Yet the stocks of real estate investment trusts (REITs), which are popular among income-oriented retail investors, are still trading at high enough levels that discount just a garden-variety recession in commercial real estate. REITs were designed to invest in portfolios of rental properties, and generally pay no corporate income taxes if they distribute at least 90% of their profits as dividends to their shareholders.

REITs were designed to thrive in an environment of steadily rising property values and rents. But in this ice age for commercial real estate, the REIT business model will cease to function properly; a REIT’s tax-free status doesn’t allow it to retain much excess capital during lean times. Since REITs pay out all their earnings, they cannot grow without taking on more debt. During the boom, a REIT strategy encompassing growth, leverage, and acquisitions was a virtuous cycle that led to juicy dividends and soaring stocks; in this bust, it’s morphed into a vicious cycle of dividend cuts, dilutive equity offerings, debt offerings at double-digit interest rates, and bankruptcies.

The REITs that levered up and grew too fast at the peak will go to zero in bankruptcy. Others could fall into the low single digits by year-end as the market anticipates that creditors will take title to many properties in 2009 and 2010. These developments would push the value of the REIT Index dramatically lower.

$1.6 Trillion in Commercial Real Estate Debt Needs to Be Refinanced

The REIT sector is undercapitalized – just as the big banks were last year. If you mark the value of commercial real estate to market, it tells you that REIT debt in all its forms – commercial mortgages, unsecured notes, secured lines of credit – is much too burdensome. Equity cushions that seemed adequate at the commercial property market peak are now thin. REITs don’t have to mark their assets to market each quarter like investment banks. But you can be sure that before committing a single penny to a secondary offering of REIT stock, institutional investors will mark property portfolios to market.

Marking property to market will result in many underwater commercial properties. This is critically important because the combination of underwater properties (insolvency) and imminent debt maturities (illiquidity) tends to wipe out equity. The maturities over the next five years are staggering, and these debts were sloppily underwritten near the peak of the credit bubble. According to Goldman Sachs research, roughly $1.6 trillion in commercial real estate debt is coming due 2009-2013.

Lenders will not be willing to refinance mortgages in situations where mortgage debt exceeds the value of the property – so-called “underwater” properties. In order for all of these $1.6 trillion in loans to qualify for refinancing, hundreds of billions in new equity will need to be injected into properties. This much new equity capital dedicated to commercial property ownership will not exist in the investing environment of 2009-2013, so many of these loans will default.

In a scenario of paying off staggering debt loads under stress, the claims of common shareholders are either diluted or wiped out completely. This is the scenario facing General Growth Properties, and shareholders will be lucky to recover anything. You can find shades of the General Growth saga throughout the REIT space.

The Credit Markets Are Signaling Danger for REITs

Bulls argue that REIT stocks are cheap enough to buy. After all, they’ve declined to the point that you’d be buying ownership stakes in commercial real estate at prices well below peak values. Also, the high dividend yields already reflect plenty of pessimism.

What is the credit market’s response to REIT bulls? Creditors will take title to many properties in bankruptcy, and dividends will be paid mostly in new shares of REIT stock, rather than cash. I side with the credit markets.

A review of the aggregate REIT balance sheet – and the delusional commercial real estate purchases during the 2006-2007 peak – will tell you that this won’t be a garden-variety bear market in REITs. Supply of retail, office, hotel, and industrial space will greatly exceed demand for several years. In most cases, tenants will have the upper hand in lease renegotiations. This bear market, which is still in its early stages, will go down as the worst REIT bear market in history.

Will the TALF Bail Out REIT Shareholders?

So will the TALF come to the rescue? Wasn’t the Federal Reserve’s “term asset-backed securities loan facility” (TALF) designed in part to mitigate the systemic damage from the time bombs ticking inside of CMBS? A primary reason for the recent rally in REIT shares is hope that the TALF will help restore value to equity of the most-indebted REITs by loosening up lending for commercial mortgages. The Dow Jones U.S. real estate index rallied from an intraday low of 80 in early March to a recent 130 (see chart below). But this REIT rally is based on hope, rather than strong fundamental evidence.

