Living in an Obama Nation

It's clear that, in addition to Obama's significant victory at the polls, Democrats will widen their majorities in both houses of Congress (however, it seems unlikely that the Republicans will lose the filibuster in the Senate). This is likely to have some significance in terms of tax and trade, and massive implications for foreign policy. Of particular concern is the expansion of entitlement spending, the status of trade agreements and expected increases in capital gains and income taxes.

For several reasons, I suspect that the scope of reforms under the new government will be considerably more limited than most supporters hope and many detractors fear. This is due to a lack of ideological consensus in the Democratic party, limited government resources and the difficulty of engineering substantial changes, at least in the short run. In particular, I doubt that much progress will be made on entitlement expansions or the reform of existing trade agreements. I do, however, expect that taxes on capital gains and ordinary income will increase starting in 2010.

Firstly, Democrats have gained power by endorsing candidates that are considerably more conservative (particularly on social issues) than the party's traditional platform. These "Blue Dog Democrats" tend to be somewhat more populist than Republicans, but are generally more reflective of the American mainstream on budgetary issues and entitlements. Abandoning fiscal conservatism was as much as anything what lost the Republicans power, and this is something that many Democrats (if not the Democrats) understand. While the current financial crisis has raised substantial concerns among the electorate and increased support for yet another stimulus package, the public's support for balanced budgets and budgetary restraint is unlikely to go away soon. Their enthusiasm for health care reform is limited to the extent that their standard of care isn't adversely effected.

Surveys show that the vast majority of Americans are reluctant to tolerate any reforms that would reduce the standard of care they receive in terms of health care. By and large, they find the health care they receive to be expensive, but of high quality. It is difficult to understand how patient care quality cannot go down on average if the aggregate cost and standards remain the same, while adding some numbers of people to the system. The open secret of anti-poverty initiatives is the understanding that poverty is reduced through redistribution of income and that fundamentally, the median standard of living must decline in order to alleviate poverty. This has never been particularly popular with voting Americans, and what I suspect we'll see is a repeat of the 1993 debacle, if anything, on this issue.

Congressional Democrats and the Obama Administration are also likely to feel severely constrained in the creation of entitlement programs, at least in the near term. Instead, the focus is likely to be on preserving Medicare in the coming years, as the budgetary crisis is likely to intensify in the program as it approaches bankruptcy in the 2015-2020 period. Obama has been (and is) considerably vague on his proposals in this area, reflecting his own realization that the problem is far more politically complex than many appreciate. Thus, I suspect that changes in health care are likely to be incremental - particularly over the next few years. with a focus on seeking out the low hanging fruit of technological innovation.

Obama has sent conflicting messages on free trade; there is a particular disconnect between his writings in The Audacity of Hope and much of what he's stated on the campaign trail. There appears to be a fundamental disconnect between Obama and his advisors as well on numerous issues related to NAFTA and the advantages of trade. This has inspired many of his more conservative supporters to predict he will back track on his trade rhetoric after the election. Regardless of his views on the subject, it seems unlikely that the new administration will be able to (at least unilaterally) renegotiate important trade agreements, as entrenched interests exist to maintain the existing trade regime. However, expansion seems similarly unlikely, as the mood of Congress, and of foreign governments, is generally unlikely to favor new trade agreements in the near future. Expect a great deal of thunder on this issue, but little real progress (or damage).

Due to the sunset provision in the 2001 tax legislation passed by a Republican congress, it seems likely that taxes will increase to pre-2001 levels in 2010. In particular, one should likely expect increases in the rate of taxation of dividends, capital gains and ordinary income. It is difficult to imagine how the budget deficit can be brought to manageable levels (let alone eliminated) without increases in taxes. It's safe to assume that any tax increases will be highly unpopular (and likely ineffective) if they come before 2010, and its reasonable to expect that allowing the tax reductions of 2001 to expire will be an attractive alternative to the Congressional leadership. that having been said, there will likely be efforts to simultaneously reduce taxation in certain areas (particularly capital gains on venture capital) while increasing it in others (ordinary income on high incomes). Call 2008 a good year for CPAs and you wouldn't be too far off.

If there is one area of the federal government budget that is likely to suffer, it will be defense. The intellectual heritage of the post-Vietnam Democratic party, the inherit ambivalence of the American public to the current wars and a general feeling that foreign policy is a lower priority is likely to mean that regardless of what military leaders say they require, the focus will be on a "smaller, more efficient" (i.e. cheaper) military. An emphasis on air power, conventional strategic weapons and surveillance technologies are likely to prevail, but overall, budgets will decline. Whether this reduction in "hard power" will be compensated by the increased "soft power" of an internationally popular President is a very complex question that I will leave to the political scientists. But, regardless, less money will be spent on soldiers, weapons systems and general military expenditures.

What this all leads me to conclude is that growth companies (ones that are less likely to rely on debt financing and pay dividends) are likely to outperform value stocks. Bond markets are likely to be more volatile, at least in the short term, leading one to favor more aggressive bonds and ones with shorter maturities, as the fixed income markets determine whether budget deficits are likely to remain large and taxes high, leading investors to demand larger yields to compensate for lower after-tax returns and higher risks of default.

