Weekly Owner Earnings

Weekly Thoughts

• The market wont stop going down until investors have a sustainable base, which would include a 7% savings rate like it used to be.
  
• A few good things have happened as a result of this depression:
  
  
  
  • For the younger generation the problem of funding social security, Medicare and Medicaid has been moved forward by a few years. The sooner this problem is addressed the better. An ounce of prevention is worth a point of cure.
    
  
  
• The initial decline in the economy may have happened at light speed, but the remaining decline will happen much more slowly. My anecdotal example of this is country clubs. Members are dropping out of the country club scene left and right and some country clubs have been forced into bankruptcy. The decline in membership is going to stop, temporarily however, as golf season begins. Once golf season is over and the economy has deteriorated further I would expect the declines to continue forcing even more clubs into bankruptcy. This is going to take at least a year to play out if not 3-5 years.
  
• After reading the financial statements for many banks I can tell you that the only thing keeping them afloat is all these bailouts, legalizing of lying about asset values (aka mark to model), and non stop televised propaganda, none of which changes the fundamentals. This bear market rally isn’t going to shake most shorts because they are positioned to be solvent longer then the market can afford to be irrational, myself included.
  
• Economic Forecast: House prices will find a temporary bottom based on a 5% 30 year fixed mortgage rates. Once the Fed loses control of the mortgage rates (technically they already have lost control of them, which is why they have to print money to buy them) and they go to 8% house price will continue their decline. This is going to take years to play out. Lets stop right there and think about how anticompetitive that whole concept of subsiding mortgage rates is. Subsidies lead to 1 thing: inefficiency. And inefficiency leads to low low low rates of return. Just ask K-Mart or GM. With that said the stock market is at best fairly valued, the real estate market will be declining for years, municipalities are going to doing worse not better (and so will their bonds), treasury bonds would seem to be a good investment, but the government is buying treasury bonds and as a rule of thumb you never want to be buying what the government is buying, commodity prices go down in low return world or a deflationary world (the CPI just deflated for the first time in 55 years), and why not just keep the money under the mattress with money market rates are less than 1%. That that only leaves you with high grade corporate bonds to get any type of decent return. Why put any more money into a 401k then what they match you (if they even still match you) when the only investment option is equity mutual funds (which are overvalued), bond mutual funds (which don’t work because the manager trades the bonds too much and you end up own bad quality bonds or the wrong duration), money market funds (which are yielding less than 1% if not less than .25%), or stable value funds (which Chryslers stable value fund just declined 11%, real stable.) You’d be better off investing the money into an IRA and buying high grade corporate bonds. If my forecast is right, then by the time most investors (aka the “herd”) catch on to this idea, high grade corporate bond yields will have declined from 5% to 3% and you can sell at a profit to buy the S&P 500, which will have declined from 900 to 500 (When that happens it will be a 25 year low just like Japan).
  
• Bottom line: This is going to be a very low return world going forward, especially in the US. 3 to 10 year investment grade corporate bonds look like great investments. When the stock market bottoms out in 3-5 years you can sell the bonds and buy stocks. The US is now Japan.
  
• How many people are going to plant gardens this year? How many unemployed people are watching their own kids? This is very deflationary.
  

Economic and Stock Market Forecast

I think the yields on long treasury bonds will continue to rise even though the Fed’s are buying.

Arguments supporting this thesis are:

• 1. Investors that used to buy the bonds (China, pensions, and individual investors) simply don’t have new money coming in to buy with.
  
• 2. Investors are concerned about inflation risk.
  
• 3. Investors are concerned about default risk. Although, default risk is really just inflation risk because they Fed will simply print money to pay for the bonds.
  

Arguments against this thesis are:

• 1. Flight to safety will continue. Treasury bonds are “said” to be safe or at least less risky.
  
• 2. Investors will shift their asset allocation to bonds.
  
• 3. Investors will increase their savings rate, hence increasing the demand for all investments.
  
  
  
  • a. This creates a slippery slope though, where more savings means less spending, and less spending means more people unemployed, which would mean less money to invest with.
    
  
  

As the yields rise, the Fed will buy even more Treasuries, hence increasing the money supply.

