The Caribou Factor / The Daily Reckoning

verfasst von - ELLI -, 11.03.2003, 19:02

-->The Caribou Factor

The Daily Reckoning

Paris, France

Tuesday, 11 March 2003

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

*** Fannie and Freddie - can the evil twins survive?

*** Dow takes a hit: investors on the edge of panic...Code
Fuschia (more dangerous than mauve) here at the Daily
Reckoning

*** Pension losses and hankypank...Buffett...war...and
more!


Yesterday, the stock market seemed to be on the edge of
panic. McDonald's dropped back to levels it hasn't seen in
10 years - $12.42. SBC hit 9-year lows.

Fannie Mae and Freddie Mac fell 7% and 6%, respectively,
after St. Louis Fed president William Poole wondered aloud
if they had enough capital to withstand a shock in the
mortgage market.

The two government-sponsored lenders may or may not be able
to survive a major tremor in housing...but surely many of
their customers will not. Fannie and Freddie, it might be
recalled, were set up to finance houses for people who
couldn't afford them. Gradually taking business from
competitors, and given a huge boost from lower interest
rates, they became the major players in the biggest boom
ever in the mortgage industry.

When houses are bought and sold in America - even old
houses - a curious thing happens: the net level of debt
goes up. You might think that the fact that Mr. Jones moves
out of 110 Willow Ave. and Mr. Smith moves in would be,
economically, neutral. The house is just as it was; no new
wealth has been created.

But Mr. Smith, typically, finances the purchase through
Fannie Mae at a higher price, and with less equity
remaining, than Mr. Jones had. In this manner, across the
entire U.S. of A., debt increased by $350 billion last
year, says a Fed report, much of which was spent.

Often, Mr. Jones doesn't even leave his house. He merely
refinances it. Rarely does he use the occasion to reduce
his debt; instead, he almost always increases it.

Altogether, again according to Fed figures, the debt load
on America's houses went up $700 billion - an amount equal
to 10% of the nation's total housing equity at the
beginning of the year.

This is the money that is keeping the economy growing
(barely). But the cost is high. For if Americans take out
10% of their equity every year, soon they will have none
left. They will all be renting - from Fannie Mae!

Recent signs point to a turnaround. People are getting
weary of digging deeper and deeper holes for themselves.
More of them are going bankrupt each year. Health care and
energy costs are rising steeply. ("Soaring Gas Prices
Changing Lifestyles," says a Washington Post headline.) It
has become more and more difficult to find good jobs.
They're still refinancing; they need the money. But they
are less willing to part with money when they get it.
Walmart reports slowing consumer sales. Even savings rates
are headed back up - recently clocked at about 4%, up
sharply from their level below 2% in the late '90s.

As long as they have jobs and housing prices are rising,
people will probably keep making their mortgage payments.
But come the day when housing prices fall...(the year-on-
year median price of new houses fell by 2.6% in
January)...or people lose jobs...then, Fannie & Freddie
will be in serious trouble. They may survive the shock -
but not with today's share price.

But here's Eric with yesterday's Wall Street report:

----------

Eric Fry, from New York City...

- The stock market can't seem to shake its predilection for
heading south. Try as it might, it cannot seem to find its
true north. Yesterday, the Dow took another 172 paces in
the wrong direction to close at 7,568. The Nasdaq,
following the Dow's misguided lead, headed 27 steps to the
south, ending up at 1,278.

- Gold, looking very much like the eagle scout of this
metaphor, advanced $3.90 to $354.80 an ounce. Surprisingly,
and much to the bewilderment of gold bulls, the shares of
most precious metals companies tumbled right along with the
general market yesterday. The XAU Index dropped 3.7%,
despite the rallying gold price.

- It's tough enough to make a dollar in this market,
without losing money when you're"right". But, sadly,
that's been the situation in the gold shares market for the
last several weeks. Gold has been holding solidly above
$350 an ounce, while most gold stocks have been sinking.
The XAU Index, for example, has dropped more than 15% so
far this year, even while gold has gained about 2%.

- No one can say exactly why the gold stocks are behaving
so poorly. But one plausible explanation is that, for brief
periods of time, gold stocks will behave as mere stocks,
rather than surrogates for gold itself. That's because,
when an investor looks to raise money he will often sell
his winners first. (The losers will come back, right?) Gold
stocks, being among the very few winners in most investors'
portfolios, are logical candidates for money-raising...and
so they are sold.

- But once this liquidation runs its course, and assuming
that gold remains strong, the gold sector should rebound
nicely. That's the rosy scenario, at least...

- General Electric's pension plan"gains" contributed $806
million to pretax profits in 2002, even though the
company's pension actually LOST $5.25 billion last year - a
staggering sum equivalent to 29% of GE's pretax income.

- If only such financial alchemy were possible forever, we
could enjoy a swell new bull market in no time. But, alas,
GE's pension plan"profit" last year was little more than
an accounting fiction. The company simply relied upon a
legal - albeit deceptive - accounting practice that
permitted the industrial giant to book a profit based upon
its ESTIMATED pension gain of 8.5%, rather than its ACTUAL
loss of 11.6%.

