Munger’s “Basicland”

There is an article at Slate.com making the rounds in the financial press. Warren Buffett’s partner at Berkshire Hathaway, Charlie Munger, penned a parable about America’s rise and fall, called "Basically, It’s Over."

The article details how a young, fiscally responsible country called Basicland got caught up in the "casino" of speculation, ignored its export economy, and essentially went bankrupt.

While perhaps a bit simplistic, Munger’s piece is intended as a warning about rising government debt and an over-reliance on risky financial speculation. This speculation is intended to make up for the lack of manufacturing as a major component of GDP.

Some of the statistics he throws out are a bit scary. He says "The winnings of the casinos (investment banks) eventually amounted to 25 percent of Basicland’s GDP, while 22 percent of all employee earnings in Basicland were paid to persons employed by the casinos."

I haven’t verified those numbers, but they certainly suggest an economy that’s out of balance.

As I read Munger’s article, I thought immediately of yesterday’s story about how Goldman Sachs and other investment banks may knowingly used mortgage-backed securities and CDOs to set-up AIG.

I’m sure we all believe it is any company’s right to take advantage of another company’s weakness. At the same time, however, it seems to me that at some point, a company must ask itself "at what cost?"

In the case of the housing bubble, investment banks knew the mortgage-backed securities they were selling were junk. Not only did they set AIG up for a fall, these casinos, as Munger calls them, essentially cannibalized America to make a buck.

Munger’s answer? Listen to Paul Volcker. Keep banking separate from investing. And "…produce and sell items that foreigner’s [are] willing to buy."

Let’s hope that our elected officials are not so ensnared in the casinos’ tentacles that they can make the changes that America needs.

Consolidation

An influential German business confidence survey showed a surprise drop in the country, the first in 10 months. A cold winter has apparently hurt retail sales in Germany.

That’s pressuring the euro, and providing strength for the U.S. dollar. It’s been pretty well documented that the euro does not tend to rally alongside the dollar. And that’s what we saw yesterday.

One positive note from yesterday – Maguire Properties rallied off of support at $1.50. Volume was strong and the stock broke above its 50-day moving average. You may recall yesterday, I said the stock needed to rally, and soon. Now, it needs to keep rising.

Also yesterday, TradeMaster Daily Stock Alerts‘ Jason Cimpl told us he expects consolidation for the stock market this week. (Consolidation occurs when prices don’t move much as investors adjust to a new price level.)

Yesterday, the S&P 500 traded in a tight 7-point range. And it won’t be surprising if it holds to a similar tight range today. We might anticipate the negative news from Germany to be offset by an improved reading of the Case-Shiller home price index.

Soros Bullish on the Euro?

It was just last Thursday that we discussed "talking one’s book" and made special mention of George Soros. If you missed that issue of The Daily Profit, talking one’s book means advocating a belief in public that supports one’s trading position, regardless of whether you actually believe it’s true.

So it’s interesting that Soros has a piece in today’s Financial Times where he states that "The survival of Greece would still leave the future of the euro in question." He goes on to say that the aid package for Greece won’t work for Spain, Italy, Portugal or Ireland.

Now, if we check the chart we can see that the U.S. dollar has been rallying. Part of the reason for this has been weakness of the euro due to debt problems in European countries.

$USD chart

The recent spike higher by the dollar was a response to the Fed’s discount rate hike. And quite frankly, it looks unsustainable. I think we can assume that Soros is short the euro, and he may even be trying to cover that short right now, in anticipation of a rally for the euro.

Of course, a rally for the euro would send the U.S. dollar lower. That, in turn, will be good for U.S. stocks, gold, and oil.

The Fed Moves

It’s pretty hard to ignore the big news this morning – the Fed hiked the discount rate by a quarter point to 0.75%. Now, this is different from an interest rate hike (known as the federal funds rate). The discount rate is the amount of interest the Fed charges banks for direct loans.

The move is designed to make it more expensive for banks to borrow from the Fed, thereby encouraging them to borrow from private sources.

Now, the Fed said in its last meeting that this move was coming. And I’m actually glad to see the Fed make a "surprise" move. By that I mean the markets got very accustomed to the Greenspan policy of only moving rates during policy meetings. That gives the market time to adjust ahead of the meeting. Some argue that strategy decreases the effect of the move.

With this surprise move, Bernanke has taken the market by surprise and forced it to adjust on the fly. That’s actually a good thing. I think it’s important for the Fed to show that it’s proactive.

What’s more, the Fed is also showing that it is intent on removing the emergency liquidity measures it took in the wake of the financial crisis. This is an important step toward addressing fears that cheap money will spark inflation.

The biggest takeaway from this move is that the Fed is showing confidence in the economy. The Fed clearly believes the economy is strong enough to start walking on its own, without the crutch of cheap money.

