Saturday, 20 January 2007

Risk and Reward in 2007

*** Money on the move...where it's from and where it's going...

*** $36bn trousered in bonuses... the escalators of financial worth... who's
up and who's down?

*** A peek into 2007...do the risks outweigh the rewards?

Bill Bonner, from Paris:

America's financial future is mirrored in our own family.

Cousins who live in the old manufacturing centers – Dayton, Detroit, Donora,
PA – have made no financial progress in the last 30 years. Worse than that,
they've been held in a state of virtual serfdom to the unions and their
employers. That is, even in a declining economy, with fewer opportunities
available, with many periodic layoffs and slowdowns, they still get enough
in salary, health benefits and pensions to keep them hanging around. They
should have moved out years ago.
As it has turned out, they've gotten no wage gains.
And their houses haven't even gone up in price like they have in other parts
of the country.

We remember, when we would visit these cousins in the 1950s and '60s...they
seemed so well-off in comparison to us. That was not hard to do since we
were the poorest white people we knew. Our uncles worked in mills and
factories, with high wages. They drove new cars and lived well. They were
positive...forward- looking...interested in new technology...and,
apparently, becoming wealthier every year. But now, the whole situation has
changed. Driving through the same towns is depressing. The houses are
empty...the shops are boarded up...the cars abandoned...the factories rusty.
And our cousins often seem to be discouraged...or even depressed.

Meanwhile, we have other family members who live on the coasts. One even
works for Goldman Sachs. These are the people who are doing well, enjoying
good job opportunities...and living in houses which have soared in price.
They take vacations to the Caribbean and Europe and think the economy is
just getting better and better. America is a leader in financial and
technological innovation, they believe...and it will stay that way.
Naturally, financial assets will keep going up in price.

Taken as a whole, we don't know what to make of it.
The U.S. stock market is still going up. The news is still positive.
Investors are still comatose. Today, we wonder, once more, how long the good
times can keep rolling on the top, while at the bottom of things the alpha
question still remains the same:

Are people really getting as wealthy as they seem to be?

And the answer to that still comes back: No.

What is really happening, dear reader, is that amidst modest real economic
growth, a massive amount of wealth is moving around. It is leaving the old
economy (much of it in America)...and moving. Where is it going? It is
headed to the financial intermediaries...to the people who own financial
assets (including art...and high-end property)...to the new areas of
economic growth (China, India etc.)...to areas that attract rich people and
financial industries (London, Manhattan)...and to people lucky enough to
find themselves in one of these growth areas.

"My family owned a publishing business too," explained a man we met this
weekend. "But that was back in the '60s when that kind of business didn't
have much value.
My stepmother decided she'd rather have the cash...so she sold it for $6
million. We all thought that was a lot of money. She thought she had made a
good deal.
But, that same business was sold in the late '90s, to the big Dutch
publisher, Elsevier. Guess how much it sold for? One billion dollars. Almost
all financial assets have gone up."

There are times when people put a lot of faith in financial assets. And
times when they don't. In 1949, people were so negative on the value of
General Motors that they sold the stock down to the point where it would
produce a dividend yield of 11%. They must have thought that, with the war
over, GM wouldn't be able to turn a profit. How wrong they were. The country
boomed.
All those new families wanted cars. And the economy of the '50s-'70s made it
possible for them to buy cars...houses...washing machines, everything.
Ordinary people were making more and more money. The economy was expanding.
People made money by making things for people with money to spend.

But now...how the picture has changed. Ordinary working people do not have
money to spend. For the last ten years at least, they have only been able to
expand spending by going further and further into debt. This is the picture
we've been watching here at the Daily Reckoning with such keen interest. We
want to see how it will turn out. Obviously, people can't continue to go
into debt forever. Then again, we won't live forever. The question is which
of these two will give out first – the borrowing/spending binge...or us?

