Barrons: Interview with John Moffat

The Year of Living Cautiously

By LAWRENCE C. STRAUSS

Analytic Systems' president and founder, John Moffatt, explains why he's overweight health care, financials and utilities—and why commodities like gold aren't as safe as people think

It's time to get defensive, albeit not by hoarding a lot of gold. That's the view of John Moffatt, president and founder of Analytic Systems. The Hopkinton, N.H., firm does sector analysis, based on its quantitative model comprising 20 economic factors, including inflation, demand for credit, housing, real personal income, consumer spending and the cost of energy. Moffatt, a 70-year-old Texas native whose résumé includes a stint working as an analyst for George Soros in the late 1960s and early 1970s, founded his quantitative-investment research firm in 1982. Currently, his recommended model favors health care, utilities and financials. The lone sector he rates underweight is consumer discretionary, with the rest neutral. Barron's, which profiled Moffatt 10 years ago ("Blue Skies Ahead?," May 28, 2001), interviewed him recently by phone to hear his latest thoughts on the economy, sector weightings and other topics.

Barron's: Let's start with your big-picture view, John.

Moffatt: We've been talking about a soft patch for some time, despite the consensus earlier in the year that the economy was going to accelerate by more than 4% in terms of annual gross-domestic-product growth. We are in the muddle-through camp, based on the industry groups we cover, growing at around 3%. We listened with interest to [Federal Reserve Chairman] Ben Bernanke's characterization of a soft patch in the economy, and the inflation rate as being transitory. The weakness in the economy may be transitory, but I would doubt that the increase in inflation is so transitory, and, in fact, we may see some stickiness in inflation. So in this environment, we are semidefensive, and one should be somewhat cautious. Instead of chasing high-momentum groups and names, we are opting for more safety with health care and utilities, which are both working fairly well, and financials, which aren't working yet. And we are underweight consumer discretionary. We liked that sector in '09, and we moved out subsequently. That group should probably be affected by higher commodity costs and higher gasoline costs, which are leading to some demand destruction, damping consumption. Another thing to consider is the overleveraged consumer.

You maintain that the market doesn't always discount the economy. Explain?

That's an important distinction about our service, which we have been providing for more than 29 years. We've made a lot of calls based on the premise that there are signals—and that we are able to process those signals based on economic trends that give us a reading on the future relative strength of industry groups. Our premise is that the economy is leading industry groups. Another way to put it is that the economy is leading the market, in contrast to the view that the market is leading the economy. So I would just ask those people who are saying that the market is efficient and discounting the future, what happened in 2000? Did the market discount the downdraft that occurred then? And what happened in 2008, which became a very unsettling period—and yet the market was complacent prior to the financial meltdown?

What's an example of something that's not a good predictor for your analysis?

We study which economic factors are reliable as predictors of future industry-group behavior. We have analyzed consumer-confidence surveys, for example, and tried to use them as predictors. But if you were to develop a model using those surveys as predictors, they actually throw off contrary signals. On the other hand, one of the best predictors is initial-unemployment claims issued by the states.

Why aren't consumer surveys that helpful for your research?

We come at it from strictly a mathematical point of view. Our test shows that consumer-confidence surveys aren't good predictors pertaining to industry groups' relative strength. The key is what people do, not what they say they are going to do. So we look at consumption. And it is a case where consumers may be very cautious, yet they are spending. In other cases, they may be very confident, but they are slowing their spending. So getting these economic signals from all the factors that are out there is quite tricky, and one has to look at it on a rate-of-change basis, which is what our model is based on. You have to watch the rate of change of consumption, versus the norm, as the source of information.

What's an example of a good call that you've made?

One of the best calls that we made recently was in December '08, when we overweighted the information-technology and consumer-discretionary sectors, and we underweighted consumer staples and utilities, amidst the gloom and doom of that year's fourth quarter. As we explained in our report that month, it wasn't that things were improving. It was that the deceleration in the economy was so steep, [and] we had never seen such a steep decline in factors across the board, such as consumption and spending—and we thought that steep decline was unlikely to be sustained. So we have a mean-reversion approach, and our model anticipated that we were on the verge of improvement. The economy actually started turning in June of 2009, and we were bold enough to talk about it as a V-shaped recovery in December of '08.

And what about a call that didn't pan out?

We saw the weakness in the economy in July of '07, with the headline economic conditions deteriorating sharply. Although our model was showing deceleration in the economy, we didn't take it seriously enough. We did temporarily have an underweight in financials, but we didn't hold to that underweight. We went back to market weight before the downdraft hit in '08. Our model is based on a 10-year history of data, and there was hardly any way that our model could have anticipated the dimension of that decline in '08 and early '09, so we weren't positioned defensively enough.

Why do you recommend a short duration for fixed income? Higher rates?

Everything we do is driven by our industry-group rankings. So it is very unusual that we've had both offensive and defensive industry groups ranked highly at the same time. We've had utilities and telecoms highly ranked, along with rails, steel companies and energy, up until recently. So we were trying to read what that means, and, in a sense, the high ranking of energy is acting as a tax on our economy, as payments for importing energy subtract growth from our economy. But it is also an inflationary indicator. Generally, when one sees energy as one of the best places to be, it represents a presence of inflation. So we had energy overweighted from October of 2010, until a about month ago.

