In Despicable Me, the latest animated children?s? film from 20th Century Fox, the Bank of Evil, used to finance the nefarious deeds of villains, has listed under its name ?formerly known as Lehman Brothers.?
When I wake up at 4:30 am each morning to check the overnight markets and review the opening salvo of incoming emails, I often have trouble focusing in my groggy state. So I had to blink twice when the first message in my inbox politely inquired if I had time to meet the Secretary of the Treasury in Palo Alto for lunch that day, apologizing for the short notice.
Tim Geithner was in San Francisco for a day to meet with a small group of venture capitalists and other business leaders. I can?t say who else was invited. Suffice it to say that I was the only one without an NYSE or NASDAQ listing.
When I greeted lithe, athletic, but diminutive Treasury Secretary, I could see the six secret service agents in the room visibly tense up. At 6?4? I towered over him, but he shook my hand firmly. I knew he was an avid surfer, and asked if he had stowed his board on Air Force One so he could shoot ?Steamer Lane? in nearby Santa Cruz after the meeting. He laughed, confessing that he rode the waves in a less than adequate fashion.
Geithner succinctly laid out the administration?s position on a wide range of financial and economic issues. The economy is now healing, has been growing for 20 months, but conditions were still very tough, especially if you were in construction, real estate, or small banks. Private sector investment grew of 20% in H1, but then slowed down to 10% in H2. Exports are strong.
The economy is undergoing some difficult, but necessary changes. The crisis was caused by excessive debt levels, the adjustment of which is now mostly behind us. The savings rate has soared from below 0% before the crisis to 4%-6% today. The debt burden is falling. Still, further measures are required.
Geithner thrilled his audience by proposing a permanent investment tax credit for domestic R & D. On top of that, he wants to add a one year tax credit for capital investment. It was music to the ears of those present, who were primarily engaged in the business of starting new companies. He would also eliminate tax preferences that encouraged companies to build plants overseas. At the very least, the playing field should be level.
Stepped up spending on infrastructure is a big priority, which has suffered from decades of neglect and under investment. The US is not a country with unlimited resources, and this is where the taxpayer gets the highest return on money spent. He also highlighted the urgency to extend tax cuts for the bottom 98% of the working population. The country entered the crisis with an unsustainable fiscal situation, and this would help address that.
Geithner says that the US would not engage in a debasement of its currency.? It is very important that our counterparties believe that we will fulfill our long term obligations. The US benefits from the dollar being used as a reserve currency, and there will be no non dollar reserve currency in our lifetimes.
The Dodd-Frank bill was an essential reform, as a huge financial industry had grown up outside the existing rules. Banks needed bigger shock absorbers. Governments do a very bad job at picking industries to protect, which only supports the weak at the expense of consumers.
Geithner said that by any measure, the Chinese Yuan was undervalued, and that was unfair to all of the country?s trading partners. Although this was enabling China to reap short term benefits, long term it meant that the US was setting its monetary policy. A flexible exchange rate would give China economic independence and soften the impact of imported inflation. When asked what exchange rate he would be happy with, he would only say ?HIGHER?.
The 49 year old Geithner has devoted much of his life to public service. He spent his childhood abroad while his father was a micro finance administrator for the Ford Foundation, growing up in Zimbabwe, Indonesia, and India, and finally graduating from high school in Bangkok. He did his undergrad at Dartmouth, and obtained a master?s in Asian studies at Johns Hopkins, where he gained fluency in Chinese and Japanese. I first met Tim myself two decades ago, when he was a low level Treasury attach? at the Tokyo embassy who spoke the local language flawlessly. After that, his rise was meteoric, from Undersecretary of the Treasury for International Affairs, to President of the New York Fed, to his current gig.
Geithner put on quite the performance. No matter what the question, he was able to caste it in the context of its historical background, the lead up over the past two decades, the current policy response, and parallels with other major and minor countries. We jumped from the Japanese stagnation, to the Swedish banking crisis in the early nineties, to Indonesia?s explosion of hyperinflation in the sixties, to the Mexican debt crisis, all within a minute. His canned answers to standard question rolled effortlessly off his tongue, while original problems delivered an intensity of thought one rarely sees.
