June 2003 Newsletter
Issue Six, Volume Four

MIXED SIGNALS

By Mike Gasior

The month that just passed offered a wealth of serious news stories that deserve closer examination in this newsletter and I have aggressive plans for doing precisely that. What was most striking to me as I took the time to review the topics I wanted to write about was the diverse nature of some of the news and how utterly contrary some of the stories were from each other. You will get my best effort with regard to pointing out these contradictions and you'll need to hold onto your hat since I might be doing some serious lane changing at what might be high rates of speed.

I'M SHORT

Although I actually stand a robust six feet, one inch tall, I refer to the fact that I am now officially short this stock market.

Before reading any further, PLEASE be reminded that I never intend to give investment advice of any kind to any one in this monthly newsletter and if anything I write causes you to take action with your own money PLEASE lose my email address and my phone number. With that said, I will continue.

My feelings about the current state of the economy and markets are pretty well known and extraordinarily clear; however this recent stock market rally made me unable to sit on the sidelines any longer. I needed to do some research to find that I had not occupied a position on either side of the U.S. stock market in something in excess of five years. I had been occupying those years accumulating rather large positions in Treasury and Agency fixed income securities yielding between 7% and 8.75% in my pension account and municipal closed-end funds in my taxable accounts. Obviously those looked like pretty miserable alternatives to the 20%+ that the stock market offered for a couple of those five years, but I am living in a world of redemption at this moment.

The run up in stock prices the past few weeks in the face of so much bad news (although it is said that "the market climbs a wall of worry") I could no longer resist the call of easy money and I am officially positioned on the short side of this market.

On the afternoon of June 16th, I purchased put options on the NASDAQ using options that are available on the NASDAQ 100 Trust product that trades on the American Stock Exchange under the symbol QQQ. To be specific I purchased the December 29.00 puts at $1.80, or $180 per contract. In truth, this is a little more time than I am usually comfortable paying for, but my other alternative was the September expiration and I felt that might be cutting things too closely.

So there you have it. Obviously I will let you know how I do, and you now have the ability to watch for yourself also. Remember that I warned you not to try this yourself and should you lose a penny I don't want to hear about it. Now on with the remainder of the newsletter.

GREENSPAN AND THE ECONOMY

I was pleased to see the Federal Reserve reduce rates by 25 basis points instead of the 50 basis points that it seemed the markets were beginning to anticipate, but my honest preference would have been no decrease at all. The Fed is keenly aware of the deflationary pressures all around the globe and has been for several years and I am frankly surprised they decided to expend even one 25 basis point bullet when their clip is so dangerously low on ammunition. They most certainly have learned the lessons of the Japanese Central Bank who spent literally ALL their bullets only to watch the Japanese consumer crawl into a deeper and deeper spending cave.

Had the Fed dropped rates the more dramatic 50 basis points (which would have been a 40% drop in aggregate) without any discernable improvement in the economy I think American consumers would have finally gotten the message loud and clear that things are much worse than they think. The public is smart enough to know that interest rates are at their lowest point in almost 45 years, yet this is seemingly not having an effect on the economy or spending habits. As more people become fearful they will undoubtedly follow the Japanese consumers into the cave seeking safety until economic conditions improve. Then the acceleration into deflation will begin more robustly and I made my feelings crystal clear last month that this has now reached the point of being unavoidable. The U.S. economy is a big boat, and it doesn't turn, stop or accelerate very fast. I will watch with fascination how Captain Greenspan navigates the most treacherous economic waters in over 75 years.

Since last month's edition, the evidence of Germany's march toward deflation is beginning to pile up. I also read a report by Standard & Poors that the Chinese government may be forced to inject $500 million into government run banks to prevent their collapse due to bad loans. Today's news told the story that Great Britain's economy grew at the lowest rate in a decade during May. This is not good news and there seems to be a rash of troubling stories just like this in the newspaper every day.

To illustrate the issue of "mixed messages"; consider an economic report released by my friends at the Bond Market Association just last week. An advisory panel of 29 leading economists who work for some of the world's most prestigious brokers, banks and institutions predict the economy will almost double it's growth rate for the remainder of 2003 and all of 2004 from the current 1.9% to something like 3.5% and 3.6%. A survey of 67 economists by the newspaper USA Today predicts an even rosier 3.8% growth rate by the fourth quarter of this year.

These economists are clearly all brilliant people, but you have to ask yourself what could they possibly be thinking. Obviously I do not have all the facts regarding whether or not the Bond Market Association or USA Today offered any sort of open bar while this surveys were conducted, but this would go a long way toward explaining the results of the survey to me.