As a Democrat, I am more inclined to view the outcome of the election positively. However, I do remain concerned that increased entitlement spending and (significantly) higher taxes (particularly on capital gains) will retard economic growth and that will result in lower returns for most investments. Of particular interest to me in the short term is to see how the Obama agenda begins to develop in response to what are likely to be increasingly depressing economic news over the next two or three weeks. A continuation of the populist "spread the wealth around" rhetoric that became prominent in the election would certainly cause me to temper that view. In the coming days, it will be important that our new president reassure investors that the first priority of his administration is the health of the private businesses that make up the economy, not abstract (and highly subjective) notions of social justice.

That having been said, investment values are primarily determined by investors' expectations of the future. The current leadership's low popularity has undoubtedly played a substantial role in exacerbating the effects of the recent financial crisis. Regardless of your political affiliation, there are substantial reasons to believe that the national mood (and thus stock market values) is likely to be enhanced by a new, young and (at least, currently) popular leader.

Decline in Home Prices Appears to be Stabilizing

The recent Case-Shiller Home Price Index reported that prices declined 18% nationally between August 2007 and August 2008. While this isn't exactly "good news", there is some cause for encouragement - specifically, price declines appear to be decelerating in the current environment. As the chart above shows, the rate of home price declines has slowed in the top 20 real estate markets in the US.

An end to falling home prices will be an important component in stabilizing the financial sector in the long term. Let's hope that the data continues to be encouraging.

Market Commentary

With the recent decision by the Treasury to request that congress authorize it to purchase up to $700 billion in unmarketable mortgages and guarantee the principal on money market funds, it seems appropriate to comment on these historic decisions.
While I have felt that the language used in the last week has been, at times, excessive (“Averting Financial Armageddon” and “New World Order” seem to overstate the severity of the situation), several events, including the short term breakdown of the London Interbank Offering System and the decline of the value of the Reserve Money Market Fund below one dollar, are historic in nature and would have been deeply concerning had immediate action not been taken by the world’s central banks. The cost of the various bailouts requested by Secretary Paulson (including AIG and Fannie Mae / Freddie Mac) will understandably lead to a wave of government regulations with substantial impact on the financial sector, in turn affecting the overall economy and having implications for the long-term returns of various investments.
While my views have not been dramatically altered, they have been somewhat refined by the recent events. The likely responses by congress (and the legislatures of various western countries) do suggest that certain sectors and asset classes will face specific headwinds for several years. Most obviously, all firms, not just financials, will be under pressure to reduce debt. Accordingly, the advice that I will be giving to clients in terms of overall investment policy, and what returns I expect from various investments has changed, particularly in terms of what types of fixed income and what classes of stocks clients should own.
While each client has a differing financial situation, and thus, my advice is different for each client, there are certain observations that are likely to influence what I recommend each client do. Specifically:
• Value stocks are likely to underperform growth stocks. This will probably affect both large and small companies, as value firms are more likely to rely upon debt financing and be interest rate sensitive. While I don’t expect interest rates to increase massively, access to credit for borrowers large and small will be more difficult in coming years. Growth firms will likely find equity financing easier and there will be a demand for growth firms as allocations to debt by institutions and individuals favor the most conservative types of bonds and seek to get their growth from equities.
• Large stocks will likely bifurcate in terms of regulatory headache. The most admired companies are likely to benefit, while companies in the financial sector or with complicated business models will find a challenging political environment. With a whole wave of new regulations coming, it’s reasonable to expect that some companies (e.g. Apple or Toyota) are likely to benefit as “good corporate citizens” while others (e.g. Citibank and Morgan Stanley) are likely to face stiffer rules that limit their ability to grow earnings.
• Traditionally, I have over-weighted small companies in portfolios relative to the overall stock market. While small cap stocks continue to be attractive, large cap seems more so. Small cap equities seem expensive relative to large companies by most financial ratios, and while they have outperformed large companies over the last year, a correction seems due. Given that small company stocks seem fairly valued or overvalued and large companies are probably undervalued, my bias is to neither under or overweight small stocks.
• European stocks are less attractive than US. While foreign stocks have been a traditional source of outperformance in portfolios for the last several years, the credit crisis has probably not reached its high point in Europe yet. Accounting is considerably less transparent in Europe and there are less shareholder protections. A regulatory response to any credit crisis is likely to be more severe. Recent strength by the dollar suggests that despite higher interest rates in Europe, demand for the greenback is growing. Given the fact that demographic and labor trends tend to be more challenging in the most developed EU countries, there seems to be little long or short term attractiveness to western European stock markets. Eastern Europe, particularly Poland, the Czech Republic and the Baltic countries seem to be very attractive in terms of growth potential, but that must be balanced against increased geopolitical risks, which can have substantial impact on domestic investment patterns.



• Emerging markets seem to be overheated. We have recently seen these markets break from their multiyear pattern of outperforming the US and other developed markets. Historically these are either the best or worst performing stock markets and have been highly sensitive to interest rates. For portfolios with shorter time horizons, it seems risky to invest in an asset that has performed so well in the past and which has a pattern of wild gyrations. Regression to the mean seems the primary risk, but there are plenty of compelling reasons to think that this space is overvalued in terms of financial ratios relative to US or other developed stocks.
Over the next few weeks, we will be scheduling investment policy reviews with clients. However, please don’t hesitate to take the initiative and contact me about putting an appointment on the calendar or if you would like to discuss your portfolio before then. In the meantime, we will be using the market downturn as an opportunity to harvest capital losses in taxable portfolios, so you shouldn’t be surprised to see various trades take place.
Best, Mike

Lehman Collapes - Whose next?

