Finally… Greek Austerity

Greece seems to be getting serious about its fiscal situation…finally. After all this hand-wringing, today we got some details on what it will do to tighten its belt. A few highlights:

• Slight increase in its value-added tax (If your country is ailing, raise taxes, right? Bad idea.)
• 3-yr public sector pay freeze, recruitment frozen (This is like a formal invitation for more protests.)
• Abolition of ‘13th and 14th monthly salary’ for public sector workers, 5% cut in allowances (Same. Protests!)
• No renewals for short-term public sector contracts (Same.)
• Closure of more than 800 out-dated state entities (Same.)
• Pension system: raising retirement age to 67 (from 53), cut state corporation pensions (Same.)
• Privatization: sales of state corporations; sales and leasing of state-owned properties (Same.)

So it boils down to higher taxes, cutting state employee pay and or jobs, and selling state assets. This will not be popular with Greece’s very large public employee contingent. It’s not fun to be a politician in tough times—these aren’t exactly populist moves. And probably the reason why Greek officials held out this long.   It’s a shame too because I’m not convinced the IMF/EU bailout was even necessary had they just elected to do this stuff months ago. Another reason politics and economics make strange bedfellows.   Nonetheless, Greece’s acceptance sets the stage for formal approval of the rescue package, which appears to be closer to €120bn in size at this point, but even that’s still not confirmed. The entire bailout might end up acting more as a backstop than a true need. Either way, it still appears worries this will spark a global debt contagion are overwrought. Time will tell.

Euro’s Tax Base is the Key

It’s a certainty that Greece is going to have to get leaner from a government perspective—rein in costs and keep fighting unions. That’s just a reality of their situation.

But when it comes to thinking about the future of the European Union and its broader debt woes, and whether or not this becomes a “contagion”, paring back expenses isn’t everything.

Debt for gigantic sovereign nations or groups is a different thing than debt for individuals. We tend to think about them as equals, but that’s wrong. If you have too much credit card or mortgage debt, for example, you probably have to focus on paying it down, get frugal, start eating rice and water for every meal, and so on until you dig yourself out. That’s mostly because folks generally can’t increase their earnings significantly enough year over year to otherwise surmount the issue.

That’s not really as important for big governments. What is more important is the tax base from which they get their revenues to fund operations and service their debt. Because that can shift rather radically from year to year, and is most often where the biggest fluctuations in government fiscal health come from. Don’t get me wrong—I’m no proponent of profligate bureaucratic spending binges. Quite the opposite. But debt is something governments of the world are going to use—that’s the world we live in and it ain’t changing. And that’s always been fine (and still is) if those governments are able to meet their recurring payments.

We just went through a big global recession, so tax receipts have been lower. So, why, after the chaos of the last few days, are European stocks rallying? Probably two big reasons:

• Europe Economic Confidence Improves to Two-Year High
• European Stocks Advance as Estimate-Beating Earnings Outweigh Debt Crisis

Europe’s economic recovery has been weaker and slower than much of the rest of the world, but it’s still recovering. Which means tax receipts will grow, which means they can service their debt and pay their expenses easier. This applies for states like California and other municipalities, too. Economic recovery is the thing to focus on right now—increasing the tax base.

Granted, this is one facet of the issue, but it’s a big one. Others include the ability to tap capital markets and the yield a country must pay to do so ( Greece ’s debt costs have spiked lately). But it’s basically always been true that if you increase taxes on something you get less of it. And if you lower taxes on something you’re likely to get more of it. So, lower taxes on your economy—its people and corporations—and you’re likely to get better economic growth, which actually will get you higher tax receipts in the long run. (Thank you, Mr. Art Laffer!)

Betting Against the Republic Is no Crime

With all the public hubbub and scapegoating going on with Goldman Sachs on the Hill, it would be easy to miss this startling piece in today’s Wall Street Journal:

States Bristle As Investors Make Wagers On Defaults

Essentially, investors are buying derivatives to bet municipalities will default. Oh my! Who would do such a nasty thing? Turns out, rational folks:

“These so-called credit default swaps are basically insurance contracts that have long been available to protect holders of corporate bonds against default. They became available a few years ago for municipal debt, allowing investors to short sell—or bet against—countless cities, towns and bridges, and more than a dozen states, including California, Michigan and New York.”

