Goldman's Muppet Clients

Goldman Sachs is in the news again, this time because a now former executive by the name of Greg Smith wrote a scathing resignation letter published in the New York Times titled Why I Am Leaving Goldman Sachs. In his article, Mr. Smith (who no doubt will be going to Washington when Congress calls for another investigation), accuses his former employer of putting its own interests ahead of its clients'. That may come as a shock to some people, but I would bet that most clients suspected as much anyway.

Mr. Smith says that Goldman's stock in trade for 143 years has been trust. However, he says that today a new culture has taken over, one which stresses "ripping eyeballs out" and "getting paid." Perhaps most interesting was Mr. Smith's claim that during the past 12 months he heard five different directors refer to their clients as "muppets."

Anyone familiar with the real Muppets would know that Misters Statler and Waldorf (pictured above) are the only ones who are wealthy enough to be Goldman clients. Interestingly (and this is no joke), Goldman Sachs has actually arranged financing deals for movie studios trying to raise money from hedge funds and private equity firms. I could find no evidence, however, that Goldman was involved in any of the Muppet movie deals.

In all seriousness, this is just another incident that tarnishes the reputation of Warren Buffett's favorite investment bank. Buffett, who has long been critical of investment bankers, has praised Goldman Sachs on a number of occasions. Berkshire Hathaway still holds a sizable financial interest in Goldman in the form of warrants, an investment that came about during the financial crisis when Buffett was approached by a former Goldman banker named Byron Trott.

One has to wonder what purpose Mr. Smith's public letter of resignation serves. He must have been very angry or fed up to do what he did. It certainly was one of the greatest displays of publicly burning ones bridges. His actions make it all but certain that no other bank will hire him. Yet Mr. Smith is probably wealthy enough to live comfortably for the rest of his life without having to work. I have no doubt, however, that a number of investment firms would be happy to have him on their staff. Yet criticizing Goldman so publicly for unethical behavior will also bring a certain degree of scrutiny on how exactly Mr. Smith has been earning his living over the past 12 years. Because he must know this, he must also be quite confident that he can withstand the scrutiny.

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Earnings Guidance Revisted

Earnings guidance is one of the more controversial management practices. It is something I feel strongly about. I even devoted a whole chapter to defending this practice in my 2008 book, "Even Buffett Isn't Perfect." Those who would like to see an end to guidance are basically arguing that investors are better off having less information. In a day and age when regulators are trying to increase transparency, this makes no sense.

It was wonderful to see the recent Wall Street Journal article written by Professor Baruch Lev of New York University defending guidance. It reminded me of the excellent interview I had with Professor Lev several years ago when he was a guest on the MoneyMasters video program I used to host at Forbes. Click here to watch Professor Lev's excellent defense of earnings guidance.

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Stocks Ignore Economic Woes as Apple Drives the Indexes

The following commentary is derived from a Special Report distributed to subscribers of the Forbes Special Situation Survey on March 2.

So far, 2012 is turning out to be a great year for stocks. Through Friday, March 2, the NASDAQ Composite Index was up 14.2% year-to-date and the S&P 500 was up 8.9%. Of course, both indexes benefit greatly from their inclusion of Apple Inc., which is up 34.6% year-to-date. Apple, which has a market capitalization of more than $500 billion, is about one-fourth larger than Exxon Mobil, the second largest stock in the S&P 500. Because both the NASDAQ Composite and the S&P 500 are cap-weighted, they got a big boost from Apple's outstanding performance. On the other hand, the Dow Jones Industrial Average, which does not include Apple, is up just 6.2% year-to-date. This demonstrates just how influential Apple has been to the other two indexes.

For the most part, the corporate sector of the economy is doing well. Companies have benefited greatly from low interest rates and years of cost-cutting. Profits and balance sheets are strong. Many companies are using cash to increase dividends, repurchase shares, and pay down debt (or at least refinance existing debt with cheaper debt). Yet three critical legs of the economy remain troubled.

Employment – On the surface, there appear to be significant improvements in the employment market. The unemployment rate, which peaked at 10% in October 2009, has gradually declined to 8.3%. Weekly initial jobless claims improved from 659,000 in March 2009 to 351,000 for the week ending February 25, 2012. Nonfarm payrolls increased by 243,000 in January, marking the 16th consecutive month that the economy added jobs. There is no question that these trends are good. They certainly indicate that the jobs market is moving in the right direction. However, the improvement in the unemployment rate is largely an aberration because discouraged workers, who are many, are not counted. Furthermore, initial jobless claims are still higher than they should be in a recovery, and job creation is still much too anemic. Take a look at the employment participation rate to see just how troubled the jobs market remains. This figure is calculated by dividing the civilian labor force by the civilian non-institutional population. This critical measure, which hovered above 66% before the financial crisis of 2008, is now down to just 63.7%. In other words, a smaller proportion of the population is taking part in the labor force. If you think there isn't much difference between 66% and 63.7%, you will probably be shocked to learn that had the participation rate remained at 66%, the unemployment rate today would actually be 11.8% instead of 8.3%. As bad as it is, the unemployment rate looks better simply because fewer people are participating in the jobs market. Also, don't forget that if the jobs market truly strengthens, the unemployment rate should initially rise as more people begin to look for work.

Housing – Warren Buffett argues that the housing market is near bottom. He says that over the long term, the number of housing units must rise in line with the number of households. Today, household formation is outpacing the increase in housing units. That doesn't help the housing market in the short term because there is an oversupply of homes. In the long term, however, more houses will have to be built. Furthermore, because interest rates are low and housing prices are so depressed, the cost of buying a home looks extremely attractive compared to the cost of renting. Buffett is right that the housing market will eventually improve. Of course, the critical question is when? Unfortunately, the latest S&P/Case-Shiller numbers show that we aren't there yet. Housing prices are still falling. In fact, they are almost 35% below the 2006 peak. On average, homes today are worth what they were back in early 2003. Many people who purchased a house after that date are underwater.

Energy – According to the AAA Daily Fuel Gauge Report, the national average price of regular gasoline has reached $3.74 per gallon. In some parts of the country, it is well above $4.00 per gallon. Just one month ago, the national average price was $3.45 per gallon. This 8.4% increase in a month is largely due to the rise in crude oil prices. The oil market has been particularly sensitive to rumors. For example, any talk that Israel is about to attack Iran in order to destroy that nation’s nuclear capabilities causes prices to rally. A recent rumor that a pipeline in Saudi Arabia exploded caused another spike in oil prices. Interestingly, that rumor, which turned out to be false, appears to have originated in Iran. That may not be surprising, yet the reaction showed just how nervous oil traders are. Demand for gasoline, which has been depressed since the start of the financial crisis, was starting to pick up. Higher gasoline prices, however, are likely to reduce demand again, which is not a good development for the economy. Higher gasoline prices could also fuel inflation. One energy bright spot is natural gas, which is plentiful, cheap, and not imported. Maybe it's time to start thinking more seriously about alternative sources of energy, such as T. Boone Pickens' idea of converting long-haul trucks to natural gas.

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A Commercial for Singapore

I am still a little jet-lagged after a two-week stint in Singapore teaching an intensive executive class in equity investment management. This was part of the M.S. in Finance program run by the Zicklin School of Business at Baruch College. The students were all business executives. Some were working for large international companies, including Credit Suisse and Barclays. Others were working with local companies. All of them were experienced, smart, hard-working, and motivated.

This was my first visit to Singapore and I was extremely favorably impressed, so please excuse the somewhat promotional nature of this post. I had heard a lot about this small pro-business city-state before going, but nothing beats seeing it with your own eyes. Singapore is very modern, clean, and safe. There is very little crime and you can walk where ever you want without worrying about your safety. Because the country is near the equator, you should be prepared to sweat if you plan to do a lot of walking. Unlike in most American cities, I spotted no litter or graffiti. Of course, the authorities are famous for cracking down hard on violators, but it simply is not in the nature of the population to deface property or throw trash into the streets. People seem to be extremely conscious of how their actions affect others.

I found that most prices were quite similar to those in the U.S., but a few things were clearly much more expensive. For example, a small (or should I say tall) plain cup of coffee from Starbucks costs more than $3.00 U.S. And don't even think about buying a car. A small Toyota would set you back about $80,000 U.S. This is the government's way of controlling traffic. Nonetheless, there were still plenty of nice cars on the streets. However, a car isn't even necessary since public transportation is readily available and taxis are reasonably priced.

