Agora Financial’s Rude Awakening

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Laguna Beach, California

• Goldman vs. the U.S. economy – a deceptive dislocation,
• What the “Woman Who Call Wall Street’s Meltdown” really had to say,
• The best time to stock up on inflation hedges and plenty more…

Eric Fry, reporting from Laguna Beach, California…

By the time you read this column, Goldman Sachs will have probably reported a dazzling result for the second quarter. The rumors preceding this celebrated event sparked a stupendous 185-point rally on Wall Street yesterday.

But the trading day was not all about mere rumors. It was also about hearsay, hype and giddy optimism…

Meredith Whitney, “The Woman Who Called Wall Street’s Meltdown,” according to the Fortune Magazine cover of August 18, 2008, upgraded the shares of Goldman Sachs to a “Buy,” and predicted the stock would rise 30% from current levels. “Goldman has all the benefits of the capital markets in general,” said Whitney, “Without the ‘junk in the trunk’ as I like to call it.” Goldman shares jumped 5.3%.

Based on Whitney’s upgrade, and the subsequent market action, gullible investors could have deduced that the credit crisis has ended. The rest of us could have deduced that the credit crisis took a day off.

Lost in the celebration of Whitney’s upgrade was a smattering of bad news “below the fold.” For starters, Whitney did NOT upgrade any of the other seven banks she analyses. To the contrary, Whitney damned the other seven banks – and the economy in general – with her faint praise for Goldman.

“Our more bullish outlook on Goldman Sachs shares is deeply rooted in our sustained bearish stance on the U.S. economy and the state of U.S. financials at large,” said the influential analyst. “Specifically, we expect a tsunami of debt issuance from federal/sovereign, state, and local governments to fund woefully underfunded budget gaps. In addition, we expect corporate debt issuance to be at least 60% as strong as peak cycle levels, reflecting sizable debt maturity rolls. What’s more, given fewer players in the market, not only is GS benefiting from market share gains on these products but more widely in the derivatives products.

“To be clear, our reasons for liking GS stock today are drastically different from any we have had recommending the stock on and off over the past decade. In the past, GS shares were a great play on equity markets and expansive global gross domestic product. While that may still hold true down the line, our thesis today is that we expect GS to be the key competitor in some of the most unpredictable markets: government, corporate, and municipal debt.”

As if on cue, the U.S. Treasury disclosed yesterday that the U.S. federal deficit has already topped $1 trillion for 2009…and the year is barely half over! Sure, that might seem like bad news. But it’s actually GOOD news…for Goldman Sachs. More debts mean more Treasury bonds, which mean more trading profits for Treasury bond dealers like Goldman.

Whitney, who probably possesses more intellectual honesty than most equity analysts, probably possesses legitimate reasons to fancy the shares of Goldman. But a relatively promising outlook of one company is hardly a reason for investors to chase after all the other stocks in the market.

We would be surprised to discover any correlation whatsoever between the fortunes of Goldman Sachs and the fortunes of a bakery in Des Moines or a florist in Fargo. On the other hand, we have no trouble whatsoever imagining that Goldman might flourish while bakeries and florists are going out of business from coast to coast.

The only essential point here is that Goldman, circa 2009, is hardly General Motors, circa 1954. What happens in Goldman stays in Goldman. This company is not a bellwether for the economy at large.

“We’d suggest that whatever Goldman did to goose earnings is probably not going to be possible for the rest of corporate America,” observes Dan Denning, our insightful colleague at the Australian Daily Reckoning. Furthermore, Denning points out, most other American financial institutions are continuing to play “hide the bad asset.”

“A New York Times story from yesterday,” Denning remarks, “suggests that government capital injections and loan guarantees, along with new equity offerings, have allowed banks to evade the inevitable consequences of the popped credit bubble.

“‘The capital provided by the government through TARP, etc. has allowed the banks to continue holding deteriorated assets at values far in excess of their true market value,’ says Daniel Alpert of Westwood Capital in a note to clients, according to the Times. ‘It is unrealistic to believe that home or commercial real estate values are destined to recover any meaningful portion of bubble-era pricing.’

“This means all the new equity raised by banks after the stress-tests has merely papered over capital adequacy and solvency issues for now,” Denning continues. “The banks have simply refused to revalue loans on their books and continue to carry them at unrealistically high valuations. If they sold them, they’d got a lot less for them, forcing them to raise more capital (or wiping out their capital and revealing them to be insolvent)…

“The default and foreclosure data coming out of the U.S. housing market suggest the banks are kidding themselves, or misleading shareholders, or both!” says Denning. “It’s the sort of calculated mis-truth that can cause a short-term crisis to last years and years. The correction is postponed through phony accounting. It leads to an ‘Ushinwareta Junene,’ or ‘lost decade,’ as the Japanese say.”

While Goldman is busy kicking butt, everyone else is busy kicking the can down the road – hoping that if they keep kicking the can long and far enough, the crisis will end without further incident.

In a CNBC interview last week, Bryan Marsal, CEO of Lehman Brothers Holdings, remarked, “One of my partners said yesterday that we are going to call this phase the ‘extend and pretend’ phase in our economy. Which is you extend someone’s maturity – because they are going to default – and you pretend that business will come back…Then we’ll enter phase two, which he said is the request to extend or ‘amend.’ Then ‘send.’ In other words, send the keys.

