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Friday, December 08, 2006

A Day's Pay

A Day's Pay

Over the last decade, current account balances across the world have shifted dramatically. The United States’ current account has swung into a deep and accelerating deficit while Japan and developing Asia have moved to large current account surpluses. Accompanying these swings in current account balances has been the United States’ movement to the status of a net debtor and developing Asia’s emergence as a net creditor, amassing claims on Americans in the form of treasuries, corporate equities, and direct investment. Both Latin American and Middle Eastern countries have also run significant surpluses, but they will be fleeting, as factors that affect those regions, such as rising commodity prices, are temporary and likely to be volatile in the future. The rising U.S. current account deficit is a perplexing topic for economists, as the American economy is rather mature and growing at a slow but consistent rate. The popular press frequently blames the massive imbalances on Americans’ aggressive spending habits and unwillingness to save a larger portion of their income. This “Made in the U.S.A.” argument derives from an interpretation of the macroeconomic accounting identities, but is utterly inconsistent with the data, and will be discussed later. Alternative explanations of the current account deficit have focused on blaming China as a currency manipulator, as the People’s Bank of China holds down the value of the yuan in order to gain an unfair trading advantage at the expense of the American manufacturing sector. Both the “Made in the U.S.A” and currency manipulator argument espoused by American legislators reek of sensationalism and fail to fully explain the recent trend in global current account balances. The most plausible and consistent explanation of the imbalances in current accounts across the world comes from an examination of savings and investment activity worldwide, international economic conditions, and the attractiveness of the United States’ highly liquid and well-regulated financial markets. This analysis of the global imbalances begins with an explanation of the current state of the imbalances, followed by an examination of each major region of the world and an assessment of the impacts felt in the United States.
Since the mid-1980s, the United States’ current account balance has fallen into a deep and accelerating deficit. With a brief return to surplus during a recession in the early 1990s, the excess of imports from foreigners over exports to the world has consistently risen, amounting to an annualized figure of roughly $870 billion or 6% of GDP.[1] Using the macroeconomic accounting identity, the U.S. current account can be explained by the equation, Sp + CAD = I + (G-T), which simply states that private investment and the government budget deficit must be financed by either private domestic savings or by importing foreign savings through the current account. In a closed economy, a country’s savings and investment must be equal by definition, but because of the globalization of financial markets and capital flows, a country’s savings and investment during a period need not be equal, enabling deficits and surpluses on the current account. In the United States, private savings amounts to roughly 15% of GDP, with investment and the government budget deficit weighing in at about 20% and 1% of GDP respectively, and the current account deficit at 6%.[2] As national savings is less than capital investment, the U.S. must run a current account deficit in order to finance the excess of investment over savings. Foreign savings must be imported in order to fill the gap between what Americans save and what private firms invest.
Through this savings and investment perspective of the current account, the “Made in the U.S.A.” hypothesis can be explained and ultimately refuted. As capital investment by firms has consistently outstripped savings, the need for a current account deficit has persisted. In explaining the dramatic swing to deficit during the American technology boom of the 1990s, the national accounts model is powerful. During the 1990s, productivity growth in information technologies boosted investment, and an exuberant stock market lifted household wealth, increasing consumption and reducing savings. Foreigners were also eager to participate in the investment boom, offering much needed capital to the overheating American economy in the form of the current account deficit. This explanation of the rise in the current account deficit as a result of robust investment demand outstripping savings is satisfying. The early 2000s, however, are more difficult to explain, as the current account remained in deficit despite the 2001 recession and productivity slowdown in the United States. Investment demand certainly cooled after the bubble burst, yet the current account deficit continued to widen.
Many analysts attribute the yawning deficit to a lack of savings in the United States, citing declining propensities to save because of increasing home prices and a ballooning government budget deficit. Since the 1980s, the savings rate for the United States has fallen from 18% to nearly 15% of GDP, and the household savings rate has precipitously declined to almost zero.[3] Given the accounting identity, as savings declines, the current account must fall into deficit if no other variable changes. This explanation derives itself from how the current account is defined. With the government deficit absorbing domestic savings, private investment requires financing from abroad and contributes to the current account deficit. The twin-deficit idea is theoretically valid, yet with government borrowing so low, only a small portion of the increasing current account deficit can be explained. In a recent study of the current account, researchers Menzie Chinn and Hiro Ito calculate the coefficient on the budget balance variable to be 0.21 for industrialized countries, statistically significant at a 10% level.[4] The statistically significant coefficient is evidence of the theoretical validity of the relationship between the budget balance and the current account, yet its low magnitude and a troubling adjusted-R2 for the equation are a signal that further investigation is required. The “Made in the U.S.A” explanation of the current account is grounded in theoretical validity, yet ignores the role of the rest of the world and is inconsistent with the behavior of interest rates. A decreased supply of savings in the United States because of a ravenous government and low savings rates would suggest an increase in the real interest rate, as the supply of savings decreased. This idea, however, is inconsistent with the behavior of interest rates, as the real interest rate has fallen consistently since 2000, suggesting an increase in the supply of savings.[5]
