March 24, 2005
The Real Monetary Policy is Extremely Expansive
While economists on Wall Street are whining about fed tightening, the REAL monetary polcy is extremely expansive. As you can see in the chart below, from the current issue of US Financial Data, commercial and industrial loans are soaring, reaching $939.1 billion last week. That's up $70 billion from their lows last May.
A good friend, who is also about the smartest man there is on the leveraged lending market, tells me this is the tip of the iceberg. Banks now make up only 25% of the business loan market. The other 75% of business loans is provided by non-bank leveraged lenders, who ultimately package and sell their product to mutual funds, hedge funds, and insurance companies. These buyers are so hungry for yield they will eat anything today, so much so that big lenders have changed their internal operating procedures to all but ignore credit risk. Stay tuned for the back side of this story in about 2 years. Not going to be pretty.
This is important because most people think of Fed policy as the Fed funds rate through a sort of loan market equilibrium. It is not. Monetary policy works primarily by creating periodic disequilibria in the credit markets, which causes fits and starts in credit availability.
Wicksell, Keynes, and Fisher all knew this. Non-price rationing, not price, is what clears the market. These episodes are examples of the system failure behaviors encountered in nonlinear dynamical systems, which draws on the far-from-equilibrium physics work of Ilya Prigogine.
The Fed lowered the funds rate all through 2001 and 2003, to a chorus of analysts writing about Fed easing. All the while Banks were restricting credit, which drove business loans on bank books down by $230 billion through last May. That's why the 'jobless' recovery was so slow.
Now they are talking about Fed tightening. Since May, however, when the mortgge refi boom ended, banks are lending again, up $70 billion so far.
That's why the economy, jobs, profits, and stock prices in 2005 will grow more than analysts think.
JR
Posted by John Rutledge at 9:10 PM | Comments (1)
Second Way to Save Social Security
My second modest proposal to reform Social Security is called Budget Bucks. We could pay all government expenses, including Social Security, in a new form of currency called Budget Bucks.
Budget bucks are not legal tender, but you can trade them in at the post office for real money. They will give you real money at an exchange rate equal to the number of tax dollars the Treasury collects (it still taxes you in real dollars -- sorry) divided by the number of bucks the government spends.
For example, if it spends two budget bucks for every dollar of taxes it collects, each budget buck would equal 50 cents at the post office.
The budget would balance in real money every minute of every day. You can think of this as the reducing Xerox machine plan.
A side benefit of the plan -- every interest group who gets money from the government would begin to lobby aggressively against the spending going to every other interest group. It's the only way I have figured out how to turn the lobby groups into forces for good.
JR
PS: I ran this piece yesterday for my friends at RealMoney. It is excerpted from a longer piece I wrote for Barrons so long ago they hadn't invented electricity yet so I can't give you a link to it.
Posted by John Rutledge at 8:39 PM
How to Save Social Security
When Social Security was invented in the 1930s the retirement age was intentionally set higher than the average life span (the government actually copied the 65 number from the plan that had been implemented in the Weimar Republic to great acclaim).
Here's the problem. There were 40 workers for every old guy then. Today there are 16. When all the deserving baby boomers have retired, including me, there will be less than two workers per old guy.
My plan is simple. I call it Man-On-Man Social Security. In the year 2025, when a kid graduates from high school, we will give him a diploma and assign him a personal old guy. He will have to take the old guy home, feed him, take him on walks and so forth until he dies.
Of course my kids would shoot the old guy and go directly to the beach.
Moral: The only solution that will work is raising the retirement age. Or, as an alternative, feeding retired people Big Macs until they explode.
JR
Note: You can find this piece and other articles I have written for my friends at RealMoney.com. A complete archive of my writing is available at the Rutledge capital website.
Posted by John Rutledge at 8:29 PM
US Trade Deficit Facts
The current issue of the McKinsey Quarterly points out that a big piece of the trade deficit is from US companies' activities abroad. Worth reading.
A silver lining in the US trade deficit. The US current-account deficit is bigger than ever. This trade imbalance is prompting protectionists to call for restrictions on imports, but research by the McKinsey Global Institute shows that about one-third of it comes from US trade with US-owned subsidiaries abroad. Such trade may add to the deficit, but it also creates significant value for US customers, companies, and shareholders.
JR
Posted by John Rutledge at 8:13 PM
March 23, 2005
Tokyo Land Prices Up. First Time in 14 Years.
Japan's Land, Infrastructure and Transport Ministry released a report tomorrow (I know, it's the time zone thing) indicating that land prices at five commercial areas in Tokyo edged up an average of 0.5 percent in calendar 2004 for the first increase in 14 years.
