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January 06, 2009

2009 Outlook: Angling For A Recovery
by Brady Willett and Todd Alway

Give a man to fish and you feed him for a day. Teach him how to print money and you feed him for a lifetime? Juxtaposed against this seemingly outlandish re-write of the popular Chinese proverb is the image of the U.S. trying to inflate away the ills of asset and debt deflation. To be sure, with zero-bound interest rates unable to revive the lending/borrowing/asset bubbling dynamic that has helped support U.S. economic growth for the better part of the last two decades, policy makers have resorted to directly buying toxic/illiquid assets, lending to unqualified borrowers, and investing in insolvent entities. And thanks to the power of the printing press (not to mention the continued kindness of foreigners), these activities are largely being funded out of thin air.

A good example of what the supposed bailout masters have hauled out of their tackle box can be seen in the story of Citigroup: The downfall of the World's largest financial services company serves not only to remind us of the accounting insanity FASB and the SEC have allowed companies to get away with for decades, but also of how pervasive the accumulation of engineered financial assets was during the boom years. With these 'assets' now increasingly going bust, the bailouts have multiplied in kind, and this has led to questions aplenty. Does the socialization of losses augur for a sustainable recovery? Will the U.S. be able to print/cheaply borrow enough money to fund its bailout plans? Engrossed in trying to rig the markets from falling further, will the much needed and promised regulatory changes ever arrive to increase investor transparency?

2009 may not bring definitive answers to these and other questions, yet as policy makers increasingly take on the role of hedge fund manager and as hedge fund managers increasingly become unemployed or imprisoned, they are questions unlikely to materially change anytime soon.

The Big One That Got Away (from bankruptcy)

Citigroup's 'Consolidated Variable Entity Assets' (VIEs) declined by 32% from $122 billion to $82 billion for the 9-months ending September 30, 2008, while during the same time Citigroup's 'Significant Unconsolidated VIE assets' declined by only 8.9% from $356 billion to $324 billion, and 'Qualified Special Purpose Entity' Assets (QSPEs) increased by 6.9% (from 765 billion to $812 billion). All told Citigroup reported a stunning $1.225 trillion in off-balance sheet interests at the end of September 2008.

It doesn't take much imagination to conclude that Citigroup, with only $62 billion in tangible equity, would not have been able to absorb the additional $380 billion hit that would have arrived if the company's unconsolidated interests had fallen by the same percentage amount as its consolidated interests. On the other hand it takes a great deal of imagination to conclude that with nearly every consolidated asset on Citigroup's books getting slaughtered its unconsolidated interests seemed to be doing just fine.

But whether or not Citigroup was/is hiding some losses off of its balance sheet or in Level 3 land is really immaterial. To be sure, given the widespread destruction in the financial markets in October and November it was obvious that already lame Citigroup would not be able to conceal insolvency for much longer. Faced with the prospect of another Lehman Brothers debacle, the bailout masters entered:

"As part of this agreement, Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $306 billion of loans and securities backed by residential and commercial real estate and other such assets, which will remain on Citigroup's balance sheet...In addition, Treasury will invest $20 billion in Citigroup from the Troubled Asset Relief Program in exchange for preferred stock with an 8% dividend to the Treasury." Fed

Following news of the bailout, Citigroup shares quickly doubled - disaster had apparently been averted. Pleased that their efforts had helped forestall certain collapse the Treasury updated the language of its Asset Guarantee Program last week, offering added justification for its bailout of Citigroup (weeks after the fact):

"This program provides guarantees for assets held by systemically significant financial institutions that face a high risk of losing market confidence due in large part to a portfolio of distressed or illiquid assets. This program will be applied with extreme discretion in order to improve market confidence in the systemically significant institution and in financial markets broadly. It is not anticipated that the program will be made widely available." Treasury

After having allowing the reckless borrowing/lending/asset bubbling dynamic to proliferate, and failing miserably to grasp the severity of the housing bust, U.S. policy makers are now assuring us that its most stunning bailout initiative to date will be 'applied with extreme discretion' and that 'it is not anticipated' that many other Citigroup-style bailouts remain. Talk about a good fish story...

