Did someone hear the Euro Drop?

A few months ago, all you heard about was how weak the dollar was and how Government borrowing was causing all Americans to lose wealth. Now it's the Euro's turn as they have weakness in many of the poorer nations. So while the US Economy slowly recovers and the Asian story remains unchanged, the fear that the Europeans will derail the whole thing has given us a correction.

The real question you have to consider is whether the recovery is going to be derailed. Ultimately, the value of a company is based on its profitability. Now past profitability has little relevance, so what you consider is the ability of a company to continue to be profitable and hopefully that it will increase its profitability.

Currently, most American companies are profitable and while many are still cautious, they see profitability continuing as long as the recovery continues, even at a tepid rate. So take a company like AT&T which has solid earnings, is expected to have earnings increase and is trading at about 12 times earnings and also pays a significant dividend. You can get almost 7% holding that stock. Yet it has fallen from its high of over $28 to around $24. In fact with the drop in value, it is closer to 10 times earnings than 12. Is it expected that the cell phone market is about to dry up? Not by anyone I know. The only factor that seems somewhat negative for AT&T (as well as Verizon and others) is that consumers are not as willing to sign multi-year contracts in exchange for a big phone discount.

Now, this could impact the profitability somewhat, but remember the company already has a huge subscription base among consumer and corporate customers and it reported that the I Phone is making inroads with business users.

So, the how do you account for the drop in the stock price? I mean, while admittedly there should be a premium for taking common stock risk versus buying a treasury bond, T gives you almost double the 10 year rate, doesn't tie up your money and has essentially no negative indicators of any substance. In fact by my rather simple calculations, the company is simply undervalued by the market by 15%.

Oddly, this is approximately about the percentage decline in the Euro vs. the Dollar over the last few months. So let's think about what this might mean. Suppose you think in Euros. AT&T was selling at 20 Euros a share when it was at $28 and the exchange rate was at 1.4 dollars per euro. 20 Euros will only get you $24 at an exchange rate of 1.2. So if you simply think of T in Euro terms, the price hasn't changed much at all.

Risk is its own reward

It is always interesting how the perceptions of the world economy change so much faster than the world economy actually changes. Take the so called European debt crisis. Greece and the others have been borrowing to pay for the high level of benefits they gave their citizens to win elections. Certainly, anyone with a calculator could have figured out that they couldn't keep this up forever, unless of course some new source of wealth suddenly appeared like a Goddess of Gold stepping out of a clam shell.

The risk was there, but all of a sudden the perception of that risk became widespread. Now, there are reasons for this, not the least of which being that some people can make a lot of money as the perception of risk goes up. Now, there are some scenarios where the European Union would abandon its weak sisters and let them default, but these scenarios are really quite unlikely considering the impact such an action would have on their economy. Europeans are nothing if not pragmatic and while here in the United States, certain of our officials listened to political ideologues who said "Let a big bank fail" and then suffered the consequences, as did most of us, they will use the current crisis to get the population to accept the need for some austerity and reduction in social programs, improving the future bottom lines.

Now, it would be rather cynical, perhaps justifiably so, to say that we have a certain percentage of our population who value being rich above all else. These people have always existed and they are mentioned quite unfavorably in the bible. However, much like drug lords or people who made their money during prohibition, they feel that having a lot of money will ultimately justify their methods. For example, we know a few people got very rich as the subprime mortgage industry collapsed. There is actually nothing wrong with that, but what would be wrong would be manipulating things to make an event happen that could have been avoided. Certainly, as the subprime mess developed, some actions could have transpired to mitigate it. Of course the existence of the subprime mess is directly attributable to the same mentality of profit above all else.

Now, it certainly is not my intent to say that becoming rich is a bad thing. Bill Gates became very rich because he had the foresight to create a software company at the perfect time. Quite a few others also got rich that way. What is questionable is when you are placing bets while rigging the game. Goldman Sachs created instruments that were destined to fail, and it was likely they knew they would, at least partly fail. It is likely they didn't know that the subprime collapse would be as widespread as it became, because they probably didn't think the Government would let a company like Lehman fail starting the domino effect.

The Europeans are too pragmatic to follow that example.

