Nomura's Bob Janjuah on Fed Tapering

From CNBC's NetNet:

Here's the Real Reason the Fed Will Taper QE: Pro

Noted Nomura bear Bob Janjuah believes he knows the reason why the Federal Reserve will begin pulling back its easing program, and it's not about unemployment, inflation or anything else directly related to the economy.

Instead, he believes the central bank is worried that it is creating an asset bubble that will only get worse if it keeps following the current path.

"The Fed is NOT going to taper because the economy is too strong or because we have sustained core (wage) inflation, or because we have full employment—none of these conditions will be seen for some years to come," Nomura's fixed income strategist said in a recent missive to clients....MORE

How to Recognize the Moment Elon Musk and Tesla Have Begun Their Campaign For World Domination (TSLA)

From a commenter at The Big Picture on the post "Tesla Model S Cold Weather Range Test Norway" (TSLA)":

constantnormal

June 16, 2013 at 8:47 am

With an EU-average retail gas price of about $8.33/gal (USD) (assuming I have done the arithmetic correctly), one wonders why Elon does not just build a manufacturing plant in Ireland, produce cars and charging stations, and roll everything back into the business tax-free … one would think that a model S made in Ireland would cost no more in the EU than a BMW or Volvo, and the shorter driving distances there, coupled with a lot more solar electric generation per capita, should make this extremely competitive in those markets.

Yes, the 99% in the EU are having the economic life stomped out of them, but I suspect that in the EU, just as in the US, the 1% have hardly changed their lifestyles, and Tesla should be able to sell many hundreds/thousands of these cars there, while simultaneously dominating the plug-in charging station markets.

Back in May Mr. Musk targeted July as the month he begins shipping, they already have "Tesla Stores" set up in nine European countries.

At about the same time Goldman estimated the order rate in Europe was about 200 per month, probably not enough to set up that Irish factory.

Fitch says China credit bubble unprecedented in modern world history

From The Telegraph:

China's shadow banking system is out of control and under mounting stress as borrowers struggle to roll over short-term debts, Fitch Ratings has warned.

The agency said the scale of credit was so extreme that the country would find it very hard to grow its way out of the excesses as in past episodes, implying tougher times ahead.

"The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation," said Charlene Chu, the agency's senior director in Beijing.

"There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signalling," she told The Daily Telegraph.

While the non-performing loan rate of the banks may look benign at just 1pc, this has become irrelevant as trusts, wealth-management funds, offshore vehicles and other forms of irregular lending make up over half of all new credit. "It means nothing if you can off-load any bad asset you want. A lot of the banking exposure to property is not booked as property," she said.

Concerns are rising after a string of upsets in Quingdao, Ordos, Jilin and elsewhere, in so-called trust products, a $1.4 trillion (£0.9 trillion) segment of the shadow banking system.

Bank Everbright defaulted on an interbank loan 10 days ago amid wild spikes in short-term "Shibor" borrowing rates, a sign that liquidity has suddenly dried up. "Typically stress starts in the periphery and moves to the core, and that is what we are already seeing with defaults in trust products," she said.

Fitch warned that wealth products worth $2 trillion of lending are in reality a "hidden second balance sheet" for banks, allowing them to circumvent loan curbs and dodge efforts by regulators to halt the excesses.

This niche is the epicentre of risk. Half the loans must be rolled over every three months, and another 25pc in less than six months. This has echoes of Northern Rock, Lehman Brothers and others that came to grief in the West on short-term liabilities when the wholesale capital markets froze.

Mrs Chu said the banks had been forced to park over $3 trillion in reserves at the central bank, giving them a "massive savings account that can be drawn down" in a crisis, but this may not be enough to avert trouble given the sheer scale of the lending boom.

Overall credit has jumped from $9 trillion to $23 trillion since the Lehman crisis. "They have replicated the entire US commercial banking system in five years," she said....MORE

Commodity Prices: Rocks for the Long Run

From the Economist's Free exchange blog:

SINCE late last year commodity prices have been on a long, slow downward slide. Yet many in the markets, like Jeremy Grantham, a British money manager, reckon that the commodity-price spike of the past decade is but a taste of what's to come. This week's Free exchange column looks at a paper that seeks to show what history has to say about future price moves:

David Jacks, an economist at Simon Fraser University, assembles figures on inflation-adjusted prices for 30 commodities over 160 years...Over the very long run commodity prices display a marked upward trend, having risen by 192% since 1950, and by 252% since 1900. But an upward trend has clearly not translated into global famine, and not all commodities are alike.

Long-run rises have been most pronounced for commodities that are “in the ground”, like minerals and natural gas. Energy commodities especially have boomed, soaring by roughly 300% since 1950. Prices of precious metals have also risen, as have industrial ingredients like iron ore. In contrast, prices for resources that can be grown have trended downwards (see chart). The inflation-adjusted prices of rice, corn and wheat are lower now than they were in 1950. Although the global population is 2.8 times above its 1950 level, world grain production is 3.6 times higher.

Yet over shorter horizons prices can move far out of line with the long-run trend. A price series will sometimes enter a generational departure from trend known as a supercycle. Mr Jacks finds that supercycles tend to cluster around periods of mass industrialisation or urbanisation, when soaring commodity demand butts up against supply that is slower to respond....MORE

But, see also yesterday's FT Alphsville:

The end of the end of the end of the commodities supercycle is nigh, in Asia

That’s from Deutsche Bank today.
+1
We joke, we joke. A little. Deutsche had of course already joined the commodities-supercycle-is-dead chorus, and this note is not from the commodities side but by Asia chief economists Taimur Baig and Jun Ma.


Ma, who covers China, wrote an interesting and widely-read note about China’s pollution constraints earlier this year. This one however has some key capitulation moments for some of us. For example:

It was tempting to look at China’s high-growth track record (with little variation) as a sure-fire indication of robust demand to persist for years to come. Emergence of India, which also saw accelerating economic growth, was seen as another source of persistently sizeable demand.

The underwhelming realities of those calls are just part of their explanation for why the supercycle is over. The other reasons are: structurally declining demand in OECD countries; the fruits of investment in new production bringing prices lower; and the increase in shale gas and oil production further adding to supply.

We won’t go into Deutsche’s whole rationale on energy and soft commodities. Their energy production outlooks are rely on the standard forward looking stuff (EIA forecasts and the like) which seem too early to call, especially on shale. Baig and Ma are particularly optimistic on Chinese shale gas, and say the potential for the country to beat its targets should not be discounted. But there are technology hurdles, not to mention a lack of usable water where it’s most needed.

On the other hand, there is evidence that oil demand is in structural decline in the OECD, and perhaps even in emerging countries — at least relative to GDP, in the latter group.

Anyway, here’s how Deutsche modeled some changes in gas and oil prices which they picked....MUCH MORE

The Most Expensive Homes Currently For Sale In America

From the Los Angeles Times' Money & Co. blog:

Copper Beech Farm, the waterfront mansion in Connecticut with 12 bathrooms and nine bedrooms, is priced at $190 million. (Realtor.com)

The most expensive homes in the U.S. right now are priced well above the $100-million mark, according to a compilation assembled by Forbes.

