 | | The Daily Reckoning | Monday, August 8, 2011 | - The term "credit rating" inspires hysteria...for all the wrong reasons,
- The original "hedged fund"...and how this man made a 670% profit in ten years,
- Plus, Bill Bonner on world market woes, Bubbles Greenspan to the "rescue" and much more...
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Who Gives A Damn About America's Credit Rating?
I'm SICK of hearing about Keynesian vs. Austrian, fiat currency vs. Gold, U.S. credit ratings and other BORING economic theories you have ZERO control over... "WHO CARES!?" Truth is, if you want to make money in the markets, none of that stuff even matters! Let me prove it to you by showing you...
|  | | | | The End of an Era | | From narcolepsy to hysteria in one swift credit downgrade. |  | | Eric FRy |
Eric Fry, reporting from Laguna Beach, California...
Once upon a time, the term, "credit rating," was certain to induce narcolepsy. Today, that same term promotes hysteria... especially when the credit in question is the United States government and the rating in question is a downgrade from AAA to AA+.
As most Daily Reckoning readers are aware by now, Standard & Poor's sharpened its #2 pencils and polished its green eye-shades last Friday, then downgraded the credit rating of the United States from AAA to AA+.
Warren Buffett immediately condemned the downgrade and insisted that the U.S. is still a AAA credit, if not a "quadruple A" credit. Treasury Secretary Tim Geithner also blasted S&P's downgrade -- citing the rating agency's "terrible judgment" and "stunning lack of knowledge about basic U.S. fiscal math."
Obviously, therefore, S&P is on the right track.
Buffett's reaction typifies the billionaire's intellectually dishonest public commentary of recent years. S&P is, of course, the same rating agency that stripped Berkshire Hathaway of its AAA rating last year. S&P is also the firm that changed its rating outlook this morning on Berkshire from "stable" to "negative." Buffet's opinion, in other words, reflects more than a little self-interest.
But Buffett is just a business man; he does not have his fingers on the purse strings of the nation. Geithner's reaction, therefore, is more troubling. His rebuke of the downgrade reflects the stunning lack of basic math that has guided the Treasury Department's interventionist activities during the last three years.
Geithner's Treasury -- aided and abetted by the Federal Reserve, the President and Congress -- has conducted itself as though two minus signs make a plus sign. During the 2008-9 crisis, Treasury doled out trillions of dollars in direct bailouts and indirect guarantees to a handful of well-connected financial firms. The financial firms got the money, we taxpayers got the bill. Bad trade. Terrible judgment.
And terrible judgment continues operating today. For example, it is the collective judgment of the Executive and Legislative branches of the government that $2 trillion of spending cuts (over a decade) is sufficient to close a monstrous $75 trillion debt hole. That's not just terrible judgment, that's moronic.
By now, all employees of the Congressional Budget Office know they need only red pens to do their jobs successfully. The federal government has not operated in the black for more than a decade.
The financial circus of the last few weeks -- from the Congressional bickering about the debt ceiling to the President's "redistribution" agenda to the utterly toothless debt ceiling deal to the resulting stock market selloff to the downgrade by S&P to the whining about the downgrade by Geithner and Obama -- show that the clowns are running the show.
But this circus doesn't need more clowns; it needs lion-tamers. If not, the investment capital that still resides in the United States looking for opportunities will, instead, start looking around for the "Egress."
The lesson of the story is that politicians and bureaucrats are not nearly as good at fixing economies as they are at breaking them. Politicians cannot actually cure economic problems, no matter how much of your money they spend.
Politicians say they can do all kinds of things for an economy. They say they can "stimulate growth" and "create jobs." (And they seem to genuinely believe it). But the accumulated evidence from multiple generations in multiple countries around the globe demonstrates that politicians are only good at creating legislation and stimulating taxation.
A politician's directive cannot cure an economic ill, any more than a shaman's dance can repair a broken transmission. The shaman can dance and chant and burn all the incense he wants; the transmission won't care. It will remain a broken until someone crawls under the car, starts cranking bolts and getting his hands greasy.
A broken economy is no different. It is deaf to political incantations (we call them "bills") and only responds to the hands-on efforts of capitalistic enterprise. Even so, politicians rarely admit their impotence. They rarely subject their activities to a critical analysis. Instead, they continuously indulge their urge to "do something" about almost everything. They call their incessant meddling "legislation."
