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What Would Warren Do?
Thoughts from the Frontline Weekly Newsletter
Would Warren Do?
February 15, 2008
In this issue:
Warren Buffet to the
How to Earn 20% in Tax-Free Income
What Would Warren Do?
A Crisis Creates an Opportunity
It's All About Valuations
There Are Times to Be Grateful
was only a few years ago that I use to sit down at this computer on Friday and
wonder what I would write about. In today's environment, there is enough to
write three e-letters and still leave interesting copy on the editing floor.
Today we look at the rather disturbing developments in the municipal bond
market, Warren Buffett's offer to "rescue" the tax-exempt insurers,
and ponder what the resolution will be. We also look at corporate earnings, and
note how they have been downgraded significantly over the last year. There is
(or will be) a connection between stock market prices, valuation, the current
credit crisis, and the economy. There is a lot of ground to cover.
first a quick note about my 5th annual Strategic Investment Conference, to be
held in La Jolla April 10-12 (co-hosted by my partners
at Altegris Investments). Paul McCulley of Pimco, Don Coxe of BMO (two of my
favorite economists anywhere, and simply brilliant speakers), Rob Arnott,
George Friedman of Stratfor, as well as your humble analyst and a dozen hedge
fund managers who will show you how they navigate in these troubled waters. By
the way, George's new book should be at the conference ahead of the bookstores.
He has been writing on how the geopolitical world will change over the coming
century. I have read a rough copy, and it is fascinating.
at previous conferences generally rate them as the best conference they attend
in any given year, and often the best conference they have ever been to. We do
try to do it right. The conference is limited to those with a net worth of over
$2,000,000, due to regulatory requirements. I simply hate to put limits like
that, but rules are rules. You can register and learn more by clicking on the
following link. https://hedge-fund-conference.com/invitation.aspx?ref=mauldin.
Buffet to the Rescue?
have got to hand it to Warren Buffett. He does have a sense of humor. This week
Buffett offered to take the tax-exempt insurance business from the various
monoline firms (Ambac, MBIA, FGIC) at a lowball price, and leave them with all
the toxic waste from the various structured vehicles they insured. This would
mean the investment banks who are counting on that insurance to hold down their
losses from the subprime garbage they have on their books would see any hopes
of getting anything from the monoline firms reduced to zero.
would the investment banks let that happen? Surely they should step in and recapitalize
the firms, which while expensive, would be less than the losses they would be
forced to immediately take should the monolines fail. Why let Warren
get what is a very profitable business which could eventually allow the banks
to get their money back?
and a lot of people were scratching our heads, wondering "What was Warren
thinking?" He is very savvy and shrewd, and even though he cultivates a
down-home image, he is a world-class vulture capitalist (which by the way is a
compliment in my book). So why would he make an offer that is seemingly a
be sure, if Buffett was allowed to take the tax-exempt business, the concern in
that market would immediately vanish. It would be the equivalent of walking
into a child's room in a crisis and saying, "Daddy's home. It's
to understand what I think is really going on, we have to step back and examine
the crisis (and that is almost too understated a term for it) in the normally
boring world of tax-exempt bonds.
to Earn 20% in Tax-Free Income
summer we were repeatedly told subprime problems would not spread to other
markets. "The problems will be contained," proclaimed one authority
after another. Now of course we know that this is not the case. The subprime
contagion has spread to all sorts of markets far and wide. Small towns in Norway
have lost money to subprime borrowers in the US.
most recent development has been in a rather obscure market called the
auction-rate note market. Auction-rate securities are an unusual type of
long-term bond that behaves like a short-term bond. While the terms vary, let
me quickly try and describe a typical bond, for those who are not familiar with
them. A tax-exempt authority like a school district, hospital district, or
municipality will issue a long-term bond, but within the covenants of the bond
is the stipulation that it will be auctioned every 7 or 30 days. The issuer
does this because it allows them to pay a lower overall rate.
are short-term money market funds and investors who are looking for a slightly
higher yield than they can get in a money market fund. These bonds are
auctioned by the usual suspects: Lehman, Citigroup, UBS, Merrill, and their
kin. In essence, these banks make a market in the bonds.
say a buyer says to UBS, "I will buy Small
City School District
bonds if they will pay me 4% for the next 30 days." The bonds go to the
person who is willing to take the lowest interest rate for any given period. At
the end of 30 days, I can re-bid or tell UBS that I want them to take the bonds
back. UBS will buy them back from me, and put them on the list to be sold to
another bidder the next day.
would someone be willing to take a chance on the bonds of a school or hospital
district they have no direct knowledge of? Because these various tax-exempt
authorities buy insurance from the monoline insurance companies that will give
them an investment-grade rating. An investor simply looks at the rating and
makes a buy decision.
was all well and good when you could trust the ratings. Now the
creditworthiness of the monoline insurance companies is in serious doubt.
