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July 25, 2008

Anyone for a 100 billion dollars?

This post is a guest contribution by Prieur du Plessis, writer of the Investment Postcards from Cape Town blog.

Full marks for eBay entrepreneurs for stepping in where forex traders have lost count of the zeros being added to the Zim dollar every few days. This is amid Zimbabwe's dizzying rate of inflation - officially quoted at 2.2 million per cent, but thought actually to be in the region of 12.5 million percent!

How about paying US$83 for the new Z$100 billion bank note! Although the novelty value of the Zim note is surging, the sad truth is that the note is not worth enough to buy a loaf of bread.

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Click here for a large image of the new set of notes.

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Stock Market Returns - The Wonder of Compounding

This post is a guest contribution by Prieur du Plessis, writer of the Investment Postcards from Cape Town blog.

Albert Einstein described compound growth as the eighth wonder of the world. Although he may have passed away in 1955 - coincidentally the year when yours truly saw daylight for the first time - the concept of compounding remains the single most important principle governing investment.

Back to basics: Compounding simply means that you can earn interest on your principal investment amount, as well as earn interest on top of interest. The power of compounding can make an investment grow much faster than would otherwise have been the case, and is obviously based on the assumption that interest or dividends are reinvested in the same asset.

The raison d'être of investment or wealth management is to maintain, or hopefully improve, one's standard of living, i.e. to earn a real return on the investment amount. This sounds easy enough if one considers that the S&P 500 Composite Index (and its predecessors) delivered a nominal return of 9.1% per annum from January 1871 to May 2008. With an average inflation rate of 2.2% per annum over the period, this meant a real return of 6.9% per annum.

These figures may not particularly appeal to many of today's market participants with their gun-slinging approach. I am deliberately refraining from using the word "investors" and can hear these people arguing that much better returns can be generated by "playing" the market cycles. Ah, the art of market timing! Perhaps, but keep in mind that very few people have succeeded in consistently outperforming the market over any extended period of time, especially once costs and taxes are factored in.

More compelling proof that the odds are stacked against the capital-growth-only brigade is gleaned from an analysis of the components of the total return figures. Let's go back to the total nominal return of 9.1% per annum and see how that was made up. We already know that 2.2% per annum came from inflation. Real capital growth (i.e. price movements net of inflation) added another 2.1% per annum. Where did the rest of the return come from? Wait for it, dividends - yes, boring dividends, slavishly reinvested year after year, contributed 4.7% per annum. This represents more than half the total return over time!

Still doubting the evidence? Have a look at the following chart:

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Click here for a larger image of the chart.

And for good measure, here are the numbers summarized in table format>

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Source: Plexus Asset Management (based on data from Prof Robert Shiller and I-Net Bridge)

In an environment characterized by increasingly shorter investment horizons, the concept of compounding sounds so yesteryear, but who can argue with the body of empirical market evidence? To coin a phrase often quoted, but seldom fully appreciated (or understood): It is time in the market, and not market timing that counts.

 

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Mortgage Market Week in Review

Well, here we are on Friday again and I'm trying to figure out how to summarize all that's been happening in the mortgage and financial worlds.   I could write a book about it, but I won't (at least not today....)

So, here goes:
The week started out with Wachovia (the 4th largest bank in the country) announcing that they were getting out of wholesale lending.   That started a lot of people wondering how bad things were at Wachovia because Indymac announced that on a Monday and by Friday they were shut down.    On Tuesday, Wachovia announced that they lost a LOT of money ($8.9 billion to be exact) in the 2nd quarter.   But guess what, their CEO stood up and said, "I'm confident that we're going to be fine," and their stock went up.

Then we move on to our dear friends at Washington Mutual and they only announced a loss of $5.9 billion and announced that they were going to initiate cost cutting measures that will save them $1 billion.  Oh and their CEO stood up and said, "We aren't going to need to raise any more money."   And their stock went up.

In the interest of full disclosure, Fifth Third announced our earnings (losses) for the quarter.   Compared to these two, we did quite well, but we didn't do as good as we'd like.   We came in down $202 million for the quarter.   But our CEO stood up and said, "We've made adjustments, we've raised additional money and we'll be fine."   Guess what our stock did?  Yep, it went up.

Existing Home Sales came in lower than expectations.   If you've been reading this for a while, you know my feelings on the year over year comparisons.   We've moved into a new market and comparing last year to this year is like comparing me to Tiger Woods.   There is no comparison because we aren't even on the same playing field.

Weekly unemployment claims came in higher than expected.

National City came out and announced a huge loss for the 2nd quarter - $1.78 billion.   Their CEO stood up and said (Well, you get the picture......)

Washington Mutual had to make a second statement this week that said, "We really are okay!   Honest!   We're healthy!  Everything's fine!"   The market didn't quite believe them and at the writing of this, their stock is down over 30% this week alone.

Durable good orders came out better than expected, but if you read the story behind the story at www.straighttalkaboutmortgages.com you'll see that it's not as good as it sounds.

New Home Sales came out down but not as bad as the market expected.

The House of Representatives passed the Fannie Freddie Bailout bill.   Now it's off to the Senate.   Rumor has it that they'll pass it but some of the people in the House are pushing
Bush for a veto.

Oil prices have drifted down quite nicely this week.

Consumer Confidence came in surprisingly higher - do you think it was because the price of gas started with a $3 rather than a $4?