Of course, Singapore's biggest draw is its pro-business climate, which includes low taxes. I met with Will Adamopoulos, who heads the Forbes office in Singapore. Will and his family have been living in Singapore for many years. He stressed the rising number of billionaires in Asia. I also met with Mykolas Rambus, CEO of Wealth-X, a company he founded in New York City in 2009. Wealth-X now has eight offices around the world. Mykolas moved his family to Singapore about six months ago. Other well-known residents include Eduardo Saverin, co-founder of Facebook, and billionaire investor Jim Rogers.

Singapore often shows up at the top of the world rankings of best places to conduct business. The International Finance Corporation and the World Bank rank Singapore #1 in their Doing Business 2012 report. Anyone interested in getting started can refer to the website, Guide Me Singapore.

Unfortunately, I missed the famous Singapore Airshow. It got underway the day after I left to return home. I probably would not have been able to get a ticket anyway. They sold out quickly. Fortunately, the Airshow was extremely profitable for Boeing, which scored a $22.4 billion contract with Indonesia's Lion Air for 230 new jet planes. This deal certainly highlights the growing importance of Asia in the global economy. And with the rest of the world in an economic slump, American companies that want to grow must increasingly turn their focus to Asia.

Review of The Vig

The internet is changing all kinds of businesses. It seems that no industry can escape its disruptive force. Publishing is perhaps one of the hardest hit industries. The internet's transformation of publishing started with how books were sold. It then transformed how newspapers and magazines are published and read. Now it is affecting the actual publication of books.

Not long ago, a would-be author would submit a manuscript to a publishing company. If he wanted to increase his chances of being taken seriously, he would hire an agent to try to sell the book on his behalf. However, traditional publishers don't want to take chances on unknown authors unless they feel fairly sure that a minimum number of books can be sold. If the author is a motivational speaker with a strong following or a celebrity with many fans, publishers know the book has a ready audience. A book by these kinds of authors will sell whether it is good or bad. For anyone else, however, it is almost impossible to get published by the traditional route.

However, today's promising authors are no longer at the mercy of the traditional publishing houses. Instead, they can self publish their works and put them up for sale through online retailers such as Amazon.com. Of course, many self-published books are of poor quality. Yet every once in a while, you come across a gem. That's how I would describe John Nuckel's new book, The Vig. In full disclosure, I probably would never have read this book if I did not know the author personally. While this makes me less than perfectly objective, I have to say that despite some minor flaws, I really did enjoy reading The Vig.

For those not in the know, "vig" is short for "vigorish," a term traditionally used to describe a bookie's commission. Nuckel, a former options trader at the American Stock Exchange, uses the term to describe an illegal scheme designed by the characters in his book to skim a little out of the accounts of the traders every day.

The book begins on September 11, 2001. Nuckel, who was present when the World Trade Center towers came crashing down, actually witnessed the horrific scenes of death and destruction that he describes through the eyes of the book's protagonist, a floor trader whose mind is as sharp as a calculator. When the trader is able to return to work, he realizes that something is not quite right with his accounts. They seem to be just a little off. He starts asking questions, which result in a whirlwind of murder, mystery, and intrigue. The author is especially deft at character development. One unsavory criminal doesn't hesitate to murder his own brother. A sexy female assassin is as cold blooded as any assassin literature has produced.

The book's flaws mainly involve minor copy editing issues that do not prevent the reader from enjoying the read. In fact, the book really is hard to put down. It grabs your attention immediately and it doesn't let go. At 194 pages, The Vig is a relatively quick read. While some readers may find the details of floor trading and arbitrage a little hard to follow, anyone interested in investing will enjoy those sections as much as the others. I liked this book very much and I recommend it strongly.

Mitt Romney and Taxes

I have a tendency to avoid watching presidential debates, primarily because I'm convinced that the best debater does not necessarily make the best president. Of course, debates can be quite entertaining; however, they tell us more about how well a candidate can think on his feet than they do about what he really stands for. In addition, one mistake in a debate could kill an entire campaign. Witness Rick Perry's inability to recall one of three departments he would shut down if elected president.

Nonetheless, the topic du jour is Mitt and Ann Romney's taxes. It has become a big issue, largely due to Mitt Romney's unwillingness to release information about his tax returns earlier in the campaign, as well as his inability to properly defend what he actually pays in taxes.

So instead of relying on what is being reported in the media, I decided to take a look at the Romney's just-released tax returns. In 2010, Mitt and Ann Romney reported interest income of $3,295,727. Interestingly, only $557 of that amount was non-taxable. Obviously, they are not big buyers of municipal bonds. The Romneys also reported $4,923,348 in dividend income. Of this amount, $3,327,678 were considered qualified dividends, meaning they were taxed at the lowest rate of 15%.

The Romneys also had quite a lot of capital gains, in fact $12,573,249 worth. Most of the capital gains were of the long-term variety, which means they, too, were taxed at the lowest rate of 15%. Making some relatively minor adjustments, the Romney's total adjusted gross income for 2010 was $21,646,507. That's certainly a lot of dough by almost anyone's standards.

It turns out the Romneys are also very charitable people. In fact, they donated $2,983,974 to charity in 2010. Their total allowable itemized deductions came out to $4,519,140. Including their exemptions, their taxable income was $17,120,067. Their total tax bill (which includes the alternative minimum tax, self-employment tax, tax on IRA or 401(k) income, and a credit for foreign taxes paid) came out to $3,009,766. In other words, their tax rate was 17.6% of their taxable income. This is higher than the 14% tax rate widely reported in the media. The difference is explained by the fact that the media is calculating the tax rate on adjusted gross income rather than the tax rate on taxable income. But the media's calculation is misleading because it ignores things such as charitable contributions.

The Romneys also released projections of their tax return for 2011. Even though they increased their charitable contributions, their tax rate on taxable income is actually expected to rise to 21.2% for 2011, quite a bit higher than it was in 2010.

Here are two points that Mitt Romney needs to articulate better: 1) One reason the Romneys' tax rate appears low (as a percentage of adjusted gross income) is because they have been extremely charitable. If the Romneys had not donated so much money to charity, their tax rate would be substantially higher. 2) A second reason their tax rate appears low is because the vast majority of their income is in the form of qualified dividends and capital gains.

Some will argue that it isn't fair to tax capital gains and qualified dividends at a lower rate than ordinary income. I would argue that it isn't fair to tax this kind of income at all. Why? Because it has already been taxed at the corporate level. Taxing corporations is exactly the same thing as taxing shareholders directly. When corporations pay taxes, there is less money left over for the shareholders.

When a corporation hires an employee, that employee's salary is a tax-deductible expense for the corporation. As a result, it is perfectly fair to tax that employee's wages at the ordinary rate. However, when a corporation pays dividends, that money comes from after-tax earnings. When the stock price rises creating capital gains, those gains represent the after-tax performance of the corporation. If corporations were not taxed at all, the sum of the dividends and capital gains would be much larger than they are now. In that case, it would be perfectly fair to tax dividends and capital gains at the ordinary rate.

As things currently stand, the effective tax rate on dividends and capital gains is actually much higher than the effective tax rate on ordinary income. This is because the effective tax rate is actually equal to the tax rate that corporations pay plus the tax rate that individuals pay on dividends and capital gains, a figure that is closer to 50%, and much higher when state taxes are taken into account.

I have long been an advocate for a simplified tax code. Our current tax code has become so convoluted and confusing that only expert accountants can make heads or tails out of it. Furthermore, our current code fools large numbers of people into believing that the rich pay less taxes than the poor. In my perfect world, I would eliminate the tax on corporations (which would also eliminate the incentive that corporations currently have to finance themselves with tax-deductible debt). I would also eliminate ALL tax deductions (including those for mortgage interest and charitable contributions). Finally, I would introduce one low flat tax rate on all income. Although I would hate to do it, I would even be willing to go along with mildly progressive tax rates. All of this could be done in a revenue neutral manner. Yet I wouldn't hold my breath. With so many groups lobbying Congress for one exception or another, I don't really expect any of this to become reality. On the contrary, if I had to bet money, I would bet that the tax code will only get more and more convoluted as time goes on.

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Discounting the Trade Deficit

Today, the Census Bureau released trade figures for the month of November. The deficit grew to $47.752 billion in November, up from $43.271 billion in October and much larger than the consensus expectation of $44.0 billion. A larger deficit is a subtraction from GDP, but a larger deficit does not necessarily mean the economy is in trouble. For example, the deficit would increase if the increase in imports is greater than the increase in exports. Yet if both are increasing, the economy could be doing fine. Unfortunately, that wasn't the case in this report. The report showed that imports increased by $2.947 billion in November while exports decreased by $1.535 billion.

