Toro's Running of the Bulls Market Blog

Corporate Governance and 2008 Stock Performance

From Bloomberg

How well a board oversees its executives -- their pay, their performance and the risks they’re taking -- may affect a company’s shares. Morningstar Inc. assigns governance letter grades for U.S. corporations by measuring such things as how well boards monitor executive pay. From Oct. 10, 2007, when the Standard & Poor’s 500 Index peaked, to Dec. 5, 2008, shares of companies that earned A’s fell an average of 33 percent, while the index fell 44 percent; those that got F’s tumbled 63 percent.

This is not enough evidence to conclude empirically that companies with better corporate governance always outperform but it is interesting.

US Economic Growth

Putting long-term economic growth in perspective at Economic Principals

 

Increasing Productivity Growth

From Martin Neil Baily and Matthew Slaughter in The Wall Street Journal.

So how has U.S. productivity grown recently? Unfortunately, very slowly. After averaging 2.7% productivity growth from 1995 through 2002, annual growth of productivity in the nonfarming business sector has slowed dramatically -- to just 1.7% in 2005, 1.0% in 2006, and 1.4% in 2007. At this new average rate of under 1.4%, it would take nearly 52 years for average U.S. living standards to double -- versus just 26 years at the earlier average. Signs of this slowdown are apparent, particularly in the waning competitiveness of U.S. sectors like automobiles, financial services and information technology. ...

A central theme of this report is the critical role that competitive product markets play in spurring productivity growth and boosting standards of living. One of the great U.S. policy successes of recent decades has been the bipartisan removal of regulations that stifle competition and innovation in product markets. U.S. industries that face strong competitive intensity are more productive than highly regulated or otherwise sheltered industries. This competition, in turn, yields higher incomes and greater choices for consumers.

Maintaining the productivity benefits of product market competition requires sound choices in areas including trade and investment, regulation and infrastructure.

Liberalization of international trade and investment has been especially important because it exposes U.S. companies to global best practices. Global trade has generated -- and has the potential to continue generating -- large gains for the United States. Annual U.S. income could be upwards of $500 billion higher with a move to global free trade in both merchandise and services.

It is crucial to reverse the current protectionist drift already underway with further liberalization. ...

Domestic regulation of product markets plays a legitimate and vital role in areas like consumer protection and worker safety, as well as in the financial system, as a tool for regulating against systemic risk. Indiscriminate elimination of regulation is unwise, but the current need is for sounder regulation -- not more.

We should not return to the days where policymakers micromanage companies and industries. This would dull growth of productivity and overall incomes. Reform of capital markets, for example, should aim to preserve a sound overall system, not necessarily particular companies or practices.

Many parts of the U.S. public infrastructure are deteriorating rapidly. Today, one in seven miles of U.S. highway is rated "not acceptable" by the federal government. This curtails productivity in many ways, such as congestion delays that impede supply-chain networks. Expanded federal spending is only one part of the needed solution (and one that will improve productivity only if based on nonpoliticized criteria and stable funding). At least as important will be to encourage private companies to compete in the provision of public services that, until now, have suffered from rigid and inefficient bureaucracies.

Foreign investment, in particular, can play a vital role here. Many global leaders in private infrastructure are foreign multinationals that could bring their best practices to address U.S. needs. This also means expanded use of market signals in public infrastructure projects, such as market and congestion pricing for transportation services.

Buybacks and Dividends Update

We noted earlier this year that dividends and buybacks had consumed consumed all profits and more since 2004.  This is not healthy given that growth should be at least partially funded out of retained earnings, given the ephemeral nature of capital markets. 

This trend continued into the third quarter of this year.

Three numbers, courtesy of Howard Silverblatt of Standard & Poor’s, shed some light on what companies did with their cash during boom times:

Over the last four years, since the buyback boom began, from the fourth quarter of 2004 through the third quarter of 2008, companies in the S.&P. 500 showed:

Reported earnings: $2.42 trillion
Stock buybacks: $1.73 trillion
Dividends: $0.91 trillion

As a group, every dime they made, and more, went to shareholders. Roughly $2 went to shareholders who sold out for every $1 that was paid in dividends to shareholders who held on to their shares.