Some areas in Osaka and Nagoya also saw significant growth. In Nagoya, land prices at seven commercial spots around Nagoya Station climbed more than 10 percent due to the construction of high-rise buildings. The officially assessed land prices serve as a benchmark for public and private land transactions, and for government assessment of inheritance and property taxes.
This report is a big deal. It does not mean that Japan should worry about inflation (Overall, land prices of 31,230 designated locations nationwide fell by an average of 5.0 percent for the 14th consecutive year of decline.) But it is one more piece of evidence that Japan deflation is ending and their economy will continue to grow this year.
Land deflation was the eye of the hurricane, er, monsoon, that robbed Japan of more than a decade of growth. Land deflation is also the proximate indicator of worsening bad loans. The end of deflation should be very good for Japanese growth and profits and should weaken the yen against the dollar as well.
The risk? The Bank of Japan is talking about scrapping the "quantitative easing" policy that ended the deflation, in favor of old-fashioned interest rate pegging--the policy that got them into trouble in the first place--just like the Fed.
I continue to hold a long position in EWJ, the exchange traded fund for Japan.
JR
Posted by John Rutledge at 11:13 PM
Fed Recants Statement, Vows Improved Penmanship
FOR IMMEDIATE RELEASE
Dateline: Washington DC. US stock and bond markets reeled and the dollar declined against the yen and the Euro today when it was revealed that the phrase "measured pace" contained in the statement released yesterday by the Federal Open Market Committee was reported in error.
Apparently, Chairman Alan Greenspan, who had written the memo by hand during the meeting, had dragged his elbow across the still-wet ink on the paper, smearing the key phrase beyond recognition.
At a press conference today, an unnamed Fed spokesman said Chairman Greenspan had meant to write that from now on monetary policy would be a "leisured race", to show the Federal Open Market Committee's intention to both slow down and speed up the nation's money supply simultaneously.
High-ranking officials at the meeting, who declined to be identified, questioned the Chairman's recollection, saying they distinctly remember a lengthy discussion of a "treasured vase" the Chairman had recently purchased at an antique shop in Georgetown, and a second conversation at lunch during which the Chairman described the new Hooters restaurant on M Street as "quite a place."
Markets were understandably upset by the Chairman's shoddy penmanship. One bond trader indicated he had spent all day on the trading floor without seeing one "pleasured face."
xxx
NB: Monetary policy is not about words. It is about the availability of credit.
JR
Posted by John Rutledge at 10:49 PM
March 15, 2005
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 drink 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 they are willing to build, 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 home 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 left 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. It is not property inflation. It is not a housing bubble.
Housing inflation, as opposed to one-time increases in home prices, happens when there is a continuous increase in demand caused, for example, 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 expected discount rate for that period, which you can approximate by calculating expected forward interest rates rom adjacent bond yields. When the shapes of the cash flow streams we are analyzing (here determined 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 8:16 PM
Real Estate Prices
I received a comment from my good friend Jim Copley on my recent post about sizzling property markets. Jim is the CEO of the CROM Corporation, the nations's leading maker of highly-engineered municipal water storage systems. Jim is the kind of manager I would be proud to go to war with. (If you are in need of a 2 million gallon water tank please let me know.) I am proud that Rutledge Capital has an investment in Jim's company. Here is my response.
The abrupt drop in interest rates over last couple years has led to the complete re-pricing of residential and commercial real estate, as owners re-financed mortgages at the lower rates.
Essentially, we have re-capitalized the future stream of rental value embodied in the current housing stock at lower interest rates. The securitization of the US mortgage market allowed this to happen.
This leads to two sorts of problems. Some people look at the rising prices of the past year and think they will rise forever. They are the buyers lining up to draw straws for new developments today. We have seen this movie before in 1990. If you have been infected with this disease, best thing is to lie down until it goes away.
Recent price increases reflect lower interest rates, not rising future rent values (not higher future income streams), so are one-time events. In fact, the most recent report on existing home prices from the National Association of Realtors shows that prices peaked last June and have fallen since then. It is important not to get swept up in the excitement today.
The second thing I hear is talk about a real estate bubble. I don't find that worry credible because I believe interest rates will not rise much from current levels. Interest rates are ultimately determined by inflation, which I believe will remain in the 1-3% zone for a long time, both for domestic reasons (Fed, productivity growth) and global reasons (professional service price arbitrage with the countries in Asia that have fiber-optic connections with the US.) Cash returns on commercial real estate, although much lower than 2 years ago, are still somewhat attractive relative to bond yields. And both the economy and employment are rising, which will keep cash flow growing.