In contrast to the government budget deficit and consumer spending view, some economists argue that the United States actually saves plenty of its output for the accumulation of its capital stock. Acclaimed international economist Richard N. Cooper argues that in the modern knowledge-based economy, the traditional accounting identity does a poor job of describing an economy’s savings. National savings, which is measured as output less consumption and government expenditure, fails to account for savings in consumer durables, education, and research and development. Cooper explains, “The national accounts focus on productive physical capital plus housing. A broader and more appropriate concept must add at least three components of current output: consumer durables, education, and expenditure on research and development.”[6] Because investment in these three categories yields high returns in the future, they should be considered savings. Research and development, which generally yields large increases in productivity, is not even included in the national accounts, and considering education as part of consumption fails to recognize its capacity for future returns in an economy increasingly focused on information. Cooper estimates that when including these alternative forms of saving, the U.S. saves roughly one third of its GDP, which should be plenty for adequate capital accumulation to ensure future economic growth. If the United States is actually saving plenty of its output for capital accumulation and the government budget deficit cannot entirely account for the widening current account deficit, an explanation must lie outside the United States, particularly in developing Asia, Japan, and Europe.
Accompanying the dramatic rise of the U.S. current account deficit has been the movement of the rest of the world to surplus. The U.S. current account deficit is not the result of profligate consumption and a lack of savings by Americans, but is a result of savings and investment trends worldwide. From the 1980s to present, the world’s savings rate has remained relatively constant.[7] What has changed, however, are regional savings and investment rates, especially in developing Asia and the United States. Developing Asia’s savings rate has increased dramatically since the 1980s while the U.S. savings rate has declined. In the Middle East, savings has remained volatile, as it is primarily determined by changes in the price of oil exports. Both European and Japanese savings rates have remained relatively constant. Besides the shift in savings from the United States to emerging Asia, global investment rates have fallen steadily. With total world savings fairly stable and investment falling since the 1970s, the world has become awash with an excess of savings over investment, resulting in historically low real interest rates seen in the U.S. and large current account imbalances across key regions of the world.
The most dramatic change in savings and investment activity across the world has been the transformation of developing Asia from a net importer of capital to a net exporter. In 1994, developing Asia borrowed on net just over $40 billion to finance its current account deficit, yet by 2004 these countries were running large current account surpluses, amounting to nearly $180 billion, or about 3% of the region’s aggregate GDP.[8] Developing Asia’s dramatic swings in its current account balance are very noticeable in the data. Prior to 1997, investment activity made up roughly 36% of the region’s GDP, with savings weighing in at 33%, making the current account deficit 3% of GDP as noted above. 1997 marked a powerful swing in developing Asia’s current account balance, as investment dropped nearly 12 percentage points to 24% percent of GDP and the current account rose to an enormous surplus of about 7.5% of GDP.[9] This improvement in the current account is perplexing, given the scarcity of capital and its high marginal product in developing Asia relative to other regions of the world. In highly developed industrialized countries, where capital is more abundant, each additional unit of physical capital should be less productive because of the law of diminishing returns. As a larger capital stock is accumulated, the return on each unit of capital should fall, prompting investors to seek returns in countries with lower capital stocks. Also, where capital is scarce and labor is abundant, investments in capital should yield the largest returns. This theory of capital allocation seemed to play out empirically in the early 1990s, when developing Asia ran significant current account deficits, financing investment at home with savings from abroad. Indeed, profit-maximizing investors should have turned to developing Asia as the return on capital, defined as the value paid to capital owners divided by the total capital stock, was much higher than returns paid in the West, with the return in East Asia coming in at 14.4% compared a return of 9.9% in the United States.[10] Given the difference in returns, capital should flow to developing Asia, rather than to the highly industrialized and capital abundant United States. This dramatic and counterintuitive shift in capital flows can be explained by the 1997 Asian currency crises, which is responsible for much of the global current account imbalances seen today.
The developing world’s currencies were plagued by instability during the 1990s, reminding international investors of the risk and political uncertainty that accompanied their outsized returns for much of the decade. The 1994 devaluation of the Mexican peso following the Chiapas uprising and the assassination of a presidential candidate reminded investors of the risks of short-term portfolio investments in volatile areas of the world. The response was a rapid attack and devaluation of the peso, devastating the Mexican economy. Although the Mexican crisis left many investors with a bitter palate, they were eager to forget it as the Asian currency crisis erupted under similar circumstances involving a reversal of capital flows. Capital flows into Indonesia, South Korea, Malaysia, the Philippines and Thailand averaged more than $40 billion per year in the 1990s and were $70 billion in 1996 alone.[11] Large current account deficits, rising portfolio investments in speculative areas such as real estate, and a poorly regulated banking system gave rise to a mass exodus from Asian currencies. As investors realized that a real estate bubble burst was likely and that many of their portfolio investments were put to questionable and unproductive use, they prompted a bank run on the region. Central banks worked to protect their currencies by selling foreign exchange, resulting in an exhaustion of reserves. Large capital outflows also exposed weakness in the banking system, as under-regulated banks made long-term speculative investments in real estate on funds borrowed from depositors with a shorter maturity. Given a wealth-constrained investment function, the dramatic devaluation created a large contraction in domestic investment and output. As much of developing Asia’s debt was denominated in foreign currencies, such as the dollar, the real burden of debt taken on during the boom years increased dramatically, prompting bankruptcies and the deterioration of firms’ balance sheets. As leverage increased, investment fell, reflecting firms’ risk aversion. Following the currency crisis, investment in developing Asia fell to rates comparable to those of the 1970s as countries exported to strengthen their international indebtedness position and central banks sought to amass foreign exchange reserves to protect their countries against capital outflow. Developing Asia’s defensive export strategy required domestic savings to exceed investment, resulting in large current account surpluses. The high levels of savings relative to investment in developing Asia following the Asian currency crises is a striking feature of the global imbalances that will persist in the future, as current account surpluses are largely a defensive measure, generating credibility and foreign exchange for developing Asia as they export goods on net to the rest of the world.