Ideally, companies would be buying back debt and stock now.  However, over the past five years, companies tapped the capital markets not only to fund all capital expenditures but also to fund buybacks and share repurchases.  Now, capital markets are under extreme duress and companies are having to pay usurious rates of interest to fund operations.

It sure would be nice if corporate America had more financial flexibility amidst the worst credit crisis in 75 years.

Taxes as a Percentage of GDP

From Greg Mankiw

Applying the Black Swan

I like Nassim Nicholas Taleb. I have seen him speak and have Fooled by Randomness on my list of recommended investment books.  (The Black Swan is on my shelf waiting to be read.) However, Models & Agents highlights the problems of applying his theories to both the investment world and to real life.

I recently attended an investor conference where, as is typical these days, people gathered to reaffirm how clueless we are about the future of our economy.

Just to bang the point home, the keynote speaker was Nassim Taleb, author of “The Black Swan”; a “treatise” on how our failure to take into account eventualities that are possible only remotely, yet are highly consequential, can really hurt us.

These highly remote but highly consequential events are the black swans. The metaphor comes from the story that, before the discovery of Australia, everyone thought that all swans are white (what fools!). Moreover, according to Taleb, black swan events, in retrospect, appear very plausible--but only in retrospect. ...

There were certainly a few "doomsayers" (stress "a few") in the academic and investor community, who did warn about the impending downturn and the consequences of loose credit standards. Some took contrarian positions and made money! Some had even attended the economics or finance programs that Taleb dismisses.

Getting the diagnosis right is critical for coming up with the right proposals. And Taleb's proposals are either impractical or secondary (barring the plain obvious).

First, because aside from our often inadequate models, there were a few other blatant failures that contributed to the current crisis: The collapse of oversight by regulators and investors themselves, driven by a mix of uncritical laissez-faire ideology, the avid search for yield as global liquidity ballooned and, in some cases, fraud. Unless we fix these, even the most perfect models will not shield us from a black swan.

But then again, Taleb does not ask us to seek perfection. Instead he proposes we acknowledge our ignorance and protect ourselves.

“Beware of the Black swan!”, he warns. But what does this mean in practice? For example, I work at one of the top floors of a high-rise building in Manhattan—with a (less than remote) probability that my floor might get hit by a flying suicide bomber dressed as Superman.

Pretty consequential, if you care. But what should I do? Change jobs? Move to Peoria? Maybe Taleb can get me a parachute, a golden one please, which would get me to the Bahamas and solve my life worries once and for all! Alternatively, I can keep on living as I do, aware that I’m running the risk of becoming a case number in Homeland Security’s terrorist statistics.

Taleb’s recommendations on asset allocation are as impractical—barring generalities (like diversification or more equity than debt) that are indisputable for being self-evident. But what about the specifics?

Sure, you can put 80% of your money to US Treasury bills, to make your portfolio more robust. But if the world were to follow his advice, we would be effectively delegating the bulk of investment decisions to the government! Is this the kind of world we should aspire for?

Taleb also recommends that we buy insurance against good black swans—that is, investments with a tremendous (though still highly remote) upside but limited downside. For example, you could buy insurance against the (unlikely?) disappearance of Botox due to the discovery of the nectar of eternal youth. And make tons of money if it happens. Perhaps, only that, during extreme events, insurers can go bust too (a three-letter acronym comes to mind).

Ultimately, no matter how imperfect our models are, the problem lies in our failure to use our brain. Only “using our brain” does not mean buying Treasuries. It means identifying investments that are productive and viable, improve our quality of life and create jobs. It also means knowing what our models are designed to capture and what they are not--in which case overriding our models is the appropriate response.