The Fed does not restore equity value to leveraged financial companies sitting on toxic assets; it merely tries to prevent stressed borrowers from unwinding positions too quickly. Look at how little equity value the Fed’s unprecedented lending facilities salvaged for Citigroup shareholders. TALF will do little to preserve equity value for highly indebted REITs. The Fed did not eat the losses on Lehman Bros.’ garbage securities, nor will the Fed or the Treasury eat losses that must be first absorbed by shareholders of overleveraged REITs.

Plus, potential limits on executive pay could limit interest in TALF participation. Special Inspector General Neil Barofsky said in a recently published report that executives involved with the TALF program “could be subject to the executive compensation restrictions.” Whether or not compensation restrictions are enacted as part of TALF, the mere threat of capricious rule changes and taxes imposed by Congress and the administration will scare many potential managers away from TALF.

While there are certainly opportunities to be had in this market, as I see it, REITs aren’t one of them. That said, after the closing bell today, I’m recommending an exciting new play to my Strategic Short Report readers that could generate as much as $200,000 in profits. If you want to be one of the first to act on this opportunity, visit the Strategic Short Report website for more details.

Regards,
Dan Amoss

July 10, 2009

Beware of the REIT Reality was originally featured in the Penny Sleuth.

It all begins with the struggling consumer: your neighbor. His home is worth 20% less than it was just a couple of years ago and he’s upside down on his mortgage. He was laid off from a good job back in November when everyone started to fear the worst—and was forced to take a job that pays much less.

During better times, your neighbor would pay lip service to the idea of saving money — without actually following through, of course… But the situation has now become far more serious. It’s time to save some dough and pay those bills on time… or risk losing it all.

But where to cut back? Here is a list of the average household’s top expenses, in order:

1. Social Security taxes
2. Mortgage
3. Car payment(s)
4. Groceries
5. Restaurant meals

Your neighbor can’t cut back on payroll taxes. And he has to pay the mortgage to keep a roof over his family’s head. He also needs to keep his car so he can make the drive to his job every morning. But he can always cut back on food… the easiest and most effective way to balance any family’s ailing budget.

Buying cheaper groceries is a start. But cutting back on restaurant food is crucial. As far as we’re concerned, there are three kinds of restaurant food: fine dining, casual dining, and take-out.

As you’ve probably already guessed, fine dining stocks are getting crushed right now. Morton’s Restaurant Group Inc. (NYSE: MRT) — the folks who brought us the posh Morton’s Steakhouse restaurants — have seen shares plummet more than 80% since September.

The other end of the dining spectrum is where we can make our money. As revenues at casual and fine dining establishments sag, cheap take-out and fast food joints will continue to attract cash-strapped customers. After all, a sack of burgers can sometimes be a cheaper alternative to buying groceries and cooking at home.

The ultimate in cheap food is pizza. You can’t go anywhere else and buy so much food for such a small amount of money. Your down-on-his-luck neighbor can even swing by a pizza chain on his way home from work and pick up dinner for his entire family for $10 to $15.

That’s why we’re turning to pizza’s fast food roots — Domino’s Pizza Inc. (NYSE: DPZ). This stock was $13 in September. Now, at about $7 per share, Domino’s is trading at seven times earnings and less than half sales.

Domino’s competitor Papa John’s Inc. (NASDAQ: PZZA) — also a small-cap—has seen share rise more than 50% since November. With a more reasonable multiple approaching more reasonable levels, Papa John’s has managed to sustain revenue throughout the 2008 fiscal year.

Be sure to add these names to your short list of recession-resistant plays. Both stocks warrant additional research.

Best,
Greg Guenthner

February 10, 2009

Recession-Resistant Restaurant Stocks was originally featured in the Penny Sleuth.

As you can see from this chart, existing home sales in December shot to the upside. In fact, compared to November, home sales were up 4% in the Midwest, 7.4% in the South and a stunning 13.6% in the West. And while the Northeast took a bit of a hit, all told home sales in the U.S. rose a respectable 6.5%!