The good news is that the report tells us what happened two months ago. As a result, it may not be giving us a good indication of what is happening now. Other economic figures indicate that the economy is improving. Nonfarm payrolls, housing starts, and consumer sentiment are moving in the right direction. While today's trade report is not consistent with an improving economy, we shouldn't put too much weight on it.

2012 Should Be Better Than 2011

I spoke with Tracy Byrnes at Fox News about a couple of issues including the tendency for stocks to rally in January and why I think 2012 could be a better year than 2011 was for U.S. stocks. You can see the discussion here.

RIMM Hangs Up on Amazon, Microsoft, and Nokia

It is difficult to find a stock that is more out of favor than Research in Motion (RIMM), the company best known for the BlackBerry smartphone. RIMM is led by a pair of co-CEOs, a highly unusual arrangement for any publicly-traded company and one that has proven extremely ineffective in recent periods. This dysfunctional structure has resulted in one misstep after another. In particular, the company has delayed the launch of key new models and new software a number of times. RIMM also had a disastrous launch of its tablet computer dubbed the PlayBook. Although some experts claim the PlayBook is technologically superior to other tablets, consumers complain that there are too few apps.

It turns out that at least a few companies thought RIMM was worth buying. While it isn't clear if any formal offers were made, Amazon.com, Microsoft, and Nokia were all recently mentioned in press reports as possible suitors. In any case, it seems that RIMM's co-CEOs weren't keen to be bought out. They apparently refused to entertain any offers. Instead, they continue to believe that they can orchestrate a turnaround by themselves.

Whether they will succeed or not remains to be seen. What is clear, however, is that RIMM is no Lehman Brothers. Although the company is losing market share in the U.S., it is still a leader in several key international markets. In fact, the company's subscriber base actually surged 35% year-over-year during the most recently completed quarter. The board of directors will release a report in January that is widely expected to recommend some drastic changes.

Management has been begging investors to exercise a little more patience. Instead, investors have been selling the stock. Today's news caused the stock to rally. The fact that any company sees value in RIMM is giving investors some assurance--at least for now. In any case, it is much too early to write RIMM's obituary. Despite reduced earnings expectations ($4.10 per share for fiscal 2012), with absolutely no debt on the books, well over a $1 billion in cash, and the real possibility of a management shake up, RIMM is worth a second look.

Disclosure - Vahan Janjigian holds RIMM in portfolios he manages.

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Unemployment vs. Participation: Which Shows a Truer Picture?

Equity futures were up strongly this morning thanks to reports that the International Monetary Fund would get involved to help resolve the European debt crisis. Futures remained strong when the U.S. employment report came out showing a big drop in the unemployment rate. The unemployment rate, however, is misleading and by early afternoon, stocks gave up much of their gains as investors looked deeper into the numbers.

According to the Bureau of Labor Statistics, nonfarm payrolls rose by 120,000 in November. Nonfarm private payrolls rose by 140,000. Both figures were close to the consensus estimates and they show that the economy is creating jobs, albeit at an anemic pace. The big surprise, however, was the dramatic decline in the unemployment rate. It fell to 8.6%, much better than the consensus estimate of 9.0%. While this grabbed the headlines, things beneath the surface don't look as rosy.

The unemployment rate is defined as the number of unemployed (but looking for work) divided by the civilian labor force. As a result, the unemployment rate can improve simply because fewer people are looking for jobs. This can happen when they get discouraged and drop out of the labor force.

A better measure of the state of employment is the participation rate. This rate divides the civilian labor force by the civilian noninstitutional population. The denominator includes everyone aged 16 and over who is not institutionalized, meaning that they are not in the military, jail, mental institution, or home for the aged. Everyone else is considered capable of working. Of course, some people have legitimate reasons not to work. Perhaps they are still in school, or they prefer to stay at home with the kids, or they have retired. As a result, the participation rate will always be below 100%; however, in a healthy economy, it should be somewhere near 70%.

The bad news is that the participation rate fell from 64.2% in October to 64.0% in November. In fact, as shown in the figure below, this rate has been declining steadily for quite some time.


I don't want to throw cold water on today's jobs report. The nonfarm payroll figures are somewhat encouraging and at least they show that the economy is moving in the right direction. However, don't get fooled by the lower unemployment rate. It may make some people in the White House feel a little better, but the economy won't be out of the woods until the participation rate improves significantly.

I had a discussion in late October about this with Karen Gibbs in Chicago. Interestingly, MoneyShow decided to release the video today in conjunction with the employment report. As you'll see in the video, I stress the importance of focusing on the the participation rate.

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Retail Investors Staying Away From Stocks

Bank of America recently conducted a survey of about 1,000 "mass affluent" investors. The results are found in its Merrill Edge Report: November 2011.

The mass affluent are defined as people who have $50,000 to $250,000 in investable assets. These people are not rich. In fact, they are solidly in the middle class. They are extremely important because there are so many of them and they form the backbone of the investing public. An estimated 28 million households fall into this category. That's about a quarter of total U.S. households.

Some of the findings are encouraging. For example, about a quarter of those surveyed said their financial situation is better than it was a year ago because they are spending less, paying bills on time, and sticking with a budget. Other results, however, are worrisome. More than a quarter of the respondents said they are dipping into savings to meet short-term needs and they are neglecting their long-term goals. Almost half think they will retire later than they had hoped just a year ago, and more than 40% have become more conservative with their investments.

Interestingly, these people are taking less risk with their investments at a time when the Federal Reserve is trying to encourage risk taking. These people would rather hold cash, which pays little or no interest, than take the risk of losing money in the stock market. I discussed some of this with Tracy Byrnes today on Fox Business.

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How Much Cash Does Apple Have?

Commentators sometimes make exaggerated remarks about the amount of cash Apple Inc. holds. The figure often cited is that Apple has about $80 billion in cash. That's not quite right, but this is how they arrive at that number.

According to the company's recently filed 10-K, Apple actually has $9.8 billion in cash and cash equivalents. It also holds another $16.1 billion in short-term marketable securities. Although these securities are not exactly cash, they can be converted into cash rather quickly if needed. Including short-term marketable securities in the mix is not unusual. So that brings us to about $26 billion. In addition to this, Apple also has $55.6 billion invested in long-term marketable securities. These securities are less cash-like than short-term marketable securities. It is true that they could be sold and converted into cash, but so could any long-term asset. It isn't quite right to classify long-term assets, even the ones that are marketable, as cash. Nonetheless, the total of cash, cash equivalents, and marketable securities (both short and long term) does come out $81.6 billion, or approximately $87.70 per share of outstanding common stock. Any way you look at it, that's a lot of dough.

Where is all this money invested? Apple holds U.S. Treasury and agency securities, foreign government securities, certificates of deposit, commercial paper, corporate securities, and municipal securities. The company's 10-K states that in fiscal 2011, the entire amount earned a weighted average interest rate of 0.77%! Can Apple find no better use for this money? Perhaps a dividend is in order.

By the way, Apple says $54.3 billion of the total is held by foreign subsidiaries. This money would be subject to U.S. taxes of as much as 35% if Apple ever tried to repatriate it. But the tax would not end there. If Apple repatriated the money and then paid a dividend, shareholders would have to pay an additional tax. Is it any wonder that the company is sitting on so much money earning next to nothing? It is high time for Congress to revisit this inane tax policy.

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Defense Stocks Could Rally on Supercommittee Compromise

The so-called supecommittee, tasked with finding a way to reduce the national debt by at least $1.2 trillion over 10 years, is facing a looming deadline. It it fails to agree on a proposal by November 23, there will be automatic spending cuts. There are those who would welcome such a dire outcome. The problem is that some of those automatic cuts would put our national security at risk. Defense Secretary Leon Panetta warned that such cuts would be devastating.

For this reason, I am still hopeful that the committee will find some resolution. It is difficult to believe that even the most partisan politician would be willing to put our nation at risk. If a compromise is reached, defense stocks could rally. Some of my favorites include Raytheon (RTN), ManTech International (MANT), and ITT Exelis (XLS). All three also pay generous dividends.

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Should You Mimic Buffett?

A few years ago, a couple of academic scholars did some research on Warren Buffett's trades. Their paper, entitled Imitation is the Sincerest Form of Flattery, concluded that investors could indeed have earned excess returns simply by buying the same stocks Warren Buffett bought for Berkshire Hathaway. This is true even if they bought the stocks after the information became public.

In today's interview with CNBC I discuss some of Buffett's recent investments, including IBM, and explain why it matters if Buffett is actually buying the common stock or if he is making a private investment in public equity (PIPE).

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Supercommittee Rally?

