Wednesday, December 28, 2005

Inverted yield curve predicts 06 recession

11 months ago – per the enclosed – I wondered whether the yield curve and the stock market were predicting a recession in 2006. With the S&P 500 looking to return a meager 4% in 2005 after a 9% increase in 2004, the stock market seems to be suggesting an economic slowdown ahead.

But as today’s Wall Street Journal proclaimed, the inverted yield curve has finally arrived. This is important because
the last six recessions have been preceded by an inverted yield curve.

The yield curve maps the interest rates that lenders charge those who borrow money over different periods of time. In an expanding economy, the short term interest rates, for say 2-year borrowers, are lower than the rates for long-term, say 20-year borrowers.

With such an upward sloping yield curve, banks can pay depositors, say 2%, while lending to long term borrowers at a higher, say 6%, interest rate. Such an upward sloping yield curve would let banks earn a 4% spread, encouraging them to lend out as much as possible. This lending would let borrowers finance purchases and investments -- leading to economic growth.

However, the Fed’s role is to stop inflation and such debt-fueled growth inevitably leads to inflation unless the Fed takes away the punch bowl by raising short-term interest rates. In the last 18 months, the Fed has done just that.
Yesterday, the two-year interest rate rose above the 10-year rate by a fraction. If this condition persists and worsens, then that positive lending spread I mentioned above is wiped out.

Under such an inverted yield curve, it becomes more profitable for banks to hold onto their deposits and to force borrowers to repay their loans so the banks can invest the funds in short-term government securities. This lending retrenchment withdraws liquidity from the economy. Asset purchases financed by this lending slow down. Borrowers are forced to sell these assets to raise the cash needed to pay back the loans.

The quick asset sales cause asset prices to drop which leads to a decline in the ratio of the value of bank loans to the collateral backing them. Since these ratios are stipulated in the lending contracts, when the contract covenants are tripped, the banks have the option of demanding immediate repayment of the loans. This can cause a nasty and rapid tumble in the value of those assets.

With a rising rate at which banks book loans as uncollectible – particularly
consumer loan charge-offs -- trouble may lie ahead for the economy which depends on the consumer for 70% of its growth. This is a particular concern considering that homeowners’ total and mortgage obligations are at a record 16.6% and 10.8% of disposable income.

Whether yesterday’s inverted yield curve is an aberration or a flashing danger signal remains to be seen. But if the current trajectory continues, a recession could be in the (credit) cards (and housing market) for 2006.

-----Original Message-----From: Peter Cohan [] Sent: Monday, January 31, 2005 9:13 PMSubject: Are the yield curve and stock market predicting a recession?

The stock market began 2005 on a down note – declining 3%. However, a flurry of mergers announced in the last few days – coupled with apparent market relief over the results of the Iraqi election – seem to have changed investor sentiment.

But it appears way too early to predict a longer term trend based on one good day. In fact, one of the things that I find so fascinating about the stock market is that its behavior appears to defy rational explanation.

Most market commentators seem to operate according to several pet theories. The most popular seems to be that the stock market averages forecast the condition of the economy. Just for fun, let’s assume that the stock market forecasts the condition of the economy one year ahead. Applying this theory to 2003’s stock market would seem to fit pretty well in retrospect. Recall that the S&P 500 rose 29% in 2003 and as I note in this month’s The Cohan Letter, the economy had its best year since 1999 in 2004.

Playing along with this theory, the 9% increase in 2004’s S&P 500 would be forecasting far more modest economic growth in 2005. And the down market so far in 2005 would hint at a recession in 2006.

Another theory which I first learned about after reading William Greider’s Secrets of the Temple, is yield curve analysis. As Greider explained, when short term interest rates are lower than long term rates, the economy tends to expand. This expansion happens because banks can borrow money at low short-term rates and lend it out at higher long term rates. This so-called ‘carry trade’ allows banks to strengthen their balance sheets and lets corporations borrow enough money to expand their operations.

In the typical economic cycle, however, banks are tempted to lower their standards once their best quality credits have borrowed to their limit. At some point, inflation creeps into the economy and the Fed raises short-term interest rates so high that short-term rates exceed long-term ones – creating the ‘inverted yield curve.’ The inverted yield curve is an excellent recession predictor since it tends to make it unprofitable for banks to lend -- cutting off credit and accelerating economic retrenchment.

