that its ultimate impact will be roughly 2.5 million jobs. The Congressional Budget Office, an independent agency, considers these estimates to be conservative. The program has had its flaws. But the attention they have received is wildly disproportionate to their importance. To hark back to another big government program, it’s almost as if the lasting image of the lunar space program was Apollo 6, an unmanned 1968 mission that had engine problems, and not Apollo 11, the moon landing. Even if the conventional wisdom is understandable, however, it has consequences. Because the economy is still a long way from being healthy, members of Congress are now debating another, smaller stimulus bill. (They’re calling it a “jobs bill,” seeing stimulus as a dirty word.) The logical thing to do would be to examine what worked and what didn’t in last year’s bill. But that’s not what is happening. Instead, the debate is largely disconnected from the huge stimulus experiment we just ran. Why? As Senator Scott Brown of Massachusetts, the newest member of Congress, said, in a nice summary of the misperceptions, the stimulus might have saved some jobs, but it “didn’t create one new job.”

• Happy Birthday, Dear Stimulus!

Structural Crisis: Sovereign Debt, Deficit Hawks & China

Wall St. Helped to Mask Debt Fueling Europe’s Crisis Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece and undermining the euro by enabling European governments to hide their mounting debts. As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels. Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books. Greece, for example, traded away the rights to airport fees and lottery proceeds in years to come. Critics say that such deals, because they are not recorded as loans, mislead investors and regulators about the depth of a country’s liabilities. For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives.

• We're "Absolutely" Headed for Another Crisis Without Reform, Economist Stiglitz Says
• Taming financial risk
• Number-crunchers crunched
• The role of the risk manager
• Banks and risk management
• Evaporating liquidity
• The future of financial regulation
• Risk after the crisis

The Greek Cockroach Warren Buffet’s adage “you never see just one cockroach” is going to be tested in Greek. We are about to find out if this is true as the ongoing “Odyssey” of Greece’s finances continues to unfold. The holiday weekend revelations about Greece and the use of swaps that were arranged through Goldman Sachs is just one more chapter in the Greek tragedy. Detailed reports are now available in Der Speigel, Bloomberg, Wall Street Journal, FT and elsewhere. It appears that Greece clandestinely attempted to use currency swaps as a deferral technique to project their payment obligations into the future and to hide them. Greek officials claim to the contrary; they say the transactions were reported. But an initial scan of the reports that were used in the early part of this decade does not find them. Hmmmm? It also appears that these transactions were arranged through Goldman Sachs and that subsequently GS hedged its position to a neutral one by shorting or constructively shorting Greek debt. Did Goldman act improperly? That now also is a subject of debate. Investigations are certainly coming. Witch-hunting about Goldman Sachs and their book of derivatives is very popular these days. We expect to see more of it on both sides of the Atlantic Ocean.

Deficit Hawks Want New (or double dip) Recession One of the oddest things to come out of the entire credit crisis, recession and muddling recovery has been the sudden re-emergence of deficit hawks. While a few honest deficit hawks are out there — the Peterson Institute is a good example of a group looking at long term structural issues, not immediate fiscal concerns — the vast majority of born again fiscal hawks are political hypocrites. They voted for all manner of budget busting programs — unfunded tax cuts, new entitlement programs (i.e., prescription drugs), an expensive war of choice (Iraq). How is it that they only learned of the evils of deficits after they lose power? How very convenient.The current group of anti-deficit spenders are pro-cyclical, rather than counter-cyclical. This means that during an expansion, they have no problem with expanding deficits, running big spending programs, giving generous tax cuts. During a recession is where they suddenly rediscover fiscal prudence. This is ass backwards. During an economic expansion, with employment gaining and GDP growing is when you should be thinking about saving for the next rainy day. Counter-cyclical spending means that governments should watch the budget carefully during the good times, but spend spend more freely during the downturns. What we are hearing from this crowd is the exact opposite of what should be. Many people believe the government’s early withdrawal of depression stimulus after the early 1930s is what caused another downturn circa 1938-39. But few people realize that Japan made the exact same mistakes in 1997 and 2001.That is the lesson SocGen’s Albert Edwards points to in Richard Koo’s book about Japan’s balance sheet recession, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession :

The crux of his analysis is that governments have no option but to stimulate aggressively all the while the private sector is de-leveraging. ANY attempt at fiscal cuts simply results in renewed recession and a further loss of confidence, thus making it even harder and more costly to sustain any subsequent recovery and hence the budget deficit ends up bigger than before (e.g. see chart below). This is exactly the outcome I expect.

Koo argues that the premature fiscal tightening by Japan 1997 and 2001 weakened the economy, reduced tax revenue and ultimately made the fiscal deficit even bigger: There are few things more annoying the a drinker who just discovered sobriety: Hence, those who have spent the past decade getting drunk on government spending are now suddenly proselytizing a belated sobriety. These calls are occurring exactly when government largesse would do the most good. I can’t tell what motivates these new deficit hawks — are they merely ignorant, unaware of the historical analogs? Or are they hoping for another recession as part of a debased power grab? (I don’t know). What I am sure of is that calling for fiscal temperance RIGHT NOW is essentially calling for another recession . . .

• The Age of Balance Sheet Recessions: What Post-2008 U.S., Europe and ChinaCan Learn from Japan 1990-2005
• We Need a Second Stimulus Now, Says Nobel Laureate Stiglitz, or Americans Will Be Unemployed for Years
• Stiglitz: Washington Should Stop Worrying, U.S. Has "No Problem" Paying Off Its Debts

China – The Mother of All Black Swans – By Vitaliy Katsenelson What happens in China doesn’t stay in China (not any more); it spills over to the rest of the world. China will turn from a windin the sails of the global economy to its anchor.The impact will be felt in many, and unsuspected, places. It will tank the commodity markets, commodity producers, and commodity-exporting nations.(Incremental demand from China collapses, oil prices follow, taking the Russianand Middle Eastern oil-centric economies with it). According to GaveKal Research, China accounts for 15% of Brazil’sexports (up from 1.5% a decade ago). •Demand for industrialgoods will fall off the cliff.China consumes a lot of those goods –$550 billion worth annually (according to GaveKal Research). Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boostingour interest rates higher. No more 5% mortgages and 6% car loans.

Earnings & Business Performance

Are Earnings Normalizing? At What Level? Looking a numerous earnings charts, we can come to several conclusions: First, the charts imply that the worst of the crisis and recession driven earnings collapse is over.  Second, it appears that earnings are normalizing, i.e., returning to their prior range. Third, that stocks can no longer be described as cheap. Lastly, whether stocks are art fair value or are expensive will be determined by how much equity prices gain relative to ongoing improvements in earnings.

Q4 earnings in perspective With most of the S&P 500 companies having reported financial results for Q4 2009, the chart below, courtesy of The Chart Store (via The Big Picture), shows how S&P 500 earnings declined by 92% from their Q3 2007 peak to the low of Q1 last year, and then subsequently rebounded by more than 600%. However, as shown by various measures of historical and prospective price/earnings multiples (see text in blue), the S&P 500 is not in cheap territory. Justifying current price levels will require stronger earnings growth than currently estimated by Standard & Poor’s.

Wall Street Power Shift “What happened at B of A is an embarrassment,” says John S. Reed, former co-chairman and co-CEO of Citigroup Inc. The bank’s board should have had at least two people ready to take over if Lewis resigned, Reed says. “There was no indication that the board had a clear idea of what they were looking for.” The global credit crunch and economic collapse of the past two years exposed pivotal management mistakes at the biggest U.S. banks -- from slack risk oversight to multimillion-dollar bonuses for bankers chasing short-term profit. Lewis’s exit highlights another kind of poor bank stewardship: the failure of CEOs and boards of directors to plan for an orderly succession when it’s time for the top person to leave. Inadequate planning derails a company’s strategy and destroys employee morale, former executives, investors, recruiters and leadership consultants say. In the past four years, disorganized transitions cracked the foundations under some of the world’s biggest financial institutions, including Citigroup, Merrill Lynch & Co., insurance giant American International Group Inc. and Zurich-based UBS AG.

Secret AIG List Shows Goldman Minted Most Toxic CDOs The document Issa made public cuts to the heart of the controversy over the September 2008 AIG rescue by identifying specific securities, known as collateralized-debt obligations, that had been insured with the company. The banks holding the credit-default swaps, a type of derivative, collected collateral as the insurer was downgraded and the CDOs tumbled in value. The public can now see for the first time how poorly the securities performed, with losses exceeding 75 percent of their notional value in some cases. Compounding this, the document and Bloomberg data demonstrate that the banks that bought the swaps from AIG are mostly the same firms that underwrote the CDOs in the first place “It’s almost too uncanny,” Calacci says. “If these banks had insight into the underlying loans because they had relationships with banks, originators or servicers, that’s at the least unethical.” The identification of securities in the document, known as Schedule A, and data compiled by Bloomberg show that Goldman Sachs underwrote $17.2 billion of the $62.1 billion in CDOs that AIG insured -- more than any other investment bank. Merrill Lynch & Co., now part of Bank of America Corp., created $13.2 billion of the CDOs, and Deutsche Bank AG underwrote $9.5 billion.These tallies suggest a possible reason why the New York Fed kept so much under wraps, Professor James Cox of Duke University School of Law says: “They may have been trying to shield Goldman -- for Goldman’s sake or out of macro concerns that another investment bank would be at risk.”

Wal-Mart’s U.S. sales drop another sign that the economy is turning–and a signal to put Wal-Mart on my watch list Wal-Mart (WMT) sales dropped at its U.S. stores for the quarter ended on January 31 2010. Wal-Mart comparable sales dropped? That’s the first time ever. Ever. Time to add this company to my watch list for a buy sometime within the next three months. If you’re looking for thin reeds (See my post http://jubakpicks.com/2010/02/18/my-thin-reeds-say-the-first-half-of-2010-will-be-surprisingly-strong-in-the-u-s/ ), here’s another one that says U.S. consumers are feeling better about themselves. Some portion of the consumers who found shopping at Wal-Mart so attractive during the worst of the recession has apparently decided that it’s okay to spend a little more. We’re not talking about a huge drop here. U.S. comparable store sales were down all of 2% from the year-earlier quarter. Some of that drop came from falling prices for electronics and food, the company said. Wall Street analysts say that accounted for about 0.9 percentage points of the drop. But much of the rest came from a drop in traffic caused by first, remodeling at stores that deterred shoppers, and second, a decline in store traffic. So why am I adding this stock to my buy list? Because sometimes it takes a middling quarter to show exactly how great a company is. For an example, look at what Wal-Mart managed to achieve on margins during this “bad” quarter. Gross margins climbed by 0.35 percentage points on tighter inventory controls. Operating margins rose 0.4 percentage points on higher gross margins and selling, general, and administrative expenses (SG&A) that climbed at a lower rate than sales. It didn’t hurt either than while U.S. comparable store sales were flat, sales in the international business were up 19.5% year-to-year including currency effects of 11.9% excluding currency. International sales carry higher margins than Wal-Mart gets from its more mature U.S. business. (Because Wal-Mart has been such an aggressive acquirer internationally, international comparable store sales growth isn’t a very useful number so I’m using just net sales growth for that part of Wal-Mart’s business.) Not supposed to happen like that. Margins are supposed to fall and SG&A as a percentage of sales to climb when sales struggle. And because if the economy slows in the second half of 2010 and into 2011, Wal-Mart is the kind of stock I’d like to own. (I also don’t mind that in the just-reported quarter comparable store sales grew by 5.6% in Brazil and 4.8% in China.)

• Was Lowe’s earnings report good or bad news for the economy? So when does beating low expectations stop counting as good news?It’s an important question for the stock market and for the economy as a whole. After easy to beat earnings comparisons in the first and second quarters, stocks face a bigger challenge in the third and fourth quarters of 2010 as they pass the absolute bottom for the economy.
• Dell Serves As a Reminder Lost amongst the Greeks, the Discount Rate hike, and that unpleasantness with Tiger Woods last week was Dell’s earnings news. It was not particularly good, and the stock fell to near 5 year lows. Dell’s disastrous stock performance creates a “teachable moment.” That lesson is simply “Do not blindly follow the investing strategies of billionaires.” Recall a purchase of stock by Michael Dell himself in 2006. That was $70 million worth of stock at $23.99.  This was remarkably Mr. Dell’s first ever purchase of his namesake company’s stock. According to data from Thomson Financial, he had been selling steadily every year since 1988. Put those figures into context: This $70 million purchase was less than 0.37% of his Mr. Dell’s assets. In terms of relative wealth, it is the equivalent of someone who earns a $100k per year buying 100 shares of Dell stock.Yet that did not stop many pundits and analysts from looking at the purchase as if it were an enormous vote of confidence.

ABB Taps Emerging Markets, Guards Cash to Navigate Through `Thunderstorm'  ABB Ltd. Chief Executive Officer Joe Hogan plans to expand in Brazil and India and remain selective with acquisitions, saying Europe and the U.S. may need more time to emerge from the steepest economic slump in half a century. The company identified $1 billion in additional savings until the end of this year, underscoring ABB’s reluctance to call an economic recovery, Hogan said. Zurich-based ABB, the world’s biggest maker of power-transmission equipment, will move more jobs to emerging economies, where growth will remain above 10 percent and costs are lower, he said in an interview. “Right now it’s like we’re flying through a thunderstorm, and you just want to get out the other end,” Hogan said yesterday in London. “I think too much of the world is thinking we’re back to 2007. It’s a natural reflex, but I don’t know if we’re back to where we were.”  ABB received more orders from emerging economies than from so-called mature markets in the fourth quarter. Hogan, 52, predicted the majority of the company’s workforce will shift to regions that include India, China and Russia in the next 18 months, from 45 percent now, as ABB scales back its operations in countries such as France, Ireland and Sweden. The Swiss company joins competitors including Siemens AG, which said on Jan. 26 that it’s not “out of the woods yet,” and that some markets have yet to recover. Siemens, which competes with ABB in areas including power transmission and factory automation, has trimmed expenses by merging plants, cutting back office costs and eliminating 10,000 jobs.

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Well we've been working our way down yet another track on business performance in the "New Normal" from general environmental conditions (here, here and here) to & toward general assessments (here and last post), and interweaving it with specifics, this time on the Tech Industry and Finance (general, GS as bad example).(BtW - Matt Taibbi has a follow-up takedown on GS where he channels Barry Ritholz of Big Picture using his own very unique voice that lines up with our assessment almost exactly in terms of substance, if not tone:Taibbi: “The Best 18 Months of Grifting This Country Has Ever Seen”). Over the last few years it's fair to say that almost all businesses failed to monitor the environment, walked into the downturn blind, got sideswiped by the crisis, reacted rather poorly and are still frozen. We've just had several conversations off and on over the last few weeks with other folks who're seeing the same things on a widespread basis. But there are exceptions and it seemed like a good idea to address while also creating a Tech pair to match our Finance Industry/Firm examples. Plus it's been a while since we took a really deep dive on a particular firm so we're going to address all that by looking at Cisco.

Mobility, the 4A's and Cisco's Strategic Environment

With all that in mind it may seem a little strange to start (above) with a clip pointing to NBC's Olympics coverage home page but there's a method to our madness triggered by a recent TechTicker on how upset everyone was with their coverage (NBC's Olympics Coverage Infuriates Sports Fans From Coast To Coast). Now we gave up TV years ago and see everything online and the one thing we still missed was some sports but especially the Olympics and it turns out if you actually navigate your way over there there's plenty of stories, photos and slideshows. And, lo and behold, an immense inventory of online video clips, full event coverage and live streaming broadcasts. And it's all pretty well done. Which made someone who's resurrected their career by hoping on the new media outlet using that venue to harshly criticize NBC for tape-delays disingenuous at best and appallingly ignorant at worst. We'll admit NBC has a long ways to go to better market and integrate their new stuff, cross-leverage with the old and make money but they've done a find job. In fact we've lost way too much time, including being able to watch the entirety of the complete opening ceremonies online. Which makes NBC on the bleeding edge of the 4A's - Anywhere, Anytime, Anything, Any Device. It is this brave new world that Cisco sees as being a major driver of the Tech world going forward (as does IBM, HPQ, Dell, Intal, TI, etc. etc.). The real question is who's got it right, who can develop the right capabilities and who can deliver? Now those are really interesting indeed. And to attack them and understand what making the 4A's real you need to know a bit about how all the pieces play, or not as the case more often is.

 

The graphic captures most of the relationships and capabilities required, at a certain conceptual level. It probably deserves a long and detailed dissection of each level plus examples and case studies. Rather than do that here as it happens we've already published something that might serve online (Technomediatainment Futures: Evolution, Barriers, Structure and Opportunities of a New Industry) you should probably take a look at if this is at all interesting. But just to take a perfect example of synergy requirements and breakdowns ATT is getting knocked because it's network won't support the applications demand of the iPhone, where nobody anticipated the demand for online data and applications. Now what happens if the iPad takes off - will the networks invest the next multiple $B to make the 4A world a reality? Can they afford to? At an reasonable price? There are all sorts of those complex questions running all the way thru the biggest shakeup in the Tech world we've seen in a long time and Cisco is sitting, one way or another, at ground center. What's the CEP - the circular error probability though?

Cisco in Context: Stock Price History

And even if they manage to preserve and extend their legacy businesses, position for the new ones and grow by huge rates what will that mean for them as a business? And as an investment? BtW - it's important to remember these questions apply to everybody and that much of Cisco's analysis and planning, really superb as it is, is shared by almost every other player in some form or another. So when we walk thru their stuff we're also walking thru almost every other major player in the game with a similar perspective and strategy.

The context is defined by looking back a decade - Cisco has never recovered their bubble value and has in fact, despite everything they've done, been going sideways like any mature value company for the rest of the decade. More component of the market than driver or leader. And if you look at the last five years (UR corner) they've got a very rich valuation, that's held up thru the crisis and very good but not growing earnings. From an investment perspective we have to start by saying that superb performance is already more than priced in. In fact at PEs of 20-25 they're going to have to grow at 10-15% forever. That's not just Red Queen Syndrome it's a requirement for sustained Olympic performance to collect the medals you've already got!

Strategic Encapsulation: V/S/E to New Markets and Solutions

The kernel of truth behind the Tech Bubble was a major transition in data communications technology from the old disparate networks (numerous acronyms we won't list 'cause we forgot) to TCP/IP, otherwise known as the Internet. And the subsequent discovery that not only could computers talk to computers but so could people and, more recently, that people could talk to people. And they could/now can do it with more than alphanumerics, say with pictures, video and music.

The heart of Cisco's business was and remains the networking business but the real questions are: can they keep improving it, what new transitions will be built on top of it and what new market niches will open up? This chart is kind of their strategic visions (built from sampling all the presentations at their last major analyst briefing btw, which you can find here).We actually recommend taking a looksee/listen to all of it. But basically they see three major new "lobe" transitions - virtualization out of the data center, the growth of teams and workgroup collaboration and the integration and online access of video. NB: Cisco is betting BIG TIME on the 4A Ecology emerging and its rapid development as well as being dependent on the other major players from the device makers to the application developers to the service providers to the network providers getting their stuff right. At the same time they also understand that a correct interpretation of the new emerging ecology places more burdens on them for strategy, execution and management. Plus finding and creating new sources of value - which they appear to see in the many market adjacencies where they envision creating integrated composite solutions. Whether or not that all comes to pass and in what time frame is wide open. The fact that they see it, are probably right and are bending every effort to position for it while continuing to develop their base tells us that they're already way ahead of most of the companies we know about - a true 5 on our scale.

This time after the break we keep going on more pure Cisco stuff instead of pointing to readings and focus specifically on Performance & Outlook (will they have the wherewithawl?), Execution and deeper into Strategy. We suggest you keep plowing on with us. As a reward not only will you find a bunch more chartsets and discussion of key issues but a link to a complete set of these plus a whole bunch more chartsets at the end of the next section.

Cisco's Performance History & Outlook

 If you start in the UL corner and work around this start with us you can see that financial performance has been exemplary - revenue, operating income and earnings have all grown very well indeed. Below that you can see that they have a very strong pipeline and backlog, a strong balance sheet, and need to work on operating efficiency quite a bit more. You can also see the hallmark of a mature business in that buybacks are a major item though.

In the UR corner you get a shorthand view of their worldwide strategic outlook, which is reasonable but optimistic. Our work tells us that their worldwide growth outlook is too sanguine while their guestimates on IT spending are optimistic and underestimate the damage that IT spending will have taken. At the same time it also tells us that they see offshore markets, at least in their traditional marketspaces (largely enterprise datacomm) as critical to their future.

The LR corner tells us that they know their traditional routing and switching markets will remain their bread and butter but they expect new technologies to vastly expand the number and size of marketspaces they can go after. In fact they are anticipating huge growth in those adjacent markets. The LL corner tells us what kind of operational strategies they are pursuing - which is basically to combine continued product development with services combined with vertical solutions. It also tells us that they understand how difficult the transitions to these new markets will be, both in general and on paper (hence the "Chasm" barrier!). Whether their guts know and they are prepared to do what it takes and have the capabilities are another question. But again this type of work puts them far ahead of most companies we're aware of AND is a VERY good assessment of the nature and structure of the 4A Revolution. Cisco gets it, in other words!

 Execution, Execution, Execution?

It's one thing to talk the talk and another to walk it of course. A few months back Cisco announced a radical new organizational structure that was going to be built up out of collaboration councils strategically designed and located throut the Company. Most of the reaction was, "say what?". The rest was duh? But in actual fact it's Cisco attempting to wrestle with the organosclerosis problems inherent in the complexity of their organization as is and where they want to go. So they end up with a council for products and another for services, each btw focused on a specific one, and yet another for end-market solutions. All at various levels from the operational to the executive. It might be the mother of all multi-dimensional matrix organizations gone mad (the last time somebody had to really try this it was NASA in the early days of the Space Program). At the same time it's both an honest attempt to face up the organizational and management system architectural issues innate in what they're trying to do. It is ALSO an attempt to walk the talk on what they think the brave new world of Collaboration will look like - and how new technologies can address it. In other words it is Cisco very much eating their own cooking - so much so that they're betting the Company on it. Now that's serious.

All of which you can see in these chart sets. In fact they had us with the UL where they paired Innovation with Execution (& Collins) but when the took it down the several layers we know to be necessary we started applauding. This is the only organization we're aware of that's thinking about this stuff, let alone with this much depth and detail, clearly for a long time and also clearly translating it into specific solution concerns. They, in effect, become their own laboratory and testimonial. Take a careful looksee - this is what a lot of large, complex and multinational organizations are going to have to do. And almost none are doing; in fact most aren't even aware of the problem (that is they haven't taken the first step on a 1,000 mile journey and Cisco would seem to be a couple of hundred miles down a tough road). You might compare and contrast them to our previous deconstruction of SAP or our dissection of Dell (Dell Computer: It Ain't Your Grandfather's Beige Box), a company who had some good but not well-thought ideas and is struggling mightily with execution.

Brave New World: Services and Solutions

Let's tunnel down a little farther on their articulation of Strategy - from the Enterprise conceptual to the specific and operational (as Gen. Schwarzkopf calls it the "Operational Art").  Which leads us to this next composite chart which illustrates how they intend to go after Services and Vertical Solutions, what role they play in chasm crossing and what they might look like. One of the things we emphasized repeatedly was the need to balance functional island with whole enterprise concerns in both the short- and long-terms.

Here the middle two charts tells us how Cisco is going to pursue enhancements of its existing business in the near-term while building services in the intermediate and and then solutions in the long-term. They're intending to grow the business by 12-17%, which is impressive, but know that 9-11% of that comes from their core while the rest from creating and growing new businesses. Even more impressive. The top two charts more explicitly lay out examples of the kinds of things they are talking about, at each layer of their implicit total solutions architecture and against a time-phased structure, where one thing builds on another. The bottom two charts show two particular examples. Which perhaps perfectly illustrate the critical challenge they'll face.

The creation of vertical solutions for the sports entertainment world will NOT require deep understanding of the business and will therefore more readily lend itself to a technician's approach. Healthcare on the other hand is the most complex marketspace we've ever tried to analyze. To get embedded their on the solutions side you'll have to know it about as well as the practitioners do, be able to design and develop solutions, convince and sell them and help a whole industry work it's way thru innate cultural and organizational barriers. That's one tough challenge.

And is probably endemic to the whole notion of complex business solutions at the top layers of the 4A Ecology Stack. Something Cisco will struggle with because it doesn't have the cultural background or domain knowledge - nor does anyone else. But if they can crack the code they'll be good for a long...long time to come. And everything else they're trying means they'll be good for a long time as well. It's the solutions spaces that will determine whether they can create a breakthru to new sources of significant growth - or just continue to be a very good, even excellent, company.

We'll pick up on Cisco with a second major pass, hopefully not to far in the future but this is enough to digest for now. However if you'd like to access a downloadable PPT show that has all these chart sets collected together you can find it here. 

Posted by dblwyo at 01:38 PM | Permalink | Comments (0)

We put up the GS review and deconstruction for its own sake - people need to keep paying attention and understand what really went on and is going on. But also because it's such a perfect exemplar of the general behavior and attitudes of the Industry as a whole and, more importantly, representative of the core of the challenges facing most businesses today. Those challenges are a sense of complacency in a return to business as usual, hubris that what they did before the crisis is perfectly suited to the "stormy present" and sclerotic organizations that refuse to recognize those challenges and/or are unable to adapt to them. As for the complacency we start the readings off with some recent updates on the world markets - which are turning out to be as turbulent, fragile and exposed to more structural fault lines as we warned. The biggest surprise we've had is that so many folks are surprised. Well we've spent as much time warning about the deeper structural challenges facing businesses over the next decade so you have to think the same lack of preparation is hiding behind the covers.

Earlier this week we got into a long exchange with a friend on that assessment where he thought we were on to something but wondered what our evidence was. A fair question - partly in answer we've put our online essay collections from the last three years on the subject in the readings as well as specific postings associated with other readings we think are interesting. You might recall though the accompanying graphic which shows the distribution of performance capabilities on a 1-5 scale, before, during and after the crisis. A 1 is a company at risk of collapse, a 2 one which is surviving by mostly emergency short-term measures, a 3 is one which added on some attempts at longer term improvements or investments in new products or markets, a 4 one undertaking serious efforts at major new strategic initiatives and a 5 one which is undertaking major new operational improvements and/or innovation initiatives. Both the headlines, anecdotes and multiple surveys indicate that the distribution is pretty much as we have it.