The conventional wisdom says the Supercommittee, charged with finding a way to reduce the deficit by $1.2 trillion over 10 years, will not be able to reach a compromise. If they don't, automatic spending cuts will go into effect. Cuts to defense spending would put this nation's security at risk. That's why I believe (at least hope) that the committee will put forth a reasonable proposal. The result would be a surprise rally in defense stocks. Read more at MarketWatch.

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Market Continues to React to Europe

The stock market has been paying more attention recently to events in Europe than to economic numbers in the U.S. This may continue for some time. Click here to watch and listen to a recent discussion I had about this with Tracy Byrnes of FoxBusiness.

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Berkshire Buffeted by Financial Weapons of Mass Destruction

Warren Buffett is a critic of derivative securities. Soon after his company, Berkshire Hathaway, acquired General Reinsurance, he discovered a boatload of derivatives that took years to unwind and resulted in massive losses. That's what prompted him to label derivatives, "financial weapons of mass destruction."

So it's a bit of a surprise to see Berkshire report $2.44 billion worth of derivative-related losses (on a before-tax basis) for the third quarter. These derivatives are European style equity index put options. A European option is one that can be exercised only at maturity, but never before.

Berkshire received a premium for selling these options to investors. Buffett is making a bet that stock markets will rise over time. If he is right, Berkshire keeps the premiums. But if he is wrong and stock markets fall, the investors can force Berkshire to buy the indexes from them at higher prices.

The outcome will not be known until the actual expiration dates; however, Berkshire must mark the derivatives to market every quarter. This can introduce a tremendous amount of volatility to the company's earnings. The large derivatives-related losses in the third quarter were a direct result of falling stock prices.

The good news is that Berkshire's operating businesses are doing fine. If not for the derivatives, the company would have earned close to $4 billion last quarter. Instead, it earned just $2.3 billion or $1,380 per share. Still not too shabby.

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Poverty in U.S. Lower Than Reported

We are frequently bombarded by reports about how bad things are in America for the poor. Nations not friendly to the U.S. often use our own statistics to convince their populations that life in America is intolerable. Well, it turns out the statistics are flawed.

As reported in the The New York Times, those compiling the numbers for the government have ignored all the benefits, such as food stamps, that the poor receive. It turns out that when the calculations are done correctly, the rise in poverty since 2006 is less than half of what was previously reported.

This is not to say that poverty is not a problem. It is. We should continue to make serious efforts to address the needs of the truly needy. Yet poverty in the United States is not the same thing as poverty in most parts of the world. The average American who officially lives in poverty eats regular meals, has a place to live with heat in the winter time, and owns both a car and a color television set. In many places of the world, this person would be considered very well off.

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The Power of Competition

On October 6, I wrote about President Obama's ridiculous attack on Bank of America for its plans to impose a $5.00 monthly debit-card fee, and I explained how competition is the best way to limit profits. Specifically, I said, "Bank of America may have made a mistake by introducing this fee. If so, its competitors will pounce. They will begin advertising debit card services with lower fees or no fees at all. Bank of America will notice that it is losing customers."

This is exactly what happened. Several competitors said they would not impose debit-card fees and some customers started switching banks. Here's the latest from Bloomberg: Bank of America Eliminates Plan for $5 Debit-Card Fee. It wasn't government regulation that convinced Bank of America to scrap the fee. It was competition.

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Greece Continues to Rock the Markets

In my September 1 post, I wrote about the increasing level of volatility in the markets, which continues to be one of my major concerns. The S&P 500 plunged 7.2% in September then surged 10.8% in October. Although few investors complain about upside volatility, I see it almost as problematic as downside volatility. Upside volatility provides further evidence of the high level of uncertainty currently plaguing the markets, and it does not provide comfort to the average retail investor who is sick and tired of seeing his/her portfolio balance jumping around like the electrocardiogram of a heart attack victim. And without a critical mass of retail investors, who are more likely than institutions to invest for the long term, the market is not likely to calm down.

Clearly, there were some good economic reasons for October's gains. Most importantly, the advance GDP estimate for the third quarter was better than expected. Although the 2.5% growth figure might eventually be reduced when more data becomes available, it was a pleasant surprise to many economists and investors. However, most of October's gains can be credited to growing optimism that Europe would actually be able to appropriately address its debt problems. I continue to believe this optimism is premature.

Europe's problems are serious and they are beginning to have a negative impact on U.S. companies in unexpected ways. C.R. Bard (ticker "BCR"), for example, a $7 billion (by market cap) medical device maker, took a $7 million write down in the third quarter for the impairment of Greek bonds. I have no doubt that there will be more companies taking similar write downs in coming quarters.

Despite the recent jubilation about Europe, we are already seeing trouble ahead. The latest news that the Greek government wants to hold a referendum on the bailout package it has already agreed to, has really shaken the markets. Greek politicians hope the referendum will pass and put an end to street demonstrations and riots. However, austerity measures are extremely unpopular and not likely to be approved by popular vote. This all but assures that the markets will remain incredibly volatile.

Volatility may be a trader's best friend. Those nimble enough to jump in and out of the markets can make a quick buck. (Quick bucks, by the way, are good for the government because they are taxed at higher rates.) However, volatility does not mean that long-term buy-and-hold investing is dead. But it does make entry points more important than ever. If you are a long-term investor, I suggest taking the big selloffs as good opportunities to add to positions in high-quality, profitable, dividend-paying stocks.

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Pay to Go Away (Kind of)

As most of my readers know, I am not a fan of the "Occupy Wall Street" movement. In fact, I've been quite critical of these people. But I do have to agree with OWS on one thing: Executive compensation has gotten out of hand. The latest evidence comes from Nabors Industries, which has just named a new CEO. What happens to 81-year old Eugene Isenberg, the former CEO and Chairman? Well, he's not exactly going away. He will remain Chairman. But since one of his titles is being taken away, he will get $100 million to help soothe his sorrows. Nice gig if you can get it. OWS would be right to be irate about this. I just wish those protestors felt the same way about overpaid athletes and entertainers, too.

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Obama Goes After Starbucks

Rising commodity prices are taking their toll on all kinds of manufacturers, but the latest news that Starbucks will be raising prices anywhere from five cents to a quarter per cup of "joe" has customers really worked up.

Some coffee lovers are even asking for a consumer coffee protection agency to prevent this kind of predatory pricing. They want the government to act right now. One latte lover who asked not be identified said, "I can't live without my coffee. It is completely unfair for Starbucks or any other coffee shop to just raise prices whenever they want to."

President Obama even got into the fray. While clutching a caramel macchiato with both hands, he said, "Starbucks doesn't have some inherent right just to get a certain amount of profit." He urged Congress to immediately pass legislation that would require fully transparent coffee pricing and limit by how much any coffee brewer could increase prices. He said consumers need to know exactly how much money they are paying for their coffee.

Starbucks CEO Howard Schultz defended his company. He insisted that Starbucks is already very transparent in its pricing. He said, "Every purchase is rung up on a state-of-the-art cash register. Each customer is told exactly how much he or she must fork over for our coffee. If they don't like it, they can drink that stuff from the diner down the street." Furthermore, in a complete rebuff to the President, Schultz insisted, "We at Starbucks believe we do have a right to make a profit!"

When informed of Schultz's remarks, President Obama admitted that he doesn't actually buy his own coffee anyway. "Joe Biden usually picks it up for me on the way to the office every morning."

Note to readers: In case you lack a sense of humor, this blog post was completely fabricated from my own imagination.

Competition is the Best Way to Limit Profits

A few observations:

1. Steve Jobs, who passed away yesterday, was one of the greatest innovators in the technology sector. He was also one of the world's greatest business executives. He became a very rich man because his company, Apple Inc. made tremendous profits. He was admired by those on the political left.

2. Warren Buffett is one of the greatest investors of all time. He became a very rich man because his company, Berkshire Hathaway, made tremendous profits. He is admired by those on the political left.

3. When asked about Bank of America's plan to charge its customers a fee for using their debit cards, President Obama said his administration could stop this service charge "If you say to the banks you don't have some inherent right just to get a certain amount of profit." President Obama is admired by those on the political left.

It is true that no company has a right to make a certain amount of profit, but it is also true that in the United States we don't limit how much profit a company can make. A competitive free market capitalistic system does that for us automatically. High profits invite competition. Competition drives profits down.

Bank of America may have made a mistake by introducing this fee. If so, its competitors will pounce. They will begin advertising debit card services with lower fees or no fees at all. Bank of America will notice that it is losing customers.

That doesn't mean government has no role. We need regulations to make sure the banks don't take excessive risks that leave taxpayers on the hook for their mistakes. But we don't need the government telling banks what fees they can or can't charge. As long as those fees are transparent and as long as the market is competitive, consumers can decide for themselves which services they value and where they want to maintain their accounts.