Arguments supporting this thesis are:

• 1. The Fed just announced it is going to purchase $300 Billion worth of treasuries. In the last 24 months the Fed has not reduced the size of any program like this. Instead, the Fed has only increased not only the size, but the scope as well.
  

Arguments against this thesis are:

• 1. Somehow the government steps in to prevent the Fed from devaluating the dollar. It appears Congress has no control over the Fed so this appears unlikely.
  
• 2. The dollar decline becomes so significant that the Fed will be forced to stop or risk civil unrest.
  

The inflationary result of this will be seen mostly in oil.

Arguments supporting this thesis are:

• 1. Oil supply in Mexico has been declining significantly over the last 12 months.
  
• 2. Drilling has declining significantly.
  
• 3. Oil supply everywhere would be declining naturally. (The world does not naturally produce 85 million barrels of oil a day, but it does consume it.)
  
• 4. World population is increasing.
  

Arguments against this thesis are:

• 1. Demand for oil is declining along with the rest of the economy. This decline is enough to offset any of the arguments supporting the thesis.
  
• 2. Alternative energy is reducing the demand for oil.
  
• 3. Technology (fuel efficiency) is decreasing demand.
  

There won’t be much inflation in food.

Arguments supporting this thesis are:

• 1. People will be less wasteful and use less food to meet the same demand.
  

Arguments against this thesis are:

• 1. Food supply is at decade lows.
  
• 2. Population growth.
  
• 3. Land is producing less yield because of over farming.
  

Real estate will continue to decline.

Arguments for this thesis are:

• 1. There is simply too much supply.
  
• 2. Real estate is not consumed the way food and oil is.
  

Argument against this thesis is:

• 1. Buyers have money for a down payment, have a good credit score, have a job and actually want to buy real estate at these prices.
  
• 2. The government is giving an $8,000 subsidy to buy a house.
  

Natural gas prices will continue to decline.

Arguments for this thesis are:

• 1. There is simply too much supply.
  
• 2. The decrease in economic activity make the over supply even worse.
  

Arguments against this thesis are:

• 1. Producers will stop producing; reducing supply.
  

Higher oil prices will force the consumer to reduce spending further.

Arguments for this thesis are:

• 1. People can’t spend money they don’t have when the credit markets are closed.
  

Arguments against this thesis are:

• 1. The government will give people money to spend and they’ll actually spend it unlike the last stimulus.
  

Stocks will continue to decline if the above theses are true. The sectors most likely to decline will be discretionary and financial stocks.

Arguments supporting this thesis are:

• 1. Stocks are overvalued or at best fairly valued. They are not cheap.
  
• 2. The valuation of discretionary and financial stocks can drastically change with just a small change in the economy. For example it only takes a small decline in real estate prices to wipe out all the equity in a finance company that is levered 20 to 1 and owns mostly real estate loans.
  

Arguments against this thesis are:

• 1. Stocks are undervalued and investors have the wherewithal and mentality to buy them.
  

Thoughts

Things To Anticipate Over The Next 2 Weeks

• Major bank stocks and bonds going to $0 (not necessarily bankrupt). Update: This may take longer than previously thought now that the government is going to buy bad assets (presumably at prices significantly higher than current bids)
  

20 Investing Criteria: The Time To Buy Is Near (Especially If The Current Pace Of Decline Continues) Update: The price decline has clearly reversed.

• Business Model
  
  
  
  • Liabilities (Debt, Healthcare, Lawsuits, Pensions, Lease Obligations) are low (Balance sheet, foot notes, foreign country subsidiary etc.)
    
  • Consistent (5 Year Rolling Average) Sustainable Owner Earnings (This translates into sustainable revenue, margins, prices, and cash flow)
    
  • Diversified: Multiple customers and products (Not a 1 hit wonder, but no need to diversity just to diversify)
    
  • Independent (If a competitor goes down they don't all go down. Unlike airlines, drug companies, banks, etc)
    
  • Monopoly or close to it (Buffett's "Wide Moat")
    
  
  
• Product
  
  
  
  • Consumable (Translates into sustainable consistent demand)
    
  • Established. (Product mostly sells itself) Hasn't changed in years. (Coke, Heinz, Mars, Electricity) Unlikely to change in the future. (Unlike electronics. Unlike a start up. Unlike the next "something.")
    
