Sunday, November 20, 2005


Magic 8 Ball Says: Future Cloudy. Ask Again

I happen to have access to a copy of the latest JP Morgan Private Bank letter, Portfolio, which is sort of the gold standard of full service portfolio investment. Since it comes out quarterly, it's for long term investment rather than day trading. Their economic forecasting is pretty good, but the impartiality of the writing seems to have deteriorated with the Chase merger and especially with the merger with BankOne, making it far more difficult to read. The present issue is a blend of wildly rosy brokerspeak overlaid on a far more sober economic analysis. The item by Cembalest, Caffrey, Harris, Madigan Jr., Schweitzer, and Werley is titled Investment outlook: pressure points all around The thesis of the article is that inflation, driven by energy prices, is the major problem. But read more deeply within, and one learns that everywhere else in the world has seen excellent growth. The US borrowed somewhere upwards of $300B in order to increase GDP by about the same amount. (Think about that) Europe is sluggish, but it's also not juicing its economy with deficit spending. Japan had its best growth since '97. Asia is running at 6.6%. And this shows up in markets, which are not fooled by deficits and other means to mask economic decline. In dollars, the S&P 500 is up 2.8% year to date, while Europe is up 7.8%, Japan 12.3%, Asian developing countries 17.2%, and Latin America 45.3%. Take that Hugo Chavez! Morgan thinks that investors aren't worried enough about "risky asset classes." They mention developing countries, junk bonds, and small companies, but I immediately thought of Halliburton. They think that the central banks will remember the 1970s, jack up interest rates, and that this will cause "a material slowdown in growth." They recommend "buffered equity structures." It took me a few pings on Google and a consultation with a Ouija board to figure out what that meant, but basically they seem to be reminding people that dividends might fall if growth does. Preferred stocks, undervalued stocks, and ::gulp:: futures might be means to buffer a typical small investor's equity structure. I use Turtle Wax. The strange thing is the contradiction in their advice about getting out of risky equity classes and into "structured equity." "Structured equity," which is crucial to understanding their recommendations is fundamentally an obscure term. Business Week gives a basic definition as providing a floor for losses through derivatives. Interestingly, in May of this year, Business Week said Investors smell trouble ahead. Since January, outflows from junk-bond funds have totaled $6.9 billion, while low-grade companies are struggling to borrow money. The shift in sentiment is enough to depress bond prices -- with the added leverage of derivatives intensifying any move. Says Mark H. Adelson, structured finance research director at Nomura Securities International Inc. (NMR ): "These products magnify exposure to adverse changes. When things deteriorate and defaults go up, the consequences can be even worse....Some analysts fear credit risk is, in fact, concentrated among the five largest U.S. banks. They not only issue new derivatives contracts and trade them but also are the ultimate insurers backing them...When asked about the most likely source of the next corporate crisis, one high-ranking European regulator replied: "Derivatives." I think JPM is one of the five largest banks. After pioneering their merger, JP Morgan split derivatives out from equities about 18 months ago . Portfolio has a great graph on oil. One of the toughest jobs in long-term financial analysis is figuring out what rises in price represent. For example, if the US borrows money, one possible outcome is a fall in the dollar. Prices of foreign goods would rise. But a decline in supply could also cause a rise in price. In figuring out where to invest, one wants to know how heavy a burden oil prices place on the world economy. A major cause of the crash of the 1980s was that oil costs jumped from 1% of world GDP to 4% in 1974 and then to over 6.5 in ca. 1980. To put it in familiar terms, that's as if you have an income fixed at $40K and pay $400 in gas one year, $1600 the next, and $2400 a few years later. After cutting back everywhere you can, you're probably going to be asking your boss for a raise. From the late 1980s until the the Reign of the Boy King, oil prices were at 1-2% of world GDP. They're headed for 5%. So far, wages haven't followed. If the price hikes are sustained, recessions and inflation will probably follow. Or we could start walking more and borrowing less. Morgan says that foreign stocks have risen more tha US stocks because Japan and Europe have finally gotten tough on workers, increasing profit margins. But they show a graph in which the relative profit growth of US vs. European companies flipped in 1 Q 2003 (when Euro stocks showed negative profit growth) to the present, where Euro profit growth is ca. double that of US profit growth. Does 1Q 2003 ring a bell? I thought it might. And that means that Morgan is full of... well, whatever a non-physical body possessing the rights of a citizen can be said to be full of. The profit growth flip is more plausibly due to the trashing of Brand America that a certain alcoholic National Guard deserter has been engaged in, the fact that interest rates have been tightened in response to Republican fiscal profligacy, and other consequences of invading a country whose name begins with the same letter as Inflation. Morgan's prescription to avoiding a crash of the housing bubble is raising interest rates. Of course, that means that the cost of housing (and cars) goes up, growth and jobs go down, and the risk of recession goes up. Recessions are bad for economic growth, very good for people who are positioned to take advantage of a recession. People with cash and people with puts. Bottom line is this. Morgan says market gains will continue to be "single digit" for the foreseaable future. That sounds like they won't be on average much above inflation, which means that the only advantage of stocks over cash is dividends. They advise drastically reducing exposure to US equities, especially mid- and smallcaps, dump "core fixed income" products (10 year notes?), stay about even on foreign equities, dive into "structured equity," and move as much as 5% into cash. The "structured equity" advices sounds as if they are suggesting that their customers to buy derivatives. They are positioning for very high turbulence and "buying opportunities." Americans should be positioning for joblessness and stagflation. Republicans have lost control of the country. Eventually it will sink in that they must be removed for the sake even of the wealthy. But even DLC Dems have lost so much credibility that there will be political instability. Until higher growth/lower waste policies can be implemented, there will be a struggle between inflation and interest rates. Just saying. _______ Postcript: Another reason to think twice about investing in small companies. They can essentially secretly sell large numbers of shares at discounts of up to 50% in what are called PIPES to hedge funds. The hedge funds hedge risk against the stock falling by, um, well, selling it. So, in a marvel of non-transparency, small investors learn that their holdings have been diluted by watching the stock drop. Getting your money into PIPEs isn't easy. First, you must have a net worth of at least $1 million or an annual income above $200,000 -- what it takes to buy into any hedge fund. (Fees are similar to those of most hedge funds: 1% to 2% annual management fee, plus 20% of the profits.) Even then, PIPE funds are a small and not well-known subset of the hedge fund world. "Often you have to know somebody who knows somebody to get into one of these funds," says Brian Overstreet, CEO of Sagient Research Systems, a firm that tracks PIPE deals. Until transparency is restored to its former merely foggy level, small investors should be doubly cautious about small companies. And, no, none of this is investment advice. The entirety of my investment advice is: "It's your money. Do whatever the h---l you want with it, within the bounds of the law, propriety, and common sense."
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