Ambac, MBIA, GFIC and others have been downgraded by the rating agencies or are
in imminent danger of having their ratings cut.
without their ratings, they have nothing to sell. A rating cut is essentially a
death knell for the company. But it is also a potential crisis for those who
have bought the insurance.
now, these auctions are "failing." By that it is meant that there are
not enough buyers to take all the paper. The investment banks are being forced
to take back that paper, and they don't want it. Much of the auction market is
here is the unusual feature of most of these bonds. If for some reason the
auction fails, the interest rate is automatically set higher, so that whoever
is stuck with the bonds is compensated for the loss of liquidity. And often
that rate is a severe blow to the issuer.
the Port Authority of New Jersey
(PANJ). Their $100,000,000 auction-rate bond offering failed. Their interest
rate went from about 4% to 20%! It is costing them an extra $300,000 a week.
That is serious money. No one would seriously contend that the PANJ is a
financial risk. But buyers simply do not want to take the risk for 4%.
suspect that the PANJ will quickly put together a $100 million offering and buy
back the expensive bonds, but in the meantime they are paying higher rates than
they could get from the local Tony Soprano over by the docks.
friend and bond maven John Woolway sent me a
list of auction-rate bonds. Last week bonds from Puerto Rico,
rated AAA, were paying 4.3%. Today the bid is 8.75%, and if the auction fails
the rate goes to 12%! The taxpayers of Puerto Rico will
have to pay that extra cost. Does anyone seriously think Puerto Rico
is not creditworthy? But this is a market that is simply frozen. Buyers are on
are bonds of many solid issuers that are bidding almost 10% and will reset to
15% if their auctions fail, up from 4-5% last week. Understand, less than 1% of
tax-exempt bonds fail. These are good-quality tax-free credits we are talking
about, yet the possible interest rate is higher than CCC junk bonds.
increased cost of interest is a serious blow to some smaller issuers. One
hospital district would lose 25% of the operating profits that allow it to
purchase new equipment and maintain their facilities. School districts could
have to make very ugly choices about where to make cuts in their budgets.
what are they doing? They are calling every politician on their rolodexes
complaining about the problem. Fix the problem NOW. This week. So, what does
Governor Elliot Spitzer of New York
do yesterday? He threatens the monoline companies, telling them they have three
to five days to find sufficient capital or the state will step in and take
charge. And the state does in effect have that authority, as the states are the
concept being floated is to break the monolines up into two banks, a good bank
and a bad bank. The good bank would get the very profitable tax-exempt
insurance business, and the bad bank would get all the bad subprime and
structured vehicle debt. Another is that the monolines raise enough capital to
get through the crisis. Some suggest the government step in, as it did with
the negotiations for additional capital are going rather slowly, or so it seems
to those sitting on the outside. (I am sure if you'r on the inside it seems
like warp speed.) To get the US
government to step in would take even more time. And as I said last week, the
spearhead for solving the current credit crisis is fixing the monolines.
Nothing is going to get resolved with the current credit crisis until their
problems are fixed.
Would Warren Do?
now makes Buffett's offer rather intriguing. Spitzer the very next day comes in
and says you have 3-5 days to get something done. That may or may not be
possible. The issues are exceedingly complex and the egos are huge. Careers are
on the line.
"easy button" for the regulators is "Let Warren Do It."
Problem solved. Of course, investment banks and other investors (pension plans,
insurance companies, hedge funds, and mutual funds) are out tens of billions of
dollars. But they can just go get some more capital from Abu
Dhabi or China.
Why should we worry about large investment banks, who basically created the
gentle reader, it is not that simple. UBS estimates that investment banks from
around the world could have to write off yet another $203 billion in debt if
the monolines fail, in addition to the $152 billion they have already written
am not so concerned about the stock prices of the investment banks taking a
hit. That is just the cost of their greed. I am more concerned about the hit to
the US and
European economies. Those large investment banks are the source of loans to
and Europe, and too much of the rest of the world. They
finance our credit cards and auto loans. And when their capital base is
impaired, it means that credit becomes harder to obtain. Interest rates go up.