Before he left, I pulled out all the cash in my wallet and pointed out to Geithner that while I had bills signed by previous Treasury Secretaries Larry Summers, Paul O?Neil, and Robert Rubin, I lacked one with his illegible scrawl. Did he have any which he could exchange with me? He sheepishly admitted that while such bills existed, they we being held back from circulation until the Treasury?s existing stockpile of Hank Paulson bills ran out, in order to deliver taxpayers good value for money. I would only see his bills once the economy recovers and the growth of M1 starts to accelerate. That is truly an answer one would expect from the 75th Treasury Secretary.
?If You?ve lived long enough on Wall Street, you know that we shoot our wounded and eat our young,? said Brad Hintz, an analyst with Sandford Bernstein.
?Oh, how I despise the yen, let me count the ways.? I?m sure Shakespeare would have come up with a line of iambic pentameter similar to this if he were a foreign exchange trader. I firmly believe that a short position in the yen should be at the core of any hedged portfolio for the next decade, but so far every time I have dipped my toe in the water, it has gotten chewed off by a piranha.
To remind you why you hate the Japanese currency, I?ll refresh your memory with this short list:
* With the world?s weakest major economy, Japan is certain to be the last country to raise interest rates.
* This is inciting big hedge funds to borrow yen and sell it to finance longs in every other corner of the financial markets.
* Japan has the world?s worst demographic outlook that assures its problems will only get worse. They?re not making Japanese any more.
* The sovereign debt crisis in Europe is prompting investors to scan the horizon for the next troubled country. With gross debt approaching 200% of GDP, or 100% when you net out inter agency crossholdings, Japan is at the top of the list.
* The Japanese long bond market, with a yield of 0.1.2%, is a disaster waiting to happen.
* You have two willing co-conspirators in this trade, the Ministry of Finance and the Bank of Japan, who will move Mount Fuji if they must to get the yen down and bail out the country?s beleaguered exporters.
When the big turn inevitably comes, we?re going to ?100, then ?120, then ?150. That works out to a price of $40 for the (YCS), which last traded at $16.35. But it might take a few years to get there. The Japanese government has some on my side with this trade, not that this is any great comfort. Four intervention attempts have so been able to weaken the Japanese currency only for a few nanoseconds.
If you think this is extreme, let me remind you that when I first went to Japan in the early seventies, the yen was trading at ?305, and had just been revalued from the Peace Treaty Dodge line rate of ?360. To me the ?83 I see on my screen today is unbelievable. That would then give you a neat 15 year double top.
It?s All Over For the Yen
?At some point in 2012, knuckles are going to be turning white, and we?ll see whatever rabbits Ben Bernanke is going to have to pull out of his hat," said David Rosenberg of Gluskin, Sheff in Associates
There are a lot of belles at the ball, but you can?t dance with all of them.
While a student at UCLA in the early seventies, I took a World Politics course which required me to pick a country, analyze its economy, and make recommendations for its economic development. I chose Algeria, a country where I had spent the summer of 1968 caravanning among the Bedouins, crawling out of the desert half starved, lice ridden, and half dead.? I concluded that the North African country should immediately nationalize the oil industry, and raise prices from $3/barrel to $10.? I knew that Los Angeles based Occidental Petroleum (OXY) was interested in exploring for oil there, so I sent my paper to the company for review. They called the next day and invited me to their imposing downtown headquarters, then the tallest building in Los Angeles.
I was ushered into the office of Dr. Armand Hammer, one of the great independent oil moguls of the day, a larger than life figure who owned a spectacular impressionist art collection, and who confidently displayed a priceless Faberg? egg on his desk. He said he was impressed with my paper, and then spent two hours grilling me. Why should oil prices go up? Who did I know there? What did I see? What was the state of their infrastructure? Roads? Bridges? Rail lines? Did I see any oil derricks? Did I see any Russians? I told him everything I knew, including the two weeks in an Algiers jail for taking pictures in the wrong places. His parting advice was to never take my eye off the oil industry, as it is the driver of everything else. I have followed that advice ever since.
When I went back to UCLA I told a CIA friend of mine that I had just spent the afternoon with the eminent doctor (Marsha, call me!). She told me that he had been a close advisor of Vladimir Lenin after the Russian Revolution, had been a double agent for the Soviets ever since, that the FBI had known this all along, and was currently funneling illegal campaign donations to President Richard Nixon. Shocked, I kicked myself for going into an interview so ill prepared, and had missed a golden opportunity to ask some great questions. I never made that mistake again.
