February 27, 2005
America's Silent Telecom Crisis
You can download a PDF file of the full article by licking on the pink FT image on the home page of the Rutledge Capital website, www.rutledgecapital.com. Ft subscribers can go to the IT Review section of the FT website for more on technology investing from our friend, Andrew Baxter, who edits the section.
It is very important that Congress gets it right when they rewrite the US telecom law this year. Our communications network is the central nervous system of the entire US economy. Our productivity and our competitiveness depend on it.
Posted by John Rutledge at 9:45 PM
International Debt Comparisons
Thought I would inject a few facts into the debate over US debt levels. As you can see in the chart, the US is not actually one of the higher-debt countries. Germany, France, Italy, Canada, and Japan have larger government debt relative to GDP.
The best measure of indebtedness is relative to net worth, not GDP. By that measure the US is in even better shape. We have the deepest capital markets in the world. The most recent data from the Federal Reserve Board show that on September 30, 2004, households owned $21.7 trillion in tangible assets (houses, cars and the like) and $35.3 trillion in financial assets such as stocks and bonds. Against this $57 trillion in total assets, US households had $10.3 trillion in liabilities, mostly in the form of mortgages. Their net worth was $46.7 trillion, about 4 years worth of GDP.
When you include the other sectors, financial assets grow to $105 trillion and tangible assets grow to more than $40 trillion--not including the market value of the 750 million acres of land owned by the federal government.
Folks, we are OK here.
JR
Posted by John Rutledge at 9:40 PM
February 24, 2005
CNBC Bullseye tonight 6-7PM EST
I will be appearing on CNBC Bullseye tonight (Thursday) with host Dylan Ratigan. Bullseye runs 6-7PM EST. Will be on both the Perspective segment and the closing segment, Whine and Cheese, where we get to drink real wine and complain about all the things that are wrong with the world and what to do to fix it.
Don't know the specific topics yet but I can bet that Korea's decision to shift away from dollar reserves will be on the list, as will "George and Valadimir's Excellent Adventure" in Europe this week.
Hope to see you there.
Posted by John Rutledge at 1:12 PM | Comments (1)
February 23, 2005
The Economy Will Grow More than People think in 2005
In my WSJ op-ed in November 2001, and many other places since, I argued that in spite of sharp reductions in Fed funds rates, monetary policy was actually very tight. Because banks has systematically withdrawn from lending to business customers. Between then and May, 2004 bank business loans totaled minus $230 billion. How? By collecting $230 billion from business customers than they loaned to business customers every week for three and a half years.
This is why we had a slow, jobless recovery over that period. Big companies borrow money from the bond market; small companies have to borrow from banks. Small companies make up more than half of GDP and create 3 of every 4 new jobs.
Over this period we had a half a recovery, because only half the companies in America had access to credit.
As a result, the Fed had to push market rates much lower than would have been necessary. The result was a recovery dominated by large companies and the mortgage market, both of which are driven by fed funds and T-bill rates.
Since last May this is all changed. The mortgage refi game is over. Banks are lending to businesses again. Loans have increased by $63 billion since May. This is giving small companies a dramatic increase in working capital and drop in cost of capital that is not being reflected in (rising) fed funds rates.
Implications.
GDP, employment, and profits will grow faster than economists think this year, the mirror image of the jobless recovery that preceded it.
Fed funds rates could increase a great deal without stopping the recovery.
The surprising productivity gain of the past 5 years has been accomplished by big businesses alone. Now small companies are getting the working capital they need to make the IT investments to duplicate those gains. Add increased availability of broadband (new telecom act this year; I am on the working group) and cheaper, more scalable technology; the result is a small business led productivity jump.
Together, these factors mean small company profits will grow faster than big company profits. Small cap stocks will outperform large caps this year by a wide margin. (This is why I have a long position in US small cap stocks at the moment.)
Moral of the story:
is it is misleading to make judgments about the economy and investing, or to set monetary policy, by thinking about big public companies alone. When you dig under the numbers, the US is a two-cylinder economy. They both need to work for us to really grow.
John
Posted by John Rutledge at 3:00 PM
February 22, 2005
Gulf Economic and Financial News Source
When I give lectures, people ask me what information source I use to understand the Gulf region economies and financial markets. the best source, of course, is lots of sand in your shoes and spending lots of time visiting friends there.
Checkov said it better. "If you want to know about Bulgarians, you have to go to Bulgaria. You can't just read about them in the newspapers."