This is called hedging. It’s normal and risk mitigating and a perfectly fine thing to do. With many municipalities and states ailing after—let’s be honest—decades of gross fiscal mismanagement…these folks are actually upset investors want to protect themselves?

“In recent weeks, the treasurer received initial information in letters from the banks, but he is probing further to find out who is buying the products and whether the bank is trading in-house for its own profit. The underwriters who have been questioned are J.P. Morgan Chase & Co.; Merrill Lynch and its parent, Bank of America Corp.; Citigroup Inc.; and Barclays PLC. All the banks told California their activity is making it easier for the derivatives to trade without large price moves and that they aren’t driving up the issuers’ borrowing costs.”

This isn’t a far cry from what Goldman Sachs is going through right now on the federal level. I’d respectfully suggest those folks in charge of said states and cities focus on running a tighter ship so they can attract the capital they need rather than whine about the fact there is now better price discovery on their operations. There is nothing wrong with an investor paying to insure their own risk exposure.

PS—how many folks would’ve said that by April 2010 there’d be talk that some of the larger economies in the world are growing so fast they could overheat? That’s today’s world—stronger and more resilient than most could fathom a year ago.

Mr. Buffett Goes to Washington

Well, well. Look who’s arrived on the Beltway—the grandfather of investing himself, Mr. Warren Buffett. Suddenly, Mr. Buffett finds himself in the middle of a political maelstrom, as his company went the political route this weekend, seeking a provision to avoid a significant financial hit from the Obama financial overhaul. Essentially, the idea was to exempt existing derivative contracts from the proposed regulations, thereby allowing Berkshire ’s (and other financial institutions) current contracts to remain unfettered by the new laws.

And who can blame him? New derivative regulation as currently outlined would probably hack out a hefty bit of Berkshire ’s business (used for hedging, I might add), or at the very least cause a great deal of headaches for the company.

Who led this initial prodding on Buffett’s behalf? Why none other than Senator Ben Nelson himself—now widely known as the political pariah who traded his allegiance on the healthcare bill for benefits for his home state of Nebraska. But as of late today, looks like that provision has been killed. Sorry, Warren .

All this speaks to the inherent perversity and chaos of what’s going on with the financial overhaul right now. It’s nothing short of ridiculous that a company with a sterling reputation like Berkshire Hathaway, which, again, overwhelmingly uses derivatives to mitigate risk, is being punished by this new bill. And it also shows just how dislocating some of this bill could potentially be if even the (mostly) politically agnostic Buffett feels he must bring his mighty influence to bear.

Competition Is Still the Best Regulator

I’m often on the opposing side of economist Robert Reich’s views, but I found myself unconsciously nodding my head as I read his piece at the Motley Fool today:

Break Up the Banks

By Robert Reich, The Motley Fool

I don’t much care for the way he approaches the subject, but I’m generally with him on the idea of breaking up the giant Financials as opposed to enacting the lumbering, opaque reform about to be debated in the Senate. (Actually, putting derivatives through a clearing house seems fine enough to me, though I do worry some transactions are best done “over-the-counter”, and forcing an all-encompassing clearinghouse might actually choke off some types of useful derivatives…but I digress.)

Ultimately, competition is still the best of all regulators. Poor Teddy Roosevelt is probably spinning in his grave right now at the sight of this financial overhaul—whatever happened to the anti-trust spirit? Read the gory details of the proposed legislation in its current form here.

Think of it this way: It’s potentially even more hazardous to have giant “private” companies like the banks in close cahoots with the government’s lumbering oversight agencies than the outright taking over the means of production. The former is a kind of neo-fascism, the latter is socialism. Both are pretty bad.

Rather, instead of perpetuating what’s tantamount in many ways to an oligopoly in big Financials with huge government oversight, why not focus on increasing competition?

Have a great weekend.