Some 40 years later, while trolling the markets for great buying opportunities set up by the BP oil spill, I stumbled across (OXY) once more (click here for their site at?http://www.oxy.com ). (OXY) has a minimal offshore presence, nothing in deep water, and huge operations in the Middle East and South America. It was the first US oil company to go back into Libya when the sanctions were lifted in 2005. (OXY?s) substantial California production is expected to leap to 45% to 200,000 barrels a day over the next four years. Its horizontal multistage fracturing technology will enable it to dominate California shale. The has raised its dividend for the eighth year in a row, by 15% to 1.60%. Need I say more?
The clear message that has come out of the BP oil spill is that onshore energy resources are now more valuable than offshore ones. I decided to add it to my model portfolio. Energy is one of a tiny handful of industries I am willing to put my money in these days (technology and commodities are the others), and BP has handed me a rare opportunity to get in as the tightwad that I truly am.
Oh, and I got an A+ on the paper, and the following year Algeria raised the price of oil to $12.
A Faberge Egg
I always thought that a great strategy for a new hedge fund would be to only buy positions from existing hedge funds that were blowing up. That fund would buy securities subject to margin calls and distressed liquidations, which are by definition at six standard deviation extremes. It would not trade very often, but few it executed on would be humdingers.
If I were running such a fund today, I would be getting reading to short natural gas.
There has been a lot of talk about using CH4 to bridge our way to a carbon free economy because it produces half the CO2 that coal does. But virtually nothing has been done to put the infrastructure in place needed to consume the newly found 100 year supply in the US. To burn significantly more of this simple molecule, you need vastly more pipelines, power plant conversions, and above all, storage, than we have now. So far there has been a lot of talk (thanks, Boone), but little action.
Until then, the big production companies, like Chesapeake Energy (CHK) and Devon Energy (DVN) are going to race to out produce each other, praying they can use volume to offset price cuts, creating a huge weight on prices.
When natural gas was trading at $6 at the beginning of the year, I warned readers to stay away. Gas then launched into an agonizing, three month plunge, where it lost one third of its value. The ETF (UNG) did even worse, spiraling down 38%, as the widening contango decimated investors.
Since October, battered CH4 has rallied 28% off its $3.50 low. Talking heads on TV have explained this is because of the the record breaking cold weather we are seeing this winter, the imminent passage of a gas subsidies in congress, or because of crude supply shortages caused by the deep water drilling ban.
Don?t believe a single word of this. The supply overhang and storage shortage for this diminutive molecule is still as bad as it ever was. If we can claw our way back to the last high of $5, I think natural gas would be a screaming short again. The way to play this will be to short the United States Natural Gas Fund (UNG), which because of the straightjacket that limits its investment to near month futures contracts, is one of the worst performing funds in ETF land with the greatest tracking error to the underlying.
Natural Gas Prices Are Headed For Another Fall
I received some questions last week on my recent solar pieces as to whether I minded paying more money for ?green? power. My answer is ?hell no,? and I?ll tell you why. My annual electric bill comes to $1,500 a year. Since the California power authorities have set a goal of 33% alternative energy sources by 2020, PG&E (PGE) has the most aggressive green energy program in the country. More expensive solar, wind, geothermal, and biodiesel power sources mean that my electric bill may rise by $150-$300 a year.
Now let?s combine my electricity and gasoline bills. Driving 15,000 miles a year, my current gasoline engine powered car uses 750 gallons a year, which at $3/gallon for gas costs me $2,250/year. So my annual power/gasoline bill is $3,750. My new all electric Nissan Leaf (NSANY) will cost me $180/year to cover the same distance. Even if my power bill goes up 20%, as it eventually will, thanks to the Leaf, my power/gasoline bill plunges to $1,980, down 47%.
There is an additional sweetener which I?m not even counting. I also spend $1,000/year on maintenance on my old car, including tune ups and oil changes. The Nissan Leaf will cost me next to nothing, as there are no oil changes or tune ups, and my engine drops from using 400 overcooked parts to just five. We?re basically talking tires and brake pads only.
There is a further enormous pay off down the road. We are currently spending $100 billion a year in cash up front fighting our wars in the Middle East, or $273 million a day! Add to that another $200 billion in back end costs, including wear and tear on capital equipment, and lifetime medical care for 3 million veterans, some of whom are severely torn up.
