Saturday, November 15, 2008

Buy Baby, Buy

What happened? Were we bushwhacked, or should we have seen it coming? How did we end up in the middle of a perfect storm at a most imperfect and inconvenient time? Here we are, supposedly the most sophisticated and certainly the most technology adept and computerized country in the world, suddenly confronted with doubts as to whether a capitalistic based society is, as almost universally accepted by our citizens, the best system within to live and prosper.

Popular Delusions

It is only eight years ago that the bubble burst, and investors thought. “Never again, we learned our lesson.” But it seems that mankind has a deficient “bubble” gene that malfunctions when least expected. That malady might be best expressed as follows: “Popular delusions began so early, spread so widely, and have lasted so long, that instead of two or three volumes, fifty would scarcely [be] sufficient to detail their history. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first…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.”

Those thoughts were written in 1841 by Charles Mackay as part of the preface to the seminal book titled, Extraordinary Popular Delusions, and the Madness of Crowds. The book was influential enough for Bernard Baruch to credit it for his withdrawal from the stock market ahead of the Crash of 1929. The book described the Dutch Tulip mania in the 17 th century, the South Sea Bubble in England in 1711-1720, and the Mississippi Scheme in France in 1720. More recently we can chart the Nifty Fifty stocks in the early 1970’s, Japanese stocks in the late 1980’s, and the Bubble in the late 1990’s. The worst of the lot of course was the Crash of 1929, when according to a recent article in the Wall Street Journal, “The Dow Jones Industrial Average closed at 41.63, down 91 percent from its level exactly three years earlier.”

Bubbles Do Burst

The problem is that the vast majority of professionals, much less individual investors, do not recognize––or at least suggest––that a bubble is in the making until it has burst. James Grant, editor of Grant’s Interest Rate Observer was quoted in The New York Times as providing the following humorous explanation: “People keep stepping on the same rake because money, like romance, is only partly an intellectual experience.” Mr. Grant continued, “Money, like sex, brings out some thought––but also much heavy breathing and little stored knowledge. In finance the process is cyclical. Some people learn from their ancestors, but mostly they repeat the same mistakes. Thus it has always been, and thus it will always be.”

Past failures to recognize a bubble in some tangible manner have led to a number of dire consequences. For example, the last bear market––March 2000 to October 2003––resulted in the S&P 500 Index dropping over 49 percent. About 75 years ago, in 1932, the Index fell some 60 percent over the following five-year period. There are some who predict that the current disaster could end up even worse than the 1929 debacle. Others believe that unlike the inaction of the Hoover administration then, the aggressive intervention currently, will produce much better results.

Is Now the Time to Buy?

So, what should the average investor do now? There are very few people smart enough and reliable enough to answer that question. (I certainly am not one of them.) However I can cite the opinions of a few that I believe might fit the bill. One happens to be the financial genius I admire most.

In an op-ed piece in the Wall Street Journal, the following headline appeared:Buy American, I Am.” The opening paragraph read, “The financial world is a mess, both in the United States and abroad. Its problems moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter, and headlines will continue to be scary.” The author continued, “So…I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but U.S. government bonds.” Who do you think would have been smart enough to plan a stock-free personal portfolio, and thus avoided the recent stock market meltdown? If you haven’t guessed the author of that op-ed piece by now, it’s Warren Buffett.

It’s his recommendation that prompted the Buy Baby, Buy headline at the top of this article. He explains his philosophy quite succinctly writing, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly fear is now widespread, gripping even seasoned investors.”

A brand new 950 page authorized biography titled The Snowball: Warren Buffett and the Business of Life was just released and is already number one on The New York Times bestseller list. Some might remember my six part series of articles published here in Viewpointe a few years ago. I described the enormous influence of Benjamin Graham, Buffett’s teacher at Columbia University, who also became his mentor and idol. In the 1929 Crash, just eight days before stocks hit rock bottom, Graham summarized, “…stocks always sell at unduly low prices after a boom collapses.” He went on, “Or stated differently, it happens because those with enterprise haven’t the money, and those with money haven’t the enterprise.”

Buffett learned well at his master’s feet and wrote accordingly in his op-ed piece, “Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month – or a year – from now. What is likely however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.” He ends his piece this way: “I don’t like to opine on the stock market and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: ‘Put your mouth where your money was.’ Today my money and my mouth both say equities.”

Sage Advice?

