'Tis Only My Opinion! - May 2003

Volume 23 - Number 5

Who is really ripping the investor off?

$1.4 Billion in fines for Wall Street - but who gets it?

Heralding a new day on Wall Street and for investors, Bill Donaldson, the new head of the SEC, announced the final settlement with 10 major Wall Street brokerage firms on the unsavory practices between investment research and investment banking.  Whether the investor will actually benefit by improved research in the future is open to serious question.

Nevertheless, the SEC, the NY Attorney General and state regulators are using this settlement to attempt to improve investor confidence in Wall Street.

Unfortunately, I view the whole affair from a different perspective.  It was just another shake-down of an industry by an ambitious politician, Eliot Spitzer, who found willing allies to feed at the trough of so-called justice. 

When I was a young security analyst and fund manager on Wall Street, my mentors insisted that we challenge any research report prepared by a Wall Street firm and to do our own due-diligence before investing. That often meant that we poured over the available public data including SEC filings, visited the company, attended trade shows and visited the company's customers, and prepared our own internal research reports.

When in doubt, follow the money!

$1.4 Billion in fines and the SEC believes that $387 million is enough to compensate the defrauded investors. Of course, class action lawyers can file civil lawsuits on contingency fees and go after the rest of the money. But even then, the lawyers will take home between 33 1/3% and 70% of any recovery.

Once again, the investor is ripped off and this time, the justice system deems it to be legal.


According to the settlement, a fund of more than $387 million will be set up for customers of the 10 firms; the remainder of the fines will go to the states. The airing of the regulators' allegations could open the way for a flurry of private lawsuits against the firms by investors who believe they were defrauded.

Let's see, the stock market lost how many billions, or was it trillions, of dollars in capitalization since March 2000.  Certainly, $387 million ought to cover investor losses while the states get $1 billion in fines to help them meet their budget deficits.  Hardly seems fair to me but then when politicians and lawyers get in a back room, anything can happen and often does.

And look who comes out smelling like roses and who was thrown to the wolves.  Sometimes, I wonder how regulators can actually live with their decisions.  To give Sandy Weill and other top managers of the ten Wall Street firms immunity from prosecution is beyond the pale in my judgment.  The whole affair is just another case of letting the big ones slip thru the net while picking up the small fry.

Guess the big fish contributed too much money to various politicians in years past and gave assurances of more in the future.

And did anyone go to prison?  I guess that if you rip off investors for billions that doesn't deserve jail time. But steal a loaf of bread and a gallon of milk to feed your family when you have lost your job due to down-sizing and your house because you can't make the mortgage payment any more and you get 10 years.  Somehow the system is out-of-whack!

Are mutual funds another rip-off with the deck stacked against good performance!

Recently, I had the opportunity to listen to the portfolio managers of a small mutual fund comment on their performance for 2002.  Their presentation was largely based upon the fact that they had outperformed by 80 basis points the average of the mutual fund sector in which their fund was located.  To these managers and their board of directors, their 2002 performance was very good.

However, their shareholders probably had a different perspective.  During the same period, the mutual fund had lost 20% of its value. 

The mutual fund environment because of SEC regulations and the prospectus under which the fund operates prevents many funds from ever doing much different over the long run than the market averages for the sector.

One reason for this performance is that most mutual funds are required to maintain relatively low levels of cash and are prevented from shorting stocks.  The theory behind basically full-investment is to prevent a disaster from happening if every mutual fund headed for the exit door at once.

Another reason is that portfolio diversification does not allow the mutual funds to concentrate their holdings in only a few stock positions.  For any mutual fund over $1 billion in assets, the number of companies in which they can invest becomes limited.  As a fund moves in and out of a stock position except for large cap stocks, these transactions can move markets.

As the size of the mutual fund is reduced, the ability to diversify the portfolio increases as there are more companies available for investment.  Depending upon the available float in shares, it becomes even more difficult to assemble or sell a position of size in these stocks.

Individual investors who want to maximize performance are often advised to limit the number of positions to only a few.  William J. O'Neil cites 6-10 stocks at a time. Others advocate no more than 20.

Some mutual funds have portfolios that exceed 150 stocks.  Very few only have 20 stocks in their portfolio.  If a stock doubles and the portfolio is roughly balanced, what effect does the gain have on a 150 stock mutual fund versus one with 20 stocks.  If you do the math, you would want to have a mutual fund with relatively few positions.

The problem of portfolio diversification for mutual funds along with the requirement to remain invested with relatively small cash positions puts the mutual fund at the mercy of the market and/or sector averages.

Thus, I have a major problem with mutual funds.  Getting a 0.5% to 2% fee on assets for delivering performance that is 80 basis points above the sector average while losing 20% of the stockholders equity is not acceptable in my book.  Being rewarded for lousy performance based upon the amount of assets in the fund is just plain criminal.


The U.S. dollar crisis won't go away!

Despite the military success in Iraq, the aftermath does not portend well for the US dollar. The following chart shows the trend of the US trade weighted dollar index since 1985.  In 1995, the U.S. instituted a strong dollar policy under Secretary Robert Rubin which peaked in January 2002.

Following Easy Al's testimony today before Congress, the U.S. dollar dropped below its previous resistance level as shown on the following chart.

The next resistance level is about 92 and it could only be a matter of a few weeks before that level is reached.

Our trade deficit is about 5% of GDP, and foreign interests, both governmental and individuals, hold a large proportion of our assets as well as our debt instruments.

With the federal budget approaching a $500 billion mark in this budget year, the credit worthiness and the dollar's value is under scrutiny in foreign countries.

Add in the major disasters looming in state and local budgets and you have a recipe for disaster in the bond markets.  The Federal Reserve has been lowering interest rates in an attempt to prime the economic pump.  Of course, one of the major side benefits has been a major reduction in the interest to be paid on the federal, state and local debt. 

The growth in the U.S. federal debt has been explosive since 1977 as shown in the following chart.  The U.S. federal debt limit is now at $6.450 trillion and the U. S. Treasury while waiting for Congress to authorize an increase in the debt limit is using accounting sleight-of-hand that would make Enron and Arthur Anderson look like angels.

At about the same point in time, the U.S. began its descent from being the largest creditor nation until today it is the largest debtor in the world.

The financial outlook for the state and local governments have also taken a recent plunge into red ink as shown in the following graph.

As the economy has slowed during the past three years, state and local tax receipts have fallen dramatically. Politicians were unable to reduce program costs which would have enabled them to live within their budgets. Their only remedies are to either borrow money or increase taxes.  To date, the politicians have opted to borrow money.  But that has added to the pressure on the bond market which has required the Federal Reserve to also adopt a more expansive money supply.

The next war is underway and it is against the US dollar's reserve currency status.

The nations of Old Europe including France, Germany, Belgium and the Luxembourg along the Islamic oil-producing nations are undertaking an economic war against the dominance of the U.S. military.  With the manufacturing base of the U.S. largely destroyed through multi-national companies continual move to low cost countries, the massive debt and foreign holdings of our fiat currency is the Achilles heel.  The U.S. Treasury acknowledges that over 40% of all U.S. Treasury debt is held by foreign governments.

The question of how many U.S. greenbacks are floating around outside the U.S. has been vexing authorities for years.  The years of drug money, illegal arms deals, Russian mafia transfers of IMF loans, and many other illicit transactions make it difficult to determine the exact amount of U.S. dollars in overseas hands.

The recent finds in Iraq of huge stashes of U.S. currency is probably just the tip of the iceberg.  For years, many terrorist and governments opposed to the U.S. have sought to counterfeit U.S. currency.  The U.S. Secret Service is charged with protection of the currency.  But don't ask them to make an estimate of how much counterfeit U.S. currency is floating around offshore. The last time we asked the question the answer was, "Who knows?"

As China and Russia move to increase their gold currency reserves and the Malaysian gold dinar becomes accepted as a currency to conduct international trade coupled with a move to price oil shipments in euro's rather than U.S. dollars, the pressure on the U.S. dollar will increase.  Bijan Latif of the Iranian Central Bank, states that "the establishment of a gold-based currency is rebellion against the IMF, as it is distinctly forbidden under IMF rules." In fact, if the gold dinar is implemented, the role of the IMF and that of fiat currencies will be forever changed.

Was Adam Smith right?

Adam Smith postulated that wealth can only be created through asset creation and/or the exploitation of natural resources.  The following chart shows that the percentage of U.S. labor engaged in manufacturing goods has fallen.

Paul Craig Roberts nailed the problem in his article in the March 7th, 2003 Washington Times when he wrote: 

Adam Smith's argument for free trade is an argument against self-sufficiency in all goods and services. It is not an argument for exporting a country's productive capability to countries with the lowest labor costs.

An economy can, of course, stand some outsourcing. But when goods and services in general are outsourced, where is the economy?

The enormous untapped labor pools in China, India, Indonesia and the Philippines exceed in size the U.S. population. They are sufficiently large to hold down living standards and wages in those countries until all U.S. manufacturing and information technology jobs have been outsourced in order to boost corporate profits.

The U.S. has become a service economy.  Unfortunately, when a service economy is in trouble along with the world economy, services also become subject to the low-cost syndrome.  During the last 50 years, manufacturing jobs have moved overseas.

Today, we are seeing an increasing exodus of professional and service jobs to 3rd world nations.  For example, Microsoft has 1,300 Ph.d's working in Beijing of whom about half received their training in the U.S.  McKinsey & Co., a large multi-national consulting firm, sends a lot of its consulting support work to India for cost-savings as well as being able to take advantage of the difference in time zones.

When NAFTA became law, U.S. labor unions were worried about jobs being exported to Mexico.  Today, Mexico is worried about jobs being exported to China and other 3rd world countries.

The real problem is labor costs.  The average labor cost in manufacturing in the U.S. is $15 per hour whereas in China, it is $.35 per hour.  Some difference.  There is a limit to the productivity game.   Many years ago, our company build the most modern production facility in the world in our industry.  Our American directors were against installing the equipment in our Hong Kong facility until we explained about the difference in both labor costs and manufacturing efficiency. With that plant operating, we were the lowest cost producer in the world and in a short time held 80% of the world market.

If we are truly on our way to a global economy, one of the major problems to overcome is the vast disparity in labor costs and standards of living.  In fact, because of this disparity, it is my belief that the multi-national economy is doomed to failure.  Recently, an article in a newsletter proposed a global minimum wage for workers.

At some point, national or associative self-interest will redraw the geo-political map.  At a recent meeting, I was asked, "How do we stop the decline of U.S. living standards?"  My answer was simply this, "Stop buying foreign made goods?"  If the American consumer refused to buy goods from overseas at Wal-Mart and other discounters, what do you think would happen?

The following graph shows the rapid growth of the deficit in the U.S. current accounts since 1991.

Just how much longer will our creditors allow this to go on?


Beware Chinese bearing gifts of low-cost imports!

  China also plays the currency game with great cunning. The renminbi has been level with the U.S. dollar for several years enabling it to build up its U.S. dollar and foreign currency reserves including its gold holdings.

By keeping the value of the renminbi artificially low relative to not only the US dollar but also other currencies, the Chinese government is able to increase its export market penetration while continuing to increase the job market in China and negatively impact manufacturing competition from other countries.

During the past twelve months, China has also increased its foreign reserves. At the current time, China exports about $8 to the U.S. for every $1 it imports.  It has become the second largest foreign holder of U.S. dollars and may soon challenge Japan for the lead.

However, during the last six months, the Chinese government has also embarked upon a program to place 15% of its currency reserves in gold, and up to 25% of those reserves in Euro's.  This program will materially affect the US dollar as it sells our currency.


What will be the reaction of gold to the dollar falling?

Gold has historically had an inverse relationship to the value of the U.S. dollar. Richard Russell, of Dow Theory fame, suggests that gold could increase in price to over $3,000 per oz.

The following chart shows the price action of gold today.

Quite clearly, the gold market believes that Easy Al's speech today was positive for gold. I agree as he clearly seemed to suggest that if the economy does not improve shortly, another interest rate cut could be in the offing.


Is this a real bull market rally, or are we in a bear trap?

I doubt if any person really knows the answer to that question. However, in my opinion, the market fundamentals are not improving and the market is overbought.

Using historical numbers, the P/E ratios for the DJIA, S&P 500, and Nasdaq are all higher than conservative investors would like to see.  The outlook for earnings growth is still precarious and loaded into estimates some 6 - 9 months in the future.  Of course, some day the Wall Street analysts may get it right.

But with the problems facing the U.S. dollar, the huge deficits facing local, state and federal governments, layoffs continuing, there are many question marks in any forecast.  Many of the companies reporting increased earnings have also reported revenue decreases.  You can only squeeze so much blood out of a company through financial engineering until the company needs a major transfusion or goes into bankruptcy.  The airlines are a perfect example of revenue decreases, financial engineering to cut costs, government handouts, cost structures out of line and over capacity.

Capital spending continues in the doldrums for business as plant capacity remains below 75%. With outsourcing increasing, plant capacity may continue to decrease in the future.  As a larger percentage of a company's products and/or services is outsourced overseas, its profits become more dependent upon currency exchange rates.  Coca-Cola is a great example of a company whose profits can be positively and/or negatively impacted substantially by currency exchange rates.

Also, the seasonal bias in the market ended yesterday.  While there may be a few more breakout stocks and increased earning outlooks to buoy investors enthusiasm, we are still looking at perhaps a 2% growth in GDP.


How should a conservative investor play this market?

Very carefully!  Maintain a close watch on your investments and set Action Points or Stop Loss points to protect one's capital.


The investor is being really ripped off by both Wall Street as well as their government. The value of an American dollar in 1900 was worth $1.00 and redeemable in either gold or silver.  Today, the value of the greenback in terms of 1900 dollars is under 4 cents and is redeemable in only more paper.

Although the U.S. may be the world's military power, the dollar and creditor position of the U.S. is its Achilles heel.  Powerful forces are moving into the Forex arena to challenge the dominance of the U.S. dollar as the reserve currency.  If successful, the ability of the U.S. to continue to fund the deficit in the current account will be compromised.  At that point, the U.S. Treasury and the Federal Reserve are left with very few options, none of which are good for the U.S.

The Bush administration's inaction on placing a substantial portion of the U.S. Treasury debt on a 30 year basis at all-time record low interest rates is a decision that will haunt them in months and years to come.  In effect, by reducing the maturity curve, the U.S. Treasury has lowered the interest rate cost to the federal government in the near term.  When interest rates go back up, and they always do, the interest rate cost on the budget will be much higher.

Market risk is growing daily for investors in both stocks and bonds.  Outsourcing may reduce costs but it also reduces jobs for the U.S.  Do we really want to become a 3rd world country?

In Germany, in 1922, the Reichmark eventually became used as toilet paper since toilet paper cost more to buy.  That is the lesson of fiat currencies.  I hope that we find a way to prevent that from happening to the U.S. dollar.


But then - 'Tis Only My Opinion!

Fred Richards
May 2003

Corruptisima republica plurimae leges. [The more corrupt a republic, the more laws.] -- Tacitus, Annals III 27

This issue of 'Tis Only My Opinion was copyrighted by Adrich Corporation in 2003.
All rights reserved. Quotation with attribution is encouraged.
'Tis Only My Opinion is intended to provoke thinking, then dialogue among our readers.

Last revised April 30, 2003