We import 9.1 million barrels of oil each day, or 3.3 billion barrels a year, worth $270 billion at $82/barrel. Some 2 million b/d, or 730 million barrels/year worth $60 billion comes from the Middle East. That means we are paying a de facto tax which amounts to $136/barrel, taking the true price for Saudi crude up to a staggering $219/barrel!
We are literally spending $100 billion extra to buy $60 billion worth of oil, and that?s not counting the lives lost. Even worse, all of the new growth in Middle Eastern oil exports is to China, so we are now spending this money to assure their supplies more than ours. Only a government could come up with such an idiotic plan.
There is another factor to count in. Anyone in the oil industry will tell you that, of the current $90 price for crude, $30 is a risk premium driven by fears of instability in the Middle East. The Strategic Petroleum Reserve, every available tanker, and thousands of rail cars are all chocked full with unwanted oil. This is why prices remain high.
The International Energy Agency says the world is now using 87 million b/d, or 32 billion barrels a year worth $2.6 trillion. This means that the risk premium is costing global consumers $950 billion/year. If we abandon that oil source, the risk premium should fall substantially, or disappear completely. What instability there is becomes China?s headache, not ours.
If enough of the country converts to alternatives and adopts major conservation measures, then we can quit importing oil from that violent part of the world.? No more sending our president to bow and shake hands with King Abdullah. Oil prices would fall, our military budget would drop, the federal budget deficit would shrink, and our taxes would likely get cut.
One Leaf shrinks demand for 750 gallons of gasoline, or 1,500 gallons of oil per year. That means that we need 20.4 million Leafs on the road to eliminate the need for the 2 million barrels/day we are importing from the Middle East. The Department of Energy has provided a $1.6 billion loan to build a Nissan plant in Smyrna, Tennessee that will pump out 150,000 Leafs a year by end 2012. Add that to the million Volts, Tesla S-1?s, is Mitsubishi iMiEV?s hitting the market in the next few years. Also taking a bite out of our oil consumption are the 1 million hybrids now on the road to be joined by a second million in the next two years. That goal is not so far off.
Yes, these are simplistic, back of the envelop calculations that don?t take into account other national security considerations, or our presence on the global stage. But these numbers show that even a modest conversion to alternatives can have an outsized impact on the bigger picture.
By the way, please don?t tell ExxonMobile (XOM) or BP (BP) I told you this. They get 80% of their earnings from importing oil to the US. I don?t want to get a knock on the door in the middle of the night.
Is This Worth It?
We have been pretending that we?re too big to fail. We?re not too big to fail, You can jump off of a 90 story building and feel fine for the first 89 stories. It?s the sudden stop at the end that tells you you?re not.? said Tom Friedman, New York Times columnist and author of Hot, Flat and Crowded.
I normally avoid the diplomatic circuit, as the few non committal comments and soggy appetizers I get aren?t worth the investment of time. But I jumped at the chance to celebrate the 61st anniversary of the founding of the People?s Republic of China with San Francisco consul general Gao Zhansheng.
Happy Birthday China!
When I casually mention that I survived the Cultural Revolution and interviewed major political figures like premier Deng Xiaoping, who launched the Middle Kingdom into the modern era, and his predecessor, Zhou Enlai, modern day Chinese are enthralled. It?s like going to a Fourth of July party and letting drop that I palled around with Thomas Jefferson and Benjamin Franklin.
Five minutes into the great hall, and I ran into my old friend Wen, who started out her career with the Chinese Intelligence Service, and had made the jump to the Foreign Ministry, as all their best people did. She was passing through town with a visiting trade mission.
When I was touring China in the seventies as the guest of the Bank of China, Wen was assigned as my guide and translator, and we kept in touch over the years. I was assigned a bodyguard who doubled as the driver of a tank like Russian sedan. The Cultural Revolution was on, and while the major cities were safe, we ran the risk of running into a renegade band of xenophobic Red Guards, with potentially fatal consequences.
I asked Wen when China was going to float the Yuan? She explained that this is something China knew it had to do, but it wasn?t going to be rushed into by some opportunistic foreign politicians. If it moves too soon, millions will lose jobs, creating political instability, something the central government wants to avoid at all costs. Many of the largest scale employers were only marginally profitable, and a hike in the renminbi of only a few percent would force them out of business. I pointed out that that was exactly what was happening in the US.