But Buffett is not the only sage recommending equities. Two well known and highly respected finance professors echo Buffett’s philosophy. Burton G. Malkiel, economic professor at Princeton says, “But just because stock markets have panicked, investors should not. The best position for investors today is not ‘fetal and 100% in cash.’ We are not going to have a depression, and we have survived financial crises before. A century of investing experience, as well as insights from the field of behavioral finance, suggest that investors who bail out of equities during times like these are almost always making the wrong decision.”

Professor Jeremy Siegel at the University of Pennsylvania Wharton School wrote in U.S. News & World Report, “I think these [low] prices will be viewed as extremely cheap even a year from now and people will wish they had the guts to go in. We’ve come back from every bear market and moved on to new highs. Those people with long horizons should look at this as an excellent opportunity to accumulate stocks.”

But note the phrase “long horizon.” Therein lies the rub. According to S&P Index Services, since the 1930’s there were 11 bear markets. The average incurred a loss of 34.1% over a 20-month period. However the worst one in the 1930’s lost 60% of its value and lasted for 62 moths. There was also about a 16-year period when the Dow started at 825 and ended in 1982 at only 826, no gain whatsoever. However, offsetting that, over the same 78 odd year period from the 1930’s, there were 12 occurrences of bull markets that averaged a 164% gain over an average of 57 months each. In other words, the average bull market not only outperforms the bears by five times, it also lasts almost three times as long.

The point here is that while historically speaking, Warren Buffett, the professors, and the above headline are probably correct, it depends on your time horizon. If you are at a point in life when you repeat the old saying, “I don’t buy green bananas,” more caution might be desirable. However, when my son, who is also a Buffett aficionado, asked my opinion of Buffett’s advice, I suggested, “Buy Baby, Buy!”

Saturday, November 01, 2008

Infrastructure Insanity — Part IV

In 1919, a young Army Lieutenant Colonel traveled with a convoy of Army vehicles on a cross-country trip from Washington D.C. to San Francisco for the purpose of establishing the viability of the nation’s highway in the event of a military emergency. He wrote, “The road is one succession of dust, ruts, pits and holes,” also reporting of impassable and unstable sand and wooden bridges that cracked beneath the weight of the trucks. Even more telling was the startling revelation that in Illinois the convoy “started on dirt roads and practically no more pavement was encountered until reaching California.” Not surprisingly, the trip took 62 days.

As reported in Mother Jones magazine, “37 years later, this same Army officer, Dwight Eisenhower, as President of the United States, completed a quest inspired by this youthful journey and by his World War II observations of Germany’s autobahns, to build a national road system for the United States.”

It was in 1956 that Eisenhower signed the Federal Aid Highway Act that some called “the greatest public work project in human history.” Mother Jones describes it as calling for “the federal and state governments to build 41,000 miles of high quality road across the nation, over rivers and gorges, swamp and deserts, over and through vast mountain ranges.” Despite his reputation as an old-style fiscal conservative, he considered this interstate highway system so vital to the public interest, he authorized the federal government to assume 900 percent of the huge cost. Despite the significant expenditure, think of the beneficial consequences of this action in terms of job creation, economic impact, and productivity enhancements.

Costs Are Astronomical

In spite of the mammoth undertaking that resulted in our current interstate highway system as well as our local roads and bridges, a 2006 report on the “Status of the Nation’s Highways, Bridges and Transit,” estimated the cost to just maintain that existing infrastructure at $78.8 billion annually through 2024. But that’s just the beginning. The cost to improve highways and bridges would exceed $131 billion annually.

With the current financial crisis now facing us, including a probable recession; an existing astronomical $10 trillion debt plus the half a trillion deficit for the current year; the $10 billion a month expenses in Iraq; our exploding under funding for Social Security, Medicare and Medicaid; will there be any degree of political will to fully fund our infrastructure needs? There may be a solution, but first let’s address the American Society of Civil Engineers (ASCE) Report Card on the various Infrastructure categories.

The Report Card

As indicated in last month’s article, Roads received a grade of D, Bridges a C, [Public] Transit (that recently became one of the fastest growing categories) a D+, and Aviation (that has deteriorated sharply from 2005) a D+. Drinking water received a D- (federal funding is less than 10 percent of what is needed), and Wastewater, where systems discharge billions of gallons of untreated sewage into U.S. surface waters each year; Navigable Waterways also received D- (50 percent of locks are obsolete despite the fact that one barge can move the same amount of cargo as 58 semi-trucks at one tenth the cost).