Topping the list at $190 million is Copper Beech Farm on 50 acres in Greenwich, Conn. The 1980s French Renaissance-style home of 13,519 square feet sits on the waterfront.

In Los Angeles' Holmby Hills area, Owlwood is being shopped outside the Multiple Listing Service at $150 million. The storied 10-acre estate, with former owners including Sonny and Cher and Tony Curtis, is being marketed through the Agency in Beverly Hills.

PHOTOS: Malibu estate listed at $57.5 million

A 25-acre spread in Dallas with 42,500 square feet of living space is asking $135 million....MORE

And from the linked Forbes article:

There are many reasons the de Guigne estate in Hillsborough, Calif., could be called a trophy property. For starters the 16,000-square-foot Mediterranean mansion was constructed a century ago and has remained within the same family since. Located at the end of a 4,500-foot driveway, the historic home has a grand ballroom, a flower arranging room and staff quarters that include two chauffeurs’ rooms.  But the property’s most unique feature isn’t the home itself – it’s the land.

The estate encompasses 47 prime acres 20 minutes south of San Francisco, halfway between the city and Silicon Valley. “This is the first time since this land was acquired 150 years ago by the de Guigne family that such a large amount of land in such a desirable location is coming to market,” says Gregg Lynn, a Sotheby’s International Realty agent co-listing the property with colleague Bernadette Lamothe. “In the town of Hillsborough all of its large estates have been subdivided over the last 50 years and this estate remains one of the only two [of this size] left.”...MORE


To the south of the Golden Gate Bridge, large parcels of land are rare. Located half-way between San Francisco & the Silicon Valley in the bucolic Town of Hillsborough, an approximately 16,000 sqft. Mediterranean-styled, Bliss & Faville mansion is positioned on approximately 47-acres which have been owned for 150 years by one family.

"Germany Has Become the Cut-Rate Prostitution Capital of the World"

Not sure what this means but if it should turn out to be as insightful an indicator as Bronte Capital's Latvian Hooker Index it's something we want in the toolbox. For now though it just reads as a story of abuse.
From Time Magazine:

The presence of thousands of brothels and hundreds of thousands of prostitutes has heightened competition and pushed prices down steeply in the German sex trade. One tourist from Florida, who visits the country three times annually to pay for cheap sex, compares the scene to a discount supermarket: “Germany is like Aldi for prostitutes,” he says.


Prostitution became legal in Germany in 2002, and the open sex trade has taken off in the years since. There are reportedly around 3,000 red-light establishments in the country, and 500 brothels in Berlin alone. It’s been estimated that more than 1 million men pay for sex in Germany every day.

One of the classic arguments for legalizing prostitution is that recognizing and regulating the world’s oldest profession would improve the conditions of sex workers. Instead, recent reports paint legalized prostitution in Germany largely as a failure....MORE

Interview With Grantham Mayo's James Montier

I feel I should apologize to Mr. Van Otterloo, I dropped his name from the headline for brevity not out of any disrespect.

I'll rationalize that it's like Merrill's dropping Fenner & Beane who despite being the largest commodity commission house and second largest wirehouse in the country when acquired by MER, are now virtually unknown.

In Mr. Beane's case, his name was dropped in favor of Winthrop Smith, early employee and eventually managing partner and whose son wrote the epitaph for Merrill when it was saved by the merger into Bank of America.

Long digression, here's the interview via Advisor Perspectives:

Asset allocation is the most important decision in constructing portfolios that meet clients’ goals. Two prominent figures in the investment world recently offered sharply different perspectives on the most prudent approach for advisors.

Central bank policies have distorted markets to such a degree that investors are devoid of any buy-and-hold asset classes, according to James Montier. But according to Richard Bernstein, the flood of liquidity unleashed through quantitative easing (QE) now offers investors compelling opportunities.

Montier is a member of the asset allocation team at Boston-based Grantham Mayo van Otterloo. Bernstein is the chief executive officer of New York-based Richard Bernstein Advisors. The two squared off in a panel discussion at the 2013 Morningstar Investment Conference in Chicago last week.

“This is the hardest time to be an asset allocator,” Montier said. “Normally, you find that safe-haven assets are expensive and riskier assets are cheap – and vice versa. But today, largely because of the central banks around the world, we’ve got a very distorted opportunity set, such that there is nothing you can buy and hold.”

Bernstein agreed that QE has upset traditional valuation dynamics, but he said investors still have choices.
“There are pockets that are very, very attractive,” he said. “People are generally unaware of those pockets.”
Let’s look at the key assumptions around Federal Reserve policies that led these two investors to such divergent views of the markets.

Fed policy and its impact on the markets
Low inflation and low interest rates have driven most asset classes to unacceptably high valuations, Montier said.

Montier explained that GMO uses a valuation methodology based on reversion to the mean. It looks at metrics such as margins, earnings and sales growth, then analyzes what the impact will be on prices if those values revert to their long-term averages over a seven-year time horizon.

Those forecasts are published on GMO’s website. As of the end of May, stocks – with the exception of emerging markets, which I will come back to in a moment – offered real (inflation-adjusted) returns ranging from -3.1% to 3.4%. Bonds were even worse – only emerging debt had a positive expected return.

The U.S. economy remains “miles away” from the Fed’s preconditions for ending its QE measures, Montier said. The Fed explicitly stated that unemployment must fall below 6.5% and inflation must rise to 2.5% before it will tighten. Right now, with 7.6% unemployment and 1% inflation (measured, as the Fed does, by the personal consumption expenditure (PCE)), Montier said it is unlikely the Fed will tighten any time soon.

Since the end of 2012, Montier said the market has made a “huge” shift, from pricing in 20-plus years of financial repression to assuming that repression will end in the next decade. That has resulted in a steepening of the real-interest-rate term structure....MUCH MORE

Here's Win Smith Jr.'s speech on the occasion of Merrill's shareholders approving the acquisition by BAC:
Goodbye Merrill Lynch - 'Shame, Shame, Shame' (Winthrop H. Smith: Address to the Shareholders of Merrill Lynch)

High-Frequency Trading Is Bad For Profits, Including Those Of High-Speed Traders: Study

Mark Gongloff is a lot less funny since he went crypto-fascist and started accepting Koch brothers funding.
From the Huffington Post:

High-frequency trading is bad for everybody, including high-frequency traders, according to new research from a university that produces economic reports that are sold early to high-frequency traders.

Congratulations, world, these are your modern financial markets. The study, by the University of Michigan's engineering department, focuses on one particular tactic of high-speed trading, known as "latency arbitrage."

This is the practice of gaming the split-second lags between the time trades are made and the time those trades are crunched by a central clearing house called the Security Information Processor into a price quote called the National Best Bid And Offer. Traders with super-fast computers can calculate the NBBO faster than the Security Information Processor can do it, and they take advantage of the tiny gaps between the old NBBO and the new NBBO.