“Those are the phases we are in right now.” Marsal concluded. “Everyone is trying to buy time, as opposed to dealing with the leverage, they are trying to buy time. Whether you are a banker or a company, they are all trying to buy time.”

Maybe all of this can-kicking will produce the desired outcome. But the more likely scenario is that the U.S. government will continue to throw newly printed dollars bills at the problem until eventually something that looks like a lot like a recovery will appear. Shortly thereafter, the recovery will yield to something that looks a lot like debilitating hyperinflation.

In today’s edition of the Rude Awakening, Chris Mayer continues the discussion…

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Gold…If Not Now, When
By Chris Mayer

Gold stocks are taking a drubbing, as are most of the other classic inflation hedges.

Why? Because inflation fears have abated. The deflationist view of the world is the one that now prevails. That’s why 10-year Treasury yields have dropped all the way down to 3.35% from a high of 3.95% one month ago.

The deflationist view, which makes some compelling and elegant arguments, maintains that the credit losses in the U.S. financial system far surpass the size of the government’s monetary and fiscal stimulus. All those trillions in bad loans – plus the yanking of credit from consumers and businesses – overwhelm new money creation. The Fed, in other words, is trying to fill a swimming pool with a Dixie cup. This might take a while.

Therefore, this reasoning goes, the greater risk is that asset prices continue to fall. This is the classic debt-deflation point of view. I don’t dismiss these arguments lightly. I’ve spent some time going over the arguments of some of deflation’s most persuasive and sophisticated advocates – like the successful Treasury bond investor, Van Hoisington and the insightful economist, David Rosenberg.

Still, I think the endgame is for inflation — which is when paper currencies buy less. Given the choice of holding U.S. dollars or real assets (such as gold or iron ore or land), I’ll take real assets.

Over the weekend, Thomas Donlan at Barron’s presented a good analogy for it all. He asked what you would rather own as store of value, bananas or corn? The obvious answer is corn, because you can store it for months. Corn lasts longer than bananas. Fruit rots. You can also use corn for a lot of different things — corn flour, animal feed, etc. You can also arrange to sell corn into the future, say, by arranging to deliver corn so many days from today.

Corn can lose value, obviously, as can any real asset. But it is a better choice than holding the bananas.

Donlan likens paper money to bananas and natural resources to corn. “In the modern economy,” he writes, “a barrel of oil is much like a bag of corn… Paper money and bank balances are more like the bag of bananas.” When currency rots, we call that inflation.

The problem with the deflation arguments long term, it seems to me, is that you are betting against a government’s ability to destroy its own currency. Governments are seldom good at anything, but one thing they are undeniably good at is destroying their own currencies. The dollar has lost 95% or so of its value since 1913, the year the United States established the Federal Reserve. Enough said.

Long-term, betting that a government will safeguard its currency seems like a very bad bet. Deflation – or at least symptoms of deflation – may prevail today, but the real question is for how long. My own crystal ball is frustratingly cloudy on the issue. But the great rewards in investing are always with the out-of-consensus view.

The upside from holding Treasuries seems hardly worth the risk of being wrong, for instance. On the other hand, if we are right about currency rot, then we’ll make multiples of our money on natural resource stocks.

The downside on many commodities seems low, because the prices have already corrected. In several instances, as with oil and natural gas and iron ore, we are already below the marginal cost of production for much of the industry. So unless we don’t need these things at all anymore, the simple economics of the businesses involved help support a certain price structure.

And anyway, as far as the case for gold is concerned, I’ve been arguing that it is less about inflation or deflation than it is about creditworthiness in general. Gold does well during times of credit troubles. It did well in the 1930s, for instance, even though that was largely a deflationary era. Banking troubles made investors turn to gold.

On that front, we’ve got plenty of banking troubles on the way. Yesterday’s Wall Street Journal headline, buried in the middle of the paper, hints at what’s to come: “Pick-a-Pay Loans: Worse Than Subprime.” The piece begins:

“For the third straight month, option adjustable-rate mortgages are generating proportionately more delinquencies and foreclosures than subprime mortgages, the scourge of the U.S.”

These loans require only partial-interest payments each month. So the loan balances on many of these loans have actually gone up while housing prices have tumbled. Bad combination. As of April, 36% of these loans were at least 60 days past due.

These troubled loans will mean more large losses for banks — in particular for Wells Fargo, J.P. Morgan Chase and others who were active in these markets. Wells Fargo, the WSJ points out, has a mountain of this stuff — $115 billion of it.

So as long as we have banking troubles, we have the potential for fear to return in a big way. And that is when gold does well…with or without inflation. But I’m not counting inflation out just yet.

I’d use the market weakness in the gold price and in gold shares to pick up your favorite gold miners.

Joel’s Note: Mr. Mayer, a longtime Rude favorite, recently finished compiling a resource “royalty play” report. Basically, it’s a way of squeezing royalty-like payments out of some rock-solid resource companies, without the risk of actually owning them outright. Chris has more information on it here.

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[Rude Endnote: The global recession is over…if you believe a single day’s trading on the back of a single earnings report.

After Wall Street’s indexes posted their biggest gains in six weeks yesterday, markets in Europe and Asia joined the party. Japan’s Nikkei 225 leapt 2.25% overnight. Hong Kong’s Hang Seng and the Aussie rallied around 3.5% each.

Major measures in Europe were all heading towards 1% gains for the session last we checked.

So there you are. All is well. Go back to sleep, investors…your government is in control.

We’ll be back with more Rude views on the morrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com