~ DN Bi-Weekly Blog – Week of December 5, 2011 ~

~ Market Sentiment ~

 The Dow Jones Industrial Average (DJIA) finished the week up 7% despite a late downturn as the market closed on Friday. This marks the second biggest weekly gain in the index’s history. The S&P 500 and the Nasdaq Composite finished the week up 7.4% and 7.6% respectively. Investors responded positively to reports early in the week that unemployment had fallen to 8.6% and that 120,000 nonfarm jobs were created in the month of November. This is a broad indicator that the US’ ailing economy is improving, but analysts are quick to caution that we are not out of the woods yet. There are still major concerns looming over the European debt crisis and although domestic manufacturing is on the rise, the interdependencies in world economies could create serious problems as Europe slides into a recession.

The leaders of the 17-nation Euro zone will meet for a summit on Thursday and Friday of this upcoming week and investors will continue to follow measures to ease the debt crisis closely. The European Central Bank (ECB) recently pledged 200 billion euros to the International Monetary Fund to be used in alleviating the fiscal woes of countries such as Italy, Greece, and Spain.

Oil finished the week at over $100/barrel and energy stocks performed extremely well on the whole. This sector is awaiting a final decision on a proposal from TransCanada (TRP) to build a pipeline from Canada to the Gulf of Mexico. While the Obama administration has initially rejected the idea over concerns about safety and the environmental impact the pipeline may have, House Republicans have introduced a bill to legislatively force approval. Proponents of the project say the pipeline would create 20,000 jobs and release problematic oil gluts in places like Cushing, OK.

Financial stocks posted huge gains as three out of four companies listed on the DJIA ended with positive numbers for the week. European banks benefited from Angela Merkel’s comments early in the week on plans to reach a tighter fiscal union in the EU. American bank shares responded well to the positive labor reports but, like every other sector of the economy, are still extremely vulnerable to economic unrest in Europe.

~ The Week in Review ~

 Business Deals and Headlines

SAP announced plans to buy Success Factors for $3.4 Billion. Success Factors is a Web-based software company and is valued around $40 a share. This move by SAP comes in response to rival Oracle’s acquisition of RightNow Technologies for $1.43 billion this past October. This move highlights the purchase of smaller software companies as larger companies look to compete in cloud technology.

Buffet to buy Newspaper

Warren Buffet looks to by the publisher of the Nebraska principal daily newspaper. Berkshire Hathaway reportedly is buying Buffet’s hometown newspaper. Terms of the deal have not been revealed, but this marks and interesting buy of the Omaha World- Herald company.

Initial Public Offerings

Zynga looks to its future public offering, and plans to be valued around $10 billion. Zynga is an online game site that has experienced increased popularity as it nears their IPO.

Citigroup Case

Judge Jed Rakoff of the District Court in Manhattan denied a settlement between Citigroup and the Security and Exchange Commission. Citigroups was seeking to pay $285 million to the SEC without having to admit any illegal practices. This signifies a crackdown by the courts in wanting companies to acknowledge their offenses.

Barney Frank

Congressman Barney Frank stated that he will not seek reelection in 2012. Frank was one of the longest serving members in the House of Representatives. Frank blamed the redistricting constraints that would be placed on him and the challenges were too difficult to overcome.

Court Battle

 The court battle between Carl Icahn and William Ackman has finally ended. The two men have become wealthy due to the success of hedge funds; and their seven-year case is finally settled. Mr. Ackman and Mr. Icahn were fighting over $4.5 million suit, a minute amount in terms of their overall worth.

AMR Bankruptcy

American Airlines’ parent company AMR Corporation filed for Chapter 11 bankruptcy protection last Monday.  The company currently faces $29.6 billion in debt that continues to grow as a result of operating losses.  During reorganization, the airline company will likely aim to reduce labor costs, leaving many worried that wage-cuts and layoffs may come in the near future.

AMR stated that American Airlines “expects to continue normal business operations throughout the reconstruction process.”  Specifically, American and American Eagle assured customers that they would fly normal schedules, honor tickets and reservations, maintain frequent flyer miles, and continue to pay employee wages as well as provide health benefits”.