While the average working man is not making financial progress, some people
are doing better than any people have ever done. The top five Wall Street
firms gave away $36 billion in bonuses last year. The aforementioned Goldman
Sachs provided its employees with average bonuses of about $400,000. In
London, one employee got a bonus of almost $100 million.

We would tell you more, but we have to run to a meeting now; our entire
salary could fit into one tiny part of that Goldman bonus...but it's what we
get, and we have to earn it.

-------------------------

And more views:

*** We would have liked to tell you also about our speech to the City of
London on Friday...and about the magnificent wedding we attended on
Saturday...but all that will have to wait until tomorrow...

***
Meanwhile, from the Independent comes this report, describing the good times
that the financial industry is enjoying at its new capital – London:

"...Last week's £9bn orgy of excess - it seems to get bigger each year - saw
more than 4,000 inhabitants of the Square Mile promised new year gifts of
more than a million pounds, in addition to their regular salary.
Several hundred of their number even joined the ranks of the super-rich,
trousering bonuses in the tens of millions. And in a move branded "obscene"
by trade unions, one high-flying Goldman Sachs "rain-maker"
received a single payment of £50m.

What is truly staggering, though, is the sheer scale of this cash-wave,
which bunged six-figure sums to even relatively junior City workers. At
Sachs, which employs 4,500 in the UK, the bonuses averaged £320,000. PAs,
secretaries and canteen workers get a share of the booty.

Britain's millionaires club, once a true élite, now boasts hundreds of
thousands of members. On the back of what has swiftly been described as this
"unprecedented"
bonus season, its ranks are being swelled at a rate of 10 per cent a year.

According to Tulip Financial Research, Britain has some 135,000
"high-net-worth" individuals, with liquid assets averaging £6.4m. They are
described, by the cognoscenti, as HNWs. People with tens of millions are
UHNWs: ultra-high-net-worths.

Much of their money is being poured straight into London's bouncy property
market, which is already forecasting double-figure growth for next year.
This festive season, other portions will also be splashed out on traditional
luxuries: cars, champagne, and fancy holidays.

But after the party: the hangover. Scenes of conspicuous seasonal
consumption also promise to illustrate a greater truth: that a fast-growing
financial élite is changing the way all Britons live and work, and not
necessarily for the better.

Beyond the massed ranks of pinstriped City boys, several super-rich clans
are installing themselves on these shores. The international mega-rich are
coming in their droves - be they Russian oligarchs, Arab sheikhs or a
growing clique of free-spending Hollywood stars.
In the past fortnight, Sheikh Mohammed, the ruler of Dubai, joined Roman
Abramovich in the élite club of Premier League proprietors, taking control
of Liverpool FC. Meanwhile, down in rural Sussex, residents of a sleepy
village near East Grinstead gained new
neighbours: Tom Cruise and Katie Holmes.

It's not as if we didn't already boast plenty of homegrown squillionaires.
In modern Britain, the scions of inherited wealth are being constantly
challenged by entrepreneurial industrialists, over-paid footballers, or some
of the 2,000 winners of the National Lottery, which recently celebrated its
12th birthday.
Back in November, one such HNW hit the headlines:
mobile phone tycoon John Caudwell decided, out of the goodness of his heart,
to give long-serving staff almost £3m, by way of a colourful leaving present
from his firm, Phones4u.

Days earlier, Forbes magazine had created waves by declaring London to be
the official billionaire's playground of the Western world, with 23 dollar
billionaires calling our capital city their home.
Only one city, New York, boasts more resident billionaires - 34. But most of
those were American- born; London, by contrast, is now pulling in property
barons, internet moguls, and hedge-fund kings from across the developed
world.

"Many cities vie for the title of the world's capital, but London attracts
the élite of the world's rich and successful," read the magazine's report,
by Paul Maidment. "It can lay claim unchallenged to one title:
it is now the magnet for the world's billionaires."
The economic impact of this phenomenon is relatively easy to measure. Our
capital city - now known, only half in jest, as Switzerland-on-Thames - is
overtaking Zurich and Geneva in importance as an international financial
hub.