There are a couple of written sources worth reading.
To understand the flow of news that a Guld investor reads you should go to the Middle East and Northern Africa Financial Network (MENAFN)website. Better yet subscribe to their free weekly newsletter, which will deliver clipings of all the region's papers to your desktop.
Global Investment House in Kuwait is the best source of company research and market information for the Gulf markets. Global is run by my friend Maja Al-Ghunaim, they do legitimate discounted free cash flow analysis for the major companies and markets in the region, including Iraq. (My partner, Rob Tucker and I, trained their analysts.) And they know everything happenibng in the region.
Why is this important? One reason is the best measure of political risk in the region is the value of stock and real estate markets. They have been tremendous performers in recent months. A second reason is that Gulf equities could be a very interesting alternative assete in pension fund portfolios. The plans for the GCC (Gulf Cooperation Council) countries to adopt a common currency will make this easier to do. What's next? How about an Exchangge Traded Fund for GCC markets?
John
Posted by John Rutledge at 10:52 PM
Thoughts About Russia
Would love to be a fly on the wall when Bush and Putin get together. Here are a few of the things on my mind regarding US/Russia relations.
1. The Reagan/Volcker commodity deflation/disinflation, more than Star Wars, is what bankrupted the USSR. Their biggest sources of cash were and are oil, gas, gold, other metals. China's return to growth has pushed commodity prices higher again which has given Russia a new grab at wealth and influence. They still own a lot of warheads. How will they use this power?
2. World will need +10 MBD of oil in next ten years to grow China and India. After Saudi Arabia and Iraq, Russia will supply that oil. Russian Minister visiting Saudi this month talking about closer cooperation. Russian pipeline to China. Russian technical advisors (nuclear physicists) in Iran helping their nuclear missile program. Don't like the prospect of Russia, Iran, China becoming bosom buddies again; don't like to see Saudi Arabie separated from the US camp. That separation, not the Sept 11 attacks, has been Al Queda's biggest victory. That was their objective in the first place.
3. Putin replacing democracy in Russia is, ironically, good for business. It is much easier for a CEO to deal with a dictator than a fragile, i.e., unpredictable, democratic government; capital flows into Russia to develop their oil fields and other assets are increasing.
4. President Bush's job. We blew the opportunity under father Bush to trade food for warheads when the Russians were hungry. When I recommended doing so to the White House at the time they said they couldn't afford it; the budget deficit would have been too high. Another example of budget deficit myopia. The Russians aren't hungry any more. President Bush needs to be very tough on the issue of Russian aid to Iran's nuclear program.
5. I would think the Europeans are much more sensitive than we are to the resurgence of thug-Russia. Could this be the catalyst to mend fences with the Germans? French?
John
Posted by John Rutledge at 10:18 PM
China and Japan Clash Over Gas Fields
An article in today's Japan Times highlights the growing conflict between Japan and china over rights to the gas deposits in the Sea of Japan (East China Sea).
BEIJING (Kyodo) Japan's demand that Beijing halt its gas exploration projects in the East China Sea and provide information about them is "unacceptable," a Chinese government official said Tuesday.
It is clear that China'a growing economic and military strength is the reason behind recent changes in Japanese policy including 1) a new defense policy focused on developing a missile defense system capable of hitting Shanghai, 2) their recent statement that the defense system will only be used against missiles targeting Japan, not those overflying Japan on the way to another destimation (any guesses?, and 3) their recent announcement that they will reduce financial support for US military presence in the area.
I am convinced that the worldwide scramble for oil, occasioned by China and India's dramatic increases in demand, is moving all the pieces on the board. When China or India sign long-term supply contracts with Russia and Iran, their security council votes are included in the deal. We should not forget that the proximate cause of the Pearl Harbor bombing was the american ebargo of south Asian coal from reaching Japan.
It is vitally important that we develop increased oil supplies, along with oil substitutes in the coming years.
John
Posted by John Rutledge at 10:03 PM | Comments (1)
February 17, 2005
Heads Up: CNBC Bullseye Appearance Friday Night
FYI, I will be appearing on CNBC Bullseye with guest host Steve Liesman from 6:30PM-7:00PM New york time. I am sure that our topics will include the consolidation of the telecom sector, the Fed and the stock market, recent evidence of slowing in China and Japan, and the President's reform initiatives. Hope you enjoy.
