Rockhaven Views

Rockhaven Capital Management, LLC. ("Rockhaven") is a Registered Investment Advisor ("RIA"), registered in the State of Pennsylvania. This blog is intended to provide general market information and views. It is not intended to offer investment advice. Market data, articles and other content in this blog are based on generally-available information and are believed to be reliable. Rockhaven does not guarantee the accuracy of the information contained in this blog. www.rockhavencapital.com

Wednesday, November 23, 2011

Happy Thanksgiving

Happy Thanksgiving,

This is by far my favorite holiday of the year, a time to briefly reflect on how blessed I've been.

For all the doom, and gloom I often write about it's nice to step back and remember how much we have to be thankful for.

America, for all of its detractors, is still the most productive economy in the world even in the middle of the worst recession since the Great Depression; its crime rate is the lowest in four decades; it has the world's strongest, most battle-tested military; and it remains the source of the best ideas, both technological and cultural, in the world.

Personally, I'm thankful for my wonderful family, and all the friends that give me strength and laughter.

And lastly, I'm thankful that the worst pre-Thanksgiving trading week in history is over. Here's to Friday.

Wishing you and yours a wonderful Thanksgiving holiday.

Be careful out there, and keep the lights on,

Chris Wiles, CFA
412-260-7917

www.rockhavencapital.com

For prior Rockhaven Views visit:
www.rockhavencapmgmt.blogspot.com

This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Friday, November 18, 2011

Running On Empty

Running on - running on empty

Running on - running blind

Running on - running into the sun

But I'm running behind

Jackson Browne 1977 Running on Empty

A little more than a week ago a friend said I was being too negative, a real "Debbie Downer," and challenged me to write a piece looking at the glass as half full. Well, after a week of searching I couldn't find the glass (fortunately I'm not opposed to drinking out of the bottle). Sorry, I just can't seem to find enough positives to overcome these massive negatives.

First, the world is in the early stages of working off decades of profligate spending. There is no way around it, for years our governments were able to issue debt to pay for their promises. Buyers were willing to accept Greek or Italian bonds at a slight yield advantage versus German bonds, until they weren't. Now countries are rapidly seeing what happens when the buyers disappear. The end game to Keynesian deficit spending occurs when your interest payments exceed your revenues. See Greece, and soon Italy, Spain, etc.

A closer look at the immediate situation in Europe reveals a very binary scenario. On the one hand, the Germans decide to bail out the rest of Europe. On the other hand they don't.

The German's could allow the ECB to hoover up all the EU sovereign debt that no one else will buy, which would cause a huge rally in euro bonds and global equities. A short-lived rally but a rally nonetheless. Now of course Germany/ECB will have no power to control other countries finances or the ability to tax their citizens, therefore they are just throwing good money after bad. The problems of zero growth and insolvency will remain, in addition to the destruction of the ECB's balance sheet. Inflation will spiral, the Euro will devalue, and the German citizens will have to suffer inflation imposed on them by other Europeans.

On the other hand, the German's can decide to leave their fellow Europeans to the mercy of the markets. Nations and bondholders get crushed, resulting in a severe deflationary recession/depression. This is what debt deflation looks like, this is how you pay for years profligacy. The euro is preserved but liquidity and business go away. Germany will remain Europe's economic power, but Europe as a whole will be much weaker.

In my mind neither of these scenarios looks like a glass half full.

Here in the United States we have the Debt Super committee (doesn't that sound like a name a toddler gives himself before jumping off the couch), meeting to decide what our first step into austerity should look like. I'm willing to bet that the plan will be anything but super. If they agree on anything, it will probably start innocently with a modest tax increase on the rich, the same way you might pluck a turkey before chopping its head off. The simple fact is that this country is out of money, poor people don't have any, rich people do, and the middle class has almost figured out how voting works. It's not that the middle class hates the rich, they've always believed that they had a chance of becoming rich too. But lately, thanks to crushing debt loads the middle class is giving up on their dreams of wealth, and instead opting to transfer money from total strangers to themselves - a process often referred to as fairness. In the meantime the rich are actively looking for escape plans.