Good news? No doubt about it. Rising home sales mean that buyers are coming back into the market. And that means that one of the biggest investments out there for most people — buying and paying for a house — is showing signs of health. Now, factor in the ripple effect sparked by home sales transactions — including banking business, contractor activity and a boost in tons of home-related products and services — and the news gets even better.

But that’s not all. The latest report from the National Association of Realtors also shows that the supply of existing homes is falling. With about 3.7 million units on hand, current existing home inventory amounts to 9.3 months of supply. That’s the lowest supply level in a year and is significantly off last year’s high of 11.2 months booked in April.

The culprit? No big surprise here: Tumbling home prices. In fact, during December the average home in the United States fetched $175,400, down 15% from the year-ago period’s $207,000. And while that’s painful for home sellers, it’s also the sign of a sector beginning to right itself.

Here’s my point…

Imagine you’re an average retail store owner. You’re managing the store day-in and day-out, and you know that times are tough. Sales are weak and customer flow is just not what it used to be. And while your daily bank deposit isn’t terrible, it’s certainly not what is used to be.

So, what do you do? In a nutshell, you hunker down. You buy the products that carry high-margins — read: high profits — and that are in big demand. You keep inventories lean by buying just enough to keep the store stocked. And for those inventories that haven’t been moving, you make the oldest move in the book to get them off the shelf: You drop prices.

That’s exactly what the real estate market is doing: It’s lowering prices and, as a result, sales are beginning to spark. And while that may seem plain and simple, I don’t have to remind you of markets where, no matter how low the prices fell, no one wanted to buy.

Bottom-line: While the real estate market is hardly out of the woods, the latest data is certainly a step in the right direction. And no matter how you slice it, that’s a positive for the broader economy and the stock market.

Best wishes,
Wayne Burritt

January 28, 2009

Existing Home Sales Show Glimmer of Hope was originally featured in the Penny Sleuth.

Cycles are an inseparable part of the landscape of markets. Fortunes are often made in the valleys. I was thinking of this after I read several obituaries of Trammel Crow, who died this month. He was a guy who saw many booms and busts over his 94-year life.

Trammell Crow was a big-time developer and died a rich man. The Wall Street Journal once described him as “America’s biggest landlord.” His firm, Trammell Crow Co., estimates it built some 500 million square feet of real estate space. But it was a long road to get there from humble beginnings. His life is one of those great American success stories.

Unable to attend college because of the Great Depression, he took a number of odd jobs, including plucking chickens and unloading boxcars. Eventually, he landed a job at a bank, and then studied to become a public accountant. By 1938, at the age of 24, he was the youngest CPA in the state of Texas.

After World War II, he got his first experience in construction building grain elevators with Doggett Grain. Eventually, he managed to build his first warehouse with a partner and leased it to Rayovac Battery Co. It was his first real estate success. He was on his way.

There would be good times and hard times on this journey. The 1970s downturn nearly bankrupted him. But it didn’t take out any of his risk-taking nature. “I once heard it said that the cat that is burned on an oven range will never touch a hot one again,” he said in a 1980 interview. “True enough, but that cat won’t go near cold ovens either. The same is true for business. Failures that transform a businessman into a super-cautious individual can cripple.”

I also remember Trammell Crow from my career in banking. I started out banking when I was 22 years old. I remember working with a senior lender on a deal to finance a big real estate project. He pointed out that we had to be sure we liked the collateral because the developer might toss us the keys, like Trammell Crow. I must’ve had a somewhat puzzled look on my face because the lender asked me, “You know who Trammell Crow is, right?” And he asked it in a way that you might ask someone today if they know Barack Obama.

I honestly can’t remember what my answer was. I remember the embarrassment of not knowing who he was. Yet he was among the most famous developers in the country. A 22-year-old always thinks he knows more than he does. It’s one of those things.

Anyway, the senior lender was referring to a well-known episode Trammell Crow had with his bankers. He basically tossed a bunch of keys on the table on told them they could either give him new terms on his mortgages or take the keys. They reworked terms.