The researchers say this trade somehow reduces the total amount of profits in the system -- in other words, it not only hurts regular, slowpoke investors, but also other high-speed traders. Whatever profit each individual robot makes on a latency arbitrage trade is less than the amount of profit that is destroyed by the practice, according to the report. This is just more evidence that zapping thousands of trades per second does nothing for society.

High-speed trading's defenders, including academics whose research is bankrolled by high-speed trading firms, claim that this sort of foolishness improves market function and makes trading cheaper for everybody, which gives investors more money to spend on puppies and charity and whatnot.

But the University of Michigan researchers, who were paid by grants from the National Science Foundation, say the latency arbitrage trading they studied actually hurts market efficiency by widening the spread between the prices that buyers will pay and the prices that sellers will accept....MORE

Just kidding about the Koch Bros/crypto-Mussolini thing, I think Mark is actually an anarcho-capitalist and has an endowed chair, or seat or...
See also:
The Costs and Benefits of High Frequency Trading: A Profoundly Deep Dive
"High-Frequency Trading: Not as Profitable as You Think"
 Morgan Stanley on High Frequency Trading and the Inevitable Destruction of the Equity Market (futures too)

Convergence: Nanotechnology researchers 3D print microbatteries for implants and tiny robots

Sure but where's the asteroid mining?
From NanoWerk News:

3D printing can now be used to print lithium-ion microbatteries the size of a grain of sand. The printed microbatteries could supply electricity to tiny devices in fields from medicine to communications, including many that have lingered on lab benches for lack of a battery small enough to fit the device, yet provide enough stored energy to power them.

To make the microbatteries, a team based at Harvard University and the University of Illinois at Urbana-Champaign printed precisely interlaced stacks of tiny battery electrodes, each less than the width of a human hair.

"Not only did we demonstrate for the first time that we can 3D-print a battery, we demonstrated it in the most rigorous way," said Jennifer Lewis, Ph.D., senior author of the study, who is also the Hansjörg Wyss Professor of Biologically Inspired Engineering at the Harvard School of Engineering and Applied Sciences (SEAS), and a Core Faculty Member of the Wyss Institute for Biologically Inspired Engineering at Harvard University. Lewis led the project in her prior position at the University of Illinois at Urbana-Champaign, in collaboration with co-author Shen Dillon, an Assistant Professor of Materials Science and Engineering there.

The results will be published online on June 18 in the journal Advanced Materials ("3D Printing of Interdigitated Li-Ion Microbattery Architectures").

For the first time, a research team from the Wyss Institute at Harvard University and the University of Illinois at Urbana-Champaign demonstrated the ability to 3-D print a battery. This image shows the interlaced stack of electrodes that were printed layer by layer to create the working anode and cathode of a microbattery.

...MORE

"How Quincy, Florida Became a Town of Secret Coca-Cola Millionaires"

From Joshua Kennon:

In the 1920′s and 1930′s, a banker named Pat Munroe in the small town of Quincy, Florida noticed that even during the depths of the Great Depression, otherwise impoverished people would spend their last nickel to buy a glass of Coca-Cola.  With good returns on capital and a once-in-a-century valuation where the business was trading for less than the cash in the bank, “Mr. Pat”, as he was called, encouraged everyone he knew to buy an ownership stake in the firm.  He would even underwrite bank loans, backed by Coca-Cola stock, for his responsible depositors to encourage people to acquire equity.

Coca-Cola had gone public at $40 per share but a conflict with the sugar industry resulted in a 50% crash shortly thereafter, when it reached $19 per share.  Focusing on the bottom-line profits, and the power of the brand, Pat Munroe kept buying.  And he kept telling everyone else to buy, too.

That one observation, and Mr. Pat’s business skills in convincing others to buy assets that produced cash irrespective of short-term market fluctuations, not only changed lives, it saved the farm town during the Great Depression as the local economy was supported by Coca-Cola dividends.  It has also supported the town in “every recession since”, according to the man who now runs the trust department in the bank that was once headed by Munroe.

When crops fail, it was the Coca-Cola cash that kept people employed.  When the national economy collapsed, it was the Coca-Cola cash that allowed people to stay in their homes.  When times were good, and Coke was cheap, more shares were purchased.

Quincy became the richest town per capita in the entire United States at the time.  At least 67 appropriately dubbed “Coca-Cola millionaires” amassed significant fortunes before passing these on to children and grandchildren, in some cases through outright gifts and in other cases through the use of trust funds.  The bank where it all started has Coca-Cola on display and, as of four years ago, a staggering 65% of the trust assets under management are still invested in Coke stock.  (Coke has had a nice run since then as profits increased and the world recovered from the crash in 2009, so I’d imagine it is even greater today, all else being equal.)

 A single share with dividends reinvested is worth $10,000,000 in 2013.  It would be gushing $270,000 in pre-tax cash dividends to the owner by sending a check for $67,500 or so in March, June, September, and November of each year....MORE

HT: Value Investing World 

The power of reinvested dividends, Mr. Kennon's link above: "Reinvesting Dividends vs. Not Reinvesting Dividends: A 50-Year Case Study of Coca-Cola Stock".

Freeport McMoRan Vice Chair Buys 1.1 Million Shares (FCX; PXP)

Mr. Flores just had a bit of a payday when he closed on the sale of Plains Exploration, of which he was Chair/CEO, to FCX for $16.3 Bil.
This purchase of $34 million worth of Freeport is as much a show of faith in the combined company as it is a bet.

Still, it's a big show of faith. And it was open market.
Here's the filing from SECForm4.

"Gundlach’s Next Call – Short Gold"

Gold is trading at $1366, down $16.60. We are more negative on gold than even Mr. Gundlach, possibly $875 sometime next year.
From Attain Capital Management:

Like most predictions, calls for markets to go higher or lower have a 50% chance of getting it right, and a 50% chance of coming up short. But more than just getting the direction right, people want to know if prognosticators can identify the big moves, and investing heavyweight Jeff Gundlach of Doubleline has made a few outstanding calls in the last year. Cases in point: his suggestions to go short Apple/long Natural Gas in April of 2012 and short Yen/long Nikkei in December 2012. Besides spurring lots of attention, Gundlach’s recommendations both posted some impressive gains when we looked at them earlier this year.

With those two big calls looking to be wrapped up, does Gundlach have another predication to follow? Yep … Gold.  Just yesterday we wrote about how Gold is coming off a historic high, and has been continuing on a downward slope. It just so happens, Gundlach predicts a continuation of falling gold prices:

“I’m not really that fond of gold,” Gundlach said. “I think gold makes it to 12 handle, maybe $1280.”

Gundlach’s earlier predictions proved quite prescient… but with Gold already down significantly, his call here is more in the domain of trend following rather than top and bottom calls. But as long as he keeps making bold predications like this, we’ll find out in the long run whether or not he’s just flipping coins.
By the way – here’s Gundlach’s previous two “calls” through present day.