I will never forget an appearance I made on CNBC back in 1999 in which I noticed that the yield curve was becoming inverted. The reporter, Liz Clayman, asked me whether I thought that we were heading for a recession. And I am embarrassed to say that I had consumed enough New Economy Kool-Aid to answer ‘no.’

Of course a recession was not that far away. And as the yield curve flattens out, it may be that 2004’s modest stock market performance coupled with January’s negative result could be predicting another recession on the horizon. Let’s hope that our record levels of government borrowing don’t lead to a record level of retrenchment.

Saturday, December 17, 2005

AOL rebounding

Aided by a spiky kick in the posterior from Carl Icahn, AOL is rebounding. But Google’s deal with AOL appears to undervalue AOL significantly.

The deal with Google blocks Microsoft from gaining control of AOL and gives AOL advertisements special placement on Google’s site. By agreeing to change its business practices for this deal, Google blocked a potentially significant challenge from a combination of AOL and Microsoft and temporarily secures Google’s leadership in search advertising.

The deal reminds me of how far AOL has fallen from its peak. Google’s $1B deal for 5% of AOL values AOL at $20 B – an 88% decline from AOL’s $166 B valuation six years ago. At 20 million, AOL has roughly the same number of subscribers
now as it did in January 2000. Back then, AOL was valued at $8,300 per subscriber, today’s deal values those subscribers at an 88% discount of $1,000 per subscriber. But since its low of $8.70 in July 2003, the company’s market capitalization has more than doubled.

Carl Icahn has alleged that he would sue AOL’s board if it does a deal that undervalues AOL and called this deal
a travesty. With TWX stuck at roughly Icahn’s basis, it has become clearer that Icahn’s bark is worse than his bite. However, he and his colleagues may have increased AOL’s sense of urgency.

While Icahn may be overstating his case, the Google deal appears to undervalue AOL. How so? Based on an estimate of
110 million unique monthly visitors (UMV), the Google deal values AOL at $181/UMV. While not perfect comparisons, Yahoo, with 169 million UMVs, trades at $355/UMV, is worth roughly twice the implied valuation of AOL based on the Google deal. Google, with 88 million UMVs, is worth $1,477/UMV, over eight times AOL.

That a deal happened at all may be a testament to Icahn’s influence. But this potential valuation gap will give Icahn another spike with which to prod Parsons.

Sunday, December 11, 2005

Decisions of a disturbed mind

I believe the current oval office occupant is a disturbed individual who makes mostly bad decisions.

The disturbed individual part would really be none of my business was it not for the power of the office which the individual occupies. George W. Bush is a recovering alcoholic (although a
September 21, 2005 report in the estimable National Enquirer and other unpublished observations would suggest that he has fallen off the wagon). Alcoholism is a disease which leads to some nasty interpersonal behavior – obsessive secrecy, inability to take responsibility for one’s actions, angry lashing out at others, and a keen ability to create a network of co-dependents. Regrettably, these symptoms do not evaporate when an individual undergoes a God-for-booze-swap as this president allegedly did.

I believe that alcoholism does not fully explain the disturbed nature of this individual. Another important factor is the more- pronounced-than-usual oedipal complex in the relationship between the father and the son. While the father was captain of the baseball team, the son was a cheerleader. While the father aced Yale in three years, the son did not. While the father succeeded in the oil business, the son flopped.

In the field of politics, however, there has been an interesting role reversal. Where the father raised taxes to stanch the flow of budget red ink, the son cut them. Where the father built an international coalition to oust Saddam from Kuwait – while leaving Saddam in power -- the son launched a unilateral preemptive war to capture Saddam. And while the father coasted downhill on his popularity following a war win – leading to a second term defeat -- the son was reelected to a second term.

But the role reversal has done nothing to minimize the son’s maternal fixation. Instead the
Bush Bubble holds most reality at bay – staffed mostly by a loyal circle of women including his mother, his wife, Secretary of State Condoleezza Rice, Undersecretary of State Karen Hughes, and White House Counsel Harriett Miers. Interestingly, Bush rarely talks with his father – viewing a recent New Yorker article by his father’s National Security Advisor, Brent Scowcroft, as his father’s latest disloyalty to the son.