Although China was left unscathed from the currency crises affecting developing Asia, it was not immune to the effects of devaluations or concerned about how rapid capital outflow could be a threat to its economy in the future. Governor of the Reserve Bank of Australia, I.J. MacFarlane, correctly predicted the movement of developing Asia’s current accounts to surplus when he wrote in 1998 that “a number of emerging market countries will take the safety-first policy of building up large international reserves--a new type of mercantilism.”[12] This “safety-first” policy requires countries to undervalue their currencies in an effort support export growth and run current account surpluses. Not only do countries such as China gain credibility through their exports, but they accumulate foreign exchange reserves, insulating themselves from capital outflow and providing a form of insurance for foreign direct investment. China’s $1 trillion war chest of foreign exchange acts as a form of security for Western firms that would otherwise be reluctant to invest directly in China for fear of political uncertainty and nationalization. In order to dispel investors’ qualms of financial distress precipitated by banking system weakness or a government usurpation of the private sector, China has followed Thailand and South Korea’s precautionary movement toward a surplus in the current account and an accumulation of reserves.
In contrast to the rest of developing Asia, both savings and investment have increased markedly in China, satisfying the government’s development strategy and need for foreign exchange reserves to hold down the value of the yuan. While China’s trend toward current account surplus overall has followed that of the rest of developing Asia, savings and investment in China have not. With an already high savings rate of nearly 40% of GDP in the 1990s, Chinese savings increased to nearly 50% of GDP in the early 2000s.[13] Household savings is high at almost 25% of income, reflecting individuals’ concerns over the availability of crucial services such as healthcare and housing, previously exclusively provided by the government. The high rate of savings is likely to continue as the economy shifts to a fully market-based system, introducing further volatility and uncertainty to an economy accustomed to central planning. Also, corporate saving has risen rapidly, reflecting both fatter profit margins in private corporations and a lack of functioning capital markets. Because firms cannot seek financing through domestic capital markets, Chinese companies are frequently forced to finance their own growth through their retained earnings, encouraging companies to save if they wish to make capital investments in the future. The ratio of investment to GDP has also risen substantially after the Asian currency crisis, being primarily concentrated in infrastructure and manufacturing.[14] China’s persistent trade surplus is partly a reaction to the need for foreign exchange reserves and stability following the Asian currency crisis, but is also an integral part of the country’s development strategy and method of absorbing the hundreds of millions of Chinese peasants who will migrate to the coastal areas in search of high wages over the next several decades.
Apart from the Asian currency crisis, the trend toward an accelerating improvement in developing Asia’s current account can be explained with the Bretton Woods Revived thesis. In an effort to graduate their economies from the developing world, or the periphery, developing Asia has focused on export growth to boost economic performance and improve their capital stocks through foreign direct investment from the West. The development strategy requires large amounts of saving, undervalued currencies, and a thriving export sector. In an effort to upgrade their capital stocks and promote economic growth, countries in the periphery require Western technology in the form of physical and human capital. Importing this capital entails foreign direct investment by Western firms, which can only be seduced with large amounts of foreign exchange reserves as a form of collateral. Developing Asia’s role in the global imbalances is important not only because it makes up the largest part of the global imbalances, with a surplus amounting to nearly $180 billion in 2004, but because its export of capital flows the wrong direction, away from capital poor regions, to areas of significant capital saturation. Developing Asia’s status as a net exporter will likely persist until the region’s development needs are met, requiring continued savings and undervalued currencies.
In addition to developing Asia, both Japan and Germany have run significant current account surpluses in recent years. As individual countries, Japan and Germany have the largest current account surpluses, amounting to $172 billion and $104 billion respectively in 2004.[15] Both the savings and investment model from the national accounts and the demand model of the current account are useful in explaining the swelling current accounts in these industrialized countries. Common to both nations has been a prolonged economic downturn in recent years, structural difficulties in the economies, and rapidly aging populations. Since the crash of its soaring equity and real estate markets in 1989, Japan has been in a deep recession with creeping deflation.[16] Germany has been plagued with slow economic growth over the last four years, clocking in at less than 2% on an annualized basis and an increasing unemployment rate of over 10%.[17] Problems in Germany lie in its exorbitant tax rates and inflexible labor markets, as high marginal tax rates provide an obvious disincentive to do business in the country. More important in Germany is the high level of labor market inflexibility, with strong unions and governments dictating increases in the minimum wage and regressive employment laws that discourage hiring and keep unit labor costs elevated relative to its European peers.
Stagnant economic growth in both Japan and Germany has contributed to rising current account surpluses, increasing global imbalances worldwide. Using the demand model of the current account, the current account is a function of the nation’s income, foreign nations’ incomes, and the real exchange rate. Both Japan and Germany’s incomes have remained relatively constant while the rest of the world has seen output grow at a greater rate, contributing to current account surpluses. In addition, Japan has seen a significant depreciation in its currency, cheapening Japanese exports and making imports relatively more expensive. Furthermore, both Japanese and German demographics are posed to change dramatically. A larger proportion of each country’s population will be elderly in coming years, inducing them to save now. As individuals prepare for retirement, each society’s propensity to save should increase, making current account surpluses more persistent.[18] An additional factor contributing to persistent current account surpluses in Japan and Germany is set forth by Richard N. Cooper, who argues that since World War II, both Japan and Germany have built a psychological dependence upon strong export performance. If exports suffer and their current accounts become less positive, the countries will respond with additional savings, bringing them to surplus once again.[19] Using fiscal stimulus in Japan and Germany to reinvigorate the economy and stimulate import demand is not a viable policy option, as budget deficits in both regions are already high, amounting to 4% of GDP in Germany and nearly 8% of GDP in Japan.[20] For structural, psychological, and financial reasons, both Japan and Germany are likely to remain in surplus for the foreseeable future, contributing to the existence of the global imbalances.