Today, the Dow Jones Industrial Average ended down by 504.48 points on Monday, off 4.4%, at its daily low of 10917.51. This brings the blue chip average down 18% on the year. The S&P 500 declined 4.71% and the Nasdaq, 3.6%. In both percentage and absolute value, this was the worst one day decline since September 11, 2001. The carnage was indiscriminate; every stock in the Dow declined.

The general drop can be attributed to Lehman Brothers’ declaration of bankruptcy this morning, following Treasury Secretary Paulson’s notification on Friday that no bailout package (ala Bear Stearns) was coming. It’s true to point out that any earlier effort to cut its losses would have meant a dramatic reduction in Lehman’s size and scope, but obviously, the alternative was worse. Lehman made a gamble that liquidity would return to the high risk mortgage market and it was wrong.

American International Group experienced a dramatic decline (60.8%!) as investors finally accepted the reality that the international insurer has very unclear exposure to risks coming out of Europe and that some kind of save the shareholder – type bailout seems unlikely. The insurer is facing substantial downgrades of its credit ratings, which would likely devastate the firm’s ability to continue as a growing company. It is, in fact, possible that AIG may not be able to honor insurance contracts. Given the massive capital that the company directs ($1 trillion by some estimates), the potential consequences to other companies of an AIG collapse seem to necessitate some kind of government – mandated recovery plan. A shareholder “wipe out” seems likely.

“Deleveraging” seems the order of the day. Trying to unload junk (bonds, loans) to make your balance sheet look better. Banks have been trying to shed risky mortgages, investment banks have been trying to shed commercial loans and everyone seems to be trying to shed real estate. Attempting to strengthen one’s financial situation has led companies to dump assets, which in turn has driven down prices; forcing banks to shed more assets and so forth; A classic viscous cycle.

The question now seems to be what degree of “spillover” will occur between the investment and commercial banks that are now deleveraging (or collapsing) and the broader economy. Will the losses that banks have taken on commercial and personal loans turn into tighter lending standards, which will, in turn, hamper broader economic growth?

My guess is that the effects are being overblown at present. While the collapses of Lehman and (potentially) AIG are concerning, they are a necessary and normal part of the gyrations of the capital markets. While their destruction has been hard on the company’s shareholders and employees, they will generally free up investor funds to be allocated to companies deserving of investors’ money. The bailout of Bear Stearns and the government sponsored enterprises (Fannie Mae and Freddie Mac), while necessary, sent a message (and gave hope) to corporate boards that the consequences of being poor stewards of investors money could be blunted by the taxpayer. Hopefully, this will encourage greater diligence and responsibility. Ultimately, these events are good things for investors in the short term.

So, does this mean that I’m doing anything differently?

By and large, these recent events aren’t affecting my investment strategy. Most of what I’m updating has been little changed by the recent turmoil in the credit markets.

As I have stated pretty much consistently since last summer; I believe that large financial companies are likely to find growth hampered by both governments and investors. It is likely that smaller banks will benefit in the environment going forward. “Too big to fail” are words that no one wants to hear and capital is likely to be much looser for smaller private banks, which will likely dominate aggressive (and profitable) residential and small scale commercial lending. Credit markets are likely to be more discriminate over the next few years, but not completely seize up. This is basically a good thing.

Value indexes, dominated by banks and insurance companies, are likely to experience slower growth for the foreseeable future. And it is for this reason that I think growth stocks are likely to outperform value in the next market upswing.
I suspect that companies that don’t enjoy high levels of investor goodwill and without high levels of transparency in their earnings (e.g. insurance companies) will underperform companies with high visibility. For this reason, I’m recommending that clients reallocate their portfolios towards companies with solid names and positive public perception.

Because of lower accounting standards and more friendly relations with regulators, I suspect that the worst isn’t over for European and Japanese banks. Given the greater sensitivity to banks that the non-US developed economies have historically experienced, I expect that European and Japanese equities will underperform the US for the next few years.

Emerging markets are highly sensitive to credit, investor appetites and regression to the mean. I continue to believe that the risks outweigh the potential benefits of holding these companies and I am recommending that we significantly reduce exposure to these stocks for all, but the longest time horizon portfolios.

For investors in fixed income investments, I have favored cash over bonds for some time. This has been generally the wrong approach, as interest rates have continued to decline over the last year, increasing the value of bonds. But, at this point, I am not intending to change this strategy, as I still feel that investing in longer maturities simply doesn’t justify the risk and the consequences of holding cash over bonds has not been particularly dramatic.

For the truly aggressive, spreads on high yield bonds are looking attractive and it makes sense to start delving into these spaces if one can handle a rocky ride over the next few years. The same thing is true for (shiver) mortgages, which represent probably some of the best buying opportunities for the next several years.

I plan on touching base with all of our clients over the next few weeks to review their portfolios as we approach the end of the year, but, as always, please don’t hesitate to give me a call to discuss your portfolio before then.

Unemployment getting worse...

Unemployment has reared its ugly head ever higher. The recent Bureau of Labor statistics data probably is overstating the rate somewhat at 6.1% (the initial data generally only captures larger employers), but we have clearly entered into the "ugly" realm of labor statistics. The only sector demonstrating growth in the last quarter has been health care - which is hardly the ideal growth engine of the economy.

