Janet Yellen and popping speculative bubbles

During her Senate confirmation hearing, Janet Yellen, the soon-to-be Fed chief, was asked what action she would take if she saw a speculative bubble forming in financial markets.  Would she, like her predecessor Alan Greenspan, simply watch it grow, while presumably making ready to pick up the pieces after it popped?  …or would she act–presumably by raising interest rates–to nip it in the bud?

She said she would do the latter.  She added that at present she sees no bubbles on the financial horizon.

I’m not sure what this means.

It could just be that she’s saying she doesn’t believe in the theory of “rational expectations.” a simplifying assumption of academic economists that people are cold, calculating, wealth-maximizing automatons all of the time.  This is also a premise of most academic research in finance, despite centuries’ worth of overwhelming evidence that real people seldom act that way.

Or it could be that she’s making a stronger statement  …that if she’d been in charge, she would have raised interest rates to pop the Internet bubble of 1998-99  …and that she’d have done the same to pop the housing bubble of 2006-07, as well.

At the moment, I think her’s is a statement without much content.  Millions of Americans laid off in the Great Recession are still out of work.  The economy is scarcely overheating (although I think what we’re seeing now is as good as it will get).  And government policy in Washington is retarding economic expansion, not helping it along.  So it’s hard to see where the impetus for higher interest rates would come from–which is what the Fed is communicating by saying it will leave short-term interest rates at the current zero for at least the next two years.  Also, the Fed can’t get more accommodative than it is now.

Still, I think the Yellen statement is one to keep filed away for future reference.  It implies that when we eventually get out of the mess we’re in–and assuming Ms. Yellen is still around–that the financial markets will be on a shorter leash than during the professional lives of just about everybody working on Wall Street.  Chances are what she does will take Wall Street completely by surprise.

 

why commodities companies overinvest, turning boom to bust

This is a continuation of my post from yesterday.

It may be that, as Chris Hackett suggests in a comment to yesterday’s post, that everyone has his head in the sand, not only commodities company CEOs and boards.  Maybe it’s some deep-seated psychological need to have the good times continue, or maybe a denial of the finitude of man, or…  Yes, commodities companies aren’t the only ones who extrapolate chiefly from the recent past in forecasting the future.  Nevertheless, I can think of three reasons why commodities companies feel most comfortable reinvesting cyclical cash windfalls back into new capacity in their primary business–even though that action itself inevitably triggers a cyclical downturn.

1.. It may be the best they can do.

Looking back at yesterday’s post, I think I was a little unfair in saying that there firms never think of diversifying.  During the first oil crisis in the early 1970s, all the big oils did diversify.  Gulf Oil bought the Barnum and Bailey circus (great job, Gulf; no wonder you got taken over); Mobil bought Montgomery Ward and Container Corp of America (both disasters); Exxon started a venture capital arm, which produced nothing of note.

Peter Lynch, of Fidelity fame, called this kind of move “diworsification.”  Ugly word, but an accurate observation.  Look at HPQ or Microsoft as other serial diworsifiers.

Of course, this is not really the best a company can do, either.  The firm could pay a special dividend to shareholders, but this sensible action rarely occurs to CEOs.  Reinvesting in a business they has some expertise in always seems to be the safest bet.

2.  Holding on to cash may be personally risky to a CEO, for two reasons:

–a cash hoard may make the company a takeover target.  Great for shareholders, not so much for the ego of a person who’s a demi-god to employees, but just a broken down old guy (albeit a rich one) if he loses his position.

–a sensible strategy would be to amass cash with the intention of buying assets on the cheap from semi-bankrupt competitors a couple of years after the cycle turns.  Suppose the cycle lasts longer than the CEO expects, however.  His profits are less than competitors; his company’s stock underperforms.  Maybe he’s ousted before he can act and his successor reaps the glory of making canny acquisitions.

Arguably you have more job security by staying with the herd.

3.  I can believe that adding capacity at or near the top of the cycle can make a perverse kind of sense under three (or maybe four) conditions.  They are the assumptions that:

–all attempts to diversify into other businesses will end in disaster,

–the company’s industry is in secular expansion, so that new capacity will be very valuable in the next upcycle,

–the company will be the first to add significant capacity, and will therefore have a year or two of supernormal profits from the new plant.   That will ease the pain of the downturn and put the firm in a stronger market position in the next upturn.

–(the, maybe, fourth)  even if a firm can’t be alone as the first to add new capacity, it should expand anyway.  This extra industry capacity will at least foil rivals’ plans to cash in big with their expansions.  Yes, the downturn will come earlier than otherwise, but the present market structure will be preserved.  A bit Machiavellian, and maybe giving undue credit to guys who think buying the circus is a great idea.  But it’s possible.