Another prominent feature of today’s global imbalances is the large current account surpluses emanating from the Middle East. The recent increase in the price of oil over the last several years has dramatically altered the balance of payments between Middle Eastern countries, notably Saudi Arabia, and oil-importing countries. As the value of Saudi Arabian exports has risen, the country’s current account balance has correspondingly improved. The International Monetary Fund calculates Saudi Arabia’s 2005 current account surplus at over $100 billion, or about 30% of GDP.[21] Relative to the size of its economy, the Saudi current account surplus dwarfs East Asian current account balances. Current account surpluses in the Middle East, however, are likely to be transitory, as the price of oil has tended to be volatile and should not be a persistent contributor to the global imbalances.
Given developing Asia’s concerns about future risk and volatility, and Japan and Germany’s poor investment opportunities, it is not surprising that nearly all of the world’s current account surpluses flow to the United States, allowing the U.S. to run a large current account deficit. Through the international capital flows lens, CA + KA + ORT = 0, it becomes apparent why the United States runs such a significant current account deficit. Because of foreigners’ strong demand for our financial assets, including bonds, corporate stock, and private equity, the United States is able to run a large current account deficit. Demand for U.S. assets abroad induces countries to pay for American financial assets with their exports, making the U.S. capital account rise and the current account fall into negative territory. Because the United States has the most sophisticated and liquid capital markets in the world, offering a vast array of any type of security and derivative imaginable, it is a particularly attractive location to place one’s savings. Furthermore, well defined property rights, low political risk, and acceptable returns attract foreign capital to the U.S., enabling it to run a significant current account deficit. The current account deficit will continue indefinitely until foreigners no longer perceive U.S. financial claims as highly desirable assets and refuse to purchase them. In this view, the deteriorating U.S. current account position is perfectly sustainable for the immediate term. Furthermore, as development in East Asia is dependent upon the accumulation of U.S. assets, demand for the dollar will likely persist. The leading authority on the U.S. current account position, Catherine Mann, however, explains that prolonged current account deficits and a deteriorating international investment position is associated with a depreciation of the exchange rate.[22] While an ever-increasing supply of American assets abroad may eventually cause a depreciation of the dollar, because dollar is the preferred unit of account internationally, an adjustment via dollar depreciation seems unlikely with the current account deficit at only 6% of U.S. GDP. The centrality of the U.S. dollar and its importance in developing nations’ export strategies make a significant dollar depreciation and reversal of the current account improbable.
An alternative explanation of the U.S. current account deficit focuses not on the abundance of Asian savings, but seeks to explain the decline in U.S. savings and increasing propensity to run a current account deficit by examining the decline in U.S. business cycle volatility. Fogli and Perri estimate that 20% of the current account deficit can be attributed to the lower volatility of U.S. GDP relative to other nations.[23] As the standard deviation of output growth in the U.S. economy has fallen over the last century, known as the Great Moderation, Americans have reduced their precautionary savings and increased foreign indebtedness. This explanation of the current account is also consistent with the experience of developing Asia. As country specific risk has increased because of GDP fluctuations, precautionary savings has risen and foreign indebtedness has declined for many of these countries. Fogli and Perri explain that a portion of the U.S. current account deficit is easily explained and is a natural reaction to the decline in volatility seen in U.S. GDP growth.
While many commentators cite the rising U.S. current account surplus as a threat to the U.S. economy and a sign of weakness, the rising trade deficit has actually been a boon to U.S. consumers, businesses, and central bankers alike. Because of a decrease in investment abroad, particularly East Asia, and the attractiveness of U.S. financial assets, the supply of savings available to the United States has increased. Not only is the current account deficit a sign of the attractiveness of U.S. assets and the dollar, but the supply of savings offered by the rest of the world has lowered real interest rates, fuelling a great boom in housing demand and enabling more Americans to obtain homes and extract wealth from existing residential investment. Also, increased exports from low cost areas of the world, such as East Asia, have made central banking in the United States much easier by lowering the trade off between inflation and unemployment. The increased supply of low-cost goods from Asia can be viewed as a favorable supply shock, shifting the Phillips curve inward and improving the classic trade off. Essentially, the increasing U.S. current account deficit has been a benefit on net and will likely continue unless the improbable case of a dollar depreciation causes an increase in inflation via exchange rate pass through-effects.
Much of the attention placed on the global imbalances in the business and financial press focuses on its origins in the U.S. government budget deficit and American consumers’ willingness to spend. This analysis of the current account has, however, demonstrated that while domestic savings and the budget balance do have an impact on the global imbalances, a more meaningful and appropriate analysis of it must begin abroad, specifically in developing Asia. Because of the Asian currency crisis and the region’s development strategy, the Asian surpluses will continue. Both Germany and Japan face major obstacles in moving to a current account deficit but may do so as economic growth accelerates and their populations age. Middle Eastern surpluses will likely be ephemeral as energy prices drop and investment demand in the region increases. The current state of the global imbalances will continue in the immediate future, but over the long run, the United States will have to become a net exporting nation to repay the debt owed to foreigners. The global imbalances will ultimately be resolved as developing Asia satisfies its development strategy and economic growth accelerates in Japan and the Euro Area.