Also taping a Reuters TV spot on global growth and investment issues to air on a later date. Will let you know when it will appear.
regards,
John
Posted by John Rutledge at 10:28 PM
February 16, 2005
Mazda Mines Oldest Energy Source
Mazda Motor Corp. said Wednesday it recently opened a hydrogen filling station near its headquarters in Hiroshima Prefecture for the development of hydrogen rotary vehicles.
The hydrogen station can fuel some 10 vehicles daily, the automaker said.
Mazda conducted the world's first public road tests of a dual-fuel rotary engine vehicle in October and plans to start selling such vehicles to the public and businesses in two years, it said.
The dual-fuel vehicle runs on either hydrogen or gasoline.
The Japan Times: Feb. 17, 2005
Alternate title (with apologies to James Carville), "It's the Energy Stupid."
The physics of energy is straightforward. All life on earth is supported by the flood of energy we receive from the sun. the ongoing thermonuclear reactions in the sun make the sun very hot (duh!) in comparison with the earth. The first law of thermodynamics tells us this cannot persist; heat flows from hot to cold objects. The second law tells us it is a one-way street.
If we were forced to live on the energy in current sunlight alone we would live as hunters and gatherers. We could eat nuts and berries--products of sunlight-driven photosynthesis. We could eat the animals that eat the berries. But there would be no heated homes, no cars to drive, no books, no I-Pods.
We have managed to increases our living standard above the hunter-gatherer level by "mining the past." The sunlight of long ago grew plants that were transfornmed into dinosaurs that were transformed into oil reserves. We mine and transform that stored sunlight into heat and work to raise our living standards today. You could in principle attach vintage years to the sunlight represented in each drop of oil.
Like any other wine cellar, after you drink all the wine it is gone.
If we can learn to use hydrogen where we now use oil and gas we will be mining the most plentiful, and the oldest, store of energy in the universe.
This is very important stuff. Somehow, we must come up with an additional 10 million barrels of oil per day (the world today uses about 80 MBD; the US about 20 MBD) within the next 10 years just to satisfy the demands created by the growth of China. This is already creating tensions around the world. To do so in the Persian Gulf--the only readily tappable known source--will require $750 billion oc capital spending. Invetors will not rovide the funds unless the Gulf region is politically stable. Translation--somebody's army is going to be in Iraq for a very long time.
We face a compelling need to increase the productivity of our available energy resources. That includes anything that gives us more GDP and real wages per drop of oil. Any solution that reduces our consumption will help make this happen. We are going to see more efficient lighting systems, hybrid gas/electric vehicles, hydrogen-powered vehicles, and a shift of the composition of GDP to make this happen. It's time we recognize that using less energy is the same as producing more of it.
We need to view Mazda's hydrogen program, along with the Honda hydrogen cars, and the Honda, Toyota, and Ford hybrids, as sources of energy, and treat them as such in public policy.
I have no interest in learning first-hand about the life of a hunter-gatherer. Do you?
John
jr@rutledgecapital.com
Posted by John Rutledge at 11:13 PM
February 4, 2005
Facts and Beliefs about Telecom Competition
There are two articles in today's Wall Street Journal that you should see. On the righthand column of B1, Telecom Mergers Limit Choices of Customers talks about how the pending SBC/AT&T and MCI/Qwest mergers are going to limit consumer choices, raise costs and decrease innovation in spite of the fact that consumers are inundated by a tsunami of communication choices and technologies. An explanation for this lack of vision is in the lefthand column in Science Journal, People Believe a 'Fact' That Fits Their Views Even if It's Clearly False. This article talks about how people believe what they want to believe, facts be damned, if it violates their mental model of how the world works. You will see the same thing in people's reactions to growth numbers and social security reform. More on this later.
Posted by John Rutledge at 12:35 PM
February 2, 2005
Iraq Elections, Berlin Memories
As I watched the lines of people waiting to dip their fingers in a pot of ink and vote for the first time in their lives I could not help remembering a time long ago in West Berlin.
I wish we could all put aside our politics for just one moment and celebrate the courage of the people standing in line so they could put their finger into a pot of ink and vote for the first time in their lives. It does not matter if you think the war was a good idea or a terrible idea. It doesn’t matter if you were for Bush or Kerry. Let’s take a minute to celebrate their courage and their joy on the first day in their lives where their opinions mattered to anybody.
I was especially touched by the photos showing long lines of women in the traditional black garments I have seen so many times on my 100 or so trips to the Gulf region over the past 30 years.