A little legislation is sometimes helpful. The US Constitution comes to mind. But more than a little is usually a disaster. We cannot prove it empirically -- or maybe we could and are just too lazy -- but a very strong inverse correlation seems to operate between government involvement and economic vitality. The greater the amount of central planning, the smaller the economic output. The former Soviet Union illustrates the point.
When the Soviet Union ultimately collapsed, the wealthy nations of the West gloated about the superiority of capitalism. But the days of gloating about the Soviet's "flawed economic model" may be drawing to a close. With each passing day -- and each passing legislation -- the "mature economies" of the West are enhancing their Soviet look and feel. The weight of regulation, taxation and an "entitlement culture" is crushing the dynamism that produces economic growth.
The wealthier a nation becomes, the greater the political temptation to tax that wealth and spend it on something...anything.
The process begins slowly and innocently at first: A little bit of taxation and a little bit of spending. But before you know it, the politicians are spending -- and promising to spend -- money the government does not even have. Taxes go up. Borrowing goes up...and up...and up. Government deficits accumulate year-by-year, like knick-knacks in an attic. The nation's fiscal condition deteriorates and...well...you know the rest of the story.
Eventually, the government piles up liabilities that are so large, it has no chance of ever repaying them. The fiscal game-playing begins -- the goal of which is to ship debts out to some faceless future generation, like New York City shipping its garbage out to sea on a barge.
This story of seriously distressed government finances is unfolding right before our eyes, both here at home and on the European continent. Greece is the most conspicuous example, but it is hardly the only example. The plight of Greece is a shot across the bow of the entire Western World -- warning the mature economies of the West that spendthrift governments produce bankrupt nations.
That's "basic fiscal math," Mr. Geithner.
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| | | | | | | The Daily Reckoning Presents | | Hedge Yourself! | |  | | Chris Mayer |
Alfred Winslow Jones was an unlikely figure for Wall Street. He had a Ph.D. in sociology and then served in the Foreign Service in Berlin in the 1930s. Later, he became a journalist. He wrote for Fortune magazine and Time-Life, mostly on nonfinancial topics such as Atlantic convoys, farm co-ops and boys prep schools.
Somewhere in that cocktail of experiences, Jones hatched an idea for making money in stocks. In 1949, he cobbled together A.W. Jones & Co. with $100,000 in capital, $40,000 of which was his own money and the rest was from friends. Importantly, A.W. Jones & Co. was a partnership, not a mutual fund. So he escaped certain regulations and operated with greater freedom than his regulated peers. He could borrow money. He could "go short" (thereby profiting when stocks fell). He could operate with greater secrecy.
Jones' fund was what many consider the first hedge fund. Actually, he called it a "hedged fund." The original idea was to hedge against risks, such that the fund suffered less when the market fell.
Jones went on to compile the best record of his era. He made his original investors millionaires. Jones himself became a wealthy man.
Jones labored in obscurity for the most part until an April 1966 article in Fortune by Carol Loomis. I have a copy of the article in front of me as I write this. It's titled "The Jones Nobody Keeps up With." It features a picture of A.W. Jones, then a 65-year-old with dark-rimmed glasses and a white tuft of hair, on vacation in Mexico City.
Loomis lifted the veil of obscurity on Jones. She begins, "There are reasons to believe that the best professional manager of investors' money these days is a quiet-spoken, seldom photographed man named Alfred Winslow Jones."
The reasons were all found in his knockout performance figures. Over the previous five years, the best mutual fund in the business was Fidelity's Trend Fund. It posted a gain of 225%. A.W. Jones & Co. made 325%. Over the previous 10 years, the best mutual fund was the Dreyfus Fund, up 358%. A.W. Jones crushed it. He was up 670%! Here was a Wall Street outsider, running circles around Wall Street's best!
Jones described how he ran his fund with an example. Say he had $100,000. He would borrow $50,000 more against that. With $150,000, he would buy $110,000 in stocks and sell short $40,000 (thereby profiting if stocks fell). With $40,000 "hedged," he had only $70,000 exposed to the market. "Speculative techniques for conservative ends," is how Jones put it.
After Loomis' piece, copycats sprang up everywhere and the hedge fund industry was born. By 1968, there were about 140 hedge funds in operation.
