Bad for Banks, Good for You

People hate banks.  Especially US banks.

In 2008, when President George W. Bush signed into law the biggest corporate bailouts in history, banks became the enemy.  They are retirement killers, staffed by toga-party heathens.  They are social pariahs.  Few mutual fund managers dare to buy them.  And this is what makes them great.

The Frost Report has been recommending bank stocks during every dip in the market since 2008 (which has been a great strategy), and things only look better for the future.

As of Oct 3, 2012, the six largest US lenders - including Bank of America, Citigroup, and JP Morgan - earned a combined $63 billion in profits.  In Q2, Wells Fargo had its most profitable quarter in 160 years.  Despite this, many bank shares are still trading at below book value, and at single-digit PE ratios.  In other words, despite sustained earnings, US banks remain ridiculously cheap.

Enter the complainers.

Wall Street hates regulation.  There is a natural tension between the motives of short-term profit and long-term sustainability.  Without regulation (and sometimes despite it), the creative minds of Wall Street regularly devise new ways to make vast hordes of money before self-destructing.  It is the loathsome job of government to prevent the latter by preventing the former.

When bankers are complaining about downsizing and frugal compensation, complaining about low leverage (which reduces risk, but also the opportunity to profit), complaining about high capital requirements and complaining about trading restrictions, you know that your money is both profitable and safe.

The greater the number of people who live in fear of bank stocks - while those banks continue to earn excellent profits - the better.

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"The future looks very dim."

Michael Greenberger, University of Maryland, regarding US Banks

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US Housing Market strong for Softwood

The US housing market has gone from disaster to doldrums.  Although some areas have bounced back quickly (New York and San Francisco most notably), the overall market appears to be stagnant.  But is it?  To know the real story, take a look at the industry that supplies the hungry US market.

 

Major Canadian softwood manufacturers, whose precarious profitability depends upon accurate forecasting, are predicting US housing starts of 835-900,000 in 2013, up from an estimated 746,000 in 2012.  By comparison, housing starts hit a low of 558,000 in 2008.

 

Already, the composite price of Random Lengths framing lumber (the most common wood used in homebuilding) has risen 27% in 2012, both from increased demand and the expectation of more.

 

The US housing recession is not over.  Yet, with immigration and family development continuing faster than housing starts, a full recovery is only a matter of time.

 

Doubting the US housing recovery is a popular pastime at present - but it is not wise to bet against such obvious statistics.

 

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"The best thing about the future is that it comes one day at a time."

 

Abraham Lincoln

 

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Dear Workers of America

Actually, it IS your fault.

Barack Obama was raked over the coals this week (at least on Fox news) for suggesting that the US is not as competitive as it used to be, and that Americans are becoming complacent about their #1 position in the world.

What is interesting about Obama’s comment is that so many people agree that the US is not as competitive as it used to be, yet refuse to believe that they personally have anything to do with the situation.

I know many Chinese parents whose children are enrolled in soccer camp, take swimming lessons and piano lessons, have math tutoring, and yet still have time to meet their friends for several “playdates” per week – after finishing their homework, of course.  They have this much free time because they are only allowed to watch 2-3 hours of television per week, with another 1-2 hours per week to surf the Internet or play video games.  In contrast, I also know many American families whose children do almost nothing except watch television and play computer games.

The above is merely anecdotal evidence, of course, and doesn’t prove a thing.  But can we really call the average American family “motivated and driven to succeed?”

To find out if you are part of the problem or exempt from scorn, ask yourself the following questions:

1)      Do you watch 3 hours or more of television per day?  How about your children?

2)      How many books have you read in the last month?

3)      Do you currently have 3-6 months of emergency savings in cash, in case of injury, unemployment, or other unforeseen disasters?  If not, why not?

4)      Do you have trouble saving money?  If so, what have you recently done to drastically reduce your spending or increase your income (or both).  Or, do you just complain that bills are hard to pay but do nothing about it?

5)      During the last few years, have you purchased items like recreation vehicles, sports equipment, home decorations, electronics etc. on credit that you did not pay back at the end of the month?  Why?

6)      Have you been with your company for five years or longer?  If so, have you recently upgraded your skills/taken training courses etc on your own time?  Have you expanded your skill set to improve your employability outside your currently industry?