More than 200 foreign law firms now have offices in the UK, while more cash
is said to be managed out of a couple of square miles of Mayfair than in the
whole of Germany..."

("The super rich: Britain's billionaires," Guy Adams and Sarah Harris, The
Independent, December 17, 2006.)


The Daily Reckoning PRESENTS: What should investors look out for in 2007 and
where might there still be rewards to be had...


Where the risks and rewards lie in 2007
By BRIAN DURRANT

Each year the gap between the fears expressed by opinion formers and the
risks discounted by financial markets get wider and wider. While
commentators have become increasingly alarmist the markets have been ever
more serene. The start of this year is no exception.
Economic optimism is well-founded in 2007, but the geo- political risks are
heightened.

The headlines and opinion formers are not short of topics to make us
anxious. There is an arc of instability running from Afghanistan, through
Pakistan, Iran, Iraq, Syria, Lebanon to Israel. In each theatre the
situation deteriorated last year. The Taleban are resurgent in Afghanistan,
President Musharaf has failed to quell Islamo-fanatics within his borders,
an increasingly confident Iran craves a nuclear deterrent, Iraq descended
into civil war, Syria continues to cause mischief in its neighbourhood,
progress in Lebanon has gone abruptly into reverse gear and Israel was
trigger happy in dealing with threats north of its border. US policy in this
area has backfired but the lame duck President Bush does not appear to want
to entertain plan "B" embodied by the Iraq Study Group's findings.

At the same time America's trade deficit widens inexorably and protectionist
pressures are mounting. US economic activity has been underpinned by
unprecedented levels of public and private borrowing. Meanwhile falling
house prices and globalisation induced job insecurity have contributed to
high levels middle class economic anxiety. Yet stock prices in the US are
close to all-time highs. The risk premiums to cover the possibility of
default that corporations and developing countries have to borrow money are
at or near historic lows. Meanwhile the estimates of volatility of stock
prices, bond prices and foreign exchange rates calculated from options
prices are near record lows.

Two key responses triggered by 9/11

How has this divergence of views between the commentariat and the markets
come about? The source of the divergence was the epochal event on September
11 2001. The US engaged in two policy responses. In foreign policy it took a
more pro-active stance described as the War on Terror, engineering regime
change through the overt use of military force. But this policy has had
unintended consequences. The Middle East and its neighbours are now
considerably more unstable than in 2001. In particular President Bush has
done more to help the Islamic Republic of Iran to achieve its objectives
than anyone else in 27 years.
When the Ayatollah came to power in 1979 the objectives were simple;
neutralise the military threat of Saddam Hussein, extend the Shia revolution
and its brand of Islamic fundamentalism and propagate the view that America
is the "Great Satan" in the region.

The other policy response has been more successful.
Following the 9/11 attacks the US administration was determined that the
assaults were not going to propel the US economy into recession. In response
to the destruction of the Twin Towers the Federal reserve cut interest rates
from 3.5% to 1.75% in the space of three months. Monetary policy remained
accommodative with the key Fed funds rate reaching a low of 1%, while the
first interest rate hike post-9/11 was over 33 months after the attacks.

So despite all the adverse news on the political front, the world economy in
aggregate grew more during the last five years than in any five year period
since the second world war. The Federal Reserve's highly accommodative
monetary policy was crucial to achieving this. If US interest rates had not
stayed low, the economic boom in China would not have been so virulent.
Even today the US is enjoying a happy combination of relatively low
inflation and 4.5% unemployment and has not suffered a deep recession for a
quarter of a century. It follows that given the tendency of markets to
extrapolate from recent experience, there is considerable optimism embedded
in financial market prices right now.