 

How the Mighty Fall: Collins' Five States of Decrepitude

If we're right about the strategic outlook for the next decade, and so far the evidence has born us out for the last several years, then even the Fours will be facing real struggles and anybody at Three or below will be at serious risk. Contrary to popular opinion all businesses are neither equal nor machines of immaculate strategy, excellent execution or effective governance. Rather just the opposite in fact. One guy with a "Name" in exploring that is Jim Collins who published his third major book last year and gave an outstanding set of interviews for Business Week (you can find the link the homepage of the special report with a bunch of video clips that we strongly urge you to listen to where he discusses each of the 5 Stages plus answers some questions on Leadership and saving a failing company).

The graphic outlines the five stages and clicking on it will take you to the first interview where starts in on the backstory. S1 is success-born hubris, S2 is grasping after more, S3 denial of reality and continued frantic pursuit of more, S4 is grasping for salvation, where a company announces big bang after big bang (the new product, the merger, the major new geography, ...) and S5 capitulation to irrelevance and death (roll over and die). Any resemblance between those stages and what we've just gone thru with the last two bubbles is purely coincidental of course. The really sad part is that the taxpayers saved the Finance Industry from stage 5 and now they've reverted to Stage 3. Collins has a pronounced ability to boil down complexities to essences, put in plain but compelling language that makes it stick and provide easily observable indicators that anyone can apply. In other words as an investor, employee, customer or stakeholder he's given you a great diagnostic toolkit. We think our work takes it down the next several levels and is complementary. The Five Stages tell you how to tell what kind of trouble a company is in while our stuff provides the toolkit to assess and treat the problems in a structured, systematic and systemic manner.

Who Won the Superbowl: the Quarterback Myths vs. the Coaches Realities

Sports analogies are popular with a lot of folks, not least because they work if you're familiar with the sport. Sadly Rugby, Cricket and Soccer don't convey much to us and American analogies seem tow work only in America. But we're going to pursue it nonetheless and talk about the Superbowl, which is a great story. Underdog team from beaten down city pulls it out in the second half and testifies to the resilience of can do and we shall overcome. There are some major elements of truth in all that but it's not the real story.

Years ago Bill James started applying statistical analysis to Baseball and came up with the discipline of Sabrmetrics. First adopted big time by Billy Beane and the Oakland A's and popularized by Michael Lewis in his book, "Moneyball". Since then a lot of other teams have adopted the techniques and put more resources behind. The Red Sox being the poster children for how to win two World Series by being thoughtful and disciplined as well as just expensive. Similar techniques have been developed in other sports and the folks over at Football Outsiders have been working away for years. And created a football version that works pretty well. Anyway their take on the game is a lot different - they argue, at length with a lot of data and good thinking, that they keys were the second half calls of the New Orleans coach. Achievable of course by having a good team that put a lot of time, preparation and heart into getting ready for the game and then played well. The kind of detailed analysis on a player by player basis using their analytic approach is captured in the graphic (trust us - this one you must click on to read). And in the readings you'll find their detailed discussion of the game.

Getting Prepared for the Future: Moving the Curve Rightward

Well we think the same kind of thing can, should and must be done for every enterprise. Just that most aren't doing it. Partly for Collins symptoms problems but mostly, we suspect, because like Bill James early days there's limited awareness that it can be done. If you put all the pieces together (the structural changes in the world economy, current business performance, etc.) what we're saying is that businesses in general need to move onto the blue curve and you need to find those that do. The details of how and how to tell are collected in the readings, both in general and for a lot of different companies and industries - not enough space to re-review them all. We used our BizzXceleration framework to assess GS for example and you can find some of the graphic from questions to principles to engineering analysis to general assessments by clicking on thru.

Climbing Mt. Everest: Environment Awareness

In one of the interviews Collins talks about the waterline problem - it's one thing to take a big risk if the damage will be above the waterline and something else if it's below. BSC, LEH and MER are no longer with us because they took big risks below the waterline. And rumors to the contrary so did GS - they were saved by the government in a multiple ways, as we reviewed last post. Another analogy we liked is comparing the journey from trouble to salvation to greatness as being like climbing a major mountain. Now on Mt. Everest there are two major routes that have been developed. If it's the beginning of the climb and you're at the base camp there's plenty of supplies, the weather is likely warm(er) and plenty of help if you get in trouble. If it's your 3rd attempt and your at Camp 7 at 25,000', tired, exhausted and out of supplies in a regime where things happen faster and more unpredictably there's no margin for complacency or error. If we're right about the post-crisis world we're all at Camp 7 and there are a lot of folks acting like they're basecamp bystanders.

There's a bunch of readings but three in particular deserve some attention. One is the pair between mis-reported earnings based on cost cutting (yet again) and the overwhelming evidence that layoffs do long-term, permanent and structural damage to enterprise performance. Lots of 3's have turned themselves in 2's and 1's without knowing it. The other is a Fortune article on the new magic 1# fix, whether it was stock prices, stockholder returns, ROI or ROA. The new magic number is EVA and it couldn't be more wrong. In fact perhaps the most important finding we have made over thirty years and especially the last severn is that it's the other way around. The numbers will be good if you start with business performance - the real mantra is Value - Execution - Delivery and that requires good judgment, executive leadership, the right team, a decent strategy and outstanding execution. The numbers will follow. Which makes the whole set of readings "Leadership, Performance & Governance" critical - if there's anything truly fundamentally broken it's the level of management governance from C-level to Board we've been getting. Now that there's no place left to hide the question is will we start getting it?

State of the World

Video Clips

·          Gluskin Sheff BNN speaks to Bill Webb, executive VP and chief investment officer, Gluskin Sheff. ·          Q4 Earnings Season Crosses Halfway Point Thomson Reuters market analyst Ashwani Kaul talks to BNN about corporate earnings. ·          Economic Recovery in Doubt A dismal U.S. jobs report sparks a commodity selloff, and China won't be of any help, according to Lincoln Ellis, managing director, Linn Group. ·          Market Decade BNN speaks to Stephen Freedman, global investment strategist for wealth management research, UBS. ·          Strategy for Turbulence Diverse opinion about today's Canada and U.S. job numbers underline the need for a nimble and flexible investment strategy. BNN speaks to Peter Gibson, managing director, head of strategy and quantitative research, CIBC World Markets.

Europe's Economic Recovery Almost Stalls as Germany Unexpectedly Stagnates

Europe’s recovery almost stalled in the fourth quarter as waning spending and investment in Germany unexpectedly brought growth in the region’s largest economy to a halt. Gross domestic product in the 16-nation euro region rose 0.1 percent from the third quarter, when it gained 0.4 percent, the European Union’s statistics office in Luxembourg said today. Economists forecast expansion of 0.3 percent, the median of 34 estimates in a Bloomberg survey showed. The recession in Greece deepened, with GDP falling 0.8 percent in the fourth quarter after a 0.5 percent slump in the previous three months. European governments are struggling to contain the fall-out from Greece’s budget crisis as they phase out the stimulus measures used to pull the economy out of a recession. As market turmoil pushes bond yields higher across southern Europe, the recovery is in danger of losing momentum.

EU Leaders Deploy `Bazooka' to Defend Greece as Threats to Stability Mount  European leaders closed ranks to defend Greece from the punishment of investors in a pledge of support that may soon be tested. German Chancellor Angela Merkel and her counterparts yesterday pledged “determined and coordinated action” to support Greece’s efforts to regain control of its finances. They stopped short of providing taxpayers’ money or diluting their own demands for the country to cut the European Union’s biggest budget deficit. While bonds gained, the euro slipped for a third day today and pressure is now on the governments to show how they would back up their words with action. Investors’ attention now turns to a meeting of finance ministers in Brussels on Feb. 15-16.

China's Central Bank Raises Banks' Reserve Requirement by 50 BPS  China ordered banks to set aside more deposits as reserves for the second time in a month to cool the fastest-growing economy after loan growth accelerated and property prices surged. The reserve requirement will increase 50 basis points, or 0.5 percentage point, effective Feb. 25, the People’s Bank of China said on its Web site today. The current level is 16 percent for big banks and 14 percent for smaller ones. Stocks reversed gains in Europe after the announcement on concern that tighter lending in China will damp the global economic recovery.

• China Raises Reserve Requirement for Second Time in a Month to Cool Growth

Commodities Drop as China Acts to Cool Expansion; Oil, Copper, Gold Plunge  Crude oil and copper led the worst decline in commodities in a week as China, the world’s fastest- growing major economy, sought to cool growth. The S&P GSCI Index of 24 raw materials retreated 1.7 percent to 493.2 as of 11:21 a.m. in London, the steepest drop since Feb. 5. Oil fell 2.1 percent in New York trading and copper slid 2.6 percent in London. Aluminum, wheat, gold and platinum also declined. China, the world’s biggest copper consumer and second- largest oil user, ordered banks to set aside more deposits as reserves for the second time in a month after loan growth accelerated and property prices surged. Commodity markets have counted on China to prop up demand as developed economies recover from the steepest slump since World War II.

Asia’s Exposure to Europe’s Woes On the surface, it seems right that there are no Greece-like sovereign debt problems in Asia. Asia’s government balance sheets outside Japan and Vietnam are in good shape, with about $5 trillion of foreign-exchange reserves backing up economies that have manageable budget deficits and limited borrowing from abroad. Local banks are better capitalized and solid economic growth should keep default rates low. But there’s more to fear than just a sovereign default contagion spreading down the Silk Road. Asia’s real worry is that Europe’s debt woes will drag down the Continent’s economic recovery, dampening demand for Asian goods. A weak euro doesn’t help Asia either, as it becomes more expensive for Europeans to buy Asian products.

Business Practice & Principles

Football as Field Experiment

In the NFL, Bigger Isn't Always Better The Colts' success stems from a philosophy that borders on treason in the modern NFL: the idea that bigger is not always better. The average NFL player has grown over time to 246 pounds this past season, according to Stats Inc. That's a 6% increase over the average two decades ago and 12% more than the average 50 years ago. Simple physics would suggest that this is a good idea—that it's easier for a player with more mass to move a player with less. Height on defense also helps players knock down passes thrown by the opposing team's quarterback, or to leap high enough in the air to disrupt the other team's receivers. By carrying less mass, the Colts believe their players are quicker to the ball and less fatigued late in games. "I would compare us to Google," says Colts linebacker Freddy Keiaho, who clocks in at 5-foot-11, 226 pounds. "Google is a small company, but they make billions and billions of dollars and they're a world leader in everything they do. We're built to endure."  As their larger opponents on the offensive side of the ball begin to slow down and lose focus, the Colts say they start gaining an edge. "It allows you to play faster," says Colts cornerback Kelvin Hayden. "In the fourth quarter, those guys who are big on the offense tend to wear down. As the game goes on, our front seven are not as tired." According to an operational study of National Football League teams prepared for The Wall Street Journal by Boston Consulting Group, the typical NFL season requires 514,000 hours of labor per team. That's about eight times the effort it took to conceptualize, build and market Apple's iPod, according to BCG, and enough time to build 25 America's Cup yachts. If both Super Bowl teams dedicated themselves to construction rather than football, their members could have built the Empire State Building in seven seasons.

What It Takes to Win the Super Bowl  According to an operational study of National Football League teams prepared for The Wall Street Journal by Boston Consulting Group, the typical NFL season requires 514,000 hours of labor per team. That's about eight times the effort it took to conceptualize, build and market Apple's iPod, according to BCG, and enough time to build 25 America's Cup yachts. If both Super Bowl teams dedicated themselves to construction rather than football, their members could have built the Empire State Building in seven seasons.

Coach Leach Goes Deep, Very Deep The first play Leach called against Texas A.&M. was the first play on Cody Hodges's wrist. That wrist held a mere 23 ordinary plays, 9 red-zone plays (for situations inside an opponent's 20-yard line), 6 goal-line plays, 2 2-point-conversion plays and 5 trick plays. "There's two ways to make it more complex for the defense," Leach says. "One is to have a whole bunch of different plays, but that's no good because then the offense experiences as much complexity as the defense. Another is a small number of plays and run it out of lots of different formations." Leach prefers new formations. "That way, you don't have to teach a guy a new thing to do," he says. "You just have to teach him new places to stand." Texas Tech's offense has no playbook; Cody Hodges's wrist and Mike Leach's back pocket hold the only formal written records of what is widely regarded as one of the most intricate offenses ever to take a football field. The plays change too often, in response to the defense and the talents of the players on hand, to bother recording them.

Super Bowl XLIV Quick Reads Well, the instant narrative that has spilled out of Super Bowl XLIV is that "Payton beat Peyton": Sean Payton made amazingly brave decisions, and Peyton Manning couldn't come up big when he needed to. The "Manning choked" talk is just as silly on its face as it was five years ago and deserves little respect, so we're going to focus on a much more quantifiable part of the game: Payton's decisions. In a game that often paralyzes coaches with its importance, Sean Payton made two extremely bold, unconventional moves. To steal our favorite phrase from Herm Edwards, Payton coached to win the game. An evaluation of those decisions -- even without considering the outcome of the game, which is mostly independent of his two biggest strategic choices -- proves them to be correct. His first bold move was to go for it on fourth-and-goal from the Colts 1, with 1:49 to go. You can take issue with the specifics of the playcall and whether the Saints might have been better off running behind guard Jahri Evans or putting the ball in Drew Brees's hands, but the logic behind the decision is sound. Starting off the second half with an onside kick was an even bolder move, but it was again mathematically correct. Football Outsiders has found that the recovery rates for unexpected onside kicks has been, historically, 70.5 percent. That jibes with Payton himself, who estimated it to be better than a 60 or 70 percent chance during the week. That historical rate is again conservative, since it doesn't account for the nature of the Super Bowl; all surprises aren't created equal, and nobody in their right mind was expecting an onside kick, especially after Payton's big decision had just come up short. We can keep going and adjust those figures for quality of defense, but you get the idea. The point is simple: Each time Payton made his decision, despite the fact that coaches tend to be risk-averse and that one of his decisions didn't pan out, he was making the mathematically correct choice. Sean Payton wasn't wrong when the Colts stuffed Pierre Thomas, and he wasn't right until the final horn sounded and he was being carried onto the field by his players. He was right the moment he kept his offense on the field, and he was right the moment he told Morstead to execute the onside kick. Here's to hoping that more coaches show his level of bravery when teams try and figure out the Saints' formula for success moving forward.

• Audibles at the Line: Super Bowl XLIV
• NFL Standings, 2000-2009
• A Thinking Man's Guide to Pro Football By Paul Zimmerman (68-980)

Dumbest Moments in Business

Dumbest moments in business 2009 Loudmouth CEOs, islands in the desert and bringing dead celebrities back to life. Our annual list of the business world's bonehead plays marches on. Dumbest 2009: Midyear edition From Tropicana's botched redesign to KFC's chicken run, here are 17 dumb moments in business. Dumbest of the decade As the first 10 years of the century draw to a close, we take a long hard look at exactly what got us into this mess. Dumbest decade in business Windows Vista, the financial collapse and maestro Alan Greenspan highlight the dumbest moments of the decade.

Business Performance: Cases, Tools, Histories and Trends

The world's most respected companies What price respect? If the concept seems too high-minded for pecuniary assessment, just consider that when it comes to calculating asset values -- physical, financial or reputational -- Wall Street is never at a loss. Investors pay up for respect, in part because respected companies tend to hold their value longer. "Respected companies aren't going to fall as far in the bad times, and they come back better," says David Hartzell of Cornell Capital Management, a participant in the survey that helped Barron's produce a list of the 100 most respected companies. (See the full list at the bottom of this article.) In 2009's roller-coaster market, the top-ranked stocks generally experienced lower volatility and outperformed during the bear leg. And now, even after the broad market's furious rally, the value of respect is still felt: For the most part, shares of the most respected companies are either above or not much below their pre-Lehman-bankruptcy levels and have beaten the market since that crisis erupted. Defining respect isn't easy. "It's a difficult concept," says Paul Jackson of Paul Jackson & Associates. "You might think a company like McDonald's (MCD, news, msgs) isn't respected. All they do is make burgers. But they make millions of them, and they are very good at it. Are they are respected because of the innovations or because of the good profit numbers?" Mickey D's, which arguably deserves respect for both, is No. 7 this year, just as it was in 2009. Survey participants say respected companies have strong management, good governance, valuable products and services, and strong stock returns. They treat their shareholders, customers and employees well. They act ethically. And while some money managers name respect as the first cut in their investment process, others say respect is more often the result of a sound investment process. John Roberts, a portfolio manager with Denver Investments, contends that respect answers the question "Is management going to be a good steward of our clients' money?" He says, "Respect takes a long time to build, and it's easily destroyed."

Ill-prepared, Flat-footed and Slow: Business Responses to the Economic Crisis and the Impacts Businesses did not anticipate the depth and severity of the economic crisis, in spite of numerous warning signs, and were got badly prepared, flat-footed and reacted slowly and poorly. Now we a semblance of normality returning a renewed sense of complacency is settling in that does not prepare them for the challenges of the new normal. Here we look at how they reacted, or didn't, lay out some general principles, examine Wal-Mart in depth as an example of the kind of foresighted re-thinkings required to deal with the New Normal and consider some of the challenges and failures. In particular we lay out the disruptive changes they should be anticipating as well as examine the failures of leadership that contributed to the poor responses. Since business performance will dictate how well we deal with our new challenges the future of growth, profits and employment are very dependent on the adaptability, resilience and innovation of business and the outlook is not promising.

• Business Performance, Investments and the Economy: Unprepared Into the Storm
• Business Performance II: Moving Toward Crisis, Managing By Hubris

Renewing the Enterprise: Governance, Innovation and Performance in the New Normal This next decade, the "Age of the New Normal" is going to be more challenging than most enterprises or organizations are prepared or are preparing for. To deal with the on-going challenges AND create new sources of value will require new management systems, enterprise governance, and emphasis on performance and, especially, dedicated and effective investment in Innovation. In these essays we sketch out the character of the New Normal, diagnose the barriers to adaptation and innovation and propose new mechanisms for managing both Innovation and current operations. We're in for interesting times and the organizations that do well in what promises to be a very difficult environment will be those that develop and apply approaches like this.

Major Issues and Elements

For Some Firms, a Case of ‘Quadrophobia A new study provides further evidence suggesting many companies tweak quarterly earnings to meet investor expectations, and the companies that adjust most often are more likely to restate earnings or be charged with accounting violations. The study, which examined nearly half a million earnings reports over a 27-year period, reached its conclusion by going beyond the standard per-share earnings results that are reported in pennies and analyzing the numbers down to the 10th of a cent. That deeper look showed that companies tend to nudge their earnings numbers up by a 10th of a cent or two. That lets them round results up to the highest cent. Investors often snap up shares of companies that beat earnings expectations, even by a cent, and, likewise, sell off shares of companies that don't make their numbers. "Managements will exercise accounting discretion to try to make their numbers look better for Wall Street … in a number of subtle ways," said Joseph Grundfest, one of the study's authors. Mr. Grundfest is a law professor at Stanford University and a former member of the Securities and Exchange Commission. Mr. Grundfest and co-author Nadya Malenko, a doctoral candidate at the Stanford Graduate School of Business, said the accounting maneuvers may be legal, even when they have the effect of boosting reported earnings per share. Most of the tactics involve judgment calls, such as the value of inventory or the amount that should be set aside for loans that won't be repaid. The Securities and Exchange Commission declined to comment.

• Quadrophobia: Strategic Rounding of EPS Data
• CEOs Raising Forecasts at Record Pace Fail to Persuade Analysts on Profits

Cost Cutting Boosts Profits  Fourth-quarter earnings for U.S. companies so far have rocked compared with a year ago. The question for this year: How much more can earnings improve? Among those posting results thus far, the melody has been sweet. Financial-services companies Visa Inc. and MasterCard Inc., for instance, reported profits rose 33% and 23%, respectively, over a year ago. Earnings overall are running well ahead of last year's dreadful fourth quarter. Through Wednesday, with 280 members of the Standard & Poor's 500 index reporting, operating earnings are rising sharply, but the year-ago quarter was the first time the group as a whole ever lost money. Excluding financial companies, earnings are up about 47%. Sales gains are more muted, up only 5.9% for S&P 500 companies thus far, and expected to rise about 0.9% from the year-earlier quarter. That doesn't even match the current inflation rate. Perhaps most heartening about the quarter's results is that sales are on track to break a string of four consecutive double-digit-percentage declines. Still, the projected increase is well below the average 3.95% gain since 1994, according to S&P. Despite modest sales growth, corporations have managed to craft their profit growth mainly through massive cost cutting. For the beat to continue, companies will need to drive the top line, and that looks to be a key challenge for an economy where demand is depressed, with at least 10% of the work force unemployed and another large swath underemployed. "Until nonfinancials [corporations] see sustained sales growth, they will not be hiring, and that is the whole ballgame," said Howard Silverblatt, S&P's senior index analyst.

• Unilever Prepares For Slow Recovery

Lay Off the Layoffs Airlines faced not only the tragedy of 9/11 but the fact that economy was entering a recession. So almost immediately, all the U.S. airlines, save one, did what so many U.S. corporations are particularly skilled at doing: they began announcing tens of thousands of layoffs. Today the one airline that didn't cut staff, Southwest, still has never had an involuntary layoff in its almost 40-year history. It's now the largest domestic U.S. airline and has a market capitalization bigger than all its domestic competitors combined. As its former head of human resources once told me: "If people are your most important assets, why would you get rid of them?" It's an attitude that's all too rare in executive suites these days. As the U.S. economy emerges from recession, Americans continue to suffer through the worst labor market in a generation. But the majority of the layoffs that have taken place during this recession—at financial-services firms, retailers, technology companies, and many others—aren't the result of a broken business model. Like the airlines' response to 9/11, these staff reductions were a response to a temporary drop in demand; many of these firms expect to start growing (and hiring) again when the recession ends. They're cutting jobs to minimize hits to profits, not to ensure their survival. As for firms that have no choice but to cut jobs, if your company is the 21st-century equivalent of the proverbial buggy-whip industry, don't fool yourself—downsizing will only postpone, not prevent, your eventual demise. For many managers, these actions feel unavoidable. But even if downsizing, right-sizing, or restructuring (choose your euphemism) is an accepted weapon in the modern management arsenal, it's often a big mistake. In fact, there is a growing body of academic research suggesting that firms incur big costs when they cut workers. Some of these costs are obvious, such as the direct costs of severance and outplacement, and some are intuitive, such as the toll on morale and productivity as anxiety ("Will I be next?") infects remaining workers. But some of the drawbacks are surprising. Much of the conventional wisdom about downsizing—like the fact that it automatically drives a company's stock price higher, or increases profitability—turns out to be wrong.

Radical Shifts Take Hold in U.S. Manufacturing America's industrial base is undergoing its most radical restructuring in decades as manufacturers rethink their businesses in the wake of the recession. From Dow Chemical Co. to Intel Corp., iconic companies are telling stories of wrenching change—both contraction and recovery—as they report their earnings for 2009. Dow Chemical said Tuesday it is aiming to shed some $2 billion worth of basic-chemical factories and other assets this year as it moves into more-profitable specialty chemicals. Appliance maker Whirlpool Corp. said it cut about a tenth of its capacity in 2009 as it struggled with a 9.6% drop in sales. Intel, by contrast, is investing billions of dollars in its U.S. plants as demand for computer gear recovers. "We are emerging from one of the most challenging economic environments we've seen in decades," said Whirlpool Chief Executive Jeff Fettig, on a conference call Tuesday. The latest moves are accelerating the U.S. manufacturing economy's longer-term shrinkage, as well as its shift away from heavy sectors, such as automobiles and basic chemicals, toward higher-tech products like super-fast computer chips. In some cases, as with auto makers, companies are stripping down to adjust to diminished U.S. demand or investing in smaller, more-efficient facilities. In other cases, as with chemical makers, they are relocating labor-intensive operations to countries where wages are cheaper.

• Volkswagen Takes Aim at Rival's Top Perch
• The Self-Inflicted Collapse of the Auto Industry

A new financial checkup In business as in life, be careful what you wish for. I know a company that wished for a better return on equity. What could be wrong with that? It paid its executives according to that measure, and man, did they deliver. In some years the firm had the best ROE in its industry. It was winning bigtime.The firm was Lehman Brothers, now dead because managing for ROE caused executives to overborrow; after all, debt is capital that earns a return (in good times). Yet it isn't equity, so extreme leverage simply juices ROE until bad times arrive. Wishing for the wrong thing -- managing for the wrong ratio -- killed the company.The larger, chilling reality is that every other ratio out there can lead to the same disaster. Gross margin? Earnings per share? It's easy to make any of them look better while damaging the business.Which is why a new ratio that you've never heard of, EVA momentum, is so intriguing. It has been developed by consultant Bennett Stewart, one of the creators (with Joel Stern) of the measure called economic value added, or EVA.

• Renewing the Enterprise 2: Governance, Measurement & Performance

 When money doesn't talk Money is overrated: In fact, pay has little, if anything at all, to do with motivation in the workplace. That's the controversial argument put forth by best-selling author Daniel Pink in his new book, Drive: The Surprising Truth About What Motivates Us (Riverhead Books). "Pay for performance has to be exposed as folklore," he says.Pink contends that, provided employees receive a baseline level of compensation, three other factors matter more than moola: a sense of autonomy, of mastery over one's labor, and of serving a purpose larger than oneself. Hmmm. There may be something in all this -- but the executives at Goldman Sachs (GS, Fortune 500) aren't exactly busting a gut to adjust. Like others on Wall Street, the banking giant, which is expected to earn $6 per share in the fourth quarter, argues that fat bonuses are crucial to making its numbers.Responds Pink, in a now common refrain: That's precisely the attitude that led to the recent financial meltdown, as traders and mortgage brokers focused on short-term rewards that encouraged "cheating, shortcuts, and unethical behavior."Moreover, the 45-year-old author and former Al Gore speechwriter cites social-science experiments and experiences at such workplaces as Google (GOOG, Fortune 500), JetBlue (JBLU), 3M (MMM, Fortune 500), online shoe retailer Zappos, and software companies Meddius and Atlassian.

