3rd Quarter 2007

Third Quarter 2007
Market Commentary

 

In our last commentary, we wrote about the impact and influence of private equity in our stock market. We touched upon a number of data points in that report, several of which are worth reviewing. These data points include:

A focus on interest rates, and a discussion of the forces affecting it now.

The absolute size of private equity transactions and corporate buybacks.

The leveraging of corporate America and investment rationale for such activity.

A) A Focus on Interest Rates

The world of finance revolves around interest rates. Insofar as economic activity is concerned, lower interest rates tend to spur business activity; higher rates tend to retard it. The Federal Reserve determines and sets short-term rates. Bond issuers and bond investors determine the level of long-term rates, and banks and intermediate lenders set the price of everything in between.

There have been wide swings in interest rates in recent years. The Federal Reserve Bank, after first raising rates from 3% in early 1994 to 6% in June 2000, kept it around 6% for 11 months of 2001. Then the Fed lowered rates from 5. 75% in early 2001 to 1% and under during late 2003 until June 2004. Then they sharply raised rates again from 1% in June 2004 through 2005 and up to 5% in the summer of 2006.

The high rates of the late 1990s contributed to the recession of 2000 and 2001; the low rates in 2003 and 2004 contributed to the explosion in home refinancings. These, in turn, helped drive real estate prices higher, but also put in place the sub-prime mortgage problem, which is still spreading. In turn, this may in fact ultimately trigger a consumer slowdown, and/or recession, or both, before its over.

Nevertheless, since 2006, the Fed has now kept (short term) interest rates constant for the past year at 5. 25% overnight (Federal Funds) rate. Historically, at any given point in time, interest rates tend to rise as maturities are extended, thus creating what bond investors term a normal, positive or upward sloping yield curve.

Over the past month, the yield market has returned to a normal pattern, after having been either flat or inverted for the prior 2-3 years. An example of an inverted yield curve is one wherein the interest rate on a 3 or 6 month obligation is greater than rates from the same borrower for 3,5, or 10 years. The treasury market has typified this pattern, until the last month.

What has happened here is significant in that it portends, in our opinion, the beginning of what could be a major shift in interest rates. One has to go back a step to follow our logic in this, particularly since most Wall Street analysts and economists over the past six months have been looking for the Fed to lower, not raise interest rates when they signal the next change of Fed policy.

The reason many market observers have forecasted lower rates is that interest rate policy by the Fed has historically been a function of how they interpret inflationary forces in our economy. Given the monthly readings on (core) inflation by the Labor Department, and to the degree one accepts these numbers, inflation appears to be non-existent. Prices are relatively stable, (remember that core excludes energy and food) output is steady, manufacturing is starting to rise again, and unemployment remains low. Further, real estate prices (residential) have begun to fall, new housing starts are in a downtrend, foreclosures are increasing, and banks and other institutions, which are heavy in mortgages, have yet to pull themselves out of the sub-prime mess referred to above. All of the above would argue for lower rates, which is where a lot of analysts are coming from.

In our opinion, they are looking at the wrong set of variables. The key variable is international, and the key player is China. We have written about the impact China and other foreign suppliers are having on our yield curve. China alone is sitting on over a trillion dollars of foreign exchange reserves, most of which is dollar denominated; and they are accumulating additional reserves at a rate of over $4 billion per week. Some believe that the strength of China increases markedly with each passing day - due to the fact that they could seriously disrupt our markets if they ever sold their huge holdings of treasury obligations. Remember that when bonds are sold there is pressure on prices to fall, and correspondingly, yields instantly rise. Cooler heads argue that even if China could do this, it is not in their vested interest to do so, since we are their market. Further, we indirectly employ a huge chunk of their labor force, which in turn, keeps Chinese dissidents off the streets.