Stock market fallout was modest

Meanwhile some of the divergence between the media editorials and the
markets reflects the fact that markets focus on specifics. September 11 may
have been an epochal event for the world of geo-politics, but apart from a
temporary impact on insurance and airline stocks, the event did not have a
lasting impact on corporate cash flows and so did not have an enduring
effect on market valuations. It is entirely appropriate for the markets to
recognise at sometime that even events of great historical importance may
not affect the value of particular assets, indeed the Fed's loose monetary
policy had in the long run the impact of lifting asset prices across the
board.

Meanwhile the financial system is much more robust than it was ten years
ago. In September last year Brian Hunter, a natural gas trader for the
Amaranth hedge fund lost $6bn, a colossal amount of money to lose. It
surpassed the losses at Long-Term Capital Management (LTCM), the hedge fund
that Wall Street banks put up $3.6bn to rescue in 1998. Back then this was a
serious matter for the Fed, but the distress caused by huge losses at
Amaranth was absorbed without disruption to the overall financial system.
There were plenty of banks and hedge funds around willing to buy up
Amaranth's assets at bargain prices. Indeed these greatly enlarged pools of
speculative capital act to reduce market volatility by pouncing any time an
asset price gets significantly out of line. The problem is that institutions
have in turn felt more comfortable in taking positions they might have been
reluctant to hold a decade ago.

The markets also point out that those headline writers who are excessively
pessimistic have "cried wolf" too often. It is an easy path for editorials
to predict a disaster. If a disaster occurs, it is foretold. If it does not,
credit can be given for a timely warning or simply the readers forget about
it. On the other hand markets are often complacent at the moments of
greatest danger. Over the last 20 years the markets have been taken by
surprise by the October 1987 stock market crash, Russia's default in 1998
and bursting of the dot.com bubble. So the media are too pessimistic and the
markets are too complacent, the truth lies somewhere in between.

Where danger lurks for the investor...

Here we try to assess where the greatest danger lies.
Our first port of call is the UK housing market.
Pundits have been calling the imminent crash in the UK property market for
over ten years now. The higher the house prices rise relative to income, the
more nervous commentators have become. However as we argued last month for
the housing market to fall it must be the victim of the economy not its
assassin. Every previous crash in UK house prices, in the early 1930's,
1973-76 and the early 1990's has been accompanied by a severe recession.
Indeed the crash of the early 1990's followed the doubling of interest rates
to 15% and a near doubling of unemployment. With monetary policy in the
capable hands of an independent Bank of England, there is no reason to
believe a house price crash is imminent.

Another potential source of instability is a collapse in the US dollar. The
reasons for the US currency's imminent demise have been well rehearsed.
America consumes more than it produces and the yawning trade deficit is
unsustainable. The dollar, we are told, needs to fall substantially to
correct these imbalances. But sizeable US trade deficits have been with us
for over twenty years. In the early 1980's, the Reagan administration cut
taxes and boosted the defence spending, the budget deficit ballooned and the
trade deficit followed suit. Commentators in 1983 said that the US dollar
would collapse, instead it skyrocketed.
So that in 1985 the dollar was almost at parity with the pound.

The foreign exchange markets have a habit of making mugs out of currency
forecasters. We are no exception.
In April last year we noted that US interest rates had been raised to a
higher level than UK rates for the first time in five years. In the past on
the rare occasions when this situation prevailed, the pound had tended to
weaken against the dollar. This is what we forecast in April, but it didn't
happen. Then in late November last year the dollar was on the ropes and the
pound was at a 14-year high, analysts were predicting an imminent breach of
the $2 mark. Six weeks on we are still awaiting the move. The lesson is if
the world and his wife expect the dollar to fall this year then it probably
won't.

What about the world economy? The fact that global growth in the last five
years has been higher than for any five-year period since the second world
war, it is tempting to forecast that this can't last and the good times are
coming to an end. However, the period of greatest risk to the world economy
is probably already over. Interest rates may not have peaked in Europe, but
the big tightening of US monetary policy, the doubling of oil prices and the
correction in the US housing market have now happened. Looking forward,
China looks like accelerating rather than slowing in the year ahead as the
Chinese government gears up for the 2008 Beijing Olympics. Moreover the
freshly refinanced commercial banks will start multiplying the $50bn of
capital they have raised from Western investors into new lending of $400bn
or more.