• People & Performance: Assets or Fungible Commodities?
• Aaargh, Captain Ye Best Take Care of the Crew
• Aholes, Shirkers and Performance: a Draft People Principles Policy

Innovation Teams Lack Data, Structure Of course, large companies make innovation decisions in a structured, data-driven way. But do smaller innovation teams do the same? "I'm going to be blunt with you: The answer is no," says Paul, a product development staffer at a US medical device company. "Our team hasn't thought much about how it makes decisions. I don't know exactly what a team approach should look like; though for starters, we need a better way to communicate, to use the same language and data." Paul was part of our recent Babson Executive Education study of innovation team leaders at 21 science and engineering-based companies (special thanks Dipali Desai at Kepner-Tregoe for her input during this study). Only six respondents report that their innovation teams make decisions in a structured and data-driven way, while 18 reported that their organization-wide innovation process — a stage gate or a drug pipeline, for example — tends to be much more disciplined and data-driven. Why the gap in data orientation between organizations and their teams? Though our analysis is still preliminary, and our sample size small, interviewees report having at least one of three concerns:

• A Bit of Xmas Cheer: Innovation As The Future
• Renewing the Enterprise 1: the Proper Management of Innovation

Looking for a Quick Recovery? Why America's Recession Differs From the Great Depression The Great Depression was a period of innovation? Carlson: Yes. When you think of the '30s, you tend to think of high unemployment and low capacity. But it was also a period of creative destruction. We got synthetic fabrics like rayon and nylon, plastics, aluminum. Automobile transmissions and motors improved, as did the aircraft industry. Knowledge@Emory:What was the reason for this innovation? Carlson: Because so many old businesses were in trouble, opportunities arose for new technologies and new firms that wanted to do things to try to survive in this difficult time.  Knowledge@Emory: Can you name a few of the "new" companies that were created during this time? Carlson: The 1930’s saw the consolidation of the automobile industry into the “big three,” and the rise of aircraft manufacturing companies like Boeing, Lockheed and Douglas. Cross-country truck companies became important rivals to the railroad. Modern airline companies also came into being. A number of big companies became active in private research and development, including RCA, AT&T, IBM, DuPont, Alcoa, GM, Kodak, and General Electric. These companies became leaders of US industry after World War II.

Leadership, Governance & Performance

Ten Management Practices to Axe Every few years, a management book or philosophy emerges to change our thinking about the best ways to lead employees. From The One Minute Manager to Who Moved My Cheese?, new and revived leadership concepts have shaped the way we organize, evaluate, inspire, and reward team members. With so many competing management theories in the mix, some ill-conceived practices were bound to take hold—and indeed, many have. Here's our list of the 10 most brainless and injurious:

Frightened, clueless or uninformed? In the face of significant change and opportunity, people are often one of the three. If you're going to be of assistance, it helps to know which one. Uninformed people need information and insight in order to figure out what to do next. They are approaching the problem with optimism and calm, but they need to be taught. Uninformed is not a pejorative term, it's a temporary state. Clueless people don't know what to do and they don't know that they don't know what to do. They don't know the right questions to ask. Giving them instructions is insufficient. First, they need to be sold on what the platform even looks like.And frightened people will resist any help you can give them, and they will blame you for the stress the change is causing. Scared people like to shoot the messenger. Duck. The worst kind of frightened person is one with power. Someone in a mob of other frightened people, someone with a gun, someone who is the CEO. When confronted with a scared CEO, time to run. Before someone can change, they have to learn, and before they learn, they have to cease being scared. One reason so many big ideas come from small organizations is that there is far less fear of change at the top. One mistake board members and shareholders make is that they reward the scared but hyper-confident CEO, instead of calling him on the carpet as he rages at change. When I first encountered surfing, I was scared of it. It looks cool, but an old guy like me can get hurt. A patient instructor allayed my fears until I was willing to get started. When you first start out, the things you think are important are actually irrelevant, and it's the stuff you don't know is important that gets you thrown into the ocean. Finally, and only then, was I smart enough to actually learn. I'm bad at surfing now, but at least I know why.Comfort the frightened, coach the clueless and teach the uninformed.

Which of these six leadership styles works best?  Leadership is a big, vague, amorphous topic. We can write about great leaders at great length. But practically speaking, how do you become one? A good start is to focus on leadership styles. Daniel Goleman, who popularized the notion of "emotional intelligence," has described the following six different styles that leaders use to motivate others. Our view is these are not mutually exclusive. You don't need to adopt one and ignore the others. Rather, the best leaders move among these styles, using the one that meets the needs of the moment. Think of them all as part of your management repertoire. Note that what distinguishes each leadership style above is not the personal characteristics of the leader, but rather the nature and needs of those who are being led. As James MacGregor Burns argued in his path-breaking 1978 book, Leadership: "Leadership over human beings is exercised when persons with certain motives and purposes mobilize, in competition or conflict with others, institutional, political, psychological and other resources so as to arouse, engage and satisfy the motives of followers." Unlike "naked power wielding," he writes, "leadership is thus inseparable from followers' needs and goals." The good leader, in other words, must understand what motivates those he or she wishes to lead.

Why Winning Streaks End That crashing sound you hear is not an accident caused by sudden acceleration of your hybrid car; it is the continuing toppling of idols, such as hybrid car companies, off their pedestals. Listen hard, lest you be next. Toyota, the world's leading auto company, faces a series of product problems causing a $2 billion recall, an investigation by the National Highway Traffic Safety Administration, and a galling loss of face for a company from face-conscious Japan. This follows its first annual financial loss in 50 years, with profitability regained partly through cost-cutting. Sayonara for a while to Toyota's reputation for quality control and invincibility. But in Dearborn, Michigan, there are no smug smiles. Ford announced that it is also fixing electronic brakes in its hybrid cars after a damaging review by Consumer Reports and more generalized concerns about electronics in cars. The noise continues. In banking, the latest jackhammer blow to any remaining pedestal pieces is a civil fraud lawsuit against former Bank of America CEO Kenneth Lewis. Okay, bankers might not be saints, but the saintly are crashing, too. Ten U.S. missionaries were arrested in Haiti on charges of abducting children, apparently admitting that they had neglected to secure all the necessary permissions, and with hints that some of the "orphans" had living parents. Do some people who feel they are doing good think that they can bend a few inconvenient rules to do it? And if these weren't enough reminders about fallen idols for one week, the Super Bowl did not feature my favorite team, the New England Patriots, whose period of NFL dominance snapped this fall among hints of eroding focus and discipline. All too often, long periods of continued success are undermined not by the competition but by self-inflicted wounds.

• Dealing With the Brave New World: Resilience vs. Sclerosis
• Renewing the Enterprise 2: Governance, Measurement & Performance

What We All Lost When Business Lost Respect I want to explore the growing malaise around business, in particular in widely-held, publicly traded corporations. I believe we have migrated — quite by accident — to a set of conditions such that in order to operate their corporations, senior executives are pressured toward a form of existence that is substantially inauthentic. And in the course of leading inauthentic business lives, they lose their moral compasses and play games that make them feel ever more inauthentic. This will take several posts, so bear with me while I lay out the first tranche of the argument. Now let's fast forward to the 21st century. Since the early 1980s, the mantra has become that the purpose of the corporation is to maximize shareholder value. Shareholding has become a short-term and opaque thing. Program traders shift positions daily based on tiny price variations and most share certificates are held in 'street form' — i.e., not registered to an individual because they are owned by a fiduciary institution like a mutual or pension fund that stands between the corporation and the shareholder.

Corporation Killers The failure of the financial system in 2008 wasn't simply a massive failure of common sense, regulation, and leadership. It was also a failure of corporate governance. In theory, the corporate boards at Lehman Brothers, Bear Stearns, AIG, and General Motors were paid handsome sums to oversee the activity of the executives and protect shareholders' interest. In practice, they slept as the CEOs ran the companies into the ground. In Money for Nothing: How the Failure of Corporate Boards Is Ruining American Business and Costing Us Trillions, coauthors John Gillespie and David Zweig chronicle the role boards played in the recent debacles and propose solutions. NEWSWEEK's Daniel Gross spoke with Gillespie, a former investment banker at both Lehman and Bear. A podcast of their conversation can be heard here. Gross: Just seven or eight years ago, after the failure of Enron, WorldCom, and Global Crossing, we were having similar conversations about boards of directors. What was different about this round of corporate-governance problems? Gillespie: This set had to do with excessive risk taking in combination with excessive executive compensation that incentivized that type of risk taking. Our sense of the entire issue was the CEOs have gotten most of the attention as the cause within companies, when they're supposed to be reporting to boards of directors. If we could fix that problem, we could possibly help prevent this the next time around.

Countering CEO Disengagement in the Age of TARP With many organizations set to reexamining the metrics used to determine CEO compensation, and with the turmoil over executive compensation in general, it's definitely enough to be of concern to CEOs, says Pearl Meyer, the senior managing director at Steven Hall & Partners, an executive compensation consulting firm based in New York City, who adds that "I don't necessarily think executive pay will decrease significantly." Ken Blanchard disagrees. "I think it's almost an ethical imperative that CEO compensation come down," says Blanchard, the author of numerous management books, including the classic The One-Minute Manager. "In the old days, the rule was CEO compensation was five times that of the lowest-paid employee." Even by the $500,000 minimum TARP standards, the formula isn't relevant today. Regardless of whether the threat to CEO pay is grounded in reality or overhyped speculation, human resources officers and board members should be on the lookout for CEO disengagement and learn what they can do to remedy it, according to Meyer. The signs of CEO disengagement are fairly easy to identify, says Neil Jacobs, head of Northeast America for YSC, a global business psychology consulting firm in New York.

• CEOs Who Create Bang for the Bucks
• Rethinking CEO Stock Options
• Bonuses and Scrutiny Fail CEOs
• Redefining the CEO Role
• Why We Need to Limit Executive Compensation

Why doing good is good for business He makes an economic argument: Globalization has made it increasingly difficult for companies to differentiate themselves based on their products alone. Whatever your product or service might be, chances are that someone on the other side of the world can copy and sell it for less money. And if money is the only bond between you and your employees, they will quit the moment another firm offers them more cash.All the more important, then, for companies to compete at the level of behavior: crucially, how they treat customers and employees. "It's about who has the most trust in their relationships, and where most people want to work," Seidman told me. "This will be the soft currency of the 21st century."But can you really measure the impact of good behavior? One promising area of research is around trust. The practice of corporate social responsibility has been on the rise for some time, evidenced most recently by the outpouring of U.S. corporate donations to support earthquake relief in Haiti. But Seidman believes it should go well beyond a company's CSR department.

• The Cusp Point is Here: Lessons From Davos
• Beyond Specifics to Principles: Business Performance Principles & Outlooks
• Leaders, Leadership & Culture: Crisis, Values and Performance
• Predator Prey Symbiosis: Crisis, Leadership and Values

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At this point we're generally tired of talking about the general performance of the Finance Industry, Wall St. in particular and especially continue the apparently futile flaying/flailing at Goldman Sachs. Forgive the headline btw - we were savoring our own cleverness. Nonetheless let's take one more pass at least for several reasons. First, because as the recent Davos conference shows everybody else is tired too but the Industry still is pretty smug in its attitudes and fails to acknowledge fundamental breakdowns in its business models or lack of value creation. Second, though the pressures have picked up, the Industry is still fighting as hard as possible to avoid fixing the problems or adapting to re-regulation. And third, but most importantly, because PBS's Newshour just did two short segments on GS that take apart the sources of its profits and the sources of its liquidity and funding. Guess what - all the angry pitchfork bearing populists have it exactly right if you believe PBS. A position and attitude summarized, from the inside remember, in Hoofy and Boo's takedown of Goldfellas from Minyanaville (which is about inside as it gets).

Where the Vampire Squid Makes Its Money

The first segment is interesting and asks the fundamental question of where does GS makes its money. Ostensibly they are an Investment Bank who makes it advice, fees for M&A, Deals, capital raising, e.g. floating bonds or IPO's, etc. or all those other similar activities that go on in the mysterious bowls of the financial engineers. In actual fact now that GS is a bank holding company it's required to report its profits. It turns out that traditional IB activities - the things that arguably are their reason for being and what is supposed to be their value-add to society - are about 10% of revenues last year. The other 90% comes from vampire squid activities, speaking loosely. In fact 75% of their profits appear to come from proprietary trading! Which includes front-running their own clients. When the President proposed before Xmas that banks be forbidden from having prop trading, private equity or hedge funds in essence he was talking about GS.

As several people have put it, including a Republican investment banker who served in the previous administration, "Goldman is a hedge fund disguised as an Investment Bank".

 

Where Do the Goldfellas Get Their Funds: Federal Subsidies and Yield Curves

You can't be a hedge fund without huge piles of capital to "invest" with, that would be speculative trading to the rest of us on a polite day or casino gambling to the rest of the real world. So where did GS get the funds to bet with in this last year? Well first the Federal bailout of AIG, absolutely essential to avoid a GD 2.0 that would have made GD 1.0 look like a walk in the park, saved GS and put it in a position to trade in a well-capitalized position in 2009. The really odd thing is that AIG got into trouble when it was taken over by a meglomaniacal idiot who didn't know what he was doing he took them from 5% subprime mortgage CDSs to 95% without having a clue. When they first got into that business the primary trading partner was, you guessed it, GS. When in 2006/2007 they were thinking about getting out it was GS and the other big firms that assured them the assets were sound. Yet we now know GS had already bailed out of that market and was betting against it. They literally took out insurance on a bad, drunk driver, jimmied his brakes and then greased Deadman's Curve. All in the name of being better traitors, oops traders, than anybody else. After all caveat emptor.

The second source of their funding is government guarantees they have access to as a bank holding company, which an IB does NOT. The third is the yield curve. The Fed is deliberately and necessarily holding down short-term rates to near zero% while Treasuries are priced around 3-3 1/2%. So GS and the other banks are borrowing from the Fed thru one door and walking across the street to play the yield curve at the Treasury. The Fed must do this to keep the economy on track but an implicit and hoped for benefit is that the big banks would rebuild their capital bases thru this implicit subsidy. That "re-building" would include writing down toxic assets, including the mortgages that were over-valued and are going to get more so, building up reserves, and so forth. There's a pretty strong case to be made that paying all those bonuses based on trading with public money instead of doing what they should have is a violation of fiduciary trust. And all the big banks are guilty but GS is the exemplar.

GS Profit Story in Previous Incarnations

Perhaps you'll decide that all this is simply PBS getting on the populist bandwagon, despite their well-earned and -deserved reputation as independent, careful reporters. Well it turns out they're not only right they're about about seven months late to the story. Which may tells us much background effort they put into researching it. You see most of this was covered in the blogosphere last summer. Unlike the MSM who not only ignored it, completely neglected digging into the biggest financial story of 2009 but also completely poopoohed the one guy who did (admittedly over the top) dig in. Matt Taibbi of Rolling Stone. And least you think he was to far gone the Columbia Journalism Review dug into his facts and said, in effect, what do you know, he knows what he's talking about. In the readings along with the PBS links you'll find three major readings that lay out all the background facts we're setting before you here.

All of which is laid in this composite chart drawn from those various blog sources, largely (MAJOR hattip) channeled via BigPicture. One thing we forgot to mention is the consequence of TBTF Syndrome - the markets are treating GS as having an implicit government guarantee which means when it borrows it gets a few points above Treasuries! Amazing!! Which shows up in this chart where in the UL they were stunningly re-leveraged, in the UR made their money from trading and in the bottom two you get the breakdown by type of trading. Just remember this is all your money they're gambling with. Frankly the case for a comprehensive windfall profits tax that would pay back TARP and offset huge chunks of the deficit seem ironclad to us. After all every other investor in the Universe expects to get a share of the returns, right? Another chart (sadly we admit very hard to read) that compares GS to the rest of the Industry for whether or not its being treated as a fiduciary banking institution or a hedge fund is here. Not surprisingly, unlike the rest of the Industry, the markets tend to view GS stock as being more a speculative option than they do a stock. Interesting indeed, eh what?

GS, the Industry and the Public Trust

In the readings you'll find a fairly complete collection of our recent postings on the Industry and the business case for leaving it alone as opposed to reforming it. Since we've summarized the various conclusions ad nauseum we'll leave well enough alone. You'll also find the entire collection of previous GS readings plus a slew on the analysis and business case for a windfall profits tax. Just skimming them should pretty well make our arguments for us from supplementary sources.

What we will do is jog your memory, here where we treating GS as both a standalone and as Industry exemplar, by reminding you of what society has a right to expect from a value-creating business. And how we judge the Industry has performed by line of business. And judging by their behaviors this last year, by which we particularly mean using public funds to subsidize trading and pay themselves bonuses, is how they see the world in the world now and in the future.

So, write your Congressmen first thing and tell 'em it's time to get off the dime and fix what they refuse to fix for themselves.

Readings and Sources

PBS Newshour Segments & Key Readings

Unraveling the Profit Puzzle at Goldman Sachs  As part of his continuing series of reports making sense of business and the economy, Paul Solman examines the inner workings of investment powerhouse Goldman Sachs and how it makes money. PAUL SOLMAN: Kicking off last month's inaugural hearing of President Obama's Financial Crisis Inquiry Commission, CEOs of the four biggest banks -- in the hottest of the hot seats, Lloyd Blankfein of Goldman Sachs. PHIL ANGELIDES: In the end of the day -- and I'm going to press you on this -- it seems to me that you survived with extraordinary government assistance. LLOYD BLANKFEIN, CEO, Goldman Sachs: We never anticipated the government help. We weren't relying on those mechanisms. PAUL SOLMAN: And just a year later, venerable Goldman Sachs, beneficiary of bailout largess, is the most profitable firm in Wall Street history. So, how did they do it? Lloyd Blankfein told The Times of London: "We're very important. We help companies to grow by helping them to raise capital," and that he was just a banker doing God's work. Now, the interview seemed to play better as comedy than P.R.

Is Taxpayer Money Behind Profits at Goldman Sachs? Paul Solman continues his series of reports examining investment powerhouse Goldman Sachs and how it makes money. But this story is about the claim that Goldman has been getting most of the money to trade from you and me, via our government. Nomi Prins, a 10-year veteran of Wall Street trading, left Goldman after 9/11. NOMI PRINS, former managing director, Goldman Sachs: First, of course, they received $10 billion in TARP money. Even though, a year later, they can say, "Well, we didn't really need it," They really needed it. PAUL SOLMAN: They' needed it, says MIT's Simon Johnson, who is working on a book about the undue influence of Wall Street, because, during the panic of 2008, they were on the brink.SIMON JOHNSON, former International Monetary Fund chief economist: Goldman Sachs and Morgan Stanley had a problem, which is, they were about to fail, and that everyone felt that this was coming, and they couldn't borrow easily from the Fed, because they weren't banks. PAUL SOLMAN: Then the authorities had a vision of salvation, according to Johnson. SIMON JOHNSON: And they said, aha, we will turn them into bank holding companies, so they get -- they have access to this cheap money from the Fed. PAUL SOLMAN: Bank holding companies own or control one or more U.S. banks. Though no one from Goldman would give us an interview, CEO Blankfein recently told the Financial Crisis Commission that the firm wasn't necessarily on the brink after Lehman Brothers collapsed in mid-September 2008. LLOYD BLANKFEIN: That weekend, when we became a bank holding company, the next day, we capitalized ourselves, in part privately, with Warren Buffett. And the day after that, we did a capital raise for $5.75 billion, which you could have made a lot higher. We had access to the capital markets. And we could have made more. And we weren't relying on that government help. PAUL SOLMAN: But others are dubious that Goldman could have raised so much money without government help. NOMI PRINS: You don't go to the Fed on a Sunday night and say, I really need to become a bank holding company now because I want to help out all my competitors. You go because you need capital, and this was a way to do it.

The Man Who Crashed the World Here is an amazing fact: nearly a year after perhaps the most sensational corporate collapse in the history of finance, a collapse that, without the intervention of the government, would have led to the bankruptcy of every major American financial institution, plus a lot of foreign ones, too, A.I.G.’s losses and the trades that led to them still haven’t been properly explained. How did they happen? Unlike, say, Bernie Madoff’s pyramid scheme, they don’t seem to have been raw theft. They may have been an outrageous departure from financial norms, but, if so, why hasn’t anyone in the place been charged with a crime? How did an insurance company become so entangled in the sophisticated end of Wall Street and wind up the fool at the poker table? How could the U.S. government simply hand over $54 billion in taxpayer dollars to Goldman Sachs and Merrill Lynch and all the rest to make good on the subprime insurance A.I.G. F.P. had sold to them—especially after Goldman Sachs was coming out and saying that it had hedged itself by betting against A.I.G.? How and why their miracle became a catastrophe, A.I.G. F.P.’s traders say, is a complicated story, but it begins simply: with a change in the way decisions were made, brought about by a change in its leadership. At the end of 2001 its second C.E.O., Tom Savage, retired, and his former deputy, Joe Cassano, was elevated. Savage is a trained mathematician who understood the models used by A.I.G. traders to price the risk they were running—and thus ensure that they were fairly paid for it. He enjoyed debates about both the models and the merits of A.I.G. F.P.’s various trades. Cassano knew a lot less math and had much less interest in debate. “The culture changed,” says a third. “The fear level was so high that when we had these morning meetings you presented what you did not to upset him. And if you were critical of the organization, all hell would break loose.” According to traders, Cassano was one of those people whose insecurities manifested themselves in a need for obedience and total control. They went from being 2 percent subprime mortgages to being 95 percent subprime mortgages. And yet no one at A.I.G. said anything about it—not C.E.O. Martin Sullivan, not Joe Cassano, not Al Frost, the guy in A.I.G. F.P.’s Connecticut office in charge of selling his firm’s credit-default-swap services to the big Wall Street firms. The deals, by all accounts, were simply rubber-stamped by Cassano and then again by A.I.G. brass—and, on the theory that this was just more of the same, no one paid them special attention. Together with Park and a few others, Cassano set out on a series of meetings with Morgan Stanley, Goldman Sachs, and the rest—all of whom argued how unlikely it was for housing prices to fall all at once. “They all said the same thing,” says one of the traders present. “They’d go back to historical real-estate prices over 60 years and say they had never fallen all at once.” (The lone exception, he said, was Goldman Sachs. Two months after their meeting with the investment bank, one of the A.I.G. F.P. traders bumped into the Goldman guy who had defended the bonds, who said, Between you and me, you’re right. These things are going to blow up.)

Tenacious G The Goldman domination of the meetings might not have raised eyebrows if a private solution had been forthcoming. But on Tuesday, Paulson reversed course and announced that the government would step in and save AIG, spending $85 billion in government money to buy a majority stake. The argument was that AIG was not only too big to fail but too interconnected: The loss of the billions it owed to the banks and other counterparties could collapse the global financial system. The plan was to sell off the insurer for parts and pay the banks their cash collateral. Of the $52 billion paid to AIG’s counterparties, Goldman Sachs was the biggest recipient: $13 billion, the entire balance of its claim. The amount was surprising: Banks like Merrill Lynch that had bought credit-default swaps from failed insurers other than AIG were paid 13 cents on the dollar in deals moderated by New York’s insurance regulator. Not a single Wall Street executive I spoke with, including several Goldman Sachs alumni, believe those hedges would have survived an overall collapse of the financial system. A large loss would have been inevitable as lending evaporated, and Goldman Sachs would have struggled to shrink the company to a fraction of its size overnight. But the most glaring argument against Goldman is Goldman’s own: If AIG’s biggest and most important bank customer was hedged against losses in AIG, as it claims, why did the government need to pay Goldman Sachs the full $13 billion? Lost in the haze of Goldman’s recent record profits is the fact that the firm nearly went under even after the AIG bailout last fall. As the market continued to plunge and Goldman’s stock price nose-dived, people inside the firm �were freaking out, says a former Goldman executive who maintains close ties to the company. There is no evidence that Goldman was directly gambling with taxpayer money. But it seems clear that none of this would have been possible without government intervention without the AIG bailout, the TARP money, the FDIC bonds, the fact that without Lehman Brothers it had one less competitor in the field. This doesn’t sit right with some. Much of their recent profits seemed to be derived from trading,’ which typically means gambling not lending, says Joseph Stiglitz, the Nobel Prize winning economist who teaches at Columbia University. It is lending which is required if our economy is to be revived; it was gambling that got our financial system into trouble.Even Goldman alumni were struck by the company’s shameless posture in ramping up the leverage again so soon after the government bailouts. It’s a statement of arrogance,says one former executive. What they’re saying by keeping leverage high is, We’re smarter than anybody else.’ On Wall Street, there are two interpretations of this business model: Either the firm is so brilliant at making near-riskless bets that it continually attracts more clients, who don’t mind being used for the golden database if it means more profits for them or it’s a giant casino in which the house has gamed the system by knowing every hand at the table and using that information to enrich itself at the expense of others.