7)      Do you hate your job?    If so, what have you done to change careers or companies?  Have you updated your resume and practiced your interview skills?  How many jobs have you applied for?

In street interviews, website comments, and in social media, it is apparent that many Americans believe things will never get better: that they will always be unemployed, never get out of debt etc.   The more healthy reaction, of course, would be to say, “Wow, I was really stupid to rack up all that debt on my credit cards and house.  Now I’m going to have to study and train and work three times as hard.”

Of course, self-analysis is a difficult process and most people avoid it.  So, just continue to believe you are unemployed because of the President of the United States.


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People who are unable to motivate themselves must be content with mediocrity, no matter how impressive their other talents."

Andrew Carnegie

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see also:

Market of Sad Pandas

Today’s front-page headlines:

Think the Economy's Bad? 'You Haven't Seen Anything': CNBC, US

Shares fall of Greek deficit fear: BBC News – Business, UK

Markets take a turn for the worse: Financial Post, Canada

Wall Street drops as Greece overshadows ISM data: Delhi Business Standard, India

Is it just me, or is this constant vacillation between panic and complacency getting a bit tedious? I mean, seriously, it's been going on for 3 years now.

Everyone who reads this blog knows that the Chinese market is overbuilt and due to crash. Everyone knows that Greece is in trouble, and that European countries supporting Eastern European countries will suffer contagion. Everyone knows that the US economy is still in the tank, and although holding its own (and I would argue, poised for a comeback) will nonetheless remain there for some time. None of this is news. And yet, people are“reacting” to this news by selling their stocks - again.

Not that I am complaining, exactly. I love it when people sell their stocks at low prices, because I like to buy them. Canadian resource companies are my current favorite, since the chart for virtually every one of them has the shape of an inverted ‘V.”

No, this does not mean that I am suddenly one of those chart-wielding soothsayers who use terms like “reverse head and shoulders formation” or other such nonsense. It just means that no entire sector of a profitable industry deserves to be priced so low. Of course, this was one of my predictions in a previous article (The Fortune Teller), and I am now taking full advantage.

As one wonderfully sarcastic writer commented on a financial site today: “I would recommend you panic.”

Panic and fear are an intelligent investor’s best friends, as long as you watch but do not partake.  Don’t be a sad panda.

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"One must not let oneself be overwhelmed by sadness."

Jackie Kennedy

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From www.urbandictionary.com

Sad Panda, noun:

An unhappy, disappointed person. The phrase can be traced back to an episode of the cartoon South Park, in which the "Sexual Harassment Panda" teaches the children what is and isn't sexual harassment.
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Culling the Sheep - again

This week marked the single biggest wave of selling by retail investors ever recorded.

On Monday Aug 8th 2011 alone, Swiss bank UBS recorded retail outflows of 1.3 billion dollars! No wonder the markets crashed.

In The Intelligent Investor’s Mind, I speak about "myopic loss aversion" – the tendency for people with long-term goals (such as retirement) to focus on short-term events, especially the gyrations of the stock market. Myopia literally means “shortsightedness.” Such shortsightedness typically beds with "recency bias" – the tendency to think that the current situation (good or bad) will last forever. This week’s market activity shows just how strongly these cognitive errors can destroy people’s financial well-being: usually their own.

If you doubt the intensity of this week’s retail investor freakout, check out these choice quotes:

"Investing in U.S. Markets is DEAD....DEAD… and it is NOT COMING BACK!!"

"Yeah, it's different all right, as in it is ALL coming down."

"Their plan is to get rid of paper currency and go to digital currency so they can make you a slave."

"666, whatever you'd like to call it is coming."

Yet the market rollercoastered, showing that as much as retail investors were frantically selling, professionals and value investors were swooping in to pick up the spoils. Bloomberg reported that insider buying by S&P 500 company executives reached levels not seen since March 2009.