Investors Ignore Buffett's Obama Endorsement

Warren Buffett is admired for his investment prowess. Unfortunately for Democrats, that admiration is not translating into influence in the political sphere. The White House is counting on Buffett to help raise lots of money for President Obama's campaign, and for the Democratic party in general. The president even dubbed his initiative of making "millionaires and billionaires" pay at least the same tax rate as those in the middle class the "Buffett Rule." He should have called it the "Buffett Tax."

The name results from Buffett's claim that his tax rate is well below that of his secretary's even though he makes much more money than she does. Although Buffett has not released his tax returns, we can assume his favorable tax rate occurs because his income is primarily in the form of dividends and long-term capital gains, which are taxed at just 15%, and because of the large deductions he probably takes for his charitable contributions. His secretary's income, on the other hand, consists primarily of her salary, which is considered ordinary income and taxed at a higher rate.

Before trying to occupy Wall Street, consider the following: First, it is not true that most millionaires and billionaires pay taxes at a lower rate than the middle class. In fact, figures from the IRS prove they pay taxes at much higher rates. Even if they have a lot of deductions, they get snared by the alternative minimum tax. If Buffett's tax rate is indeed as low as he claims, that's highly unusual. Rather than raising rates on everybody, let's first scrutinize Buffett's tax return.

Second, there is a valid reason why dividends and long-term capital gains are taxed at only 15%. It is because that money has already been taxed at the corporate level. It would make perfect sense to tax dividends and capital gains at the same rate as any other income, but only if we eliminate the tax on corporations first.

Getting back to Warren Buffett's rather insubstantial political influence, The New York Times recently reported that the turnout was disappointing at a recent fundraiser for President Obama hosted by Buffett. While investors no doubt still prize Buffett's keen sense for detecting undervalued assets, they apparently have much less admiration for his political views.

Volatility Likely to Subside

The following commentary was released earlier to subscribers of the Forbes Special Situation Survey investment newsletter.

August was a particularly trying month for equity investors. During the first six trading days alone the S&P 500 Index lost a whopping 13.4%. Even though stocks rallied nicely over the last seven trading days, the Index still lost 5.6% for the full month. That’s the kind of return one might expect for a full year. For a single month, it is extremely unusual.

Perhaps more surprising was the extremely high level of volatility. While investors know that buying stocks is risky, few investors, if any, expected to see the kind of explosive volatility that has plagued the markets in recent periods. It wasn’t this way when 2011 began. At the start of the year, the markets were quite calm, but the incidence of large price swings began to rise as the year progressed. This surge in volatility is seen quite clearly in the table below. The table notes the number of trading days for each month on which the S&P 500 moved up or down by at least 1%. For example, there were only three trading days in January on which the Index moved between 1% and 2% and there was none on which it move by more than 2%. Now take a look at August. The difference is stark. In August the Index moved by more than 1% on 14 trading days. On six of those days it moved by at least 4% and on one remarkable day it moved by more than 6%; unfortunately, that was a down day. Since there were only 23 trading days in the entire month, these are rather remarkable statistics.


Stocks recommended by the Forbes Special Situation Survey were also hit by this staggering level of volatility and most closed lower. One stock, however, bucked the trend. Remarkably, Research in Motion (RIMM) surged 30% in August. Of course, that does not negate the fact that RIMM is still down by half since we recommended it in January. It does demonstrate, however, how sudden changes in investor sentiment can cause violent movements in stock prices, both up and down.

Given the economic uncertainties in the U.S. and abroad, volatility will likely remain high, yet it should subside well below the levels seen in August. A calmer market alone could give individual investors the confidence they require to start buying stocks again.

Vahan Janjigian and his clients at Greenwich Wealth Management have positions in the stocks mentioned in this column.

Stop Taxing Corporations on Foreign Earnings

As many investors know, U.S. corporations are holding large amounts of cash on their balance sheets. Some commentators argue they are doing so because they believe investing is too risky right now. Furthermore, they ask, if these corporations, which are run by very sophisticated managers, are unwilling to put their money to work, does it make sense for ordinary investors to risk their own money in the stock market at this time?

I took a look at some of the largest corporations in the S&P 500. I examined their most recent SEC filings. As shown in the table below, they are indeed holding lots of cash and short-term marketable securities that could be quickly converted into cash.



Perhaps we can conclude from these large cash balances that these companies are reluctant to invest because of economic uncertainties and other risks, including political risks. Yet, at least to some extent, we can also conclude that the decision to pile up cash is motivated by taxes. After all, many of these companies have significant operations abroad. To a large extent, their cash balances reflect profits earned overseas. Repatriating those profits would result in significant U.S. tax liabilities.

Consider this statement from Google's most recent 10-Q filing with the SEC, "As of June 30, 2011, $18.8 billion of the $39.1 billion of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds."

Perhaps Google does not need to invest the money in the U.S. right now, but it is clearly objecting to the tax consequences it would face if it did try to bring the money home. It's pretty clear that Google would probably repatriate at least some of this $18.8 billion if it did not have to pay an onerous tax.

Google is not the only company on the list to mention repatriation and taxes. Several companies commented on this. Here's what Microsoft had to say in its most recent 10-K: "We earn a significant amount of our operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions may result in higher effective tax rates for the company."

By forcing companies to pay a tax that runs as high as 35% on repatriated profits, our government is all but ensuring that the money stays overseas. It seems like common sense to reduce this tax rate dramatically. Better yet, why not eliminate it entirely? Doing so could be one of the most effective job creation initiatives the government could take.

Warrants Warrant Warren's Investment

The big news for a while this morning was Steve Jobs' resignation as CEO of Apple. But it wasn't long before Warren Buffett stole the headlines. On Berkshire Hathaway's behalf, Buffett decided to invest $5 billion in Bank of America. Berkshire is buying cumulative preferred stock that pays 6% dividends. But that's not all. The preferred stock also comes with warrants that give Berkshire the right to buy 700 million shares of common stock at $7.14 per share.

Yesterday, before the deal was announced, shares of Bank of America rallied 11% to close at $6.99. Today, after the deal was announced, the stock opened at $8.29. That means the warrants immediately went into the money.

I discuss this kind of deal, known as a PIPE (private investment in public equity), in my book Even Buffett Isn't Perfect. PIPEs are not available to ordinary investors. Buffett used this structure not too long ago to invest in Goldman Sachs and General Electric. So far, at least, those stocks haven't done very well.

It remains to be seen if Bank of America pays off for Berkshire in the long run. But given the exercise price on the warrants, the odds are certainly in Berkshire's favor.

Is France Next?

Last Friday, in a widely telegraphed move, Standard & Poor's downgraded America's credit rating one notch from AAA to AA+. The real surprise was the timing, not the downgrade. Nonetheless, officials at the Treasury Department went ballistic, in part due to an error in the calculation of projected debt. Yet after acknowledging the error, S&P stood by its downgrade.

Whether the downgrade was deserved or not, it has clearly shaken up financial markets around the world. Stocks, in particular, sold off everywhere. Yet U.S. bonds rallied. This seemingly nonsensical reaction in the bond market is due to investors trying to reduce risk. They are selling "risky" stocks and buying "safe" bonds. In other words, they believe the S&P downgrade is more a comment about dysfunction in the U.S. government than it is a concern about the government's inability to pay back its debts. As for stocks, the lower they go, the safer they get.

What comes next? No doubt the other rating agencies, Moody's and Fitch, are doing their homework and might issue downgrades of their own. I don't expect that to happen in the very near future. More likely, Moody's and Fitch will wait until they see how Washington reacts. The recent agreement to raise the debt ceiling and reduce spending requires the formation of a commission to come up with the cuts. Members of this commission have yet to be named. If the commission looks credible and if it makes serious recommendations in a timely fashion, Moody's and Fitch will likely maintain their prime ratings on U.S. credit. But if the commission turns out to be another dysfunctional political group that cannot agree on serious spending cuts, more ratings cuts are likely.

Now that S&P has downgraded America, you have to wonder about the remaining countries that still enjoy AAA ratings. France, in particular, looks vulnerable. Ten-year notes in France are yielding significantly more than 10-year notes in America--even after America's downgrade. In other words, investors are telling S&P it is wrong. They perceive French bonds to be riskier. Remember, the U.S. can always print more money. France no longer has its own currency. After downgrading the U.S., it would be entirely inconsistent for S&P to maintain its prime rating on France. I expect a downgrade of France will be the next shoe to drop.