Don’t Dismiss Taibbi Mainstream financial journalism is doing its level, eye-rolling, heavy-sighing best to stuff Matt Taibbi back into the alt-press hole he came from, but he’s not going along with it, and the mainstreamers in any case are making a big mistake.The Rolling Stone writer cemented his status as the enfant terrible of the business press with “The Great American Bubble Machine,” a 10,000-word excoriation of Goldman Sachs, a muckraker’s-eye view of Goldman history, exploring the bank’s and Wall Street’s contributions to various financial disasters, starting with the Great Depression, skipping to the Tech Wreck, the Mortgage Wreck, the oil bubble of 2008, the bailout, and the looming cap-and-trade plan. Salted with “fuck”s, “shit”s and written with brio and hyperbole in the New Journalism tradition, it caught the financial community, which very much includes the financial media, utterly off-guard, unused as it is to hearing its flagship described as a “giant vampire squid wrapped around the face of humanity.” As Taibbi (who needs no help defending himself) pointed out on his own blog, Moore addresses precisely none of the substantive criticisms that have been leveled at the bank, including big ones, like (1) buying predatory loans, (2) selling defective mortgage-backed securities while (3) shorting them at the same time, and (4) buying defective insurance from American International Group, then having those bad bets redeemed in full by government programs ratified by ex-Goldman executives. This is to say nothing of the role ex-Goldman alums played in laying the groundwork for the decade’s financial recklessness—Robert Rubin’s contribution to deconstructing financial regulation and Henry Paulson’s lobbying to loosen capital restrictions in 2004, to name just two. First, it’s worth noting that the debate about “Bubble” hasn’t been about the accuracy of the facts in the piece (though it’s not, I’m sorry to say, problem-free, as we’ll see below). Instead, the discussion is about the arrangement of the facts and the conclusions drawn from them. Now, manipulation in bad faith of true facts is probably as bad a journalism sin as any other. Still, the facts here are really not the issue. So one question to think about is, when does being “technically right” become simply being “right,” at least in the sense that a piece makes valid points by marshaling true facts?Indeed, subsequent reporting and events have only provided support for Taibbi’s basic argument—that Goldman and Wall Street have played important roles in a series of harmful events over the years (come to think of it, is this even controversial?). His idea that Goldman gamed the bailout, for instance, got backing from Joe Hagan’s recent piece in New York, which makes a strong case that the AIG bailout saved Goldman from disaster and was not, as some defenders weakly maintain, a matter of indifference to the bank:

Previous Postings

• More Darkside Earnings Tales: Banks,Goldman und Unsinn
• BaU vs. NN I: Finance Fumes, Realities and Pecora II
• Ask Not For Whom the Siren Shrieks: Let the Finance Wars Begin
• Bonus Fantasies vs Political Realities: the Reform Firestorm This Time
• Firestorm Flaring up: Finance Reform, Compensation Wars & Sausages
• Paying the Piper: Finance Industry, Performance, Value & Regulation
• The Business of Banking: Challenges, Issues & Outlook
• Pecora 2 Hearings, Malfeasances, Your Future & Cusp Points
• Comes 'round, Goes 'round: Hastening Forward Slowly to Finance Reform
• Finance Industry Futures: Performance, Governance, Reform & Politics

GS as Exemplar

What Is Goldman Sachs? Recall that in Q4 2008 brokerage firms (Goldman Sachs, Morgan Stanley) and finance companies (CIT, GMAC) were given permission to convert into commercial banks. They did this to get access to better sources of funding during the dark days last fall. Now that Goldman Sachs is a commercial bank comes a new set of public reporting requirements. One of these public reports is linked above, and below is a series of charts and tables from this report. The first chart shows total credit exposure to risk-based capital for the five largest commercial banks. Below the chart is a table showing the the underlying data. Goldman Sachs is among the five largest commercial banks. Regarding their credit exposure to capital relative to their peers, we believe the technical term is “wow!” The next chart shows quarterly trading revenue at the top five banks. Notice the blue bar under Goldman Sachs, it is their Q1 2009 results. Trading revenue accounted for 69% of gross revenue. No other large bank is even close to having trading be this large a part of their gross revenue. Combined with the charts above and we can see that Goldman’s revenues primarily come from credit trading. What happened to investment banking? The charts note two different dates. The first is February 8, 2007, the date we believe the credit crisis began [11] (the date HSBC, or “patient zero”, restated 2006 earnings because of subprime losses). The second date is September 5, 2008. This was the day Fannie Mae and Freddie Mac were placed in conservatorship and a week before Lehman Brothers failed. Since February 7, 2008 both Goldman’s stock and the bank index has been highly correlated to credit. Neither was highly correlated before this date. Since September 5, 2008 Goldman’s relationship to credit held, but the bank index’ relationship has begun to diverge. So, in answering the question, “do stock traders understand that Goldman is essentially a large credit protfolio”, these charts suggest the answer is “yes.”

• Goldman execs sell $700 million in stock: report
• With Big Profit, Goldman Sees Big Payday Ahead
• Behind Goldman Sachs’ second quarter profit
• Bank of America Posts a Profit on Trading Gains, BofA, Citigroup Battle Credit Losses
• Finance Woes Sink GE Net

Shining Results Aren't Solid Gold Only months after the government rescued Wall Street, risk is back in fashion. Or at least it is on Broad Street, home to Goldman Sachs Group. As investors expected, the firm Tuesday reported blowout second-quarter profits. The secret? Putting risk capital to work as markets revived. Goldman reported net income of $2.7 billion on record net revenue of $13.8 billion. The stellar results raise two big questions: Are they sustainable for Goldman? And do they suggest the broader financial system is on the mend? On the first, Goldman recognized early that sentiment was changing. It didn't shrink from using its balance sheet to make markets for clients stampeding back into recovering markets. And Goldman appears to have booked solid proprietary-trading profits alongside increased client activity. Full marks for timing. More-cautious rivals may have lost out on a possibly fleeting period of hefty profits. But Goldman swung for the fences to post these second-quarter numbers, judging by its value-at-risk -- an industry risk measure that estimates the one-day loss on trading positions in certain adverse conditions. Granted, VaR is an imperfect and narrow measure. It gave no warning of the huge recent losses at banks. It is hard to reconcile across firms. And Goldman has higher capital buffers today to absorb potential losses. Even so, the big gap between Goldman's latest VaR and first-quarter numbers from other firms is raising eyebrows. In the second quarter, Goldman's VaR climbed to $245 million, its highest quarterly level since the firm went public in 1999. At Morgan Stanley, VaR was $142 million in the first quarter, while J.P. Morgan Chase's trading VaR was $190 million. Goldman's first-quarter figure also was higher at $240 million. Embracing risk could keep working for Goldman if market conditions continue to improve or, at least, stabilize. However, Goldman increased VaR the most in equities. And stock markets have weakened so far this quarter, notes Michael Hecht at JMP Securities. In addition, credit markets could easily swoon again, especially if massive government programs aimed at shoring up bond prices lose their impact.

• Deal Journal: One-Quarter Wonder?
• Goldman Firing on (Almost) All Cylinders
• Keeping up with the Goldmans Goldman Sachs's record profits owe more to lack of competition than market recovery.
• Can Wall Street Catch Up to Goldman Sachs?

Re-visiting Goldman

Goldman facing compensation, derivative inquiries Goldman Sachs Group Inc., one of the banking industry's top performers, said Wednesday that government agencies have asked about its compensation practices and use of credit derivatives. been among the most hot-button topics in the financial services industry since the credit crisis peaked last fall. In a filing with the Securities and Exchange Commission, Goldman said it is cooperating with the requests from undisclosed regulators. A spokesman from Goldman declined to provide further details about the inquiries. Politicians have recently questioned the methods big banks use to determine compensation packages, especially in the wake the government's bailout last fall of the banking sector, known as the Troubled Asset Relief Program. Banks have also faced criticism for use of risky derivatives contracts, which have been partly blamed for the collapse of Goldman's competitor Lehman Brothers Holdings Inc. and the near-collapse of insurer American International Group Inc. Fearing more fallout after Lehman and AIG's problems, the government launched the bank bailout program. Goldman, however, has been quickly able to rebound from last fall's sector-wide troubles to return to its perch as a highly profitable Wall Street trading giant. During the second quarter, Goldman ramped back up its aggressive trading practices as markets began to stabilize and posted a profit of more than $2.7 billion. Profits were strengthened by fixed income, currency and commodities trading.

• Despite Bailouts, Business as Usual at Goldman
• Goldman: Is Its Trading Performance Statistically Reasonable?
• Goldman Sachs' 97% Win Percentage Possible but Not Probable
• Goldman’s 42 $100MM+ Trading Days In Q2 - An Absolute, Unprecedented Record; Just Two Days Of Trading Losses
• Goldman Sachs's Barry Bonds Complex
• The 8-point 'Goldman Socialist Manifesto'
• Don’t Dismiss Taibbi
• Goldman Sachs may be bad, but it’s far from the worst
• Goldman Toaster Alone Can't Reheat Global Economy

Windfall Profits and Taxes

Bankers had cashed in before the music stopped In 2000-07, the top five executives at Bear and Lehman pocketed cash bonuses exceeding $300m and $150m respectively (adjusted to 2009 dollars). Although the financial results on which bonus payments were based were sharply reversed in 2008, pay arrangements allowed executives to keep past bonuses. Furthermore, executives regularly took large amounts of money off the table by unloading shares and options. Overall, in 2000-08 the top-five teams at Bear and Lehman cashed out close to $2bn in this way: about $1.1bn at Bear and $850m at Lehman. Indeed, the teams sold more shares during the years preceding the firms’ collapse than they held when the music stopped in 2008.Altogether, equity sales and bonuses over that period provided the top five at the two banks with cash of about $1.4bn and $1bn respectively (an average of almost $250m each). These cash proceeds considerably exceed the value of the executives’ holdings at the beginning of 2000 (which we estimate to be in the order of a respective $800m and $600m). Our analysis undermines the claims that executives’ losses on shares during the collapses establish that they did not have incentives to take excessive risks. The fact that the executives did not sell all the shares they could prior to the meltdown does indicate that they did not anticipate collapse in the near future. But repeatedly cashing in large amounts of performance-based compensation based on short-term results did provide perverse incentives – incentives to improve short-term results even at the cost of an excessive rise in the risk of large losses at some (uncertain) point in the future. To be sure, executives’ risk-taking might have been driven by a failure to recognise risks or by excessive optimism, and thus would have taken place even in the absence of these incentives. But given the structure of executive pay, the possibility that risk-taking was influenced by these incentives should be taken seriously. The need to reform pay structures is not, as many have claimed, simply a politically convenient sideshow. Even if the type of incentives given to executives of Bear and Lehman – and others with similar pay structures – were not the cause of risk-taking in the past, they could be in future. Financial institutions, and the regulators overseeing them, should give the necessary priority to redesigning bonuses and equity-based compensation to avoid rewarding executives for short-term results that are subsequently reversed.

• The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008

A Windfall Profits Tax for Goldman Sachs? People are angry at Goldman Sachs. They have become so angry that these people have become blind to the real issues surrounding Goldman’s coming supersized bonus announcements. The real issues are twofold. First, how much are Goldman’s profits and bonus payments related to the benefits provided by the federal government during the financial crisis? Second, how should this compensation, if and when paid, be structured to prevent future undue risk-taking? In this mix is the specter of a windfall profits tax on Goldman Sachs and others in the banking industry to claw back any excess benefit these institutions have received. The crux of the first issue depends upon the amount of Goldman’s profits attributable to assistance provided by the federal government. And Goldman has clearly benefited. Goldman and others are taking advantage of this opening to restore themselves and the financial system to health. The banking industry’s profits should diminish as other new players seek to occupy this open space. But make no doubt, for the time being a good measure of Goldman’s profits are derived from a benefit that Goldman and other financial institutions have obtained from the efforts of the federal government. This benefit fits the circumstances for the imposition of a windfall tax. A windfall tax is best suited when the gain is unexpected, like winning the lottery. Taxing it is appropriate since the payees do not expect a windfall and so taxing the amount does not distort their future economic actions. This alone would justify a tax.But there is another justified reason for a tax on Goldman Sachs. A portion of Goldman’s profits are really the government’s profits. Allowing Goldman to keep this money is simply allowing the investment bank to keep money earned from the efforts of the federal government. This would be a simple wealth transfer from the American taxpayer to the partners of Goldman Sachs. Don’t be fooled by any billion-dollar donation Goldman may announce — the benefits it has received far exceed this number.

Windfalls Show That Bonus Tax Makes Sense(WSJ) A windfall tax is blunt, arbitrary and something supporters of free markets usually instinctively avoid. Even so, following news that Goldman Sachs Group has already set aside a $16.7 billion bonus pool for 2009, the case for windfall taxes on banks that pay giant bonuses is becoming unanswerable. This year's bank profits are windfalls in the purest sense. They aren't the due rewards for exceptional skill but gifts from taxpayers. Many banks are earning huge, risk-free profits borrowing from central banks at ultralow interest rates and lending back to governments at much-higher rates. If this giant, hidden subsidy was being used to support new lending, fair enough. Instead, it looks destined for bankers' pockets. Government action is logical. There are two legitimate policy objectives: to encourage banks to build capital to support new lending; and to help cut fiscal deficits run up during the crisis. Ideally, governments should act together to avoid damaging competitiveness.

Tax the windfall banking bonuses First, all the institutions making exceptional profits do so because they are beneficiaries of unlimited state insurance for themselves and their counterparties. Second, the profits being made today are in large part the fruit of the free money provided by the central bank, an arm of the state. Third, the case for generous subventions is to restore the financial system – and so the economy – to health. It is not to enrich bankers, particularly not those engaged in the sorts of trading activities that destroyed the financial system in the first place. Fourth, ordinary people can accept that risk takers receive huge rewards. But such rewards for those who have been rescued by the state and bear substantial responsibility for the crisis are surely intolerable. What makes them yet more so is that the crisis has devastated the prospects of tens, if not hundreds, of millions of innocents all over the globe. The public finances will be devastated for decades: taxes will be higher and public spending lower. Meanwhile, bankers are about to reap huge rewards. This damages the legitimacy of the market economy. Fifth, it is hard to argue in favour of exceptional interventions to bail out the financial sector at times of crisis, and also against exceptional interventions to recoup costs when the crisis is past. “Windfall” support should be matched by windfall taxes. Finally, these are genuine windfalls. They are, as George Soros has said, “hidden gifts” from the state. What the state gives, the state is entitled to take back, if it is not used for the state’s purposes.

• Thumbs Up For the U.K. Bonus Tax Where London has led, will others follow? The U.K. government's decision to introduce a windfall tax on bank bonuses is a justifiable response to the sector's failure to exercise self-restraint throughout the crisis. That the U.K. has found a way to tax payouts that provides an incentive to conserve capital is smart—and provides a template for other countries grappling with this issue. 

Wall Street Bonus Culture Ready to Rest in Peace: David Pauly  Condolences to Wall Street’s finest. The huge cash bonuses they have longed for and savored are history. Goldman Sachs Group Inc., the profit king of the securities business, has made sure of that. Goldman last week said its 30 top executives will get their traditional year-end bonuses in stock instead of cash -- and the shares have serious restrictions. Recipients won’t be able to sell the stock for five years, though it vests in three. And they might lose the shares if Goldman determines later that the executives earned them by taking heedless risks. Goldman shareholders now will also be allowed to vote on the company’s pay, though their yes or no won’t be binding on management. Bonuses per se aren’t dead. Goldman and rivals Morgan Stanley and JPMorgan Chase & Co. will dish out $29.7 billion in 2009 bonuses, analysts estimate. Some of that should be in cash, and the stock handed out will, with luck, be worth a nice sum years from now. But the time-honored bonus culture featuring large cash payments needed to end. Even a Goldman Sachs director admitted that the day before the firm’s new bonus arrangement was announced. William George, who is also a professor at Harvard Business School, said the practice “has got to move on,” and that compensation needs to be closely tied to long-term performance. Instead of 60 percent of investment firm pay coming from year-end handouts, more will be in salary. And there may be less of that too, because of the pressure on banks from the government and myriad critics to become sounder institutions by raising capital and taking fewer risks. That will reduce profit and the ability to pay. The bonus era seemed over a year ago, when Wall Street eliminated the payouts after those horrendous losses on mortgage-related securities. Then this year, Goldman began earmarking a percentage of its 2009 profit, which has been large, for bonuses. For the first nine months of this year, the amount was $16.7 billion. There were outcries from Washington to Walla Walla from folks who thought Goldman, as a recipient of government bailout money, should have been more circumspect.

• Wall Street's Bonus Culture: RIP

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Having covered general business and Finance let's turn our attention to the Tech Industries but start by noticing that market turbulence continues in a policy-dependent environment. This last week China tightened loan standards (scaring everybody around the world), Benanke testified about exit strategies, Greece was dancing with default (& the Euro came under pressure as a result while their was a flight to quality) and the German/European economies performed poorly last quarter. Gee, where have we heard any of that before (Policy-dependence, Transitions and Turbulence: Market and Economy in the New Normal,Active Allocation, Active Investing: Investing Guidelines for Lost Decade #2)? But don't take our word for it - this recent interview with the CIO of Gluskin-Sheff, the Canadian investment management firm where David Rosenberg works, is the best overview of the real state of affairs, the outlook and the implications for investment strategy and tactics we've heard in a long time. It's kind of a long interview but it sure sets the stage for everything we want to say about where things are at and going. Which is that the markets are re-discovering fragility, dependencies and how weak the recovery will be.

Tech Stock Performance

Let's tunnel down on the Tech stocks a bit with a variety of views, just so we can frame up that discussion. There's a certain lingering romance as well as perennial optimism about the Tech outlook that we need to do a serious reality check on, starting with this composite in the UL corner and working 'round clockwise. The top two UL charts show the NDX vs. XLK vs. AAPL performance. Notice the broad markets haven't gone anywhere in 15 years or 5, for either the top 100 or the broader market. Apple has out-performed, as it should have. The three charts on the right are four leading tech companies in different timeframes (1,5 & 15 years) for HPQ, SAP, CSCO and IBM. Each has its own story you need to know but broadly speaking nobody's where they were. Let's think of it as Red Queen syndrome - running faster and faster and harder and harder just to stay in place. We'll leave you to de-construct the individual stories but rest assured they each have one. Taking SAP, who's CEO resigned in a complete surprise this last week, as the example. Over ten years we see flat earnings and compressed PE's (the latter something we'd expect in a range-bound market as well as a mature industry and/or a maturing - perhaps increasingly sclerotic - company).

Cisco Fever vs. Economic Realities

Cisco came out with its earnings and an extremely positive outlook, not a real surprise from Mr. Chambers. But what's the underlying economic realities that have driven flat market performance? BtW - the readings start off with a bubblicious story about the Tech outlook spun up by the Cisco news followed by a regional assessment of Silicon Valley's abysmal economic outlook. Hardly consistent, eh what? And include a brief introduction for non-technical readers on "Cloud Computing" - which becomes really important for this logic thread since everybody's betting on it for future growth and adapting their strategies accordingly. Are they drinking some Koolaid? Let's look at the actual data.

As we keep trying to remind folks capital spending is a lagging cyclic variable, tech spending as much as any. The grounds for Chamberistic optimism are in the UL corner where the QtQ tech spending numbers show a big jump. But when you compare it to the YoY GDP numbers it's still down over -10%. The chart set in the UR corner shows the correlations since 1995 between Capex and Tech Investment and GDP. A steep curve tells us that the reaction is asymmetric - in other words both tend to fall very sharply and abruptly in a downturn but surge in an upturn. But to really get cranking requires real GDP growth north of 4%. The chart in the LR is taken from the recently released Economic Report of the President - sobering, realistic and pragmatic document that anticipates slow growth for the next year to two, a cyclic recovery to a couple of years of 3-4% real growth, very weak job creation for a long time and a steady-state of 2.5% real growth. We may get a bit of a surge in the intermediate term but at 2.5% we'll be lucky to see 5% growth in Capex or Tech Investment! Downtrending and compressing PE's are not, therefore a surprise; the long-term outlook is for a stable, even stagnant, and maturing industry who's glory days are long....long past. We particularly like the ERofP chart which shows a secular/structural downtrend in Capex and some very funny trends in Tech. After spurting from 75-85 it was stagnant from 85-95, surged during the Tech Bubble, cliff-dove afterwords and appears to be stabilizing (we hope) around 3.5% of GDP (at best).

Performance in a Tough Environment: the Case of SAP

O.K. - weak economy, constrained Tech spending, compressing PE's - now what? The answer of course is business performance - understand the market, develop good strategies, execute well, if not flawlessly and measure, measure, measure. Leo Apothekar (who we admit to knowing slightly since he was a Board member for a startup we worked at) was faced with a major downturn in a mature market and an aging product set. He appears however to have lost the trust and confidence of both Employees and Customers. Nonetheless for a man with his track record and decades of experience to be run out after a single year says more about SAP than it does about him. For the next several years the Strategy SAP executes on will necessarily be what he left behind. It was and will be, necessarily again, based on what he inherited. Which is the reason we went to SAP's web site, downloaded their most recent (Dec09?) major analyst briefing and built this chart. Which we now propose to decade, deconstruct and freely interpret. Have they got it right? More importantly can they deliver? We think this is the sort of thing everybody needs to do for any target investment, for example all the other companies (MSFT, IBM, CSCO, ATT, or Sprint) in the readings.

The UL corner tells us how they've been doing. But it also tells us that Services not only got hurt less badly than core Software sales. Where this is important is that both SAP and ORCL (and everybody else) has been forced onto a services revenue model - consulting, upgrades, etc. etc. and away from selling license. It helps to know that the original theory of the case was that apps vendors were going to change the world by automating the most difficult processes and embedding re-engineerable best practices in the code. Didn't happen - instead they sold lots of licenses to the largest companies (mostly) for back office stuff, not running the business, and lots of those licenses are still lying around fallow. Nor have they ever figured out how to get into the SMB space. There's a lot of Industry background you need to really understand the structure, dynamics, etc. that would take pages and posts - fortunately we already did that and you can read it all here:Technomediatainment Futures: Evolution, Barriers, Structure and Opportunities of a New Industry .

The UR corner tells you how they view the market, the competition, the opportunity and what their strategy is. In a word they're going to focus on major business applications as the best opportunity where they face the least competition, have the greatest presence and best value proposition. On the other hand ORCL is going after Middleware, Databases and Applications. And with the SUN acquisition hardware as well (something we think is one of the worst ideas we've ever heard but confirms the maturity of the Industry). It also helps to know that each major functional solution is very hard to get to work with every one component, that SAP has largely chosen to grow organically and build their own and ORCL has acquired it's way to a disparate and jumbled portfolio of stuff that's NOT on a common code base. Thereby increasing their overhead, support costs, integration problems and investment requirements. Rationalizing that mess on a common code base and a shared infrastructure is a vital strategic requirement. On the other hand SAP has been struggling for years to create a new software platform to re-develop its codebase as well as struggling to bring its integration platform to market (Netweaver). Those were all strategies, challenges and breakages that Apothekar inherited (ever wonder why Aggasiz left so abruptly a few years back when he was touted as the fair-haired savior who was going to fix all that?). All of which is reflected in the next set of charts, moving around the clock.

The LL chart tells us their primary business is still large enterprises where the target is onsite license sales and their strategic goal is, as it has been for years, to offer scaled down or network-hosted (i.e. run in the cloud) solutions for the SMB space where the great untapped opportunity is. The LL corner is actually a four-chart composite that tells us how they think they're going to double the addressable market (by adding more solutions to the core, making it easier to integrate, linking to strategic ecology partners therewith, and increasing access to the SMB, Industry solutions and end user services spaces - all things they've been talking about since 1995!). All of which they think can be glued together using the SAP Business Process platform into a smoothly working and integrated solution for custom problems. Wow - great ideas, enormously difficult of execution. And all dependent on re-vamping the code, adding major new components based on it, getting Netweaver and the Process solution working and sold, an outstanding Sales and Services organization, deep....deep...deep industry expertise and (MOST importantly) cloud-based delivery. We should mention btw that integrating complex solutions in the could, when most enterprises have failed to do it on-site, is one of THE critical challenges.

If SAP can solve these problems (across the spectrum of requirements - Market Analysis, Design, Construction, Delivery, Sales & Service and Support) they will be smack in the middle of the Red Queen problem. They need to do all this just to keep things turning over well and maintaining their current relative position. With what we see here we don't see the magic breakthru that returns them to a stellar growth position unless they get a major breakthru into the SMB space. Which we consider unlikely at best and more likely to crater. But good luck to them. But as an investment, we're sorry to see, nothing pops out to us that suggest a surge in profits and earnings growth and a jump in valuations.

Oddly enough that still puts them in a position to both outperform their peers or even other exemplars. All of whom are struggling with similar problems, or worse, and all of whom have come to simlar conclusions. The other thing that this one massive, ideographic composite tells you is how the marketspace is structured - not just in SAP's opinion but largely by all the players. Bon Appetit'

Technology Industries Readings

Spending, Outlook, Issues

Tech spending starts to bounce back  Business spending on technology goods and services is returning as the economy mends, pumping new life into suppliers such as Cisco Systems Inc., though it has been slower to reach other sectors. The big maker of networking gear Wednesday posted a 23% jump in quarterly profit and 8% gain in revenue, its first such increases in a year. The economy has entered a new "phase of the recovery," said John Chambers, Cisco's chief executive, in a call with analysts, adding that he planned to hire up to 3,000 workers in coming quarters. "This is one of the most robust positive turnarounds I've seen in my career," he added. Cisco's results add to a growing body of evidence that companies are starting to open their wallets after the recession. The Commerce Department last week said business spending on equipment and software rose at a 13.3% annual rate in the fourth quarter, adjusting for inflation. That was the fastest growth since early 2006. Still, spending was 18.5% below the level it reached in late 2007. Just to keep pace with depreciation, economists reckon companies will need to continue raising capital-spending levels in the quarters to come.That might happen, especially with improved corporate profits helping to fuel optimism. Through Tuesday night, with 255 companies in the Standard & Poor's 500 having reported, earnings were 47% higher than a year ago, excluding financial-services companies whose troubles last year would skew the figures. Sales growth was 3.8% so far, excluding financial-services companies, noted S&P. Mr. Chambers said in an interview that Cisco's return to growth was partly a result of a rising tide. Cisco's growth "was too uniform" across product lines and geographies for it not to signal a greater shift in the economy, he said. Companies appear particularly eager to spend on technology, which forms the backbone of many corporate infrastructures and can boost productivity. As a result, Cisco and its peers, which fell into a severe slump starting in the fourth quarter of 2008, have rebounded sooner than companies in other sectors, such as industrial equipment. While most of the tech sector's initial gains came from selling products such as laptop computers and smart phones to consumers, recent results point to improvement in sales to business.