Suffice to say, Citigroup represents the final final line in the sand by U.S. policy makers; the line that says anything deemed 'systemically significant' will not be allowed to fail. Period. There will not be anymore stress-filled weekends with policy makers covertly trying to orchestrate takeovers and conjure up new ingenious lending schemes, there is not going to be another lengthy and confusing TARP saga, and there will most definitely not be any more Lehman Bros. breakdowns. Rather, if, and more likely when, someone important is in trouble the Fed, Treasury, and FDIC will backstop losses, provide loans, and/or directly invest using taxpayer funds. This is the really big story of 2008 - one that engenders both confidence that that the worst is over and fear that the worst is yet to come.

Hidden within Citigroup's VIEs and QSPEs are billions of dollars that are 'invested' in CDOs, SIVs, ABCPs, MBSs, CDSs, and other financial instruments. The Fed and Treasury, by their own admission, do not know how to effectively value these investments, and with many engineered financial products threatening to become endangered species it is unclear if any 'value' will soon be observable. There is, by contrast, the viewpoint that current market prices, or lack thereof, do not represent a fair value given the amount of cash some of these products may continue to throw off. As 2009 begins it is this speculation that leads to a particle of optimism insofar as the bailouts are concerned:

* Perhaps U.S. policy makers are not recklessly expanding the taxpayers involvement in the largest financial calamity since the Great Depression but simply investing in distressed assets to generate positive returns in the future?

With investors watching the economy wade into deeper recessionary waters their lifejackets have been stuffed with variants of the above. Will investors really be gullible enough to buy into this belief hook, line, and sinker?

Needless to say, the correct policy response to the financial crisis and recession that picked-up speed in 2008 would have been to do nothing; to allow bad debts to be written off and to allow free market capitalism to work. Under these conditions the fallout would have indeed been swift and deep, but it would have also brought with it much needed doses of certainty and closure. As per the band aid analogy, it is better to quickly rip it right off.

Oblivious to the need for a dramatic change in the way regulators interact with the markets, the exact opposite tact has been taken, with dozens of band-aids being haphazardly applied. Moreover, with his rod and reel in hand President Obama - whose very platform centered on the word 'CHANGE' - has emerged from the murky waters and is angling for even more bailouts, a massive government stimulus package, and tax cuts. Apparently change can wait...

Suffice to say, straddling the already saddled U.S. taxpayer with more debt obligations threatens to exasperate the current crisis rather than cure it, because the U.S. is ill-prepared for the day when foreign appetite for U.S. debt wanes. As for Citigroup, the entire financial apparatus may well have fallen down if it had been allowed to fail, but from this rubble a new attitude might have also emerged. It is this 'attitude' that the U.S. has sorely lacked for a very long-time. In other words, as was the case with LTCM - a point we highlighted years ago - Citigroup should have been allowed to fail.

Fishing For Returns In 2009

We highlighted 8 prophecies in this space last year, and with the possible exception of gold not seeing a historic bust (the verdict is still out), all 8 came true. Given that in all probability we will never replicate the uncanny accuracy of last year's prophecies, please allow us to indulge for a moment before conjuring up the spirits of 2009:

2008 prophecies (abbreviated - from Jan 7, 2008)

1) As the U.S. economy enters recession the rest of the world will feel the consequences.

2) As 'decoupling' proves itself fiction and U.S. investors check their confidence in foreign stocks, U.S. equities will outperform many world markets in 2008.

3) The U.S. dollar will tread water for much of 2008 rather than drown...don't be surprised by a stable greenback in 2008. Despite models and rap-stars flashing their admiration for Euros in 2007, it is still in the best interest of most of the financial world to support rather than run away from the dollar.

4) Gold is headed for a historic bust akin to that of 1980. This bust will arrive once the U.S. economic slowdown starts to deeply erode strength in emerging markets and/or once investors recognize that central banks are unable to quickly reflate the financial markets. With nearly everyone growing deeply enamored with the idea of 'stagflation', our gold bust theory is based upon the yet unseen threat of deflation.

5) China will burn out but will not fade away...Like the U.S. based internet mania, no one can be exactly sure when, but a great Chinese stock market bust is coming. When it starts everyone will claim it was obvious, although only a handful of analysts are bearish on Chinese stocks today.

6) Commodity prices will decline in 2008. Going against the grain with this call (not to mention the surging price of 'grains')...As the global economy 'recouples' demand for many commodities will flatten and commodity super-cyclists will spin their wheels as no new driver powers the commodities train forward. We see base metals as leading this softening commodities price trend by mid-late 2008.