- Deceptive pension accounting is but one of the many
fictions that helped perpetuate the late-1990s bull market.
Unfortunately, dear reader, fiction must yield to
reality...eventually. And in the case of pension plan
fundamentals,"Reality bites!"

- If, for example, the S&P 500 companies had included their
actual pension plan losses in their 2001 earnings - instead
of their fictional gains - earnings for the S&P 500 would
have been about 69% lower than what the companies reported
for 2001, according to Credit Suisse First Boston Corp. In
other words, without fictional pension plan profits the S&P
500 would have reported earnings of $68.7 billion in 2001,
rather than $219 billion.

- Stock market declines in the past two years have led to
more than $200 billion in pension fund losses for S&P 500
companies, according to the CSFB study. Incredibly, almost
none of those losses have appeared on corporate income
statements. (GE's monster pension loss, for example,
appeared only in a footnote on page 27 of its latest annual
report). But these multi-billion dollar losses are no less
real for being well concealed.

- Therefore, even if the economy were to improve
dramatically tomorrow, the accumulated fictions upon which
our beloved stock market rests are so considerable that
corporate earnings - the real kind - are unlikely to make
any significant headway any time soon. To the contrary,
lower profits and therefore, lower share prices are the
more likely outcome.

-"This is a secular bear market," David Tice explains in a
recent interview with Newsday."It has a long way to run.
As much as we would like there to be prosperity in the
U.S., we see that the excesses and imbalances from this
excess boom have got to be wrung out of the system."

- Tice, as many Daily Reckoning readers know, is the
manager of the Prudent Bear Fund and a regular contributor
to Strategic Investment."We partied hard," says Tice,"but
now we will experience the hangover." Tice advises
investors to sell stocks and buy gold."That's how we're
playing it," he says.

- Reasons for macro-economic caution are certainly not in
short supply. The nation's dismal unemployment trend may be
one of the very best reasons to worry that corporate
profits will remain under pressure.

-"The percentage of Americans who have been out of work
for six months or longer reached the highest level in more
than a decade last month and could soon exceed the peak of
the 1990 recession," USA Today reports."The steady rise in
the number of long-term jobless, who made up 22.1% of all
unemployed workers in February, according to the Labor
Department, is a telling sign the economy is in worse shape
than the headline 5.8% unemployment rate would suggest.
Further, private-sector payrolls, measured on a year-over-
year basis, have been falling for 20 months. That's the
longest decline since the mid-1940s, according to the
Economic Policy Institute, a think tank...The percentage of
people out of work for more than 26 weeks hasn't been this
high since October 1992, when the economy was recovering
from recession."

- Workers who don't work very quickly become consumers who
don't consume...and we all know where that leads.

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

Back in Paris....

*** Warren Buffett:"Occasionally, successful investing
requires inactivity." Buffett thinks this is one of those
times. Well, yes...if you already got out of stocks. If
not, we remind you, dear reader, it is Code Fuschia here at
the Daily Reckoning office. Get out of stocks. Buy gold and
eurobonds. Then, you can be as inert as congressman.

*** Oh là là...when will the Nikkei ever find its bottom?
Yesterday it dropped below 8,000...10 years after investors
thought it had bottomed out in 1993.

*** Maria is featured in this week's Madame Figaro
magazine. She is pictured in a variety of exotic get-ups,
with the island of Mauritius as the background.

*** War, war, war....it seems as though it is all anyone
talks about. Last night, at a small gathering of Americans
who have lived in Paris for many years, the talk was
war...and almost all were appalled by it.

"Did you see what they are doing to those prisoners...."
one began."You know, those people arrested as suspected
terrorists. They're putting hoods on their heads and
forcing them to kneel for long periods. They aren't allowed
to sleep...I don't know what else....but it sounds
barbaric."

"People in the U.S. seem to be in favor of this kind of
thing....they support the war against Iraq," she continued.

"But I don't get it....they've all gone a little nutty. Did
you see that they arrested some guy coming out of a
shopping mall for wearing an anti-war tee-shirt...and
they're searching grandmothers at airports? I mean, does
anyone really think that my grandmother is a terrorist?

"Yes, it's a kind of hysteria," another agreed,"it's like
the McCarthy years...a witch hunt..."

"Now wait a minute," your editor rose to defend his dead
countrymen."Everybody compares the McCarthy period to the
Salem witch hunt. But that was a time when America really
did seem to be in danger. The Soviet Union had just beaten
the German army, had atomic bombs, and had a man much worse
than Saddam Hussein in power - Josef Stalin. McCarthy
wasn't looking for witches; they don't exist. He was
looking for communists...and there were at least a few. As
moronic as it was to be looking for bolsheviks in Hollywood
in the late '40s, it was probably less silly than
pretending that every grandmother and girl scout is
planning to attack the Pentagon today."

*** Even at the bar where your editor had lunch yesterday,
the talk was war. Two elderly gentlemen came in with a
chess set. They sat down at a nearby table, spread out the
game, and ordered beers. One wore a small hat and never
took his eyes off the board. The other chatted, swore, got
up a few times, and fidgeted.