Market Snubs Congress

Conventional wisdom said stocks would rally once Congress settled on an agreement to raise the debt ceiling and cut spending. Yet on the same day that President Obama signed the Budget Control Act of 2011 into law, the S&P 500 sold off more than 2.5%. The S&P is down almost 7% in the last seven trading days.

Of course, the selloff can't be blamed entirely on the events in Washington. Economic factors deserve some of the blame. For example, yesterday's ISM manufacturing index came in at just 50.9 for July, well below expectations and well below the 55.3 reading for June. Because the figure was greater than 50, it indicates expansion, yet the pace of growth in the manufacturing sector has markedly slowed. Tomorrow, ISM will release its services index, which has been weaker than the manufacturing index in recent months. Economists expect a reading of 53.7, but there is a good chance the index will fall below the critical 50 level.

Yet the bulk of the blame for the selloff must go to Congress and the president. Even those politicians who voted for the bill were anything but happy. There was no backslapping and President Obama chose not to host a signing ceremony. And as soon as he signed the bill in the privacy of his office, he talked about the need to increase taxes on the so-called rich. In his book that means people making as little as $200,000 per year. How they can be called millionaires and billionaires, I don't know. In any case, investors understood that today's bill was nothing but a temporary fix. They see nothing but more political dysfunction ahead. Investors came to one conclusion: Risk Off!

The Dysfunctional U.S. Government

It's Friday afternoon and amazingly the U.S. Congress has yet to agree on a bill that raises the debt ceiling and reduces spending. This is forcing investors to deal with an unprecedented level of uncertainty. Stocks have been selling off despite recent financial reports that largely show strong revenue and earnings growth. Despite strong earnings, a number of CEOs have commented that increased macroeconomic uncertainty and political risk make it extremely difficult to plan for the future.

On top of all this, the latest GDP report was extremely disappointing. All of the increased spending by the government to try to save the economy appears to have been for naught. The Advance Estimate for Q1 showed extremely meager growth of just 1.3%. As disappointing as that figure is, the downward revisions for prior quarters were even worse. In fact, for the entire 2007-2010 period, the Commerce Department had previously estimated that the economy grew at an average annual rate of 0.1%. In other words, it hardly grew at all. Yet now the Commerce Department says the economy actually shrank at an average annual rate of 0.3%. Furthermore, the average annual rate of growth of real disposable income during the period was halved from 1.2% to 0.6%.

These revisions make it clear that the U.S. economy was doing much worse than the government’s already dismal statistics suggested. Of course, all those unemployed people who are still having trouble finding jobs already knew that. However, during the same period, most corporations have done an excellent job of getting their own houses in order. Although the Commerce Department revised corporate profits down by 1.1% for 2008, it revised profits up 8.3% in 2009 and 10.8% in 2010. Unlike the government, corporations don’t have the luxury of financing losses ad infinitum with indefinite amounts of borrowing. Corporations that can’t generate profits do not stay in business for very long. If there was any doubt, recent events in Washington confirm that the average corporation is much better run than the government is.

A last minute compromise between Republicans and Democrats is still possible. However, the dysfunctional manner in which an agreement is being hashed out makes it almost a certainty that America’s credit rating will eventually be lowered. While a downgrade would be unfortunate indeed, it does not necessarily mean that interest rates will skyrocket. While events in Washington make it clear that U.S. government securities are more risky than investors previously believed, there is little doubt that most investors would still prefer to own U.S. bonds than the bonds issued by almost any other nation. Even so, shares of well run companies would probably provide a safer haven.

Interest Rates May Not Surge After Ratings Downgrade

Contrary to popular belief, Standard & Poor's has not reduced its rating on U.S. government debt--at least not yet. Last April, S&P did reduce its outlook on U.S. government debt. That was its way of warning that a downgrade was possible. In particular, at that time, S&P assigned a one-in-three chance of reducing the rating within two years. Last week, S&P made things more formal. It placed U.S. government debt on CreditWatch negative. This time S&P said there is a one-in-two chance it will reduce the rating within 90 days.

This is serious stuff. Investors have long considered U.S. government debt to be risk free. Business schools have long encouraged this line of thinking. Finance professors all across the country have long taught their students about the Capital Asset Pricing Model. One of the variables in the CAPM is the risk-free rate of interest, which is merely a theoretical concept. But professors have told their students that it is probably safe to assume that the rate on U.S. Treasury securities is a good proxy for the theoretical risk-free rate. Not anymore. S&P's threat to downgrade U.S. debt means Treasury securities should not be considered risk free.

All things equal, a reduction in the credit rating should result in higher interest rates because higher perceived risk means investors will demand greater expected return. Higher rates for government debt will likely mean higher rates for all kinds of loans, including home mortgages. Clearly, that's not a good thing when the housing market is in such bad shape.

If there is any glimmer of hope, it is that a downgrade in America's credit rating may not cause interest rates to rise as much as many investors currently fear. This is because relative to other countries, U.S. government debt will still look good. I am not saying that rates won't rise. I'm only saying that any increase may not be as great as some people expect. That's assuming, of course, that inflation remains tame.

I discussed some of these issues, as well as the still surprising strength in retail sales, with Tracy Byrnes. You can watch the interview here.

Buffett Won't Pay More Taxes Until He Must

Warren Buffett appears on CNBC so often, you would be forgiven for thinking he was part of the staff. He was on the tube again this morning defending his view that the rich should pay more taxes. The media has always handled Buffett with kid gloves, rarely putting him on the spot or pushing a point. Therefore, I give kudos to Joe Kernen who this morning tried hard to question Buffett about taxes.

Kernen asked Buffett why he gives so much money to charity instead of voluntarily paying more taxes. Kernen asked if it was because he thought charities would spend the money more wisely than the government would. This is no doubt true. Buffett acknowledged that charities do some things better than the government does, but for the most part he dodged the question. Instead of addressing the issue, he opined that a voluntary tax would not be effective and cited statistics showing that very little money is voluntarily donated to the government by individuals willing to pay more taxes. He argued that, as a result, we have to tax the rich more in order to force them to pay more.

As they said when I was a kid, "What does this have to do with the price of tea in China?" There are really only two reasons why the rich don't voluntarily pay more taxes: 1) They believe they are already taxed too much, and 2) they believe the government does not do a good job of handling their money. In any case, no one is suggesting that taxes be voluntary. We're only wondering why Buffett dodges taxes (albeit legally) if he really believes the rich should pay more.

Perhaps Kernen could have phrased the question differently, or maybe he should have followed up. Buffett's argument that voluntary taxes won't work is entirely irrelevant. Besides, it overlooks the fact that charitable contributions are also voluntary. Yet Americans keep on giving generously to charity. In fact, Americans donate about $300 billion annually to charity--all of it voluntarily.

Some people argue that the rich donate to charity only to take advantage of a tax deduction. In fact, Bill Gates' dad once made this argument in Congress. He argued that lower tax rates would reduce the value of the tax deduction and, as a result, would reduce the amount of money contributed to charity. This is bunk. As I explain in Chapter 9 of Even Buffett Isn't Perfect charitable contributions actually increased during periods when tax rates were reduced. Why? Because lower tax rates leave people with more money to donate to charity.

Buffett is in an untenable position. He says the rich should be taxed more, yet he keeps his own money out of the hands of government. Not only does he take full advantage of the tax breaks he is entitled to, but he will also avoid much of the estate tax by giving away the bulk of his fortune before he passes on.

In short, Buffett's argument can be paraphrased as follows. "The rich should pay more taxes. Because I'm rich, I also should pay more taxes. However, I refuse to lead by example. I won't pay more taxes until the government forces all rich folks to pay more taxes."

The Coming Housing Boom

The following commentary is also available at The Fiscal Times.

Yes, you read that right. Get ready for the next housing boom. You're probably thinking, "How can that be?" With all the mortgage delinquencies and foreclosures going on, and the record levels of housing inventory, how could we possibly have another housing boom?

It's not going to happen soon. In fact, it may not happen for several more years. Yet despite all the problems we are seeing today, pent up demand will create the next housing boom. This is because demand for housing is closely tied to the rate of household formation. As society creates more households, society needs more houses. Right now, due to the poor economy and the dismal jobs market, household formation is on hold. This is one reason why the housing market continues to remain depressed.

A household is simply a residential unit. It refers to a person or persons living under one roof. Traditionally, a household has been thought of as a nuclear family. Boy meets girl, boy marries girls, boy and girl buy a house or rent an apartment. In this way, marriage creates more households and demand for more places to live. Divorce, too, creates more households and demand for more housing. People who get divorced do not want to continue living together under the same roof. Households are also formed when children grow up and move out. Most kids can’t wait to get their own place.