Where does that leave us?   I'm going to quote John Augustine, a senior investment advisor at Fifth Third Investment Advisors because he summed it up quite nicely:

We now need better news in at least two of the below three areas to help support the recent Financial-led rebound in stocks -

  1. lower crude oil (...happening)
  2. better US housing market news (...not happening)
  3. calmer credit market (...not happening - credit spreads widening again with and continued concern about US loan losses).

I'll leave you with a couple of thoughts:

1. If it sounds too good to be true, it probably is.   If it sounds too good to be true that bank stocks are going up in light of all of the losses, it probably is.

2. If someone says we're at the bottom, good luck in believing that.   We've got a lot of inventory to work through and a lot of loan losses to sort out.

3. Something really interesting has happened - the spread between conforming and jumbo mortgages has all but disappeared.  Why?   Because of the problems that Fannie and Freddie are in and the pending bailout.


I'll continue to keep in touch, let me know how I can be of help.

Thanks!

Tom Vanderwell

Quote of the week: When asked how to solve the housing crisis, Bill Gross, from PIMCO, replied: "One of the wisest men I know has this serious but admittedly impractical solution: have the government buy one million new/unoccupied homes, blow them up, and then start all over again. Absent that, he's not quite sure what to do, nor am I."

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Thinking Ahead at Ford and Charlie Brown's Football

This post is a guest contribution by John S. Boyd, writer of the BlindReason blog.

This piece about Ford's just announced $8.7 billion loss was interesting via the FT here with an excerpt below:

Ford has unveiled an ambitious facelift for its troubled North American operations aimed at shifting its focus from big pick-up trucks and sport-utility vehicles towards smaller, more fuel-efficient passenger cars.

Announcing a net second-quarter loss of $8.7bn, the number-two Detroit carmaker said on Thursday that it would bring six small European models to north America, and convert three existing truck and SUV assembly plants to small cars.

The conversions are in addition to plans announced earlier to cut SUV and pick-up production for the remainder of this year.

The carmaker also plans to accelerate the introduction of a new fuel-efficient V6 engine and to double four-cylinder engine capacity. It quashed speculation that it might eliminate the Mercury premium brand from its product line-up.

Alan Mulally, chief executive, said the moves were designed to respond "to the rapidly changing business environment".

Ford's US sales volumes shrank by 14 per cent in the first half of 2008 from a year earlier, including a 28 per cent dive in June, due largely to plummeting sales of such former mainstays as the F-Series pick-ups and the Explorer SUV.

Essentially Ford's message was-- "Hey we just lost $8.7 billion. But don't worry, we got this idea...we are going to make smaller cars".

Now don't get me wrong, it seems like an obviously sound idea but I wonder if they are not a little late on this and more than a dollar short.  All the US car makers are in the same boat and their pace of adaption to business changes are glacially slow so I am not picking on Ford alone here.   Chrysler which is privately owned now seems equally flat footed so I don't think it's necessarily a function of managing short term business profits to long term strategic plans.

This would ordinarily be 20/20 hindsight commentary but this has happened before in the 1970s and 1980s. High oil prices caused a shift to higher fuel economy cars and smaller cars and the Japanese destroyed these companies for decades with various crisis and requests for bailout assistance.  

No question Americans love big SUVs, and they don't mind forking over a higher margin for them temping car companies all around the world..  

Much like Charlie Brown aiming for the football with Lucy promising that the football won't be pulled away again these high margins seem especially tempting for American car companies.  But are the short term higher margins worth the big write offs you take when the fuel price jumps and you have to retool plants?

Since Americans don't mind paying so much for large SUV's why not just make them with alternative fuel engines that give them ultra high fuel economy.  It may cost quite a bit more but American's have shown a propensity to pay extra for big behemoths and it would shield them from fluctuations in gasoline.  Of course if they do this they will sell less of them but they won't have to retool plants and risk bankruptcy on huge write offs every 20 years.  This thinking never seems to be factored in, time and again-- Just like Charlie Brown and his football..

With the plummeting dollar, and an increasingly competitive manufacturing base in the United States you would think this would give US car makers, particularly export oriented ones like GM a big edge selling to the 1.3 billion new consumers entering the marketplace. US based auto manufacturers actually have a huge opportunity to expand and grow as the US dollar provides a very large cushion of competitiveness.

If the US auto makers actually shifted to a new more technologically advanced fuel standard, wouldn't this give them a huge edge over foreign competitors? Wouldn't other countries be tempted to migrate to this new standard given the largest market in the world had shifted? This might be a chance for the American auto makers to become technological leaders for the first time in 40 years but they'd rather keeping kicking that same football.

Do we need a "Tabula Rasa" to get this kind of change in the industry? i.e. something like a bankruptcy to have these companies start from scratch or can management make the changes needed.

What's the reason for management's inability to adapt quickly or prepare for change? Why is it so much worse than other US industries?

Energy prices have been rising for years but why are the US companies caught so flat footed over and over?

  • Is it the relationship between the companies and unions? Either lack of flexibility in contrasts or built in costs that give them a competitive disadvantage compared to everyone else?
  • Is the misalignment with our fuel taxes in the US vs Europe and Japan the reason our companies can't adapt quickly? I.e. if our gas prices are always lower are car companies that much more vulnerable when we experience big price surges because of the elasticity of demand for gasoline?
  • Is it a case of be careful what you wish for? The US Auto industry has lobbied tooth and nail to keep higher fuel economy standards from becoming law and the US has severely lagged against the rest of the world in these standards.  But the billions in political pork and back room lobbying has got them lower standards but has it now come back to haunt them?
  • Is it all of these combined or is it something completely different causing this. If so what?


You can reach John for comments as johnspencerboyd@gmail.com

 

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