According to the Financial Times, this marks the end of company’s decade-long attempt to avoid Chapter 11.  In 2003, American chose to avoid bankruptcy, while many of its peers chose to use Chapter 11 to reduce structural costs and cut pension plans, putting American at comparative disadvantage.  For example, the company claims that it is currently paying at least $600 million more for labor contracts than other airlines such as Delta and United who were able to eliminate existing contracts after filing chapter 11.

Federal bankruptcy rules allows a company filing for Chapter 11 the ability to reject contracts.  As such, AMR will be able to take a stronger stance when it renegotiates with labor unions.  This will be one of the first steps AMR will take in its attempt to use reorganization to become more efficient, competitive, and financially secure.

~ DN Bi-Weekly Blog – Week of November 14, 2011 ~

~ Market Sentiment ~

After opening the week strong, the Dow Jones Industrial Average (DJIA) sustained severe losses at the opening bell on Wednesday, finishing the day down 3.2%. This overnight drop was caused predominantly by the news that Italy’s borrowing costs would continue to rise. Investors acted on concerns about the credit status of Italy and instability in the Eurozone in general. The market bounced back on Friday as plans for an interim government after the imminent resignation of Prime Minister Silvio Berlusconi began to emerge. As expected, Berlusconi resigned on Saturday as the lower chamber of Italy’s parliament approved new austerity measures in a revised budget bill. Mario Monti, an economist and former European commissioner, was announced as Berlusconi’s successor effective Sunday night. Investors will likely react favorably to this decision by parliament given the extremely negative perception that the international community at large held with respect to Berlusconi’s leadership.

Europe’s debt crisis remains one of the most significant roadblocks to sustainable increases in the markets. On the whole, the economy is slowly recovering as is reflected in generally fair valuations and better-than-expected quarterly earnings reports. Eurostat will release reports on industrial production and inflation within the Eurozone on November 14 and November 16 respectively. These reports will provide important insight into the overall economic health of the countries that investors have been so focused on. Investors are also worried about the increasing spreads in yield premiums between Germany and other large Eurozone countries such as France, Austria, and Belgium. If these spreads do not tighten over the next week, the market will likely fall off the gains it made late this past week.

Earnings reports from Walt Disney Corp. (DIS +0.95%) were released this week. Disney announced a rise in fourth-quarter earnings Thursday afternoon, giving investors a pleasant surprise. Bond markets were closed for Veteran’s Day on Friday but positive developments over the weekend in Europe (specifically in Italy) should promulgate a bond selloff on Monday that could push equities even higher. Of course, this increase will likely not be sustainable unless regulators can come up with a viable plan to keep Italy’s and other struggling countries’ borrowing costs low.

~ Deals & Acquisitions ~

MF Global

The liquidation of MF Global resulted in 1,066 layoffs this past week. After MF Global filled for bankruptcy on October 31st of this year, the court appointed trustee has been overseeing the brokerage firm. FBI investigators are investigating the company and searching for $600 million missing in customer money. The CME group pledged $300 million to aid MF Global’s current customers. However, the recent lay-offs will not make up for the missing money.

Starbucks

Starbucks bought Evolution Fresh, a juice company, for $30 million. The recent purchase represents a shift for the company in seeking juice profits. Starbucks main competitors in the juice industry will be Odwalla, owned by Coca-Cola, and Naked Juice, owned by PepsiCo. In purchasing Evolution Fresh, Starbucks is looking to expand its menu and entice a different sort of customers.

Energy

BP plans to sell its majority stake in Pan American Energy, an Argentinean oil producer, for an estimated $7.1 billion. However, the potential deal ended after the buyer, Bridas Corporation backed out.

Fraud

A federal judge convicted Raj Rajaratnam — the former hedge fund manager and founder of the Galleon Group — of insider trading The judge ordered Rajaratnam to pay the largest ever penalty of $92.8 million assessed against an individual and he was also sentenced to 11 years in prison.