Jones, by the way, never approved of the morphing of his term "hedged fund" to "hedge fund." The scholarly Jones once said his original expression was "the proper one" and that he still regarded "‘hedge fund,' which makes a noun serve for an adjective, with distaste."
But more than just the name changed, as the new funds strayed from Jones' conservative hedged approach. As James McWhinney writes in his A Brief History of the Hedge Fund: "In an effort to maximize returns, many funds... chose instead to engage in riskier strategies based on long-term leverage."
The results were predictable. In 1969–70, hedge funds took heavy losses for these riskier strategies. By the time the bear market of 1973–74 rolled around, a number of them were no longer around.
But hedge funds would come back. And blow up again. And come back again. Of more recent vintage, Long-Term Capital Management (LTCM) was probably the most infamous blowup, and an example of the extremes to which some professional investors would take Jones' idea. LTCM was a star-studded fund. John Meriwether, a former vice chairman of Solomon Brothers, was a partner. So were two Nobel Prize-winning economists. LTCM had an army of Ph.D's and high-powered computing power. Only select investors were allowed in — the head of Merrill Lynch invested, as did the CEOs of PaineWebber and Bear Stearns. The Bank of China was an investor.
So was Julius Baer, a respected Swiss Bank. And many more. It was, as Edward Chancellor called it, the "Rolls-Royce of hedge funds."
Yet it blew up in June 1998, losing $2 billion — half of its capital — in just one month when the market quaked on news that Russia defaulted on its bonds. Three weeks later, the Federal Reserve arranged a bailout, as LTCM disclosed it had a giant $1.4 trillion in positions against only $1 billion in equity. It was so big that many thought that if LTCM failed, a raft of banks and financial institutions would go also go under.
For those kinds of blowups, hedge funds earned a poor reputation. As Mario Gabelli once said: "If asked to define a hedge fund, I suspect most folks would characterize it as a highly speculative vehicle for unwitting fat cats and careless financial institutions to lose their shirts."
You can't blame Jones for that. John Brooks reflected on Jones achievement in The Go-Go Years: "[Hedge funds] were the parlor cars of the new gravy train. It was fitting that their key figure was a man who had taken up stock investing as a sideline, an elegant amateur of the market who liked to think of himself as an intellectual, above and beyond the profit motive." Later in life, A.W. Jones became a philanthropist and took long Peace Corps assignments to South America and Africa. He died in his sleep at his home in Connecticut in 1989 at the age of 88.
In the volatile financial markets of 2011, Jones' old idea of a "hedged" fund seems as timely as ever. Looking out over the coming decade, hedged strategies may become increasingly valuable.
Regards,
Chris Mayer,
for The Daily Reckoning
P.S. I recently recommended the stock of a publicly traded investment manager that utilizes Jones-style hedged strategies. It would not be fair to my subscribers to divulge the name.
However, there are still some firms pursuing the old traditional idea of a "hedged" fund. You can invest in one of the best of these firms (not the fund) and could receive a dividend yield of 10% next year. My own Capital & Crisis research letter details these and other investment techniques for those looking to invest differently from the herd. Find out more here. | | | | Chris Mayer's Capital & Crisis Presents:
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| | | And now over to Bill Bonner with the rest of today's Reckoning
from Poitou, France... | | It's Not Armageddon? | | World Markets Plunge on a Rare Dose of Reality |  | | Bill Bonner |
Oh la la "it's not Armageddon, but it feels like it!"
Sometimes the news flow is slow. Here at the Daily Reckoning, your editor is forced to write about theory...history...or the weather.
But sometimes the news comes so fast he can barely keep up with it.
Last week, for example.
"Europe sparks global sell-off," was the Financial Times' lead headline on Thursday.
Italy's debt was sinking in the bond market. The Italians need to borrow more than $200 billion a year to stay afloat. But yields (the cost of borrowing) were rising to the point where it would soon be impossible. And Europe's bailout fund doesn't have enough money to save the Italians. The European Central Bank announced that it was buying bonds on the open market. But nobody believed the ECB could or would be able to support the market on its own.
This was followed by Friday's FT headline:
"Stock markets plunge worldwide."
All over the world, stocks fell on Thursday (reported on Friday). Some sellers sold because they were afraid of Europe. Some sold because they were afraid of Asia. Some sold because they were nervous about the US. And some sold just because everyone else was selling.