I have no illusions that peace and light will break out in Iraq now they have held an election. There is too much oil wealth in Iraq; its geography is too strategically important, and its ability to defend itself is too low. Violence will continue and somebody’s army will be in Iraq for a very long time. But it is a very good day.
This is the second time in my life I have been able to witness such a day. When I was 18 years old I somehow thought it was a good idea to spend a year living in West Berlin. Temporary insanity I guess. I told my parents I was going there to study. And I guess there was a little truth in it—I enrolled in classes at the infamous Freie Universitat Berlin. According to my memory, I never actually attended a class; my schedule was too full for that luxury. The clubs opened at 6PM, and didn’t close until 6AM which, allowing for breakfast and dinner, I viewed as a full time job.
My first taste of East Germany was when my train was stopped in the night so that armed guards with dogs could search the undercarriages of the cars for East Germans trying to escape. My friends and I rented an apartment in Alt Buckow, a tiny village in the southernmost sector of Berlin, nestled right under the searchlights of the Berlin Wall. Actually, it wasn’t a wall in our sector—that was only downtown for the TV cameras. It was a 12 foot high metal fence, then a mine field, then search lights, motion detectors, sirens, guard towers with automatic-firing machine guns.
We walked along the wall every evening, trying to strike up conversations with the East German soldiers. They rarely risked a word. Some nights we were woken by sirens and gunfire. Altogether, the guards killed some 5000 people trying to cross the wall--Die Mauer--into West Berlin.
I have only been back to Berlin once. In November, 1989, I heard that students in Berlin were hacking holes in the wall. I boarded a plane, bought a hammer, and spent two days beating Die Mauer to dust. I still have pieces of colorful, asbestos-laden cement on my dresser at home so that I never forget.
So let’s take a break from politics and celebrate the courage and joy of the Iraqi people on their first election day. And let’s make sure that we never forget the freedoms we enjoy here every day.
Posted by John Rutledge at 12:43 AM
February 1, 2005
Business Loans, Growth, Small Cap Bet
Why growth will be stronger in 2005 than people think.
Why I have a bet on small cap stocks
Banks loaned businesses minus $230B between November 2000 and May 2004. That means banks collected about $1 billion more from businesses than they loaned to businesses ever week for three and one half years. As you can see in the chart, and at the FRBSL website, this was the sharpest contraction of bank credit since the Great Depression.
I wrote an op-ed about this subject in November, 2001 warning that non-price credit rationing would hit small businesses very hard, that small businesses make up more than half of GDP and 3 out of every 4 jobs. This was the reason we had a jobless recovery for so long.
Last May banks opened their doors to business borrowers again, as you can see in the chart. This corresponded to the end of the refi boom. Since then business loans have increased by about $40 billion. To date, this increase in lending has been restricted to small banks—large banks are too busy being investment banks to bother with business loans.
Doesn’t take a genius to figure out what that means for growth. Both GDP and job growth will be surprisingly strong in 2005, just as they were surprisingly weak in 2001-2003. Profits will be stronger than people think too; double digits for the year.
This explains why I hold a bet on small cap stocks today. As you know, I manage my equity portfolio by tracking storm systems—situations where an abrupt policy change has produced an after-tax yield differential. Yield gaps attract the attention of arbitrageurs. If you put your bet down early they will give you a free ride as they create capital gains by driving returns into line.
Large companies don’t borrow money from banks; small ones do. This story means small companies are enjoying a sharp drop in their effective cost of capital. They will grow faster; faster than before and faster than big companies. I think small caps will outperform the overall market in 2005.
How to place a bet? There is an exchange traded fund (ETF) that owns the S&P small cap index. It’s ticker is IJR.
Posted by John Rutledge at 9:20 PM
Geek Think: Housing Boom Phase Diagrams
Warning, this article may only be interesting to geeks. If you are not a geek, the DELETE button is on the upper right hand corner of your keyboard.
Thought it would be useful for some readers to give you a more formal statement of the property market analysis in the previous entry.
As my old friends know, I am a big fan of making sure you distinguish between asset markets and flow markets when thinking about the economy. The reason is pretty simple. GDP is a number of about $12 trillion, chump change in comparison with our $155 trillion asset market, including $105 trillion in financial assets and $50 trillion in real estate and other tangible (George Carlin) stuff, according to the most recent Fed Flow of Funds reports.
Bottom line: if a policy does not impact the asset markets it does not matter.