  • It's what the customer needs, wants and does. You'll be surprised what customers ultimately need and want. (Cell phones)
    
  • Value (Affordable): Price is what you pay, value is what you get. (Amazon, DeWalt, Honda, Visa)
    
  
  
• Management
  
  
  
  • Adaptable (It's not the strongest or the most intelligent that survives, it's the one most adaptable to change)
    
  • CEO is realistic (You can judge this by watching them speak. VERY RARE!)
    
  • Disciplined (Unlike Time Warner when they bought AOL)
    
  • Employees have a good relationship with the company (Unlike Unions)
    
  • Executes (Translates into earnings growth etc)
    
  • Honest (Translates into reliable financial statements)
    
  
  
• General Rule
  
  
  
  • Simple: Simple product. Simple business model. Simple financial statements. That way any idiot can run the company.
    
  • Know the Competition
    
  
  
• Litmus Test
  
  
  
  • Consumers would be affected negatively if the company went out of business
    
  • Personally understand the company and use the product.
    
  • Willing to invest 10% of your net worth into the company
    
  
  

Prices that have come down:

• Real estate, but mostly if you’re buying a house. I haven’t heard of rent coming down much.
  
• Gasoline (Still high compared to 2004 prices)
  
• Natural Gas
  
• Car Insurance
  
• Restaurant Prices (Especially if you have a coupon, which I’ve seen the frequency of coupons increase.)
  
• Interest payments (If you have debt.) However, for the people that have savings, the opposite is true and the savers are earning much less interest on their savings.
  

Price that have stayed the same or increased:

• Electricity
  
• Insurance (Medical, Dental, Vision, Life, Homeowners)
  
• Clothing (Even with all the “sales” I haven’t noticed the sale prices being lower then previous sales prices I saw years ago; especially in business clothing.)
  
• Food (Milk, Cheese, Meat, Cat Food)
  
• Internet
  
• Cell phone
  
• Parking
  
• Trash
  
• Beer
  
• Real estate taxes
  
• Income taxes (Federal, State, Local, Social Security, Medicare, and Medicaid)
  

Reasons The US Economy Will Get Worse

• Employment
  
  
  
  • More people will lose their jobs. As of 3-25-09 there are 5.5 million people on State unemployment and 1.5 million on Federal unemployment. Expect about 2 million more to become unemployed to bring the total number to 9 million. That can easily be accomplished by losing 650,000 per month for 3 months. Once you start thinking about it 5 million job losses is possible if the 250,000 job losses per month continues into 2010.
    
  • More people will have reduced hours.
    
  • More people will have reduced pay or no pay increase
    
  • More people, especially the baby boomers, who would have retired won’t retire because they need the money, hence increasing the supply of labor. This creates a negative feedback loop where baby boomers staying in their jobs prevent other generations from advancing in the labor force. The end result is the baby boomers end up doing all the work and having to give a significant amount of their money away (either as straight gifts to their children or as taxes) just to sustain all those other people that can’t get a job. This scenario partially explains the current economic situation we are in now because the baby boomers were the ones making all the money over the last few years.
    
  
  
  
• Real Estate: Housing
  
  
  
  • House prices are still unaffordable (relative to income, which is declining.). In 2000, the average home price was $150,000. (I agree, I don’t like to use averages, but this is the information I have available.) At the end of 2008 the average home price was $175,000. Do you think people are making more money, or that more people are employed, then there were in 2000? No. So for the average home price to drop to $150,000 seems very realistic. That would be a 15% decline from today. And to boot, just like prices overshoot to the upside, prices overshoot to the downside. At a 2007 median HOUSEHOLD income of $50,000 the average American can’t afford much. I’ll do some math on that later.
    
  • House inventory is still too high. In 2008 4.5 million existing homes were sold. Problem is realtor.com has 4 million listings alone. That is at least 10 months supply. The norm is 6 months.
    
  • Vacant houses have increased to 2.23 million.
    
  • Home ownership was at an all time high, which means demand for houses will decrease.
    