This week also revealed some great moments in calm and cool leadership. First was Barack Obama’s matter-of-fact speech regarding the S&P debt downgrade, where he basically said (I’m paraphrasing), “I didn’t need a downgrade by S&P to tell me that our government had a dysfunctional moment. We need to fix the way our government works.” The second was from Federal Reserve chairman Ben Bernanke, who said that he would keep interest rates low (which makes it easy for businesses to expand & develop), but other than that, the markets just need to grow up and get on with it. The final moment was an interview with Bank of America’s Jamie Dimon, who demonstrated the sensibility of long-term thinking (see video below). Interestingly, all of these great moments were regarded negatively by the public, who just wanted their leaders to DO SOMETHING!

As usual, the counterintuitive nature of the stock market is at work: those who are fearful of losing their money are losing their money; those who are unafraid of losing their money are making more.

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"There is no comparison between fear and greed. Fear is instant, pervasive and intense. Greed is slower. Fear hits."

Warren Buffett, Aug. 11, 2011

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United States Loses AAA Credit Rating

Standard and Poors, a once-excellent bond rating agency that now largely ignores economics and instead reflects market sentiment, downgraded the US to a AA+ rating this week. After holding back a big yawn, I took another sip of coffee and went to get a danish.

The Economist magazine said it best (with complete lack of emotion) a few weeks ago: "America's net indebtedness is a perfectly affordable 65% of GDP...the current problems, rather, are political." Yet, this reality has not stopped pundits and game-playing politicians from making it seem like America will go bankrupt tomorrow.

After the US Treasury pointed out that S&P had miscalculated by a couple of trillion dollars while making its decision, S&P responded that they have decided to maintain the downgrade anyway.

Ratings changes are great for business. S&P’s well-timed downgrade will give stockbrokers around the world a fantastic excuse to call their already-flustered clients on Monday to solicit new trades.

Panic and churn!

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Churn (verb):

1) Agitate milk or cream in order to produce butter.
2) Excess trading of a client’s account in order to increase broker’s commissions.

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"If anything, it may change my opinion on S&P."

Warren Buffett, when asked if S&P's debt downgrade will change his opinion about U.S. treasuries.

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Stocks I Like - New Millennium Iron

New Millennium Iron (stock symbol: NML) is the revised name for New Millennium Capital. This change is appropriate, since the fortunes of the company are now firmly in iron.

New Millennium’s DSO (Direct Shipping Ore) project in Canada is scheduled to start producing ore in 2012, and ramp up production through 2013.

Of course, mining companies commonly give estimated completion dates for their projects even if they haven’t secured funding, and even if the mine has virtually no chance of ever being constructed. Giving a completion schedule is an old trick to increase the stock price. So what makes New Millennium different?

When a mining company signs up a multinational end-user of their product as a partner, this shows that the property has serious potential. It also means that the project will likely be developed with minimum dilution of shares. When Copper Mountain Mining, for example, announced that it was partnering with Mitsubishi, I bought shares immediately and have been very pleased with the result.

New Millennium’s partner is the massive Tata Group (you may be most familiar with Tata Motors, makers of low-cost cars in India). Tata Steel Minerals Canada has acquired 80% of the DSO project, and has an agreement to purchase 100% of its production. In other words, Tata Group’s industrial companies will be using the iron produced by New Millennium, and have a vested interest in seeing the project’s timely completion.

In addition to the DSO project, New Millennium has other nice properties making up the “Taconite Project,” which contains an estimated 9+ billion tonnes of iron ore. In fact, NML’s total projects are so interesting that Tata Steel has acquired 27.1% of the entire company, and has 3 members on the board of directors.

If you buy NML now, I recommend holding it through every conceivable credit crunch or world disaster until about 2017, since this is when all of NML’s current projects are likely to have been completed and producing cash. Any time after 2017, you have my blessing to sell.

NML promises to be a long-term cash flow giant.

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"Blood, iron and gold promise victory. But even the greatest material resources do not avail, if the human qualities necessary to animate them are lacking."

John Keegan

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For further information, see: New Millennium Iron's official website.
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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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PS - In case any directors from NML are reading this website...

Please don't do the same stupid s**t that so many other mining companies do after they become successful. That is, once you start raking in the cash, do not immediately look for new acquisitions to spend your money on. With estimated mine lives in the decades, you can afford to wait. Pay out dividends instead. Thank you.

