Market Update: June 2012

Thus far the first half of the year has kept up to expectations.  The first part of the year was a straight run up in the equity markets.  Unemployment in the US has remained exceptionally high and isn’t coming down, the global economy is still suffering from a dramatic hangover and the euro threatens to break up as I write this update.

(Note that I could have written the exact same paragraph in June 2011 or June 2010.  Hope springs eternal at the start of each year – now we need to see real change before market growth is warranted.)

Our perspective on these events, as outlined in my previous articles on the paradigm shifts in our economy, is that we are only part way through a decade long shift back to a core of economic growth.  Asset bubbles in the 90s and 00s helped to mask the true problems, and those bubbles made the economic situation far worse as each popped in a destructive fashion.  Behind these bubbles, aside from the political aspects, is a financial services industry that has learned to extract a hefty toll from investors with the support of our political system.

Yes, it may be a dour assessment, but the realities are there to be seen.  It is more a function of our willingness to see.

Facebook – Anatomy of a Botched IPO

What many failed to see, or were unwilling to admit, was that Facebook’s initial public offering (IPO) was flawed from the very outset.  Before Morgan Stanley juiced the price, before Facebook’s CFO ignored conventional wisdom, before Goldman Sachs started their own fund to cash in on the hype, Facebook was a bubble created by the financial services industry.  The surprise was not that Facebook was grossly overvalued (as I have asserted for the past six months), but that the bubble popped so soon.

Normally with these bubbles, they perpetuate until the inflated asset is so far down the investor food chain that no one person or institution can make a significant stink about getting fleeced.  Those folks are the “average” retail investor who either believed in the hype and bought the shares at the wrong time, or are heavily invested in mutual funds which are holding the shares.  With trillions of dollars sitting in 401(k) plans with such funds as their only investment choice, the least informed of investors are the ones most harmed.

What was unusual this time was that the music stopped early.  On the first day of trading, the share price struggled to stay positive.  Within a week it had lost 15%.  As of this writing, Facebook is down 27% from the IPO price, and 34% from the high.  This infers an actual loss to investors of $4.3 billion who bought shares in the IPO.  While that seems to be enormous, it is insignificant compared to other overblown IPOs of the past, where hundreds of billions were lost when stock prices came down from dizzying heights at the peak of the dot-com bubble.

But the timing here is different.  The decline began the day after the IPO – concentrating the losses among a handful of early buyers and those who own shares from the IPO.  As a result, lawsuits are piling up and the debacle is still on the front page.

When viewed from afar, there is little doubt that the IPO would not end well.  The initial IPO valuation of Facebook started at $50 billion last winter.  It quickly climbed to $100 billion as Goldman peddled the shares in the pre-IPO market.  Under current SEC guidelines, Facebook could have up to 500 shareholders before being treated like a public company.  These 500 institutions and investors swapped shares, and reaped profits as they cashed out on the hype.

The next step was to allow those 500 to cash out to the public.  That was the IPO.  What was initially supposed to be a $5 billion cash-out became a $16 billion cash-out as the greed spread.  And the bubble would have continued in the public markets if the initial trading was not botched, and if Facebook had not oversized the float.

A good anecdote is a friend’s grandmother who asked her broker to buy shares on Facebook on the day of the IPO because of what she was reading in the newspaper.  She is in retirement and living off the income from their savings.  The misaligned risk of such an investment would have been enormous.  The fact that she was convinced that Facebook would make them money is a revealing insight into human psychology.  (The broker did not buy the shares – fortunately)

JPMorgan (Chase*)

Another good example, but less obvious, is the trading loss reported by JPMorgan.  What was initially estimated as a $2 billion hedging loss ballooned to $3 billion a week later and may reach $5 billion.  The fact that they can lose this much money so quickly is alarming.  The fact that just three weeks earlier their CEO dismissed the rumors as “a tempest in a teapot” is sheer arrogance.[1]  The fact that they were doing this with government insured funds is nauseating.[2]

Remember, JPMorgan’s full name includes “Chase Bank”.  Chase is one of the largest consumer banks in the country.  They sit on $1.1 trillion of customer deposits.  They invest those funds as they see fit to generate larger profits.  Those are the investments they were “hedging” with this trade.  The losses themselves are not going to threaten the viability of the bank, but the pattern is distressing.  It was just four years ago that most of the major banks suffered enormously because of unbridled risk-taking in the sub-prime mortgage market.  Having survived that crisis intact, JPMorgan repeatedly reminded the regulators that they were “special” – because of strong management they do not need strict oversight.  This argument has been at the core of the current debate over bank regulations.