 

Disclaimer: past performance is not necessarily indicative of future results.

Short Apply/long Natural Gas continued its upward course, peaking at nearly a 75% return in March (and remember, his original call was to leverage both up to 10x). Since then, a bit of a rebound in Apple and a stall in the Natural Gas climb has suggested that the run might due for a break....MORE

EIA Monthly Short Term Energy Outlook: Global Liquid Fuels Consumption

From the EIA's STEO:
Released June 11, next release date July 9.

Relative Changes in the VIX Near FOMC Announcement days (VIX; VXX; XIV)

The VIX is at 16.57 down 1.31%.
From VIX and More:

The VIX and the Pre-FOMC + Post-FOMC Trades

Back in December 2008, in VIX Trends Around FOMC Announcement Days, I posted a chart of the average movements in the VIX in the ten trading day leading up to and following “Fed Days,” otherwise known as days in which the Federal Open Market Committee (FOMC) makes its policy statement announcement. Several long-time readers who recall that chart – and an earlier incarnation from VIX Price Movement Around FOMC Meetings – have recently asked for an updated version. With all eyes on the Fed’s statement and Ben Bernanke’s press conference on Wednesday, this seems like a good time to revisit how the VIX moves in the days leading up to and following FOMC announcements....MUCH MORE

Commodities: Backwardation vs. Normal Backwardation

We're going to be hearing these terms a lot in the next few weeks.
Even very sharp people can have trouble integrating the concepts into their investing worldview so that the relationships are seen automatically and you can use your brain for other, important, things.
First up, the framework:

contango: CURRENT spot price < future price
backwardation: CURRENT spot price > future price

normal contango: EXPECTED spot price < future price
normal backwardation: EXPECTED spot price > future price

That's it.

If a person can get the picture at a subconscious level they have a chance at making it in commodities.

I dumped this stuff on the reader in February's "The Trouble With Gold (GLD)" without much explanation (I'm a lousy teacher):

....So there you have it. Anyone messing with commodities must have this stuff incorporated into their worldview the way a bond trader uses the interest rate/bond price see-saw without even thinking about it.

Now, you can either re-read "Gold, the rate of reburying trade" or you can read "The Working Curve and Commodity Storage under Backwardation":

 Abstract

There remains controversy over whether the empirical curve relating intertemporal commodity price spreads and stocks, originally drawn by Holbrook Working in 1933 (i.e., the Working curve), is a valid stylized fact in commodity markets. The core of the controversy is the portion of the curve representing commodity stocks under backwardation. In this article we analyze the original data used by Working, plus more disaggregated numbers. We find that the Working curve is indeed valid. The diversity of stockholders and different stockholding motives most likely explain the empirical Working curve relationship. 

But if you're going to do that you should probably read Keynes' "theory of normal backwardation" (not to be confused with backwardation).

Working differed with Keynes on some very basic points, see "The Theory of Speculation Under Alternative Regimes of Markets". And then...

...just read Izzy.

Or dip into "Backwardation as the Long-Term Driver of Commodity Futures Performance; Evidence from Soy, Corn and Wheat Futures from 1950 to 2004"

to understand what Goldman was doing to their "Long-only index investors" with the GSCI swaps (it's no accident that the GSCI is so weighted to oil) or...
...just read Izzy.

Front futures $1,676.20.

For the visually attuned here are the relevant  charts and a pretty good discussion at Investopedia:
Contango Vs. Normal Backwardation 

...Normal and Inverted: Snapshot in TimeA contango market is often confused with a normal futures curve; and a normal backwardation market is confused with an inverted futures curve.

Let's start by getting an understanding of the difference between the two. Start with a static picture of a futures curve. A static picture of the futures curve plots futures prices (y-axis) against contract maturities (i.e., terms to maturity). This is analogous to a plot of the term structure of interest rates: we are looking at prices for many different maturities as they extend into the horizon. The chart below plots a normal market in greenand an inverted market in red:

Copyright ã 2007 Investopedia.com

Figure 1

The plot above is a hypothetical plot for crude oil futures. There is no reason to expect a flat line. The current price is called the spot price. In the chart above, the spot price is $60. In the normal (green line) market, a one-year futures contract is priced at $90. Therefore, if you take a long position in the one-year contract, you promise to purchase one contract for $90 in one year. Our long position is not an option in the future - it is an obligation in the future.

Supply/Demand Determines the Shape
The red line in Figure 1, on the other hand, depicts an inverted market. In an inverted market, the futures price for faraway deliveries is less than the spot price. Why would a futures curve invert? Because, in the case of a physical asset, there may be some benefit to owning the asset (called the convenience yield) or, in the case of a financial asset, ownership may confer a dividend to the owner.

A few fundamental factors (i.e., the cost to carry a physical asset or finance a financial asset) inform supply/demand for the commodity, which ultimately determines the shape of the futures curve. If we really want to be precise, we could say that fundamentals like storage cost, financing cost (cost to carry) and convenience yield inform supply and demand. Supply meets demand where market participants are willing to agree about the expected future spot price. Their consensus view sets the futures price. And that's why a futures price changes over time: market participants update their views about the future expected spot price.

The traditional crude oil futures curve, for example, is typically humped: it is normal in the short-term but gives way to an inverted market for longer maturities.

Contango and Normal Backwardation: Patterns over Time
We have established that a futures market is normal if futures prices are higher at longer maturities and inverted if futures prices are lower at distant maturities.

This is where the concept gets a little tricky, so we'll start with two key ideas:

• As we approach contract maturity (we might be long or short the futures contract, it doesn't matter), the futures price must converge toward the spot price. The difference is called the basis. That's because, on the maturity date, the futures price must equal the spot price. If they don't converge on maturity, anybody could make free money with an easy arbitrage.
• The most rational futures price is the expected future spot price. For example, if you and your counterparty both could foresee that the spot price in crude oil would be $80 in one year, you would rationally settle on an $80 futures price. Anything above or below would represent a loss for one of you!

Now we can define contango and normal backwardation. The difference is that normal/inverted refers to the shape of the curve as we take a snapshot in time. Contango and normal backwardation refer to the pattern of prices over time. Specifically, is the price of our contract rising or falling?

Suppose we entered into a December 2012 futures contract, today, for $100. Now go forward one month. The same December 2012 future contract could still be $100, but it might also have increased to $110 (this implies normal backwardation) or it might have decreased to $90 (implies contango). The definitions are as follows:

• Contango is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies that futures prices are falling over time as new information brings them into line with the expected future spot price.
• Normal backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who are "net long" in their positions: they want the futures price to increase. So, normal backwardation is when the futures prices are increasing.

