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Tuesday, August 31, 2010

US Banks: What a Difference a Year Makes

Although recent financial news has a decidedly cataclysmic tone, evidence continues to mount that things are improving frustratingly slowly and steadily, exactly as expected.



Today, the FDIC announced that US banks earned, in aggregate, 21.6 billion dollars in the second quarter of this year (FDIC). Though this is still well below historical standards, what is striking is that most banks (80% of them) have returned to profitability.

Back in May, when I first publicly recommended bank stocks (US Banks), headlines warned that the government might force banks to be broken up and sold, that financial regulation could destroy them, and that a new debt crisis (ex. Greece) might soon cripple them. None of these things has materialized.

Since May the US financials index (XLF) has nonetheless dropped from $15.36 to $13.44, despite quantitative improvements in all areas of banking: decreased leverage, reduced loan loss provisions, increased profitability, improved credit market stability, and more.

The new worries for banks include a flattened yield curve (making credit spreads less profitable), a potential double-dip in housing, and that Barack Obama is secretly a communist Muslim and/or Biblical Anti-Christ whose intention is to destroy the US financial system.

If you truly believe that the US economy will never improve, and that US families will never again buy cars or houses, use credit cards or keep bank accounts, you should definitely stay away from bank stocks.

If you believe that banking has a future in America (and that America has a future at all), this year’s prices may well mark the single greatest buying opportunity we will see in our lifetimes.
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"After 1929, so many people had been traumatized by the stock market crash that there was a lost generation."

Ron Chernow
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Disclosure and Disclaimer

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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Related amusement:

Monday, August 30, 2010

Happy Birthday, Warren



The richest man in America turns 80 today.

In his time, Warren Buffett has positively affected the lives of thousands of investors, including those who became wealthy employing his techniques (based on the work of Benjamin Graham), as well as those who simply bought his stock (BRK.A & BRK.B).




In addition to being a great investor, people connect with Buffett because he just doesn’t act like a typical billionaire. He is frequently spotted chatting with shareholders, enjoying T-bones at the local steakhouse, or playing bridge. Several years ago, a shareholder was surprised to see Buffett and his friend, Bill Gates, walking around a McDonalds restaurant in China, looking for a table.

In recent years, Buffett has developed an almost saintly reputation, which is not entirely accurate. He has always had a complicated social life that includes “female friends.” He unapologetically buys stocks of military hardware developers, tobacco companies and breweries if he considers them to be of good value. He takes advantage of the suffering of large companies (like all good value investors) by rescuing them in return for convertible preferred shares paying high rates of interest.

Despite his arguable flaws, however, most agree that his positive attributes - both personal and business - vastly outweigh them. While most billionaires are hated simply because they are billionaires, Warren Buffett’s likability and charm have actually grown with his riches.

Honesty and humility go a long way.

Rationality adds still more.
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”Testing…one million, two million, three million.”

Warren Buffett, at the microphone of the University of Florida
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Wednesday, August 25, 2010

Is the US Recovery in Danger?


This week saw low sales numbers in housing, lowered (but still rising) durable goods orders, and a generally pessimistic attitude all across the board.

In fact, “pessimistic” may be an understatement. One website effectively summarized the prevailing mood: “Things will never get better. We are all doomed.”

One of many problems with doom and gloom reporting is the resulting dialectical materialism (George Soros calls it “reflexivity”). When people believe something it can become a reality, even if it wasn’t a reality at the time people began to believe it. For example, if people believe there is an increasing chance they will lose their jobs or homes due to recession, they will curtail their spending, thereby causing the recession that they feared. Despite the reflexivity effect, however, I do not believe that this recovery is endangered.

Consumer “entrenchment mentality” is already in full force, and has been for some time. As noted earlier in The Frost Report (The Spending Zone), Americans have been paying off their debts and increasing their savings for seven months straight, and are almost at the point where their free cash flow will increase substantially. As a result of these debt repayments and savings, consumer credit scores are already the highest they have been since 1998.

The corporate world largely reflects the personal one: businesses have vast amounts of emergency cash, have paid down and/or refinanced debts, and have streamlined staff and operations. Corporate America is mean and hungry. With solid balance sheets and low stock prices, M&A activity should rise soon and remain high for months.