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The Sick Man of Asia

In the last few years, Chinese companies have bought out shell companies on North American stock exchanges (mostly the Nasdaq and TMX) to become listed in North America. Buying out a company that is already listed is a quick and easy way to become publicly-traded, without the cost and public scrutiny (due diligence) that comes when being newly-listed. Therein lies the trouble.

If one does a stock screener search of companies with great earnings, great return on equity, low debt levels and low stock price, many of the companies which turn up are Chinese (see list at end of this article). Why are these great companies so undervalued? Why are so many of the undervalued companies Chinese? The answer: they are undervalued because investors worry many publicly-traded Chinese companies may not actually exist.

Last week, Sino-Forest Corporation brought this problem into full view. Once Canada’s largest publicly-traded timber company, Sino-Forest’s stock price has dropped 83% in two weeks, losing 3.7 billion dollars in value to investors. There are allegations that Sino-Forest has vastly overstated its assets, and that many of its trades may actually be to subsidiaries of itself. In other words, the company as stated may not be real.

This is certainly not the first time a Chinese company has seemed suspect. There are multi-million dollar pharmaceutical companies in China which claim to sell hundreds of popular products, yet none of my Chinese friends (even those who work in the pharmaceutical industry) have ever heard of them.

The Chinese problem weighs so heavily on the minds of investors that it extends to even good companies. One of my favourite mining companies, Hawthorne Gold, merged with a Chinese company and changed its name to China Minerals Mining Corporation. Within weeks its price dropped in half. Clearly, having “China” in your company name is like developing leprosy.

The Chinese market - both in the stock market and in real estate – seems to be composed of many empty shells.

Beware.

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Click above to expand
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For further information, see:
Key partner casts doubt on Sino-Forest claim

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US Home Prices Drop Again

But is that bad?

In a story on CNBC, Home Prices fall for 8th straight month, David Blitzer, chairman of the Index Committee at S&P Indices, is quoted as saying, "There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing." When I read the same statement, I thought it was good news. Why the difference?

Everyone uses mental models in their daily life - whether they are aware of it or not. A mental model is a way of thinking, usually learned from the culture one grows up in, but often changed by education. A clear example is that in the West, most people believe that the mind/soul and body are separate. University educated individuals tend to use the scientific method to discover things, rather than logic or meditation.

Fictional character Sherlock Holmes famously uses “deductive reasoning” to solve crimes. Deductive reasoning is eliminating anything that must be false in order to find the last remaining item, which must be the truth. It is said that Sherlock Holme's author, Sir Arthur Conan Doyle, learned this technique from his university medical professor, who used it to diagnose patients.

Warren Buffett’s business partner, Charlie Munger, commonly uses “inversion.” Inversion is looking at every problem from the opposite direction from the normal one: for example, instead of asking, “How can we improve customer service?” Munger might ask, “How can we have terrible customer service?” The opposite of that answer is the way to have great customer service.

In Iraq, US soldiers and politicians often become annoyed because the Iraqis do not think of the relationship between cause-and-effect the same way we do. That is, they view the relationship between cause and effect as weak. If Iraqis take a day off to play cricket instead of building a new water pipeline, they don’t necessarily see the connection to having no clean water later that month. This difference in thinking is so frustrating for American troops that there is a whole series of military intelligence "lessons learned" documents devoted to it.

Now to examine David Blitzer’s comment: "There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing." Under normal circumstances, this statement would be perfectly logical. In a normal economic cycle, all these things indicate a weakening economy. David is inferring that low sales, low construction, and falling prices are bad – the traditional economist’s view. But is it truly bad? Or is David using a “fossilized mental model” – one that is not relevant for the situation?

The US had a housing bubble: that means there were unrealistic prices, oversupply, and sales to people who were not qualified. The remedy for a housing recovery is therefore lower prices, no new construction (until excess inventory is gone), and low new home sales (since foreclosures will be sold first). In other words, today's statistical weakness is exactly what the housing market needs to recover. At this point, strength in any of these numbers would be negative.

The banks can only release foreclosures onto the market at the same rate as the market is ready to absorb them. Since the banks control the flow of this inventory, new home sales and price stats are meaningless: any increase in market strength will be met by the release of foreclosures to match.