7) Crystal ball grabag: The Federal Funds rate will end the year at or below 2%. Long-term U.S. interest rates will end 2008 flat or lower. U.S. equities will end 2008 lower, although they will not be down as much as many world markets. The contrarian dream of Japanese equities will remain exactly that.

8) Greenspan is already receiving his share of bad press, but by the end of 2008 his image will be fully transformed from that of miracle worker to wacko alchemist. No one will remember the 'good times' Greenspan supposedly helped create as times turn increasingly bad.

Based upon the above, our intentions leading in 2008 were to "lower our precious metals position as the gold price rises and slowly add to our equities position as stock prices decline". And while we basically followed this outlook via a reduction in precious metals in early 2008 and the addition of a couple of stocks throughout the year, what we did not envision is that stocks would decline so rapidly and policy makers would attempt to reflate so desperately. In other words, there are valid reasons to believe that the record gold high seen in 2008 was not the start of a historic bust but ground zero for the next launch.

Before getting to 2009, it is worth pointing out that we are generally conservative investors and the speculations below are undertaken in an attempt to flush out some basic macro ideas. They are not, in any way, a method by which to generate profits. We believe that owning companies you understand at attractive market prices and being aware of longer-term advantages of owning gold instead of the liabilities of a government are useful. We have held firm to this stance since 1999. Without further adieu, here are the prophecies:

1) The global recession will deepen to begin 2009, unemployment will not bottom until mid/late 2009, and a sustainable recovery is years away. But this does not mean we are in another Great Depression. The key difference between the Great Depression and today is that policy makers have taken away many of the panic-pathways previously available to frightened investors. In other words, with systemically important bad debts being backed by government and Fed, with post-depression efforts insuring bank deposits, and with much of the money in 'the markets' either passively controlled or restricted from being removed, the risk of a complete meltdown is remote.

Caveat: If more and more investors continue to move into gold out of a fear that paper assets will continue to be destroyed all bets are off.

2) The great U.S. dollar bust will draw closer but will not come to pass in 2009. Those that believed that the financial crisis in the U.S. would spell the end of USD hegemony were patently wrong. Instead of a global panic out of dollars in the latter half of 2008 there was a global panic into dollars. We would speculate that the U.S. dollar now has room to fall without sparking a panic, and that no real alternative to USD hegemony is coming into view. As for the contention that precious metals are a major contender to USD hegemony, we agree that longer term this may be the case although the parties that are funding the U.S.'s borrowing extravagance (i.e. central banks) have not shown the same penchant for gold as private investors.

To get a better understanding of why the U.S. dollar will remain ultra-important in 2009 consider that as recently as June 2008 the IMF was giving serious consideration to the possibility of the Russian Ruble becoming a major reserve currency. Only months later, with Russia devaluing the ruble, fears of outright collapse have surfaced. Also consider that the bloom has come off of the Euro's rose, the Chinese Yuan is showing no sign of revaluing higher, and the Yen is rising for reasons wholly unrelated to reserve currency considerations. In short, the question that those calling for the destruction of USD (or the 'hyperinflation' crowd) need to ask is: when people run out of U.S. dollars what do (or more appropriately 'can') they run into?

3)U.S. stocks will end the year flat or higher and will continue to outperform on a relative basis. The Fed has done its best to induce risk taking and there is a lot of 'cash' that could move back into equities. These two points alone augur for a rebound in stocks, even if such a rebound proves unsustainable.

For the record, we do not think that U.S. stocks are as 'cheap' as many value orientated investors believe. Rather, from a book value perspective we would argue that stocks are down right expensive! In the case of the Dow, it ended 2008 at 2.01 times book value and if you back out intangibles the Dow would be trading at 4.13 times book (against 1982's tangible P/B reading of 1.03 - Excel). As for the easily manipulated headline earnings numbers, given the earnings and economic uncertainty leading into 2009, single digit P/E multiples would seem to be called for. Instead the S&P 500 trades at 18-times trailing earnings and more than 20-times forward earnings ("Operating Earnings" - S&P 500)

4) Long-term U.S. interest rates will defy extreme expectations and end the year flat or only moderately higher. The mad rush into U.S. Treasuries is likely over, but this doesn't necessarily foreshadow a mad rush out of Treasuries. Many supposedly intelligent investors are contending that U.S. Treasuries represent another 'bubble' while at the same time arguing that a prolonged and painful global recession is directly ahead. We would argue that unless a viable alternative to USD hegemony suddenly jumps out of the water, these two viewpoints contradict each other.