The combination of high cash flow, lower debts, higher savings, and excellent credit ratings simply does not match the “we are all doomed” mentality. Similar to cult members who wait for the mother ship, at some point people will realize that the economic apocalypse they are preparing for is simply not going to occur.

Based on the numbers, I suspect that this revelation will strike the US consumer within the next 3 quarters. Regular (if not exceptional) spending will resume shortly thereafter, and corporate America will follow suit with mergers, expansions and hiring.

Though the international picture is deteriorating, it will not be enough to derail the US turnaround.
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“Hysteria has now disappeared from Wall Street.”

The Times of London, November 2, 1929
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Monday, August 23, 2010

Canada’s Banking Albatross

And How to Benefit from it.



Deathly afraid to enter the stock market, Canadian retail investors are keeping their money in low-yielding GICs and bond funds - if they are investing at all. Mortgage and refinance business has collapsed. The self-employed have entrenched. Business is slow.

With mortgages newly dead and rigor mortis setting in on investing, there is nothing to sustain the currently high stock prices of Canadian banks. As an investor, what can you do to protect yourself, and perhaps make some money in the process? The Frost Report states the case in black and white.

First off, sell your Canadian bank stocks, as well as your Canadian dividend mutual funds (which usually contain 50% bank stocks). In order for stocks to drop, banks don’t need to have a disastrous quarter; they just need to have a quarter that is less spectacular than the last one.

Secondly, sell your Canadian REITs (Real Estate Investment/Income Trusts). There is no point holding on to REITs to generate income when you know that income from real estate will soon drop, and the price of REITs along with it.

Thirdly, buy distant at-the-money put options on Canadian banks, so that you can make a profit on the coming stock price decline. If you don’t know what an at-the-money put option is or how it works, completely ignore this piece of advice, for now is not the time to be learning.

Alternatively, you can buy Inverse financial ETFs, such as the Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF 2X, (symbol HFD). Again, if you just read this description and have no idea what any of it means, don’t even consider buying HFD. For those who understand, read the full prospectus.

Lastly, Canadians should start paying down debts and building cash reserves. While everyone else is experiencing a crisis, you can be comfortable. Cash gives you a sense of control & security, and, when things start to pick up again (which they always do), you can take advantage of the bargains that will be everywhere.

The Bank of Canada shot the albatross with its low interest rates months ago, and for a while the results looked good. Now, however, the storm is approaching. As with any other impending disaster, preparation is crucial.
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Bank of Montreal reports Tuesday Aug 24th. Analysts expect third-quarter share profit of $1.21, up from $1.05.

Canadian Imperial Bank of Commerce reports Wednesday Aug 25th. Analysts expect third-quarter share profit of $1.53, up from $1.36.

Royal Bank of Canada reports Thursday Aug 26th. Analysts expect third-quarter share profit of $1.02, down from $1.21.
National Bank of Canada also reports Thursday Aug 26th. A third-quarter share profit of $1.52 is expected, down from $1.79.

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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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“Instead of the cross, the albatross / About my neck was hung”

The Rime of the Ancyent Marinere, Samuel Taylor Coleridge.
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Sunday, August 22, 2010

Canadian Real Estate: Stick a Fork in It

IT'S DONE.



The Canadian housing boom is officially over.

In addition to the myriad of anecdotal stories from real estate agents and mortgage specialists who tell me that the market “has shifted in favor of buyers,” banks are finally experiencing the inevitable decline.

Back in July, I mentioned that the mortgage pipeline was drying up, and that the results should soon hit the banks. Well, they have. According to my contacts at three of Canada’s major banks, new mortgage and refinance business has fallen off a cliff. Pre-approved mortgage applications – an indication of sales beyond 30 days - are virtually non-existent. Any of this may be confirmed by a casual visit to a local bank or credit union, which reveals empty reception areas and bored lenders.

In an effort to kick some life back into the markets, major Canadian banks reduced their mortgage rates twice in the past two weeks, but it had no impact whatsoever. In light of these circumstances, I suspect the Bank of Canada will rethink its intention to slowly raise interest rates.

At the same time as the Canadian media was announcing that home prices have dropped, sales have slipped, and housing starts fallen, the Canadian Real Estate Association was busy announcing that home prices will continue to rise. I love the CREA. When sales and demand increase, they announce that real estate prices will rise. When sales and demand drop, they announce that real estate prices will rise. You can say a lot about the CREA, but you can’t fault them for inconsistency.