JR
Posted by John Rutledge at 6:16 PM
March 6, 2005
Sunday Brain Dump
Some things bouncing around in my brain today:
1. James Altucher, a fellow author on Realmoney.com wrote a very insightful article on household debt a while ago, where he points out,
if you take the full financial obligations ratio (which includes house payments, auto loans, insurance payments, as well as debt payments) and divide by household income then we are right now at the lowest we've been in 11 quarters and at the same level we were at in 1989. In other words, no big deal. Most economists only look at credit card payments, which is misleading since credit cards have become a larger part of how we, as a culture, simply do our household accounting (easier to see your full budget if you put everything on a card and then pay it off before interest hits.Also recommend James's book, Trade Like Warren Buffett.
2. Lots of people ask where I get the weird newspapers I read. I get them delivered to my desktop by newspapersdirect.com evert day. Costs $9.95 per month. They deliver too, but that's sooo 20th century. They have 200 newspapers from 55 countries including my favorites, the Shanghai Daily, the Times of India, and Izvestiia, along with all the usual European papers. How could a person not do this?
3. Got to talk to a terrific group of brokers and financial planners in Portland Oregon last week. Their biggest problem; clients still too afraid to invest, sitting in cash. The market is up more than 50% in the past 2 years. America was not built by people afraid to take a risk. Equities are a good value today.
4. footnote: the Portland airport is beautiful. Spotless concourses, uncrowded ticket counters, security points, and shops. Then I learned why--there are no planes! Can't get there from here. I think they do it to keep the rest of us out.
5. State and local governments collected $20B in taxes on your phone calls last year at rates reaching above 20%. $7B of it was collected at rates above general business and sales taxes. That $7B could be invested in faster networks (they have them already in Korea, China, and India)or paid out as dividends. We need to focus here.
6. There are signs that some of the investors in the Gulf region are starting to think about taking some of the profits they have made there in the past 2 years off the table, and investing it around the world. Will help their sizzling markets stabilize.
7. Saw a real estate project in Maui this weekend where 300 people were drawing lots to buy 50 properties. This is one of the signs the hot market is over. Prices will be flat to down next year in the US.
8. Good piece fron my friends at CEI on how political price regulation causes problems.
9. Big jobs number on Friday (+262,000 in February) surprised people. Shouldn't have. There has been a dramatic thawing in bank and leveraged lender attitudes in the past 9 months. They are back to making silly loans again, pushing paper out the door as fast as hedge funds and mutual fundds can buy it. This will make small businesses grow faster than big ones this year and push growth, profit, and dividend numbers higher than people think. That's why I own a big position in small cap stocks today. It will also set up the next banana peel for the economy in 2-3 years when the loans go bad again.
10. Huge upward revision in the productivity growth numbers last week. Overall productivity grew 4.0% last year, with 5.2% in mfg., and 6.3% in durables. Durable goods productivuty rose 7.2% in Q42005. Yikes! This is why the inflation numbers are surprising people on the downside and will continue to do so all year. If we get a new telecom law productivity will accelerate further.
11. Productivity, growth, and profits up, inflation and interest rates contained. Stay invested!
Would love to hear from you about the things you are seeing. You are welcome to lob in comments on the blog, or email me directly at jr@rutledgecapital.com.
Regards,
John
Posted by John Rutledge at 9:35 PM | Comments (2)
March 5, 2005
Why You should Read Michael Crichton's State of Fear
I received an interesting paper from my old friend and mentor S. Fred Singer today. Fred may be the most knowledgeable man alive on issues of Oceans and Atmospheres--a legitimate rocket science physicist who has held every position of importance in the field, including first Director of the National Weather Satellite Service. Fred is now president of the Science and Environmental Policy Project .
The paper is a pre-published draft of State of Fear, by Prof. David Deming, a geoscientist at the University of Oklahoma; the paper will appear in the June, 2005 issue of the Journal of Scientific Exploration. You can see the paper at the SEPP website in the March 5 issue of their newsletter, The Week that Was.
Professor Deming's paper is not about Crichton's book; it is about what Chrichton's book reveals about how science has been politicized. For example, the Medeival Warming Period (MWP) was the 300 year warm period between 1000 AD and the beginning of the Little Ice Age that froze the Dutch canals and drove the Vikings out of Greenland in the 14th and 15th centuries. During the MWP, rising temperatures increased crop yields, dried up swamps, and killed mosquitos, which reduced infant mortality rates and increased the population of Europe from 40 million to 60 million between 1100 AD and 1300 AD.
But the MWP had to go because it showed that mean surface global temperature over most of the last 10,000 years was significantly warmer than the late 20th-century, anathema to the global warming supporters. Professor Deming reveals the extraordinary scientific fruad that was committed by politically-motivated researchers to make this happen.