What seems to have happened, consistent with so many debacles in the past twenty years, is that the drive for profit and personal enrichment eventually outstripped common sense.  Don’t be fooled by the technical jargon, fancy strategies or elevated titles.  The mistake they made is simply foolish.  The same trader had previously made some large bets that paid well.  So if big bets can work, let’s make a ginormous bet – as the thinking goes.  The notional value of the bet was so large (estimated at $100 billion) on such an arcane trade (risk of default on just a handful of companies) that they went from playing in the casino to becoming the casino.  As is almost always the case, the trade eventually went against them and they barricaded themselves inside a burning building.

That fire is still burning, and while their CEO is desperately trying to salvage the bank’s reputation (and his job) the lesson is a simple one.  JPMorgan is allowed to gamble in the casino with nearly unbridled risk taking.  Yet they are one in the same as Chase Bank, the depository for millions.  Until the 1990s, this type of combination was strictly forbidden for obvious reasons (which became obvious in the crash of 1929).  Somehow the bankers were able to convince the politicians that bankers were smarter and better than before.  Hence, there was no need for separation between investment banks and deposit banks (also know as the Glass-Steagall Act)[3].  Fast-forward ten years, and the verdict is fairly plain.  Greed does not change.  Bankers are just smarter at making sure that they don’t have to pay for failure.

If the point needs any further clarification – look at the salaries and bonuses at the heart of the crisis.  The CIO in charge of this failed bet made $14 million last year alone.  She is one employee out of dozens who make that kind of money for taking these sorts of bets.  Expand this  across the entire bank, across all the major investment banks, across all developed markets, and it amounts to billions of dollars that are generated from these activities that end up in the pockets of a few.  My statement is a simple one: How does one justify such outsized compensation for potentially irresponsible behavior?  If the investment banks want to pursue these trades then they need to bear the cost of their failures as well without putting the economy at risk.

To be fair, there are plenty of legitimate banking activities that occur every day which create true value in a fair and equitable environment.  The issue I address here is the major investment banks who are too-big-to-fail while being funded with government insured consumer deposits.  They have engineered a government-sanctioned mandate to take irresponsible risks with those deposits while maintaining full protection from failure.  It is a dynamic that creates repeated asset bubbles, in which the repeated loser is the individual investor who has few choices beyond the mutual funds in their 401(k) accounts.  The system does not serve them well.

Iceland, Inc.

While the anecdote of Facebook or JPMorgan may seem limited in scope, the pattern does not end here.  Our next stop is Iceland.  For those of you who don’t remember, the three major banks of Iceland went insolvent in 2008 requiring such a massive government bailout that the entire nation was on the verge of bankruptcy.  As The Economist stated in December of that year, relative to the size of the economy it was the largest banking collapse ever suffered in economic history.

The source of the collapse was – you guessed it – asset bubbles.  In this case, it was cheap loans to foreign investors to support real estate speculation.  Everyone in the financial food chain profited from the speculation until the real estate market collapsed.  The taxpayers were left to clean up the mess.  Governments from around Europe compensated their citizens for deposits lost to these banks, to the tune of billions of euros.  Again, irresponsible risk taking by the banks was condoned by the government until the game ended.  Individuals profited enormously.  Entire economies suffered.

While the Iceland collapse was minor relative to the global economy, the pain was acute in a handful of places.  Greece, however, will not be so localized.  While much has been written here the message is the same:  ridiculous borrowing by the government that was unsustainable and facilitated by you know who – the banking sector.  Greece’s ultimate default – albeit an orderly default – impacted the global banks to the tune of billions.  Those banks are now receiving government funds to supports the losses.  If Greece does not abide by the terms of their bailout or withdraws from the euro the losses will grow rapidly.