I don't generally see unemployment as being strongly related to stock prices, but it certainly speaks volumes about the general consumer sentiment and will undoubtedly influence stock markets. What makes visibility tougher, however, is that oil has continued to decline with an increasingly less optimistic economic picture. Oil's price increases have been attributed to the stock market's difficulties this year, so there is some assumption that declines will have the reverse effect.

European and British Central Banks Hold Interest Rates Steady...

Increasingly concerned language regarding inflation has continued from both the European Central Bank and the Bank of England in virtually every policy paper and governor's comment over the last few months. Accordingly, both institutions' decision today to keep interest rates steady, despite significant evidence of a broad-based slowdown in Europe, was hardly surprising.

This, of course, begs the question "why isn't the Federal Reserve as concerned about inflation?" With European short term rates at 4.75% and US rates at 2%, it would seem logical that the US would be more concerned that low borrowing costs are likely to be similarly inflationary; Presumably more so...

While there is certainly dissention among the ranks at the US Fed, the general view in American circles is that the recent declines in commodity prices are likely to have disinflationary effects. Clearly, despite negative real interest rates, yesterday's Beige Book revealed that credit conditions have tightened throughout the country. But, as the ECB's report today pointed out, this appears to be the case in Europe as well. So, why are the Europeans holding rates at a relatively high level, while the Americans are not?

Largely this can be attributed to the labor market differentials between Europe and the US. One of the reasons why recent US recessions have been so mild can be attributed to the relatively weak influence of labor. By and large inflation has helped keep in check by slow growth in wages and increased productivity. The recent increase in unit labor costs of just 0.6% (vs. inflation that averaging somewhere around 4%) is an example of the flexibility that employers enjoy when business slows down. This avoids creating a stagflationary situation where the economy slows and inflation doesn't abate because wages continue to rise.

This stands in contrast to the far more regulated and unionized economies of Western Europe, where wages are often required to be indexed to inflation. This is particularly frustrating when inflationary pressures may be temporary or caused by highly volatile factors (like energy and food prices). For this reason, the ECB's President Jean-Claude Trichet has made it abundantly clear that the reason they are holding such a strong line against what they agree are temporary inflationary factors - which they agree are likely to abate (i.e. oil prices) is because of fears that high rates of inflation will cause a wage-inflationary spiral (i.e. stagflation).

The Governing Council has repeatedly expressed its concern about the existence of schemes in which nominal wages are indexed to consumer prices. Such schemes involve the risk of upward shocks in inflation leading to a wage-price spiral, which would be detrimental to employment and competitiveness in the countries concerned. The Governing Council calls for these schemes to be abolished.

What Trichet is essentially saying is that the indexing of wages to inflation reduces the flexibility that he and his fellow governors enjoy in determining monetary policy.
For these reasons, I think that we need to view the ECB and US Federal Reserve's divergence in policy as a consequence of the labor environment that both must operate within, rather than caused by a belief that commodity prices are likely to continue inflating.

Beige Book Looks Kinda Grey....

The Federal Reserve Bank's "Beige Book" - in which the 12 banks survey the conditions in their individual regions - was largely filled with little new or interesting data. More than likely, short term investors are going to focus on the high level of export growth seen over the last few months and the fact that while interest rates have not appreciated much (if at all), all reports are that credit is much more difficult to obtain than it was last year.

By and large, my experience supports the observation that most banks have become much less willing to extend credit. But, what I am seeing are those clients whose applications for business or personal loans conform to what were considered standard ratios just a few years ago, are finding credit fairly easily to get - at least from institutions who haven't been battered by the sub-prime debacle. In short, I would say that the period of easy credit (lets say from 2005-2008) has come to an end, but conditions are fairly conducive to responsible borrowing. And, those institutions who didn't expose themselves unduly to high risk lending are benefiting from less competition and low interest rates.

To me, this suggests a significant bifurcation has developed between institutions and borrowers. Highly rated credit seekers and well-run borrowers are likely to benefit, while more speculative enterprises are similarly more likely to suffer. Unfortunately, speculation is the primary method by which high returns on equity are achieved and by which aggregate growth is driven. Let's hope that those institutions who haven't been battered by the recent financial turmoil see this as an opportunity to extend their reach into more speculative sectors. But, that they do so with more prudence than their predecessors...

Recent home price declines

Regardless of what data source you're looking at - all point to reduced sale prices in homes over the last year. The real estate recession's flames continue to be fanned by the media with reports of continued declines in home prices, and by realtors who are hungry for bargain hunters' commissions.
My preferred measure is the Case Shiller Index from Standard & Poors, which I believe is a fairly accurate and unbiased indicator. It's calculated monthly and the most recent data for June has been released.

While it shows home prices have fallen significantly since the beginning of the year, a longer term view shows that home prices age generally above their 2003 levels.

Unless you are a fairly short-term investor (and you aren't supposed to view your primary residence that way), then your home has likely been a poorly performing part of your aggregate portfolio of assets recently, but by no means a does that mean that it will be a poor long term investment.

Is unemployment high? It depends on who you ask....

