Tuesday, March 13, 2007

Seeing Through the Smoke and Noise

The stock market fell sharply again today on weak retail sales and continued worries about the subprime mortgage market. The air is getting thick with worries: Weakening US economic data, Mr. Greenspan’s utterance of the “R-word,” and bad news in the real estate market. When economic worries begin to mount, I believe the best way to understand the “real” economic risks in the markets is to ask the question of each problem, ”Whose lap is this situation ultimately going to fall in?” If the wallet that is in the hip pocket of that lap is financially loaded, the problem will be solved in a short time. If the wallet doesn’t have much in it but family pictures and a maxed out credit card, the problem will keep going and growing. Here’s the shortlist of the problems and my analysis of whose lap the problem is headed toward. 1. Over the past week, there has been a string of weaker US economic data. GDP is now tracking just about 2%, down from earlier reports of over 3%. Retails sales were weaker than expected, job growth was muted, and the capital goods sector appears to have slowed sharply. This slow-down in the US economy is the natural result of the Fed’s string of rate hikes. When interest rates go up, it is a form of a price hike, and under the law of supply and demand, higher prices, ultimately, lead to a softening in demand. The Fed had a major responsibility for putting the brakes on the economy to slow inflation, and by law, they have the responsibility to deal with the slowdown by cutting rates. I have been back and forth on when the rates cuts will happen, but I have remained steadfast in saying that real estate problems would, ultimately, be the driver of lower rates. 2. Ex-Fed Chairman, Alan Greenspan, said in a speech in Hong Kong that he thought there was a 33% chance of a recession in the US. Those odds were much higher than Wall Street estimates, and as a result, he has been roundly criticized for sticking his nose where it doesn’t belong. As I have thought about it, I believe Mr. Greenspan might have been speaking directly to Ben Bernanke and his cohorts at the Federal Reserve, advising them that they cannot wait until they actually see a fall in inflationary data before cutting rates. That is the old lagging Fed policy that Mr. Greenspan exposed as a failing strategy during his 18 years on the job. The Fed has to lead, and in this case, that means cutting rates before improved inflation data are evident. I believe the real risk in the US and world economy is just this: Will Bernanke and the Fed have the nerve to lead, by cutting rates soon, or will they employ the lagging policy that lead to booms and busts in the 40 years prior to Greenspan. I believe Mr. Greenspan was saying “pay attention boys and girls. Don’t just watch the data, get out and kick the tires. See if they are moving, or parked in the back lot.” 3. Real Estate worries: For the last 9 months, my contention has been that real estate was in worse shape than the public perception. The subprime market is a small piece of the US mortgage market and the troubles there would not seem to be causing such a row in the overall market. Here’s the bottom line on why the subprime market is important. The capital the subprime lenders loaned to their high-risk customers was borrowed from big mortgage and investment banks. The real worry that is now gripping the market is: how much of this high-risk debt do the big banks have and who has it? In my mind, this is the easiest of the issues to answer. Major US banks and investment banking houses are in the best financial shape they have been in since before the savings and loan crisis of the early 1990s. The subprime loan problems are not big enough to cause permanent damage to the majority of major US and international banks. Subprime troubles will continue to fill the headlines, but the lap they are falling into (the big banks) has a wallet that can easily handle the losses. The stock market is jittery and will continue to bounce around, but let me remind all of you dividend investors: Your income is unchanged; indeed, there is the strong probability that it will grow in the year ahead. Bouncing stocks are speculators tossing them back and forth for the sport of it. The intrinsic values of your companies are not changed by the headlines and the prognostications of this trader or that stock market guru. The intrinsic values of your companies are determined by how well our companies can execute their business strategies and how much of their profits their boards of directors decide to share with you. We have carefully chosen companies that have a steady hand and have an ironclad history of writing dividend checks that mirror their profits. As I stated in my most recent blog, John Burr Williams and Arnold Bernhard were convinced that the stock market was much more volatile than the underlying value of the average company. These two giants of the investment business complained about market volatility and tried in every way they knew how to help people see through the smoke and noise of stock market volatility to the true value of stock. That is our mission, as well. History has proved that Mr. Williams’ and Mr. Bernhard’s theories of valuation were correct, but most investors still refuse to take the time to do the math. If they did, they would find a lot of bargains today.