Old Crow was an American original. He left quite a legacy, and not only in the millions of square feet of real estate and the fortune he leaves behind. Many talented people came out of the Trammel Crow ranks and went on to become major real estate players. He had a huge influence on the industry.

Until next time,
Chris Mayer

January 26, 2009

Trammel Crow: Lessons in Real Estate Investing was originally featured in the Penny Sleuth.

When our portfolios are headed higher, we usually go out and spend like the dickens.  After all, with nice fat investments we feel like we have a lot more money to spend.  And, as well all know, spending drives the economy.  Result:  Stock prices and the economy get a boost.

In addition, the wealth effect is a brand of self-fulfilling prophecy, which makes it even more powerful…

By investing in stocks that go up, we have more wealth.  Having more wealth causes us to go out and spend.  That spending, in turn, causes the economy to grow.  Economic growth then leads to better times for companies which, in turn, lead to higher stock prices.

Unfortunately, the power of the wealth effect works in reverse as well…

When we see our stock portfolios getting hammered, we feel a lot less wealthy.  That loss of wealth causes us to pull back on spending.  Less spending means slower economic growth, which is lousy for companies.  Poor outlooks for companies mean lower stock prices.

And declining wealth isn’t limited to stocks.  Take a look at this chart of real estate prices…

As you can see from this graph, the year-over-year change in home values — indicated by the dark solid line — began to slow around the beginning of 2006.  But economic growth — indicated by the red dashed line — didn’t begin to slow until the middle of 2008.

In other words, the wealth effect in real estate wore off long before the economy began to sputter.  In this case, the declining value in real estate was a huge leading indicator of poor economic activity to come.

In fact, changes in just about any asset — from stocks to houses to commodities — can cause their owners to adjust their spending habits.  And those spending adjustments are going to happen after the owners’ assets take a hit.  And that makes them a great predictor of where things are headed.

I’ve told my readers time and time again that a recovery in real estate prices — and stability in the real estate market — is likely going to be one of the biggest pluses for a stabilized economy and higher stock market values.  Real estate got us into this mess and it’s going to get us out.

Using These Leading Indicators for Profit

So, how can you make money off the predictive abilities of the stock market and other asset classes?

Simple.  While others are waiting for the big economic indicators — such as solid growth, the labor market, and the credit crisis — to get back on their feet, you can slip into key investments long before anybody else gets wind. The markets are telling us loud and clear patience will be rewarded.

Best wishes,
Wayne Burritt

January 7, 2009

Profiting from the Wealth Effect was originally featured in the Penny Sleuth.

Inflation is the silent predator that’s constantly stalking your retirement savings.  Normally, you have to outpace inflation to stay ahead of the game, and realize any significant returns. But, in some cases, inflation can be good for your investments.

Today we’ve found five penny stocks that could actually rise in value as the dollar falls.

With the Treasury printing money like its going out of style, and with the bailouts ongoing, the government is in danger of creating a huge inflationary bounce back in the wake of this economic crisis.

So, how can penny stock investors profit from the pending inflation?  Well, why don’t we take a look at what gold did yesterday:

The spot price of gold jumped from $840 to near $860 after the rate cut was announced yesterday.  The gold rally continue this morning, with gold rising to as much as $880.  In less than 24 hours, the spot price of gold increased by roughly 4.76%

Take a look at what our colleague Ed Bugos, editor of Gold & Options Trader , said recently about gold:

“The fundamentals are significantly bullish for gold. I’d like to say they are bearish for the dollar, but in truth, they are increasingly bearish for all paper currencies. Outside of the Bank of Japan, everyone is inflating madly.”

Higher inflation means higher gold prices. It only make sense that if there are more dollars in circulation, and each dollar is worth less, than it will take more dollars to buy an ounce of gold.

Since Dec. 5, when the price of gold fell below $760 per ounce, it has increased an astounding $120. That’s a 15.79% gain in a matter of only 12 days.

Now is a great time for penny stock investors to buy up stock in gold miners. Many of these gold stocks have been slammed over the past few months, and they can now be picked up at extremely cheap prices.