Smoot-Hawley Revisited

Lessons for the incoming Obama administration and the clowns in Congress from The Economist.

The signature by President Hoover of the Hawley-Smoot Tariff Bill at Washington is the tragi-comic finale to one of the most amazing chapters in world tariff history, and it is one that protectionist enthusiasts the world over would do well to study. The reason for tariff revision was a desire to restore a balance of protection which had been tilted to the disadvantage of the agriculturalist. But so soon as ever the tariff schedules were cast into the melting-pot of revision, log-rollers and politicians set to work stirring with all their might, and a measure which started with the single object of giving satisfaction to the farmer emerges as a full-fledged high tariff act in which nearly 900 duties have been raised, some extravagantly. Such is the inevitable result of vested interests working through political influence, ending in signature by a president, antagonistic to the bill, under compulsion of political necessities. No one, except the interests who fancy their own pockets may benefit, wanted the tariff; big business in the East is against it; the economists of America have condemned it in unison; the motor manufacturers have implored Mr Hoover to use his veto; and the fear of its economic consequences at home and abroad was mainly responsible for the heaviest slump of the year in Wall Street. Yet it is now the law of that land, and we have the spectacle of a great country, at a moment of severe trade depression, and faced with a growing necessity to export her manufactures, deliberately erecting barriers against trade with the rest of the world. Here, indeed, is a classic example of what happens to a country which once starts on the slope of protection. Protection, meant to be a good servant, becomes a dominant and costly master. President Hoover, we see, endeavours to coat the pill by suggesting that the "flexible" provisions will be used to mitigate the effects of the tariff, where it may be found to be irksome. This hope is surely illusory, as similar hopes held out in the past have proved to lie. In the first two years of President Coolidge's administration a number of duties were raised, but only two reduced—namely, on the vital items of bran and live bobwhite quail. We are compelled to accept the view expressed some years ago by Dr Taussig that "the interests involved in tariff-making are so powerful, and can exert such influence on the party in power, that disinterested and non-partisan administration of the flexible provisions is a vain dream." If there is any comfort to be derived from this latest chapter in tariff folly, it is the belief that American eyes will be forcibly opened to the fact that they are faced by a reductio ad absurdum. Incidentally, every week brings new evidence of the realisation by American business leaders of the dangers of the fiscal path which America is treading. In a contribution to the Annals of the American Academy of Political and Social Science Mr Edward A. Filene, while disavowing Free Trade convictions, argues powerfully that a lowering of American tariffs is essential for the stimulation both of world trade in general and American exports in particular. Magna est veritas et prevalebit.

Merry Christmas to All

Here is wishing a happy holidays to all of you and your families.  I hope 2009 is good to you.

T.

Corporate Bond Spreads

A graph on RealMoney.

Corporate bond spreads are higher than they were during the Great Depression.

Amazing.

EDIT - By the way, the stock market bottomed on July 8, 1932, a month after the Depression peak in corporate credit spreads.  A year later, the S&P 500 was up 171%.

Good News - Home Price Declines Accelerate

From Bloomberg

Sales prices for existing U.S. homes fell the most on record in November, tearing a deeper hole into households’ already tattered finances.

The median resale price fell 13 percent from a year before, to $181,300, “probably the largest price decline since the Great Depression,” National Association of Realtors Chief Economist Lawrence Yun said in Washington. Sales slid to an annual rate of 4.49 million, lower than forecast.

Sliding property values mean more Americans will be under water on their mortgages, likely leading to a further increase in already record foreclosure rates. Along with the wealth destruction from slumping stock portfolios, they also undermine consumers’ purchasing power.

Why is this good news?  Because a significant decline in home prices had to happen. 

All the mechanisms designed to prop up the housing economy merely delays the inevitable.  It is best to deal with the bad stuff now so the economy can find an equilibrium and stabilize.  The quicker we take the pain, the quicker we will clean out the excesses and get to the recovery.