Sunday, December 17, 2006

Board Independence is no Guarantee

Several months ago I interviewed former SEC Chairman Harvey Pitt about options backdating for my MoneyMasters video program. Pitt is a strong critic of backdating. He argues it is outright fraud.

Recently, I've been spending a lot of time studying up on Warren Buffett. Buffett is one of America's most admired CEOs. He has a clean reputation. He has been a vocal critic of executive greed. He believes many CEOs are overpaid. He also opposes the use of options to compensate executives.

Berkshire Hathaway, Buffett's company, has long been criticized for poor corporate governance practices. In particular, the board long suffered from a distinct lack of independence. Berkshire has a greater number of independent directors today, but this is only because of new NYSE listing requirements.

Despite poor governance, Berkshire Hathaway has been an outstanding stock. It has gained more than 20% annually for several decades. Indeed, there isn't any convincing evidence that companies with independent boards turn in better stock price performance than companies whose boards are not independent. However, proponents of independence say companies are less likely to end up in some sort of scandal when the board is independent.

But a new study produced by three professors argues that even independent directors may be subject to temptation. According to this study, many outside directors profited from options backdating. Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer claim that 1,400 outside directors from 460 companies benefited from options backdating between 1996 to 2005. Their study indicates that the problem is less common at firms that have a majority of independent directors. But board independence provides no guarantee against options backdating.

The moral of the story is that investing is a risky game. The company's business model may succeed or it may fail. Shareholders can't even be certain the board and executives will always act in their best interests. Even independent directors may choose to enrich themselves at the expense of shareholders. The only way you can be sure that a company you own is being run to your full benefit is to run it yourself.

Tuesday, December 12, 2006

Fed Continues to Worry More About Inflation

The bond market has been betting for some time that the Fed would soon start cutting interest rates. But today's statement from the Fed indicates that a rate cut in the near future is not likely. The statement did talk about slowing economic growth, but it seemed to focus more on elevated levels of core inflation.

The Fed voted to stand pat on interest rates. Jeffrey Lacker, however, voted for a rate increase. The Fed seems to be leaning more toward raising rates than lowering them.

The statement specifically mentioned "a substantial cooling of the housing market." Some would say the housing market is collapsing. Indeed, that's exactly what Gary Shilling said when I interviewed him today for my MoneyMasters video program. Shilling is worried that we could see a 25% price decline nationwide, leading to an economic recession. This video will be available for viewing on Dec. 28.

Sunday, December 10, 2006

High Energy Prices and Weak Housing Will Finally Take Toll on Economy

Energy prices and the health of the housing market are perhaps two of the most important factors affecting our economy today. Stocks have rallied in recent months largely due to optimistic outlooks for both of these factors. My outlook is much more pessimistic.

Oil prices peaked around $78 per barrel in late summer. Investors cheered as prices came back down. But I've been pointing out that prices are still very high. Even at $40 to $50 per barrel, they would be much higher than they were just a few short years ago. These days they are hovering above $60 and OPEC seems to be getting serious about cutting production.

OPEC has learned a very valuable lesson. Oil producing nations like to get as high a price as possible, but OPEC was always worried that if prices went too high, economies might go into recession causing demand for oil to plummet. The lesson they learned is that most economies could easily sustain $40, $50, even $60 per barrel. OPEC's target range for oil prices used to be about $25 to $30 per barrel. Today, $60 is the new $30. Now OPEC fears falling prices more than rising prices. It seems to be getting serious about cutting production to keep prices around $60. That is not good news for the U.S. economy.

Housing is also a major problem. Most economists were betting on a soft landing in the housing market. Right now, it looks like the landing may be fairly rough. Inventories are high, prices are falling, cancellation rates are rising, foreclosures are up, and the sub-prime mortgage market is seeing rising defaults.

This double whammy of high energy prices and a collapsing housing market means GDP growth in 2007 will likely be less than 2%.

Wednesday, December 06, 2006

Housing Stocks Surge in Response to Bad News and Lower Interest Rates

On Nov. 13 I wrote about the options-backdating scandal at KB Home and the resignation of the company's CEO and other top officials. The stock has rallied 20% since then. But it isn't the only homebuilder to surge in the past month. All the stocks in that sector are up including Hovnanian Enterprises and Toll Brothers.

Toll Brothers recently announced fairly lousy financial results, but gave some indication that it may be seeing the bottom. That helped boost the stock. Yet the housing stocks are also responding to lower interest rates. In fact, the rate for a 30-year mortgage is down 25 basis points over the past month to 5.58%. Investors are betting that lower rates will save the industry and once again spur demand for new homes.

Lower rates may stabilize the housing industry, but I seriously doubt we will see a surge in demand. This market is saturated. Speculators have already moved on to other things. Defaults are on the rise--especially in the sub-prime market. Foreclosures are also up. I don't see interest rates falling low enough to save those who are seriously overextended.