Tom: got this PM from Russett this AM...he couldn't remember what thread you and I were debating mortgages on. He wanted to contribute this Fleck Piece. I'm passing it on sans comment, except for saying: THANKS, RUSSETT
OPEN QUOTE:
I can't remember what thread I wanted to send this too,...where you were having a
debate about mortgage loans. I figure the best thing is to just PM you and you can
decide, as it argues in favor of many of your points, and this guy is loved by many
goldbugs and silverbugs so he is hard for them to argue with.
moneycentral.msn.com
Contrarian Chronicles
Contrarians in the trenches speak out
One noted insider takes a look at historical stock returns and finds Dow 5,000
reasonable, and we hear from two readers whose bubble has already popped.
By Bill Fleckenstein
Misconception is a weed that feasts on denial and chokes off fact. Wall Street is its
natural habitat. To tackle some much-needed pruning, we’ve deputized a couple of
helpers here at the Contrarian Chronicles. One wields fact to uproot the
misconception that stocks always deliver superior returns over the long term. Another
exposes the myth about benign bubble aftermaths through his grass-roots look at
unemployment in the software industry. And at the risk of straining our garden
metaphor, we’ll also have some thoughts on misconceptions about the hedge-fund
community.
Safiring blanks
Let's begin by spending a minute on an article by William Safire titled "Beware the
Hedgehogs." Normally, he is someone I agree with, but his recent piece in The New
York Times is way off -base. In it, he attempts to blame the market's problems on
volatility, for which he points the finger at hedge funds. His implied reason for all of
that is lack of disclosure and excess leverage on the part of hedge funds.
Of course, the real culprit is overvaluation, not volatility. While the proliferation of
hedge funds has definitely added to volatility (especially the euphemistically titled
"long/short" or "market-neutral" funds, which have really exploded, and which I believe
tend to be even more leveraged), Mister Market will, over time, take care of all the
hedge-fund operators who shouldn't be in the business. I don't particularly think that
more regulation would hurt anything, but it certainly won't solve the problem, because
as I stated, the problem is overvaluation. Regular readers all know what the
overvaluation was caused by. (See, I'm going to stick to my promise from last week
not to mention a certain Fed chairman.)
As I have pointed out frequently in the past, stocks can be down from some much
higher price and still remain far too expensive. From time to time, I've stated publicly
that I believe the market could easily drop 30% or 40% before this is all through. Bill
Gross, the famous bond manager, wrote a paper about stocks that I completely agree
with. Here, I'd like to share a couple of his succinctly worded thoughts with readers:
A look under the hoodwink
"Stocks stink and will continue to do so until they're priced appropriately, probably
somewhere around Dow 5,000, S&P 650, or Nasdaq God knows where. Now I guess
I'm on somewhat of a rant here, but come on people, get a hold of yourselves.
Earnings have been phonied up for years, and the market still sells at high multiples of
phony earnings. Dividends and dividend increases have been miserly, to say the
least, for several decades now, and you've been hoodwinked into believing the
corporation should hold on to them for you so that they can convert them into capital
gains and save you taxes."
He continues: "Companies have been diluting your equity via stock options, claiming
that management needs incentives of millions of dollars, just to get up in the morning
and come in to work. Then they pick you off by trading on insider information, selling
shares before the bad news hits and you have a chance to get out. If you try to get a
hot IPO, you find all the shares are taken -- by Bernie Ebbers. Come on, stockholders
of America, are you naive, stupid, masochistic, or better yet, in this for the 'long run?'"
He concludes: "Ah, that's it. You own stocks for the 'long run.' We bond managers may
have had a few good relative years, but who can deny Stocks for the Long Run? Not
Jeremy Siegel, not Peter Lynch, maybe not even Bill Gross if you stretch the time
period long enough -- 20, 30, 40 years. But short of that, stocks can be, and often
have been poor investments. The return on them depends significantly on their
beginning valuation, and right now, valuation remains poor. Dow 5,000 is more
reasonable."
I believe that sums it up. The gist of his argument, which is supported by facts, not
opinions, is that the superior, historical long-term rate of return from equities stems
from dividend yield and the low valuation that these studies tend to begin from. By
extension, then, given our paltry rate of return and high valuation, it is almost
impossible that people's expectations for future returns can be met. These arguments
are not new, but he puts them in a way that people may understand at this moment in
time, when I believe they are receptive to comprehending the math behind rates of
return. So I encourage you all to go there and read every word of what he has to say,
and to read his article more than once so that you completely understand it. It will be
an invaluable tool for battling the stock market in future years.