Fisher Investments Analyst’s Book Review: It’s Not as Bad as You Think

Brian Wesbury is an economist, has a column in Forbes (with Robert Stein), and is someone I’ve become a fan of over the last few years. His new book, It’s Not as Bad as You Think: Why Capitalism Trumps Fear and the Economy Will Thrive (co-written with Amity Shlaes) is one of the finest, shortest, and easiest supply side economics books I’ve picked up in awhile. On the heels of last week’s review on Milton Friedman, this is an ideal next step. In parts, it’s almost as if Wesbury channels Friedman via Ouija board, and in others, it’s a near perfect supply side account of world events over the last three years or so (both Friedman’s monetarism and supply side views are closely linked). Wesbury’s views are razor sharp and accurate—citing the government’s part in the panic, the insidious role of accounting rule FAS 157, and very importantly, that the actual panic part of the bear market and widespread global recession simply didn’t have to be. Yes, most of the global economy was in pretty darn good shape entering the crisis, and that’s a big reason it’s emerging from the crisis so quickly. Hear, hear. Wesbury makes a strange move relative to today’s dour mood—one that’s almost Reagan-esque in tone—citing optimism as the centerpiece of his views, and further, that capitalism is the mechanism supporting that hope. Which reminds me of an interview I saw on one of those Sunday morning political shows featuring prominent economist Robert B. Reich. Mr. Reich is, broadly speaking, a pessimist—he cannot see from whence demand will come once stimulus money subsides: Unemployment is high, many factories stand idle, the housing industry is anemic, and so on. Mr. Reich cannot see how the economy can thrive without strong demand to bolster things, and he does not believe today’s consumers have it in them. With this book, Mr. Wesbury excoriates such views, describing in very simple and clear terms why supply—that is, innovation, productivity, and wealth creation—is the true mechanism that will lift (already has lifted?) the economy from recession. But who to believe? And why? In the end, Fisher Investments believes they are both ideologies, both points of view about how the world should work in theory. Instead of theory, look to the data. For the pessimistic demand-side narrative to be true, the economy should not be recovering in the way it is. The capital markets and subsequent economic revival—globally—cannot be fully (barely partially) attributed to stimulus spending, much of which has yet to be spent. Indeed, gains in productivity and operating leverage have formed a basis for new business spending and revived trade—those components of GDP gained the most as the US economy swung from recession back to growth. Indeed, the last 13 months or so of reality have bolstered the supply siders and confounded the demand siders. (And, to my mind, the last 200 years of history have done the same.) Yet, as excellent an economic analysis as this is, Wesbury’s investing advice misses the mark. As I said last week, overdependence on ideology often steers investors in strange directions. Mr. Wesbury sees the big stock rally continuing, but accompanied by very high inflation, and advises investors begin bracing for it in portfolios here and now. This is the monetarist in Mr. Wesbury taking over, and I just can’t go there with him. Is inflation a threat in the future? Yes. But inflation hawks have been cawing for well over a year now, and globally the needle has barely moved. Deflation is still a bigger threat in many regions. Indeed, to my view, Bernanke and his Fed cohorts are right to have a bias toward keeping rates accommodative for now (keeping the money supply loose) to give the recovery a continued tailwind. Bolstering a nascent recovery is more important than inflation at this moment—the Fed and other central banks will have plenty of time to rein in excess money down the road. Whether they do that right or not is questionable. But that is not an issue for right here and now—maybe they’ll start tightening later in the year, but that will be a tough sell with what’s sure to be a vicious midterm election come November. My guess is they can wait all the way into 2011 and possibly beyond before monetary belt-tightening becomes essential. All of this rolls up into a great lesson about money management—that folks can share views of the world, have similar analyses, look at the same data, and yet come to wildly different investing conclusions. It’s hard to go along with Mr. Wesbury’s advice simply because there is no discipline provided to explain it. What of selecting an appropriate benchmark? What of positioning assets based on goals and time horizon? For instance, the book alludes to the wisdom of having a slug of bonds in investor portfolios. But what if an investor wants growth and has a time horizon of 15 or more years? Are bonds really a great option then? Particularly when Mr. Wesbury agrees a lot more bull market is ahead? If harmful inflation truly looms—that doesn’t necessarily mean you shouldn’t be in stocks. Without those parameters as context, giving investing advice to the broad public is treacherous. Cogent economic analysis is only half the battle in investing. As I say in my own book, 20/20 Money, successful long-term investing is far more discipline than it is genius. Though it doesn’t hurt to have a little of both.