"Merde..." said he, after his rook was taken.

"Look at that...my side of the board looks like a
battlefield....look at all the fallen soldiers..." he
continued to himself...

"It reminds me of the battles of Clovis [King of the
Frankish tribes, A.D. 466-511]...I don't know why....I was
just thinking of Clovis...we think he was such a great
king. But he was really just a barbarian.

"But Bush...you know, he's a barbarian too...a modern
barbarian."


The Daily Reckoning PRESENTS:"Life," says Extreme Value
editor Dan Ferris,"is a kind of 'caribou' avoidance and
recovery game. From inflation, war and corporate
downsizing, to icy streets, drunk drivers and empty parking
lots late at night. There are caribou everywhere." What the
heck is he talking about? Some rather sound investment
advice, for starters. Take a look...


THE CARIBOU FACTOR
by Dan Ferris

In the 1970s, it was feared that construction on the Trans-
Alaskan pipeline would disrupt the migratory patterns and
feeding habits of the Porcupine Caribou Herd. Speaking on
behalf of their cloven-hoofed brothers, environmentalists
held up construction of the pipeline for about eight years.
This caused Atlantic Richfield, the pipeline's owner, to
re-price the bonds it had issued to finance the project. In
other words, they lost a lot of money.

Since then, costly complications that turn up halfway
through a big project have been referred to in the
investment community as"the caribou factor".

When you think about, though, it's not just the big
financial projects where such factors figure. Recognizing
the caribou factor is a simple acknowledgment that you
don't own a crystal ball, and you can't predict the future.
All of life is a kind of caribou avoidance and recovery
game. From inflation, war and corporate downsizing, to icy
streets, drunk drivers and empty parking lots late at
night. There are caribou everywhere.

Investing, as ARCO learned in the 1970s, is no different
than anything else in this life. Consider all the variables
most common stock investors watch. Revenues, profits,
returns on equity, debt and dividends. Not to mention share
volume, intra-day highs and lows and closing prices. The
list goes on and on...

You control none of those things.

To you, they're all potential caribou herds, waiting to
migrate to your portfolio. In other words, your money
leaves your control when you buy stocks and bonds.

Marty Whitman, chief of Third Avenue Funds, refers to you
and I (and often himself) as OPMIs. That's Outside Passive
Minority Investors. If that doesn't sound like a very
powerful position, you're right, it's not.

In a bankruptcy, OPMIs, in their normal role as common
shareholders, are last in line. They usually leave empty-
handed.

So-called investment professionals can't help you much,
either. It's common knowledge that over 90% of all mutual
funds fail to beat the market. They fail to avoid the
caribou. They should call themselves financial safari
guides. They seem to find caribou for a living.

There is, however, a powerful ray of hope for investors.

You can call it your timing, or when you buy or even what
you buy. No matter how you arrive at it, no matter what
incantations you intone or what stars you plot, or how much
accounting you know, or how many numbers you run, or if
you're Warren Buffett or John Q. Public...Investing boils
down to one, simple assessment that you, the investor, and
you alone must determine: the price you pay.

Given that the caribou factor takes over after you buy, it
behooves you to spend more time on assessing the price you
pay than on anything else. That goes for any passive
investment you make: stocks, bonds, futures, options,
MITTs, TIPs, you name it. Your number-one concern, I
believe, is what it's worth to you, and how much you'll
pay. All other factors move across your financial
landscape, on bad days alternately devouring and befouling
it, on good days...ignoring you and not providing you with
one iota of benefit.

If you want to obsess about something as an investor,
obsess about the price you pay. Low price to book is,
obviously, one way to buy on the cheap. High earnings
yield, more commonly known as low P/E, is another way.

Buy a $10 stock trading at half of book value, and you
could profit, even if the company shuts down. Buy the same
stock at $40, and you're placing a long shot bet that
caribou won't like the flavor of your money.

If you buy the S&P 500 at 20 times earnings, and it reverts
to its historical mean of 16 times earnings...and then
falls in half from there, well, don't be surprised. That
kind of price (i.e. high) is a signed, sealed invitation to
every caribou in the countryside. When stocks fall well
below 16 times earnings, the food supply dries up, and
caribou herds thin out.

Invest in a company that trades at a market cap of $177
million, and owns a few billion dollars worth of land, and
you could still get hit with a caribou infestation. But the
odds are against it. Buy the same company for a premium to
the fair market land values, and you're playing craps at
the Caribou Casino.

In the stock market, tilting the odds in your favor - by
controlling the price you pay - is the best you can do. In
fact, buying low price to book value stocks and selling
them every two years produced a 22% average annual return
between 1930 and 1980. Those aren't entirely caribou-free
returns, but they're as good as it gets.

Buying value at extreme lows in price is one of the most
reliable caribou repellents around. Maybe cheap stocks
smell like Eskimos. High prices, on the other hand, smell
like female caribou in heat.

Fortunately, you get to choose which scent you'll wear -
what price you'll pay.


Happy investing,

Dan Ferris,
for The Daily Reckoning

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• The Caribou Factor / The Daily Reckoning - - ELLI -, 11.03.2003, 19:02