Worth More Than Meets the Eye
I warned that if the Middle Kingdom waited too long, Washington would force them into an appreciation through punitive import duties and anti dumping actions, as we did with Japan 40 years ago. It was Nixon?s surprise ban on textile imports in 1971 that finally persuaded Japan to float the yen, then at ?360. If that didn?t convince the Chinese, then imported inflation would. The longer China delays, the bigger the pop when their currency is finally set free.
Wen then went on the offensive, claiming that Chinese workers were being exploited by American companies keeping wages low. The product that China made for $1, and sold for $2, was then sold by Wal-Mart (WMT) for $20, which kept all the profits. She pointed out that the Walton family had a combined net worth of $100 billion, more than the total worth of the lower 40% of the US population. This could never happen in China.? I told her that by selling the product at $20, Wal-Mart wiped out another US company that used to make that product domestically and sold it for $40, throwing those people out of work.
Modern Times in China
I then asked Wen what were her country?s plans for its massive foreign exchange reserves, now at $2.5 trillion? She agreed that this was a problem because the reserves were pouring in so fast, at an embarrassingly high rate of $10 billion a month, and that it was the most rapid accumulation of wealth in history (click here for the data at http://www.chinability.com/Reserves.htm ). While it had more than enough Treasury bonds, any attempt to sell might cause their value to collapse and freeze relations with the US. I suggested China should start hedging its gigantic holdings without selling them, or some managers would be facing a firing squad in the future.
China has therefore begun directing new reserve inflows into other instruments, like gold, Japanese government bonds, and PIIGS bonds in Europe. While the Europeans were more than happy to take the money, the Japanese were complaining that China?s modest purchases were driving up the yen, further depressing their own economy. We all know what has happened to gold.
China tried to recycle its surpluses by buying foreign companies that produce the natural resources it desperately needs. But takeover attempts were fought tooth and nail as a foreign invasion, or on national security grounds, such as the attempt to buy California?s Unocal in 2005 and Australia?s Oz Minerals last year. It was now using a strategy of buying low profile minority stakes in foreign resource companies. China took a big stake in the recent Petrobras (PBR) secondary equity offering, and Wen would not be surprised if they took a run at Potash (POT), now that it is on the table.
Check Out This tasty Little Morsel
I asked her about the real estate bubble in China that was causing so many foreign investors to lose sleep. She said it was true that sales were slow at some luxury buildings in Beijing and Shanghai, but the great majority of developments were aimed at working people, and were filling up as soon as they came on the market. The 40% down payment demanded by the People?s Bank of China headed off the rampant speculation that brought the American financial system down.
Rooms With Views
Wen then complained about the aggressive military stance the US was taking towards China, ringing it in with the Seventh Fleet. Holding a knife so close to the country?s foreign supply line jugular vein made them nervous. China was basically indefensible. All it would take was the sinking of a few grain ships, and 100 million would starve within a year. President Bush was rattling his saber as soon as he moved into office, until 9/11 diverted his attention to Afghanistan and Iraq.
Wen told me there is a school of thought in Beijing that as the country?s economic power grows- it is passing Japan to become second in GDP this year-- that the US will increasingly perceive it as a military threat. That would lead America to mete out the same hostile treatment to China as it did Russia during the cold war.
Walking Softly, But Carrying a Big Stick
I assured her that the Seventh Fleet was there to watch and listen, but to do nothing. It was really in position to provide a security blanket for allies, like Japan and South Korea, but nothing more. China wasn?t engaging in the belligerent behavior that Russia was at the height of the cold war, like blockading Berlin, basing missiles in Cuba, stationing fast attack nuclear submarines off our coasts, and invading Afghanistan.
I argued that if China truly has no expansionary intentions, the more we know about you, the better. It is always prudent for a potential adversary to conclude you are not a threat, and that no action is needed. The more you help the US do that, the better. China is decades behind the US in military technology, and you really have nothing we want. Little more than 200 nuclear weapons without an ICMB or submarine delivery systems were hardly viewed as a major threat.
Wen seemed perturbed that I was aware of her country?s nuclear stockpiles, and asked how I knew this. I said CIA director Leon Panetta told me. She said ?Oh.? I asked what was that test downing of a satellite in space about, anyway? She didn?t answer.