*The content contained in this article represents only the opinions and viewpoints of theFisher Investments editorial staff.

IMF Indecision

I’ve never really been able to understand why folks look to the IMF for economic forecasts. Granted, they have access to information most others don’t, and are an organization designed to monitor the global landscape…but they’re generally no more accurate than anyone else. Personally, I’d rather the OECD projections, but both types are imperfect. That’s ok—global economic estimates are a messy business and precision is elusive no matter how good the agency.

I get a great kick out of these things because they’re revised so darn often, and usually after the market and other investors have figured things out anyway. Like a lot of ratings and forecasting agencies, government bureaus, and think tanks—there’s a tendency to be more reactive than proactive. These folks are seldom ahead of the curve. And so, today we get this:

• IMF Raises 2010 U.S. Growth Estimate to 3.1% From 2.7%, Warns About Debt
• IMF Raises 2010 Latin America Economic-Growth Forecast to 4% From 2.9%

The irony is, as the IMF raises its global economic forecast, in the same breath it warned of a ‘New Phase’ in the Crisis. As investors—what are we supposed to do with this kind of talk? Only a group that’s ultimately not responsible for their predictions can say such things—well, it’s gonna be better but actually it could get worse. An investor could never think this way or they’d be constantly paralyzed.

Central Planning – The Chinese Way

China is, as are much of the emerging markets, an investing land of opportunity today, no doubt.  All I ask is a bit of skepticism here and there.  After all, these guys are still commies.

This week, Chinese officials directed banks to stop making loans for the purchase of 3rd homes in cities with “excessive property price inflation”.  China’s state council also said that local officials will be “held responsible” for determining which cities qualify as “excessive property price inflation” and for any failure to appropriately enforce these mechanisms.

(How’d you like to have your mayor suddenly say you can’t have a loan because your city is experiencing “excessive property price inflation”?)

Right now, China has an excess of commercial property and luxury homes, but  a shortage of housing in general.  Therefore, the state is attempting to significantly increase the supply of low-income housing this year to help facilitate the urbanization of its population.  However, it is also increasingly cracking down on housing demand.  Wealthy Chinese citizens have often parked significant levels of cash in the property market given their limited investment options (tied to strict capital controls) and low carrying costs due to no property taxes.

I shudder to think of US politicians tinkering with housing supply and demand.  (Though, sadly, a lot of this goes on already in the US). Ultimately any asset in China (stocks, real estate, etc) is beholden to the whims of Chinese officials.  And, ultimately, that kind of thing causes a lot of trouble at some point or another for society and capital markets.  Capitalism has its booms and busts, but give me those over a bureaucratic figurehead at the helm any day.

Sensational Economics

Whenever folks contemplate recent events, the coloring of emotion tends to cloud much clear thinking (this tends to hold true for policy-markers, critics, and historians alike).

Here are some colorful words and phrases from a recent Paul Krugman article via the New York Times, which nicely encompass one prominent current view of Wall Street. Call this what you will, but don’t call it objective economics. At least we know where the gentleman stands.

• Looting
• Fraud
• Predatory
• Complex
• Lured
• Didn’t understand
• Failed
• Abusive
• Surely knowing
• Designed to fail
• Magnified
• Deepening
• Toxic waste
• Bubble burst
• Catastrophe
• Moral
• Urgent
• Change
• Financial industry racket
• Game
• Handful of people
• Lavishly paid
• Mislead
• Exploit

Fisher Investments Analyst’s Book Review: Starting with a True Classic

Over the next year this column will review contemporary and classic economic, business, and investing books. I won’t endeavor to find the definitive investing “Bible.” There is no hallowed list or canon of investing literature. I’ve known many folks over the years—across a variety of disciplines—who search for “the” texts. As if an investing Holy Grail is out there waiting to be uncovered.