TransCanada Pipeline

The approval process for the Keystone XL pipeline has been delayed; the pipeline would cross the international border with Canada and new possible alternate routes are being discussed. Initial estimates on the cost of the project have reached $1.9 billion.

~ Weekly Book Review ~

A Random Walk Down Wall Street

By Christina Huang

Money Lying on the Ground and an Ape Throwing Darts: two stories in A Random Walk Down Wall Street strikes me the most: first, if you are walking on the street and see a $100 bill lying on the ground, you should not pick it up. Second, a blindfolded ape throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts. And these two stories illustrate the main point of the book: the stock market is efficient and no one can earn above-average returns without accepting above-average risks. Therefore, an average person who invests in index funds can even do better than a professional who actively manages a fund. Besides this thesis, the book also introduces some investment vehicles and strategies. The question is: should I recommend this book as an introduction book to an intelligent friend with no investment experience? The answer to this question depends on what my friend’s situation is. Specifically, it would concern my friend’s intended length of investment, market she chooses to invest in and her purpose of investing. In the following, I will mainly talk about situations where I won’t recommend the book to my friend.

The book’s Efficient Market Hypothesis might not work well if my friend wants to invest short-term. If she sees a $100 bill on the street, why wouldn’t she pick it up just because it should or will disappear eventually?( The EMH says that the bill should or will disappear.) In other words, if my friend wants to invest in the short-term, why would she refuse to grab the short-term benefits just because it will disappear in the long run? Say that if my friend needs to send her children to college in four years, she can only invest the inheritance for the next four years. She might be better off by investing in an actively management fund. She probably will get much money by buying some tech stocks in 1995 and selling them in 1999, even though the internet bubble busted later on. If one is investing in a short period of time, the book’s theory will not necessarily apply since the thesis is based on long term. In this case, I won’t recommend the book to my friend. Instead, she will benefit more from a book that introduces different strategies on how to select stocks or fund managers.

The place the “ape”(average investor) is at also matters. “King Kong was a king and a god in the world he knew, but now he comes to civilization merely a captive,” says Carl Denham in King Kong. Index funds might not outperform the actively managed ones at certain places. For example, if my friend is in China, she might be better off by hiring a good manager to manage her funds because the Chinese stock market is highly speculative and relatively opaque. According to the China Securities Regulatory Commission, as high as 65% to 70% of the investors in the Chinese stock market consists of private individuals. Partly because individuals tend to aim at the short-term rather than the long term compared to institutions, the Chinese stock market can swing dramatically and easily go out of norm. In the book, the market always adjusts itself to normal state. However, if abnormality is the rule, rather than the exception, like the Chinese stock market, the abnormal state becomes the new norm. Since it would be difficult to tell when the market will correct itself, one can do better by just following the trends or the new norm. Moreover, information from the public companies is not highly transparent, which prevents the market from performing efficiently. Since the Efficient Market Hypothesis is a condition for the superiority of index funds over actively managed funds, sticking with index funds, as promoted by the book, might not work well. Sometimes, the big mutual fund management companies have insider information that helps them take advantage of market inefficiencies and perform better than the index funds. (Note that the Chinese law system is not mature enough to prevent that from happening.)

In fact, a recent research on S and P has shown that in some areas, stock picking outperforms passive investing. For example, more than half of actively managed large- and small-cap value funds beat the benchmarks in the past five-year period. Actively managed large-cap value funds did particularly well, returning 2.2% per year on average, versus 0.63% for the index; actively managed small value funds earned 3.79% per year, versus 2.96% for the index. The average actively managed international small-cap fund returned 4.91% per year over the last five years, more than triple the index. (Walll Street Journal) Index funds might be the “King and God” of stock market in some areas, but merely “a captive” to actively- managed funds in the other areas.

Moreover, the purpose of investing matters. If my friend is on the street to appreciate the spectacular architectures, a $100 bill lying on the ground will not be appealing to her. If my friend wants to invest to have fun, she would not derive much pleasure from just passively investing in index funds. Rather, I would recommend some other book that goes into the details of how to pick stocks to her. In another case, if my friend is investing to learn about companies or behavior of equities, she would not learn much with index funds. On the other hand, if my friend just wants to get rich slowly, the book by Malkiel is the right one.