Of course, the Fed has also reiterated that real interest rates, or the fed funds rate, will stay low for an "extended period of time." And most still consider that to mean there will be no interest rate hikes until early 2011. And we can look at today’s Consumer Price Index (CPI) to see why.

Prices at the consumer level rose just 0.2% for the 5th month in a row. Take out food and energy, and consumer prices actually fell for the first time since 1982.

The reason is pretty clear: unemployment. With less demand, companies can’t raise prices. So clearly, the Fed can’t raise rates until the employment picture improves.

Soros Talks His Book

You’ve heard me call out big-name investors who are "talking their book" in the past. An investors is "talking his or her book" when he/she states an opinion as fact for the sole purpose of helping a particular trade.

We’ve seen Warren Buffett do this. Last year, it was widely known that he was massively short the U.S. dollar. And he continued to say he thought the dollar was collapsing, even as it hit important support. Then we learned later that Buffett was covering his dollar short, all the while extolling its weakness.

Obviously, Buffett, in true P.T. Barnum fashion, was attempting to use his influence to talk the dollar down while he covered. He only needed to fool people for a short time as he exited the trade.

Last month at the Davos conference in Switzerland, George Soros did his version of talking his book. He made headlines when he said "The ultimate asset bubble is gold."

I always view statements like these with skepticism. And sure, recent SEC filings reveal that at the same time Soros was saying gold was a bubble, his Soros Fund Management was buying 6.2 million shares of the SPDR Gold Trust ETF (NYSE: GLD) for $663 million.

chart

Looking at this 6 month chart of GLD, it’s a reasonable guess that Soros was buying between $105 and $110 in December (you may need to zoom in on the chart in order to see all the information). Gold is on the verge of breaking above that range now.

It would be easy to think that Soros was simply pulling a fast one on unsuspecting investors. But this is a case where it pays to know a little more about the man and his methods. Here is a Soros quote from the early ’90s:

"Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited."

I love that quote, even though it’s a bit cynical and perhaps depressing. But what he is saying should be a revelation to any investor, because it requires the investor to maintain a sense of skepticism.

I also want to emphasize that companies do make money, they grow, and their stock prices will reflect this. In other words, there are fundamental reasons for stocks to move. But Soros is talking about making the big money.

As late as 2007, Soros was calling the housing boom a bubble. I also think we can assume he made a lot of money during the housing bubble in the sectors that were supporting the housing bubble, like commodities. And there’s no doubt he was well-positioned when the bubble burst.

Lennar’s Windfall

So far this year 15 banks have been closed by the FDIC. Last year, it was 134, if I’m counting the closing figures right as posted on the FDIC website. Some of you may remember the last time there were mass amounts of bank closings during the S&L crisis of the late ’80s and early ’90s. At the time, a special agency, the Resolution Trust Corporation (RTC) was set up to dispose of the assets of these banks.

The RTC was controversial because many times it sold assets at prices far below market value. Ultimately though, the RTC succeeded in getting assets seized from insolvent banks into stronger hands. And because some of these "stronger hands" had low cost structures due to low up front costs, a new phase of growth was born.

A similar thing is happening now. Lennar Corporation (NYSE: LEN), a homebuilder, recently picked up $3 billion worth of unfinished homes from the FDIC for about 40 cents on the dollar. Lennar only had to put up $243 million. The FDIC kicked in $365 million and provided 0% interest financing.

Because Lennar’s upfront costs are so low, it will be able to hire the workers needed to finish the homes and offer those homes for sale at a price that makes sense for buyers. This is how growth returns after a bubble.

But this time there’s a twist. The $365 million put up by the FDIC? It’s an equity stake. Yes, rather than simply disposing of the assets to the highest bidder the FDIC, and by extension the government, now has a stake in those unfinished homes.

The FDIC could turn a profit here. But by offering financing and providing an interest-free loan, the FDIC is also supporting home valuations by not letting these unfinished homes sell at absolute rock bottom prices.

Pawns in a Rich Man’s Game

Bespoke Investment Group is reporting that 10% of U.S. corporations are raising earnings expectations, compared to 4.1% that are lowering them. That’s the largest gap on record, and suggests that analysts still have earnings projections that are too low.

It’s hard to blame the analysts for being cautious. While the economy has improved, uncertainty about unemployment is an issue. It’s easy to imagine that consumer demand could drop. Still, let’s not ignore what corporations are saying. After all, they are the ones in direct communication with their customers. I can’t help but be a little optimistic that there is more upside for the stock market.

Don’t ignore the consolidation news from the commercial real estate sector this morning. Mall owner Simon Properties (NYSE: SPG) is offering $10 billion for its rival, General Growth Properties (NYSE: GGP).

Several investors and economists believe commercial real estate will be the next shoe to drop. And within that sector, shopping malls are probably the most beaten down group. That Simon Properties is considering a buyout means that it sees opportunity. And it is moves like these that often mark a bottom for an industry or sector.