In any case, with our military fully committed fighting two wars in the Middle East, we lacked the resources for an Asian offensive if we were so inclined, even against a piddling, mismanaged, rogue state like North Korea. But looking at the world for the next 30 years, who is the Pentagon going to model and war game against, but China, with its 2.5 million man army?
Wen countered that the People?s Liberation Army was purely a defensive force. With a 12,000 mile land border, an 11,000 mile coastline, and dubious neighbors like Russia, Iran, and India, they have no other choice. Its ability to project force over great distances, as the US can, is virtually nonexistent. Its 1979 invasion of Vietnam was about reclaiming ten miles of lost territory. China got involved in Korea only after general Douglas MacArthur threatened to rain atomic bombs on the mainland, losing 2 million men, including Chairman Mao?s son. China could have done a lot more in the Vietnam War, but didn?t, limiting its participation to a supply, logistical, and advisory role.
That?s a Lot of Border to Defend
I then warned that if you really are worried about the Pentagon, you should stop hacking into our computers. She replied that the US started this by emptying out Chinese mainframes many times, and they were only responding in kind. I said yes, but that China was targeting private companies, like Google (GOOG), Hewlett Packard (HPQ), and Oracle (ORCL), that without military grade software, were unable to defend themselves. The Chinese agencies involved then used the data to their own commercial advantage.
What Did You Say the Password Was Again?
By the time Wen married, China had already adopted its one child policy. As much as she wanted more children, she understood the government?s need to adopt such a drastic policy. Without it, the population today would be 1.6 billion, not 1.2 billion, and all of the money that went into buying capital goods would have been spent on food imports instead. The country would have stagnated at its 1980 per capita income of $100/year. There would have been no Chinese economic miracle. She was very proud of her one son, who was a software engineer at Microsoft (MSFT) in Beijing.
Her husband, a mid level official at the Ministry of Commerce, fared less well, dying of lung cancer at a relatively early age. The US and Europe had exported their worst polluting industries to China to take advantage of lax environmental controls, turning the air in Beijing into a choking haze. Sometimes her son would come home from school coughing and wheezing so badly that he couldn?t play outside. The two packs of cigarettes a day her husband smoked didn?t help either.
Imported From the USA
I asked if she recalled our first trip together and a dark cloud came over her face. We were touring a section of Fuzhou when three policemen marched up. They started shouting at Wen that we were in a restricted section of the city where foreigners were not allowed. They started mercilessly beating her with clubs.
I was about to intercede when my wife, Kyoko, let go with a blood curdling tirade in Japanese that froze them in their tracks. I saw from the fear in their faces that she had ignited their wartime fear of Japanese authority, and they beat a hasty retreat. To this day, I?m not exactly sure what Kyoko said. We took Wen back to our hotel room and bandaged her up, putting ice on the giant goose egg on her head. When I left, I gave her my copy of HG Well?s A Short History of the World, which she treasured, as the book was then banned in China.
Wen mentioned that she was approaching the mandatory retirement age of 60, and soon would be leaving the Foreign Service. I suggested she move to San Francisco, which offered a thriving Chinese community and home prices that had recently dropped by half. She laughed. No matter how much prices had fallen, she could never afford anything here on a Chinese civil servant?s salary.
Wen told me that China was grateful for the billions of dollars that foreigners had poured into her country as a result of my writings. I replied that I was simply trying to show my readers where to make some money, nothing more. One of my recommendations, for Chinese search engine Baidu (BIDU), was up nearly tenfold in less than two years. Did she happen to know about any more future Baidu?s? Wen said that she wasn?t that close to the stock market, but that she would get back to me.
I asked Wen if she still had the book I gave her nearly four decades ago. She said it had become a family heirloom, and was being passed down through the generations. As she smiled, I notice the faint scar on her eyebrow from that unpleasantness so long ago.
In view of Wen?s comments, I think you have to include China in any long term portfolio. But as long as they are raising interest rates and tightening up bank reserve resquirements to fight inflation, I will admire it from the sidelines. As soon as they stop, you better revisit my stock picks in the area, including Baidu (BIDU), China Mobile (CHL), Build Your Dreams (BYDDF), and China Telecom (CHA).