My bottom line:  long-cycle commodities, epitomized by base metals mining, are a true boom and bust industry.  As such, they’re a value investor’s dream come true.  For the rest of us, if we want to play we have to be in the uncomfortable position of buying when the stocks are very beaten down and it seems all hope is lost.  If you’re not accustomed to thinking this way, picking the right point to buy will be very difficult.  In any event, that point is not today.

the decline phase of the base metals cycle–where we are now

I started my career as a securities analyst as a generalist.  I covered companies in the oil and gas, utilities, and electronics industries as I learned the trade.  After I’d been working for a few months, our oil analyst was headhunted away and–poof!–I was the new oil analyst.  That reoriented my progress for several years much more toward natural resource companies.

One of the more peculiar ones I encountered as I expanded my coverage was Moore McCormack.  A conglomerate, Moore McCormack was originally a shipping firm but had expanded into iron ore and coal mining, cement, and oil and gas drilling.

On the theory that most things happen for a reason–no matter how hard it may be to see the rationale from the outside–I asked the CFO how the company had evolved in such a singular way (I was thinking “into such a ragbag of sub-scale commodities businesses” but phrased my question differently).  He told me that Moore McCormack deliberately specialized in holding long-lived assets that required large amounts of up-front capital investment and where the firm was essentially a price taker.  In other words, it specialized in commodity mining and shipping.

Why do this?  …because, he said (incorrectly, as it turned out), the key to success in these business lines was how the capital investment is financed.  And Moore McCormack was an expert in financing.

The company dissolved during the Second Oil Crisis of 1978 and the ensuing recession.  It couldn’t survive the sharp shrinkage of cash flow in all of its business lines caused by the ending of an almost decade-long commodities boom and the economic downturn that accompanied/intensified it.

How did this happen?

The base metals industry–shipping, too–is extremely cyclical.  But each cycle lasts a decade or so, much longer than an ordinary business cycle.  A boom begins when garden-variety economic growth expands to the point where demand for metals exceeds available supply.  Fabricators need more copper for construction or  iron ore for steel car bodies than existing mines can handle.  Or, say, the developed world is using more petroleum than the existing fleet of tankers can carry.

Because it may take five years to open a new mine, or a similar span of time to get a new cargo ship from the yards (a year+ to build, a four-year waiting list), the only way a user can get the commodity inputs he needs is to bid them away from everyone else.  So prices go through the roof.

But commodity producers in general, and base metals firms and shippers in particular, are like lemmings.  Everyone is making money hand over fist; everyone plows the cash into expanding capacity like there’s no tomorrow.  No one puts much cash away for a rainy day; no one diversifies sensibly.

Then–several years, maybe half a decade, into the boom–the first new capacity begins to enter the market.  Prices begin to flatten.  Then a cascade of new output comes online–much more than anyone can possibly use.  Commodity producers frantically put as much of their expansion on hold as they can.  But it’s too late.  Prices sag.  Cash flow shrinks drastically.  And the industry waits for world demand to grow big enough to create demand for all the new capacity there is.  The bust lasts maybe another five years.  And then the cycle begins again.

For base metals, we’re in the decline phase now.  I don’t have any idea how long the current period of weakness will last.  But I don’t think the turnaround is any time soon.

To me, the interesting question is why managements of companies in long-cycle industries exhibit the same imprudent behavior cycle after cycle.  Don’t they know their own industries?  Don’t they remember what happened last time around?  If they do, they somehow convince themselves that this time will be different.

More on this tomorrow.

A side note:  Moore McCormack thought it was diversified, even though it recognized that all its divisions had the same economic characteristics.  Sort of like thinking a balanced meal consists of several different flavors of ice cream.

accredited investors and the JOBS Act

“accredited” investors

When you open a brokerage account in the US, you fill out a form that requests information about your income, risk tolerances and investment knowledge.  From what I can see, it gets only superficial scrutiny.  But saying that you have some money and understand the risks of investing in various types of publicly traded securities does two things.  It gets you a seat at the table and it protects your broker from customer lawsuits claiming they lost money because they didn’t understand what they were getting into.  In a sense, passing this vetting process makes you accredited–but that’s not what the term “accredited” usually means.

Instead, it refers to the same kind of vetting process, but for private placements–purchases of securities not registered with the SEC and not sold through the traditional (expensive and time-consuming) IPO process carried out by the big brokerage houses.

For individuals, “accredited” means you have $1 million in assets, not including your principal residence, or you earn at least $200,000 a year.  (There’s a different criterion for institutional investors who want to trade in non-registered–usually foreign–securities.  To be accredited in that sense means having $100 million in investable funds under management.)