Deals don't get done.
and my partners talk to people (mostly in hedge funds) in the credit markets a
lot. I can tell you that the leveraged loan business is almost nonexistent.
There has not been a new CLO created since May. SIVs are for all intents and
purposes being shut down as fast as possible. Credit standards at banks are
tightening and getting into territory that typically reflects recessionary
good news is that the monolines will not have to come up with 100% of the
capital of a failed subprime CDO, for example, all at once. The original CDO
would have a theoretical life of 30 years. So the monoline would have 30 years
to pay out the interest and principle. With enough initial capital, they could
buy enough time to survive. The key is getting enough in a tough credit
environment, with the main potential investors already suffering from capital
looks like we will know in a few weeks. And maybe Buffett's offer goes from
being a joke to being gold for his investors. It would be interesting to know
if he had any idea that Spitzer was going to hold a gun to the monolines'
collective heads. Or maybe he is just the beneficiary of good timing. We will
Crisis Creates an Opportunity
bank loans are currently routinely trading below junk bonds from the same
corporation. This is of course crazy. If there is a problem with a corporation,
the bank loans get paid first, while the bonds wait in line. So why are they
trading beneath the junk bonds? Because there are forced sellers in the
marketplace. Many CLOs which own corporate debt have covenants that force them
to liquidate under certain conditions. They are often selling medium-term high-quality
bank loans for prices as low as $.80 to par value (or $1.00). This potential
extra return is on top of rising credit spreads. This will eventually correct
itself. The value of the bank loans will rise and/or the value of the junk
bonds will fall. But the forced selling is creating some very interesting
are some very attractive rates if you understand the credit markets. If you
don't, it is too late to go to school on credit, but there will be some very
interesting opportunities for those who do. And while most of us will not get a
chance to play in this market, it is important that there are those who can, as
it will help get things back to normal. And by normal, I mean risk premiums
from the early part of the decade, not those of 2006-7.
All About Valuations
week we saw consumer confidence in the US
drop to the lowest level since 1992. Manufacturing is flat to down, depending
on which survey you read. Ben Bernanke all but said we are in recession, or as
nearly as a Fed Chairman can. But the stock market is not paying attention.
Things are going to get better, we continually hear. The recession is already
priced into the stock market. So now is the time to buy.
might suggest a little caution. I was having dinner with good friend and savvy
analyst Ed Easterling last Tuesday, and about
halfway through dinner he slyly asked if I had looked lately at the estimates
for 2008 earnings from S&P for the S&P 500. As I had not, he pulled out
a few sheets of paper and showed me some rather interesting numbers.
the record, I wrote in early 2007 that earnings estimates would be lowered as
we moved into recession. So, now let's look at whether that has come to pass.
January 18, 2007 S&P
estimated that as-reported earnings for 2007 would be $89.10 per share. The
index was at 1426, which gave a forward P/E (price to earnings) of 16.
the real number for 2007? It was $71.56, so down about 20% from the estimates
at the beginning of the year, and down 12% from 2006. Not a good year, as it
S&P came out with an estimate for 2008 on March 30 of last year. They
projected earnings of $92.30 for this year. By the end of the year that was
down to $83.98, which would give a forward P/E of 17.48, which is starting to
what are they currently projecting for 2008? $71.20, which is roughly what the
earnings were for 2007. That also puts us into a rather sporty P/E at current
levels of 19.2 on a forward basis.
wait. It gets worse. They project that for the four quarters ending in June the
earnings will be down to $65.15, which yields a very high P/E of 21 at today's
prices. Do you think the stock market could be at risk if we get into a
full-blown recession and P/E ratios are at the top of historical valuations,
except for the 2000 bubble valuations?
earnings typically soften during a recession, so it is likely that actual
earnings will go down from here. S&P estimates that earnings for the
S&P 500 will rise 20% in the 3rd and 4th quarters of 2008, from 2007. That
is a rather robust recovery in their projections. And one that is looking
I have written before, the research shows that the reason bear markets stretch
out over time is that it takes several earnings disappointments to truly put
the majority of investors in a bearish mood. Of course, the opposite is true,
in that several earnings surprises in a row will make investors much more
should we expect earnings to fall for two years in a row? As it turns out, Ed
has done some research that suggests we should. Look at the following graph. It
shows earnings growth or decline since 1950 (www.crestmontresearch.com)
the past six decades, there was a fairly consistent pattern of three to five
years of strong profit growth followed by a year or two of profit declines.