Our position is that the Chinese don't have to sell in order to achieve the same result. They just don't have to buy. It may be happening right now. The treasury auction of June 11th offered $60 billion of T-Bills for sale, and foreigners - who have been buying a large percentage of our government bill auctions, only bought $11 billion. This has been a factor in the market pricing in higher rates, which have driven 10 year treasury yields from 4. 65% at the end of May to 5. 30% in mid June, and back to 5. 0% currently. We believe the absence of the Chinese from our treasury auction was a big factor in prices falling and yields rising. It's demand and supply. Higher rates bring in more buyers, and investors who are looking over their shoulder at a falling dollar may not be a player at 4. 6%, but will probably come on board at 5. 3% particularly with a high supply being offered. It's that simple, and it doesn't take much, at the margin to cause prices to change; even in the market for U. S. Treasuries, which arguably is the largest in the world.

In addition, China has stated that they intend to diversify their foreign exchange holdings, and will shift the mix more towards Euro, Yen and other Far East securities, as opposed to just holding dollars. Meanwhile, they're keeping their currency closely linked to the dollar, refusing to let it appreciate by any significant amount. In theory, if a country (like the U. S. ) buys more from a country (like China) than they sell to it, the demand for the (Chinese) currency should rise vis a vis (the dollar), bringing a sense of balance back to the equation and restoring parity among the currencies of the two nations. China has failed to do this, and our growing dependency on them for our day to day products lessens our bargaining power and gives them no incentive to play by the rules.

B) The Size of Private Equity

This brings us full circle back to corporate buy backs and private equity. Last year there were corporate buy backs of $400 billion in stock taken off the market. Corporations like this sweetheart deal with China because it keeps their labor costs way low (50¢ per hour) versus $20-$35 in the U. S. ; and the corresponding labor savings have left corporate America flush with cash. In fact, Barrons reported late last year, that the S&P 500 companies were sitting on over $1 trillion of cash, the largest stockpile in history.

Meanwhile, M&A (Mergers and Acquisition) activity is continuing at a feverish pace. Last year, according to ISI, there were $160 billion of new private equity partnerships formed. On average, this money is leveraged between 4-5 times. At four times, the amount of dollars circling around publicly trading companies available for buyouts, is $640 billion. Add this to the $400 billion plus of corporate stock repurchases mentioned above, and we see that over $1 trillion of stock value was removed from the market in 2006. The S&P 500 Index, which represents the vast majority of the value of all NYSE listed stocks is valued at between $14 - $15 trillion, and the entire listed market, including the top 100 NASDAQ companies, is estimated to be worth approximately $18 trillion. Thus, one can see that by taking $1 trillion of stock away from the listed market, there can be a tremendous upward pressure on stock prices; for even if net income remains constant - per share earnings will go up by the percentage that the fractional purchases reduce outstanding shares.

This year, the pace of both corporate buy backs and private equity investments is increasing.

Both measures of activity were running at higher levels for the first five months of this year versus 2006. We reported in our last commentary that large private equity groups like Cerebrus, Blackstone, Kohlberg Kavitz ET AL, along with investment banking heavyweights like Goldman Sachs and Lehman, are changing and remodeling the landscape of Wall Street with their M&A activities. So what has happened to cause us to revisit this scenario at this time?Well, in addition to the Chinese wanting to diversify their foreign exchange holdings away from U. S. bonds, they have decided that U. S. stocks may be a good place for them to invest their dollar holdings as well.

China has just agreed to put $3 billion in Blackstone, one of the large private equity groups, who, interestingly enough, just raised another $4 billion via an IPO (initial public offering of common stock). While this underwriting is designed to allow the public to participate in the large profits Blackstone has generated, our take is that Blackstone (and others) may be feeling pressure from their lenders to pay down some of their leverage, and the public market would seem to be a good place to do it. Further, the four or five to one leverage they were granted is generally tied to floating rate debt, so deals done at 4% to 5% interest rates in their projections either aren't as likely to get done, or its going to take more money to do it. So we see the probability of a number of these deals coming down the pike for the reasons listed above.