The limits of 1.6 gallons per flush
Turning to its top cop, let's tarry a minute at the portals of the SEC for some thoughts
on Harvey Pitt. Specifically, while catching up on my reading material recently, I
noticed a surprising little story about him in Forbes. Here is a direct quote from the
writer's account of Pitt's speech at a seminar for in-house corporate counsels in
October 2000: "Included in his advice: Chief financial officers whose e-mails detail
too-cozy conversations with analysts about earnings estimates should 'destroy the
incriminating messages because somebody is going to find this, and it will probably
be the SEC when they investigate.' But, he added, destruction should stop 'when you
hear about an inquiry ramping up.' Mere role playing, Pitt now says."
Well, I don't know about you, but it doesn't appear to me that this is precisely the
advice for a current SEC chairman to have been dispensing prior to assuming his
duties as Wall Street's top cop. Maybe I'm wrong, but I would have expected him to
say, don't do this, rather than, do it and then destroy the evidence. Then again,
perhaps I'm just a hopeless optimist.
Segueing to the compelling-reasons-analysts-are-optimistic department, I'd like to
highlight an important nugget from a recent story in The Wall Street Journal titled
"CSFB Analysts Felt Pressured on Stock Reports." What the piece has done is to
depict a pretty clear indictment of the investment-banking community at Credit Suisse
Group (CSR, news, msgs) leaning on analysts to produce cheery reports. Not that
many of them probably needed much inducement, mind you, but the story
nevertheless runs counter to what the firms have been saying all along.
CSFB will probably face renewed risk, despite the early resolution of an IPO
investigation brought against it by the SEC. At the time, I didn't understand why the
SEC was so quick to settle, rather than probe further into this and other matters. Now,
its thoroughness looks somewhat questionable, with more dirty laundry apparently
coming to light.
In fact, according to the story, all the investment banks are currently the subject of
inquiries, with individual state attorneys general assigned to handle each
investigation. For example, Massachusetts is looking into CSFB, whereas New York
is examining Merrill Lynch (MER, news, msgs). So, I think people who own financial
stocks that have brokerage arms might want to be aware of a problem that doesn't
appear to be going away, and will probably get worse before it gets better.
Wreck rooms carpeted in 'Mania Mauve'
On that score, we could also be talking about the problem of overleveraged
homeowners, which is what The Wall Street Journal did recently in a story titled
"Foreclosures Hit Record Levels." This fine piece illuminated many of the risky
lending practices that have helped to increase housing demand and housing prices. I
note a lot of debate on the issue of housing vs. stocks, and why a bubble in the
housing market does not exist because it doesn't resemble the recent bubble in the
equity market. The people who say that the housing market can't be seeing a bubble
argue that it's more heterogeneous, whereas the equity market is more
homogeneous, in terms of money flowing back between different securities. (This is
one of the arguments promoted by the man whose name, to repeat, we don't mention
anymore.)
It is true that real estate is more of a regional market, but it can still turn into a bubble. I
recall what the real estate market of the late 1970s looked like. It was a bubble -- just
not as big as our most recent equity bubble. I think that's one of the things that
confuses people. Our equity bubble was so large that nothing looks like a bubble, by
comparison.
But the Journal story gives some statistics that certainly describe reckless behavior in
progress. The second quarter saw a record 1.23% of all home loans in the
foreclosure process. (The previous record was set in the first quarter of 1999.) In
addition, 4.77% of all home loans outstanding were at least 30 days past due -- one
of the highest rates in the last 10 years, though not as high as the 6.07% recorded in
1985. The article also cites a quadrupling of phone calls to Auriton Solutions, a
nonprofit credit-counseling agency in St. Paul, Minn.
Semidetached housing
So, cracks are appearing in the dike. That doesn't necessarily mean there's going to
be a problem in the housing market tomorrow. The timing of when bubbles burst is
always elusive; witness our stock mania. Also, given the aforementioned fact about
housing markets not being homogeneous, the bubble is more pronounced in some
areas than others, and at different price points. Here in Seattle where I live, things are
rather muted in certain areas of the market because of the fallout from the stock
bubble, but in other places, that is not the case. In any event, it's important to
understand that we do have a bubble occurring in the housing market.
Further, it's worth emphasizing that housing prices require some income stream to
support the prices that people pay, and therefore, housing prices cannot be
completely detached from current average income levels. The latter may receive a
boost from stock options, or from equity that people have built up in other areas,
enabling them to reduce their monthly payments. Nevertheless, what strength we are
seeing is a remnant from the stock bubble being directed toward inflating a housing
bubble. If one pictures a pig working its way through a python, that's kind of what's
happening.