No such thing. The process of investing is about—at least in part—the spirit of exploration. Not just delving into today’s headlines and data, but also knowing what has come before and why. Traversing the territory of thought on just about any topic is adventurous—there’s a great deal of fluff, wrongheadedness, misdirection, brilliance, insight, and all in between. Plenty to agree and disagree with. Ultimately, a good investor shouldn’t ever be indoctrinated, but should know the context before forging one’s own path forward.

So let’s start with a read that’s a synthesis of my favorite kinds of books: Short, timeless, insightful, clear, and often witty—GC Selden’s Psychology of the Stock Market.

Originally published in 1912, this little 125-page book appeared just a handful of years after the Panic of 1907, and some parts are clearly a reaction to it. Yet, despite its old age, this work is still around. Why? When studying market history, often the starkest and most obvious truth is how much doesn’t change. Selden’s opening chapter, “The Speculative Cycle,” could appear in Forbes today and few would doubt it was penned expressly for the most recent bear. Of particular note is Selden’s often ignored observation (to this day) that markets in the short term can become both over- and under-valued—one of the prime lessons of 2009. Overshooting can (and almost always does) happen in both directions.

“The broad movements of the market, covering periods of months or even years, are always the result of general financial conditions; but the smaller intermediate fluctuations represent changes in the state of the public mind, which may or may not coincide with alterations in basic factors.”

Selden’s heart is that of a trader’s (he’s often concerned with liquidity, another important feature of the most recent bear), but his insight rings true for longer-term investors too.

The beginning of the 20th century was a heady time: The US was on the cusp of superpower might, modernism was entering the culture, the Industrial Revolution (and thus capital markets) were thriving. Selden seems acutely aware of the prevailing intellectual movements of his time. Just to use the word “psychology” in the title is interesting—William James, Sigmund Freud, and others were just then giving birth to modern psychology. We can’t know if Selden studied those folks, but we can safely say he favored pragmatism over theory—he saw occasional anomaly where classical economics modeled most everything on rationality and “invisible hand” notions.

Indeed, Selden’s chapter, “Confusing the Present with the Future-Discounting,” is cutting-edge thinking for its time—ostensibly an affirmation of Louis Bachelier’s 1900 dissertation and generally accepted founding doctrine of the efficient market hypothesis, “The Theory of Speculation.” Those debates—on the role of behavioral psychology and market efficiency still rage to this day and aren’t as new as we often believe.

“The psychological aspects of speculation may be considered from two points of view, equally important. One question is, What effect do varying mental attitudes of the public have upon the course of prices? How is the character of the market influenced by psychological conditions? A second consideration is, How does the mental attitude of the individual trader affect his chances of success? To what extent, and how, can he overcome the obstacles placed in his pathway by his own hopes and fears, his timidities and his obstinacies?”

Selden was acutely self-aware, and this is where the majority of his wisdom emerges. He doesn’t claim to know what’s in the hearts of men—he just claims emotion is more than capable of overruling the rational. Ultimately, humans are at the core of markets—no matter the epoch or level of technological sophistication.

He preaches the notion of knowing oneself first and foremost—to gain mastery of one’s emotion and perspective. In a word, it’s discipline—the least sexy but possibly most important part of investing over the long term. Simply, Selden recognized his own limitations, what he could and could not know, and therefore how he could move within the market system. He’s nothing if not a pragmatist (a virtue, as the true vice of psychology is often to delve into the fanciful and theoretical). Over and again he recognizes implicitly that to forecast the stock market is brutally difficult, and that even the best at it will often be wrong.

It would be easy to call Selden a contrarian, but that isn’t nearly right. Not purely technical, not purely intuitive, Selden’s work is an amalgam of insight over years of experience in a time long before we had the mechanics of Ben Graham or even the “animal spirits” of Keynes. He offers a rare glimpse into a view less obscured by today’s hyper-defined investing categories and schools—and that makes his often still-valid wisdom all the more ingenuous today.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.