The recent BLS press release indicates that the US rate of unemployment rose to 5.7% - a 4 year high. Not surprisingly, the market is interpreting this negatively, but not as negatively as one might expect. I am increasingly coming to the opinion that the professional investment community sees 5% as the magic number - below is "good" and above is "bad". Probably above 6% is "ugly". By and large, the last 8 years have been characterized by fairly low rates of joblessness - between 4 and 6.3%. This has been interpreted as generally "good" by professional investors who prize stability (which means predictability) - 5% is a nice median number, but that has not been the general view of the broader population, who have by and large expressed great concerns about unemployment and the economy in general.

For individual investors (and the journalists who are their primary window on the world) unemployment is a very difficult number to isolate in terms of preference. Since 1951, the jobless rate has been as high as 10.8% (1982) and as low as 2.6% (1951). During what are commonly remembered as "good times" there has also been a dramatic dispersion in the rate. In the 1950s, the rate was as low as 2.6 and as high as 7.5%! In the 1990s, the rate was as high as 7.5% and as low as 3.9%. With "low" a very relative number, it probably is largely a matter of who your talking to on whether the employment situation is concerning or not. The old joke is probably correct - "it's a recession when your neighbor loses their job and a depression when you lose yours." My guess is that individual investors are largely concerned with the trajectory of unemployment - going down is "good" and going up is "bad".

My guess is that pretty much for everyone; If unemployment rates go above 7.5% - that's not consistent with "good times" (i.e. the 1950s or 1990s), so probably that's "ugly"by most people's standards.

The Budget Deficit: How "bad" is it?

As one looks at the precision with which the various official data is dissected throughout the media, one would assume that there exist defined standards for what numbers "should be" under "normal" conditions. (Whatever "normal" means.) I have frequently heard clients describe economic conditions as one way when I, or my industry colleagues have a very different interpretation of the same facts or figures that are widely reported and universally regarded as important bell-weathers. I find this to be the result of widely different views expressed depending upon the news outlet and a lack of historical perspective by both journalists and readers. In particular, there is a wide cleavage in basic analysis between financial journalists in the mass media, the reporters in the financial press, the professional investment community's own analysts, and politicians who, in a 24 hour news cycle, feel compelled to provide an opinion of every piece of data - even before any economic or financial professional has done so.

The recent revelation that the federal budget deficit in 2009 will be larger than predicted - and a new absolute value record at $490 billion has been described as evidence by the Democratic leadership that the country is rapidly deteriorating. Budget Committee Chair Sen. Kent Conrad blasted the administration for being "reckless" and commented that George W. Bush "will be remembered as the most fiscally irresponsible president in our nation's history."

The current deficit equates to approximately 3.3% of the projected 2009 US Gross Domestic Product. While the dollar number is historically high, its actual impact is pretty much in-line with history and the current budget status other developed countries - most of the EU economies have run equivalent budget deficits to the US in recent years. The US government has rarely run a surplus in the last century and 3.3% is pretty much "normal" for historic patterns of deficits and in the range of what seems to be an "ordained" and structurally tolerable rate of 3% enshrined in the EU's monetary accords for its member states. Accordingly, policymakers and institutional investors are likely to share a similar mindset on the current budget numbers (at least privately). However, expressing outrage is likely to remain popular among opposition politicians as long as the number is negative. I suspect that the institutional investor community looks at these matters relatively (i.e. what are the deficits for other developed countries?), and like individual investors on unemployment - are more responsive to the trajectory of the number, rather than its value.

Going forward, expect that policymakers globally will see 3% as goal- above "bad", below "good. Unfortunately, there's a fundamental disconnect here between policymakers and the general (and investing) population. They are likely to view any negative number as "bad" any only will interpret a negative number as "good". Opinion polls consistently show strong support for balanced budgets and concern for the deficit. This "unexpected" increase can largely be attributed to the federal governments' stimulus package. Ironically, the deficit would have been smaller than expected had the bipartisan stimulus package not been implemented. This is an example of both institutions and politicians viewing things very differently from the man on the street.



The balance of the budget is an area that may be viewed with a degree of neutrality by institutional investors, and be a matter of party affiliation (largely) by politicians, but to the individual, the matter is clear. They don't like deficits and they act as a depressor of public opinion. Thus, a budget deficit is likely to influence investor behavior negatively if its perceived as "bad" and the trajectory is negative.

Why is KKR Going Public?

With investors avoiding anything with unclear risks attached and a general feeling that interest rates are going up, it seems like a bad time to try and sell part of a company whose sole business is borrowing money and investing it in risky ventures. Yet one of the world's leading private equity firms is doing just that.

Private equity and leveraged buyout firm Kohlberg Kravis Roberts & Co has announced its intention to file for an IPO. The firm, most remembered in the public mind for it's negotiation of the RJR Nabisco buyout in the 80s (and dramatized in the book Barbarians at the Gate) is picking an unusual time to conduct this offering, given that IPOs for private equity firms like Blackstone and Fortress have performed so poorly since their entrances in early 2007. And by poorly, I mean both are down more than 50% from their IPO prices. KKR's stated reason for choosing this time is to generate sufficient capital to keep its European affiliate afloat amid difficult market conditions. KKR's publicly traded subsidiary - KKR Private Equity Partners LP (traded on the Euronext) is trading down 44% from it's IPO in May 2006.

Understanding as well as anyone the challenges of the current environment, several covenants are being put in place which will make it difficult for the partners to liquidate their holdings for several years, seeking to reassure investors that they aren't looking for an exit opportunity. Buyers will be doing so because they believe that KKR can continue to deliver the average annual return of 26% that the partnership has enjoyed for the last 30 years. The offering is also being touted as a pretty reasonably priced deal because the company is only being valued at 10 to 12 times its expected 2009 earnings.