I am very skeptical of people who are too sure about what they believe about a subject, especially if their belief preceded their homework. And I am even more skeptical about people who try to sell their ideas by appealing to people's fears. Global warmers have done both. I have not yet made up my mind on the global warming debate.
Regardless of your belief, I strongly recommend Crichton's book, if only to increase your skepticism about believing anything you hear from strident evangelists of all colors. If you don't agree with his ideas, so much the better. Reading things you don't agree with is the only way to learn.
I find the success of Crichton's State of Fear very uplifting. Not because of its viewpoint; because it shows that people are again willing to read books that challenge accepted dogma. People in America were deeply frightened by the terrorist attacks. History shows that when people are frightened they are willing to sell their soul, and their freedom, to anyone who promises order. The worst tragedies in history have occurred during the reactionary period after a major trauma. Their willingness to read this book may be a sign those fears are beginning to fade.
JR
Posted by John Rutledge at 7:59 PM
Conference on Innovation in Communications Next Wednesday
Next week I have the opportunity to speak at a press conference in WDC featuring Clayton Christenson, the current guru of innovation and author of a string of books on the subject. The clip below from Reuter's Daybook has the details.
9:30 a.m. - (COMMUNICATION) DISCUSSION - Harvard Business School professor, Clayton Christensen, participates in a discussion on change and innovation in communications and impact on the industry's future. Clayton Christensen, Robert and Jane Cizik, a professor of business administration at Harvard Business School; John Rutledge, chairman of Rutledge Capital and Rutledge Institute for Capital; and Connie Murray, a commissioner at Missouri Public Service Commission, participate. Location: National Press Club, 14th and F streets NW Contact: 202-380-0620
I have been reading Clayton's books in preparation for the meeting, and while I don't expect them to replace the Holy Bible or the McKinsey Report in total sales, they are books I think you should read. Clayton's current book is titled Seeing What's Next has a lot of material on the technology and telecommunications ssectors. Two previous books, The Innovator's Dilemma, and The Innovator's Solution, serve up the same ideas. (Read the new one.) I will post reviews of all three books on the John's Bookshelf page of the Rutledge Capital website in the next few days.
A special treat for me is I get to work on the panel with Connie Murray. Connie serves as a Commissioner on the Missouri Public Service Commission, and is one of the finest thinkers on the subject I have met in the industry. And a very nice person to boot. Hope to see you there.
John
Posted by John Rutledge at 4:38 PM
March 2, 2005
India Increases Telecom Investment to $2.7B
Add to the previous story. Telecom Asia reported a big jump in India's investment in new telecom networks.
With increased focus on telecom services as a thrust area of infrastructure, the government has raised the total planned outlay of the Department of Telecom by 21.79% over last fiscal to Rs 118.01 billion ($2.7 billion) in 2005 to 2006.State-run Bharat Sanchar Nigam Limited (BSNL), which has been entrusted with the task of connecting the rural India in a major way, has been given a major chunk of this outlay at Rs 96.96 billion, an increase of over 46%.
Hello? Washington? Is there anybody home?
While their government builds networks, our government holds hearings about phone conpany mergers. We need to turn off C-SPAN and rewrite the telecom law to provide a solid foundation for investing in new networks so American companies can have the benefit of the latest technologies too.
JR
Posted by John Rutledge at 2:59 AM
India Ups the Ante--Again
India's new government budget, released on Monday, will further intensify global competition for capital. The budget cuts corporate tax rates from 35% to 33% and cuts nonfarm tariffs from 20% to 15%. Simultaneopusly India's central bank announced new, less restrictive, rules on foreign bank ownership.
Last Friday India's cabinet announced it has lifted foreign investor restraints on land ownership. In recent weeks, their government lifter the allowable foreign ownership on telecom companies from about 50% to about 75%.
India's government gets it. The country that does the best job attracting and holding capital will have the fastest increases in living standards. This year India will grow 7%, about like they did last year.
We can learn from India. Tax rates and regulations are powerful tools that can be used to attract, or repel, capital.
America is not competing for jobs with India; we are competing for capital. Our children's paychecks are at stake.
JR
Posted by John Rutledge at 2:40 AM
March 1, 2005
Household Balance Sheets are OK
We hear so much about the overburdened consumer that I thought you would like to see the actual numbers showing household assets and debts.
As of Q3/2004 (most recent data) US households and nonprofit organizations owned $21.7 trillion in tangible assets, like homes, and $35.3 trillion in financial assets for a total of $57.0 trillion is assets. Against that they owed $10.7 trillion, mostly in the form of mortgages. Their net worth was $46.7 trillion.
This is a big country. Our balance sheet is in very good shape.
Posted by John Rutledge at 2:54 PM