The Fed has promised that if required to so it will buy Treasuries to try and stimulate the economy. The Fed may do exactly that in 2009. The Treasury 'bubble' does not go pop in 2009.

5) While last year's 'historic bust' in gold may prove to be shorter-lived and not as deep as we previously believed, gold will, on a relative basis, underperform most asset classes in 2009. With attempts to reflate the global economy proving only mildly effective, no serious threat of inflation will take root (at least not in the government statistics). Furthermore, with policy makers potentially backstopping further destruction in the financial markets, the risks of a complete financial collapse are remote. Gold is, first and foremost, an inflation hedge and, secondly, a financial crisis hedge. With the worst of the 'crisis' potentially over, extreme inflation/deflation expectations may be required to get gold moving above record highs.

Disclosure: We remain long-term gold bugs and see no reason to reduce exposure to precious metals completely. We envision ourselves as potential buyers of precious metals at some point in 2009/10.

6) A historic opportunity to purchase crude oil and other commodities will arrive in 2009. The great, and long anticipated commodities bust arrived in full force in 2008, and with it speculative activity has been dealt a serious blow. From a contrarian perspective the meltdown in commodities represents a potential opportunity. Furthermore, unlike common stocks, which can go to zero, many commodities are near levels that are nearing the cost of production and cannot fall significantly further for very long.

As mentioned in our 2009 report, we envision an opportunity to purchase a specific and optionable commodities ETF in 2009 that could produce excellent returns over a 20-year period, even if little or no returns are generated over the next 5-10 years. In other words, we think that those hoping for a dramatic turnaround in commodity prices in 2009 may have to wait, but it will be worth the wait.

7) China's painful slowdown may well intensify over the short term, but after being punished in 2008 Chinese stocks have the potential to do better than most stock indices going forward. We would be remiss when mentioning China not to note that this is a unique period in its growth phase that could carry with it lots of surprises. One such surprise we envision in 2009 is a weaker yuan.

8) A very short run of the data suggests that those Dow components that produce the fewest words in 10Qs and 10Ks outperform those that produce the most. With some of the shadiest Dow components producing 10Ks in 2009 that may breach 1,000 pages, an investment theory similar to the 'Dogs of the Dow' may be born.

9) The Wish List will outperform the markets (again). Not quick to tout short-term performance, we nonetheless believe that the companies we own offer the potential for superior returns going forward. During the 2000-2002 bear market we favored REITs and gold stocks, while today we like select smaller cap situations and solid dividend/distribution companies. Entering year 9 this is the second bear market the Wish List has been involved in, and for the first time since 2003 we are growing eager to discover more undervalued opportunities.

Conclusion

Unwilling to let the free market work, U.S. policymakers have adopted the audacious goal of trying to kick-start a deeply flawed financial system; a system grounded upon unsustainable increases in asset prices and debt. Not unlike the 2003 'recovery' that was backed by cheap money and regulatory neglect, these policies are destined to fail. However, there are degrees of failure that are more enviable than others. One potentially amiable outcome would be to string out the losses over many years, thus avoiding the jarring consequences that would otherwise result from Wall Street (and its global counterparties) imploding inside of a few weeks. That said, we will never know if the hands-off approach to dealing with downturns is preferable to the interventionist path adopted last year.

Amidst this ongoing period of painful write-downs and much needed U.S. consumer frugalness, investment opportunities are unlikely to be found by throwing a dart at the next hot asset class or stock market sector. Rather, the theme leading into 2009 is that of being selective; of patiently dropping your line into the water and waiting for a nibble. Contrast this tranquil activity with that of policy makers frantically casting a wide-net and bottom trawling the lake. While the consequences of overfishing vary, the basic story is that by fishing too much today you reduce the stock of fish available for consumption tomorrow.

Faced with the prospect of his country's banking system melting down, Iceland Prime Minister, Geir Haarde argued that "We are too small a country to sustain such a big banking system" and "We will be fine. We can eat what we can fish." While the solution for the US may not lurk in the bounty of the sea, it most definitely does not lie in further financial machinations and delusions.

Brady Willett and Dr. Todd Alway
FallStreet.com

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