Consider a futures contract that we purchase today, due in exactly one year. Assume the expected future spot price is $60 (see the blue flat line in Figure 2 below). If today's cost for the one-year futures contract is $90 (the red line), the futures price is above the expected future spot price. This is a contango scenario. Unless the expected future spot price changes, the contract price must drop. If we go forward in time one month, note that we will be referring to an 11-month contract; in six months, it will be a six-month contract.

Copyright ã 2007 Investopedia.com

Figure 2

Sorting out the Confusion
Clearly, it is more precise to say that in contango, futures prices for a given maturity date are falling. In normal backwardation, futures are rising. This is not exactly the same as the shape of the futures curve because futures prices are constantly adjusting to consensus expectations about the expected future spot price.

Finally, consider a distinction that seems to exist only to confuse. Normal backwardation is not quite the same as backwardation. (For more insight on this, pick up a copy of "Futures, Options And Swaps" (2007) by Robert Kolb and James Overdahl). Backwardation is the same as inverted when futures prices are lower than spot prices. But in many cases, it's better to stick with inverted and drop backwardation altogether....

Monks on Planes: Buddhist Bling

From the Bangkok Post:


A photo captured from a video clip at YouTube features a group of monks with sunglasses on a private jet. The monks’ behaviour has drawn heavy criticism from online viewers.

Office director Nopparat Benjawattananan said Monday it was not wrong for monks to fly on a private jet, as seen in a recent YouTube video, since the jet did not belong to them, but was donated....MORE

The Louis Vuitton folks couldn't have bought better product placement.

"Pro-forma I'm Miss America" (insurance and nakedness)

This is a repost from February 2010:
"Insurance and Nakedness": The Guy Who Saw the 2007-2009 Meltdown Coming and Described Exactly What Would Happen
I collect prognostications.
This weekend I was going through a file of forecasts that various people had made from 2000 through 2005 and saw one that I had printed out on April 22, 2002.
Truly amazing.

Insurance and Nakedness

Before I get to the title of this piece, I'd ask you to take a short quiz -- two questions. I'll be referring back to these two items later in this article. First question: What are the odds of someone winning the lottery?

If you're like most people, you answered something like, "they're very low." But that would be incorrect, because you answered a question that I didn't ask. The question you likely answered is the one that you're most familiar with: What are the odds that you (or another specific person, named in advance) will win the lottery?
But rather than looking at it from the point of view you're used to, look at the lottery as a whole. That's the question I asked. Someone usually does win the lottery. In fact, the point can be made even more plainly if we take the example of a charity raffle. You've probably been to one of these. Everybody buys a ticket and someone will win the prize. If the first winner isn't there, they pick another ticket out of the fishbowl. They keep doing it until someone wins. We don't know who will winin advance, but there's a 100% chance that someone will win.

Hopefully, you'll see my point later on and not think it's just a stupid question where I could say, "Fooled ya! Fooled ya!" But first, lets get to the second question which is more straightforward and rhetorical:

If a company has 90% market share of a market that is mature and is not growing, and the company isn't expanding into any other lines of business, how much more can the company grow?

Probably not much. In fact, the things that can happen are mostly bad. There's 10% more upside, but a whole lot of potential downside. A new competitor might undercut on price or on service and take away 10-15% of the market. Somebody might give away your product or service as a loss-leader to get the customer's business on something else. Another product or service might displace yours or make it obsolete, etc., etc. The point being, there is a time when the market becomes saturated and the risk becomes greater than the reward.
Hereafter, I'll be referring to these two items as the lottery example and the 90% problem.

Is Everybody Already Into The Pool Of Available Buyers?
In a previous piece, I asked a question that I'll put to you again: name an asset that you cannot buy with 100% financing. There are very, very few. Ironically, stocks are one of the few I can think of. Cars, boats, houses, furniture, stereos, you name it -- 100% financing is available. And that's a stingy deal. Nowadays it's no down, no payments, and no interest for a year or two. Greater than 100% financing on houses is often available. Twenty years ago, it was not like this. Even ten years ago it wasn't like this. The increase in credit availability is the reason for much of the increased demand in certain sectors of the economy.

The ability to purchase an asset on credit creates a huge additional demand for the asset because it increases the pool of available buyers. If we all had to pay cash for cars, let's say $30,000, the pool of available buyers would be small because many people have very little in the way of savings. But if the car can be purchased for a payment of several hundred dollars a month, the pool of available buyers increases dramatically. That's wonderful as the credit availability is being increased. But if it decreases, it also takes away potential buyers.

As an investor in assets, of course, you want the pool of available buyers to be small -- less competition. The time to buy real estate, for example, is when interest rates are 12-13%, no banks will lend money anyway, and nobody has cash. Nobody but you. Conversely, when lenders are offering easy credit, 125% financing, the lowest interest rates in 40 yrs, etc., this is about as big as the pool of available buyers is going to get. No one knows where the exact saturation point is, but it will come.

As discussed last time, much of the credit creation in this current bubble has taken place outside of the banking system itself. Now I'll invoke the lottery example and suggest that again we need to look at the whole -- the total amount of both money and credit available -- not just one specific part of it. Rather than looking at just the official banking numbers (M1, M2, M3, MZM, etc) for signs of an increasing money supply as we may be used to doing, we must also look at the increase in credit outside the banking system. It has exploded. Credit can affect asset prices just as much as real money. But, alas, at some point the market will get saturated with credit (whose payments still must be made), as the borrower simply cannot afford more payments given his current income. Then there are no new buyers, asset prices begin to fall, credit becomes less available, and the entire scheme goes into reverse.

Debt, Derivatives, SPEs, SPVs, and SUVs
It's quite possible that much of this credit has been effected because of a single faulty premise. If you think that's not possible, let's remember it was a very short time ago that almost the entire internet bubble was brought about by the single flawed premise that advertising would cover the costs of running a web site. Sure, you had some retailers and other businesses trying to sell stuff, but by and large everybody thought they could provide content for free, and make money from advertising. Almost everyone involved with the internet believed that faulty premise.
Where credit creation is concerned, that flawed premise may be the concept of financial insurance. Of all the "financial insurance" products, credit insurance is among the most worrisome. Think of credit insurance as being a bit like co-signing on a loan. If the borrower can't pay, you're on the hook. It would obviously be much riskier to cosign for an irresponsible teenager than for a reputable, able, qualified borrower. However, able borrowers obviously don't need a co-signer.

But Wall Street would have us believe something different. They would have us believe that you can take a bunch of sub-prime auto loans, consumer loans, or mortgage loans, etc., place them into an SPE (Special Purpose Entity) or SPV (Special Purpose Vehicle), slap a credit insurance product on them to turn them into AAA-rated paper, and the risk is somehow hedged away and just magically disappears into the system.

This is nonsense. I contend that not only is credit insurance not an insurance product, but the risks cannot be hedged away, and, in fact, the very existence of such "financial insurance" products is almost destined to bring about the very type of conditions that will expose their speciousness.