  • Housing starts are still higher than the amount of new houses sold. Technically, new home completions, at 750,000, are almost 100% higher then new home sales, at 400,000, as of December 2008.
    
  • Mentality towards housing has changed and people are looking for smaller houses.
    
  • Mentality towards housing has changed also because speculators and investors are no longer considering real estate as an investment.
    
  • It is taking significantly longer to sell houses. It used to take 3-6 months. Now it takes 6-9 months.
    
  • Mortgagee’s would rather default than refinancing their loan.
    
  • More people will default on their mortgages, including Alt-A and Prime
    
  • Shadow inventory of houses is huge. People that want to sell have not put the for sale sign up because they know they can’t sell their house at the price they want (more than it’s worth) in this environment. REO’s that aren’t listed and foreclosures that are being delayed are also adding to this.
    
  
  
  
• Real Estate: Commercial
  
  
  
  • Demand for commercial space is declining.
    
  • For many tenants, commercial real estate is unaffordable.
    
  • Inventory is still growing.
    
  
  
  
• Credit: Consumer
  
  
  
  • FICO score requirements have increased while many consumers have actually seen their FICO scores decrease.
    
  • Consumers are simply reducing their demand for credit.
    
  • Income requirements have increased while many consumers have obviously lost their job.
    
  • Down payments requirements have increased (From zero to 20%)
    
  
  
  
• Credit: Business
  
  
  
  • Business’s balance sheets will deteriorate further.
    
  
  
  
• Spending: Consumer
  
  
  
  • Consumers are trading down in quality and quantity.
    
  • Consumer spending is declining from an unsustainably high level.
    
  • Spending frugally is now considered “cool.”
    
  
  
  
• Spending: Business
  
  
  
  • Many companies are reducing the amount of CapEx they will spend compared to previous years.
    
  • State and local government are also reducing the amount of projects.
    
  
  
  
• Spending: Government
  
  
  
  • State tax revenue is down so the state budget is being cut accordingly.
    
  • Local tax revenue is down so the local budget is being cut accordingly.
    
  • Federal tax revenue is down, but they can just print money.
    
  • Borrowing costs have increased for state and local governments.
    
  
  
  
• The Consumer
  
  
  
  • Consumers don’t have any savings to fall back on.
    
  • Consumers that do have savings saved in stock. When they need to use their savings they’ll have to sell stock.
    
  • People are saving more (paying down debt), which means they are spending less.
    
  • Savings are still too low so consumers will have to save even more.
    
  • Growth from real estate and stocks is no longer a substitute for savings.
    
  • More consumers are falling behind on their mortgage.
    
  • More consumers are falling behind on their credit cards.
    
  
  
  
• Consumer Psychology
  
  
  
  • Consumers spend less when their assets decline.
    
  • Asset declines beget more asset declines. Aka negative feedback loops.
    
  • Consumers with the money to spend feel guilty spending it so they save it instead.
    
  
  
  
• Velocity of money will slow down further.
  
• Less kids will go to college which means less people need to be employed at the college.
  
• More frauds, like Madoff, will be uncovered. (As if the whole finance industry isn’t)
  
• As the US currency weakens the demand for interest rates on US assets increases.
  
• Investors are looking to decrease risk, not increase it.
  
• The recession is global.
  
• The Federal debt is increasing. It’s either going to have to be paid back or defaulted on.
  
• The Federal deficit is increasing.
  
• Unexpected natural or man made disaster may strike.
  
• There is too much supply of everything except jobs and income.
  
• There is too little demand for everything except jobs and income.
  
• Retail inventories are too high.
  
• Retail revenue is declining. Certainly in total cost, but maybe even units sold.
  
• Deleveraging will continue to reduce demand.
  
• Until very recently the dollar had been strengthening and exports have been declining.
  
• Stimulus package won’t be enough to offset job losses etc.
  
• Oil demand is declining, which means less oil will be sold.
  
• Oil prices are still too high (Only at 2004 prices.)
  
• Many companies that should be bankrupt aren’t because of all these bailouts. When these companies finally do go bankrupt there will be significant job losses.
  