Our friend Dan Amoss, editor of Strategic Short Report , suggests that investors take a look at precious metal stocks as the inflationary storm approaches. “How can you profit from this unprecedented inflation,” Dan asked, “By owning precious metals and precious metals stocks.”

As the dollar becomes weaker, and gold prices continue to rise, gold miners could see a huge boost in their share price.  Below are five small cap miners with a share price below $10 and with a market cap under $1 billion:

• Apollo Gold Corporation (AGT: AMEX) is involved in the acquisition, exploration and development of gold deposits, with current projects in the United States, Canada, and Mexico
• Aurizon Mines Ltd (AZK: AMEX) is a Canadian gold producer focused on developing its site in northwestern Quebec.  Aurizon is also conducting the exploration of three additional gold projects in the Quebec region.
• Fronteer Development Group Inc. (FRG: AMEX) is another Canadian-based gold exploration company.  In addition to its Canadian projects, Fronteer also has sites in Nevada and Turkey.
• Ivanhoe Mines Limited (IVN: NYSE) is an international miner focused on the Asia Pacific region.  Ivanhoe is currently exploring multiple sites in China and Mongolia.
• Minco Gold Corporation (ADR) (MGH: AMEX) is involved in the acquisition and development of gold properties in China.  At this time, Minco has five gold projects throughout China.

So, check out these miners for yourself and see what you think.  Feel free to post your thoughts on these companies in the comments section, as well as any other gold miners you might come across.

Best Regards,

John Schuler
December 17, 2008

Gold Penny Stocks should bounce after Fed’s Rate Cut was originally featured in the Penny Sleuth.

We teeter closer to the sequel no one wants to see: Great Depression II. We got horrible news on the job front last week. Unemployment climbed to 6.7% as the nation lost another half a million jobs in the month of November alone. It was the worst rack of numbers in 34 years. One in 10 American mortgages is now either behind on its payments or in foreclosure.

Businesses are cutting back. Consumers are cutting back. Commodity prices have collapsed. The stock market is down more than 40% this year. When we close out the books for 2008, you’ll have to go back to the 1930s to find a comparable disaster for stocks in a single year.

So I find myself looking back at the 1930s often these days. What survived and what did not? The story of American Home Products is worth a quick look, as it offers one idea of what did make it — and winded up doing pretty well.

American Home Products was an anomaly in American business. Started in 1926 by a group of businessman long since forgotten, AHP was a maker of household products. It started out as a true small cap and grew quickly through acquisitions. Nothing so unusual about the tale so far. After all, the second great merger boom in American business took place in the 1920s. The period gave us many names we still know — including General Motors.

But AHP was unusual in two respects. First, it continued its acquisition spree through the Great Depression when everyone else was battening down the hatches. It could do this because its finances were top-notch and its earnings power robust. Ben Graham, that great old investment writer from long ago, gave AHP a mention in his 1940 edition of Security Analysis. He gives us an appendix with the stock prices, earnings and dividends of AHP from 1929-1939.

AHP was not immune to the Great Depression, whose effects linger on its financial record. But the stock never came close to reporting a loss. Peak earnings of $5.49 per share in 1929 fell to $3.93 in the depths of 1932. It recovered by ‘39, turning in $5.23 per share.

Investors who held it through the Great Depression did all right. The stock price bounced all over the place, as you would expect. It hit a high of $86 in 1929 and a low of $25 in 1932. But by the late 1930s, it was still humming along in the $50s and would hit $60 per share in 1939.

All the while, it paid its investors nice dividends — a total of $34.35 over the decade. Considering what happened to the rest of market, and keeping in mind the dollar held its value better then, you would’ve been happy to park some money in AHP that decade.

There is a second trait that marks AHP as an anomaly: It bought businesses in unrelated industries. It owned firms in floor wax, coffee, oil, cheese products, insecticides and much more. It was the early model of a conglomerate. In this, AHP defied the wisdom of the times, which consolidated related business. It was the age of General Motors and General Foods and International Harvester. Big empires built in one industry. But perhaps AHP’s diverse platform helped it weather the Depression better than if it had only a floor wax business.