Aside: This is no different than asking whether the earth orbits the sun or the other way around. Most people know the sun is the big dog in this story, therefore the earth orbits the sun. Actually this is not true. You can get a free srink at a cocktail party by telling people that actually both the sun and the earth rotate the center of mass of the sun-earth system, which is a point inside the sun but not its center. The end.
This is important because almost all of what passes for macroeconomic analysis today is simply descriptions of who is spending how much money in the GDP accounts. That analysis leads these thinkers to make big mistakes, which gives us great opportunities to make money.
Regarding real estate, take a look at the following diagram.
In this diagram, the graph on the upper left represents the asset market in which the price P of the existing housing stock, K, is determined.
The graph on the upper right represents the new construction (flow) market in which the price of an existing home interacts with the marginal costs of contractors to determine the number of homes or buildings that will be built, which we denote by lower-case k.
The lower right graph is simply a device for bringing big K and little k together on the same graph, which I have placed in the lower left. That is where all the action takes place.
Start with housing stock K(0) and demand for homes D(0) which determine the initial price of a house at P(0) in the upper left graph. A drop in interet rates increases the number of homes demanded at each price, creates an excess demand for homes, and pushes the price of an existing hime up to P(1).
In the new construction market in the upper right graph, the higher home price results in more homes being built per year, k(1), than was the case at higher interest rates.
Now the hard part. The graph in the lower lef is a phase diagram, a concept we can use to help think about dynamics. the critical concept is the stationary state line descending from the origin downward and to the right. That line represents combinations of K(t) and k(t) that leave the existing housing stock unchanged. This will happen when the construction of new homes, k(t) is just big enough to replace the number of homes that have worn out through depreciation (you know, like when your teen-agers come home). I have assumed that delta percent of existing homes die each year through depreciation. For example, if a home lasts 50 years, then delta would be 2% per year.
Assume we start at K(0) and k(0), which is a point on the line described above, i.e., we start in a situation where the housing stock is neither growing now shrinking. I can do this--it is my chart!
Now lower interest rates. The higher demand in the upper left graph increases the price to P(1), which increases housing construction in the upper right to k(1). But at k(1), we are building more houses than needed to replace the ones wearing out. Therefore the housing stock is growing. In fact, a little thought and 2 glasses of wine will convince you that all the points downward and to the left of the line in the lower left graph represent situations of a growing housing stock. In fact, the distance from the line indicates how fast it is rising or falling. Conversely, all points to the right of the line represent a shrinking housing stock. The housing stock will continue to grow until construction and depreciation are once more equal and the housing stock is in a new stationary state. (Geek note: Ludwig von Mises would have referred to such points as evenly rotating. Richard Dawkins would call them ESS, or evolutionary stable systems.)
A drop in interest rates will make a permanent increase in housing prices but, over time, the growing housing stock will mitigate some of the price and construction pressure, which means the initial burst of activity, and possibly of price, are likely to moderate somewhat over time. To an information theorist the initial spike in price is a way of amplifying the initial information signal that housing is now scarce in order to get everybody's attention so they get out their hammers and build more houses.
So interest-rate induced housing inflation is largely a one-time event, not property inflation, not a housing bubble.
Housing inflation, as opposed to one-time increases in home prices, happens wehen there is a continuous increase in demand, caused by systematically inflationary monetary policy. We do not have that today.
Housing bubbles pop when a sudden reversal of interest rates, or a sudden reduction in the availability of mortgage financing, causes a sudden, one-time, drop in demand. I don't think that is going to happen either. Inflation today is likely to remain low for some time.
Conclusion: There were good reasons why home prices increased over the past two years. But don't get caught in either the trap of believing they will continue to rise, or that there is an unavoidable housing bubble. Prices will be relatively flat over the next year.
Final geek note--I promise. The construct of present values, which underlies the construction of the stock demand curve in the upper left quadrant of our story, and we use all the time in finance, is weak stuff. Usually done by using the discount rate, a single number that is supposed to represent the opportunity cost of alternative assets during the life of the house. What we should use is estimates of the rental value of the house for each future year, each discounted by the relevant discount rate for that period. When the shapes of the cash flow streams we are analyzing (here determioned by the choice of depreciation rate) are different from the shapes of the cash flows of the bond we are using to measure interest rates, this causes problems. Especially true for the housing stock, which certainly has a duration longer than any government bond today.)
JR
Posted by John Rutledge at 7:15 PM