Report says Silicon Valley economy sputtering Silicon Valley's economy took a big hit during the global meltdown and could have trouble climbing out, according to a report released Wednesday. The 2010 Index of Silicon Valley said the region is entering a "new phase of uncertainty" where job losses, a shrinking foreign talent pool, a drop in investments and state legislative gridlock could put its standing as the center of technology at risk. The report, released annually by local nonprofit groups the Silicon Valley Community Foundation and Joint Venture, examines trends in employment, housing, education and other issues to provide a snapshot of the region's well-being. "It's a report with a lot of bad news in it. Most years, Silicon Valley has all this good news. But this year, it's not entirely clear when the recession ends if we're going to be able to very easily get back. That's not a given," said Russell Hancock, president and chief executive of Joint Venture, an alliance of business and community institutions. The report noted that the region lost 90,000 jobs from November 2008 to November 2009, and unemployment is higher than national levels. It's also the worst in the region since 2005. And there are other signs of weakness. The number of patents dipped slightly in 2008, and venture capital financing, which provides money to start-ups, plunged. Office vacancy rates also were up 33 percent from 2008 to 2009, and incomes dropped 5 percent between 2007 and 2009, to $62,003. The authors also worried that as other areas seek to compete with Silicon Valley, including India and China, the region will have a hard time attracting top talent, particularly for science and engineering positions. The report noted high high-school dropout rates, fewer students meeting basic state college entrance requirements and persistent racial disparities in education. Silicon Valley's woes aren't totally unique -- the recession has hit industries and geographic regions worldwide -- but many people thought the high tech sector that drove the region was immune, and for a while, it was, said Stephen Levy, senior economist at the Center for the Continuing Study of the California Economy. "What changed is that this became a worldwide recession and financial panic set in and exports were falling. There may have been an individual product that thrived, like the iPhone, but overall we couldn't sustain it," said Levy, who is also an adviser on the study. The authors suggest Silicon Valley revisit its roots as one way to emerge from the recession thriving.

What Exactly Is 'Cloud Computing'? For a lot of small-business owners, "cloud computing" is the latest IT buzzword to leave them scratching their heads. To demystify things, here's a primer for companies looking to wade into cloud services for the first time. Broadly speaking, any service or program sent over an Internet connection can be considered a cloud service. An outside vendor runs the servers and software, so the buyer doesn't have to worry about the technical issues in-house—and can focus on its own business.The services come in a number of forms. Many businesses are already familiar with one aspect of cloud computing: software delivered over the Web. Along with email services like Google Inc.'s Gmail, there are programs that help salespeople keep track of customer information, such as Salesforce.com Inc.'s software, and backup data-storage services from providers such as Amazon.com Inc. Some businesses don't just use software services, they buy computing power from vendors such as Verizon Communications Inc.—much like buying power from a utility. Let's say a retailer expects lots of additional business during the holidays, and its in-house servers can't handle the load of customer orders. The company might pay a vendor for the use of its servers, to shoulder part of the computing work as the need arises. Other companies, meanwhile, might buy computing power on a regular basis. They might drop one or more in-house servers entirely—or not buy the hardware in the first place—and let a vendor run their vital programs on its machines. Once again, the buyer would pay a fee based on how much computing power it used.

Tech Industry Readings

Microsoft’s Creative Destruction AS they marvel at Apple’s new iPad tablet computer, the technorati seem to be focusing on where this leaves Amazon’s popular e-book business. But the much more important question is why Microsoft, America’s most famous and prosperous technology company, no longer brings us the future, whether it’s tablet computers like the iPad, e-books like Amazon’s Kindle, smartphones like the BlackBerry and iPhone, search engines like Google, digital music systems like iPod and iTunes or popular Web services like Facebook and Twitter. Microsoft has become a clumsy, uncompetitive innovator. Its products are lampooned, often unfairly but sometimes with good reason. Its image has never recovered from the antitrust prosecution of the 1990s. Its marketing has been inept for years; remember the 2008 ad in which Bill Gates was somehow persuaded to literally wiggle his behind at the camera? While Apple continues to gain market share in many products, Microsoft has lost share in Web browsers, high-end laptops and smartphones. Despite billions in investment, its Xbox line is still at best an equal contender in the game console business. It first ignored and then stumbled in personal music players until that business was locked up by Apple. What happened? Unlike other companies, Microsoft never developed a true system for innovation. Some of my former colleagues argue that it actually developed a system to thwart innovation. Despite having one of the largest and best corporate laboratories in the world, and the luxury of not one but three chief technology officers, the company routinely manages to frustrate the efforts of its visionary thinkers. Internal competition is common at great companies. It can be wisely encouraged to force ideas to compete. The problem comes when the competition becomes uncontrolled and destructive. At Microsoft, it has created a dysfunctional corporate culture in which the big established groups are allowed to prey upon emerging teams, belittle their efforts, compete unfairly against them for resources, and over time hector them out of existence. It’s not an accident that almost all the executives in charge of Microsoft’s music, e-books, phone, online, search and tablet efforts over the past decade have left.

• Talking Business: the Outlook vs. the Preparations
• Windows 7 Fails to Boost PC Makers' Profit
• Sony Returns to a Profit and Raises Its Outlook

CEO of SAP Resigns German business software maker SAP AG late Sunday said Chief Executive Leo Apotheker resigned effective immediately. He will be succeeded by two insiders, who were named co-CEOs. The company said it had "reached a mutual agreement" with Mr. Apotheker not to renew his contract after less than a year as SAP's solo chief executive. The company wouldn't elaborate on the reasons behind Mr. Apotheker's departure, but SAP and its chief executive have been under increasing pressure to jump-start growth after flagging sales and profits. SAP has long been a leader in the $67 billion market for enterprise software but the global economic downturn, intense competition and the fast-evolving business software field have threatened to crimp SAP's growth. The co-CEOs will be Bill McDermott, head of field organization, and Jim Hagemann Snabe, head of product development, both already members of the SAP executive board. During Mr. Apotheker's tenure at the helm, SAP was hit by the economic downturn resulting in a slump of demand for business software, which helps companies manage their customer relations management and payrolls, for example. Last month, SAP, whose programs help companies do back-office work such as payroll, inventory management and accounting, said its fourth quarter net income fell 12% to €727 million ($993.4 million) because of difficult market conditions, but said it expected an improvement this year. For all of 2009, SAP reported that earnings fell 4% to €1.79 billion, or €1.54 a share. SAP said earlier this year it will no longer force customers to opt for a more expensive support-fee model. "The new setup of the SAP executive board will allow SAP to better align product innovation with customer needs. The new leadership team will continue to drive forward SAP's strategy and focus on profitable growth, and will deliver its innovations in 2010 to expand SAP's leadership of the business software market," said Mr. Plattner. SAP also said that Vishal Sikka, chief technology officer, has been appointed to the SAP executive board. "SAP needs a good technologist in place as they have to right-side the roadmap," said R "Ray" Wang, analyst at Altimeter Group, San Mateo, Calif., said. "McDermott is an excellent sales guy, but the issues is not sales, it's products. Snabe and Vishal will need strong product vision to right SAP and point it in a forward direction. Engineering and products need more attention."

• SAP Management Upheaval Pits Plattner Against Ellison in Market Share Spat  The 66-year-old supervisory board chairman, who’s also the company’s biggest shareholder, is assuming a greater management role at the world’s largest business-management software maker, helming what he said yesterday was an effort to “re-establish trust inside and outside” the company.
• Apotheker Says He Did What Was Best
• What SAP Needs After Apotheker

 IBM Seeks Edge With New Chips IBM  IBM Corp. is introducing its next generation of microprocessor chips and systems that use them, hoping to extend the computer giant's recent lead in the market for midrange servers. The computer maker says its Power7 chip, which it's announcing Monday, is four times faster than its predecessor. IBM is also announcing new servers for chores like processing cancer-research data, managing electrical grids and analytics for financial institutions. Sales of these systems, which run versions of the Unix operating system, total about $14 billion a year.The IBM announcement comes amid a flurry of activity in chips aimed at servers. On Monday, for example, Intel Corp. is expected to introduce a long-delayed version of its high-end Itanium product family, a separate product family from the x86 chips used in most personal computers and lower-priced servers. IBM's Power7, meanwhile, boasts 1.2 billion transistors, eight processing cores and can handle 32 threads. Nathan Brookwood, an analyst with the research firm Insight 64, adds that each of the IBM cores are unusually powerful. That combination, he said, yields performance for high-end calculating tasks that will be hard to match. "Power7 has clearly established itself as the chip to beat," Mr. Brookwood said. "IBM is just leaving the others guys in the dust." Larry Ellison, chief executive of software giant Oracle Corp., has recently suggested his company's acquisition of Sun Microsystems—a major player in Unix servers—will spell trouble for IBM. But IBM executives say the Power7 announcement only ensures their market-share lead in the Unix market; IDC, a research firm, says IBM's share of the market for Unix systems has swelled to 39% today from 25% in 2003. IBM's "Power has taken over the Unix marketplace," said Joe Clabby, president of Clabby Analytics in Maine. "Sun has been losing share pretty heavily for the last three years."

Telecomm Industry Readings

Cisco’s Profit Surges 23 Percent John T. Chambers, the chief executive of Cisco Systems, prides himself on forecasting technology and economic shifts ahead of his company’s peers and competitors. On Wednesday, Mr. Chambers declared that spending on technology had moved to a higher gear, reflecting a much healthier global economy. In response, Cisco plans to hire up to 3,000 people over the next several quarters. His optimism about the economy, expressed as the company released strong second-quarter financial results, stood out even among the generally upbeat talk from executives at other technology companies in recent weeks.Customers have demonstrated more consistent and widespread demand for Cisco’s networking equipment, Mr. Chambers said in an interview. “There was major momentum. It was quite remarkably balanced across the board, and you would say we are on our way to a reasonably good recovery.” Cisco plans to adjust to the improved conditions by increasing its internal spending on nascent businesses and adding to its current work force of about 66,000. Last month, other technology heavyweights, including Intel, Microsoft and I.B.M., beat Wall Street expectations as sales of their flagship products and services improved at higher-than-expected rates. The quarterly results of those companies painted a picture of technology spending through the end of last year.

• Cisco Reports Cisco reported an EPS of $0.40 when it released its Q2 results after the markets closed. BNN speaks to Joanna Makris, managing director, communications technology equity research, Brigantine Advisors, for instant analysis.
• Cisco Tries to Break Out of the Data Center Role
• Cisco’s Run of Spending

AT&T's iPhone Mess AT&T has stumbled into a quagmire. When it secured exclusive rights to support Apple's iPhone on its wireless network in June 2007, investors hailed the deal as a masterstroke. Here was stodgy, safe AT&T positioning itself to gulp profits from a cutting-edge technology. But AT&T and Apple vastly underestimated the iPhone's appeal. At launch, Real Steve Jobs said he'd be happy if the device could grab 1% of the global cell-phone market, or about 10 million units for 2008. Instead, Apple has sold at least 42.4 million—25.1 million in 2009 alone, 14% of the global smartphone market. AT&T, which markets the iPhone in the U.S., simply can't handle the traffic. Making matters worse is the proliferation of "apps," those bandwidth-sucking programs that make smartphones so much smarter. According to Apple, iPhone users have downloaded at least 140,000 different apps a total of 3 billion times. Watching broadcasts of Major League Baseball games and studying the globe via Google (GOOG) Earth on a palm-size device feels like a promise from the future, but the networks delivering all this data are still just catching up with the present. "We expected this was going to open up a new level of engagement, and we knew we'd be successful in the market," says AT&T Operations President John Stankey. "We missed on our usage estimates." Case in point: It's not atypical, he says, for 80% of a college football crowd to be using their iPhones. The rise of iPhone Nation—with its media-savvy and data-greedy citizenry—has left AT&T with a tough set of options. It could significantly upgrade its network to handle all the new demand, but that would cripple profits. It could charge more for network access or limit what customers can do on their phones, but that would enrage the all-you-can-eat subscriber base as well as Net Neutrality types who seek to prevent telecom companies from dictating customers' options. It could permanently halt iPhone sales in overcrowded markets, but that would bring more mockery, not to mention place AT&T in the unusual position of denying consumers access to a product it doesn't even make.

• Apple's Hard iPad Sell

Sprint's Never-Ending Mobile Marathon In the wireless endurance contest, Sprint Nextel continues to fall behind. Admittedly, the carrier is doing less badly. Sprint lost 148,000 net subscribers in the fourth quarter, from 1.27 million a year earlier. The decline in highly valuable contract customers, who generate average monthly revenue of $55, fell by more than half, to 504,000. More important, though, was a slowdown in growth for Sprint's "prepaid" business, in which the carrier last year aggressively cut prices. Tougher competition appears to be hurting. Net gains in prepaid slowed to 435,000, down sharply from the third quarter. Sprint isn't sitting still. It plans to target different segments of the prepaid market using multiple brands, including newly acquired Virgin Mobile. Wednesday, it even seemed to leave the door open for a run at prepaid rival Leap Wireless. This strategy makes sense given the prepaid market is expanding much faster than that for higher-end plans requiring contracts. What isn't clear is how Sprint can expand in prepaid, where its monthly revenue per subscriber was $31 in the quarter, without significant cost-cutting. As Sanford C. Bernstein analyst Craig Moffett notes, Sprint's cost structure is designed for the postpaid world dominated by bigger rivals AT&T and Verizon Wireless. Aside from a chain of stores and heavy advertising, that involves operating a nationwide cell network—or two, in Sprint's case. Mr. Moffett recently estimated Sprint's monthly cash cost per subscriber in the third quarter was higher than other wireless carriers in either the postpaid or prepaid world. Sprint needs to figure out which race it wants to run.

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The next cluster of stories will be drawn from the Finance Industry. It's a story that touches a lot of bases including general economic conditions, business performance, corporate governance, politics and policy and, after re-reviewing the Davos video clips, some really fundamental issues about the nature of capitalism. The point we made earlier about enterprise management having to be increasingly alert, proactively and constructively, in monitoring geo-political trends couldn't be made more strongly by these clips. Beyond our earlier collection we added a couple specifically focused on these issues, cherry-picked the ones that bear directly and created a governance and regulation for Finance subset (in the readings). Since such large questions are being asked and are so fundamental we also embedded the last two years of work on analyzing the performance of the Industry (in online accessible whitepapers) and also included more recent blog posts. Whether you can to the opening Davos session to the last there is a constant refrain - the need for deep re-thinking of the Industry, new worldwide regulatory regimes, changes in governance and compensation, more value-creating business models or deep uncertainty about the "First Principles" of Capitalism. Two in particular stand out:Rethinking Market Capitalism led and moderated by Bil George (of Harvard and Medtronics) and After the Financial Crisis: Consequences and Lessons Learned.

Separately the WEF has been working for a couple of years with the Oliver Wyman consulting firm to re-examine the Industry and the 2009/2010 position papers are linked and excerpted in the readings, along with our readings. What we found fascinating (especially given the disparity in resources) is that we came to nearly identical conclusions, central to which are: 1) a need to re-examine the regulatory regime, 2) the sustained poor performance of the Industry (though our timeframe is longer), 3) the need to act proactively in a socially responsible way (though again in channeling Drucker we were able to get more constructive and prescriptive) and 4) the need to re-think, re-design and re-build business models and management systems. Here we think our specific suggestions go several levels deeper than the folks in Switzerland were able to go, though admittedly we don't have to serve all their constituencies or deal with their constraints. But just to set the table you might start by listening to this recent interview of David Stockman, Reagan's Budget Director. Frankly, we think you'll be shocked by many things he has to say. The really interesting thing is that Mr. Stockman, the Davos participants and the popular judgments in the cartoons have pretty commone sentiments!

Genesis of the Crisis: Causes and Consequences

We're going to put our focus on the charts and arguments embodied in the WEF report and start by looking at the situation leading up to the crisis and the consequences of it. The L.H. column of sub-charts shows the growth of US total debt, the worldwide holdings of external debt (remember that the sloshing excess savings were caused by global trade imbalances with China pushing exports and the US/Developed world financing them with leveraged debt drawn from currency-manipulated sources). The final sub-chart shows what happened as systemic risk metastasized - scary. Particularly the current path.

The R.H. column shows the impacts on trade, domestic economic activity and the consequences for GDP and Employment. Interesting to note the stylized fact of China's holding things together - they created 8 million jobs but nonetheless (so the stories go may have lost 20 in the background); and are now extremely vulnerable to re-balancing. The cartoons have a pretty good case it would seem.

Consequences & Risk Factors: Intervention + Trust

If we were at all involved in the Industry, trying to assess or re-think it's future, a supplier or customer or a potential investor the set of WEF charts we'd pay the most attention to is this next one. In some ways they speak for themselves but what they argue is that the Industry has squandered decades of carefully built up public trust with one decade of malfeasant financial engineering and short-term thinking. The two really interesting things though are, first, that ALL the finance speakers recognized fault but dodged the blame (no mea culpas in other words) and warned about over-regulation. There are two fundamental flaws in their reasoning that we've delved into before but let's review.

Flaw Set I: Systemic Breakdown Factors

In our discussions of the Pecora II hearings we summarized the findings in combination with our own to argue that there were 3+2 major causal factors are the core of the crisis: 1) a worldwide excess of loanable funds sloshing around because of an unbalanced world economy, 2) the invention of a general purpose financial engineering technology (synthetic debt instruments and securitization) that changed the basic business model from originate to own (requiring sound business judgment on the quality of the original loan) to originate to distribute (securing loans to pass on to securitizers, emphasizing deal flow and compensation and encouraging increasingly poor judgment on risks by paying people to move things thru the pipelines) and 3) a failure of the regulatory regime to intervene, even within the scope of existing regulations. The two we'll add are hubris (actually Mark Zandi made that point) and a failure of management judgment and responsibility, i.e poor management systems, controls and governance. At the end of the day not doing stupid or socially damaging things is the responsibility of management. What we got instead was the triumph of short-termism, the destruction of value and and long-lasting damage to the socionomic system.

Flaw Set II: Business Case Factors

What strikes us as complacency on the part of the Financial Community is based on the value of the Industry in making the economy work better. In other words on the business case. Nobody seems to be talking about that though we've done so extensively, with data, charts and graphs even, but summarized (again): 1) the Industry almost collapsed the world economy (we were within 24 hrs. of a systemic collapse at one point), 2) they nearly destroyed the Industry itself and did destroy decades worth of profits, 3) they saddled the consumer and the real economy with huge and growing debts, 4) by draining savings investment in new capital was curtailed in favor of financial speculation and economic growth was badly damaged and 5) since the original innovations of the de-regulatory era the Industry has not created any new value for society (Volcker's quip about ATMs comes to mind). Since then two more major costs have shown up. First, monetary policy has created a yield-curve based carry trade which should have gone to writing down toxic assets and re-building capital bases but was instead used for bonuses and government intervention to contain the crisis is going to saddle the world's major economies with huge debts that will constrain growth in the future for years. Taken all together the business case against the Industry and for reform is pretty over-whelming, at least if you believe our analysis.

Re-think, Re-design, Re-build: Business Models, Governance and Performance

The one conclusions we really liked from the WEF studies was that the Industry needs to return to basics and re-think its business models. This is born out in the second chart set (the middle on the L.H. side) which shows the major Risk Factors. We find it fascinating that the ones they're worried about most are the short-term ones driven by the backlash while the deep structural ones, e.g. global re-balancing, are only given nods. More specifically this next chart set summarizes the findings and conclusions of the studies. We really think this is a chart that everyone at all concerned needs to pay attention to. The high-level concerns are with restoring trust and confidence plus re-thinking strategies, business models and strategic outlook. The major driving factors, the strategic consequences and the major decisions required though are even more interesting. What the report doesn't cover but gets much more attention in our white paper are the questions of business model design, governance, performance management and constructive social responsibility. The white papers are linked in the readings but you can jumpstart by looking at four charts using our BizzXceleration framework: Business Models, Strategic Re-Think, Socially Responsible Governance and Evolution & Re-Think. Sadly, however we're aware of no evidence that this kind of work is actually going on inside the Industry where it needs to.

Gong Cosmic: Re-thinking Market Capitalism and Adam Smith

If you go to your local farmer's market to buy some oranges the vendor will not stiff you because you know him and if he screws you around once you'll go to somebody else. In that one anecdote the heart of the trust relationships, fair exchange, honest dealing and value received for value given that are at the heart of Capitalism are illustrated. Oddly enough most of the Wall St. transactions are done with a phone call using the same implicit presumptions. When society gets large and complex informal mechanisms for managing the even more complex webs of dependencies and relationship no longer suffice. Instead we need more formal institutions that define property rights, establish security and provide ways to adjudicate disputes when conditions change. For example futures markets came into existence after interested parties came up with agreements on standards quality indicators and contracts. The real heart of capitalism is the ability to invest for the long-term. Man has a natural propensity to truck, barter and exchange but without a society that is secure and stable for the long-run nobody in their right mind will invest in long-lived ventures. The sanctity of the moral fundamentals is in fact the sine qua non of an efficient and effective capitalist society, and we all depend on it. When it's broken it's not analogous to being a little bit pregnant - it's more like being a little bit infected with cancer.

Not to get all "cosmic" and philosophical on you but one of the recurrent themes of the Davos sessions was the moral silence or neutrality of markets. They are flat wrong and nothing could be further from the truth. During the 20thC we ran history's largest field experiments in comparative sociobiology and political economy (& moral philosophy for that matter). And the price was $Ts and millions and millions of lives testing Capitalism vs. Fascism vs. Communism. We settled that question but the one we're going to wrestle with this century, on which everything else no depends, is how do we govern Capitalism. And contrary to the common wisdom Capitalism is highly moral and socially responsible - at it's heart is the concept of the fair exchange freely done. Or a fair day's work for a fair day's pay, or value received for value given. There will always be opportunists in any system who will sacrifice the soundness of the system on which they depend for short-term and narrow gains. Making sure that exchange is free and fair and honest are what our institutions have to be designed and managed for.

The cosmic Ur-Father of market capitalism is Adam Smith, the Scottish philosopher and economist. People often forget that he and David Hume were moral philosophers concerned with the healthy and prosperous society that channeled man's energies into more constructive channels. In fact his primary concern was finding a different way of organizing society so as not to revisit the Wars of Religion. Despite what he really was or actually said he's almost always taken out of context so our last graphic puts him back in context. We think you'll find that he was as well aware of the short-comings of Capitalism and out of control self-interest as anyone else. (BtW - the title to this section was intended to be Going Cosmic but we think the Freudian type of "Gong Cosmic" has its own set of messages here).

Re-applying the real Smithian philosophy (The Real Adam Smith, Real Quotes from Adam) is going to be our challenge going forward but we will one way or another. Think of it as a problem in scenario planning - either we'll succeed and things will keep moving forward. Or we won't and.... well you get the idea. And if you don't think think this all has immediate repurcusions, along with the turbulence and turmoil of soverign defaluts, policy-driven uncertainties, etc. check out the markets recently. The real catch though is that we didn't hear from any Davos session or participant laying out any constructive ways forward - there was just heartfelt consensus on the problems and the need for new approaches. Not any new proposals.

UPDATES: Getting Channeled by the White House?

It's always a wonder to wonder who might be reading your work. But just in case you thought we wre kidding about the pressures for reform on the Industry here's Simon Johnson and James Kwak (an e-friend) via the NYT:Is Summers Ready to Get Tough on Big Banks?. As it happens the Economic Report of the President is just hot off the press and the NYT Economix blog loves their charts in this excerptSo That’s What ‘Too Big to Fail’ Means.Which looks startlingly like some work - much cruder in our case of course - we did almost six months ago that was later picked up by David Wessel at the WSJ: Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness. Whether true or not or simply amusing, conincidental and a brief fantasy interlude is irrelevent to the fact that a lot of what we've been arguing for for a long time appears to be getting airspeed. So that might make what we had to say in this post a bit more relevent, if not prescient? :)!

Finance: Re-regulation and Performance

Video Clips & Related Readings

Reagan Budget Chief Offers a 'Gunslinger' Defense of Obama's Bank Reforms With President Obama pushing a bipartisan deal on reforming banking regulations, Paul Solman talks with David Stockman, former Reagan budget chief and Wall Street "gunslinger," about the proposal to tax banks on their size and amount of risk.

View from the Top with Tony James, president of Blackstone Chrystia Freeland, US managing editor, interviewed Tony James, president of Blackstone about the proposed Volcker rule, capital requirements for institutions engaged in proprietary trading and whether private equity and hedge funds pose a systemic risk to the financial system. Part 1, Part 2, Part 3, Part 4

Banking Reform - Part One BNN speaks to Suzanne Labarge, former vice chair and chief risk officer, RBC, and board member, Deutsche Bank. Part Two, Part Three.

Sovereign Debt, Risky Countries Vs. Safer Ones Debt woes in Greece, Italy and Spain have dominated headlines; are there other fiscal crises looming? BNN goes Under the Microscope to examine sovereign debt.

• Spain’s Problem, Illustrated, Know Your Deficits, Euro perspective, Anatomy of a Euromess

Readings and References

The Future of the Global Financial System The phase one report identifies a near-term industry outlook characterized by an expanded scope for regulatory oversight, back to basics in the banking sector, some restructuring by alternative investment firms and the emergence of a new set of winners and losers. Over the long-term, a range of external forces and critical uncertainties will further shape the industry. In particular, our study found that the pace of power shifts from today’s advanced economies to the emerging world and the degree of international coordination on financial policy are the two most critical uncertainties for the future of the global financial system. The report therefore explores four challenging scenarios.

New Financial Architecture The report sketches three themes which are shaping the financial services industry in the near to medium term: 1. Rethinking business models in a lower profit world – A multitude of factors point to lower run-rate industry profitability in the near and medium term. Financial institutions will need to rethink their business and human capital models in order to adjust and differentiate as a result. 2. Increasing client focus – In light of lower industry profitability and more demanding customers and regulators, substantive value creation for customers and society will be a key driver of success. They will need to promote and enforce positive values such as integrity and responsibility. 3. Polarization of the competitive landscape – Strategic choices in terms of regional footprint, product offering and risk appetite will increasingly polarize as financial institutions seek to justify their strategies to investors and regulators who apply a much greater level of scrutiny.