So here we have a model of survival in the worst of times. AHP was a well-financed business that did more than one thing. It was an opportunistic business in the best sense of the term. It bought firms when and where they were cheap, without regard to the lines that divide industries.

Well, maybe the conglomerates of today will also fare better in today’s harsh climate. We own quite a few of these kinds of businesses in our Capital & Crisis portfolio. You can join my readers and check out these stocks while they can still be had on the cheap.

Until next time,
Chris Mayer
December 9, 2008

Conglomerate Stocks: The Great Depression Success of American Home Products was originally featured in the Penny Sleuth.

There are fears that banks will never expand lending again, and that everyone with debt wants to pay it down as fast as possible.

I think these fears are excessive. They ignore the massive and limitless inflation schemes coming from the Treasury and the Fed.

Those fearing deflation assume that every American consumer is stereotypical: an overextended, credit card-addicted, house-flipping gambler. This is simply not the case. Many Americans don’t have a mortgage. And most Americans with mortgages are still making their payments.  They have, however, temporarily reigned in discretionary spending because of falling house and stock prices.

Those fearing deflation also assume that demand for debt is low and falling. But demand for debt doesn’t always come from businesses or households looking to invest more or spend more. Any business or household looking to refinance existing debt at lower rates — and there are many — is a source of demand for new debt. Banks borrowing at the Fed window at 1% or less will be looking to supply this new debt by make highly profitable loans to creditworthy borrowers.

Once borrowers refinance, they may not be as aggressive about spending or expanding business as they used to be. But at least they will have access to credit. In the Great Depression, they did not. So the economy fell into a negative feedback loop of asset sales, bank failures, and rising unemployment.

Treasury and the Fed will keep taking extreme measures to slow down the pace of credit contraction and housing prices — cutting off this deflationary feedback loop. This could include nationalizing Fannie Mae and Freddie Mac and using the Treasury’s low borrowing costs to refinance hundreds of billions in existing mortgage debt into new 40- or 50-year mortgages with reduced principal balances.

Sure, such an action would guarantee a decade or more of stagnation in housing prices, but it will also slow or flatten the rapid decline in prices. This is the essence of the Treasury and Fed actions: to stop the deleveraging from getting out of control — even at the cost of future economic stagnation. Like it or not, I think this is the most likely outcome from this crisis.

If this new debt is too much for savers and foreigners to absorb, I’m sure the Fed would set up an Enron-style conduit to buy up, or “monetize” new Fannie Mae paper.

Remember, Fed Chairman Bernanke believes that the Great Depression and the Japanese deflation grew steadily worse because the government and central banks weren’t radical and decisive enough in their pro-inflation policies.  So there’s every reason to expect radical new inflation policies in the coming months.

Best Regards,
Dan Amoss
November 17, 2008

Rising Inflation: How the Fed’s Pro-Inflation Policies Spell Opportunity was originally featured in the Penny Sleuth.

Jeremy Siegel, one of Wall Street’s best investment minds, said that, “Some of the most successful investments of the last thirty years have come from industries whose performances have been utterly horrendous.”

And if ever there was a horrendous market, housing’s it. The housing industry has sunk almost 40% this year, sending most investors heading for the hills…but not all…

There’s a niche in the housing market that’s actually been doing quite well over the last month, returning 36.4% when the S&P was fighting off some of the worst losses in history.

Putting the Fab in Prefab

Prefab manufactured housing has been making a comeback in spades. The industry has been growing at a steady clip for one obvious reason: in today’s credit crunched economy, people are looking for low-cost means to home ownership.

Prefab manufactured housing is the sector of the housing market that includes things like trailers and RVs, as well as higher end modular homes that are built off-site and put together at the construction site. The beauty of these kinds of homes is the low purchase cost for consumers.

Because prefab homes are so much less expensive to build in a factory setting than a traditional home at a construction site, they’re becoming a welcome alternative for those who don’t have the money to pony up for a custom-built home.

And why shouldn’t consumers love prefab homes? From a quality standpoint, there’s almost no difference between a completed prefab home and a custom-built one. According to an article in BusinessWeek, “Thanks to style-conscious architects, today’s manufactured houses prove you can combine low cost and high design — and they’re selling well.”