I suspect that several months will pass before the severity of the downturn becomes fully apparent. By then, it should be so obvious that not even the CREA will be able to ignore it.
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Further reading:

The CREA's Use of Spin (The Frost Report)
The Canadian Real Estate Market - Trouble in the Pipeline (The Frost Report)
Housing Starts Slip in July
Shaky Days in the Housing Market
Homeowners Sell, Start Renting Instead
CREA's Resale Housing Forecast

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Friday, August 20, 2010

The Golden Age of Appraisals



“What are you looking for?” the man on the phone would ask me. At the time, I was a retail lender for a major bank.

“Uh, they need 680 thousand,” I would answer. A few days later, the appraisal would arrive on my desk. The home’s appraised value: exactly $680,000.

I miss the golden age of appraisals; the days when an appraiser would ask their banker what value they needed to complete the deal, and the result would neatly correspond. Of course, it didn’t always happen that way. Occasionally, when a client was buying a property that was obscenely overvalued, the appraiser just wouldn’t do it. “The most I can give you is “X,” they would tell me, apologetically.

The Golden Age of Appraisals (and the housing bubble itself) resulted from general human psychology, and a lack of regulation to counteract it. The government wanted a robust market so that voters would be happy. Bank executives wanted stunning results so they could exercise their stock options. Lenders wanted to underwrite mortgages to exceed their targets and get good bonuses. Appraisers wanted to keep lenders happy and get bank business. Clients wanted to be approved so they could buy homes to flip and get rich. And so, everyone worked together to create a royal mess.

At the time, I didn’t even realize that by answering the appraiser’s question, “What are you looking for?” I was contributing to a bubble. I recognized that the question was suspect, but thought I was simply helping them cheat at their jobs by giving them an anchor figure to work from.

Housing appraisals go by either “replacement value” or “the comparison approach,” the latter of which is the most common. In this approach, a home is compared to the recent sales of similar homes in the area, adding or subtracting value for any differences. In the bubble years, the values given to differences were often generous. After all, who’s to say that the $500 of gardening supplies and weekend of sweaty work didn’t add $20,000 to the value of the home? It’s a judgment call.

These days, most appraisers no longer ask their banker what he is “looking for.” They rarely assign a value of $20,000 to a small garden plot, or $30,000 to a new paint job. And, they often anchor their appraisal based on the price of the nearest foreclosure, knowing that foreclosures drag down prices for everyone. The old days are gone. Appraisals are becoming – dare I say it – accurate.

That is, until the next hot economy…
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“Until you play it, St. Andrews looks like the sort of real estate you couldn't give away.”

Sam Snead
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Tuesday, August 17, 2010

FOR and "The Spending Zone"

AND ITS IMPORTANCE TO THE US ECONOMIC RECOVERY





The FOR, or “Financial Obligations Ratio,” is a surprisingly overlooked indicator of a nations economic health; specifically, an indicator of the financial health of its citizens. If the US is to truly experience an economic turnaround, the FOR is the number to watch.

The Financial Obligations Ratio is a ratio of the amount of debt that citizens of the US pay in comparison to income. For example, an individual with an income of $4000 per month (before tax) that makes monthly payments (rent, car, credit card, and other payments) of $2000 has a FOR of 50% ($2000 / $4000). The “safe zone,” where living is easy and spending is comfortable, is a FOR or 40% or less, with 32-35% being optimal. The higher the FOR, the more difficult it will be for a person to save for emergencies, spend, or invest.

As we well know, during the boom ending in 2007 many US citizens overextended themselves. In some cases, people were running at debt levels of 50% of more – a completely unsustainable level. Sometimes this was to “get rich quick” by investing in real estate. In other cases it was merely to keep up appearances.

In 2008 - with the collapse of housing and the markets in general - people finally woke up to the dangers of borrowing and started paying off their debts. In some cases, credit was cancelled and they were forced to start paying off debts.

The FOR statistic, as reported by the Fed, is somewhat deceptive. Retired people who tend to have almost no debt whatsoever skew the reported numbers downward. Most people in the U.S. do not actually have a FOR as low as 16%, for example. In reality, the average working person runs at 30% - 45% (even though 40% is the maximum recommended).