The twin towers of oil and Islam

Indeed the biggest risks stem not from economics but from politics. There is
a risk of an outbreak of a full-scale war in the Middle East perhaps
precipitated by a "pre-emptive strike" by Israel on Iran. Although
commentators have been alerting us to this possibility for sometime, the
risks have increased. As we have discussed above, US foreign policy has
inadvertently played into Iran's hands. With oil prices high and Iraq in
turmoil, Iran can entertain nuclear ambitions. It is not only Israel that
has much to fear from Iran acquiring nuclear weapons, it is Saudi Arabia.
Worried Saudi hardliners have indicated that if American troops are
withdrawn early as recommended by the Baker report, then Saudi Arabia would
have no choice but to intervene to stop Iranian-backed Shia militias
butchering Iraqi Sunnis. The US and Mr Blair have made it increasingly clear
that they will be backing the Saudis. Consider the Prime Minister's personal
intervention to close the SFO investigation into alleged bribery of the
Saudi Royal family and his Dubai speech in which he called for an "arc of
moderation" to pin back Iran's advances in the Middle East. Meanwhile
President Bush has ignored the Baker report, whose other advice was to open
up diplomatic channels with Tehran, and is indeed calling for greater troop
deployments.

Accordingly the revelation that Israel has plans for a nuclear strike on
Iran is not a surprise. Two Israeli air force squadrons are training to blow
up Iranian uranium enrichment facilities using "low-yield" nuclear bunker
busters. Mossad believes that Iran is on the verge of producing enough
enriched uranium to make nuclear weapons within two years. Although the
Pentagon is unlikely to give the go-ahead to the use of nuclear weapons,
Israel may seek approval "after the event" as it did when it crippled Iraq's
nuclear reactor at Osirik in 1981. If this occurred Iran would try to close
the Strait of Hormuz, the route for 20% of the world's oil. The implications
for the world economy would be very serious.

Where investors should look in 2007

But for this catastrophic risk, everything in the global economy looks
"hunky dory". So where do the investment opportunities lie? The tide of
liquidity has lifted the prices of most asset classes be it property,
equities, gilts or commodities. But one sector has been left behind, the
prices of shares of larger capitalisation stocks. The FTSE 100 index is
currently trading on a historic p/e of 13.3 with a yield of 3.1%, whereas
the FTSE 250 index has a p/e of 19.2 and yields only 2.0%.

There are two main explanations for this development.
The weak dollar has been partly to blame. Many large cap companies earn a
significant amount of their revenue in dollars, either from direct sales or
because they deal in dollar denominated assets like oil. Now if we suspect,
the dollar might not fall like a stone this year, then larger cap stocks
will come back into favour.

The influence of takeover activity has also been important. Although FTSE
100 constituents may have attracted more bids last year than in any year
since its inception in 1984, the FTSE 250 series has seen a higher
proportion of takeover activity; some 5.5% of its market capitalisation
compared with 3% for the FTSE 100 index. The mid-cap index rallied 27% last
year to stand more than 50% above its 2000 peak. In contrast the FTSE 100
index closed last year 11% down from its millennial high, rising 10% last
year. In fact takeover activity has been a vital factor determining
performance within the FTSE 100 index last year. If you strip out the twenty
largest mega-cap stocks which are simply too big to be taken over, the FTSE
80 rose by 20% in 2006. But as the average deal size is likely to get larger
this year we expect more acquisitions in higher cap stocks.

Best wishes,

Brian Durrant
For The Daily Reckoning


P.S: Remember the 1970s...just before the good old
days of Austin Allegros and fondue parties were
buried by oil-driven inflation and a plunging
stock market.

No comments: