MF Global, Now What & How to Protect Yourself

So given that it appears MF Global was running an apparent ponzi scheme at the end of its life, and one would assume the executives behind this would be going to jail.  One would be wrong.

Joe Nocera of the NYT reports (via another NYT article) that prosecutors can’t identify a “smoking gun“ linking anyone to the theft.  Further, “a number of federal prosecutors have expressed doubts… that anyone at MF Global… intentionally misused customer money.” 

Translation, it was chaotic at the end: people at the firm were racing to find money, and maybe accidentally took it from client accounts.  I don’t buy this.  Neither does Nocera, who also suggested maybe executives thought they could repay the money back.

Those would have to be the two most good natured excuses outside of downright theft; however, it would seem neither would be grounds to escape prosecution as may happen.  In fact, some executives might still get their bonuses in hopes maybe they can assist in finding the missing money.  

Nocera mentions why a lack of prosecution sets another terrible precedent:

A failure to prosecute anyone at MF Global would be, if anything, even worse. It would mean that executives at a broker-dealer can indeed steal customer money and get away with it — so long as it was “unintentional.” And it would only deepen the cynicism so many people feel about government.

This quote points to my growing concern of crony capitalism, which is non-partisan.  CEO Jon Corzine was Democratic Senator, Governor of New Jersey, and big fundraiser for President Obama. 

Regardless of my feelings and the fallout, how can investors protect themselves?  Barry Ritholtz, listed a few ways:

1. Don’t leave your money with a firm that trades with their own funds.  They might raid your accounts for cash.
2. Use a third party custodian that only holds your cash and investments.  

I will add, have online access, for an extra layer of protection, and lastly just read the news.  If it appears your broker is in trouble get your funds out of there.

MF Global Customers, What Happened?

Roughly $1.6B in customer cash went missing after the MF Global collapsed.  This was almost 25% of customer funds.  Who were these customers?  Farmers, grain operators and hedge funds who used MF Global to trade in commodities.

Initially it was believed that these funds would be hard to recover.  Luckily, it appears most claims will be settled for 90% of face value.   Does anyone want to take a 10% haircut?  Of course not, but at this point getting 90 cents on the dollar is better than 0.

When I started reading about this I was a bit shocked.  I was under the impression that MF Global could not touch this money.  If a broker-dealer goes bankrupt, client accounts are supposed to be segregated and safe, held at a custodian.  

But in this case, it appears executives stole money from these accounts in hopes that they could save the business.  The firm was highly leveraged and largely went bankrupt in October from bets that went south on European debt.  Essentially these funds would have been used as collateral for their creditors, to pay off creditors or used to double down on existing trades.

In the end, MF Global may have intended to pay the money back to customers, just like Madoff or any other Ponzi scheme.  In my next post, I will update the current prosecution against MF Global and how you can protect yourself against this type of broker-dealer raiding.  

What are Investors Most Worried About?

Business Insider recently ran a poll on “What's the #1 thing you're worried about for the US economy?”  Once I answered, it provided the current results. Here were the top 3 answers:

1. A debt crisis in the US
2. Gasoline prices
3. A war in Iran

Here are my thoughts on those 3.

1. I am not quite sure what this means.  If we are referring to US public debt I have mentioned many times why I am not overly concerned now about a rise in Treasury rates or the inability of the US government to “fund” itself.  If we are talking about private debt, then I think that has more to do with the mess in Europe spilling over here. 
2. This is a concern, but not at current levels.  Check out this blog post from Econbrowser.  You can see gas prices, while at the high end of the range over the last 6 years are not at the peak.  Further, as a percentage of consumer spending on energy goods we are below the average since 1960.
3. Above I said at current levels.  A war with Iran would I imagine cause gas prices to sky rocket.  So this would be a concern on many fronts, but the likelihood is hard to gauge.  Recently a former Mossad head came out against an attack, but there are also articles making an attack seem imminent. The more imminent an Israel military mission looks, and the more economic pressure applied, the more likely Iran is to find some diplomatic solution. This is nearly impossible to handicap.

What are my top 3 concerns?  Below I listed my top three choices from the poll, and do so in bullet form as I give them all roughly an equal weighting:

• European collapse.  This points to the first concern of the masses.  Again, this would be all on the private side (e.g. US banks holding sovereign debt or insuring that debt).
• Fiscal tightening in 2013.  I have mentioned again and again my preference is for more or at least status quo short-term spending.  While I think we are closer to a self sustaining recovery, I see no reason to chance it by cutting back fiscally or monetarily.
• Tie: A war in Iran or a China hard landing.  For the former, see above.  On the latter, there seems to be solid reasons on both sides (hard and soft landings).  A hard landing would certainly have a large impact.

Thanks to TheArmoTrader for highlighting the poll and providing some insight.   

Wow on the Dow

At the time of writing this, the Dow is sitting around 13,000.  In 2007, the Dow reached its peak of around 14,000, so we are inching our way back to the top.

But what is the Dow?  According to Investopedia:

The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The DJIA was invented by Charles Dow back in 1896.

So let’s break that down, “price weighted”, according to Investopedia:

A stock index in which each stock influences the index in proportion to its price per share. The value of the index is generated by adding the prices of each of the stocks in the index and dividing them by the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index.

And how are those 30 significant stocks chosen?  This according to Indexology:

Typically a company is added to The Dow only if has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. While it’s true that both Apple and Google would certainly seem to meet these criteria, this qualification doesn’t necessitate their inclusion in The Dow—nor does their sheer size, although it also weighs in their favor. The Dow’s methodology allows for subjectivity, and ultimately stock changes are made at the discretion of the Averages Committee.

So where does this leave us?  A concentrated index that is heavily influenced by price where stocks are added at the discretion of a committee.  Therefore, the selection of a stock added to an index can have a huge impact on the index level.

According to Buzzblog, three years ago the committee had to pick a stock to replace General Motors.  They selected Cisco.  Adam Nash of Greylock Partners wondered where the Dow would have been if they selected Apple.  The answer?  Right around 15,000 – a new high!

Looks Good, but not Without Reservation

Bloomberg posted an article last week claiming “Stocks Cheaper Than Any U.S. Peak in 23 Years”.  The first sentence sums up what I believe most investors are thinking:

Corporate profits that doubled since 2009 have left the Standard & Poor’s 500 Index cheaper than at all 34 peaks since 1989, even as options traders push the cost of protecting against losses to the highest in four years.

Let’s break this down, first I will address part I of that sentence.

• Corporate profits are strong.
• Valuations are not moving higher with the rise in profits.

In a vacuum, this is good news.  Profits are up; valuations are not correspondingly rising, so it must be a good time to buy stocks.  Not so fast though, you can’t ignore part II of the sentence (insurance costs are high):

• There are still a lot of risks out there; the article alludes to a few:  Eurozone credit crisis, rising oil prices, China hard landing, possible softening US economy (not noted is the removal of stimulus from the system), abnormally high profit margins.
• Given the above, multiples remain low and insurance costs remain high.
• Further, I should note valuations are subjective and not all valuations models tell the same story.

So now what?  If we can avoid the risks mentioned above, given the improving US data, strong profits, and lower valuation level, stocks should have a good year.  That said, the risks mentioned are voluminous and highly impactful. 

Thus, the current state of the markets seems reasonable and supports my overall opinion of the state of the markets this year.

Another Problem with the Demise of America Theory

Last week I showed how America still has the world’s largest economy.  On the heels of that, I read a Vanity Fair article entitled “The Wrath of Putin”.  The article details the relationship between recently elected (again) President Vladimir Putin and Mikhail Khodorkovsky, former Yukos head and owner.

Essentially Khodorkovsky, who was the richest man in Russia at the time of his arrest in 2003, began to call into question Russian business practices after Putin’s initial election win.  Khodorkovsky wants Russia to join the modern world – a place where the rule of law trumps bureaucracy.

Putin, not liking this, appeared to have trumped up some charges and put Khodorkovsky in jail, (conceivably forever, although after Putin’s win the Russian prosecutor will “study” the case) looted his company and caused many other Yukos employees to flee Russia.  In the meantime, Khodorkovsky has become the opposition voice the Putin’s government.

I encourage you to read the whole article; however, my purpose for sharing it is that it does a good job of illustrating the problem with many burgeoning economies – bureaucratic corruption that leads to a breakdown in the rule of law and looting at the top.

Without the rule of law and bureaucratic threats, the following can take place:

• Civil unrest
• Stifling entrepreneurship
• Capital flight
• Brain drain
• Massive misallocation of capital
• Central planning

Until that gets cleaned up in emerging economies, America’s position won’t change. 

Housing Bottom?

One of the best housing (and economic) blogs out there, Calculated Risk, recently announced he believes the bottom in home prices is in (March of this year).  He cites the massive decline in the home prices to rent ratio and home inventory decreasing.  Admittedly, the timing of this is bad as home prices again recently declined.   

Will Calculated Risk ultimately be right on the bottom call?  While I don’t have the answer, much of what I read points to the end of the drop in home prices in the near future.  Some of the more pessimistic prognosticators are calling for another 10% drop.   Even if we have another 10% drop from here the damage is done as we are already 30% off the peak.  Further, individuals and institutions are more prepared than at the peak in prices. 

It should also be noted that housing starts have almost certainly bottomed, making them no longer a drag on economic output.

The worst in housing appears to be over or close to being over.  I certainly am not trying to say we will have a massive rebound in prices.  In fact I think it will be long process, and am trying to relay that home prices won’t continue their downward decent forever and the turnaround will probably be sooner rather than later.

The US in Perspective

It’s fashionable now to talk up Emerging Markets, America’s decline, and a “New Paradigm”.  I can see all the rage, just take a look at the markets recently - Emerging Markets are killing it!  Especially India.

But where exactly does the US stand economically right now?  The answer is still far above the rest.  Per the Pragmatic Capitalist: 

• Our GDP per capita is 6x China’s
• Our nominal GDP is 23% of world output
• (Brazil + Russia + India + China) < US economy
• US Exports Alone > nominal GDP of Russia

And from my own digging (Bespoke & IMF numbers):

• The US % of World Equity Market Cap is 30%
• Brazil + Russia + India + China (includes Hong Kong) = 21% of World Equity Market Cap
• Japan + Germany + France + UK = 20% of World Equity Market Cap
• Japan + Germany + France + UK = 13.6T Nominal GDP in US$, which is less than the 14.5T Nominal GDP in the US

Am I denying that our economic position in the world is getting relatively smaller?  No, it certainly is.  I am only pointing that we are still the top dog and by a lot.  The death of America’s economic influence has greatly been exaggerated.

Further, just because our position is getting smaller doesn't mean we lose.  If world GDP and market cap grow and ours does along with it, everyone wins. 

Positive Employment News

While on hiatus, I came across a variety of good news on employment.  First, weekly unemployment claims continue to move downward:

Manufacturing hours continue to climb, at some point factories will have to start hiring as hours are maxed out.

Third, the unemployment rate is at 8.30% and moving down while the long-term unemployed rate is also going down. 

Lastly, the Washington Post recently noted that there is a shortage of skilled workers.   

If the employment picture continues to get better so will the economy.  That will in turn lead to more positive feedback loops that are self sustaining.  This is one of, if the not main reason, why I think we can have a really good year in the market – absent a large negative event (e.g. European credit about face, middle east escalation).