However, much of this activity is currently on hold. In a recent interview on National Public Radio, Karl Case (one half of the famous S&P/Case-Shiller duo) recently said, “The process of generating new households seems to have stopped.” Due to the poor economy, some people are postponing marriage. Others are postponing divorce. And as much as they would like to be independent, many grown children are staying put. Some can't find jobs even after graduating from college, so they are choosing to live with mom and dad just a little longer. Even those lucky enough to be employed are moving in with their parents in order to cut expenses.

Believe it or not, this lack of household formation could be good news for housing in the long run. It means there is a lot of pent up demand for housing, and chances are it is growing. Current household formation may be depressed, yet potential household demand is strong. Once the economy begins to pick up steam and more people start to find jobs, household formation will surge. Once that happens, demand for houses and apartments will also surge.

This is not to say that any of this is imminent. More likely than not, the process could take a few more years. Yet unless you believe the United States is on a permanent trajectory toward economic decline, you have to believe that the housing market will eventually turn around. All that pent up demand for household formation should create a strong rebound in the demand for housing. Maybe this time if we are smart enough to keep our wits about us, we will avoid another housing bubble.

FoxBusiness

Here's a link to a recent hit I did on FoxBusiness by Skype. We discussed the economy and housing markets.

Interpreting the Fed

The Federal Reserve released the following statement after its meeting on Wednesday. Because people sometimes complain that the Fed's language isn't entirely clear, I have taken the liberty of interpreting the statement for you in what I hope is a more comprehensible form. Below is the full text of the Fed's statement. Following each paragraph, I have written my interpretation in italics of what the Fed really meant to say:

Information received since the Federal Open Market Committee met in April indicates that the economic recovery is continuing at a moderate pace, though somewhat more slowly than the Committee had expected. Also, recent labor market indicators have been weaker than anticipated. The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan. Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed. Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions. However, longer-term inflation expectations have remained stable.

The economy is still stuck in a rut and things are not getting better. Ain't nobody getting jobs. We are hoping and praying that the bad state of the economy improves and that higher food and gasoline prices go back down. We also hope the earthquake/tsunami/nuclear catastrophe in Japan does not prevent that country from making things again. On a positive note, people keep spending more money and companies are buying more things. But don't get your hopes up because nobody is investing and nobody wants to buy a house. Like we said before, food and gasoline prices have gone up. Despite those rising prices, we are still pretending that nobody expects prices to keep going up.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The unemployment rate remains elevated; however, the Committee expects the pace of recovery to pick up over coming quarters and the unemployment rate to resume its gradual decline toward levels that the Committee judges to be consistent with its dual mandate. Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

Congress wants us to create more jobs and keep a lid on inflation at the same time. We know this is impossible, but we're trying anyway. People still can't find jobs, but we're hoping they will find them soon so that the unemployment rate will continue going lower. Oh wait, the unemployment rate has been going higher. Never mind. Anyway, just in case you didn't understand us the first two times, we want to tell you again that prices are going up. Despite that, we are hoping nobody really notices. But the next time we go shopping, we'll be sure to check if prices are still going up.

To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The Committee will complete its purchases of $600 billion of longer-term Treasury securities by the end of this month and will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

All you old folks out there who were hoping to earn more interest on your savings account, well you can forget about that. We're not kidding. You really can forget about earning more interest in your bank account because we're going to make sure interest rates stay low. We told you we would complete QE2 and we meant it. And just in case you don't like it, tough. Get used to it because we might even do QE3.

The Committee will monitor the economic outlook and financial developments and will act as needed to best foster maximum employment and price stability.

We'll be watching CNBC just like the rest of you so don't be surprised if we do something stupid just to spite Rick Santelli.

Oil Prices Should Ease on OPEC's Failure to Reach Agreement

A cartel is a formal agreement among competing firms to control the price and supply of a particular good or service. In order to promote competition, U.S. companies are prohibited from forming cartels. In theory, cartels should not last anyway because there is too much incentive to cheat.

That hasn’t prevented OPEC, the world’s best known cartel, from defying theory. The Organization of Petroleum Exporting Countries, currently consisting of a dozen nations, has been thriving since it was first formed in 1960. OPEC operates under a system of production quotas agreed to by its members. Saudi Arabia, the largest producer by far, is also the most influential.

That didn’t stop Ali Naimi, Saudi Arabia’s Minister of Petroleum and Resources, from calling Wednesday’s OPEC meeting in Vienna one of the worst ever saying, “In my 16 years as a minister, I have not seen as obstinate a position without move like this meeting.” He was referring to the hard line taken by Iran and OPEC’s subsequent failure to reach agreement to increase supply. Oil prices immediately surged on the news.

They shouldn’t have. Naimi went on to explain that Saudi Arabia, Kuwait, Qatar, and the United Arab Emirates “are able and willing to supply whatever the market needs,” which he currently estimates as an additional 1.5 million barrels per day. He made it clear that there would be no shortage of supply.

Does this portend the end of OPEC? Probably not. Yet cheating on production quotas has been going on for a long time. Most oil producing nations would love to sell as much as possible at the current $100 per barrel. Now that OPEC has failed to reach an agreement, the spigots should open wider. It shouldn’t take long before oil falls to $90 per barrel.

Stocks Suddenly Losing Favor

The following commentary was released today to subscribers of the Forbes Special Situation Survey.

Stocks have suddenly exhibited weakness with the S&P 500 down about 6% since its April 29 high. Housing, employment, and energy continue to present the greatest headwinds. The latest S&P/Case-Shiller figures indicate that existing housing prices have double-dipped, setting new lows since their 2006 highs; nonfarm payroll figures have weakened once again with the unemployment rate jumping to 9.1%; and although energy prices have backed off their recent highs, the high cost of gasoline continues to present a significant challenge to most consumers.

Furthermore, high levels of debt remain a serious concern. Some economists argue that government debt as a proportion of GDP is not out of line, at least when compared to WWII era levels. However, if we include unfunded liabilities (i.e., social security, Medicare and Medicaid), state and local government debt, corporate debt, and consumer debt, total debt as a percent of GDP is at record levels. Government’s inability to properly address the debt and deficit is becoming an increasingly worrisome issue for the economy and investors.

One concern not often discussed is the increasing amount of programmed trading taking place in the markets. Programmed trading was behind the “flash crash” of May 6, 2010 when the Dow plunged 600 points in a matter of minutes. As institutional investors increase their reliance on computerized algorithms to execute orders, fewer human beings are involved in the actual decision-making process of buying and selling stocks. This is exaggerating the movements in stock prices. Investing, as opposed to trading, becomes more challenging in this kind of market. While it is still safe to assume that relying on fundamentals makes sense over the long term, irrational behavior can dominate the markets over the short term. Just as bubbles often get larger before they burst, undervalued stocks can get cheaper before investors come to their senses. Research in Motion (RIMM), one of the stocks on our buy list, is getting hammered by this kind of activity. A combination of irrational behavior and programmed trading appears to have contributed to the stock’s decline.

Given the serious problems in the economy, there really was no justification for the market’s strong rally from last September through April. Although some stocks appear to be extremely cheap, investors should remain extremely cautious about the overall market’s prospects. I recently had the opportunity to meet with several experienced investors including Forbes columnists Gary Shilling and Ken Fisher. Shilling continues to be bearish on stocks. That’s no surprise. Fisher, who is usually bullish, says he now expects stocks to finish relatively flat for the year. Given the serious challenges that must be overcome, it’s starting to look as if even a flat year might be too optimistic of a forecast.

A Chink in His Armor

A couple of weeks ago, Berkshire Hathaway's audit committee issued an 18-page report about David Sokol's stock trades in Lubrizol Corporation. What stood out was how vigorously the report defended Warren Buffett, how strongly it blamed David Sokol, and how much it differed from Warren Buffett's own news release dated just one month earlier.

The audit committee concluded that Sokol had violated company policies and that he made misleading and incomplete disclosures about his stock trades. All that might be true, yet Buffett's earlier release defended Sokol and his stock trades. Buffett wrote, "Neither Dave nor I feel his Lubrizol trades were in any way unlawful." That statement might also be true. So far, at least, Sokol has not been charged with a crime. However, since the SEC is still investigating, the matter isn't closed. In any case, it certainly does appear that Sokol violated his fiduciary responsibility to Berkshire Hathaway. It seems that Lubrizol's CEO and the Citigroup bankers who brought Lubrizol to Sokol's attention were under the impression that Sokol was representing Berkshire Hathaway. Sokol should not have been using that information to execute trades in his own account.