The most important thing to know is that free cash flow (spending money) becomes vastly more available as FOR declines. Say, for example, that someone has an income of about $50K, or $4167 per month. If they have a FOR of 45%, they will have approx. $1000 spending money available per month after paying bills and taxes. That's $1000 for groceries, evenings out, vacations, clothes - everything. However, if they pay down their debts to get a FOR of 40%, they will have approx $1210 per month. That's a 21% increase in spending money from a FOR only 5% lower!

Economists - ignoring reality, as usual - refer to the process of people paying off their debts and saving money as “consumer weakness.” The media often laments the currently high US savings rate, saying that it is “bad” for the economy. I could not disagree more. In order to have a long-term, sustainable economic advantage, the US needs to be a creditor nation, whose people use debt wisely and sparingly.

After people started paying off their debts in 2007, dramatic things happened. The national FOR rate for homeowners has dropped from 17.64 to 15.93 – the lowest level since 2002.

Since debts have been paid down and savings increased, credit ratings have consequently improved. The media routinely tells us about the thousands of consumers whose credit has been ruined since the crisis, but they ignore the millions of consumers whose credit has vastly improved. Equifax Inc. (commonly known as “the credit bureau”) reported that as of July 2010, the average credit score of the US consumer rose to 704 – the highest level since 1998.

Once people pay off enough debt to get into the spending zone (15.5% average), they will have enough cash flow to simultaneously spend freely and save. In addition, they will have better credit ratings than at any point in the last decade. It is a pivotal point that will cause the economy to turn around faster than anyone expects.

If current trends continue, this magic 15.5% cash flow level will be reached by the end of 2010.

For additional information, see
The Federal Reserve - household debt
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"Never keep up with the Joneses. Drag them down to your level. It's cheaper."

Quentin Crisp, Raconteur

Friday, August 13, 2010

US Foreclosures – The “Las Vegas Index”

In the past few months, foreclosure rates have climbed.



Under any normal circumstances, an increasing rate of foreclosures would indicate that the housing market and economy are declining/struggling/suffering. But, these are not normal circumstances.

As everyone knows, US banks are sitting on large numbers of properties where the owners have not paid in months. Previously, the banks wanted to foreclose on these properties but could not, since any increase in foreclosures would have only added to the already large glut. The fact that foreclosures are climbing means that banks are actually able to foreclose. Put another way, foreclosure rates are climbing because the economy is improving, and banks are able to sell their foreclosed properties faster than they were several months ago.

To illustrate, I give you The Frost Report’s “Las Vegas Index.” I chose Las Vegas to measure the nation’s real estate health because it is, officially, the worst housing market in America - with the highest percentage of foreclosures and the largest peak-to-trough drop in prices. The Las Vegas Index is simple: it measures the number of detached foreclosures and listed properties available for sale between 0-$1 million USD, with 1 bed and 1 bath or more.



There are two things that are clearly evident by studying this chart. First, non-foreclosed properties are simply not selling. Therefore, many of the existing home sales statistics are, at this point in the economic recovery, essentially meaningless. Foreclosures will have to clear before regular home sales will make any meaningful recovery. Secondly, the number of foreclosures on the market has not increased in recent months, despite a larger number of properties being foreclosed upon: this means they are selling.

The increasing rate of foreclosures is a positive sign, not a negative one, for the US economic recovery. The sooner bad mortgages and loans clear out, the sooner bankers (and citizens) can get on with their lives. The US real estate market, though it has a long way to go, is improving steadily.

PS - If you were ever considering purchasing real estate in Las Vegas, now would be a very, very good time.
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"...the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated."

The Federal Reserve, Aug 10th 2010

Thursday, August 12, 2010

Are U.S. Stocks “Cheap?”

Reading the news, one could easily be duped into believing that stock prices accurately reflect the business potential and economic health of a nation. Of course, this is false.



Although stocks do, over the long run, tend to reflect underlying profitability and growth, in the short term stock prices and reality are not even necessarily related.

In the short term, stock prices are largely dependent upon the mood of investors. During times of pessimism, a company's earnings of $1.00 per share may give the stock a value of approx $10-14, or a P/E of 10-14. During times of optimism, the exact same stock with the exact same earnings may be valued at between $17-20, with a P/E of 17-20 or higher.

At present, the DOW 30 Index (thirty of the largest corporations in the US) has a collective P/E ratio of approx 18. Is this cheap? No. Is this expensive? It depends on your expectations.