• An Inquiry into the Nature and Causes of the Wealth of Nations: Premium Edition by Adam Smith
• The Theory of Moral Sentiments by Adam Smith
• Structure and Change in Economic History by Douglass Cecil North
• Power and Prosperity: Outgrowing Communist and Capitalist Dictatorships by Mancur Olson
• The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities by Mancur Olson
• The Wealth of Man by Peter Jay
• The Portable Machiavelli by Niccolo Machiavelli, Peter Bondanella, and Mark Musa

Readings

BIS Says Banks Need More Capital to Withstand Shocks Capital requirements on banks aren’t sufficient to ensure financial stability and lenders should hold enough liquid assets to survive a temporary loss of access to funding, the head of the Bank for International Settlements said. The capacity and incentives to take risks have “clearly overwhelmed” any improvements in risk management, Jaime Caruana wrote in a paper he delivered to a gathering of central bankers in Sydney today. Financial companies alone can’t keep underlying risks in check and will need help from regulators to prevent any system-wide threat, he said. Regulators worldwide have been wrestling with plans to increase supervision of banks following the global financial crisis, in which credit markets shut down and policy makers were forced to bail out lenders. The Basel Committee on Banking Supervision proposed changes in December that would improve the quality and quantity of capital as well as bolster easily sellable assets that lenders should hold to meet short-term liquidity needs.

Will We Ever Again Trust Wall Street? For many investors, the market's turbulence hasn't just destroyed wealth. It has shattered their faith in the financial system itself.. Late last year, Decision Research of Eugene, Ore., asked Americans how much they trusted bankers and other Wall Street leaders "to reduce the risk of the financial challenges the country is facing now." On a scale of 1 to 5, with 1 meaning no trust at all, the rating averaged a paltry 1.7. With such a loss of faith, how will companies be able to obtain the capital they need to expand? The foundations of the financial markets ultimately rest upon the confidence of mom-and-pop investors across the country. But every investor has a fundamental need to believe that the world is just—that good people are ultimately rewarded, that bad people are eventually punished and that the system isn't rigged to favor an undeserving few. This belief in a just world is partly delusional; most of us realize that nice guys often finish last. But this delusion makes short-term setbacks endurable. This time around, however, many investors who followed the best advice were punished the worst. Someone who held a total-stock-market index fund lost more than 58% from October 2007 through March 2009 and remains 31% behind even after last year's recovery. These people can't blame themselves; they did as they had been told. Meanwhile, they watched Wall Street firms parcel out billions in bonuses.

I believe the old truths remain valid: Buying and holding a diversified stock portfolio still makes sense. Paradoxically, as fewer people cling to their faith in traditional stock investing, the future rewards from it are likely to grow greater. How can faith be restored?Wall Street firms need to be forthright in admitting their shortcomings. The more they protest their innocence, the more they make the typical investor feel that the financial world is unjust. The Pecora hearings, held in the U.S. Senate in the 1930s, served partly as a form of public expiation, in which Wall Street's leaders apologized for their firms' conduct. The Financial Crisis Inquiry Commission, formed by Congress in 2009 and now holding its own hearings, may help investors feel that Wall Street can own up to its mistakes. Finally, financial advisers need to be much less dogmatic and confident in their predictions. By admitting the extent of their own ignorance today, they would help prevent investors from feeling railroaded tomorrow.

Gut-wrenching stuff FINANCIAL crises are often described as stomach-churning. For Hank Paulson that was literally true. Horribly sleep-deprived as he struggled to stop the world financial system falling apart in 2008, America’s then treasury secretary succumbed regularly to the dry heaves. In one meeting, he pretended to need to relieve himself of his last Diet Coke so he could get out into the corridor to retch. If finance was on the brink, so was the health of at least one of those tasked with saving it. There is the occasional jaw-dropping revelation: for instance, that Russia urged China to sell its Fannie and Freddie bonds to force a bail-out of the mortgage agencies. Equally compelling is the picture of imaginative, seat-of-the-pants policymaking that emerges as the tale progresses. Supported by the real heroes—a phalanx of bleary-eyed staffers—Mr Paulson, Ben Bernanke, the Federal Reserve chairman, and Tim Geithner, head of the New York Fed (and now Mr Paulson’s successor as treasury secretary), rushed to string together loans, guarantees and whatever else was needed, interpreting the law creatively to get things done. It helped that the three worked well together. As a former boss of Goldman Sachs, Mr Paulson’s street smarts complemented Mr Bernanke’s deep historical knowledge of crises and Mr Geithner’s technocratic skills. Mr Paulson drew inspiration from his president, as well as the Almighty. His effusive praise of George Bush, seen by many at the time as hopelessly out of touch, will raise eyebrows. Mr Bush shored up his lieutenant with pep talks, and he showed great courage, Mr Paulson says, in supporting bail-outs to which he was instinctively opposed. Others are portrayed less flatteringly, such as the publicity-seeking Chris Dodd, a key lawmaker, and Dick Fuld, Lehman’s delusional boss.

• Henry Paulson 'On the Brink' But just as one crazy caper ended, a new one was about to begin. The reason: The Wall Street banks were royal screw-ups. Without passing judgment on them—these were members of his former fraternity—Paulson treats us to a parade of big shots asking the government to save their banks from their own incompetence. Here's Chuck Prince, Citigroup's hapless chief executive, at a dinner in June 2007: "Isn't there something you can do to order us not to take all of these risks?" Lehman Brothers chief executive Richard Fuld calls from India to ask if Paulson can get him flyover rights from Russia to get home more quickly. Then on the day before Lehman Brothers went bankrupt, Fuld pleads: "Hank, you have to figure something out." John Mack of Morgan Stanley begs: "Hank, the SEC needs to act before the short sellers destroy Morgan Stanley."
• What They Got Away With
• The Greediest People of All Time

Goldman Helped Push A.I.G. to Precipice Billions of dollars were at stake when 21 executives of Goldman Sachs and the American International Group convened a conference call on Jan. 28, 2008, to try to resolve a rancorous dispute that had been escalating for months. A.I.G. had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, A.I.G., once the world’s biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer. A.I.G. executives wanted some of its money back, insisting that Goldman — like a homeowner overestimating the damages in a storm to get a bigger insurance payment — had inflated the potential losses. Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities. After more than an hour of debate, the two sides on the call signed off with nothing settled, according to internal A.I.G. documents and an audio recording reviewed by The New York Times. Behind-the-scenes disputes over huge sums are common in banking, but the standoff between A.I.G. and Goldman would become one of the most momentous in Wall Street history. Well before the federal government bailed out A.I.G. in September 2008, Goldman’s demands for billions of dollars from the insurer helped put it in a precarious financial position by bleeding much-needed cash. That ultimately provoked the government to step in. With taxpayer assistance to A.I.G. currently totaling $180 billion, regulatory and Congressional scrutiny of Goldman’s role in the insurer’s downfall is increasing. The Securities and Exchange Commission is examining the payment demands that a number of firms — most prominently Goldman — made during 2007 and 2008 as the mortgage market imploded. The S.E.C. wants to know whether any of the demands improperly distressed the mortgage market, according to people briefed on the matter who requested anonymity because the inquiry was intended to be confidential. In just the year before the A.I.G. bailout, Goldman collected more than $7 billion from A.I.G. And Goldman received billions more after the rescue. Though other banks also benefited, Goldman received more taxpayer money, $12.9 billion, than any other firm. In addition, according to two people with knowledge of the positions, a portion of the $11 billion in taxpayer money that went to Société Générale, a French bank that traded with A.I.G., was subsequently transferred to Goldman under a deal the two banks had struck. Goldman stood to gain from the housing market’s implosion because in late 2006, the firm had begun to make huge trades that would pay off if the mortgage market soured. The further mortgage securities’ prices fell, the greater were Goldman’s profits.

• The Great American Bubble Machine, Don’t Dismiss Taibbi
• What Is Goldman Sachs(Big Picture), What Is Goldman Sachs?
• A Windfall Profits Tax for Goldman Sachs?

• The Man Who Crashed the World Almost a year after A.I.G.’s collapse, despite a tidal wave of outrage, there still has been no clear explanation of what toppled the insurance giant. The author decides to ask the people involved—the silent, shell-shocked traders of the A.I.G. Financial Products unit—and finds that the story may have a villain, whose reign of terror over 400 employees brought the company, the U.S. economy, and the global financial system to their knees.

Dodd Says Financial Overhaul Legislation Is at an ‘Impasse’ The senator who is shepherding the Obama administration’s package of Wall Street reforms through Congress said on Friday morning that talks with his Republican counterpart had broken down.The senator, Christopher J. Dodd, indicated that Democrats would forge ahead with their own bill, following months of talks that had been aimed at reaching a bipartisan consensus. Mr. Dodd, a Connecticut Democrat who is chairman of the Senate Banking Committee, has led closed-door negotiations since November over the regulatory overhaul. Throughout the week — which included two hearings on the White House’s latest proposals to rein in the size and activities of banks — Mr. Dodd had one-on-one talks with the committee’s senior Republican member, Richard C. Shelby of Alabama. Mr. Dodd’s statement left many questions unanswered over the path ahead for regulatory restructuring. With their majority in the Senate reduced to 59 seats — one short of the margin needed to overcome Republican filibusters — the Democrats will have to secure at least some measure of support from across the aisle. Democratic leaders have repeatedly warned that they do not want a repeat of last year’s bruising fight over the health care overhaul, but Mr. Dodd’s statement makes a fight more likely. Popular anger over the bailout of big financial institutions, the high unemployment rate and Wall Street bonuses could work to the advantage of Democrats as they head into the midterm elections, particularly if they manage to portray Republicans as obstructing reform. President Obama put forward a package of regulatory changes last June, and the House passed a sweeping overhaul in December, largely along partisan lines. The House bill would create a separate consumer financial protection agency and a council of regulators to oversee systemic risk; establish a process for dissolving institutions considered “too big to fail” without requiring government bailouts; give shareholders an advisory vote on executive pay; strengthen the Securities and Exchange Commission’s power to protect investors; and regulate over-the-counter derivatives. Many — if not most — of the provisions have attracted bipartisan support. But the proposal for separate consumer protection agency — which would regulate credit cards, mortgages, debt collection and other financial services — has emerged as a sticking point. President Obama has expressed support for the notion, but some Democratic senators have favored a compromise that would create a consumer protection unit within an existing agency.

Another View: Looking Beyond the Volcker Rule  Notwithstanding all the riveting talk about political motivations, President Obama has finally decided to wrest control of financial reform efforts from his somewhat tone-deaf minions and the “too hard to tackle” crowd in Congress. Better late than never. But in belatedly joining forces with Paul A. Volcker, the former Federal Reserve chairman, who will ultimately go down in history as the wisest regulator of his generation (sorry, Maestro Greenspan), Mr. Obama has waded into an immeasurably complicated debate that is enormously difficult for the general public to comprehend.  Regulation of the financial sector of economies is a subject that easily offers as many opinions as there are people who study, write on and enforce regulation. Mr. Volcker’s Group of 30 report, compiled a year ago during the depths of the financial crisis, is a work we fundamentally agree with in most respects. But it is written in policy maker’s prose, the full meaning of which eludes many legislators — to say nothing of the public and some in the financial press. In his testimony this week, Mr. Volcker did a yeoman’s job of laying things out for the Senate Banking Committee, and he dispensed with the notion that his proposals, known as the Volcker Rule, would be too difficult to put into effect or would yield consequences he hadn’t intended or already considered and accommodated. But the very fact that we so enjoyed the give-and-take between Mr. Volcker and the committee members, being way too wonkish ourselves, gives us pause with regard to the appreciation of this critical issue by a broader constituency.

Volcker Rule unabridged

• Banks As Businesses: Performance, Reform and Blindsidedness
• The Firestorm is Coming: Financial Sector Reform, Puschbak, Sausage-making and the Public Interest
• Comes 'round, Goes 'round: Hastening Forward Slowly to Finance Reform
• Pecora 2 Hearings, Malfeasances, Your Future & Cusp Points

The Regulatory Landscape for Private Equity The time for regulatory reform is nigh. The bulk of attention is directed at financial institutions and addressing systemic risk, but private equity is being caught in the regulatory wave. Current regulatory proposals have the potential to change the way private equity conducts business both domestically and internationally. Here are some of the significant issues: The first possible regulatory change is the registration of private equity fund advisers. The second big issue affecting private equity is the Volcker Rule. Exact details of the White House proposal remain unclear, but in general, the Volcker Rule would prohibit banks and bank holding companies from owning limited partnership assets or running private equity firms. The third big issue for private equity and the one most likely to affect the industry is new capital and securitization requirements for financial institutions. The House bill requires firms that securitize and originate asset-backed securities to maintain 5 percent of the credit risk. The Senate bill applies only to securitizers and sets a 10 percent requirement. Both bills include enhanced disclosure requirements and the Senate bills has a due diligence requirement. It all spells an uncertain future for private equity and no doubt one that will find it tangled in fair measure in new regulation. It is likely to slow down an industry already hampered by a 2006 and 2007 crop of uncertain and distressed investments.

• Alternative Investments, Strategic Futures of PE and Lessons?

Super Return: Black Sees Better Days Ahead Leon D. Black of Apollo Management (right) predicts happier prospects for the private equity industry in 2010. He warned that there could be “blips” along the way, including problems in southern Europe — read: Greece — or “clouds” arising from commercial real estate. But to Mr. Black, a well-known player in distressed assets, those real estate clouds represent opportunity, more than anything. He trumpeted the virtues of distressed-restructuring deals as well as the commercial real estate market.By comparison, he expects a dearth of “plain vanilla” leveraged buyouts. Instead, there should be a rise in deals that combine distressed debt and restructuring, like the agreement Apollo struck with Parallel Petroleum, a Texas oil and gas company. While he was essentially optimistic, Mr. Black said private equity firms have good reasons to stay on the sidelines. “The larger buyout firms have been pretty dismal vis-à-vis price,” he said. “That’s their choice. Now you could always say, they’ll lose their discipline or get impatient. But there’s also something else happening now which is holding them back.” What’s holding back deals? According to Mr. Black, three reasons: The prices seem too high - The financing isn’t attractive enough - There’s still an unstable economic environment. “All these things factors in,” he told reporters. “It’s beyond just the G.P.’s choice.”

Shareholders Deciding a Dividend Wouldn’t it be great if we could turn back the clock to 2007? Life was far simpler then. The Dow was cresting above 14,000, buyouts were booming and “global financial meltdown” was not yet the topic of elevator conversations. It seems a consortium of private equity investors misses those heady days so much that it replayed a nifty financial move last week that feels very 2007. It didn’t get a lot of coverage, but HCA, the giant hospital chain, announced that it was paying its shareholders a $1.75 billion special dividend. Normally, such a large dividend might be a bullish sign about the health care industry — and perhaps even the broader economy. But look a little closer. Recall that HCA, which the family of former Senator Bill Frist founded in 1968 as the Hospital Corporation of America, was taken private in 2006 at the height of the buyout boom for $33 billion. Its buyers included Merrill Lynch, Bain Capital, Kohlberg Kravis Roberts and, yes, some of HCA’s own managers. Collectively, the group put down $5.5 billion in cash — the rest was a giant loan from a syndicate of banks. So when HCA says it will pay a dividend to its shareholders, what it really means is that its shareholders — the private equity firms that control the board — have decided to pay themselves. That might be a reasonable thing to do in a bull market with a highly profitable company that has little debt. But just look at HCA’s balance sheet: it has a staggering $25.7 billion worth of debt that it still needs to pay off. As Vicki Bryan, an analyst at Gimme Credit, wrote in a report to clients, HCA’s $1.75 billion dividend payment last week “completely offsets the comparatively meager $1.6 billion in debt paid off in 2008-2009.” Worse, Ms. Bryan noted, “most of that debt reduction was funded not from HCA’s chronically weak free cash flow but by $1.6 billion in asset sales.” Not one to mince words, she titled her report “Shell Game.”Back in 2007, if you’ll recall, private equity firms, buoyed by a peaking market, routinely paid themselves huge dividends. They would often take out new loans to write themselves giant checks, just like homeowners took out second mortgages to buy flat-screen TVs and boats. So when the economy turned against them, the companies owned by private equity firms found themselves with little cushion and were forced to resort to layoffs and to cut back on research and development; some were forced to file for bankruptcy, like the Simmons Company, which makes bedding.

The 'Greater Fool' Strategy Three years ago, when Cerberus acquired Chrysler, the collective reaction was to ask how the firm could possibly pull it off. At the time, before the crisis, it wasn't so much about casting doubts as it was a genuine curiosity about what kind of pixie dust Steve Feinberg had at his disposal that would make the PT Cruiser cool. A lot of deals elicited that same reaction back then. EMI, Clear Channel and a few others come immediately to mind.As it turns out, nobody had any magical fixes. The investments, for the most part, were based on the "greater fool" theory that someone dumber would come along and pay more. It's no coincidence that this strategy seemed to attract the industry's DIGJAMs (damn, I'm good; just ask me); Feinberg, perhaps being the exception. Now that we're knee-deep in a downturn, there have been a few deals that still evoke the same kind of wonderment.

Seeking a Safer Way to Securitization Can the world be made safe for the return of securitizations? That is a question of great importance to those like John C. Dugan, the comptroller of the currency, who say they believe that the banking system on its own is unlikely to have the ability to provide enough credit to sustain an economic recovery in the United States. “We need a vibrant, credible securitization market to help fund the real economy going forward,” Mr. Dugan said this week. He was preaching to the choir — a meeting of the American Securitization Forum — but it is an opinion widely held in financial markets. It is possible to question that thesis. Securitization grew as a way for banks to get around capital rules, not because of any profound desire by investors for such assets or any real unwillingness by banks to make the loans. But since it was more expensive to hold capital against the risk if the loans were not securitized, they were securitized. That also opened the market to new players, who neither wanted to, nor could amass, the capital to hold onto loans. Together, those developments undoubtedly made mortgage loans less expensive for borrowers. That was welcome to politicians and to regulators, who wrongly thought that securitization had moved a lot of risk outside the banking system.  Then the whole structure collapsed. If they have no way to gain capital advantages from securitization, banks might choose to make more loans anyway, and the economy could get by without securitization.

Warren: Banks’ Sabotage of Overhaul Will Hurt Them Banking is based on trust. The banks get our paychecks and hold our savings; they know where we spend our money and they keep it private. If we don't trust them, the whole system breaks down. Yet for years, Wall Street CEOs have thrown away customer trust like so much worthless trash. Banks and brokers have sold deceptive mortgages for more than a decade. Financial wizards made billions by packaging and repackaging those loans into securities. And federal regulators played the role of lookout at a bank robbery, holding back anyone who tried to stop the massive looting from middle-class families. When they weren't selling deceptive mortgages, Wall Street invented new credit card tricks and clever overdraft fees.In October 2008, when all the risks accumulated and the economy went into a tailspin, Wall Street CEOs squandered what little trust was left when they accepted taxpayer bailouts. As the economy stabilized and it seemed like we would change the rules that got us into this crisis—including the rules that let big banks trick their customers for so many years—it looked like things might come out all right.Now, a year later, President Obama's proposals for reform are bottled up in the Senate. The same Wall Street CEOs who brought the economy to its knees have spent more than a year and hundreds of millions of dollars furiously lobbying Washington to kill the president's proposal for a Consumer Financial Protection Agency (CFPA). This generation of Wall Street CEOs could be the ones to forfeit America's trust. When the history of the Great Recession is written, they can be singled out as the bonus babies who were so short-sighted that they put the economy at risk and contributed to the destruction of their own companies. Or they can acknowledge how Americans' trust has been lost and take the first steps to earn it back.

Davos Sessions on Re-regulation and Market Capitalism

Welcoming Remarks by Doris Leuthard, President of the Swiss Confederation and Federal Councillor of Economic Affairs Klaus Schwab, Founder and Executive Chairman, World Economic Forum Davos Annual Meeting 2010 - Nicolas Sarkozy Opening Address by Nicolas Sarkozy, President of France Chaired by Klaus Schwab, Founder and Executive Chairman, World Economic Forum

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

After the Financial Crisis: Consequences and Lessons Learned The financial crisis has caused an economic crisis around the world. Drastic state measures have prevented the collapse of the economic system: governments have established rescue funds for failing banks or nationalized banks for relaunching economic growth. At the same time, central banks have intervened with important injections of liquidity and have lowered interest rates. Speakers: Ziya Akkurt, Christine Lagarde, Patrick Odier, Nikolaus Schneider, Joseph E. Stiglitz, Stephan Klapproth, Juan Somavia

Rethinking Systemic Financial Risk In 2009, the G20 tasked the Financial Stability Board (FSB) and the Basel Committee on Banking 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

Redesigning Financial Regulation An Internet search of "global financial regulation" results in over 17 million possible entries to explore. How should the largest financial institutions in the world be regulated domestically and internationally? Speakers: Agustin Carstens, Pravin Gordhan, Davide Serra, Tidjane Thiam, Jean-Claude Trichet, Barry Eichengreen, Stanley Fischer

BizzXceleration Whitepapers on the Finance Industry

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 misbehaviors 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. Specifically it must do three things as a component of society. First, it must create no harm as the result of its operations. When it does it’s obligated to correct that as soon as feasible. Second, where the industry collectively creates a harm, it is the responsibility of the business to band together to address those harms, when otherwise individual firms would not be able to do so affordably. And third, when society is itself suffering from larger ills, for example pollution, healthcare or education challenges, it is in business own interests to contribute to solving those problems. At the end of the day it is in any business’s own self-interest to create the environment and ecology that best balances its own opportunities with the overall health of society. It is in fact a fundamental responsibility of management to act in a socially responsible manner. A failure to do so can be considered a failure of fiduciary responsibility in the broadest sense.

• The Firestorm is Coming: Financial Sector Reform, Puschbak, Sausage-making and the Public Interest

Banks As Businesses: Performance, Reform and Blindsidedness 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. First, and most obviously, by almost destroying Western Civilization (that’s really not much exaggeration either – we came within a gnat’s eyelash of a second Great Depression which might have been much worse because of the accumulated debts engineered across the entire society by the Industry). Next, they came with inches of destroying their Industry itself, and certainly destroyed a decade’s worth of paper profits, as reported but actually more funny-money than reality. Third, thru the magic of financial engineering the Industry has been the prime mover, admittedly with the heartfelt cooperation of the consumer, has saddled the economy with expanding and exponentiating debts. Then that debt has seriously hampered economic growth, driven savings to negative rates and resulted in decades of declining and stagnant growth with negative total job creation. In other words rather than efficiently and effectively allocating capital to help the economy they have managed to harm it in a profound way. And done so by by creating paper profits on which they paid themselves exhorbitant bonuses. Finally, there have been few, or no, major innovations in the market (aside from internal products and services that simply worsened the fundamental problem) that created new value for the rest of society.

• The Broken Finance Industry: Credit, Crisis, Collapse and Broken Business Models
• The Broken Finance Industry II: Crisis, Adaptation, Innovation and Value?
• Facing the Firestorm: Finance Industry, Popular Anger and Re-regulation

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With the refresh on current Economic and Market news in place it's time to dive into applying the ecology to evaluating the outlook for business. We have an interesting choice here - continue topdown by sharing some recent stuff we've found on top-down principles, which would continue our approach. Or take it more bottom-up. We're going to do that because there's so much stuff floating around we'll end up with three separate postings on traditional businesses, technology and Finance. Which'll give us a chance to take a deeper dive on various aspects of each domain. But before we dive in let's add in some more economic and market news update, at last a tad. You'll find some more in the readings but AP just updated its economic stress map (which if you'll click thru will take you to the interactive, online version). You might also want to listen to this morning's PBS interview with David Wessel of the WSJ:Businesses Reluctant To Hire New Workers.

We've sampled the stress map monthly at four points from Dec07 to now(which would be Dec09) and you can read it clockwise. The point AP makes is that the stress is HIGHER than it was, which is a natural cyclic timepath and explains all the sturm und drang in the political arena. We also had multiple conversations with friends and neighbors over the weekend and the general take is that people are worried about jobs, cutting back their spending, thinking about selling their houses and facing major credit/debt problems. The things that are not in the data are a likely next wave of foreclosures, increasing debt problems, major problems with small businesses and worse problems with state and local budgets that are offsetting federal stimulus spending. Not to mention a whole host of international problems giving the markets big time jitters, as detailed in the readings (including a much more detailed YouTube of Jim Chanos assessment of China!).

 

Business Outlook: the Retail Industry

Our constantly harped on theme is that businesses need to adapt to the new normal, adopt new operational and innovation strategies and improve their performance mangement and governance. We've also argued that most businesses are lagging in their responses. Let's put that another way - every business is facing major structural changes at every level from the firm to the Industry to the global economy to geo-poitics and doesn't appear, on the best available evidence that we've seen, to be doing what needs to be done. Let's take the Retail Industry as the exemplarly case in point (exemplar in the sense of example not in the sense of ideal!). Bloomberg did us the favor of taking an outstanding look at the elephant in the room for the last decade - the fact that Retail is grossly over-stored. If you'll click on thru the graphic you'll be taken to another interactive graphic that will allow you to play with their model. Given the economic context of extended weakness PLUS the hidden anectoral evidence the outlook has to be judged as very poor.

Value-investing, the PFE Case and Investing Strategy

In the readings you'll find a bunch of other stories and cases from Harley's struggles with financing, to a slew of stuff on Toyota (wow, can you imagine - the poster child of well-managed company!), Hershey's continued struggles with dysfunctional executive leadership, a bunch of stuff on major shakeups and shakeouts in the Healthcare Industry and the really good story of the Fung brothers of Li and Fung who have managed to not only roll with the punch and more. How they've managed that is well worth studying - especially if you know that Li and Fung have been worldwide poster children for adaptive innovation for decades. You'll also find a link to the FT's "View From the Top" interview with Indra Nooyi of PepsiCo and a set of TechTicker interviews with a friend of our Vitality Katsenelsen, of Active Value Investing fame, discussing the market outlook, China and especially value investing in a range-bound market and taking PFE as his exemplar. We've seen Vitaliy's analysis and it's about as thoughtful and long-range a piece of fundamental analysis as we've ever read. The catch is that he argues that PFE is worth investing in because the PE's discount a total lack of effectiveness in drug development and they have great cash flow. So if anything pops on their huge R&D investments it's all gravy. Our problem - having looked at how badly broken the big pharma development methods are and knowing some folks in the Industry, we're not so sure that revenue is sustainable in the future. On the one hand you ought to look into both views, on another you ought to consider the tradeoffs and on the gripping hand we can split the difference. In the intermediate term Vitaliy's value-analysis probably has a lot of merit but in the long-term we think our breakage assessment will eventually triumph (the analogy that comes to mind is a few years back when we poopoohed Lamberts real estate-base financial engineering at Sears; a view since born out big time but one that took a few years to ripple on thru).