The '87 Crash Revisited
If there are two things that we should have learned from the stock market crash of 1987, they are these: (1) portfolio insurance was a flawed concept that served as nothing more than a giant stop-loss order, and (2) writing naked puts on the stock market seems like a great idea when the market is flat or going up, but you can get wiped out in a hurry when there is a large move down.

Now, in my opinion, Wall Street has combined these two great flavors to give us the new and improved concept of credit insurance. I want to make clear that when I speak of credit insurance I'm talking about the type of insurance used during the last 5-7 years (during the boom) in conjunction with the "structured finance" products: asset-backed securities, mortgage-backed securities, collateralized debt obligations, et al. This entire industry, in it's current form, is extremely young -- maybe 10 years old. It is a boom-time creation.

Credit insurance, as a concept, began by companies insuring municipal bond obligations. That, I consider to be a different and legitimate business. You're dealing with a municipality who has taxing authority and is providing a necessity to the citizenry. But then the industry began to expand into insuring other products to the point where in the last 5-7 years, I believe they are taking ridiculous risks in the structured finance area.

An insurable event must be random and mutually exclusive in order for an insurer to be able to pool a number of insureds, do the actuarial calculations, and charge an appropriate premium. Usually an insurable event is one that is mutually exclusive by geography, and/or demographics, and/or industry, and it is also not possible for the events to be contagious or interconnected, etc.

The point can be made clear with an example. An automobile insurance company, for example, may insure drivers in Dallas, Los Angeles, Denver, Omaha, etc. A car accident in Dallas is not going to cause one in Denver. Sure, accidents will happen at the same time in different cities, but it is all more-or-less random, whether happening to a 36-year-old or a 57-year-old, male or female, working in pharmaceutical sales or as a homemaker.

But now lets take that same concept and apply it to one type of financial insurance: stock portfolio insurance. None of the randomness and mutual exclusivity is there. All of your insureds are all taking part in the same event (in this case, a stock market downturn), which is cyclical rather than random. Imagine the CEO of a stock portfolio insurance company boasting, "We have a diversified insurance portfolio. Diversified geographically: we insure against stock losses in Dallas, LA, New York and Omaha. Diversified demographically: we insure people from age 28 all the way up to age 75 against stock losses. We're also diversified by industry sector, insuring against stock losses in the financial, retailing, real estate, and manufacturing sectors. We're very well diversified."

Obviously, such a portfolio is not diversified at all. The losses will come to all of your insureds in one fell swoop when the stock market heads down, regardless of their location, their age, or their industry. Attempting to write insurance for something cyclical is not insurance. It's guaranteed losses at some point, the only question is when.

Self-Fulfilling Problems
But it gets even worse than that. The very existence of financial insurance for something cyclical will almost certainly lead to a boom followed by an inevitable bust -- the very thing the "insurance company" cannot withstand. Just so that we don't over-use the stock market as our only example of "insuring" a cyclical event, let's "insure" against a downturn in the semiconductor industry. What will happen? A boom. It's almost guaranteed. With "insurance" available, every semi manufacturer would go out and build as many new plants as possible in order to gain market share. After all, its losses are limited -- it's got "insurance." Every semi company would do the same. There would be a temporary boom. And the ultimate liabilities for the insurer would only get bigger as the boom grew. You'd get massive over-capacity that would lead to a huge bust in the industry, and huge losses for the insurer. The existence of the insurance product brings about the very bust it cannot withstand.

There is no way you could charge enough for the product because every semiconductor company will have losses. Even if you knew in advance that there would be $5 million in losses for one company, you'd have to charge more than $5 million for the "insurance" policy, because all of your other insureds would have losses too. There are no offsetting "unharmed" insureds (whose premiums you get to keep) to make up for the claims you have to pay out. Everyone would be hit. Everyone would have a claim. Any attempts to hedge the risk dynamically would mean selling into a declining market and would only exacerbate the problem.

Much like insuring against a downturn in the stock market or in the semiconductor industry, the credit insurers are really insuring against a serious downturn in the economy. Loans everywhere will all go bad at the same time. And just as the semi manufacturers thought they could build with reckless abandon because they have "insurance," the purchasers of all this credit are willing to buy with abandon because the securities they are purchasing are insured. They're AAA-rated.
So it seems to me that this type of "credit insurance," can only exist for one of two reasons: (1) it is either massively under-priced and the under-pricing will be exposed during a significant downturn, or (2) it is properly priced and the buyers are stupid to buy it. Personally, I'd lean very heavily toward thinking it's number one. There is huge risk out there somewhere. As we've witnessed with recent events, these things can be hidden for some time. The credit insurers boast of very, very small losses. So small that one wonders why anyone would pay premiums for their products.

Much of the credit creation in the economy has occurred because there are ready buyers of this credit. The purchasers of these structured securities are buying them because they are AAA-rated. This is only possible because of credit insurance. If that insurance becomes too expensive or goes away because the insurers start suffering large losses or receive credit downgrades, etc., the AAA-rating would also go away, meaning the purchasers of these securities would disappear, and much of the credit creation could seize up very quickly. Thus, a significant portion of the money supply could contract, quickly. This is why I do not discount a financial accident scenario. Not to say that it will happen, only that it could.

Many of the hedge funds and leveraged speculators playing the chase-the-yield game and buying these asset-backs and mortgage-backs, et al, could go broke very quickly. Banks could be on the hook for loans to many of those hedge funds. The entire area of structured finance, in its current form, is new and untested by a significant economic downturn. It is a chain of many weak links. Debt, derivatives, credit insurance, hedge funds, special vehicles, banks, etc., are all interconnected. The losses can be contagious. Another LTCM-type debacle is not out of the question. We seem to just keep ignoring these head-on collisions and keep speculating wildly as though nothing happened. Just hose the blood off the dashboard and let somebody new start driving the car.

The Availability Of Financial Insurance Can Disappear Quickly
Interestingly, one of the reasons Kmart cited for having to file bankruptcy when they did was the "evaporation of the surety-bond market." I heard an analyst say that the potential losses from the surety companies on Enron transactions alone (we haven't even discussed the potential for fraud, which tends to be rife during bubbles) could amount to something like 75% of all surety premiums collected by all surety companies for the year.

Many money market funds are dropping default insurance because premiums have soared. USAA, Fidelity Investments, and Putnam Investments, have all dropped insurance. Vanguard and others are considering doing so. Those funds just got a lot riskier. One has to assume they weren't blowing the shareholders' money on insurance for no reason. Now it's no big deal?
My personal belief is that the puny additional yield in money market funds is no longer worth the risk.

If there are huge losses out there, they are likely to show up without warning. Take seriously the fact that money market funds are not federally insured. I will be keeping any uninvested funds in things that are federally insured or direct obligations of the US government. Because yields are so low (another unintended consequence of cramming interest rates down), many money funds are already absorbing expenses so investors don't take losses. There's the potential for funds to take additional risk to chase yield. We should also remember that money market funds are susceptible to the equivalent of bank runs. Obviously not in the sense that there are fractional reserves like at a bank, but in the sense that too many withdrawals could force funds to go bankrupt. Just because this has rarely happened before does not mean the risk isn't there.