Paying it back

Greece, Spain, Portugal, and quite a few other countries have been spending more than they have been taking in, especially since the recession started. To make up the difference they have to borrow, and all things being equal, you can’t borrow unless you are going to pay back the debt. Now, one of the phenomena’s of the modern world is the fact that many countries, including the United States, run a permanent deficit. This means that year after year, they have to borrow to make up the difference. Of course, as the debt grows the interest on the debt grows, thereby increasing the deficit even more.
Now, when you look at any enterprise that spends more than it takes in, you have to consider the reason. It is fairly acceptable to borrow a large amount now to pay for an unusual purchase that you will pay back over a future period, say a mortgage on a house. Of course, the loan is that case is secured and the risk to the lender is based on the underlying asset value. If, on the other hand you have to borrow every month just to buy groceries, you would need a dramatic shift in your fortunes to pay that back.
So what are these countries borrowing money for? Well unfortunately, much of the borrowing is going to fund current accounts, the day to day expenses of the government. Now, how are they going to pay it back? Well, the only way to pay it back is to run a surplus, not a deficit. Now, sometimes you can grow your way into a surplus, meaning that if the economy starts to boom, the tax revenues will start to increase, and if you don’t increase spending eventually the taxes collected will exceed the expenses. Now, when you set up programs that guarantee spending growth, you need more growth in your tax receipts.
Now, to some extent, certain countries are going through a particularly bad spell due to demographics. The number of baby boomers in the population is going to create demands on resources that are not sufficient to cover the demand. It might be reasonable, to run a deficit until this reverses itself, as long as the underlying math shows that it will reverse itself in the future.

Losing strategy

Is the market overvalued or undervalued? We have seen a reaction in May to issues that have existed all along, causing the stock market to go into a correction. Now, of course some argue that we were seeing a bear market rally and that this ”correction” is in fact a resumption of the bear market.
If you watch the markets and follow technical analysis, the simple fact is that when you see markets declining, you sell with the expectation of buying back your positions at a later date and at a lower price. The same basic technical analysis applies when the trend goes upward.
The issue for individual small investors is that most do not have either the time to watch the markets all day long, the money to be day traders or enough money to be in a hedge fund. So in times of high volatility, many people simple get disgusted at the unpredictability of the market. Take a profitable, dividend paying stock like ATT&T. Certainly nothing has changed very much in the last month or so. It is profitable and pays a nice secure dividend. Yet it has fallen with the rest of the market as external fears took control. Now, if you are holding it for the dividend and don’t intend to trade it, it really doesn’t matter since the dividend is in no real danger.
In fact, the rise and fall of many people’s investments is something they observe and worry about, but unless they are living off of them is more a mathematical exercise than a real concern. It has been shown that if you can buy when the market is down, you substantially increase your overall returns. Most small investors tend to do the opposite and that’s the pity.

currency

I had a discussion with some people about how to determine the strength of a currency, specifically the US Dollar. Now it is fairly well accepted by most economists that a certain level of inflation is not only to be expected but is also desirable. Now, any level of inflation means you can buy less with your dollar year after year. Does this mean the dollar is weak and getting weaker? The general scenario of the last few years would argue the other way, many things have gotten cheaper. Houses are a great example. Electronics seem to get cheaper all the time. Many other items have experienced price declines over the last few years, even if the retailer’s like to pretend they can sell for “list”.
So, if I can buy more house or better electronics for less money than two years ago, has the dollar increased in value? That seems to be the very definition of an increase in value. Yet the majority of us feel that the dollar is weak and getting weaker.
Some of this is based on the rhetoric we hear all the time. It is actually fairly easy intellectually to say what should happen to a currency. If you subtract the rate of inflation from the rate of productivity growth you will get either a negative or a positive number. A positive number would indicate that goods and services are getting cheaper a negative number would indicate the opposite. A positive number should imply that goods and services are getting cheaper.
Now the increases in productivity may have other consequences concerning employment but it clearly has good implications for the currency.

Ethnocentricity

It is probably impossible not to be ethno-centric. We all feel that the things we are used to and the way we were taught are the best. Now it is true that some switch cultures and generally that is such a significant event that the converts become more ethno-centric about their new culture than those who were raised in it.
Now, some customs from other cultures may seem barbaric or cruel to outsiders. For example, in cultures where circumcision is the norm, those who don’t practice it find it barbaric. Now, by the same token, some who quite willingly deform themselves with piercings or surgical enhancements to their own body decry practices they find barbaric.
It may seem to us that a particular culture oppresses a part of its society. For example, in India the caste system certainly seems punitive to the lowest castes and I believe the influence of western culture has alleviated many aspects of it. It originally provided a predefined role for people based on the inherited caste and eliminated certain levels of conflict.
When we look at certain cultures, we may feel that certain people are oppressed and by our standards they are. It is impossible to discuss all the ramifications of various cultures around the world, but it is also clearly not logical to assume that our culture is the only one that should count. In many societies women for example occupy a traditional role that in the view of many is oppressive. However, is it really our right to dictate how these societies behave?

Up and Down

We’ve seen some dramatic movements in stock prices over the last week as the worries about Europe seemed to overcome common sense. Greece was in a position that certainly wasn’t desirable, but since it is now part of the European Union and since a default by Greece would certainly be catastrophic for that union, it was not really a possibility.
Of course, even things that aren’t real possibilities can happen and after we saw the financial meltdown caused by the impossible collapse of housing it is easy to make people fearful. It also doesn’t matter if you know better if you see stock prices plummet. It was clear that the only logical option was to get out of positions before you lost too much.
There is of course a big advantage to being a big trader. When the European Union announced its plans to create a fund to cover the debts of the troubled countries, it was non-business hours in the US. Hedge funds and others are able to trade at all hours. The rest of us don’t generally have this privilege and by the time we could trade the price movements had mostly happened.
Imagine the people who got scared out of the Market on Friday, only to see the prices jump so much on Monday. They would have been unable to do anything except wonder about the unfairness of it all.