Lastly, you never know if your friend will be the next Warren Buffet. It is always worth a try. If I recommend the random walk book to my friend up front, she might become a passive investor and just give up picking her stocks and developing her own investment strategies. A potential Warren Buffet might just get covered up in the mascot of a “blindfolded ape”.

References:

Morgan, Sarah. “When Index Funds Lose ”Smart Money, Wall Street Journal, Sep 2011

Anonymous. “Ten questions with Burton Malkiel on A Random Walk Down Wall Street”, Journal of Financial Planning, Apr 2005;18.4; ProQuest

Arvedlund, Erin E. “Fund of Information: Mr. random walk”, Barron’s,Apr 2003; 83,15; ProQuest

 

~ DN Bi-Weekly Blog – Week of October 24, 2011 ~

~ Market Sentiment ~

Dow industrials bounced back from a rocky start to ride a Friday rally to a 1.4% gain for the week. This week is the fourth straight that the DJIA has seen overall returns, a mark not matched since January of this year. The S&P 500 rose by 1.1% while the Nasdaq 100 dropped by the same amount.
Trading opened down this week as investor confidence was shaken following pessimistic comments made by German Chancellor Angela Merkel’s spokesperson Steffen Seibert. Seibert indicated that an agreement on a solution for the European sovereign debt crisis would likely not be reached at the EU summit planned for October 23. Markets remained volatile over the course of the week as new information was leaked on prospects for the summit. The euro recouped the losses it sustained earlier in the week on Friday as German finance minister Wolfgang Schaeuble contradicted Merkel and said that he hoped for a resolution.
A number of S&P 500 companies released third quarter earnings reports this week. The tech sector as a whole generally reported losses and missed earnings targets while a recent spate of mergers and acquisitions in the energy industry has boosted that sector. Bank of America (BAC) reported a profit of $6.2 billion while Goldman Sachs (GS) reported only their second quarterly net loss since the company went public in 1999. The market reaction to BofA’s report was mixed, however, as much of those profits were due to accounting methods and a one time sale of China Construction Bank stock. McDonald’s (MCD) stock price rose to record heights following third-quarter earnings gains of 8.6% on the back of same-stores sales growth.
By and large, big corporations returned healthy profits and are maintaining healthy balance books. Demand is still sluggish in the US market where the economy is still stagnating but many S&P 500 companies are offsetting this by increasing their exposure to overseas markets. Ultimately, while this is good for the S&P, small business owners are left at a huge disadvantage moving forward.
Bottom Line: the markets are currently in flux, waiting for any potential resolutions from this weekend’s summit. Investors are seeking clarity on recapitalization for European banks and how much Greek bondholders’ losses will affect those banks.

~ Deals and Acquisitions ~

Pipeline giant Kinder Morgan announced that it will buy rival company El Paso Corp for $21.1 billion in cash and stock. With the acquisition, Kinder Morgan will become the largest operator of nature-gas pipelines in the United States. This deal puts increased faith in the future of natural gas a potential energy source and will catapult Kinder Morgan to the fourth largest energy company in America. Kinder Morgan recently became a public company this year and raised $2.9 Billion in its February IPO.

~ Groupon ~

Groupon, which is heading towards its public offering, expects to sell 30 million shares at about $16 to $18 a share, valuing the company at as much as $11.4 billion. Groupon hopes to break even before their public offering around November 3rd. Groupon is an internet start up that finds discounts at local restaurants and stores, and now is approaching 150 millions subscribers.

~ Insider Trading ~

Denver Hedge fund manager Drew Brownstein was convicted of insider trading. Mr. Brownstein admitted to making nearly $2.5 million on an insider trading tip about Mariner Energy. Brownstein received the information from a friend, Mr. Drew Peterson, who has also pleaded guilty. The typical sentencing guidelines call for 37 to 46 months of jail time with the plea.