The bottom line:  “accredited” means either you’re in the top 1% or pretty close.

not good enough for the 21st century

In the pre-internet, pre-JOBS Act, pre-Mary Jo White world, that was ok.  Private placements were restricted to a very small number of individuals, whose main characteristic is that they can afford losses they might incur in buying risky securities.  The wealth criterion also effectively preserved the near-monopoly on public issuance of securities of the big brokerage houses on Wall Street.

That’s all changing.

the new order

There are already special rules to allow crowdfunding sales of securities.

For the JOBS Act (which allows smaller, early stage companies to raise funds with only limited disclosure) to be truly effective as a  capital raising vehicle for business startups, the pool of investors has got to be larger than just the usual “accredited” suspects.

Interestingly, at the same time as the newly active SEC is saying it sees some merit in things like bitcoin, the agency is also preparing to overhaul the definition of what an accredited investor is.

The new emphasis appears to be on accrediting people who have knowledge, training or experience that gives them insight into the risks and rewards of investing in a startup rather than just being able to take their lumps if an investment goes south.

I don’t know whether this is a good thing or not.

But Washington passed the JOBS Act last year to make it much easier for startups to raise money.  And, contrary to Mary Shapiro’s foot dragging, Mary Jo White is certainly going to set rules of procedure to allow the Act to function.  And that means opening this class of investments to more potential buyers.

do think, however, that this will turn out to be another instance of a new internet-based business model undermining an older higher-cost pre-internet one.  It will be interesting to see how–and if traditional brokerage/investment banking firms will adapt.  I suspect that this change will have far greater ripple effects than anyone now expects–maybe even momentous ones.

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the EU and negative nominal interest rates

Over the past year or two, the European Central Bank has periodically talked about the possibility of engineering negative nominal interest rates in the EU.  What it is talking about?

There are two possibilities:

1.  In overly simple terms, money policy is stimulative if the real (that is, after subtracting inflation) interest rate is less than zero.  For example, if inflation is 3% and the nominal interest rate is 1%, the real interest rate is -2%.  So cash is a loser, giving a sharp economic incentive to individuals and corporations a sharp incentive to borrow money and to invest their cash balances in projects that will cause economic growth.

Suppose there’s no inflation, though, or that prices are falling by, say, 2% per year.  If the best that money policy can do is bring nominal interest rates down to zero, the real interest rate is still +2% from holding cash.  So cash is a big winner.

In this deflationary scenario, the only way to achieve a positive real interest rate is to get nominal interest rates down to, say, -4%.  How to do so?  …tax bank deposits.

That’s not enough, though.   …and here’s where things get a little wacky.

If I’m going to lose 4% a year by keeping my cash in the bank, I’m going to buy a safe, withdraw my money and keep bills and coins in my house.  Scrooge McDuck writ small!!

Government can’t accept this.  So it puts “use by” dates on currency, so money expires at the rate of 4% a year if it isn’t spent (I said this wad going to be wacky).

But wait…  Citizens won’t accept this move, either.  They run to currency dealers (or gold merchants) and convert their money into non-imploding stuff.

Government responds by imposing controls on purchases of metals, foreign currency and maybe other commodities, too.

…and so on.

Anyway, this recipe for political and economic chaos can’t be what the ECB is talking about.

2.  As evidence has been mounting that the EU economy has passed its cyclical bottom and has begun to perk up a bit, the euro has been strengthening.  From early July until late last month, for instance, the currency had risen by about 8% against the US$.  A bit of that is fallout from the government shutdown in the US, but most is because investors are beginning to reallocate funds away from other parts of the world and toward the EU, where they sense surprising positive economic momentun.  Trade is starting to increase, as well.  Both developments increase demand for the €.

Once an uptrend like this starts, it also attracts speculative inflows of cash from large banks, hedge funds–sometimes gigantic inflows–who want to bet that the uptrend will continue.

What’s wrong with this?

It’s that a rise in a currency acts very much like a rise in interest rates–it slows down economic growth.  Not exactly what the ECB wants.

So it’s jawboning.  It’s threatening to tax large inflows of speculative cash, most likely by at least enough to offset any anticipated currency gain.  It’s hoping to fend off speculators by announcing the actions it will take to drive them away.

So far, the ECB has been successful.  It wouldn’t be entirely out of the realm of possibility, however, to see taxes placed on large bank deposits (after all, big speculators are going to deal in electronic money, not bills and coins) at some point to drive speculators away.   The main point to remember is that this won’t be some loony scheme to create overall negative nominal interest rates, just losses for currency speculators.

The main effect on investors will be to lessen the attractiveness of pure domestic EU plays and to retain some allure for EU-based multinationals.