Accidents can happen

It doesn’t take much to scare investors when they are sitting on profits they don’t want to lose. We have had a significant run up in stock prices since the lows in March 2009 and given any opportunity, traders will cash in. This is normal behavior and when enough traders get jittery, the market has a correction. Of course after it falls a certain amount, they buy a lot of the stocks back and get to pocket the difference.
We saw a significant event yesterday when it seems like a trading mistake drove the market down nearly 700 points before it was corrected. Think about the fact that a single trader at a large institution could accidentally do this, if that is what happened. When you see the results, it makes you wonder if maybe someone will decide to do it on purpose. After all, the trade caused a tremendous short time drop followed by a rapid rebound. One could make a lot of money if you knew it was going to happen.
Of course we like to think that the “watchdogs” would catch such a thing. I’m not sure they have a lot of teeth left. What might be the scariest thing about the event is how it triggered other programs to take actions designed to protect portfolios. So, if you initiate enough of a market movement to get the other programs to kick in, you can watch the whole thing on autopilot.
I can think of lots of ways such an action could make money. You could be short to start and go long near the bottom. The buy programs can be manipulated too.

Do we have a name for this?

Governments don’t go out of business. It may seem obvious and while they are subject to hostile takeovers, either by other countries or by rival internal factions, they simply are there. Now, to avoid losing ground to inside factions, Governments sometimes agree to things that they can’t afford. In fact, it might be fair to say that all Governments do that to some extent. They are hoping for two things when they do it, that the problem will not arise until after they have left office and hopefully, the economy will grow making the debt more affordable.
However, if you have a worldwide recession and if the financial industry decides that your potential ability to repay your debt has become questionable, they will demand higher interest rates on loans. Of course that makes the debt less affordable. Now let’s think about the consequences of this. If all other things were equal, there would be no one who would want Greece to default. The people who have borrowed from Greece certainly want to get paid; the Greek Government wants to continue operating and the world as a whole doesn’t need further economic turmoil.
However in our current financial situation where we have created many instruments that allow large investors to bet against Greece, suddenly we have players who want Greece to default. It would mean a big payout to them as they cashed in on the speculative instruments they purchased. In fact, they want it so much they are willing to share their views on how all the efforts to avoid Greek default are likely to fail. If you have taken short positions on Greek debt, the higher the interest rate goes the better. An actual default would be the best possible outcome.
Now, we saw this in the mortgage industry. As bad as some of the problems were, I have no doubt they were exacerbated by those who bet against housing. Similarly, when short sellers attacked the banking industry we saw fundamentally sound institutions suddenly in danger and in need of short term financing from the Government.
It is not like these bets against Greece, housing or you name it are harmless, the fact that they exist creates a force for, well evil, where they want to see a country or an industry destroyed. The motivation is purely greed but if they tried to destroy countries or institutions because of political motivation, we would know what to call them.

Wealth

There was an article in the NY Times on Friday that discussed the concept of wealth, something I have talked about in few of these blogs. In it a definition of wealth by Michael Reiter is quoted as follows:
"Wealth" is the present value of the expected stream of future utility [human happiness] that an "infinitely lived individual or a dynasty" [or a nation] could hope to extract from the real resources available now and in the indefinite future, assuming these real resources are allocated and managed now, and over time, so as to maximize that present value of future utils (at the "proper" discount rate).
Now, what is pointed out in the article and what is definitely valid is that the computation of “present value” can be a tricky thing. It requires some agreement on how to discount future value. Now, in reality, while computing present value and the discount factor has challenged many students over the years, most of us simply know what the market value of our assets are.
If one year I own a house that I could sell for $400,000 and a year later the same house can only sell for $300,000, I have lost $100,000 of wealth. The reasons for this drop in value may have something to do with future utility, but if I want to sell it, I will have to accept the Market Value. In fact, if I don’t intend to sell I may still be impacted since the equity is down that amount and borrowing against the house will be impacted.
Economists like to find underlying explanations for the way the economy behaves, and in many ways the models they come up with are reasonable in talking about the past. However, it is also true that economists are not particularly good as a group in predicting the future (at least the fairly immediate future) and this is pretty much borne out by the fact that most of them do no better with investments than the rest of us.
The unpredictability of the market is partly due to the fact that in addition to all the formulas and numbers, the human condition must be added. People, for the most part do not act rationally. If real estate has gone up more than other assets, most people believe it will just keep going up. In fact, economists (at least the majority) find explanations for this behavior and extract into the future based on these trends. When it starts going down, we see the opposite.
I think the poem “If” by Kipling explains this better than most economists ever will.