“D” grades were assigned to Schools, and in what seems to be almost criminal neglect, a 2006 survey from the American Federation of Teachers noted that nearly 1,000 teachers and school staff members “reported persistent problems such as falling ceiling tiles, poor lighting, crumbling exterior walls, asbestos, severely overcrowded classrooms and hallways, freezing rooms in winter, and extreme heat in summer.” That all sounds like a third-world country. The ASCE estimated that a quarter of a trillion dollars is required to bring the nation’s school buildings up to “good” shape. A “D” was also assigned to Hazardous Waste where 1,237 contaminated sites were listed, with a possible listing of over 10,000 more.

The outlook for oil independence depends to a great extent on our ability to hook up the potential alternative energy systems to the National Power Grid. However our existing electricity transmission system is aging and a 2007 report stated, “Without additional resources, many parts of the nation, especially California, the Rocky Mountain states, New England, Texas, the Southwest, and the Mid-east could soon fall below the target capacity margins for power generation transmission.” The result is a “D” rating.

As indicated earlier in this series of articles, the above grading information is now three years old and will not be updated until 2009. The $1.6 trillion required to fund our infrastructure needs is more likely to approach $2 trillion in the report due in 2009. The following quote describes the problem most succinctly: “…the federal government has failed to provide the leadership it alone can supply. Federal spending on infrastructure, corrected for inflation is actually lower that it was in 2001 despite the [until recently] growing economy, the well-known disrepair, and obsolescence of our assets, and the rising costs of their inadequacy. And this level of spending, as a share of GDP [Gross Domestic Product] is much lower than it was two decades ago.”

A Possible Solution

That quote was from a remarkable article in the October 9 th issue of New York Review of Books, co-authored by Felix G. Rohatyn, investment banker, former ambassador, and a central player in the 1975 plan that saved New York City from bankruptcy. Expounding on the above criticism, he explains, “This public penury is lamentable, but if it conceals a second and perhaps even more fundamental problem with public policy; not only do we fund infrastructure inadequately, but the policies we have in place are incapable of funding the needed projects or creating the incentives to manage correctly what’s already been built. This is the unseen and ultimately more critical part of the infrastructure – the extent to which our spending programs are misdirecting our investments away from the best opportunities.”

In order to resolve these intrinsic problems, Mr. Rohatyn co-chaired, along with former Senator Warren Rudman, a Commission on Public Infrastructure at the Center for Strategic and International Studies in Washington D.C. to outline a new and different approach to selecting, financing and managing infrastructure. Last year, the commission produced a consensus report, and a bill to enact its approach, the National Infrastructure Bank Act of 2007, has been submitted by Senators Chris Dodd (D, Connecticut) and Chuck Hagel (R, Nevada). A companion bill has been presented in the House of Representatives.

The intent is to establish a bank similar to the World Bank, one that would replace the current unstructured and basically chaotic programs for highway, airports, mass transit, water projects, and other infrastructure projects, “streamlining them and folding them together into a new entity with a new culture and purpose. Any project seeking federal participation over a set dollar threshold would have to be submitted to the bank. A chief executive would be appointed by the resident and be confirmed by the Senate.”

As expressed in Mr. Rohatyn’s own words: The central idea “is to establish a National Infrastructure Bank, an institution that would be similar to the World Bank, a private investment bank, or any other entity that evaluates project proposals and assembles a portfolio of investments to pay for them.” He continues, “The purpose of the Bank would be to use federal resources more effectively and to raise additional funding. We propose this bank because we believe that markets for capital do work and can be harnessed to solve the critical shortfall in funding infrastructure.” Mr. Rohatyn explains that the bank would have a board of directors that included key Cabinet officers, and members appointed by both the executive branch and congressional leadership; its chief executive would be appointed by the president and confirmed by the Senate. Presumably, with this entity in place the haphazard and politically manipulated earmark type monetary allocations would be eliminated from the infrastructure process.

It is generally acknowledged that not only have our infrastructure imperatives been severely neglected in the past, but based on the extremely bleak existing economic conditions, the outlook for necessary infrastructure outlays will also worsen. It is therefore, seeing that the Infrastructure Bank Plan might be gaining traction. Particularly heartening is the fact that Barack Obama has also embraced the proposal.

There is however, another phenomenon already taking place that could revolutionize how infrastructure is funded––one that could completely change the financing dynamics, but one that has also initiated a great deal of controversy. This is a process called PPP, ˆP3’s, or Public-Private Partnerships. It could affect us right here in South Florida. Next month’s issue will discuss the pros and cons.