The fact is, the guys at KKR have an impressive track record. Given the kinds of returns they've earned for their investors - obviously they're a smart crew. You don't build a 30 year track record by luck alone. But just because they're smart and have done well in the past doesn't mean that this is a good deal for their public market investors. The hassle of being a public company - the scrutiny, the disclosure, the liability that comes from having poor little old ladies own your stock is proving increasingly onerous and a major distraction to management. Presumably, being public acts as an impediment to quick and decisive action - a characteristic assumed of high flying Wall Street financiers. The private nature of these companies was generally seen as one of their strengths. So, why choose to raise money in the public markets instead of going to institutional investors, whom they've earned such massive returns? Given the terms of the deal, the only possible reason is that they are the markets of last resort for desperate firms like KKR and Institutional investors apparently aren't interested. At all. This begs the question, why?

If you expect that KKR can continue to deliver 26% a year, then the IPO is a great deal. Historically mid cap value companies (which KKR expect to be) have returned about 13%annually. This means that KKR would be expected to be 2x as valueable as a mid cap value company. Assuming that the company is only selling for 10x next years' earnings, with the Russell Mid Cap Value index trading at about 20x last years earnings, you'd think that this was a fabulous deal. Institutional investors should be all over this deal - even with the lousyness of the markets and a general skitishness, buying a stock at 1/4 it's fair value should be a no-brainer. They shouldn't need to go public, because institutional investors (which don't include little old ladies to sue you in class action lawsuits) should be all over the deal at these terms and willing to accept the illiquidity of a private investment. Heck - how illiquid would such a great investment be if it performed anywhere near as well as it has historically? It would be a great buy even if the company only returned slightly above 8% a year given it's deep discount!

So this tells us that the "smart money" (not always an accurate way to describe institutional investors, but the most commonly used one) doesn't think that KKR will return even that low percentage return. Who knows? But given the above and the poor performance of Blackstone and Fortress, this deal shouldn't really be possible if the markets are acting rationally. What the KKR IPO will tell us is whether investors are still willing to put aside all of the reasonable data and roll the dice. If they're willing to pay up for this company, then it suggests that there is still a great deal of overvaluation in the markets. I tip my hat to Mssrs Kohlberg, Kravis and Roberts for their past accomplishments and wish them the best in the future, but this deal doesn't make sense on paper.

I hope the investment community rejects this deal, not because I want KKR to fail, but because such a rejection will tell us the markets are starting to act more rationally. By rejecting an offering so clearly fraught with problems, it suggests that they conversely look at the fundamentals and start to recognize the value of truly promising companies as well.

New housing legislation and the Fannie Mae / Freddie Mac bailout

Not surprisingly, Congress is likely to pass legislation this week which will make a limited financial commitment to the government - sponsored mortgage giants and attempt to restart the housing markets. This avoids the unpleasant alternative of guaranteeing the mortgage giants' debt, which would dramatically increase the federal government's overall debt.

The legislation will expand the government's authority over the government sponsored enterprises, particularly their minimim capital requirements (which you can expect them to use), which means pretty much that Fannie and Freddie are likely to be slow growers in the future, as they will be forced to build up their capital and stop buying as many loans. My guess is that, if this legislation proves effective at stabilizing demand for mortgage-backed securities, you'll see it applied to the rest of the financial sector. Generally, I think that banking is likely to be over-regulated over the next few years, meaning a slow growth environment for the financial sector. That having been said, it should survive. Historically, banks were slow-growing, unremarkable, but reliable investments. I think you'll likely see that trend be encourgaged by regulators for some time to come.

Congress will also likely pass legislation allowing the FHA to buy mortgages from distressed borrowers at a 15% discount. Essentially the effort seems to cover institutions that expect that the entire subprime slice is going to default on their mortgages. This will, at least, remove the most skittish debt owners from the market. Certainly pricing on the individual mortgages that I have seen has improved dramatically in the last few weeks and morgage backed securities as a class have started to improve.

As far as mortgage rates are concerned, I suspect that they will trend upward over time, but remain fairly low by historic standards. That having been said, its reasonable to expect that financing will require 25% of the purchase price and the borrowers will need to demonstrate that they will find the cost of the mortgage very easy to handle on their incomes.

NVCA Declares "Capital Crisis for Start Up Companies"

This second quarter has the dubious distinction of being first since 1978 where there were no venture capital backed IPOs. The National Venture Capital Association has recently launched a public relations campaign to get congress to reduce post Enron accounting regulations on startup companies. “Venture-backed companies that successfully enter the public markets represent a critical job creation engine for the United States economy, and that engine has completely shut down,” said Mark Heesen, president of the NVCA. “We need to put regulators, legislators, presidential candidates, and the private sector on notice that this situation represents a serious problem that will have long reaching economic implications if not addressed. We view this quarter as the ‘the canary in the coal mine’.”

Given comments by Brack Obama in his Wall Street Journal Interview and campaign's director of economic policy, Jason Furman, to Larry Kudlow, it seems likely to be an issue in coming debates and feature prominently in his economic agenda. Venture capital firms like Kleiner Perkins have been actively attempting to increase their influence on Capitol Hill over the last few years and cultivating relationships with leading Democratic politicians like Al Gore. Support for tax breaks for venture firms is also likely to be well-recieved by congressional leaders, particularly Speaker Nancy Pelosi (D-CA, San Francisco).