Of course the Debt Super committee may also propose spending cuts, which is another way of saying reneging on their promises. Voters don't particularly like politicians who renege on their promises of a good life via someone else's money. For a recent example just look at the untimely end of Papandreou in Greece, and Berlusconi in Italy. No, I wouldn't expect any serious cuts to government spending until the bond market forces them too. Remember there will be a time when investors (i.e. Chinese) refuse to buy our bonds, then interest payments will exceed revenues, and hard decisions will be forcibly implemented. (More than slight irony that we are sending troops to Australia)

Finally the glass half full's greatest hope - Corporate America is doing just swell. OK, I'll admit that earnings for corporate America have been surprisingly strong and that is clearly keeping a bid under equities, especially dividend paying equities, but lets drill a little deeper. Historically during economic recoveries, sales, profits, and employee compensation all grew in tandem. But in this economic recover profits have boomed, sales have grown, and employee compensation has lagged miserably behind. See graphs below.

Some of the best profit margins in history, but how long can corporations squeeze employees in order to grow profits? There is a point where either labor costs go up or sales fall, not sure exactly where that is, but we might be getting a tad close. A half full glass with some very thirsty employees.

We continue to be very defensively positioned with nearly 50% of our assets in cash equivalents, and very minimal positions in Europe (3% in EAFE stocks, 2% Int'l Bonds).

A client recently asked me about buying stuff outside of the financial markets - stuff like real estate, art, or jewelry. I said that it makes perfect sense to me. Faced with zero percent returns and tons of unknowns, there is nothing wrong with buying something that might also give you a zero percent return, but at least you'll get a little enjoyment out of it. In fact I'm buying a painting next week, and am actively looking at some real estate.

Wednesday, November 9, 2011

The Madness of Crowds

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

- Charles Mackay "Memoirs of Extraordinary Popular Delusions and the Madness of Crowds"

As a young finance student many, many years ago a professor recommended that I read Charles Mackay's "Memoirs of Extraordinary Popular Delusions and the Madness of Crowds" written in 1841. Skeptical as ever, but intrigued by the title, I remember searching for it in the library (that's where you used to go to get books). How could a book written in 1841 teach me anything about investing in the 1980's? Surprisingly I found it to be both highly entertaining and informative, and I later learned that it is consistently one of the most recommended investment books. Today you can download it for free on your iPad or Kindle, or here Memoirs of Extraordinary Popular Delusions and the Madness of ...

One of the most important aspects of investing is understanding crowd psychology, and more importantly being on the right side of that psychology. Recognizing bubbles, participating in them, and getting out while the getting's good. In my short career I've participated in the leveraged buyout bubble of the 1980's, the tech bubble of the 1990's, and the housing bubble of the 2000's. Bubbles can be extremely rewarding as well as extremely dangerous.

Today I'd like to talk about a different kind of bubble, the student debt bubble. As a father of two, with just a few more years left until college, I'm very cognizant of the ever escalating cost of a college education. Can the cost of a college education be a bubble? When something appreciates for nearly two decades at more than twice the rate of inflation or income growth, then it starts to look a bit bubblicious.

Now nearly everyone agrees that higher education is good for the individual and society, and therefore most governments subsidize it in one form or another. Government subsidies really got rolling with the GI Bill after WWII. The government decided that higher education would lead our country to prosperity, and therefore all taxpayers should subsidize it. It's a noble intention, but doesn't it sound just a bit like, "home ownership is a right". Washington began deciding who qualified for a loan, who could loan them money, and what interest rate they would pay. Since they told the lenders who to loan to and what interest they could charge, the lenders were indemnified against default. The result was a hugely profitable, nearly risk-free business for the banks and Sallie Mae. This system worked too well for the banks, and in 2007 Washington cut the interest they could charge in half. As the banks began to withdrawal from the business, Washington cut them out entirely in 2010 and began lending directly to the students.

The colleges, realizing that their customers have an unlimited availability of government money, have been able to raise prices at a rate that far exceeds inflation. In 1990 the average college tuition was $10,500 and was 25% of median household income of $40,800. Today the average tuition is $17,500, which is 35% of median household income of $49,500. Not surprisingly US Federal Education lending has more than doubled in just the last ten years. For students the average debt upon graduation is now $27,000, and $34,000 if you count parent-plus loans. These are just averages, the numbers for the middle class are much worse. The poor get nearly a free ride, while the rich pay cash, the middle class are by far the largest borrowers, that's why it's not unusual to find graduates with more than $50,000 in debt.