The mere fact that Sokol resigned suggests there is probably more to this story. Most likely, Sokol would not have resigned unless he was asked to resign or unless he thought he had done something wrong. Buffett wrote that Sokol's resignation "came as a surprise to me." That's a bit hard to believe, especially since Buffett also says that Sokol tried to resign twice before. Furthermore, the report issued by the audit committee states that Buffett asked Berkshire's CFO Marc Hamburg to look into Sokol's trades as early as March 15, two weeks before Sokol resigned.

Furthermore, if the company's board of directors is genuinely convinced that Sokol violated company policy by trading in Lubrizol stock, it seems they would have an obligation to all their shareholders to try and recoup Sokol's profits from those trades. Initiating legal action, however, could require that both Sokol and Buffett testify under oath; something the board might prefer to avoid.

Unfortunately, the entire matter has given Buffett's stellar reputation a bit of a blow. At worst, it appears that Buffett tacitly approved Sokol's inappropriate trades, or at least chose to ignore the matter. At best, it appears that Buffett was completely duped by one of his most trusted lieutenants. Either way, this incident has put a chink in Buffett's shining armor.

$3,000 Per Night

No doubt everyone has heard by now of the arrest of Dominique Strauss-Kahn, Managing Director of the International Monetary Fund. Mr. Strauss-Kahn, whose past exploits have earned him the nickname "The Great Seducer," is accused of sexually assaulting a chambermaid in his suite in the Sofitel hotel in New York City. If true, this is a horrendous crime. A court of law is certainly the appropriate place to decide his guilt or innocence, but things don't look good for him. At least one other woman is now claiming that he sexually assaulted her almost 10 years ago.

In any case, another question needs to be asked as well. The IMF is an international organization tasked with helping countries that have run out of money. It gets its funding from member nations, each of which pays a quota. Not surprisingly, the United States has the largest quota by far. As Managing Director, Mr. Strauss-Kahn reportedly earns well over $400,000 per year tax free. Mr. Strauss-Kahn was staying in a room that costs $3,000 per night. So here's the question: Who paid for the hotel room? Did the money come from Mr. Strauss-Kahn's own pocket (not likely), or was the U.S. taxpayer on the hook for the bulk of the bill?

Don't Blame Gouging for High Gasoline Prices

The price of gasoline is perhaps the one price consumers notice more than any other. They see it prominently displayed every time they drive by a gas station and they feel it right in their wallet every time they fill up their tank. So when gasoline prices are on the rise, it isn’t surprising to hear consumers complain. In recent weeks, they have been doing a lot of complaining.

According to the AAA’s Daily Fuel Gauge Report, the national average price of regular gasoline is currently $3.87 per gallon. That’s up from $2.85 a year ago and $3.58 just one month ago. Never mind that gasoline prices are still much cheaper in the U.S. than in most other countries, or that gasoline prices are not out of line when adjusted for inflation during the past several decades. The recent rapid rise has consumers crying foul and state attorneys general warning gas stations not to price gouge. Attorney General Martha Coakley of Massachusetts has been at the forefront of these efforts to scare gas station operators. She recently cited a provision in the law that prohibits the selling of petroleum based products at “an unconscionably high price,” whatever that means.

While some price gouging might be occurring in certain markets, in general, gouging is not nearly the universal problem some politicians would like us to believe it is. The fact of the matter is that gasoline prices are up for a number of valid economic reasons.

First, supply has been disrupted. Gasoline is made from crude oil and unrest in the Middle East, particularly Libya, has disrupted supply causing crude oil prices to rise. The Obama administration’s reluctance to allow more drilling in the U.S., especially after the BP oil spill in the Gulf of Mexico, is also having a negative impact on supply.

Second, in an attempt to stimulate the economy, the U.S. government has debased the value of the dollar. A cheaper dollar increases the price of imports. Not coincidentally, oil is our biggest import. In addition, when investors fear a falling dollar, they pile into commodity-based futures contracts, contributing to rise in prices.

Third, demand for gasoline is on the rise. Recessions soften demand for all kinds of goods and services, including gasoline. But when economies recover, demand strengthens. While the U.S. recovery has been lackluster, the fact is that jobs numbers are improving. Gasoline demand has strengthened as more people have begun commuting again to work.

Price gouging is an unlikely explanation in highly populated markets where there are several gas stations within a three or four mile radius. If you think the price is too high at one station, it is easy to go to another. For gouging to take place in such areas, gas station owners would have to be colluding with one another. Unless someone conducts a thorough forensic audit of their books, it would be impossible to prove they are gouging. On the contrary, most gasoline retailers typically make only about a nickel per gallon. While it’s true that some stations charge more than others, the difference is usually explained by higher costs. For example, a station located in a prime spot such as a busy intersection is probably paying more for its lease than one located in a more remote part of town.

If politicians really want to reduce the price of gasoline, they should get off the backs of gas station owners and focus instead on taxes. State and federal taxes add about 43 cents per gallon on average to the price of gasoline. Yet this doesn’t take into account the additional revenues they generate by taxing the profits of all the entities involved in the petroleum business. The truth is that the government makes more money when gasoline prices go up. Politicians will lend a sympathetic ear to complaining consumers, but the last thing they want is lower tax revenues.

Click on WBUR in Boston to listen to my interview on this topic.

Poor Governance at Berkshire Hathaway is Not a New Problem

Corporate governance has long been a topic of interest to financial researchers in academia. Law schools, too, have spent a lot of time on the issue. The issue of corporate governance arises from the separation of ownership and control at large publicly traded companies. After all, governance is largely irrelevant at closely held companies that are managed by the owners. If the CEO owns all the stock and shirks his responsibilities, he hurts only himself. But when there are many shareholders with only a few actually working at the company, governance becomes a big deal.

With Berkshire Hathaway's shareholders' meeting coming up next weekend, there has been much talk about governance. Warren Buffett is famous for having a hands-off approach to management. He says he buys good companies with good managers and then stays out of the way. He does not want to get involved in the operations.

However, David Sokol's recent resignation from Berkshire Hathaway has a lot of observers wondering if Buffett should not be more hands on. They are also wondering if Berkshire's board of directors is paying sufficient attention to governance.

I find this sudden attention to corporate governance at Berkshire long overdue. In fact, I devoted an entire chapter to the topic in my 2008 book, Even Buffett Isn't Perfect. Yet when the book came out, some critics wondered why anyone would worry about governance at Berkshire. With Sokol's sudden resignation and with the SEC investigating his stock trades, I suspect the critics have finally figured out the answer to that question.

Sokol Tarnishes Buffett's Reputation

Until just a few days ago, David Sokol was a star manager at Berkshire Hathaway. He was CEO of NetJets and Chairman of MidAmerican Energy Holdings. Now he's caught up in a stock trading scandal involving Lubrizol, a company Berkshire Hathaway is in the process of acquiring. I did a two-part interview on CNBC yesterday about this issue. Here is Part I, and here is Part II. In addition, here is an article I wrote about the situation for The Fiscal Times.

Housing Heads for a Double Dip

The latest S&P/Case-Shiller figures are disconcerting. There is no evidence that the housing market is improving. On the contrary, it appears to be headed for a double dip. Read my latest commentary at The Fiscal Times.

Book Review

Just want to thank Brenda Jubin who runs the blog, Reading the Markets,for the favorable review of my latest book, The Forbes/CFA Institute Investment Course co-authored with Steve Horan of the CFA Institute and Chuck Trzcinka of Indiana University.

We Could See More Selling Ahead

I'm growing increasing concerned about the behavior of the stock market. Stocks have been strong despite serious concerns about the economy, but yesterday's almost two percent selloff could be a harbinger of things to come. While I continue to find compelling buys in individual stocks (which I highlight in the Forbes Special Situation Survey, my outlook for the market as a whole is growing more bearish. I explain why in a recent posting at The Fiscal Times.

Buffett's Letter Does Not Disappoint

Buffett's annual letters to shareholders always make for interesting reading. They are full of pithy comments and there is usually a surprise or two. This year's letter was no exception. Read more at The Fiscal Times.

What's in a Name?

Have you heard about the controversy surrounding Deutsche Borse's merger with NYSE Euronext? It seems people are more concerned about what the name of the combined entity might be than they are about a German company acquiring one of America's most venerated institutions. Read more at The Fiscal Times.

Correction Ahead

I'm getting increasingly concerned that investors are being too complacent about some serious issues that will plague the economy for years to come. While investor sentiment could drive the stock market higher in the near term, unless we get our economic house in order, the long term does not look very rosy. You can read my views on these matters at The Fiscal Times and at Forbes.com.