Many people see the prefab world as the future of the housing industry — imagine, putting up a home in 2-4 weeks at a fraction of the cost of building from scratch. The trend’s an impressive one…

Like most, I grew up familiar with traditional construction. You can imagine what a surprise it was then to find that back in my home town, a new house had been constructed in just a couple of weeks in the neighborhood my parents live in. “It’s one of those modular homes,” explained my father when he noticed the confusion on my face as we drove by.

The most impressive part about the modular home phenomenon is the fact that these houses don’t look any different from any other house you’ve ever seen. They don’t feature any fewer amenities. But they do have marked advantages. Sounds like a stock play to me…

Prefab Performance

Prefab homes are a small niche with only a handful of stocks. But just look at the numbers, and there’s no question about the potency of prefab. 83% of companies in the industry saw returns in the last four weeks — almost half of which were in the double digits.

Skyline Corp (SKY: NYSE) and Champion Enterprises (CHB: NYSE) are a couple of examples of small-cap prefab home companies that saw nice returns in September. In fact, small-caps rule the roost in the prefab arena…most companies have market caps between $33M and $450M, making them an interesting play for penny stock investors.

As prefab homes catch more and more attention from real estate developers and consumers, you can bet that this trend will keep going strong.

Cheers,
Jonas Elmerraji

November 12, 2008

Bringing Down the House was originally featured in the Penny Sleuth.

Every crisis, though, brings opportunity. In this one, investors will go back to investing in simpler, more durable things (at least until forgetfulness kicks in). For instance, investing in a company that supplies grains to hungry people looks like a better bet than investing in one that sells mortgages to people who can’t afford them. The focus will shift to things we need, rather than things we want.

As I write these words, I’m in Paris, France, sitting at one of those cafes that spill out onto the sidewalks. The two towers of Notre Dame are visible across the Seine. It is a bright and cool fall afternoon. A blackboard propped up outside the cafe carries the daily fare written in chalk. A typically gruff waiter in rolled shirt sleeves takes my order after what seems like a really long time. I’ve slipped into the Parisian pace of life, in which meals take an especially leisurely turn.

The French have a chance to gloat a bit. Even though the crisis in America, the world’s biggest economy, helps no one, the French may have a better shot than most at coming through it with only flesh wounds. The housing market stinks in France, too. Housing sales in France are off 20% in the last 12 months. But the French market is not nearly as leveraged as the U.S. market was.

Financial innovation seems to occur slowly here. Mortgages in France are typically for terms of only 15 years. The French have also not embraced creativity in this field, as most mortgages bear fixed rates of interest. There is no subprime market. And French consumers did not borrow much against the rising prices of their homes. (The savings rate here is 13% of income, versus zero in America.)

The U.S. economy followed a very different path. Sometime over the past few decades, we abandoned the old-world notion of making things. We turned to making shuffling paper our stock in trade. Precisely when and why this happened will be something for historians to debate. But sometime in the 1990s, the percentage of corporate profits from finance passed that from manufacturing.

It was the first time that had happened, and the gap has only grown wider since. Before the great credit crisis hit, profits from financial firms made up nearly half of corporate profits. Only 10% came from the manufacturing sector. As recently as the mid-1960s, it was the other way around.

The French go on and on about their cheeses, wines and breads. For us, mortgages became our national product. Mortgages, before the crisis hit, made up 60% of total bank loans and the financial sector grew to become our biggest sector — bigger than health care, retail or manufacturing.

The implication of this post-finance U.S. economy is a theme we’ll explore more in this letter. As an early conclusion, though, I believe the spread between finance and manufacturing has reached millennial extremes, like a rubber band at its limits. Now begins the snap back.

Until next time,
Chris Mayer

November 3, 2008

P.S.: In the current issue of Capital & Crisis, I lay out my ideas for investing in the post-financial world. One idea focuses around a family-owned conglomerate that combines operations in pork, grains, shipping and more.

The Crisis of American Capitalism was originally featured in the Penny Sleuth.