Prices are low enough that when the housing market does return, it will do so with a roar. Just like the bubble on the upside, the longer US housing numbers stay weak the more sudden and dramatic the recovery will seem.

Several months ago, I wrote that it was a good time to buy US real estate. Since then, in most cities home prices have fallen by about 3%. I do not apologize for this imperfection.

No one knows exactly when the market will recover, yet one thing is certain – buying quality real estate at a time of low interest rates and low prices will never prove to be a bad investment. Don’t try to catch the exact bottom.

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"Don't try to buy at the bottom and sell at the top. This can't be done - except by liars."

Bernard Baruch

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China's Housing Bomb

keeps burning, though the fuse is getting shorter.



In an recent article (Year of the Hot Rabbit) I related the news that property purchase restrictions have been introduced in more than 40 of China’s major cities, in an effort to deflate their massive property bubbles.

In Beijing, for example, a property purchaser must prove residency status to purchase in that city, and is restricted to owning one primary residence and one additional property. The days where a non-resident investor could buy 20 or 30 properties is - at least according to the rules - over. For the moment, these rules seem to be working. In fact, they are working too well, and could potentially obliterate the bubble rather than deflate it slowly.

According to China Real Estate Index System (CREIS) statistics, home prices sank in most of China’s largest cities in March. For instance, prices in Shanghai dropped 7.6% in that month alone: an annualized rate of 91.2%! Most of this titanic drop occurred in the final week of March, where prices sank 5% (260% annualized). These large nationwide drops occurred despite very high volumes in “home trading” (their words, not mine).

Following the lead of real estate spokespersons throughout history, Zhu Zhongyi, Vice Secretary-General of the China Real Estate Association, said he predicts a “modest decline” in prices, adding that a large decline in real estate prices is “not quite possible.” He said this quite seriously, as if saying it seriously makes it true.

Nonetheless, not everyone has given up hope on one of the greatest booms in real estate history. Lin Lei, in charge of marketing for 21 Century Real Estate (not to be confused with Century 21, despite the libelously similar name), said that the market would drop only “if restriction policies were carried out strictly.” In other words, he hopes that if real estate prices continue to drop, government officials will simply ignore the new rules. Red "gift" envelopes are likely to fly off store shelves.

And the bubble continues...

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“Having a third party sign a mortgage loan contract on behalf of another person is a serious offense, and banks and financial institutions have to examine their own operations and investigate to find out who is responsible for such offenses.”

The China Banking Regulatory Commission, March 2011
(Showing that already, Chinese citizens are trying to get around new regulations that home buyers in a city must be residents of that city).
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For further information, see:
China's housing prices expected to drop, but not sharply, in second quarter

The FDIC - Combating Stupidity Since 2011

Those who understand behavioral finance know that sometimes you have to protect people from orchestrating their own financial doom: in The Intelligent Investor’s Mind, I devote a section of every chapter to it. Financial quants and investment professionals (who should know better) are no exception. In fact, great genius is required to create a truly phenomenal financial disaster.

On March 29th, the Federal Deposit Insurance Corporation approved new rules for mortgages – essentially “anti-greed, anti-laziness” rules - that align the interests of homeowners, bankers and investors.

Under the new rules, banks will not be able to repackage and sell a mortgage (ex. Mortgage bonds, CDOs), unless the borrower puts down a 20% or greater down payment. If the borrower puts down less than 20%, the bank will be forced to keep some of the risk on its own books - known in the industry as “keeping skin in the game.”

Effectively, these new rules force banks to care about the quality of the loans they receive from mortgage brokers, and care how those loans perform. Prior to this, a mortgage broker could underwrite a loan from someone they knew couldn’t pay, sell it to a banker who didn’t care if the owner couldn’t pay, and in turn sell it to an investor who didn’t bother (or didn’t have the skill) to check to see if the owner couldn’t pay.

The National Association of Mortgage Brokers will undoubtedly hate the new rules. They are already fuming about the Federal Reserve’s new “Truth in Lending” regulations in general. Despite pushback, however, the matter will be put to vote this week and is expected to pass.

The days of dreamers with bad credit and no cash, walking into a mortgage broker's office, getting approved, then sitting on their new sofas & waiting for riches through equity appreciation are truly over - even if the market comes back.