• The number of uninsured people is increasing and hospitals have to find a way to pay for them.
  

Reasons The US Stock Market Will Decline

• Companies will have no earnings!!! For a long long time!!!!
  
• Commodity prices have declined drastically, especially oil, so earnings from commodity companies, which had the largest percentage of the S&P 500, will decline drastically.
  
• Pension costs have increased because the value of the pension, which was mostly in stock, has decreased drastically.
  
• Companies have significantly more fixed costs (manufacturing plants, hotels, etc) then there is demand for.
  
• Revenue has declined significantly.
  
• Share buybacks will continue declining.
  
• Healthcare costs are increasing.
  
• Investors will sell stocks because:
  
  
  
  • They need the money to pay living expenses. Especially people who’ve lost their job(s).
    
  • They are panicking and just want to stop losing money
    
  • Pension funds that have to meet obligations
    
  • Hedge funds have to meet redemptions
    
  • Funds that have to sell if a company gets downgraded or share price falls too low
    
  • Investors that have to meet margin calls
    
  
  

Reasons The US Stock Market Will Increase

• Layoffs mean employee costs are decreasing. Problem is demand is decreasing faster than they can lay people off. The more people they lay off the less demand. Aka negative feedbacks loop.
  
• Interest rates are decreasing. Problem is the interest rates for many companies are actually increasing if they can even get credit at all.
  
• Commodity costs are declining. Problem is most of the earnings in the S&P 500 were from the most important commodity of all: Oil. Without that they S&P 500’s earnings will decline from $75 to $50.
  
• Investors, who have to cash to buy with, will buy stocks because:
  
  
  
  • Short sellers will cover their shorts
    
  • 401k investors who blindly contribute to stock mutual funds (ever notice the market goes up on pay day)
    
  • Long term investors that believe current prices are fair if not cheap and are able to withstand further declines (though very few have cash)
    
  • Unfunded pensions will have to contribute to their plans. If they don’t change their asset allocation then they’ll have to buy stocks.
    
  
  

Reasons the US Economy Will Improve

• Inflation is declining, especially oil. However, price declines don’t help on a global basis because any increased savings from cheaper prices in the consuming countries decreases the spending in the producing countries.
  
• Interest rates are declining. Problem is credit is harder to get and demand for credit is much lower.
  
• Unemployment benefits are increasing. Problem is the money received from unemployment benefits is less the job they had paid.
  
• Few homebuilders have gone bankrupt, so those jobs have not been lost yet. The problem is at some point these companies will go bankrupt and the jobs will be lost.
  
• Few banks have gone bankrupt, so those jobs have not been lost yet. Problem is at some point these companies will go bankrupt and the jobs will be lost.
  
• Few retailers have gone bankrupt, so those jobs have not been lost yet. Problem is at some point these companies will go bankrupt and the jobs will be lost.
  
• Few casinos have gone bankrupt, so those jobs have not been lost yet. Problem is at some point these companies will go bankrupt and the jobs will be lost.
  
• The government is spending like mad. Problem is one day all this spending is going to have to be paid for. Of all the problems out there, this is the biggest problem. Especially if this problem is paid for via war.
  
• The government is bailing almost everyone out. Problem is one day all the bailouts will have to be reversed somehow or another. If it’s through the natural course of inflation then expect to be in a recession (no growth or outright decline) for years if not decades.
  
• The US dollar will reverse its recent strength and begin the decline, which is good for exports. Problem is the economy is global so any increase in exports in the US decreases exports somewhere else.
  

Ways to improve the economy

• Let the free market work. Otherwise we will simply delay the depression. Only provide jobs for people that would have to be paid unemployment benefits anyway.
  
• Let the automakers fail. If we don’t the whole auto industry will be worse off will worse cars.
  
• Let the banks fail. If we don’t the whole financial industry will be worse off will higher rates.
  
• Increase taxes on new building permits to deter building more houses.
  
• Increase taxes on old houses and commercial buildings, especially energy inefficient ones, and provide tax break to tear them down.
  
• Provide tax breaks for investors to buy abandoned assembly plants and build windmills.
  

Things To Anticipate Over The Next 90 Days

• Service industries (retail, restaurants, hotels and affiliated) that had job growth in 2008 will begin to show declines along with everyone else.
  