~ Carlyle and Blackstone Compete for Merger-Market ~

Carlyle group and Blackstone were active in the Merger-market during the first three quarters this year, with Carlyle group completing 20 deals assessed at $4.1 billion and Blackstone signed 11 deals approximately valued at $16.9 billion. Overall data from Q3 from 2011 was up 7.4% from Q3 2010, and private equity firms completed $76.4 billion worth of deals internationally.

~ “ A Quick Opinion…”: ‘Occupy Wall Street’…where is it headed? ~

As the “Occupy Wall Street” movement continues to sweep the nation, and the 99% continue to cry for “accountability” and “justice” within the financial system — we should take heed in not only their movement, but also the glaring reality that the group is fighting a battle they simply cannot win. For despite the growing number of “Occupy xxx” groups that have sprung up across the nation (both on and off college campuses) — these protesters face a discouragingly long uphill battle.
Starting with the negative media surrounding the group’s often fragmented goals, and ending with a financial situation that is often too complicated to explain to the average American — OWS was doomed from the start. The blame the group seeks falls to no one individual, nor can the economies downturn be traced to one specific event. Beyond the desperate cries for Wall Street executives to be held “accountable” for what they have done — what the movement has failed to realize is that they are not protesting the greed and corruption of the “financial system,” but those of American society. The full-bodied, drastic changes OWS wish to see implemented would only come only at the cost of broad-spectrum changes to American consumer culture and massive disruptions to the American economy. Without even taking a stance on the movement, it is easy to see that the group’s vision completely outdistances the realities of our current situation. There is no doubt that the glaring disparities in wealth, education and living standards need to be addressed within our society — but protesting the men and women who have the means and the ability to keep themselves in the 1% is not the best way to get there. To attack the principals of capitalism — the foundation upon which this nation was built — is but to alienate yourself to a position where you can no longer create the meaningful change you wish to create.

~ Bi- Weekly Book Review: The Big Short (by Michael Lewis) ~
(Part of DBN’s Bi-Weekly Reviews of Influential Finance Books)

What’s Short of the Big Short?