People will always find new and ingenious ways to ruin themselves financially. Even so, it’s nice to see the old gaps being closed.

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"If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring."

George Soros
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Japan Finds the Downside to Nuclear Energy

About 5 years ago, I toured the Hamaoka nuclear power plant in Japan. Like all things Japanese, the mood and theme surprised me. Nuclear energy, I learned, is really fun!

First was the powerful “green energy” spin. Part of the tour included watching a show of robotic animation characters (similar to “Bear Country Jamboree” at Disneyland), singing and dancing about the joys of safe and green nuclear energy. There were nuclear games and activities for kids. There were clam-digging tours out back of the reactor. Clams and other shellfish thrive in the heated waters expelled by the nuclear reactor, so local residents dig for clams there. Paradise!

The Hamaoka Nuclear Power Plant's IMAX theatre is, at the time of writing this article, playing "IMAX Under the Sea," and advertising the upcoming Walt Disney flick, "Mars Needs Moms."

Yet, there were always reminders about the negative side of nuclear energy. Worker exposure to radiation makes the news regularly. My friend Mamoru, a nuclear safety inspector, was on NHK news one night explaining how a small crack in the retainer at one of the plants was nothing serious. Then there was the time I had to write diplomatic letters to the Kazakhstani government, asking them to allow human blood samples from radioactive fallout victims to be shipped to Japan via courier for study.

Yes, nuclear energy is a big source of power in Japan, and has thus far been relatively safe. We shall see if it stays that way. If you live on the West Coast of the United States, buy iodine just in case.

As for stock picks as a result of the disaster…Sekisui house (a Japanese homebuilder and Division of Sekisui Chemical) seems like a smart buy. Sekisui builds semi-prefabricated homes, and forms a large part of the new home market. Importantly, Sekisui has seismic test platforms in their factory, and they shake the living hell out of each new home design to make sure they stay together. No doubt, many people will be replacing their traditional homes (or destroyed homes) with Sekisui branded homes.

For obvious reasons, Tokyo Electric Power Company (TEPCO - the nuclear plant owner) is a “sell” until further notice.

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For further information, see:

Sekisui Earthquake Resistant Housing

Nuclear Power Plant safety measures

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Reflexivity and the Decline in Home Sales

Recent headlines confidently announced that the 33% reduction in U.S. new home sales for May 2010 was due to the expiration of the new-home buyer’s tax credit at the end of April.

In other words, we are supposed to believe that home sales were robust due to an $8000 tax credit, and now that this credit is over the housing market is bust. Nonsense.

In fact, the reversal in new home sales was primarily caused by an equally large decline in psychological wealth that occurred at the beginning of May - which had nothing to do with tax credits.

Rapid declines in consumer spending are caused by rapid declines in asset values, such as stocks or real estate. While there is much talk about how a drop in stock prices can “predict” an economic downturn, there is little notice that a drop in stock prices, rather than predicting a downturn, may actually be the cause of one.

When people see their net worth decline, they compensate by saving. That is, they decrease their spending and increase their margin of safety, further exacerbating the symptoms of the decline.



The “flash crash” of May 6th 2010 punched the confidence out of retail investors, psychologically forcing them to transfer billions of dollars out of equity investments. So, while April saw inflows to equity mutual funds of $13.89 billion, May saw outflows of $29.94 billion (www.ici.org). Negative headlines caused retail investors to run for the hills - and they haven’t stopped running. These days, the market fluctuates wildly from the trades of hedge funds and volume traders, while those working with retail clients (such as Financial Planners and Brokers) sit at their desks, bored.

Stocks are reasonably priced, with little room for a disastrous collapse like the one from the peak. Home prices are low. Interest rates are low. Despite problems in Europe and Asia, the U.S. economy has all the logical conditions which make it ready to rise from the ashes. However, retail investors and consumers are anything but logical.

Until the chat-room anger and gloom subsides, both stock and housing markets will linger - and the buying opportunities for rational long-term investors will be sublime.
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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 moderate for a time.”
The Federal Reserve, Press Release, June 23 2010

“Housing cannot lift the United States from its new state of Marxist depression, you bunch of morons. The American Dream is just that. Rest in Peace, USA.”
Anonymous comment on a financial news website, June 24 2010
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See also: Reverse Attribution

How to Speak Fed

The Federal Reserve: seen by some as an economic savior, and by others as an evil force.