C) The Rationale for Leveraging

Finally, item C, the leveraging of corporate America continues unabated. A lot of this has to do with something referenced, but not discussed in detail last quarter. That is the earnings yield of stock. As opposed to the dividend yield, which are dividends/share price, or P/E multiples, which areprice/earnings; the earnings yield is earnings/price or the inverse of the P/E multiple. Translated, what this does is show someone who wants to buy an entire company i. e. all the shares of stock instead of a percent of outstanding shares, how long it will take to recapture their investment, given a constant earnings stream. (i. e. an earnings yield of 8. 5% will take 12 years; an earnings yield of 10% will take 10 years. )

No one has taken this to heart more advantageously than private equity groups. Private equity groups have essentially been given unlimited access to capital, and they have been borrowing in huge amounts; as mentioned above. Compare their activities to what many of us have experienced in the real estate market. If one buys a $500,000 piece of property with $100,000 or 20% down, and 5 years later the property is worth $1,000,000, the equity value of this investment will have increased five fold - $100,000 to $500,000 (market value - debt = equity).

The appreciation that homeowners have enjoyed over the past five plus years is now being accomplished in the public equity market; only this time, private equity groups have leveraged publicly held companies, and taken them private.

The difference is that homeowners buy property with a long term time horizon, live on the property, and make it their home. The corporate buyouts are purely business transactions designed to squeeze whatever long term value exists in a business in as short a period of time as possible. In many cases, this can be accomplished by leveraging the assets, and then using the spread between the earnings yield and the cost of borrowing to capture the spread.

Taken individually, each of these deals can be looked at as phenomenal success stories - which is why so many investors wanted in on the Blackstone offering.

In the aggregate, however, one has to wonder where all this liquidity and conversion of free assets to indebtedness leads us; and whether or not the size of these endeavors puts a serious risk on the financial system and hence on the whole economy.

We are concerned about this, in that the major banks are stretched - and have shifted a large part of their lendable funds to a smaller group of borrowers. It's a profitable business for both the banks and the buyout firms as long as the earnings (net income) of a business exceeds the cost of capital (borrowing rate). But, as stated above, interest rates fluctuate quite a bit, and increasingly, foreigners are a factor in determining what these rates will be. It's no longer just the province of the Federal Reserve.

As an example, lets review a hypothetical transaction. Suppose a public company can be purchased at 12 times earnings. If the PE is 12-1, then the inverse, 8. 5, is the earnings yield. So if a private equity firm can borrow at prime less two (8% minus 2%) or 6%, and simultaneously enjoy an earnings yield (earnings / price paid for the business) of 8. 5%, that firm can enjoy a positive spread of 2. 5% on capital invested.

If that capital is 20% equity and 80% debt, then the parameters of the investment change sharply if the cost of carrying the 80% debt goes up. Margins narrow, profits tighten, investors are looking for higher returns, the cost of carrying debt rises, and banks get nervous and want more equity. This, in our judgment, is why Blackstone went public, and we foresee more to come.

In the meantime, it isn't Greenspan or Bernanke who will be ratcheting rates up this time; it will

be China, India, et al, as they are the ones accumulating surplus dollars through their trade surpluses with us. And the Fed will have little choice but to allow rates to rise in order to accommodate them; for as the agent for the treasury, they realize rates may have to rise to allow the treasury to get the money they need to pay for our indebtedness. This is the reality, at least at the present time, of the global world we are racing into.

Conclusion

Rising interest rates will eventually slow the American economy down, and particularly affect interest rate sensitive industries such as housing and autos, but the sheer dollar amount of M&A, private equity and stock buyback activity should act to drive stocks higher and overcompensate for any near term weakness in the economy.

 

Sincerely,

William H. Schnieders

John C. Schnieders, CFA, CFP®

James F. Schnieders, CFA

See our commentary on Real Estate in the Fourth Quarter 2006 for a broad overview.

 

The recent call on Bear Stearns to ante up over $3billion to keep collateralized mortgage obligations afloat, attest to the severity of this problem.

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