So let's consider PFE as investors via some longer-term stock charts. The 10Yr chart is here while the 5Yr chart is shown. You need to look at the 10Yr to see how bad the overall performance is while some mid-term distortions make the PEs hard to read so look at the 5yr here. And consider that each and every case study could/should be considered the same way. Now given volatile but flat earnings a PE of 10 is indeed still cheap but the question is, is it cheap enough? On the whole, once the market sorts out we'd have to say it might be well worth while putting PFE on your watch list for the next 18 months to 5 years. In the readings you'll find some other stuff on Healthcare, the Steel Industry and Oil. We've pointed out that Oil is going thru a major structural shakeup but, in the book of unintended consequences, the stillbirth of Healthcare Reform looks to provide a major and bigger shift in the HC Industry as well! We think that the Industry, and business in general, are going to bitterly regret not getting behind reform and really pushing.

A Final Word from Indra

And just to end on a slightly cheerful note we'll point you to Indra's interview where she discusses Pepsico's strategic outlook, globalization and corporate social responsibility as well as her impressions of Davos. We were delighted and relieved to hear that her views on Davos are nearly identical to our take and even more delighted that her views on how corporations should deal with the body public are entirely in line with our channeling of Drucker's Principles. On the operational, strategic, innovation and public/geo-political fronts we'd have to judge that Pepsi gets a 5 on our performance assessment ranking (that's another hint btw!).

 

Economic/Market Readings Updates

Chanos detailed presentation on China’s Strategic Outlook

AP analysis: US economic stress hit a peak in Dec. Weakness in Western energy-producing states helped raise the average U.S. county's economic stress in December to its highest point since the recession began in December 2007, according to The Associated Press' monthly analysis of conditions in more than 3,100 U.S. counties. States such as Alaska, Wyoming and Montana lost jobs related in part to a drop in energy and mining exploration. Those states in the past had generally defied the national economy's weakness. Economic strains in the final month of last year were evident throughout the nation. Foreclosure and bankruptcy rates rose even as the national unemployment rate held steady. The spillover to Western states was inevitable, some economists say. "It's hard to stay above water when much of the rest of the country is going down around you," Sean Snaith, an economist at the University of Central Florida, said of those states. The AP's Economic Stress Index found that the average county's score in December was 10.8. That's a sharp jump from the 10.2 reading in November. The previous worst reading since the recession began in December 2007 was 10.3 in March 2009. The index calculates a score from 1 to 100 based on a county's unemployment, foreclosure and bankruptcy rates. A higher score indicates more economic stress. Under a rough rule of thumb, a county is considered stressed when its score exceeds 11. Nearly 45 percent of the nation's 3,141 counties were deemed stressed in December. That compares with less than 39 percent in the previous month. AP Interactive Economic Stress Map

• 7 U.S. States That Are Worse Off Than Greece, Portugal, Ireland, and Spain
• Consumer credit down in Nov. for record 11th month

No Job Growth for Small Business Inspires Doubts Over Sustainable Recovery  Small businesses are becoming the Achilles heel of the U.S. recovery by limiting growth and job creation. Companies with fewer than 500 employees, such as Phoenix Technologies Ltd. and Sonic Corp., helped lead the economy out of the four recessions since 1980. This time, they continue to cut capital spending and dismiss workers, eliminating 3,000 jobs in January, according to Roseland, New Jersey-based Automatic Data Processing Inc., the world’s largest payroll processor. Improvement in the unemployment rate, which fell to 9.7 in January from 10 percent in December, may stall later this year if these firms aren’t hiring, and growth likely won’t meet the median 2.7 percent annual rate forecast for 2010 by 67 economists in a Jan. 14 Bloomberg News survey. “Will you have a sustainable recovery a few years down the road without getting some small-business spending? No,” Cary Leahey, senior managing director at Decision Economics Inc. in New York and a former White House economist, said in an interview. “Wall Street gets it.” Because few economic reports capture small-business statistics, some economists say investors are being misled about the strength of recovery from the longest, deepest recession since the Great Depression. Recent numbers suggest “the official data are too heavily weighted towards bigger companies, which are doing better than credit-constrained smaller firms,” said Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd. in Valhalla, New York. “The latter employ half the workforce.”

Stock investors see threats from all directions Jittery stock traders react to each day's news as if it could be the start of Financial Crisis 2.0. On Thursday, the Standard & Poor's 500 index suffered its biggest one-day drop in more than nine months because of worries about debt problems in Greece, Portugal and Spain. Concerns about China's plans to limit economic growth and proposed regulatory bank changes from Washington also have pummeled the market.

• Weak Dollar Illusory as Correlated Trading Shows Gains Since Bretton Woods
• Corporate Bond Yield Spreads Widen the Most Since November: Credit Markets
• Reassuring talk isn’t ending the euro crisis
• End of the Bond Secular Bull Market?
• S&P 500 Equity Market Review

Is the Market ‘Priced for Perfection’? Yet in at least one important respect, there may be a significant parallel to the situation at the height of the tech bubble. Many market watchers say the late-January sell-off this year could be a sign that the market is again “priced for perfection,” said David C. Wright, managing director of Sierra Investment Management in Santa Monica, Calif.

• Get Used to Dow 10,000: Value Maven Predicts 10 More Years of Famine
• China Won't Crash But It's Time to Trim Exposure, Value Investor Says
• Vitaliy Katsenelson Reveals "The Perfect Stock for This Economy"
• How to build a global portfolio: What countries do you want to own?

Business Cases & Stories

Indra Nooyi explains why global institutions need to be rebuilt, why corporations need to give more to society, and why she’s not worried about PepsiCo’s share price on the FT View from the Top.

Retailers Likely to Close More U.S. Stores After Over-Expanding: Analysis Retailers are likely to close more U.S. stores to cut costs in the months ahead after expanding during the recession, an analysis shows. Retail Closings and Strategic Outlook (Interactive Graphics)

Harley's amazing downhill ride Today is an anniversary for motorcycle manufacturer Harley-Davidson that it would just as soon not remember. On February 3rd a year ago, with the stock market hurtling toward its March lows, Harley (HOG, Fortune 500) announced it had sold $600 million in five-year notes at a nosebleed interest rate of 15%. Yes, 15%, because the company needed the money to fund its finance company and had to pay what the market demanded. The market, in this case, included Warren Buffett, whose Berkshire-Hathaway (BRK.B) had been husbanding cash for years, and who was pleased to give $300 million of that money to Harley at 15%. The other $300 million was put up by Davis Advisors, a mutual fund company whose Chris Davis saw Harley notes as a fine investment for his funds (which, by the way, also own Harley stock). The annual $90 million of interest those notes carry certainly didn't help out Harley's 2009 results, though a recession that was killing sales of discretionary goods would have led to a financial wreck in any case. For the year, Harley reported shipments that were down 27% from 2008 and ended up with a $55 million loss -- its first red ink since 1993. Still, 2009 had its redeeming features for Harley, and these certainly began with its stock price. For the year, as investors anticipated the company regaining its zoom, its stock rose by 53%. Meanwhile, the great 2009 bull-market in junk-bond prices was producing an astounding turn in interest rates. In December, Harley sold still another block of 5-year notes -- $500 million -- at a 5¾% rate. For swings in what it costs to do business, and for a reminder of just how remarkable the securities markets were in 2009, a 15% rate down to 5¾% is an amazing ride.

Toyota’s Slow Awakening to a Deadly Problem At almost every step that led to its current predicament, Toyota underestimated the severity of the sudden-acceleration problem affecting its most popular cars. It went from discounting early reports of problems to overconfidently announcing diagnoses and insufficient fixes. As recently as the fall, Toyota was still saying it was confident that loose floor mats were the sole cause of any sudden acceleration, issuing an advisory to millions of Toyota owners to remove them. The company said on Nov. 2 that “there is no evidence to support” any other conclusion, and added that its claim was backed up by the federal traffic safety agency. But, in fact, the agency had not signed on to the explanation, and it issued a sharp rebuke. Toyota’s statement was “misleading and inaccurate,” the agency said. “This matter is not closed.” The effect on Toyota’s business is already being felt. Its sales in the United States in January are expected to drop 11 percent from a year earlier, and its market share in the United States is likely to fall to its lowest point since 2006, according to Edmunds.com, an automotive research Web site. The company has not yet projected the cost of its recalls and lost sales. But a prolonged slowdown in sales could substantially hurt a company that once minted profit. Toyota’s handling of the problem is a story of how a long-trusted carmaker lost sight of one of its bedrock principles. In Toyota lore, the ultimate symbol of the company’s attention to detail is the “andon cord,” a rope that workers on the assembly line can pull if something is wrong, immediately shutting down the entire line. The point is to fix a small problem before it becomes a larger one. But in the broadest sense, Toyota itself failed to pull the andon cord on this issue, and treated a growing safety issue as a minor glitch — a point the company’s executives are now acknowledging in a series of humbling apologies.

Where Toyota went wrong When Toyota gets around to doing one of its famous "root cause" analyses of the Great Accelerator Recall, it should start by looking in the mirror. As the company grew to become the world's largest automaker, it failed to adjust its corporate structure to accommodate its altered scale. And in its zeal to deliver profits as well as revenue, it may have overlooked fundamental principles that used to underpin its business. Toyota, in other words, forgot what the Toyota Way was all about.

• With Eye on Its Reputation, Toyota Issues Repair for Pedal, Toyota’s Sales Fall as G.M. and Ford Gain
• Toyota Says Prius Brakes Had Design Problems, Toyota Has Pattern of Slow Response on Safety Issues
• Week in Review: Watching Toyota Flunk for Once
• The Dozens of Computers That Make Modern Cars Go (and Stop)
• Auto Sales BNN speaks to George Magliano, director, automotive research for the Americas, IHS Global Insight.

News Wrap: Toyota President Apologizes for Recall In other news Friday, Toyota's president Akio Toyoda apologized for the brake problems that triggered a worldwide recall, and at least 40 people are dead in Iraq from two bomb blasts targeting Shi-ite pilgrim

Hershey Meltdown Looms With Reese Shadowing West in Failed Cadbury Merger  Hershey’s failure to find a way to combine with Cadbury -- a traditional British company with a compatible culture -- is the story of two men who stood in each other’s way on the same side of the $19 billion takeover lost to Northfield, Illinois- based Kraft Foods Inc. Their rift, as recounted in interviews with more than a dozen executives, board members, and advisers who spoke on the condition of anonymity, shows how Hershey missed its last chance to attain Cadbury’s global scale, especially in the faster-growing emerging markets of Latin America and India.

• Cocoa Peaking Means Kraft Gets Cadbury as Chocolatier Profit Margins Widen

Overhaul Failure Will Spur Mergers as U.S. Health Industry Pursues Savings Insurers, drugmakers and hospitals will likely slash costs and merge companies to maneuver through a U.S. health-care landscape marked by rising medical expenses and the loss of millions of potential paying customers. With Congress’ sweeping overhaul of the health system stalled, industry will seek its own answers to a push by government and the private sector to rein in costs, said Curtis Lane, senior managing director at MTS Health Partners, a New York-based equity fund. An aging U.S. population will spur demand for services and, at the same time, boost pressure to control spending, he said. One solution will be increased consolidation, with companies led by WellPoint Inc., the biggest U.S. insurer by enrollment, and Community Health Systems Inc., the largest publicly traded hospital chain, scooping up rivals unable to “spread rising costs across fewer customers,” said Paul Keckley, of the Deloitte Center for Health Solutions. The health-care market “certainly seems to favor bigger, innovative, scalable companies,” said Keckley, executive director of the Washington-based center, in a phone interview. Drugmakers facing the loss of patent protection on top-selling medicines “were looking at decelerating revenues, with or without reform,” he said.

• Health Care Spending Continued Climb in 2009 Health care spending grew to 17 percent of the U.S. economy last year. Betty Ann Bowser examines the impact of the figures amid questions on the future of a legislative reform push.
• Health Spending Projections Through 2019: The Recession’s Impact Continues
• If Colleges Worked Like Health Care, If Air Travel Worked Like Health Care

• Bill Would Apply Antitrust Laws To Insurance

The unstoppable Fung brothers Just as this skein of good karma threads through the Fung family, so too has Li & Fung built its business around an invisible chain. The company quietly has become one of the world's largest producers of consumer goods -- including Cannon sheets, Tommy Hilfiger polo shirts, Restoration Hardware bathroom faucets, L'Oreal cosmetics and Hello Kitty stuffed animals -- all without owning a single factory or fabric mill. Sales, which grew sevenfold over the past decade, totaled $14.3 billion in 2008. One third is hard goods; the rest is apparel. All told, Li & Fung produced more clothing last year than the apparel exported by Thailand, South Korea, and Malaysia combined. "Their size is their competitive advantage," says J.P. Morgan analyst Vineet Sharma. "They are just so much bigger than any of their competitors." And Li & Fung is growing -- fast. Like a giant squid, the company has been gobbling direct rivals and ancillary businesses in an attempt to reach its goal of $20 billion in sales by 2010. To keep growing, Li & Fung is expanding into new businesses, including LF USA, a division formed in 2004 to buy and license brands, including Royal Velvet, Cannon and a company that makes Vera Wang clothes for Kohl's (KSS, Fortune 500). The New York-based division now has $1.4 billion in sales, making it a rival to large Seventh Avenue manufacturers. "The idea was to layer the front end of design over the back end of sourcing," says Rick Darling, the division's president. It's as if Intel, in addition to supplying Dell and HP with chips, started making computers. Li & Fung says it keeps the various business lines straight by creating separate divisions for each large customer. At last count, there were 180 such divisions, each headed by a manager, known internally as a "Little John Wayne." Victor coined the phrase to convey a sense of cowboy-like freedom. These managers have wide ranging authority; they can authorize the use of a new factory in Tunisia or open alternative shipping routes -- all without corporate approval. "What they orchestrate is incredibly complex," says Marshall Fisher, a logistics expert at the University of Pennsylvania's Wharton School. "But that complexity has costs."

Beyond the black stuff In the long term, however, the firms’ success depends on sustaining reserves. The big western oil companies are trying to expand through acquisitions and investment, but the opportunities do so are becoming scarcer. The firms are spending where they can. Exxon Mobil, the biggest listed oil company, says that exploration and capital spending hit $27.1 billion in 2009, 4% higher than in 2008. The company expects to spend $25 billion to $30 billion annually to the same end over the next five years. BP intends to spend some $20 billion this year on investment in new projects and drilling, roughly the same level as last year. But there are limits to what money can buy. State-controlled rivals—in the Middle East, Russia and beyond—jealously guard oil reserves on their home patches. Few new big fields of oil, at least those that are easy to reach and cheap to exploit, have been discovered in recent years. And where new opportunities emerge, such as in Iraq, Western oil giants are scrambling to pay big sums at auctions for drilling rights in territory where the local government tightly limits their returns. Even then, competition from Chinese, Russian and other state-run oil firms can be severe. National oil companies will often pay prices that would alarm shareholders in the big listed oil companies.Thus Western firms are increasingly looking for different sorts of growth. One option is to deploy their expertise in the hunt for oil that is harder to reach, for example deep offshore, or to go for reserves such as tar sands that are trickier, and so much pricier, to refine.

Another route is to speed up the quest for other energy reserves. France’s Total has branched out into nuclear-power generation. This week Shell announced a $12 billion joint-venture with Cosan, a Brazilian producer of ethanol from sugar cane. This is something of a change of tack. Exxon and Shell are both spending money on “second generation” biofuels made from algae or waste materials, but these could take years to develop. Now Shell can sell Cosan’s “first generation” wares through it global distribution network. By far the biggest bet laid, however, has been on natural gas. Around 40% of Shell’s daily production is now in the form of gas. Total and BP are not far behind. Gas is increasingly important for power generation and heating and the global market is expected to grow by half by 2030. Big oil companies are keen to expand, calculating that their skills at managing huge capital projects will be useful when building gas-liquefaction plants that make the stuff readily transportable. Late last year Chevron, Shell and Exxon agreed to spend $37 billion to develop the Gorgon field off Australia, another potentially huge source of gas.

• Shell and Cosan team up on biofuels in Brazil
• The handful of firms that build nuclear reactors face new competition
• Why hasn't the carbon price fallen further?

A Globe Still in Need of Steel The steel industry, though buffeted by crises in past decades, remains a core part of the economy. We may now be in the information age rather than the industrial age, but people still need steel for things like cars, buildings, pipelines, machinery and appliances. Data from the World Steel Association shows an industry that, like many others, took a hit from the recession: crude output declined 8 percent in 2009 compared with 2008. But there were some geographical variations. While production plummeted in the United States and dropped in many other countries, it climbed in China. India eked out a gain, and the Middle East also showed an increase. In the United States, the biggest steel-producing states include Indiana, Ohio, Arkansas, Alabama, North Carolina, South Carolina and Texas, according to the United States Steel Manufacturers Association. And Pennsylvania remains a maker of steel, though at nothing near the level it was in Andrew Carnegie’s day.

• Steel-producing Countries Graphic
• Reality curbs China's reform of steel sector

Posted by dblwyo at 07:51 PM | Permalink | Comments (0)

With the last two posts under belts we should have a baseline on how the "New Normal" is going to play out, frankly, for the next decade and how widely our perceptions are shared or reflected among some of the world's most influential decision-makers (Chaos, Turbulence, Fragilities: Defining the New Normal, Blueprinting Business Performance, The Cusp Point is Here: Lessons From Davos). Now it's time to look at the consequences for markets and the economy. If you'll recall we've said the economy is policy-dependent while the markets were afloat, likewise, on a policy-funded carry trade and complacency. Which means that the major factors we see in the NN (jobless recovery, weak demand, deleveraging, slow sub-potential growth, re-balancing = trade wars, worldwide over-capacity) were not reflected in an arguably over-valued Market which was pricing an immaculate V and ignoring all the fragilities, risks and turbulence that we're facing. Something we've been saying since the Summer but hammering on since the early Fall. In the readings we've provided earlier links to previous posts as well as white paper collections on the markets, the economy and investment strategy that not only go thru all that but provide a lot of tools and machinery for analyzing it and investment management. So let's dig into the state of things.

Markets Re-discover Reality

In case you haven't noticed the markets are still marching in lockstep and those have been down (EM's down over 5% and developed markets down over 4% in Jan to date). The proximate triggers were a minuscule, almost meaningless tightening in Chinese monetary policy, the re-discovery of sovereign debt risks in Europe (causing a renewed flight to the $ and re-invoking $Down, Markets Up dynamic) and a growing awareness of a weak recovery. Combined with being 1/2-way thru earnings season and suddenly realizing profit growth was still largely cost-cutting (wow, deja vu') and not on organic revenue growth (Technology is a separate issue but we did cover that previously:Talking Business: the Outlook vs. the Preparations).

Because the markets are all still moving in lockstep (again a hallmark of being driven by internals and not fundamentals) we don't really need to put up the charts on each of the separate pieces but you can see Sectors & World Markets, Finance/Rates/Commodities(Oil) and Gold/Dollar Markets by clicking thru on the highlights to take you to the various composite chart sets. The composite at right compares and contrasts the short-term vs. the long-term but some complementary views of the intermediate term are here and here.

 

Those are actually pretty amusing, especially since this round's intermediate chart shows almost exactly the same things: the market bubbled up briefly over the upper bound of the downtrend which coincided almost exactly with a Fib limit. At the same we said if you were in the Markets you were trading or speculating and betting on a very fragile continued speculative bubble carrying up over those lines of resistance into a new Fib-box. It turns out being a sceptic was the right call, so far. The question is, having failed at those points, how much farther might the markets fall - bearing in mind the current outrageous long-term PE valuations? We won't read off the Fib limit resistance lines since you can do that but notice the congruences between short-term and long-term again. Yet S&P sees the markets finishing around 1215 for the year! Which is not much of a rebound but at minimum tells us that we're facing a lot of volatility and no fundamentals. At least IOHO!

Economic Fundamentals

With the first release of Q409 GDP just behind us, the new employment numbers just out, coupled with a massive re-basing of the employment data that increased total jobs lost from 7+ million to 8+ million we should ask where are we at? And what's going on? An earlier chart on GDP, Consumption and Employment is here, and as you can see by clicking thru, things have indeed turned the corner. We'll embed more on GDP and Consumption in the charts we will look at but our primary focus is going to be on Employment and Demand. The thing that the Markets, and decision-makers for that matter, seem to have so much trouble wrapping their heads around.

As the top sub-chart shows three different measures of Employment have all turned up but are still in seriously negative territory. The really important point is the second sub-chart which contrasts GDP and cumulative job losses. With the data revisions we went from being ~13 million jobs in the hole to being 14.2 million in the hole. Something we've discussed previously is that we'll need 20 million new jobs to get back to breakeven and offset labor force growth. At a likely 2.5% GDP growth rate it'll take about SEVEN years to get Unemployment back down in the 5% range. Talk about your weak recoveries!

Job Growth Realities: Negative Job Growth

Bearing in mind that even with the improvement in decreasing losses we still lost jobs, particularly in the private sector. So let's remind ourselves of what that means by looking at Private job creation over the last decade+.

In some ways the important chart here is the bottom one, which shows private jobs in total. It also shows that no new jobs have been created since Q498! In other words in eleven years the US economy has created NO new jobs! How abysmal is that?

The top chart is a repeat but let's take a closer look. We've been beating our and your chops about the last "recovery" not being organic, that is it never reached a point of self-sustaining growth where new consumption created new investment created new jobs and so forth. If you look at the top chart you can see where ALL the employment indicators reached a peak in Q106 and started dropping and then started falling off a cliff in Q407/Q108, which is exactly when the NBER called the start of the recession. Yet as late as the early Fall08 we were still arguing with people about whether or not we were in a downturn, let alone how serious it was going to be. What kept things up at all last time was the Housing bubble and home equity ATM - what're the chances for that coming back do you think? De Nada we'd say.

Demand and LT Issues: Policy, Politics and Unintended Consequences

The two poles of the economic field in the NN are the poor recovery picture in the developed world and the resulting re-balancing of the global economy. Meaning, as we argued thruout the last two posts, that the export-led economies in the rapidly emerging world would have to undergo major shifts from an external dependency to an internally-driven economy. Something which they acknowledge, claim to be working on but are not working hard or fast enough to address. Yet adjustment to the NN is NOT voluntary. Right now the geo-political pressures on China to adjust its exchange rate and growing pushback on trade are symptoms of this on-coming tsunami.

The other thing that's going on is that this is a VERY policy-dependent economy. Part of the fragility and turbulence, which the markets allowed themselves to ignore or neglect, is that meant that low rates, quantitative easing to subsidize l.t. rates and help banks re-build balance sheets (which btw they haven't but instead are paying themselves bonuses, doing the grossly inprudential thing in the jargon) and stimulus spending. Now to make it even more fun various political actors have been raising the specter of excessive deficits and debts at precisely the wrong time. That's a 3-phase problem. In the emergency massive stimulus, in the intermediate term the total debt levels in the US are manageable and the economy is still vulnerable and in the long-term (beyond 2016) and after recovery is back on its feet would be the time. Instead government is being forced to rein in stimulus. Managing all the moving parts of this transition is going to be, in a different way, as difficult and challenging as saving the world in the first place. Made more complicated by all the conflicting political partisans.

Which sets up this next chart. Our favorite indicator of future demand is the sum of the growth in Employment and Real Wages. The downturn caused a major drop in inflationary pressures, particularly as Oil prices dropped, which created a surge in real wages. Now Employment pressures are having the opposite effect. So in the bottom sub-chart you can see GDP and Employment turning up but Wages+Employment not only turning down, we're past that. Instead it's dropping and getting pretty negative. In fact about as bad as it's been for thirty years! Though not quite in the same range as it was during the brief but serious downturn in the 1980 downturn. But then we had a pretty good idea it was temporary. This time?

So there you have it. Market's delusions being stripped away a tiny bit, policy realities setting in and the prospects for demand growth rather poor on the evidence to date. And with mounting political pressures to tighten budgets - which is the same recipe that destroyed the nascent recovery from the GD in 1937. Ought to make you wonder where we'll end up, eh? But, just for the record, we're hardly alone in our views on the influences of policy on the markets and economy. For one thing you can re-review the post on Davos. Or watch this edition of Wealthtrack which digs into all the sudden structural shifts that are on transitional cusp points.

Markets

Previous Posts

• Markets & Economy: Noise, Signal, Some Worrisome Signs
• Review & Outlook: Economy, Markets and Business in the New Normal
• Chaos, Turbulence and Policy: Market Lookback, Outlook & Risks

Readings

Stimulating debate AS JANUARY goes, so goes the year. That old stockmarket saying does not augur well for 2010, given that the MSCI World index fell by 4.2% in the month, the biggest decline since February 2009, and emerging markets dropped by 5.6%. Although markets rallied a bit in early February on better-than-expected economic data, the poor start to the year reflected an inherent contradiction to the rebound of 2009. That rally seemed to be dependent both on extraordinary stimulus measures by governments and central banks, and on a vigorous economic recovery. But both cannot co-exist for long: either the recovery will not last or, if it does, the stimulus will be taken away. In addition, governments’ ability to provide that stimulus is dependent on the markets’ own willingness to fund huge deficits at very low yields. But why would investors accept meagre yields if they expected a vigorous recovery? In a sense, the market seemed to be hauling itself up by its own bootstraps. Sure enough, the bullish story has started to unravel, if only at the edges. In the developing world China has attempted to tighten monetary policy. That has caused some alarm because China was acting as the engine of global growth. And in the developed world investors have started to question the ability of governments to keep financing their deficits. The authorities face a dilemma. Reduce the stimulus now and they risk plunging the economy back into recession, as happened in America in 1937 and Japan in 1997. But leave the stimulus in place for too long, and they risk damaging long-term growth prospects. The bulls hope that the economy can escape from this trap by the simple expedient of private-sector growth. That is why they welcomed the rise in manufacturing activity signalled in this week’s latest purchasing managers’ indices. If the private sector rebounds of its own accord, unemployment will fall and budget deficits will decline. But hopes for a strong private-sector recovery are undermined by the data on credit growth. In the year to December, the broad measure of money supply fell by 0.2% in the euro zone and grew by just 3.4% in America. In Britain the annual growth rate is higher (6.4% in December), but David Owen, an economist at Jefferies International, estimates that quantitative easing (QE), whereby central banks create money to buy assets, has been boosting the figure by an annualised rate of 10%. If the Bank of England stops QE entirely, the credit-growth rate could collapse. For the stockmarket rally to resume properly in 2010, economies in the developed world need to show they can stand on their own two feet.