Daily Reckoning readers, however, did not sell. They already sold long ago, because they don't like the looks of the whole thing -- they think the whole world's capital structure is soaked in debt. Until the debt is wrung out...or dried out...they're staying away.
Friday's markets closed lower, but not much lower. The Dow lost 60 points. Gold ended the day down just $7.
And then, late in the day on Friday, another bombshell hit the newswires.
S&P downgrades U.S. credit rating for first time
By Zachary A. Goldfarb
Standard & Poor's announced Friday night that it has downgraded the sterling U.S. credit rating for the first time.
The move came even though the Treasury Department said that it had found a math error in the firm's calculations of deficit projections, according to a person familiar with the matter.
S&P decided to lower the AAA rating, held by the United States for 70 years, to AA+ after a bipartisan debt deal signed into law this week failed to assuage concerns about the nation's growing spending.
Analysts have said a downgrade could increase the cost of borrowing for the U.S. government and lead to tens of billions of dollars in more interest costs per year. That could translate into higher borrowing for consumers and businesses, too.
A downgrade would also have a cascading series of effects on states and localities that rely on federal funding, including in the Washington metro area, potentially raising the cost of borrowing for schools and parks.
But the exact impact of the downgrade won't be known at least until Sunday night, when Asian markets open, and perhaps not fully grasped for months. Analysts say the immediate term impact is likely to be modest because the markets have been expecting a downgrade by S&P for weeks.
So, what happened Sunday night? Keep reading...
And more thoughts...
Asian stocks fell hard!
BANGKOK (AP) — Asian stocks nose-dived Monday as the first-ever downgrade of the U.S. government's credit rating jolted the global financial system, reinforcing fears that the world economy is weakening.
Among the major Asian markets, Hong Kong's Hang Seng tumbled 3.8 percent to 20,145.82 and South Korea's Kospi was down 3.8 percent to 1,869.45 after briefly diving nearly 7 percent. Japan's Nikkei 225 stock average dropped 2.2 percent to 9,097.56.
Futures pointed to losses on Wall Street when it opens Monday. Dow futures were off 260 points, or 2.3 percent, at 11,142 and broader S&P 500 futures shed 31.30 points, or 2.6 percent, to 1,166.10.
"It's not Armaggedon, but it feels like it," said Hong Kong-based analyst Francis Lun.
*** Oh la la... and then what happened when markets opened in Europe? Wait...the ECB came to rescue. Here's the AP story:
Late Sunday, the central bank said it would "actively implement" its bond-buying program to calm investor concerns that Italy and Spain won't be able to pay their debts. Last week, worries over the two countries' ability to keep tapping bond markets contributed to the turmoil in global markets, which saw around $1.5 trilliion wiped off share prices.
Milan's FTSE MIB was up 2.4 percent, while Spain's rose 3 percent.
Their recoveries in the wake of dramatic declines in their borrowing costs helped most European markets open higher despite earlier falls in Asia.
*** And that, dear reader, is where it stands as markets open in America this morning.
*** Off the front pages, there were some other interesting stories.
For example, this little item from the New York Times tells how lawmakers react to a debt downgrade:
"...several lawmakers have publicly questioned whether the ratings agencies have the competence to evaluate the country's finances, and whether it was appropriate for them to be so deeply involved in discussions of fiscal politics,"
In short, they were indignant. They thought they had bought the rating agencies when they bought Wall Street. They must feel as though they have been cheated.
The feds paid trillions to bail out the automakers and the big banks. Since both industries now rely on the government for bailouts both are happy to go along with the politicians, no matter how absurd their plans. That's why Detroit climbed aboard on Washington's latest minimum gas mileage requirements. You'll recall that the last time the feds imposed mileage requirements, about 4 years ago, the automakers fought them. This time -- a major bailout later -- they roll over.
He who pays the piper calls the tune!
The feds thought they had paid enough already to get the rating agencies. Apparently not. They'll have to find another way to bring them to heel.
*** And then, Alan "Bubbles" Greenspan was back in the news too. He helpfully pointed out, according to this CNBC headline:
"No chance of default; US can print money." Yes, we're happy to see Mr. Greenspan hasn't lost his touch. He's a rascal. But he's a smart rascal. And he knows the US won't default...at least, not honestly. Instead, it will print money.
Regards,
Bill Bonner,
for The Daily Reckoning |
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