And the fun continues as move across the Mediterranean to Spain.  Their banks are now suffering from the effects of a real estate asset bubble. With losses mounting, unemployment reaching 25% and the government doubling their debt to keep it all afloat, a European bailout looks imminent.  Just recently they asked for $125 billion in help from the broader European monetary institutions after insisting that they would not need help.

Here in the US we have a real problem to face.  As Europe goes through their annual summer games of economic Armageddon, we are again facing the prospect of a failed currency, the euro.  It is not clear what would happen if the euro were to break, and it is not clear that the euro could break, but the consequences could be severe.  Again, it would focus on the solvency of the global banks and ultimately how much in government funds are needed to keep them afloat.  The mitigating factor is Germany, the key industrial power in the region that has fueled much of their growth.  With Germany’s cooperation, it is possible to protect the euro and stem any systemic collapse.  The cultural divisions are large, however, and go back decades to the original efforts to bring a single currency to the region.

Here in the US, this government support has spread to every corner of our economy.  The stimulus that has been generated is in the neighborhood of a trillion dollars.  Through extreme monetary and quantitative easing programs by the Federal Reserves, both the bond market and stock market have been propped up.[4]  The ancillary effect has been to provide a massive subsidy for banks – ultra cheap deposits that they can then deploy into profitable investments such as mortgages.  Yes, they need support, and in that support it is believed that unemployment can be ameliorated, but that should not infer that irresponsible risk taking is also condoned.

Investment Perspective

With all this depressing analysis, there are still bright spots in the world.  First, it is in no one’s interest to see the system fail.  Even the financial services sector realizes that if the entire economic equation fails then their profits end.  Whether it be the Greek Parliament or JPMorgan, at some point self-interest must give way to self-preservation.  And while I talk about stalled economies and bailouts, we should not lose sight of the strength in the global economy.  Trillions of dollars in production is generated every month and while the growth may not be all we need to rescue us from our mistakes in this moment, the prospects are strong.

Put another way, all these issues go away with global growth.  Create jobs, increase consumption, increase production, and the cycle supports itself.  While it could be an easy “out” through another job-creating asset bubble, it will take years to get there in a sustainable manner.  In the interim, we just don’t want to inflict too much additional damage in bubbles that mask the problem.  (Yet we continue to ignore the deeper issue regarding the sustainability of the consumption cycle – a topic for a different day)

At Vodia, our investment direction has remained the same as it has over the last four years.  Invest in company stocks that have stable and growing cash flow streams.  Don’t overemphasize our reliance on these stocks, but instead rely on undervalued debt instruments that have greater predictability and protection. Hedge further risks with hard commodities, heavier cash balances, and derivatives where appropriate.

For the summer we are taking a cautious view of Europe with a mildly positive view of the US.  As the US economy mends itself, emerging markets will continue to benefit.  Emerging markets will also benefit from their own prosperity, as local consumption begins to replace exporting as the primary economic driver.  In the immediate term, emerging markets have suffered as consumption in Europe and the US slowed down.  The short term movement in the emerging markets has had a sharp impact down on commodities – positions that we will continue to hold in  moderate quantities as a hedge against the long-term effects of domestic monetary easing programs.

Note that our view of the emerging markets focuses mainly on Asia and the commodities that support these economies.  We currently exclude India from any investment opportunities due to their deep-seated social issues, and avoid direct investments in China for a lack of transparency and long-term sustainability.  Yet China continues to drive the general direction of commodities as the largest consumer in a number of areas.  They need to push for blistering growth to support rapid urbanization of the population, growth that could create substantial economic disruptions if not closely managed.

The global healing process takes time, and will be quite bumpy along the way.  If the euro does break, then those bumps could be quite severe.  That is the challenge that we are addressing today.  But if we get through the summer and Europe plods closer to substantive solutions to a one-currency/multiple economy region, then we again have time for economic growth to reestablish itself.

All the best for an enjoyable summer.

Regards,

David B. Matias, CPA

Managing Principal