Works Cited
Bernanke, Ben. The Global Savings Glut and the U.S. Current Account Deficit. Virginia Association of Economists. March 2005.

Chinn, Menzie and Ito, Hiro. Current Account Balances, Financial Development and Institutions: Assaying the World “Saving Glut”. Portland State University. October 2006.

Cooper, Richard N. Living with the Global Imbalances: A Contrarian View. Institute for International Economics. November 2005.

Dooley, Michael P. et al. Savings Gluts and Interest Rates: The Missing Link to Europe. National Bureau of Economic Research. July, 2005.

Dornbusch, Rudiger and Park, Yung Chul. Contagion: How It Spreads and How It Can Be Stopped. World Bank. May, 2000.

Fogli, Alessanda and Perri, Fabrizio. The Great Moderation and the U.S. External Imbalance. Federal Reserve Bank of Minneapolis. September 2006.

Heading Down. The Economist. March, 2003.

International Monetary Fund. Global Imbalances: A Saving and Investment Perspective. World Economic Outlook. September, 2005.

Macfarlane, I.J. Payments Imbalances. China and the World Economy. 2005.

Mann, Catherine L. Perspectives on the U.S. Current Account Deficit and Sustainability. Journal of Economic Perspectives. Summer 2002.

Recycling the Petrodollars. The Economist, November 2005.

Squaring the Circle. The Economist. February, 2006.






Graphs
[1] Federal Reserve Economic Data. The second quarter U.S. current account balance amounted to -$218.41 billion on run-rate GDP of $13.2 trillion.
[2] Cooper, Richard N. Living with the Global Imbalances: A Contrarian View. Institute for International Economics. November 2005.
[3] Bernanke, Ben. The Global Savings Glut and the U.S. Current Account Deficit. Virginia Association of Economists. March 2005.
[4] Chinn, Menzie and Ito, Hiro. Current Account Balances, Financial Development and Institutions:
Assaying the World “Saving Glut”. Portland State University. October 2006.
[5] Bernanke, Ben.
[6] Cooper, Richard N.
[7] Dooley, Michael P. et al. Savings Gluts and Interest Rates: The Missing Link to Europe. National Bureau of Economic Research. July, 2005.
[8] Bernanke, Ben.
[9] International Monetary Fund. Global Imbalances: A Saving and Investment Perspective. World Economic Outlook. September, 2005.
[10] International Monetary Fund.
[11] Dornbusch, Rudiger and Park, Yung Chul. Contagion: How It Spreads and How It Can Be Stopped. World Bank. May, 2000.
[12] MacFarlane, I.J. Payments Imbalances. China and the World Economy. 2005.
[13] International Monetary Fund
[14] International Monetary Fund
[15] Bernanke, Ben.
[16] Heading Down. The Economist. March, 2003.
[17] Squaring the Circle. The Economist. February, 2006.
[18] International Monetary Fund.
[19] Cooper, Richard N.
[20] The Economist. Economic Data and Indicators.
[21] Recycling the Petrodollars. The Economist, November 2005.
[22] Mann, Catherine L. Perspectives on the U.S. Current Account Deficit and Sustainability. Journal of Economic Perspectives. Summer 2002.
[23] Fogli, Alessanda and Perri, Fabrizio. The Great Moderation and the U.S. External Imbalance. Federal Reserve Bank of Minneapolis. September 2006.

Sunday, October 22, 2006

Don't Be Gevil

Investors were euphoric last week as Google released quarterly earnings and announced nearly a 100% surge in profits. Brokerage houses responded by lifting share targets to well over $500. Does anybody remember 2000?

There is no question that Google does search well, evidenced by their hefty share of the market and dominance over Yahoo! (exclamation included) in the area. The prospect of paying 70x earnings for Google and expecting profits to continue their upward trajectory of 80% YoY seems ridiculous. Are any of Google's other products really that good? (Ok--Maps is good and Reader is just allright) After all, the company generates nearly 100% of its profits from online search advertising. Why does Google dominate search? They are certainly more profitable because of their ad placing algorithms which optimize revenue and click throughs. But this still doesn't explain why people prefer Google over other search engines. The truth is that results are fairly equal.
Check out http://www.gahooyoogle.com/ for a comparison.

My view is that search will become commoditized in the long run and Google's advantage will dissappear. Other sources of revenue are in dire need.