Interesting Chart

A recent report from the Internation Energy Agency arges that large flows of investor capital don't explain the increases in oil prices. "OPEC production is at record highs and non-OPEC producers are working at full throttle, but stocks show no unusual build. These factors demonstrate that it is mainly fundamentals pushing up the price.”
As this chart from the Department of Energy shows, oil consumption patterns have been pretty moderate over the last few years and US consumption has slowed considerably.
Certainly this type of data lends credence to the view that speculation is driving the price of oil, rather than rampant growth from China.

Bear Market Territory: Oil and the Consumer

The recent declines in the various markets, attended by the continued increases in oil prices (as reflected here by the performance of the commodities markets in this chart), have most observers concluding that the two are strongly connected. I agree; Investors, seeing rising oil prices, expect higher inflation and narrower profit margins for companies. This has led them to allocate more of their portfolios to commodity investments, cash and less to equities. This has been a trend over the last few years, and as George Soros observed to congress, has likely been at fault for the closely correlated climbs in several commodities. This naturally leads one to ask why we aren't following so many of our peers and doing the same. Ultimately, this is because I don't expect oil prices to remain this high and expect that most commodities will eventually reverse course. This is not to say that we don't have some clients invested in commodities, just not most and generally not those with very long time horizons on their portfolios.

Someone asked me the other day when I thought that oil prices were likely to decline. As anyone who knows me can attest, I've thought that the price of crude oil was artificially high for several years now and been consistently incorrect in my assumption that oil would eventually return to its "fundamental value" - a number that is generally quoted by oil industry leaders as somewhere between $45 and $65 a barrel. So, while I haven't known when oil would decline, I have been confident that it eventually would. Speculative bubbles always come to an end, and its best not to try and invest once one has begun. But oil prices have continued to increase, understandably testing the patience of many.

High oil prices have finally started to impact the American consumer. Increased gas costs have started to weigh on the national psyche. But, as the upward revision of GDP last week and higher rates of increase in consumer spending last month show, the stimulus package checks (and their expectation of arrival) have translated to stable growth in the short term. The consumer is generally holding up, however different industries (and companies) are responding differently. Clearly, the American consumer is starting to change their purchasing habits, but this hasn't translated into substantially lower spending. And what that largely suggests is that consumers will be changing their spending habits as their preferences adjust to different, more energy efficient products. Businesses are likely to follow suit, but in the short term, higher energy costs are likely to either contract profits or create inflation. It currently seems to be doing a bit of both.

The concerns of most bears in the market currently relate to a repeat of the 1970s - a dark and dismal period for just about everything but film that was characterized by high inflation, low growth and just about every number that you want to be high, being low, and every number you want to be low, being high - and getting higher. Early in the 1970s, oil prices increased dramatically and remained persistently high throughout the decade. The economy did poorly for most of the decade. But, energy prices may not have been as big of a deal as previously thought. In fact, so much went wrong in the 1970s, that it's unlikely any single cause can be seen the primary driver for the long recessionary conditions of the period.



As the relatively good economy since 2001 (the point when prices started to increase) attests (low inflation, decent growth and low unemployment), oil price spikes don't necessarily need to result in a recessions. Their cause is usually political, not economic; The oil price spike in the 1970s was a product of a foreign policy gambit by the Arab nations to force the US and Europe to drop their support of Israel in the wake of the Yom Kippur War. There wasn't a dramatic increase in oil consumption or a reduction in supply, but rather, a "shortage" was created for the purposes of forcing a policy change in Washington by disrupting the lines of supply, which adjusted themselves away from the Middle East for those countries (namely, the US) under the embargo.


The potential for Soviet intervention limiting their foreign policy alternatives, the Nixon Administration's response was to support price control measures on oil which were designed to encourage exploration, but ended up creating artificial shortages. Companies found selling "old oil" to be far less profitable then considerably less "new oil". The perverse incentive to produce less crude resulted in actual (but temporary) shortages of gasoline. Gas quickly was rationed in a way that was reminiscent of World War II. The government began advertising campaigns to encourage Americans "not to be fuel-ish". Rather than giving Americans a sense of comfort that their government was responing effectively to the energy crisis, the general interpretation of events was that the US was considerably less powerful internationally than previously thought and presumably couldn't be expected to maintain stable supplies of foreign oil. This terrified people from Main Street who then began to buy up gasoline to hoard and to Wall Street buy up oil futures to hedge.

The Saudis, the largest producer, caved under the eventual cost of the embargo. Ultimately, the relative strength of the United States as a commercial power triumphed. The Israelis won again and the balance of power in the region shifted from the to the United States. By the late 1970s Saudis had chosen to dramatically adjust their foreign policy towards an effectively vassal state status with the US.

The subsequent Energy Crisis of 1979 at the start of the Iranian Revolution was considerably less challenging for two reasons - firstly, the supply lines had become considerably more flexible in the wake of the experience earlier in the decade and secondly, the response by the government was considerably less dramatic. Once again prices spiked up and eventually came back down.

But the economy did very poorly in the 1973-1981 period and this is where a strong link was established between energy prices and future economic performance. A view I shared, until recent economic performance demonstrated that the relationship between crude oil prices and GDP growth was not necessarily causal.