Mortgage insurance is another financial insurance product of dubious nature. The Japanese mortgage insurance companies are still suffering to this day, requiring further injections of capital. Many analysts say our property bubble isn't nearly as bad as Japan's. Maybe they're right . . . but maybe not. Before it crashed, we also heard the Nasdaq wasn't a bubble and wouldn't collapse like the Nikkei.
Now, the main argument used to explain that we don't have a housing bubble is that there is no oversupply. There was no oversupply of telecom equipment either. . . . until there was. Companies couldn't keep up with demand. Remember those days? Easy money produced a temporary over-demand of telecom equipment that brought about the oversupply. When the easy money disappeared, the oversupply was exposed. In housing, I believe easy credit has made for a temporary over-demand of housing. When the easy credit disappears, there will be an oversupply.

In a recent article, Joe Birbaum, an executive retiring from Mortgage Guaranty Insurance Corp, urged caution in home lending. That's good. Except we read this, "His definition of high-risk: loans exceeding 100% of a home's value or beyond 103% for low-risk borrowers rolling closing costs into the loan; and deals requiring more than 41% of borrower income for the mortgage payment." So apparently, he thinks 100% loans are not high risk. That's scary.

Structural economic problems are often not readily visible; they're not peeling paint. The building just collapses, seemingly unexpectedly, and for no visible reason. If we have a serious economic downturn, the mortgage insurers will suffer mightily.

Good Times, Loose Morals
Keep in mind, everything gets loosey-goosey when times are good. "Close enough. Let it go through. Big fees riding on this." Normally, when a company sets up an SPE or SPV they must obtain a "true sale" opinion from a law firm, indicating that this really is a sale and not some sort of sham transaction. Stop and think about that concept for a minute. You're selling to such a closely related party that you have to get a law firm to step in and say, "Yeah, this is really a sale, not just two guys pushing paper back and forth to steal money." That's not to say such a structure can't be used legitimately; it's just to point out that this is obviously a very, very close relationship.

Now the bad news. Enron had "true-sale" opinions from a highly respected law firm. We now know that these were anything but true sales. Might there be more out there? If Wall Street is good at one thing, it's making a cookie-cutter and doing the same thing over and over. Everyone's morals become a little looser when easy money is at stake. These types of structured finance transactions have yet do go through a major economic downturn. If large losses are suffered by SPVs, do you think maybe the investors from two different entities might bicker over how the deal was set up? Or might bicker over the remaining assets? Or might sue the deep pockets (the insurers)?

The other day I saw a press release stating that a company had sold a series of AAA-rated sub-prime loans. Only on Wall Street could such an oxymoron be seen as financial genius. But somehow, turning sub-prime paper into AAA-rated paper doesn't sound risk-free to me. Somebody is holding that risk. The credit insurers claim they hedge this risk away dynamically. I don't see how this is possible. Who takes the other side of that trade? They might do it once, but once they take big losses, they won't do it again. The liquidity for such a market will disappear. Many of these SPVs also have a built-in liquidation feature where if the losses get to a level that is to great, the entire thing will be liquidated. "To whom?" one might ask. Liquidity is a coward; it disappears when things get tough.

So to use a stock market analogy, I contend that the purchasers of such credit insurance products are buying something akin to portfolio insurance, and they are buying the insurance from someone who is essentially writing naked, out-of-the-money puts on the economy. Neither is a smart thing.

[And similarly, with the bankruptcies of Kmart, Enron, Global Crossing, et al, many of the large banks are discovering that those credit lines they handed out so freely during the boom, are the equivalent of writing naked, out-of-the-money LEAP puts on a given company: very small fees collected in return for the risk of huge losses in bankruptcy. Worse, they can't "buy back" these LEAP puts in the open market. They just have to sit there and take the pain.]

Enron = MicroStrategy
MicroStrategy was the company that got everyone looking at the dubious accounting of many of the tech stocks. Everyone looked at tech revenues and earnings with a much closer eye after MicroStrategy blew up in March of 2000, if I recall. Enron will likely be the siren to go off for the larger companies and the market as a whole. Bond rating agencies will take a much closer look at companies now. We may now see a race to downgrade as none of the big three wants to be responsible for triggering credit clauses in loan agreements, or derivatives, or off-balance-sheet entities. The accounting will likely get tougher, as the accounting firms don't want to have to pay out huge lawsuit settlements.

We now find out that Enron was recording its revenues much like Priceline was. And the earnings were, well, non-existent. The self-dealing off-balance-sheet partnerships had plenty of profits, however. (It's ironic to see the Federal government, a big abuser of off-balance-sheet accounting itself, sit in judgment of Enron.)

Enron was supposed to be The World's Greatest Company. It now seems Enron's only claim to fame can be that it was Texas' biggest innovator in creative finance since Anna Nicole Smith's groundbreaking work in pioneering the viatical marriage. (In case you're not familiar with the subject, Ms. Smith, a Playboy playmate, married an octogenarian billionaire. Though men often describe her as a woman of "ample personality," whenever I see Ms. Smith on television I immediately become concerned that I may have over-inflated my tires.)

It seems Enron was over-inflating things too. But who hasn't been? And it doesn't have to be fraud. If we just counted stock options as compensation and caused them to be expensed as they should be, earnings would probably fall another 8-15% at most companies. At some companies the earnings reductions would be much, much greater. Employee stock options are basically just another type of OTC derivative. When there is no regulated exchange to establish a market price, the company sort of gets to decide what they're worth. "Uh, we'll choose zero." Fox guarding the hen house. Mark-to-market accounting and gain-on-sale accounting for OTC derivatives work much the same way. "Mark-to-meet-earnings-estimates" may be a more appropriate term.

Pro-Forma, I'm Miss America
Lets pad the top a little bit and pretend that I have long, flowing, blond hair rather than a graying, balding pate. Take a few decades off my age, and cap my teeth while you're at it. Then, imagine my excessive nose and back hair isn't really there. Ignore my pot belly. Strip away the male genitalia (ouch). And finally, make believe my disgusting toenail fungus isn't as hideous as it really is. Do all these things, and you'll see that I'm actually an incredibly attractive, slender, leggy, 21-year-old female who has some very important views on world peace, plus I have the ability to keep every single one of my beautiful teeth exposed while excitedly uttering the phrase, "I'm majoring in COMMUNICATIONS!"

The gap between GAAP earnings and pro-forma earnings has never been greater. The one-time charge is now something that occurs approximately every three months. Big bath quarters, goodwill "cookie jar" reserves, off-balance-sheet transactions, aggressive pension assumptions, revenue swapping, etc., are all part of the game. Companies are not earning as much money as they are saying. It's that simple.
This leads us to a question.