Paying for a college education is an elaborate daisy chain of moral hazard in which tuitions can soar, as lending soars, without regard for the quality of the product or the borrowers ability to pay it back. Doesn't this sound an awful lot like the housing crisis? A universally desired good is dangled as a "right" in front of an ever-growing population of borrowers at ever-higher prices, and paid for with government subsidized easy money, resulting in rising unsustainable debt and an eventual taxpayer bailout.

Today only 56% of the graduates of the Spring class of 2010 have jobs, that's down from 90% in 2007. Not surprisingly defaults are soaring. But even in bankruptcy graduates can't discharge their student loan debt, the IRS has the power to garnish wages and withhold tax refunds to get their money back. Is it any wonder that many students are angry. They've been told to go to college, graduate, and you'll get a good job, but it appears that many of them didn't read the fine print or do the math. The fine print states that you might want to think twice about paying $72,000 for a four year degree in a field where you'll make $45,000 per year (assuming you get a job). The math simply does not work.

Now these students want the taxpayers to bail them out (forgive their loans) because they overpaid for a degree that has limited real world demand. Of course our President, campaigning for that young persons vote, is more than willing to use taxpayer funds to forgive these loans. He's proposed that borrowers not pay more than 10% of their "discretionary income" each year, regardless of how much they owe. Discretionary income is defined as the difference between the borrower's adjusted gross income and 150% of the federal poverty line. For a single person the poverty line is $10,890, 150% of that would be $16,335. So if a graduate had a job paying $30,000, they would only be required to pay $1,366 per year ($113/mo) in loan payments (30,000-16,335 = 13,665 * 10% = 1,366). Don't worry if this is still a tad restrictive, if you can't pay it back in 20 years the balance due is forgiven. And, if you are lucky enough to land a "public service" job after graduation (including teaching), then your debt is forgiven in ten years.

Fortunately my oldest daughter is thinking of pursuing a career in teaching. Do you think for a moment that I might calculate the benefits of holding back her college fund, letting her max out the loans, pay the minimum for ten years, and say thanks to Mr.Taxpayer? She can apply the money I've been saving to making her loan payments, or making a downpayment on a house, pay the minimum on her loans, and have it all forgiven after 10 years. (When I was a student in the early '80's I maxed out my borrowing at 6% interest rates, invested the proceeds in an 11% money market, and used the float for essentials like beer.)

Lets do the math together for fun. Say she borrows $70,000 over four years to go to an OK school. According to the college loan calculator she'll pay interest of 6.8%, have a monthly loan payment of $805.56, and make total payments of $96,667.60 (principal & interest). Assuming she gets hired, she'll make about $40,000 as a starting teacher. Under the Presidents plan she would only have to make loan payments of $197 per month (40,000-16,355 = 23,645 * 10% = 2,365/yr.), not $805. Over the course of ten years she'll make total payments of $23,640, she'll still owe $73,027, which our generous taxpayers will graciously forgive. Shit, I think I might even vote for Obama!

Seriously, as a life-long investor I've learned that spotting financial bubbles can be the difference between success and failure. Clearly our colleges (especially for-profit colleges), and the lenders, have profited handsomely from our government sponsored student loan programs. The students who've struggled with math and borrowed more than they can ever hope to repay are the immediate victims. But, as the President and the Occupy Wall Streeters have shown, the ultimate victims will be the taxpayers.

Normally the price of a service is determined by supply and demand. A rising price depresses demand and stimulates supply, leading to a stable or lower price, and vice versa. But in a bubble the higher the price the more the demand, until it finally falls apart. We've seen it dozens of times over the decades and it never ends well. Since our government has constantly stepped in to supplement the purchase of an education, the supply/demand price equilibrium has been broken. We taxpayers will be paying for the housing bubble for years, and our payments for the education bubble are just beginning.

Eventually the taxpayers will revolt, and they will demand a restructuring of higher education. More focus on careers that provide skills that are in demand, and more alternatives to the classic four year university. Technology will clearly play a bigger role in lowering the time and cost of an education. All bubbles pop, make sure you're aware of the game you are playing.