This time around, energy prices have been driven by several factors, but most of all, they have been driven by spectacular growth in India and China and generally good growth in the rest of the world. This growth has allowed purchasers the ability to afford high prices for petrochemical products. Probably, this strong growth has allowed speculators to drive the price up to current levels. Regardless of whether that's true, the difference between now and 1973 is that the source is actually economic - too much demand. Back then, it was a product of politics. If we believe that supply and demand are related, it's safe to assume that if prices remain persistently high, consumers will adjust their preferences and buy less oil. This should in turn reduce the demand and the supply will increase, leading to lower prices.

The responses that I hear to this fairly obvious reasoning generally argue the while this may happen in the United States, China and India's economies will continue to grow and their demand for oil will as well. This ignores the fact that both these economies are primarily growing through exports. It is difficult to imagine either country ramping up sufficient domestic demand to make up for the loss of growth in their export markets - namely the United States and Europe. We are all interconnected. A much more likely scenario is that growth will more likely be severely impacted in those countries than the US, where domestic demand is the primary driver of an expanded economy. It is for this reason that I am increasingly concerned about the impact on rising energy prices on the emerging markets than the developed.

Consumer Confidence Declines to Lowest Level in 16 Years

The Conference Board's announcement yesterday has confirmed what all of us already knew- the American consumer is scared about the future. Declining home prices, problems with banks, an ever-rising cost of gasoline have all conspired to convince most Americans that the economy's prospects look dim.
One of the debates that has dominated Wall Street and Washington over the last 7 years is whether the economy is actually performing well or not. Inflation, unemployment, taxes and GDP growth have all been characterized by consistent readings that would be considered "good" by most standards. What Alan Greenspan described as the Age of Turbulence has by and large given way to an "Age of Moderation". The first decade of the 21st Century is likely to be remembered as one of relative prosperity and stability in terms of growth, against a backdrop of international tension.
That having been said, perception trumps reality - at least in the short term. And across the spectrum, there has come an increasing perception that oil prices will remain permanently higher and inflation has emerged from a long haitus that began in the mid-1980s - creating poor economic conditions and manifesting itself in a recessionary economy. As the Gallup data below reflects, this view has expanded across the economic spectrum. What is most striking has been the rapid deterioration of public perception since the beginning of the year.

This negative perception extends to the investment markets, where investor optimism, already in a secular decline since 2000, as similarly plummeted. As the chart from UBS / Gallup demonstrates, investor optimism is definitely DOWN.

Naturally, this begs the question - what does this mean for a long-term investment strategy? Research has overwhelmingly (perhaps even conclusively) indicated that no one can reliably pick the bottoms of markets, but there certainly reason to believe that we're certainly closer to the bottom than we are to the top, given the negative general attitudes that dominate the current environment. As I stated earlier, the last time that consumer attitudes were this negative was 16 years ago. As the chart below demonstrates, this was not a bad time to buy stocks.

Taxes and Campaign 2008

In the last two weeks, there has been significant press on the tax reform proposals of both Presidential candidates. Both platforms include substantial tax reductions. Unsurprisingly, McCain's cuts are likely to disproportionately favor the largest taxpayers, while the benefits of Obama's cuts would primarily effect lower income Americans. An excellent study by the Urban Institute concludes that "[The candidates] specific non-health tax proposals would reduce tax revenues by $3.7 trillion (McCain) and $2.7 trillion (Obama) over the next 10 years, or approximately 10 and 7 percent of the revenues scheduled for collection under current law, respectively." Both candidates advocate continuing the 2001 Bush Tax Cuts to some degree and both are arguing for new reductions in the corporate income tax rates, but there are some significant differences in their approaches and, as with all things, the devil is in the details.

What, on the surface, may seem like very similar proposals would have potentially very different effects on the capital markets and broad implications for our clients. Both plans have components that would dramatically influence tax receipts and the economy in general. In particular Sen. Obama's expressed desire to see both long and short term capital gains taxes increased on most assets is quite concerning, because such an increase is likely to discourage the movement of capital and this hinders the proper functioning of markets.

However, his proposals to see capital gains completely eliminated for "startups" is extremely attractive as historically innovation and jobs have overwhelmingly originated from smaller firms and such an approach would seem to be highly stimulative. What Obama's proposal represents as much as anything is the transformation of the Democratic Party - particularly the increasing dominance of Venture Capitalists and other types of financiers. Such a proposal is likely to be treated with a great deal of skepticism for the fact that the Democratic party has a less-than-stellar historic track record (nationally) of supporting small business and many forces in the party (most notably House Ways and Means Committee Chairman Charlie Rangel [D-NY])have actually argued for the rolling back of standing tax legislation that supports venture capital and private equity. It is reasonable to believe that President Obama may find a great deal of resistance to his proposals from old line Democrats, similar to the experience of Carter and Clinton following their elections as relatively economically conservative democrats.

What is most striking is that neither candidate seems to want to commit to balanced budgets in the coming future. By their own admission, but candidates would substantially worsen the fiscal situation of the federal government (at least in the short term), which many observers (myself included) would argue that this will likely highten a general sense of unease and uncertainty with the influence long-term investment patterns negatively. It's reasonable to expect significant resistance to their agendas from fiscal conservatives on either side of the aisle.

I plan on giving a detailed review of the tax proposals of both candidates in a presentation early next month.

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