New Economy Or Embezzlement?
The sole purpose of all these financial shenanigans is to make a company appear to be worth more than it really is.
If the company were private and management owned all the stock themselves, they would never report earnings to themselves this way.
It is clearly an attempt to mislead the public into bidding the prices of shares up to higher and higher levels so that insiders can sell out. At its worst, it can become the financial version of e pluribus unum. Roughly translated: from many Global Crossing shareholders. . . . to Gary Winnick.

I believe it was Teddy Roosevelt who said, "A man who has never been to college might steal a railroad car, but a man who has been to college might steal the whole railroad."
Embezzlement means to willfully take or convert to one's own use, another's money or property, of which the wrongdoer acquired possession lawfully, by reason of some office or employment or position of trust.
Not accounting for stock options, misleading accounting, etc., fits the definition of embezzlement, in my opinion. Let's call it what it is.

Employee stock options should either be accounted for fully as expenses, or outlawed for public companies. One or the other. Otherwise it's embezzlement.
Microsoft recently traded at 60 and the Jan '04 calls with a strike price of 60 were trading for 14. Think about that. At-the-money options with less than two years to expiration trade for 14, but employee options expiring in ten years are free, according to the income statement.

If we go the route of expensing options, perhaps we should consider having publicly traded 10-year LEAP options on all companies that issue employee stock options. That way, the market, not some formula, would determine their value. The more glowing hype that management spews about their company, the pricier their 10-year LEAPS would become in the market, and thus, the more expenses the company would have to deduct for new option grants. They would have to pay a current price for offering ridiculously rosy future scenarios. Employees would not be allowed to speculate in the LEAPS. (And why are employee options for 10 years anyway, with no cost of capital factored in?)

Alternatively, outlawing option grants for public companies is also worth looking into. Contrary to popular belief, I believe options do far more to pit management against shareholders, rather than put them in the same boat. Extensive use of options is only a couple of decades old (coincidentally, the same decades that stocks went up the most in history -- at least partially because of false, overstated earnings; victims are left holding the bag).

Options do much to encourage management to make money off the shareholders, rather than with them. Management has an incentive to issue bad news and drive the stock price down right before the option grant in order to get themselves a lower strike price. Options also encourage unhealthy risk-taking to get the share price up. They provide motivation for accounting chicanery and setting up structures that may be good for a few years (long enough for insiders to sell out) and then blow up later on, a la Enron. They encourage a company to engage in risky vendor financing to prop up sales and earnings short term. The list goes on. They provide much temptation for management to act in an immoral manner. What corporate board is going to vote against an option plan when they get some to? (Even when options "work," money has still been taken from shareholders because they are having to pay a higher price for the stock than it is really worth if all expenses had been accounted for.)

Private startup companies, often short on cash, could still issue whatever options they want. This would also encourage companies to stay private until their house is in order. The big risk-taking would be done in private companies and not with the public's money. But for public companies, pay management in cash after they have produced cash earnings. That way all the expenses will be accounted for. Then let the management buy stock at the market price if they want, so they are in exactly the same boat as shareholders rather than getting free lottery tickets. No sweetheart deals for management. That's the whole idea of being a fiduciary.
Officers are fiduciaries of the shareholders, meaning they are supposed to put the shareholders' interests ahead of their own, not the other way around. They are supposed to watch out for shareholders, not conceal expenses from them.
At the very least, options almost guarantee that at some point the most aggressive accounting possible will be used in order to get the stock price as high as possible. Innocents will get sucked in to purchasing at a falsely inflated price.

Now, consider reading the following headline in your local newspaper:
Strong Sex Drive Leads To Poor Punctuation Study, Says
In other words, sometimes the statement itself gives you some unintended insight into the person making it. This brings us to General Electric. GE is a large company very representative of the economy as a whole. GE's CEO Jeff Immelt recently admitted that he does not see a recovery in 2002, but at the same time announced that earnings would increase by up to 18% in 2002. Not that they might, or that they could, but that they would. Ponder that one. He's telling you the earnings will be up, even before the results have come in. That should tell you something. No executive should be making that kind of statement. If I'm not mistaken, Mr. Immelt's predecessor once remarked that they could grow earnings in any economic environment. A ridiculous statement, unless you know you're going to torture the books until they tell you the number you want.

GE's financing arm can do lots of things to make earnings look better than they are. I have no idea what GE is really earning. I don't think anybody does. Oh, I know what they're reporting, I just don't know what they're earning. I don't know the risks they're taking. But something is very fishy when the CEO announces earnings a year ahead of time.

What Can Get Better?
While many people are saying that the worst is all behind us, I don't see it that way at all. The 90% problem discussed earlier is something we face in many areas of the economy. Companies are already as aggressive as they can be with their accounting. Options aren't being accounted for. P/E ratios are either very near, or way above, all-time highs depending on whose figures you use. Unemployment is still ridiculously low for a recession. Energy prices are back down. Home ownership is at all-time highs. Home equity is at all-time lows even as home prices are at all-time highs. Interest rates are at 40-year lows and everybody has already done a ReFi on their house. Credit is available everywhere. The savings rate is nil. Consumer debt is at all-time highs. Gas is around a buck. Everybody's driving a new car they don't need but got for 0% financing. The dollar is still amazingly strong, even though the trade deficit is enormous. On and on.

What if just a couple of these things start going in the other direction? What if many of them do? Things are already leveraged to the upside in nearly every way. But you can only leverage-up once. After that, what do you do for an encore?
Isn't the risk to the downside much greater than the potential upside?

"Looking Beyond The Valley"
Every time the market rallies, we continually hear stock salesmen tell us that investors are "looking beyond the valley" to the imminent recovery, the improvement in earnings, and the inevitable increase in stock prices. This phrase paints a wonderfully rosy picture. It suggests we are standing on one high point, looking across to another high point (you can't be in the valley and looking beyond it). We aren't even in the valley yet, you see, but once we get there it's going to be so shallow, that it's not really even worth thinking about.

This reminds me of a passage in the book Cadillac Desert (a history of the American west's water resources) that has always stuck with me:
In 1539, Don Francisco Vasquez de Coronado, a nobleman who had married rich and been appointed governor of the Guadalajara by the Spanish king, set out on horseback from Mexico with a couple of hundred men, driving into the uncharted north. . . . .A few of his party on a side excursion discovered the Grand Canyon, but they were unimpressed by its beauty, and guessed the width of the Colorado River far below them at eight feet or so.

This was the biggest bubble in financial history. Step back and have an appreciation for what we're looking at.
If you're "looking across the valley" and plan to journey there, be sure you have a realistic assessment of how wide the valley is, how steep and lengthy the descent into it is, how arduous it may be to get across the valley, and how painstakingly slow and difficult the climb up the other side may be.

###

Pretty good writer eh?
Remember, that was written in February 2002, Enron was all over the headlines and the market was still eight months from the October 8, 2002 bottom that set up the five-year speculative frenzy that topped out on October 9, 2007.
The author is a fellow named Tim Picks who used to write for Gold-Eagle.
Here's the index of his essays for their site. He seems to have dropped out of sight in 2004.