Before launching into the litany of bad decisions emerging from the son’s disturbed condition, let me highlight one decision I agreed with – the invasion of Afghanistan after 9/11.

There are many I disagreed with though. To wit, he demonstrated a fatal incuriosity about the
August 6, 2001 Presidential Daily Briefing “Bin Laden Determined to Strike Inside the US”. He spent that month on a ranch in Crawford communing with God to figure out how hard to clamp the brakes on stem cell research. He decided to let Bin Laden get away in the December 2001 Battle of Tora Bora.

cut $1.6 trillion worth of taxes, 36.7% of which further enriched the top 1% of families in the US. He took a government with a $236 billion surplus and turned it into one with a $412 billion deficit while increasing its debt load by $3 trillion.

He manufactured a fake casus belli
– Saddam’s imminent threat to use nuclear, chemical and biological weapons and his ties to Al Qaeda -- to justify launching a preemptive war in Iraq. He told the world that the US would be greeted as liberators in Iraq. Although the connection has not been made to him personally, someone ordered the torture at Abu Ghraib as well as all the other places where we piously proclaim “Liberty is America’s gift the world” while we “render” prisoners to countries where they can be water-boarded outside of earshot.

He rewarded those who were wrong and loyal and fired those who were right.
He gave Presidential Medals of Honor to the architects of the Iraq disaster – General Tommy Franks, who oversaw combat in Afghanistan and the initial invasion of Iraq, former CIA Director George Tenet and former Iraq administrator L. Paul Bremer. And he fired the general who told him that it would take 300,000 troops to secure Iraq (the general was right) as well as the economic advisor who told him the war would cost $100 billion (it’s cost over $300 billion so far).

And he continues to refuse to take responsibility for any mistakes – instead lashing out at those around him – even as the broader US population slowly begins to realize the extent to which it has been deceived.

Friday, December 02, 2005

Back to the future?

I was delivering a final lecture to my Strategic Decision Making class at Babson College yesterday morning. I mentioned that I had not been invited as a guest on CNBC in a long time. In fact, the last time I had been on CNBC – after about 15 appearances since 1998 – was in August 2001 after the publication of my fourth book, e-Stocks. I am not sure what the reasons for hiatus were; however, I think it may have something to do with the dot-com crash and its aftermath which put a bit of a crimp in the technology stocks on which I had been asked to comment during those 15 appearances.

This long hiatus just ended. About noon yesterday, I received an e-mail from a producer at CNBC asking if I could appear on "'The Closing Bell" with Maria Bartiromo at 4:30pm to comment on whether Carl Icahn's battle with Time Warner would scare away possible AOL suitors. I was guessing that this producer had read my comments on this topic in the previous day’s Red Herring.

According to people who contacted me after the appearance, it went well. My take was that Time Warner’s stock is down 76% since January 2000 and at a current $18 it is trading a conglomerate discount – so it should be broken up – selling AOL to Microsoft, Google, or Yahoo and the cable business to private equity firms. I opined that since Icahn has threatened to sue Time Warner’s board of directors if it does not sell AOL for a sufficiently high price, his involvement imposes what I called the Icahn Put on Time Warner’s AOL unit. This means that there is an implicit floor on the price at which AOL is likely to be sold. If potential bidders think that floor price is too high, they may withdraw from the bidding. Bartiromo asked me what AOL was worth and I dodged the question – noting that it was worth whatever price Time Warner and the bidders agreed on. I did point out; however, that Icahn thinks all of Time Warner is worth $27 – a 50% premium over yesterday’s price.

I find Icahn’s efforts interesting for many reasons. First, it reminds me of the 1980s which featured junk-bond fueled takeovers in which Wall Street gunslingers, such as Icahn, put fear into the hearts of corporate executives. Instead of junk bonds, we now have private equity coupled with hedge funds acting as catalysts. Second, I am intrigued by the Icahn’s longevity –reportedly he has done 56 deals between 1996 and 2004, generating 53% average annual rates of return yielding $2.8B worth of gains. Forbes recently estimated his net worth at $8.5B. Third, I believe that there are many companies trading at a conglomerate discount which could be ripe for breakup – particularly if Icahn succeeds in his current efforts with Time Warner.