Through its direct manipulation of interest rates and other mechanisms, the Federal Reserve determines the overall pace of U.S. economic growth (or decline).



Since investors trend toward euphoria when times are good & panic when times are bad, the Fed’s mandate is to control the economy; for example, to stimulate a weak economy by lowering interest rates, or to slow down an overheated one by raising interest rates. Yes, that's right – the Fed sometimes purposely initiates recessions. This is not conspiracy, but rather a method of controlling human stupidity (or at least cleaning up after it).

In good times wages tend to increase, which in turn increases spending, which increases prices of goods, which increases stock and real estate prices, which induces inflation, which causes wages to increase and so on. When times are good and voters are happy, the government wants it all to continue. If an independent Fed did not exist, human greed and optimism would allow bubbles to grow to stratospheric levels, then come crashing horribly down. The recent crash and burn of the U.S. housing bubble is an example of the Fed's failure to do its job – it let the bubble grow for too long.

Importantly, while the Fed always hints at what it wants to accomplish in the future, it does so in a cryptic manner. So, while the Fed’s intentions may be crystal clear to professionals, they pass by virtually unnoticed to non-professionals – exactly as intended.

Buying reasonably priced stocks of good companies is always a good idea, but it’s an even better idea to buy them when the tide of the economy is moving with you. The purpose of this article is therefore to teach the rules of “Fed speak,” the cryptic voice that shapes the nation’s economy.


Rule #1 - The Fed Understates Everything

The Fed is aware of its huge influence in the market, and takes care not to overstep its boundaries. If the Fed simply said, for example, “we intend to raise interest rates because we think there is a bubble in technology stocks,” the market would likely dive and the Fed would be blamed. For this reason, the Fed avoids stating anything of importance directly. Thus, “this market has a bit of froth,” really means, “this is a bubble of massive proportions.” Asking, “Is there a reason to think that homes are overvalued?” means that homes are terribly overvalued. Whenever the Fed states or suggests an opinion, you can safely magnify it tenfold.


Rule #2 –Recognize Moral Suasion

Moral suasion, also known as “jawboning,” is the name for scolding market participants in order to change behavior. By sending a warning to the market, the Fed hopes that it can delay or even avoid taking a negative course of action.

For example, in 2009 the Bank of Canada (Canada’s equivalent to the Fed) stated, “the recent sharp increase in the value of the Canadian dollar, if it proves persistent, could fully offset recent positive developments in financial conditions, commodity prices, and confidence.” This stern warning (see Rule #1) told market participants that if they keep buying the Canadian dollar, the Bank will take measures to devalue it (to improve exports).

In the long run moral suasion rarely works, but in the short run it can have the desired consequences. Moral suasion also indicates the course of action the Fed will take if moral suasion fails.


Rule #3 – Read the Speeches Verbatim

The introductions and conclusions of Fed speeches are made for public consumption (the media) and generally reflect useless broad opinions (such as, "the economy is improving.")

The subtle nuances with true predictive value are in the carefully chosen text. For this reason, any online news article about a Fed speech will include a link to the Fed’s word-for-word text. This verbatim text is meant for market professionals.

Examples of Fed Speak in Action:

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
Alan Greenspan, Chairman of the Federal Reserve Board, 1996 Speech

Translation: Stocks appear to be grossly overvalued (the Internet bubble).
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"It's pretty clear that it's an unsustainable underlying pattern. People are reaching to be able to pay the prices to be able to move into a home."
Alan Greenspan, Chairman of the Federal Reserve Board, 2005 Speech

Translation: There is a housing bubble in the U.S., and it will crash.
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“With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”
Bank of Canada, Press Release, Apr 2010

Translation: We will be raising interest rates soon.
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The importance of understanding the Federal Reserve cannot be underestimated. To a large extent, the Fed determines the near-term growth or contraction of business, and therefore the direction of the stock market. In addition, the Fed is a reliable asset bubble "early warning system." Learning to speak Fed can save you a lot of anguish.