Widow Meta Search does a good job of showing the commoditization in the search area: http://www.widow.com/

Friday, October 20, 2006

New IE Web Browser

Today's WSJ reported that Microsoft is releasing a new version of its web browser. Its no surprise that a company like Microsoft is slow to introduce new products--they have significant monopoly on the operating system because of the strong network effects of the software. Why are they wasting their time with IE unless it has an exclusive built in search bar for the MSN network? Good question, and the answer may be that they didn't spend much time at all. Having a search tool bar drives traffic to a search website and MSFT has lost out on this potential benefit with the old IE, most of which run with the Google or Yahoo add-in. Monopolistic behavior may be an issue in the courts if they stack IE (and Vista, which works with Netflix login) with MSN search, but with more browsers on the market, the arguement has less substance.

Why even bother with a new browser if you can't monetize it?
No doubt MSFT has contemplated this question and figured it out--the result is a weak browser.

In my view, a Google browser is on the way.

Microsoft UpgradesInternet Explorer -- But Not Much Is New
"Microsoft's Internet Explorer Web browser is one of the most-used software products in the world. It is the main tool through which most computer users view the entire Internet. But IE hasn't had a significant overhaul in five long years. That has allowed competitors like Mozilla's Firefox and Apple's Safari to leap ahead in terms of features. In fact, many of the savviest Web users have abandoned IE in recent years, partly because of the growing feature gap and partly because of IE's persistent security problems."

Wednesday, October 18, 2006

Dow 12,000


The Dow neared 12,000 as tame CPI and PPI data was reported by the gov't. In the last FOMC meeting there was one vote for an increase in the funds rate, so a relatively hawkish outlook is correct. Inflation still looms and Bernanke's reputation is on the line. It looks like rates will stay at 5.25% for the next few months and even drop. Dow 12,000 and an impending rate cut over the next few months seems to be a conundrum: As the bond market predicts falling prices and a recession, equity markets see robust growth. Let's wait and see. I'm buying puts on the S&P given the recent rise and going long on retailers with the cold weather view.

Wednesday, June 07, 2006

Outsourcing Saving

As the price of oil sustains record highs in the neighborhood of $70 per barrel, American consumers are beginning to experience what Europeans have felt for years. The price of a gallon of petrol in America has recently spiked to an average high of about $3 and shows few signs of a letdown. American consumers and investors certainly have a bellyache over the higher cost of fuel, but the recent oil spike may in fact be a boon for the U.S. economy over the long run, and oil exporting countries should be applauded rather than cursed for the recent spike.
It is no coincidence that as the price of oil has jumped, the American current account has accelerated its free-fall and the Middle-Eastern current accounts have loosened their belts. The International Monetary Fund calculates Saudi Arabia’s 2005 current account surplus at over $100 billion, a stunning 30% of GDP. Relative to the size of its economy, the Saudi current account surplus is enormous, as it dwarfs China’s which stands at only 6% of GDP. The Saudi Arabians are simply saving too much with little opportunity to invest their windfall. While the Saudi and other oil exporting countries’ current accounts surpluses have grown, the U.S. current account deficit has fallen to record lows, amounting to nearly 7% of GDP. This growing deficit reflects the strength of the American economy relative to foreign markets as private firms and governments choose to offer their savings on global capital markets to the United States, which enables the Americans to run a current account deficit.
The growing American trade deficit has been accompanied by a curious flattening of the yield curve, as long-term yields have failed to keep pace with the Federal Reserve’s tightening and rates have remained at 25 year lows. This rate convergence phenomenon is likely the result of the recent increase in oil prices from $30 to over $75 per barrel since 2003. The Fed has increased the Funds rate sixteen times since 2004, yet the yield on the 10-Year Bond has failed to budge significantly. On average, the interest rate on the 10-Year Treasury has exceeded the Fed Funds Rate by 90 basis points for the last half-century, however in the past year, the yield curve has been generally flat and at times slightly inverted. Oil exporting countries such as Saudi Arabia generally have a higher marginal propensity to save than the United States. Because of this, this transfer of income from American consumers at the pump to oil exporters has increased the amount of global savings, driving interest rates to historic lows and making the world awash with credit.
High oil prices in the past have been the source of supply shocks, aggravating inflation and reducing output, however, this effect does not seem to hold as strongly today, as many goods are less intensive in petroleum inputs, and inflation has remained rather tame so far. While oil exporters are often portrayed as villainous greed-mongers, American consumers and investors should actually be thanking them. As consumers and businesses are forced to pay ever-higher fuel prices at the pump, they are essentially outsourcing the role of saving for the nation’s capital accumulation. Because Middle Eastern oil exporters have a significantly higher marginal propensity to save, the transfer of income from the U.S. to oil exporters increases the quantity of saving abroad, which is in turn recycled back into the United States through international capital markets. The increase in savings has driven down interest rates, providing access to low-interest mortgages, increased the quantity of investment in the United States, and offered a tremendous opportunity for the Federal government to issue cheap long-term debt with the 30 Year Bond. In effect, the United States has offshored the task of saving for long-term capital accumulation to today’s net exporting countries.

Tuesday, May 09, 2006

ASFI Collects

Asta Funding blew analysts out of the water once again as the reported earnings before the market today, beating the Street's projections by $0.07 per share. Giving the company an industry P/E of 20, the stock belongs closer to $50 a share.

Saturday, March 11, 2006

On Socially Responsible Investing

If a company were performing badly, but had noble cause, would you invest in it?