Beware the 4 new asset bubbles Less than two years after the housing market collapsed, the U.S. economy is threatened by a new bubble in asset prices. This time, four billowing balloons are hovering: two commodities -- gold and oil -- stocks, and government bonds.Don't be fooled into thinking that last week's 5% drop in the S&P, and the recent sell-off in oil, remotely makes them fairly valued, let alone bargains. Equities and commodities, as well as Treasuries, which actually rallied as stocks dropped, still have a long way to fall. The reason: They've already seen huge run-ups that put their prices far above their historic averages, and far above the levels justified by fundamentals. Two examples: Most companies can't possibly grow earnings fast enough to support their lofty valuations, and oil and gold are so expensive that we'll see what high prices always bring, a surge in new supply. That makes a price-pounding glut inevitable. Since the start of 2009, oil has returned to the danger zone by jumping 63% to $75 a barrel, and gold has risen more than 20% to set astounding new records by climbing above $1,100 an ounce. After briefly returning to historically normal valuations in March, stocks are now selling at price-to-earnings multiples 40% above their historic range of 14, and 10-year Treasuries are so pricey that they yield 1.5% less than they did in 2007. What's causing this resurgence of speculative fervor? One view blames the same policy that caused the real estate rampage -- incredibly low interest rates that are flooding the banks with cheap funds that, in theory, are available for loans. (The current Fed target rate is between 0 and 0.25%.) The one asset that definitely isn't bubbling is housing. There, prices have fallen to a level where new buyers buy a house for the same total monthly cost as rental. That's gravity operating. So how do you spot a bubble? My view is that we're now seeing the same signs that exposed the frenzy in real estate: prices flying far above their historic averages, measured either in inflation-adjusted dollars (commodities) or as a ratio of the income they produce (stocks and Treasuries). Watch for gravity to take over, just as it did in housing.

• Stocks, Commodities Drop on Concern U.S. Unemployment to Derail Recovery
• Commodities Tumble the Most Since August on Concern Consumption May Falter
• Oil falls 5 percent in steepest drop since July
• Get your portfolio ready for the profitless global economic recovery

End of TALF Means Bond Sales With Spreads Five Times Wider: Credit Markets  The end of a Federal Reserve program that helped unlock credit markets is spurring sales of asset- backed bonds with relative yields five times wider than on debt secured by car loans. The expiration of the Fed’s Term Asset-Backed Securities Loan Facility is driving companies to sell bonds tied to loans that would otherwise require higher yields. Borrowers are offering bonds backed by subprime auto loans, mortgage-servicing payments and assets that have proved hard to sell after the worst credit seizure since the Great Depression. “What we are seeing in the last couple of rounds are issuers in non-traditional asset classes and weaker issuers looking to fund as much as they can before the window closes,” said James Grady, a managing director at Deutsche Asset Management in New York. The firm has $240 billion in assets under management, including asset-backed securities.

Bernanke's Exit Strategy: Tighter Reserve Requirements Phase one of the recovery is certainly complete. Since September 2008, the Fed has bought mortgage-backed securities and Treasurys, and increased the monetary base to $2 trillion from $850 billion. The flood of dollars has bank profits booming. Sadly, banks still have all those underwater mortgage-backed securities and derivatives, but Mr. Bernanke is assuming they will just earn their way out of this problem. Banks also are not lending enough to get the job-creation engine rolling again—though sooner or later they will, at which point inflationary pressures will build tremendously. So every currency trader, bond buyer and man on the Street wants to know one thing: "What's the exit strategy, Ben?" Raise interest rates, shrink the money supply and risk cratering the economy, or keep rolling along and risk a collapsing dollar? My guess? Mr. Bernanke will leave the money out there but restrict banks' ability to create more out of thin air. He'll be called crazy. Crazy like a fox. The Fed has a once-in-a-millennium opportunity to do away with banking panics. Investors will rejoice, but Wall Street firms are not going to like it one bit. Our banking system has changed little since the days of Elizabethan goldsmiths writing more gold receipts (aka banknotes) than they had gold in their vaults. This "fractional reserve banking" system has caused every major panic in this country—I've counted at least 16 of them since 1812. Whatever the era, the story is always the same. Banks keep small reserves, and then invest in supposedly safe "sure things" to generate profits beyond the interest paid to depositors. Sure things can be real-estate loans, home equity, credit card and commercial debt. But bankers are terrible investors. There are no sure things. You do need lending for an economy to function, but you don't need all that much leverage. Increased reserves may be the best financial reform we can hope for without politicians mucking it up. No need for pay czars and repressive rules. Even a whiff of lower leverage and increased reserves will create a dollar rally, as inflationary fears—that banks will create too much money when the economy gets going again—subside. Oil at $50? Gold at $700? If I'm right, banks and Wall Street are going to scream bloody murder at their new shackles. But so what, they've had plenty of time to recapitalize themselves and show record profits and compensation, a gift of Mr. Bernanke's zero-interest-rate policy. Tighter control of money supply would mean the Fed no longer has to guess if banks are creating too much or too little. Lower leverage would keep bubbles from forming in the first place. Crazy.

Financial turmoil strikes as G-7 officials gather A bout of turmoil in global markets has provided sobering reminder to global financial leaders that the aftershocks from the worst recession in seven decades are far from over. Finance ministers and central bank presidents from the world's seven major industrial countries -- the United States, Japan, Germany, France, Britain, Italy and Canada -- were scheduled to arrive Friday for discussions in this small snow-swept Canadian town about 200 miles south of the Arctic Circle. The talks are expected to be dominated by the question of how much longer extraordinary government stimulus should be provided to lift economic growth. The risks still facing the global economy were highlighted dramatically after bad economic news sent markets plunging around the world on Thursday. The Dow Jones industrial average fell by 268 points or 2.6 percent, its biggest one-day loss in seven months. The slide had begun in Europe over concerns about high debt levels in Greece, Portugal and Spain. Worries in those countries set off broader concerns that government will have difficulty containing rising debts and borrowing more money to help revive their economies.

• Fraying at the Edges
• Investors Fear Europe’s Woes May Extend Global Slump
• European crisis highlights fragile global recovery

Mohamed El-Erian: Tough times ahead Geoff Colvin: We've had one quarter of solid economic growth. Is the recession over? Mohamed El-Erian: Yes, but an important, qualified yes. We've had one quarter of economic growth, which is probably going to be revised down, but it's going to be in the 2½% range for the third quarter. The fourth quarter will probably be in the 3% range. The question is, Can we sustain growth in 2010? And our worry is that it's going to be very difficult. What does it depend on? It depends on this handoff from very artificial sources of growth, first and foremost the stimulus. We've had the biggest stimulus in history, fiscal and monetary, and we're feeling the benefits of that. And there's a natural inventory cycle -- you come to a point where inventories are run down, and some building up begins. That's what the second half of 2009 is. These are not permanent sources of growth. So you need to hand off to the private sector -- to consumers and companies -- and for that to happen, a lot of very positive things have to occur, and they are unlikely to occur. What are the most important things that individual investors need to do differently? The average investor has two issues today. First, the average investor is too U.S.-centric. There's a reason for that; the behavioral finance people will tell you that we like the familiar, so we tend to invest in names that we know, that give us comfort. The problem is that you don't want to be too U.S.-centric in a globalizing world where the center of gravity is shifting. So the first thing for the average investor to recognize is that the asset allocation of tomorrow is much more global than the asset allocation of yesterday. Second, most of us have been very lucky -- we haven't had to worry about inflation for a long time. We're moving toward a much more fluid world in which, at some point, inflation will come back.

• Investing in a complicated world In a multimedia feature, Pimco CEO Mohamed El-Erian talks about the post-Lehman, globalizing economy.
• Investing in Turbulence: EMH, Irrational Markets & Pragmatic Decisions
• Active Allocation, Active Investing: Investing Guidelines for Lost Decade #2
• Meet the market's 10 biggest losers

Stockpickers suckered HOW do you pump up the value of your company in these difficult times? One tried and tested way is to hoodwink equity analysts, according to a new study* of 1,300 corporate bosses, board directors and analysts. The authors found that chief executives commonly respond to negative appraisals from Wall Street by managing appearances, rather than making changes that actually improve corporate governance: boards are made more formally independent, but without actually increasing their ability to control management. This is typically done by hiring directors who, although they may have no business ties to the company, are socially close to its top brass. Depressingly, these market-distorting shenanigans are part of a pattern. An earlier study found that public companies commonly enjoy lasting share-price gains from plans that please analysts, such as share buybacks and long-term incentive schemes for executives, even when they fail to follow through on announcements. Another concluded that the further a firm’s profits fall below consensus forecasts, the more favours its managers bestow on analysts—such as recommending them for jobs and even securing club memberships for them—and the lower the likelihood of a further downgrade. If investors rated analysts, those taken in by such blatant attempts at manipulation would surely earn a “sell”.

Economy and Policy

BizzX Economic Whitepapers

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.

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

Readings

Labor Market Shows Signs of Rebirth in New Data The unemployment rate unexpectedly dipped to 9.7 percent in January, from 10 percent in December, the government reported Friday, buoying hopes that the worst job market in at least a quarter-century is finally improving.But a different survey in the Labor Department’s report found that the economy lost 20,000 net jobs during the month, muddying the picture and underscoring the formidable struggles still confronting millions of Americans. Yet with the pace of decline slowing, most experts focused on signs that the economy was recovering after the longest recession since the Great Depression. Manufacturing added 11,000 jobs in January, the first monthly increase since November 2007, while the length of the average workweek rose slightly at factories. The economy added 52,000 temporary workers, and average wages increased modestly, amplifying the view that commercial activity is reawakening after two years of hibernation.

•  Is America experiencing a jobless recovery?
• Off the Charts: A Recovery That’s Factory-Built and Gaining Speed, Manufacturing Output and Employment
• Unemployment Drops to 9.7%, Employment Report: 20K Jobs Lost, 9.7% Unemployment Rate
• Employment-Population Ratio, Part Time Workers, Temporary Workers, Dissecting the NonFarm Payroll Data

Can the Chinese consumer save the global economy? All the world has to do is wait, and the Chinese consumer will pick up the shopping bags dropped by exhausted U.S. consumers and spend the global economy back to prosperity. At least that's how the hopeful story goes. But a new study from consulting company McKinsey makes me doubt exactly how much global lifting China's consumers will be able to do over the next couple of decades. The big obstacle is the heavy structural emphasis in the Chinese economy on exports and government-led investment. In 2007, China was the fifth-largest consumer market in the world, behind the United States, Japan, the United Kingdom and Germany. But consumer spending accounts for a much lower percentage of the economy in China -- just 36% in 2008 -- than in the United States (71% of gross domestic product in 2008), the United Kingdom (67%) or Japan (55%). China's consumer-consumption-to-GDP ratio is low even for the developing world. Brazil's ratio came in at 65% in 2008, India's at 57% and Thailand's at 54%. As McKinsey points out, China has the lowest consumption-to-GDP ratio of any major world economy except Saudi Arabia, where oil exports account for a huge share of the economy. In fact, China's consumer has been losing ground since 1990, when consumer consumption accounted for 51% of GDP.

China’s Strategic Outlook(Stratfor) Both investors and countries whose economies are dependent on China start February increasingly worried about the direction of the Chinese economy. Monetary tightening and misallocation of resources mean that present growth expectations are unsustainable.

China/US Relations For the first time, China has threatened to sanction U.S. arms manufacturers linked to a $6.4 billion defense deal for Taiwan. The response signals a new level of tension in the complex web of Sino-U.S. relations, analyst Matt Gertken says.

• China isn’t an asset bubble waiting to burst–it’s worse
• Time to stop believing that capitalism will liberalize China’s society
• The rout in global stocks is a tempest in the teapot of China’s command economy
• Biggest Bubble in History Is Growing Every Day: William Pesek
• Never short a country with $2 trillion in reserves?
• The myth of China’s blithe consensus
• China Rejects U.S. Complaints on Its Currency

Fiscal Scare Tactics These days it’s hard to pick up a newspaper or turn on a news program without encountering stern warnings about the federal budget deficit. The deficit threatens economic recovery, we’re told; it puts American economic stability at risk; it will undermine our influence in the world. These claims generally aren’t stated as opinions, as views held by some analysts but disputed by others. Instead, they’re reported as if they were facts, plain and simple. Yet they aren’t facts. Many economists take a much calmer view of budget deficits than anything you’ll see on TV. Nor do investors seem unduly concerned: U.S. government bonds continue to find ready buyers, even at historically low interest rates. The long-run budget outlook is problematic, but short-term deficits aren’t — and even the long-term outlook is much less frightening than the public is being led to believe. So why the sudden ubiquity of deficit scare stories? It isn’t being driven by any actual news. It has been obvious for at least a year that the U.S. government would face an extended period of large deficits, and projections of those deficits haven’t changed much since last summer. Yet the drumbeat of dire fiscal warnings has grown vastly louder. Let’s talk for a moment about budget reality. Contrary to what you often hear, the large deficit the federal government is running right now isn’t the result of runaway spending growth. Instead, well more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, required federal bailouts of financial institutions, and been met — appropriately — with temporary measures to stimulate growth and support employment. The point is that running big deficits in the face of the worst economic slump since the 1930s is actually the right thing to do. If anything, deficits should be bigger than they are because the government should be doing more than it is to create jobs. True, there is a longer-term budget problem. Even a full economic recovery wouldn’t balance the budget, and it probably wouldn’t even reduce the deficit to a permanently sustainable level. So once the economic crisis is past, the U.S. government will have to increase its revenue and control its costs. And in the long run there’s no way to make the budget math work unless something is done about health care costs. But there’s no reason to panic about budget prospects for the next few years, or even for the next decade. Consider, for example, what the latest budget proposal from the Obama administration says about interest payments on federal debt; according to the projections, a decade from now they’ll have risen to 3.5 percent of G.D.P. How scary is that? It’s about the same as interest costs under the first President Bush.

• The Real SOTU, RDPs, Go-Forward Strategies and Your Country
• Reality, Politics, Policy & Partisans: the Undiscovered Country

Q&A: Carmen Reinhart on Greece, U.S. Debt and Other ‘Scary Scenarios’ WSJ: The market is asking, ‘Who’s next?’ REINHART: There are a lot of scary scenarios out there. Take governments that were virtuous governments, and continue to be virtuous. I’m talking about Ireland now. Their public debts were trending down and they have acted quickly and they’re credible. But external debt in the private sector is huge, more than 300% of GDP. In a crisis environment, private debts become public debts pretty quickly. Who knows what will happen with the Iceland referendum, and whether they vote to default on the Danish and the Brits. WSJ: Are we seeing a second-wave of financial distress? REINHART: Ken and I have been arguing fairly forcefully that historically, following a wave of financial crises especially in financial centers, you get a wave of defaults. You go from financial crises to sovereign debt crises. I think we’re in for a period where that kind of scenario is very likely. I don’t think a repeat of the fall of 2008 is at stake here, where it looks like the world is going to end. But I do think there is still, for reasons that are beyond me, quite a bit of complacency out there. Eastern Europe is another source of concern, and Europe has limited resources. You can rescue one. You can maybe rescue two. But you can’t rescue all of them. The Baltics are very vulnerable. Romania is vulnerable. Hungary is vulnerable. Problems in these countries feed back to their lenders. Austrian bank exposure to Eastern Europe is great. The Italian exposure to Eastern Europe is great. The Swedish exposure is non-trivial. You started out with a major financial crisis in 2007 and 2008, in which some of these countries have seen their worst recessions, in a way that really harms fiscal sustainability, even if you were in a good shape fiscally at the outset of the crisis. It is the pattern that has been prevalent in the past, that these major financial crises have been followed by an afterwave of debt crises.

• Debt Problems Chip Away at Fortress Europe
• Debt Crisis in Euro Zone Is Severe Political Test for Bloc

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The primary concern of the last post was defining the "new normal" and adding on the strong suggestion that each and every business needs to be constantly monitoring external events and not keep getting blindsided by them (Chaos, Turbulence, Fragilities: Defining the New Normal, Blueprinting Business Performance).

As it happens almost everything we've had to say about the nature of the new normal, the pressures on governance and performance, etc. almost ad nauseum were discussed at last week's Davos sessions. Over the weekend we had a chance to sample many of the major presentations and 99% of the readings this time are the links to the ones we think you need to pay attention to. The real reason is that the WEF and the Davos participants have largely done your work for you in terms of assessing the multiplicity of risk factors and outlining the likely paths things will follow over the next several years. So between our work on the economy and business and theirs on the big picture environment most of what you need to populate your own dashboard is readily available. We start with a session that Bill George (Harvard, Medtronics) led on re-thinking global capitalism which gives you a pretty good flavor of the pressures that will be mounting and mounting over the rest of this decade (it's an hour+ but just the first few minutes tell you what you need to get started about trust in Business!).

 

 

READINGS: Re-thinking Business and Business Performance

 INTRODUCTION: This section starts with a selection of recent articles illustrating the state of play in serious re-examination of the spectrum of dimensions of business performance, from operations to leadership and values to metrics & controls to managing people. For each of the articles listed we also include previous work of ours that covers similar ground, often providing complementary analysis, or deep and more workable machinery or even radically different alternatives. For example the Fortune column on EVA Momentum is, we strongly suggest, exactly the wrong way to go about it being yet another search for the magic performance measurement #! Instead our radically different approach is to focus on strategy, execution and management system knowing that the performance, profits and value-creation will follow

Radical Shifts Take Hold in U.S. Manufacturing America's industrial base is undergoing its most radical restructuring in decades as manufacturers rethink their businesses in the wake of the recession. From Dow Chemical Co. to Intel Corp., iconic companies are telling stories of wrenching change—both contraction and recovery—as they report their earnings for 2009. Dow Chemical said Tuesday it is aiming to shed some $2 billion worth of basic-chemical factories and other assets this year as it moves into more-profitable specialty chemicals. Appliance maker Whirlpool Corp. said it cut about a tenth of its capacity in 2009 as it struggled with a 9.6% drop in sales. Intel, by contrast, is investing billions of dollars in its U.S. plants as demand for computer gear recovers. "We are emerging from one of the most challenging economic environments we've seen in decades," said Whirlpool Chief Executive Jeff Fettig, on a conference call Tuesday. The latest moves are accelerating the U.S. manufacturing economy's longer-term shrinkage, as well as its shift away from heavy sectors, such as automobiles and basic chemicals, toward higher-tech products like super-fast computer chips. In some cases, as with auto makers, companies are stripping down to adjust to diminished U.S. demand or investing in smaller, more-efficient facilities. In other cases, as with chemical makers, they are relocating labor-intensive operations to countries where wages are cheaper.

• Volkswagen Takes Aim at Rival's Top Perch

Global Risk Report 2010 The result of extensive input throughout the previous year by experts from business, academia, and the public sector, Global Risks 2010 highlights a number of slow-moving risks exacerbated by the financial crisis and global economic downturn, and stresses the continued need to further enhance global resilience to risks. Global governance gaps, an issue already to the fore in Global Risks 2009, continues to be at the nexus of global risks and the need for coordinated global action is increasingly urgent. Fiscal crises and unemployment, underinvestment in infrastructure and chronic disease are identified as the pivotal areas of risk over the next years. At the same time, the Report warns that there are also a number of risks to keep on the radar, including the economic and social costs of transnational crime and corruption, biodiversity losses and risks to critical systems from cybervulnerability. The Report suggests that the events of the past year have highlighted the systemic nature of global risks and the need to rethink how to manage and respond to them. Reverting to “business as usual” could have serious implications in the long term in several risk areas. This reflects the premise at the core of the Global Risk Network’s work that global risks do not manifest themselves in isolation.

Why doing good is good for business He makes an economic argument: Globalization has made it increasingly difficult for companies to differentiate themselves based on their products alone. Whatever your product or service might be, chances are that someone on the other side of the world can copy and sell it for less money. And if money is the only bond between you and your employees, they will quit the moment another firm offers them more cash.All the more important, then, for companies to compete at the level of behavior: crucially, how they treat customers and employees. "It's about who has the most trust in their relationships, and where most people want to work," Seidman told me. "This will be the soft currency of the 21st century."But can you really measure the impact of good behavior? One promising area of research is around trust. The practice of corporate social responsibility has been on the rise for some time, evidenced most recently by the outpouring of U.S. corporate donations to support earthquake relief in Haiti. But Seidman believes it should go well beyond a company's CSR department.

• The Cusp Point is Here: Lessons From Davos
• Beyond Specifics to Principles: Business Performance Principles & Outlooks
• Leaders, Leadership & Culture: Crisis, Values and Performance
• Predator Prey Symbiosis: Crisis, Leadership and Values
  

A new financial checkup In business as in life, be careful what you wish for. I know a company that wished for a better return on equity. What could be wrong with that? It paid its executives according to that measure, and man, did they deliver. In some years the firm had the best ROE in its industry. It was winning bigtime.The firm was Lehman Brothers, now dead because managing for ROE caused executives to overborrow; after all, debt is capital that earns a return (in good times). Yet it isn't equity, so extreme leverage simply juices ROE until bad times arrive. Wishing for the wrong thing -- managing for the wrong ratio -- killed the company.The larger, chilling reality is that every other ratio out there can lead to the same disaster. Gross margin? Earnings per share? It's easy to make any of them look better while damaging the business.Which is why a new ratio that you've never heard of, EVA momentum, is so intriguing. It has been developed by consultant Bennett Stewart, one of the creators (with Joel Stern) of the measure called economic value added, or EVA.

• Renewing the Enterprise 2: Governance, Measurement & Performance

 When money doesn't talk Money is overrated: In fact, pay has little, if anything at all, to do with motivation in the workplace. That's the controversial argument put forth by best-selling author Daniel Pink in his new book, Drive: The Surprising Truth About What Motivates Us (Riverhead Books). "Pay for performance has to be exposed as folklore," he says.Pink contends that, provided employees receive a baseline level of compensation, three other factors matter more than moola: a sense of autonomy, of mastery over one's labor, and of serving a purpose larger than oneself. Hmmm. There may be something in all this -- but the executives at Goldman Sachs (GS, Fortune 500) aren't exactly busting a gut to adjust. Like others on Wall Street, the banking giant, which is expected to earn $6 per share in the fourth quarter, argues that fat bonuses are crucial to making its numbers.Responds Pink, in a now common refrain: That's precisely the attitude that led to the recent financial meltdown, as traders and mortgage brokers focused on short-term rewards that encouraged "cheating, shortcuts, and unethical behavior."Moreover, the 45-year-old author and former Al Gore speechwriter cites social-science experiments and experiences at such workplaces as Google (GOOG, Fortune 500), JetBlue (JBLU), 3M (MMM, Fortune 500), online shoe retailer Zappos, and software companies Meddius and Atlassian.

• People & Performance:Assets or Fungible Commodities?
• Aaargh, Captain Ye Best Take Care of the Crew
• Aholes, Shirkers and Performance: a Draft People Principles Policy
  

Davos Sessions

Major Overview Sessions

Welcoming Remarks by Doris Leuthard, President of the Swiss Confederation and Federal Councillor of Economic Affairs Klaus Schwab, Founder and Executive Chairman, World Economic Forum Davos Annual Meeting 2010 - Nicolas Sarkozy Opening Address by Nicolas Sarkozy, President of France Chaired by Klaus Schwab, Founder and Executive Chairman, World Economic Forum

Rethinking Values in the Post-Crisis World Values are considered important and enduring principles, which are correct and desirable in life, shared by members of a community.What values need rethinking in the wake of the "Great Recession"? Speakers: Yvan Allaire, Thomas H. Glocer, Yasuchika Hasegawa, Hartmut Ostrowski, Jim Wallis, Muhammad Yunus, James H. Quigley

Davos Kick-off of the 2010 FIFA World Cup in South Africa Share in the "spirit of Davos" to support this historic event of Africa and the global community. Speakers: Mark Fish, Lucas Radebe, Klaus Schwab, Zuma

"Yes We Can?" US President and Nobel Peace Laureate Barack Obama awoke high expectations with his slogan "Yes, we can!" After one year of presidency, it can be seen where President Obama has introduced political innovation and where he has not. To what extent has the impact of the financial and economic crisis been curbed in the US? Speakers: Susan M. Collins, Riz Khan, Sir Martin Sorrell, Christine Maier, Kenneth Roth, Ulrike Lunacek

A Roadmap for a Sustainable Recovery The Annual Meeting Co-Chairs examine what industry and government should do to lead the global economy on a path of sustainability and job growth in 2010. Speakers: Azim H. Premji, Peter Sands, Ronald A. Williams, Patricia A. Woertz, Josef Ackermann, Michael Oreskes, Klaus Schwab

The Global Agenda 2010: The View from Davos Join experts from over 70 Global Agenda Councils in a brainstorming session to map the critical global issues that emerged from the World Economic Forum Annual Meeting 2010 Speakers: Brainstorming session with Nik Gowing

Being Responsible for the Future Speakers: Rowan D. Williams, Joao Rafael Brites, Tshepiso Gower, Sarah Jameel, Carmina Mancenon, Mousa Musa, Nishin Nathwani

Capitalism, Governance and Performance

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

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?

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 Mos