• Oil prices to continue falling (Still way too much supply out there in the short run)
  
• Citigroup going the route of AIG.
  
• Automaker(s) going bankrupt.
  
• Significant amount of companies being downgraded, which will mostly affect on bonds.
  
• Declining bond prices (Especially CMBS)
  
• Some companies will not be able to afford to rollover their debt and that will bankrupt them
  
• Even with all these problems, expect the government to NOT intervene as they wait for the new administration to take over. Looks like the short sellers are counting on it.
  

Things To Anticipate Over The Next Year

• The recession to last all through 2009.
  
• Borderline depression near the middle of 2009 if things get worse than the current trajectory.
  
• Net earnings on the S&P 500 to be $25.
  
• State and local governments will be reducing spending significantly unless they get bailed out.
  
• Another $500 billion fiscal stimulus package that focuses on rebuilding the US.
  
• Whatever solution the Fed comes up with, they will overdue it, but not before it’s too late.
  
• The government will continue to react to problems instead of anticipate them.
  
• The market to bottom. Probably when you least expect it.
  
• Retailers, homebuilders, mortgage insurers, insurance companies (think annuities), banks, casinos and car manufacturers all going bankrupt at the same time, their stocks and bonds go to zero, and they start over.
  
• Highly dilutive secondary stock offers of which the proceeds will be used to pay down debt.
  
• Home prices to continue declining
  
• Increased savings. Obviously you then have decreased spending.
  
• GDP to decline 5%
  
• Unemployment to rise to 10% (That’s a HUGE number)
  
• No IPO’s
  
• No Private Equity buyouts
  
• Limited corporate bond issuance
  
• A secular shift towards frugality
  
• Under funded Medicare and probably more pressing Medicaid (State Run).
  
• Underfunded unemployment trusts.
  
• All time low interest rates. (Accomplished 3-25-09)
  

Things To Be Prepared For (Not that they’ll necessarily happen)

• The S&P 500 declining to 500 and staying there for 5 years.
  
• The treasury market (especially long dated treasuries) declining 30% (the principal that is).
  
• Have enough money saved up to buy the basic necessities in case you lose your job.
  
• Have enough food in your house right now in case there is a run at the grocery store.
  
• Have enough cash (gold?) on hand in case there is a run on the bank.
  
• Have a way to defend yourself in case there are riots.
  
• Have a TV antenna just in case the cable goes out.
  
• Have a generator, but this is severely limited by how much gas you can store.
  

What Type of Investments Will Work?

• Short term corporate bonds of non financial companies that have significant amounts of cash.
  
• Fairly priced stocks of non financial companies that have significant amounts of cash and pay a significant dividend.
  

Which Companies Will Be The First To Go Bankrupt?

• Companies that don’t have enough money to make their interest payment. Next in line will be companies that don’t have enough cash to pay off debt that is rolling over. They will be forced to either reissue debt with 15% interest rates if they can get financing at all. This includes state and local governments.
  

Sayings (For lack of a better term)

• The more things change the more they stay the same. (This is the new sound, just like the old sound.)
  
  
  
  • The politicians who were in charge while this credit bubble was growing are the same politicians who are in charge now.
    
  • The car manufactures haven’t changed a thing since they’ve been given the bailout money. Neither have the banks.
    
  • Albert Einstein: "Never expect the people who caused a problem to solve it."
    
  
  
• A bird in the hand is worth 2 in the bush
  

Quotes

• Edwin LeFevre (1932): “Reckless fools lost first because they deserved to lose, and careful, wise men lost later because a world-wide earthquake doesn't ask for personal references.”
  
• Albert Einstein: "Never expect the people who caused a problem to solve it."
  
• Munger: “A small leak can sink a great ship”
  
• US Sec. of the Treasury Andrew Mellon, 1929: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people."
  

Rules to Live by

• Deep breath. Relax. Slow down.
  
• Know Yourself
  
• Think for Yourself
  
• Execute (The other rules don’t matter if you don’t execute)
  
• Write for YOURSELF. Especially any lessons learned.
  

Invest Accordingly