In a casual survey, many students surveyed at liberal arts colleges answered “Yes” enthusiastically. They explained that they wanted to help the troubled company because the world needed more of its socially responsible product or service.

Most people, understandably, find this response to be quite naive. The reasoning follows: If I buy shares of a company, the seller’s proceeds are exactly what I pay for the stock. The company doesn’t reap any of the benefit when paper representing ownership changes hands. The idea that buying a company’s stock helps them do business is simply wrong. For instance, if I were to purchase Northrop Grumman shares, the company wouldn’t benefit. Their capacity in building electronic warfare systems would be unaffected. Following this argument, the ethics of investing are of no consequence.

This logic, however, has a severe flaw. The truth is, when you buy shares of a company you are helping them do business. Your purchase of Northrop is directly helping them build weapons. The reason lies in Exit Strategy. Then Northrop offers shares to the public to finance their operations people only buy it because they believe that they will be able to sell it to someone else at some point in the futures for a capital gain. The IPO unequivocally helps a company produce its good or service. What people fail to realize is that if there were no buyers out there to purchase the stock at a time after the IPO, the company wouldn’t be able to raise any capital to fund business. The idea goes back to the concept of capital markets. If there is no market, there will likely be nobody backing a business for lack of an Exit Strategy.

Friday, March 10, 2006

That Tricky Yield Curve

It's obvious that when short-term rates are higher than long-term rates, as is the case in the U.S., that banks are in a difficult situation. This divergence in yields is how banks rake in the dough. When the yield curve is inverted the opporutnity for yield arbitrage across time dissappears.
As rates "normalize" and the risk premium for time becomes apparent in the yields, banks should see profit margins fatten substantially. It's been a popular view of B-week that banks are doomed, and frankly, by the time a critical mass of commercial media agree on an issue, it's likely no longer true. This is my view on S&L's and will be loading up the trucks (manufactured by Caterpillar) on any signs of weakness, that is Citigroup at $45.

On the regional side, IndyMac bank is another interesting story. Essentially, they are convinced that their business model is superior because of their hybrid mortgage banking/S&L model. When rates are falling their refinancing and mortgage business does exceptionally well. In a rising rate environment, they see fatter margins on interest income. Their strategy is unique in that in rising rate environments, they seek to expand their business while most banks lay-off workers. They are actively recruiting for their Pasadena HQ.

On the rates issue, there is no question that long term yields will rise. I believe the government made a savvy move in re-issuing the 30 Year Bond last month. It's cheap financing considering the likely direction of rates.

Thursday, March 09, 2006

Load up on Yahoo!

Yahoo! is the leader in one of the world's fastest growing markets and is the most visited site on the internet and most widely used portal. Sure, Google gets all the hype, but their search technology has put them in first, but the leapfrog effect is inevitable.

The company is trading at a 25% discount from a share price of $40, where I believe it belongs. Essentially, the two main elements of an investment thesis for Yahoo! are its growth potential and its extremely low valuation (only 25x earnings including their one-time capital gain from holding Google shares) and 40x earnings as evidenced by operating income (about $0.70 per share).

In terms of financial soundness, the company is supremely positioned. Current assets are over 2.8x current liabilties and debt to equity ratios are falling. Great management effectiveness ratios show that managers are responsible stewards of owners' capital. Asset turnover ratio increased almost 100 bps from 2004.

With 49% topline growth and an adjusted PE of under 40 (excluding one time charges), the recent 25% pull-back in in the valuation is compelling. We're loading up the trucks.

Jo-Ann's On Sale

Jo-Ann Stores (JAS) has come down more than 60% in the last year. Sure, management is having problems and the CEO/Chairman/President just left, but I see this as a good sign. They are conscious of the problems going on with the transition from small stores to “super-stores.” The move to super-stores is an effort to create a holistic craft shopping experience—whatever that means.

From my view, JAS is a decent company in a boring sector that is unlikely to experience any tremendous growth in the future. This is a value play in the most traditional sense: the market has pegged a price of less than the sum of the company’s parts. Let’s be conservative and say that they can never sell half of the inventory on their books. The company should fetch a value of approximately $15 a share.

I’d like to see them write-off some inventory and concentrate on what sells. I’d expect to see a jump in the share price when they announce that they’ve brought some experienced management on board. In the interim, savvy value investors like Jon Brogaard have taken a large equity stake.