I’ve recommended a commercial real estate stock that may have some terrific upside. Maguire Properties (NYSE: MPG) is back to its support level at $1.50. If you didn’t catch it there last time, you might want to give it a look.

Recession for Europe?

It’s no surprise to me Europe is experiencing weaker than expected growth. In fact, in Wyatt Investment Research 2010 Economic Predictions and Investment Outlook, I wrote that it was likely that Europe enters recession again. And when we read that Euro-zone GDP growth for the 4th quarter actually declined 2.1%, and sequential growth was just 0.1%, it appears that recession is more than just a possibility for Europe.

The contrast between the 4th quarter in the U.S. and Europe is about as stark as it gets. And it’s clear to me that the main difference is government stimulus. For instance, French car-maker Renault expects car sales in Europe to fall 10%. Car sales in the U.S. have been pretty good, and the cash for clunkers program helped. There should also be no doubt that government support for the housing market has helped.

There is also an interesting parallel between countries like Greece or Ireland and states like California and Nevada. No doubt, if California was a country and not a state, it would be on the list of countries with sovereign debt problems.

Fortunately, California’s problems are somewhat masked by the overall relative strength of the U.S. economy, but that won’t last. Debt issues in certain states have the potential to become a real drag on growth.

Dumb Luck?

My Washington DC office has been vacant all week. It’s amazing to me that record snowfalls have turned my DC staff into shut-ins (and closed the government for the third day) while life goes on at its normal pace here in Vermont.

The snowstorm that’s crippled the mid-Atlantic region will certainly have an impact on 1st quarter GDP. I would expect that 1st quarter retail numbers will be pretty bad. But there could be some good numbers for restaurants coming. The rally in the dollar over the last few weeks has lowered food costs. And I also think that once we see a thaw on the Eastern seaboard, people will shake off their cabin fever with a night out. I know I would…

I’m really on the fence with this one: did the Obama administration purposefully wait to attack the unemployment situation? Or is it just dumb luck?

I ask because it’s clear to me that now is the time to strike. If stimulus money had been used at this time last year to help the unemployment situation it wouldn’t have worked. Corporations were still in the process of cutting costs to meet lower demand. And at the time, demand itself was a moving target.

Now that the economy has stabilized, demand is returning and corporate earnings are on the upswing. So corporations are starting to hire again. New jobless claims are down again, as are continuing claims. The unemployment rate has dropped, and on-line employment ads are increasing.

The Conference Board, a non-profit global business organization, reported that online job demand is rapidly rising. According to the Conference Board, the total job vacancies advertised online today is over four million, or the same level as November 2008.

Seems to me, the added perk of government incentives, like a payroll tax holiday or tax credits for new hires, could give companies the final push needed to add employees.

Is China Caving?

The Dow Industrials cruised past 10,000 yesterday. Clearly, the news that Germany may be coming to Greece’s aid was a big relief for investors. The euro rallied against the U.S. dollar as well, an important catalyst for stock and commodity prices on U.S. exchanges.

Some stability in Europe and progress on a jobs bill in Congress will be good for stocks. Earnings are already solid and I suspect there is more upside coming.

I got on the phone with TradeMaster‘s Jason Cimpl to see if yesterday was the type of bullish activity he wanted to see from the market. He noted that although the market got a nice bounce (TradeMaster Daily Stock Alerts members closed short positions worth 15% and 5%), the close was very weak.

Typically, indices in a bull trend would have made a push higher into the close. Despite the weak close and his growing pessimism, he did note that market internals were "spectacular." The advancing volume data showed us that the upward action was more than just shorts covering their downside positions – it was also bottom feeders nibbling at the low stock prices. He’s watching the 1085 level on the S&P 500 as an important resistance point this week.

There’s also some significant news from China today. Credit Suisse is suggesting that instead of letting the yuan appreciate, it may raise wages for Chinese workers. That’s important on a number of levels.

First, higher wages for Chinese workers removes some of the competitive edge that China enjoys because it makes their goods more expensive. This move would also put more money in the average Chinese citizen’s pocket, which serves China’s bigger goal of supporting domestic demand for Chinese goods.

Being an export economy is an unsustainable model, and China knows this. It must transition to a more balanced economy. I’ve noted in the past that China needs some form of social security to unlock the massive amount of saving in that country. Higher wages is a step in that direction.

Obviously, if wages in China are higher, it will help the U.S. manufacturing sector as well. This is one of the pleasant outcomes of globalization. Ultimately, we will see a more level playing field as the standard of living in emerging economies rises.

The final takeaway of this move is political. It’s no secret that President Obama has been putting some pressure on China to remove unfair trade advantages. I won’t call it "caving in", but the fact that China would take steps to remove some of the advantage that its exports enjoy clearly shows the country is sensitive to the demands of its trading partners. Who knows, maybe China will also find a solution that lets Google stay in the country?