Only one period in the 1990s extended into a sixth year of gains. The recent
era of growth appeared to be destined to tie or exceed that record. Yet,
economics and capitalism are powerful forces--the relatively high profit surge
during the recent five year period likely led to the abrupt and unexpected
reversal. It now appears that we're set for a pair of back-to-back earnings
declines ... not at all uncommon, as history illustrates.
more accurately see the trends, we can combine a few years into a moving
average. A multi-year average smooths the short-term swings and presents an
insightful view into the earnings cycle.
the historical duration of profit surges and retreats, three years is probably
a reasonable period to use. Figure 2 presents the three-year average growth
rate for earnings, where the earnings cycle begins to show its more cyclical
that earnings swing a great deal around that 6.6% average growth. It would be
very unusual for earnings in a recessionary year to not exhibit much lower
growth. Note that in the last two recessions they dropped well below 10%. My
bet is that earnings for the S&P 500 are going to be revised down again and
again as the year goes on. A 10% drop in earnings will mean that the market has
a P/E of 22, if the market stays where it is. That is hard to imagine.
market goes in long cycles from high valuations to low valuations and back to
high. These cycles are anywhere from 13 to 17 years. We are just in the 8th
year of this cycle, and we have not seen anything close to low valuations.
Ed points out:
summary, EPS is likely to be near $90 per share in 2016. P/E is likely to be in
the range of 20-25 if inflation remains low and stable. Higher inflation or
deflation would drive P/E ratios back to the average of 15 or toward historical
secular bear cycle lows below 10. If P/Es remain above 20, total returns over
the next decade will be 4% to 6%.
P/Es decline, investors could still see the current level of the stock market
it will be different this time. But that is a dangerous assumption, as we watch
the twin bubbles of housing and the credit markets implode all over the developed
world. The bubbles may be even worse in England.
I find it hard to get enthusiastic about overall stock market returns at
today's valuations, and given the environment.
Are Times to Be Grateful
last two weeks have been emotionally tough on the Mauldin clan. My oldest
daughter Tiffani (and the person who really runs the business, as all my
partners will attest) reported a rather sizeable lump in her breast. The doctor
decided not to biopsy it but simply go ahead and remove it. It took two weeks to
schedule the operation, which was last Wednesday. You can imagine the emotions
running through our minds.
Tiff and I were in Santa Barbara
with the management team from Altegris at Jon Sundt's ranch retreat last week,
I had one of those moments that are forever seared into my mind. We were all
finishing dinner, and had been talking about the future of our lives, business,
and the world in general. Tiffani is getting married in August (08-08-08) and has actually been
talking about having a kid for the last few months (good grief, me a
grandfather?). Our business is good, and a lot of the stress is slowly getting
to reasonable levels. Life is going so well. The guys left the table to begin
clearing, and I looked over at Tiffani and could she was clearly distressed.
she said with tears in her eyes, "I'm scared." This was my strong
Tiffani, who I thought was dealing with the stress better than I was. All I
could do was mutter some lame comment about things will be fine and hug her,
and try not to cry myself. But I have to admit to being terrified. My mother
had breast cancer (some 50 years ago now, and is still quite active at 90), and
there was some on Tiffani's mother's side, so it was not something we could
was really nothing we could do but wait for Wednesday. The surgey went fine. We
knew we would get the results from the biopsy today. About mid-morning I got a
long text from Tiffani on my cell phone, and the word "worst"
immediately leaped out to my eye. My stomach felt as if it had been hit with an
iron. Then I read the full message and saw that she was saying that the pain
was the worst she had had for the last three days, and the pain medicines were
not kicking in. You can imagine the sense of relief. But it made me realize how
much this was affecting me.
this afternoon we got the text that said the biopsy was fine and the tumor was
benign. So, I am going to hit the send button a little early tonight, pick up
some of the kids, and go see Tiffani. She says she might be up for a movie,
which sounds like a good thing.
happier than you can imagine analyst,
2008 John Mauldin. All Rights Reserved
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John Mauldin is the President of Millennium
Wave Advisors, LLC (MWA) which is an investment advisory firm registered with
multiple states. John Mauldin is a registered
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material presented herein is believed to be reliable but we cannot attest to
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Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an
investment advisory firm registered with multiple states. John
Mauldin is a registered representative of Millennium Wave Securities, LLC,
(MWS), an FINRA registered
broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity
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WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN
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