Cracking the Oil Code

Background Information
Being the lifeblood of the world’s industrialized economies, crude oil is the most actively traded commodity. The world consumes roughly 80 million barrels of crude oil per day and uses petroleum products for a multitude of applications, including transportation, heating, and plastic production. Because oil is such an essential input in the production process, its price is closely followed and reported daily by the financial press. Also, most of the world’s heaviest consumers of petroleum rely on imports from Middle Eastern oil-producing nations. Since the formation of an international petroleum cartel, the Organization of Petroleum Exporting Countries (“OPEC”), the political importance of oil has escalated. In an effort to insulate the American economy from oil shocks, the U.S. government began stockpiling emergency oil reserves in 1977 as a national security policy.
The question of whether the price of oil is high or low based on market fundamentals is a contentious debate. Currently, oil is trading at about $60 per barrel in 2005 dollars, a relatively high price compared to historical averages. Many justify this price and remain bullish, adhering to the idea that the supply of petroleum is fixed and that increased demand from developing countries will drive the price higher as they accelerate growth. Others dismiss the current price as being irrational and the result of increased speculative activity by large alternative investment funds. This paper seeks to explain what determines the price of oil.Several different types of crude oil are produced and receive different market prices. For instance, North Sea crude, generally known as Brent crude, commands about a $1 premium to the OPEC Basket Price, which includes various blends of Dubai, Saharan, and Venezuelan crudes. The price quoted on the New York Mercantile Exchange, however, is for light-sweet, or West Texas Intermediate (“WTI”) crude. WTI is the most easily and widely refined crude in U.S. refineries, making it the most frequently quoted type of oil in the world. Light-sweet WTI crude on the NYMEX trades at about a $2 premium to the OPEC Basket Crude. Changes in the price of crude oil have large affects on the U.S. economy and are difficult to explain and predict. The quoted price of crude oil on the NYMEX represents the cost of one 42-gallon barrel of crude oil before transaction and transportation costs.

The Independent Variables, Functional Form, and Expected Signs of Coefficients
While it is clear that many variables affect the price of crude oil, determining the correct variables for an equation is difficult because there are several ways to measure a single phenomenon. Below are the independent variables and a detailed explanation of why each was chosen and what it means:
-Industrial Production Index: As the world’s economies grow, industrial production expands and global demand for oil increases. Because the United States economy consumes roughly 25% of the world’s crude oil, and meticulous monthly data is collected by the government, the Industrial Production Index was chosen to explain demand for oil in developed countries. The Industrial Production Index measures the monthly physical output of the manufacturing, mining, gas, and electricity industries. Other ways of measuring output, such as real GDP, are inferior to the Industrial Production Index for this model because real GDP measures output in the service and technology sectors, which consume less petroleum than heavy industries. Theory suggests that the relationship between industrial output and crude prices should be linear. Increases in industrial output should mean that oil demand has increased and that the price should rise. A positive (+) sign is expected.
-Non-OECD Consumption of Petroleum: This variable is a measure of oil consumption in the developing world. As the developing world industrializes, the world economy’s demand for petroleum accelerates. Both China and India are two of the fastest growing nations and consume large amounts of oil. Almost all literature concerning the price of oil cites Chinese demand as a driver of prices. The relationship between non-OECD consumption and the price of oil should be linear as well. As the consumption of a non-renewable resource increases, price should rise, so the expected sign of this coefficient is positive (+).
-Change in Crude Stocks: Changes in the commercial stocks of crude oil are an important driver behind changes in price. Quantities of crude oil stocks are stocks of oil held at refineries, in pipelines, in bulk terminals, or any quantities in transit to the aforementioned destinations. If this variable were the absolute level of crude stocks, an inverse function form would be theoretically accurate, because the impact of the stock levels on price would diminish as they increased. Because it is the change in stocks, only linear is appropriate. An increase in crude stocks should ease the market’s fear of a shortage, so the expected sign of this coefficient is negative (-).
-Change in U.S. Field Production: A disruption in U.S. field production should have a large impact on prices. Because the U.S. consumes more petroleum than it produces, it is forced to import crude oil from abroad. As more oil is produced in the United States, fears of a shortage will diminish and the price should fall. The relationship between changes in field production and the price of oil should be linear. The expected sign of this coefficient is negative (-).
-Change in OPEC Output: By restricting output, OPEC has been able to raise the price of oil. OPEC’s share of world oil production has decreased since the 1970’s because new oil fields have come on-line and market power has eroded; nevertheless, OPEC’s pricing power still exists. Theory suggests that the relationship between changes in OPEC output and the price of oil is linear. The expected sign of this coefficient is negative (-) because as OPEC increases output, the price of oil should fall.

NYMEX = -263.354 + 2.894 INDPROD + 0.061 NONOECD - 0.176 STOCKS
(11.600) (0.794) (-2.210)
+ 0.212 FIELDPROD + 0.062 OPEC
(0.9053) (0.676)
N = 42 Adjusted-R2 = 0.8795 DW = 1.400

INDPROD = the Industrial Production Index

OPEC = the percentage change in OPEC output


NONOECD = the percentage change in Non-OECD Consumption


STOCKS = the percentage change in commercial stocks


FIELDPROD = the percentage change in U.S. production

Abercrombie is Too Cheap

Abercrombie is trading at just 15x earnings. Most of the recent drop is due to the company failing to meet same-store-sales expectations. Analysts were looking for a whopping 13% month-on-month growth in sales, but they came in at around 6%, which is particularly robust in my opinion. What analysts forget is that February saw some of the coldest weather in recent history in the East. It doesn't take a genius to figure out that spring apparel doesn't sell when NYC is having a blizzard. The same-store-sales shortfall is likely an aberration.

The company is a proven brand creation machine. After hugely successful Hollister they are pushing forward with Reuhl, which is geared toward the twenty-something age group. I have no doubts that they will continue pushing forward solid brands, just as they did with Abercrombie Kids.

The market is currently holding a 20% off sale. Fair value is somewhere in the $68-$72 range. The market has been pessimistic in the entire retail sector. Urban Outfitters met expectations with morning but is off about 15%. It’s time to load up on ANF.

See chart: http://finance.yahoo.com/q?d=t&s=ANF