Consider these news stories that appeared during the same week that the surveys were released:

--Mortgage foreclosures reached the highest level since this statistic has been kept. As of last week, 1.2 out of every 100 mortgages in the United States is in foreclosure. Meeting monthly mortgage payments has clearly become impossible for an increasing number of Americans.

--In a separate story with a different source for the statistic, U.S. homeowner's equity in their homes is now at the lowest level since this statistic has been kept starting in 1970. This simply illustrates that homeowners borrowing against the value of their homes has placed them in an extremely precarious position should housing prices decline.

--General Motors issued the largest offering of debt ever for a U.S. company of $13 billion passing the previous record set by WorldCom of $11.8 billion. Unfortunately GM will not be using this money for the construction of new production facilities or the design of fabulous new products. They will instead use the money to shore up their badly underfunded pension fund and this is expected to be a trend followed by other corporations and also some horribly underfunded public pension plans. A recent survey shows that the companies that make up the S&P 500 have a combined underfunding problem in the neighborhood of $226 billion.

--New York Stock Exchange member firms reported that margin debt increased to the highest level in a year, although not reaching all-time record levels. This lends to the argument that the recent run up in stock prices may have been fueled, at least in part, by speculative trading.

There were more stories, but I'm trying to keep this edition under 100 pages and I think you see my point.

Although you can easily tell that I do not agree with the esteemed group of economists who were surveyed in the two studies mentioned, I need to emphasize how robustly I disagree. Even with an untrained eye, a reasonable person would look at graphics illustrating recently past economic statistics next door to the forecasts by this group and wonder what sort of detachment from reality was being suffered. How in the heck does the world's largest economy go from 1.9% growth to 3.8% growth in six months? How could that make any sense even to a total idiot?

You can get a sense that a lot of wishful thinking is involved by studying the "risks" that could affect the Bond Market Association's forecast. The study mentions the possibility of any of the following events that could cause their predictions to prove wrong:

--A terrorist attack
--An expansion of the SARS epidemic
--Increased tensions in the Middle East
--A new "significant" corporate scandal
--That businesses might be slow to increase investment or hiring
--Reduced growth in consumer spending
--Further deterioration of global economic conditions

I try to apply as much common sense as humanly possible to even the most complex financial and economic situations and any thought of the U.S. going from 1.9% growth to 3.8% growth in the near term is ludicrous and borderline asinine. It would be no different from me bench pressing 200 pounds this week but telling you I am going to start bench pressing 400 pounds next week. If I ever said such a thing to you, you would think I'm either a fool or a liar...or both.

THE FREDDIE MAC STORY

This story is a big deal and I would truthfully like to know more of the facts before I write about this subject at length, but some things need to be addressed immediately.

If you have been under a rock for the past few weeks, Freddie Mac announced it was firing or forcing into retirement three of their top executives and that they would be restating their financials something in the order of $4.5 billion.

For the purpose of full disclosure, Fannie Mae has been a client of mine in the past and Freddie Mac has sent staff to my seminars as well. With that said, there is no way anyone could view the current reports about Freddie Mac as anything less than very troubling. Unfortunately accounting scandals are nothing new and in some regards this story smacks of "been there, done that", but there are deeper concerns.

First and foremost is that Freddie Mac operates as a GSE, or Government Sponsored Enterprise and has the ability to borrow directly from the U.S. Treasury. It is also supposed to operate under stringent government oversight, which is the part of the story that intrigues me.

So here is a quick punch-list of the issues that struck me as I studied this current scandal:

--There seems to be decent evidence that previous management engaged in "earnings smoothing" and significant wrongdoing likely occurred regarding accounting policies. The truth of the matter is that the moment that Freddie Mac's board of directors were made aware of these accounting issues by their new auditor, the board moved with tremendous speed to announce what had occurred and to dismiss the offending members of management. Please remind me of the dates that Ken Lay was dismissed from Enron or Bernie Ebbers from WorldCom.

--Too much is being made of the scope of their derivatives portfolio and I have read WAY too many articles and editorials where Freddie Mac is mentioned in the same sentence as Long Term Capital Management or is compared to a hedge fund. I honestly wish journalists would please call me before writing such nonsense. Although I was somewhat surprised at the size of the portfolio, it was a long way from shocking for an institution the size of Freddie Mac, especially one engaged in the markets they are in. Many of you who have taken classes with me have discussed the new accounting standard introduced for derivatives, FAS 133, and how the new standard would effect financial reporting. It seems completely clear to me that Freddie Mac may have called certain transactions "effective hedges" in order to postpone gains or losses to later periods. If the derivative transaction was not truthfully an "effective hedge" then a financial institution is supposed to record the derivative gain or loss in the current reporting period which is what I believe will cause Freddie Mac to INCREASE their earnings for previous periods by up to $4.5 billion. This is where I think the public is particularly confused, because contrary to Enron or WorldCom, these accounting revelations are actually going to show that Freddie Mac UNDERSTATED their earnings.