But I don't expect those benefits will necessarily remain available to the housing
market going forward. At the end of the day, you cannot have housing prices that are
totally out of whack with what underlying income levels generate – which appears to
be the case today. To me, it seems impossible that the housing market is not going to
have some sort of a large setback. When, I don't know, but I feel fairly certain it is
going to happen.
Pen and ink on things that stink
Segueing to life on the dark side of the bubble, I'd like to reprise two thoughtful
e-mails from readers of my daily column on RealMoney.com, both concerning the
software business. The first one details how jobs have left the country, a trend that has
reduced the income of those workers fortunate enough to still have their jobs. The
second shows a heartbreaking example of how the misallocation of capital has hit
home, and poignantly expresses regret that the mania was not stopped much earlier. I
suspect that lots of people will come to this conclusion over time, once they realize the
true culprit behind our troubles.
Our first reader writes: "In particular, the downsizing of the U.S. software sector is
occurring at a tremendous, yet remarkably under-reported rate. One company, Quark,
finished the transfer of engineering operations from Denver to India this summer. A
story in The Denver Post describes how the company completed the first half of this
move and 'promised' that rumors of a complete transfer were exaggerated. A friend
who worked at Quark this summer reported that in fact, the rumors were the truth. The
transfer of engineering operations to India was completed in August. He and his
remaining colleagues were given two weeks' notice."
The reader continues: "The software company I used to work for has closed two
U.S.-based offices and fired over 20% of its workforce (over 300 people) in 2002.
When the company closed the first office I worked at, which employed over 50
employees, we asked if there was going to be a press release. The company
executives responded no. The office closure was not material. Since that nonmaterial
event, the company's stock has dropped (dramatically). Some of my friends have
found other software jobs. Others have completely left the industry. Collectively and
individually, we are all earning less than we did during the boom years."
Living with austerity, praying for prosperity
And now for the second reader e-mail: "I am from San Jose Silicon Valley and in
U.S.A. for five years only -- typical modern-day version of ‘49ers. Only instead of
shovel, I am with software skills. Immigration has been great so far, but it would be
hard to deny that it would have also caused labor displacement. Now that I am at the
receiving end, I know it does affect. Both myself and my wife have been working till
this spring. Life had been good. She is not working anymore, and I have turned into
underemployment. My boss can only pay half, and we are not sure how the company
will do in the next month. So we are in the job market. I want to mention that figure of
5.7% unemployment clearly masks the hardship in getting jobs. I am looking at any
nontechnical jobs (at one-fourth my regular salary), and still they are not coming. I am
with one graduate and two postgraduate degrees. We all are engineers over here!
But still job market is tough beyond comprehension."
He continues: "So, two things in this regard. Personally, we would have definitely been
better off if the 'brakes' were applied to the boom, because in the boom time, we
bought the house in Silicon Valley, and now it is the giant liability, with no secure
means of serving it. Besides, if you sell now, it will not bring us back our equity. I think
that a lot more people like us would have been better off if the boom was controlled.
Probably, nobody would have lost."
He concludes: "The second thing is, with this enormous stress in life and clear 'failure'
scenario in front, to remain cheerful is tough. So, we only see darkness in front of us. I
need to get extra strength to read all the reality-check articles. But I would say that
because of these articles, some day it will help us to face the situation clearly and
objectively. My prayers are for everyone so that it is less stressful to others. In short,
too much of damage is done -- probably more than what prosperity was brought by
the boom. Employment is horrible, and unless that improves, people will continue to
have suffering."
As a postscript, I would only add that though things are difficult for both these
gentlemen, hopefully, their insights will be helpful to others.
Materially significant scribe
Speaking of helpful insights, I encourage you to check out Carolyn Baum in the
columnists section of Bloomberg.com. I read her stuff all the time on my Bloomberg
(recently, she penned a terrific article on the unmentionable Fed head's speech), and
I'm embarrassed to admit that until this past week, I didn't know her material was
available to anyone who goes to the Web site.
William Fleckenstein is the president of Fleckenstein Capital, which manages a
hedge fund based in Seattle. He also writes a daily Market Rap column for
TheStreet.com's RealMoney. At time of publication, William Fleckenstein owned none
of the equities mentioned in this column. Positions can change at any time. Under no
circumstances does the information in this column represent a recommendation to
buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's
columns are his own and not necessarily those of CNBC on MSN Money.
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