A P/E ratio of 18 indicates that investors expect the profitability of the companies in the DOW to improve. That is, investors are willing to pay a slight premium over current earnings, with the understanding that earnings in in the near future will be greater.

Yesterday’s selloff was thousands of investors second-guessing their expectation that the US and world economies will improve. If the US economy declines, today’s stock prices are indeed slightly overpriced. If the US economy improves – even modestly – today’s stock prices are perfectly in line: neither overpriced nor underpriced.

Many world markets are set to slow down or even decline, including mainland China, Hong Kong, Taiwan, Canada, Australia, Israel and others – all of which has been well-documented in this blog. Yet, the US market will continue to improve, albeit slowly, because of various factors that I will be covering in detail in the days and weeks to come. The US economy was hit by the crisis first, and it will also be the first to emerge from the crisis, potentially stronger and more competitive that it has been in decades.

The US recovery may stall temporarily, but it is not in jeopardy. But of course I must add this caveat – in the short term, psychology trumps intrinsic value every time. That is, being fairly valued does not mean that prices cannot fall. Since I have no crystal ball, I unfortunately cannot tell you what stocks will do tomorrow.

My advice, as usual, is to buy the stocks of solid companies that are valued as if the present gloom will last forever.

PS – Don’t go looking for bargains in the Nasdaq. Thank you.
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"Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions..."

Benjamin Graham
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Sunday, August 8, 2010

Chinese Real Estate - Trip Report



Back from China…

First off, my impressions of the housing market in China - one of my primary reasons for visiting Shanghai.

Virtually everyone I spoke with admitted that the Chinese housing market is “expensive.” Yet, when asked if prices would drop, almost everyone answered with a blunt, “No.” When I inquired further (ex. “Why not?”) I received any one of a number of points exhibiting national or local pride. For example, that Shanghai is “a great place to live. Everyone wants to live here.” Or, that “the Chinese people have an entrepreneurial spirit, and so prices will keep going up.” And of course the real estate bubble classic: “There is a limited amount of space.”

Then I asked the follow-up question: “Are you planning on buying a home?” Only two out of dozens said “Yes.” A few said they already own one. Many added that they would buy “if they had enough money.” Therein lies the problem.

An inexpensive one-bedroom condo in Shanghai costs around $140,000 USD. An inexpensive two-bedroom condo costs around $205,000 USD. At the surface, this does not seem overly expensive; that is, not until one remembers the reality of Chinese prices.

For reference, I had a three-course meal and two beer at a local restaurant for $6 USD. A 30-minute subway ride costs 22 cents. Despite recent prosperity, the average salary in China is 1/7th that of the United States.

So, that one-bedroom condo is equivalent to $980,000 USD, while the two-bedroom is equivalent to $1.44 million. The average Chinese citizen has no hope of buying even a basic home (unless several generations come together to make a purchase), while wealthy Chinese continue to buy multiple homes on speculation. This cannot last.

When I first started writing about the Chinese housing bubble in January, the media was speaking about it as an “if.” Since then, reality has started to set in. The Chinese government is – to their credit – well aware of the situation, and continues to take steps to lessen the coming catastrophe.

Beginning Aug. 31st 2010, insurance companies will no longer be allowed to hold more than 10% of their assets in property development. The government is also instructing banks to tighten (again) the lending requirements for 3rd+ homebuyers in Beijing, Shanghai and Hangzhou. I would list all the bubble-busting measures the government has implemented previously, but it would be a long list.

As the Chinese and related Asian markets unravel, worldwide construction-related commodity prices (iron, coal, copper etc) should decline. In addition, one should obviously avoid Asian banks, development companies, and in fact any company with non-essential products or services that relies on China for a substantial part of its business.

Despite government measures and media warnings, the Chinese housing bubble remains steadfast: greed, pride, and cognitive dissonance are hard to break. But, as soon as the cracks appear, reality will set in with a vengeance. This bubble is BIG.
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See also: Sell the Chinese Market SHORT!
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"China's economy, in general, is in line with the government's macro-economic regulation and control."

Chinese Premier Wen Jiabao, July 18th 2010
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Shanghai Financial District

Shanghai's financial district has everything you might expect - gleaming towers, wide streets, metal detectors & bomb sniffing dogs, fake designer watches, and receptionists in high-heels galore.