--There is also much hand wringing about how little the government actually manages to regulate both Freddie Mac and Fannie Mae. The government agency that provides oversight is named the Office of Federal Housing Enterprise Oversight. With a total staff of 146 people and a budget of $32 million, you can imagine they probably have their work cut out for them. Please remember these facts if you hear any members of Congress or the Senate ask where the oversight was to prevent all this. I can't stand Monday morning quarterbacks and generally don't like politicians much either. If the government thinks there should have been more oversight or regulation of Freddie Mac, they should simply take an immediate recess from their hearings and head into the restrooms to look in the mirror. Sure, there were plenty of bad decisions made by the Freddie Mac management team, but the government had better be careful not to become too zealous in their pursuit or they may find their own behavior difficult to explain.

Let me sum up this story for you quick and easy:

--Senior executives at Freddie Mac chose to distort company earnings.

--The board of directors fired these executives immediately when the facts were brought to their attention and then admitted to the situation.

--Freddie Mac will now restate their earnings.

--The derivative portfolio is of no concern and is not unusual.

--Freddie Mac is extremely solvent and in pretty decent financial shape for the foreseeable future.

--This is no Enron or WorldCom and people need to stop being hysterical.

--The government should adequately fund regulators if they are concerned about oversight.

--Fannie Mae and Freddie Mac have been overall a massive blessing for U.S. homebuyers during the past 20 years and have made taking out mortgages the simple process it is today.

--End of story.

THE MARTHA STEWART NON-STORY

Frankly I'm totally sick of this story because there is no story. A lot of you were amused last September when I wrote:

"Well I freely admit that no one would like to see Martha in an orange jumpsuit picking up trash along I-95 more than I would, but I really didn't think much would come of this whole ImClone thing."

I have not changed my mind one bit with regard to my wishes of seeing Ms. Stewart on the side of the highway with a Hefty bag since I honestly cannot stand the woman. This dislike is not born out of my distaste of things domestic or people who make their own gift-wrap paper. I was traveling back from Juneau, Alaska a few years back when my flight from Seattle was cancelled and Martha and I ended up sitting across from one another in the first class cabin of a TWA flight from Seattle to St. Louis. I will spare you the awful details, but I will suffice by saying that this was the flight when I learned why I couldn't bring guns on airplanes.

I'm just simply unimpressed that prosecutors seem to have allocated such resources to a case that involves a total of $45,000 of illicit profits and so few really serious violations of the law. The charges brought against Ms. Stewart seem trivial and a couple of them even sounded like they were made up. One of the counts of the indictment tries to make a case for the idea that by denying her guilt when the allegations were first raised was actually an attempt to manipulate the price of her own company's stock. I have never heard of such craziness in a society where one is presumed innocent until PROVEN guilty. I suppose prosecutors will try to use her innocent plea in Federal court as further evidence of her guilt.

If you want to impress me, bring some charges against Bernie Ebbers or Ken Lay where investors were defrauded of billions and billions of dollars due to their activities and leave the chump change artists like Martha to the JV team.

Maybe next month I'll write a little about Frank Quottrone who is the latest target of overzealous prosecution.

GOODBYE TO A CLASS ACT

I was sad to hear about the passing of one the finest actresses who has ever lived, and more importantly, a wonderfully classy human being, Katherine Hepburn.

Old Saybrook, Connecticut is only a short way from where I grew up and my family would spend every summer on the Connecticut shoreline where I would spend my days riding bikes and playing golf right next door to Katherine Hepburn's home of many years in Fenwick. I would see her often riding her own bike and walking and she always have a smile and kind word for all us kids hanging around and I thought she was an extremely nice lady. Back then I don't think I'd ever seen one of her movies, although I knew she was somehow connected to show business.

She lived her life privately, and on her own terms, which is all any of us can wish for ourselves. I worry that we won't be blessed with another Katherine Hepburn for a very long time and I will miss that.

THE JUNE BRAINTEASER

I have taken an awful lot of crap lately about the brainteasers being way too simple with allegations of me going soft on my readers. I hope this month's brainteaser puts an end to some of the complaining, although this problem is certainly not of Olympic caliber. I reserve the right to trot out an extremely difficult one next month if the complaining is still viewed as too easy.

"In a class of fewer than 30 students, two received a B on a math exam, 1/7 of the class received a C, 1/2 received a D, and 1/4 of the class failed the exam. How many students received an A?"

Don't be a weenie and go and immediately look at the answer, but if you want to check how you did with your answer, just go to the following URL:

http://www.afs-seminars.com/brainteaser_June2003.html

http://www.afs-seminars.com

Copyright 2003, Michael Gasior. All Rights Reserved.

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