By Christina Huang

The world of finance is one of losers and winners. When the subprime mortgage crisis hit the market in 2007, the big Wall Street firms with huge pile of subprime mortgage bonds lost while a few wise men betting against these bonds won. In Michael Lewis’ Book “The Big Short”, Lewis recounts the story of how a handful of Wall Street misfits anticipated the doom of the subprime mortgage bonds and made a fortune betting against the home-price inflation in mid-2000s. Lewis successfully tells the story with humor and clarity, considering the complexity of the subprime mortgage bond market before the crisis. However, his account of the financial crisis in 2007 is biased in that it exaggerates the effects of the “public” feature of investment banks, ignores factors such as government’s policies that lowered borrowing standards and neglects home owners’ speculative behavior.
Lewis overstates the effects of the “public” nature of the major investment banks. Lewis points out, toward the end of his book, that what lied at heart of the crisis was that all the major investment banks went public rather than functioned as partnerships. (Lewis traced the crisis back to a decision John Gutfreund had made- when he’d turned Salomon Brothers from a private partnership into Wall Street’s first public corporation.) Here is Lewis’s logic: if a major investment bank were organized like partnership, each partner would have been more careful with their decisions and taken fewer risks. Now that these banks were public and the bankers were operating with shareholders’ money, they had few incentives to scrutinize their decisions or products because they could “transfer” risks to their shareholders; that was what led these firms to use high leverage and buy a great amount of subprime mortgages bonds without even knowing what were underlying these assets. (Lewis, 257) Lewis states that the incentives on these public Wall Street firms are “entirely wrong” because the bankers can “get rich [even] when they are making dumb” decisions. (Lewis, 256) In short, Lewis is saying that people within the investment banks took excessive risks because they had nothing to lose. This statement is not sound. First, the bankers did have many things to lose. Many individuals most responsible for the massive money loss during 2005-07 were the largest shareholders in their companies. These individuals lost money when their firms suffered. In other words, they did not “transfer” much risk to the companies’ shareholders. Even though Howie Hubler, a former trader at Morgan Stanley, got away with large bonuses, the majority of the Wall Street professionals responsible for the crisis suffered from the crisis. Jimmy Cayne(CEO of Bear Stern)’s stock declined from 1 billion to 50 million. Richard Fuld (Lehman’s chairman) lost 550 million of his Lehman stocks when Lehman Brothers went under. The bankers had a great deal of interest within these firms. These individuals did want their firms to perform well. Even though the bankers are employees in a public company, they are effectively like “partners” in a partnership company because of their large stock holdings. Therefore, the employees engaged in careless behaviors not because they were in a public firm, but rather, because of some other factors. Second, we can refute the author’s countrapositive statement: if an investment bank were not public, bankers would not have been as careless. To refute this, just imagine that an investment bank were actually a partnership. In this case, a banker would still have bought those mortgage bonds because they were led to believe that they could make profits in these bonds. The only difference would be that the bank would not have had the ability to raise funds in the stock market. In this case, these partnership firms would just have found other creative ways to raise enough capital to buy the mortgage bonds, which would eventually lead to the 2007 crisis. To conclude, the mere fact that the major investment banks were public is not important in causing the crisis.
Moreover, the book is biased in that it gives all the blame to investment banks and ignores the government’s policies’ effects on the crisis. If the government did not lower the borrowing standards and encouraged lending at Fannie Mae and Freddie Mac, the crisis might never have had happened. Here is what happened: at first, the banks were making money with bundling mortgages backed securities backed with good credit and down payment and selling them to investors. Then they became greedy and wanted to make more money by making more loans. When there were not enough people with good credit, the banks invented credit default swaps. (In the book, a trader named Mike Edman within Morgan Stanley came up with this idea). With these swaps, a bank could give out loans to people with low credit score and little down payment. However, a loan could be granted only if it fulfilled the underwriting standards designed by the government. Therefore, the banks had to persuade the politicians to ease the underwriting standards. The investment banks then spent huge amount of money to get the government ease the standards. Then Barney Frank was saying that everyone deserves to own a home and Bush was saying that everyone deserves to live the American Dream. Clearly, if the government had not relaxed lending standards, the investment banks would have never got the chance to create the CDOs, which eventually led to massive defaults of people who should not have owned houses at first place. True, the investment banks were greedy. However, without the help of the government, they would have never been able to unleash their greed.
The book also ignored that homeowner speculation also contributed to the crisis. In the book, the homeowners who got subprime loans were depicted as poor people who were told by the mortgage sellers to tell lies and who got deceived by “the teaser rate” and was later ripped off by “the real rate”. (Lewis, 19) These customers were truly the victims of the entire housing market scheme. However, we had another crowd of customers who had more than one house, to whom we should not be as sympathetic. They were buying houses as speculative investments. During 2006, 22% of homes purchased were for investment purpose, with an additional 14% purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. (Christie, 1) The widespread speculation pushed house prices up dramatically. Housing prices nearly doubled between 2000 and 2006. Many homes were purchased even when they were still under construction and then sold for a profit without the sellers ever having lived in them. The housing bubble was so big that Warren Buffett stated that it was the greatest bubble he has ever seen in his life. The question is how did the broad speculation contribute to the crisis? The rising housing price gave mortgage sellers excuses to give out subprime mortgages, whose defaults eventually led to the crash. The inflating house prices also gave credit to the CDOs that investment banks created and encouraged large trading volume of CDOs, which increased the magnitude of the crash.
As a reader, it is hard not to wonder how could Lewis know every time in advance that a crash was coming and went about documenting it, as what he did when he wrote “Liar’s Poker ” and this book. It must be that the crash had shown its signs in times of prosperity and Lewis captured these signs. We should learn to be as forward-seeing as Lewis is. We are just four years away from when the crash happened and our economy is still not fully recovered. As we gradually pull ourselves out of recession, let’s remember the lessons learned in the past and walk with great care. And here, “we” refer not only to investment banks, but also the government and every average American citizen.

References:
http://money.cnn.com/2007/04/30/real_estate/speculators_fleeing_housing_markets/index.htm By Les Christie, CNNMoney.com staff writer

 

 

DBN Business Blog

by Qasim Khan