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“Augmenting concerns about the Federal Reserve is the perception that we are a secretive organization, operating behind closed doors, not always in the interests of the nation as a whole. This is regrettable, and we continuously strive to alter this misperception.”

Alan Greenspan, Federal Reserve Board Chairman, 1996

The Canadian Housing Bubble: CREA to the Rescue

In response to a series of headlines suggesting that real estate is overpriced, visibly annoyed members of the Canadian Real Estate Association issued a statement today denying any possibility of a housing bubble, with scores of statistics and beautiful charts to support their claim.

In this article, The Frost Report reviews the CREA's rebuttal (and why they should be ashamed of themselves).

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CREA: “Canada’s solid mortgage market trends, conservative lending practices, and prudent borrowing by home buyers means that Canada will avoid a U.S.-style housing price correction.”

The Frost Report: Canada's conservative lending practices are a myth. In the heat of 2006 Canadian banks were, just like their American counterparts, doing loans without even confirming the borrower’s income. As long as the client’s credit bureau reported the name of the company they claimed to work for, this was considered enough evidence. In addition, although the Canadian Mortgage and Housing Corporation has strict guidelines regarding credit scores and income levels required for approval, a CMHC representative recently told me that they had been making exceptions to the rules "left right and center."
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CREA: The “vast majority” of Canadians have mortgages they can afford.

The Frost Report: Canadians can afford them today because of record low interest rates, which is exactly what caused the bubble to re-expand. For several months now the Bank of Canada has been warning consumers that interest rates will be increasing, and expressing concern about their personal debt levels. From June until Nov 2009, many if not most new mortgages were variable rate; this worried the Bank of Canada as well as the Big 5 banks. As a result, laws were passed stating that all buyers must qualify for a fixed rate even if they intend to take a lower (for the moment) variable rate mortgage.
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CREA: “Over the past 12 months, most new mortgages (64 per cent) have amortization periods of 25 years or less. This is an increase compared to 54 per cent one year ago.”

The Frost Report: The insinuation here is that since people are choosing 25-year mortgages (with higher payments) instead of longer-amortization mortgages, they must have money to spare. In fact, the opposite is true. In the past year home prices have become so high that the majority of home purchases have been from existing homeowners - either selling and repurchasing, or doing equity take-outs to purchase second properties. First time homebuyers are seldom able to afford 25-year amortizations. The decline in longer mortgages means that first time homebuyers are abandoning the market.
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CREA: Twenty five per cent of mortgage holders recently increased their home equity via lump sum payments against the principal and/or by increasing their mortgage payments above their scheduled payment.

The Frost Report: It is not these homeowners, but the 75% of homeowners that do not or cannot make extra payments that is concerning. The CREA's comment ignores that fact that if even a small percentage of homeowners fall behind on their payments it will bring down the entire market. In the United States in Q3 2007, subprime adjustable rate mortgages made up only 6.8% of the market, yet accounted for 43% of foreclosures.
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CREA: Most mortgage holders (77 per cent) have a home equity position of at least 25 per cent.

The Frost Report: This is because until 2006, 25% was the minimum requirement to purchase a home in Canada. At that point, the minimum down payment was changed to 0% in order to boost the housing market. Presumably because of the risks, CHMC pulled the plug on zero down payment mortgages in 2008. The minimum is now 5%.
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CREA: Housing prices will not drop. Instead, personal incomes will rise to match home prices.

The Frost Report: I feel vomit in my mouth right now.
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It's hard to imagine a more biased source of information about real estate than an organization whose purpose is to represent “more than 96,000 real estate Brokers/agents and salespeople working through more than 100 real estate Boards and Associations.” Still, the CREA could do the morally upright thing and at least present the potential downside risks. Due to the CREA's press release, hundreds of dreamy-eyed homebuyers will once again enter the market, oblivious of the dangers.

For more examples of CREA spin-doctoring, see Spin City.

For the full text of the CREA statement from which this article was based, see: Relax: It's Just Another Housing Market Cycle.

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“There is no evidence of a housing ‘bubble’ in the United States and housing demand should stay strong for years to come.”

James F. Smith, Society of Industrial and Office Realtors, 2005
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