But the implication on interest rates going up is that we are talking about inflation not being transitory—and that it is sticking. We've talked about the acceleration in inflation from 1.1%, year over year five months ago, to 3.2%, year over year currently. That's real acceleration of inflation. I don't see anything, practically speaking, except for some moderation in energy prices, that is going to act as a damping effect. Indeed, one of the biggest components of inflation—housing-rental rates—may be starting to contribute to higher inflation. And other sources of inflation, such as education, health care and transportation, suggest that inflation is here to stay and ready to edge higher. When I talk about this, frequently some of our clients point to the lack of demand, with the consumer being overextended. However, we've had inflation in the past with lackluster demand, otherwise known as stagflation. So it is a case where the dollar is weakening, and it is undermining the value of goods that we can purchase with that dollar. So it is likely to lead to inflation. We aren't talking about 5% annualized inflation, but closer to 3½% to 4%.

Why do more defensive sectors make more sense in this environment?

When you have sluggish growth, the more defensive areas are less affected by the economy. For example, the consumption of electricity is fairly stable. So even though we may have diminished economic activity, electric utilities generally will fare OK. Despite the surge in the Fed's balance sheet and the increase in the monetary base, we aren't seeing it affecting the economy that much. It's showing up as excess reserves in banks, but banks aren't lending, and small businesses are having a hard time getting credit. So there's a lack of animal spirits, generally speaking, to borrow a phrase used by economist John Maynard Keynes. There aren't enough animal spirits in this economy to show the typical growth that we would be seeing in a normal recovery. And part of the problem with the animal spirits, or lack thereof, is in residential real estate. There are still a large number of foreclosures putting pressure on home prices. When prices are under pressure, it has an automatic effect on the buyer. If one can buy something cheaper by waiting, why not wait? So that's what people are doing: waiting. They are watching these prices come down, and the banks are having a hard time getting rid of their housing inventory.

You talk about the potential of inflation, but isn't the scenario you just described one of deflation? Is this a case of the inflationary scenario winning out over the deflationary one?

They changed the method of using housing in calculating inflation. It went from the home-price effect to the rental-equivalent effect. So when there is diminished demand for houses, would-be buyers are renting housing. So when the rental market gets tighter, and rental rates increase, that impacts inflation. If we were to have a steep decline in home prices, another implosion in credit and the banks still have a lot of mortgage inventory—and if we had a real problem in home prices like we did in '08—then that could be deflationary. Deflation can't be ruled out, because we have a soft patch in the economy, and we have an overextended consumer. We have excessive debt, and we have a soft residential real-estate market. So this is a race against time, where the Fed needs to get the animal spirits to turn the housing market around before there is another downdraft, which would be deflationary. But currently, it doesn't appear that there is enough weakness to lead to that downdraft—although it is a month-by-month proposition.

Moffatt's Sector Picks

OVERWEIGHT	NEUTRAL
Financials	Materials
Utilities	Consumer Staples
Health Care	Energy
UNDERWEIGHT	Industrial
Consumer Discrectionary	Technology
Source: Analytic Systems

Residential real estate is mired in problems, and it was revealed last week that home prices had dropped to 2002 levels. Loan growth has been spotty for the banks. So why are you overweighting the financials?

Well, it is one of the few groups that hasn't yet recovered. The sector is undervalued, if it were to have normalized earnings, but we don't know when that will occur. Still, the financials are highly ranked in our model. One of the factors in their favor is that they are getting money for basically nothing, with short rates as low as they are, and the yield curve is favorable. Also, commercial and industrial loans are improving, despite the fact that credit is tight and banks aren't lending. Commercial and industrial loans bottomed last fall, but they have been showing increases every month since then. So we are seeing improvement for those loans, but not much. The weakness, however, is in mortgages. We aren't seeing enough mortgage activity to get that part of the economy going. But it is a case where the interest-rate environment is favorable, loan demand is improving, and, as the economy improves, financials should improve as well, although some firms are better positioned than others, of course. So one has to be selective, but it is an unloved group. Many of the negative factors that you talked about appear to be fully discounted, unless we have another downdraft. But it doesn't appear we are going to have one at this point.

Why are you overweight utilities?

With the yields on bonds very low, there are people searching for yield, and they've bid up the high-yield market to where it is probably too high. So utilities have a decent yield. The Utilities SPDR [an exchange-traded fund; ticker: XLU] yields about 3.9%. And utilities have a stable business model. So in this kind of muddle-through environment, utilities are another alternative.

What's your advice to individual investors?

The most important questions that their advisor can answer is, what is inflation going to do for the next 10 years, and where can I find a safe place? The one area we find to be relatively safe is large multinational companies that have a good dividend that is being earned -- that is, a decent dividend that is being well covered. I don't think Treasury bonds are safe, and I don't think gold is safe.

That's contrary to many investors, who are piling into gold as a hedge against the devaluing dollar.

We haven't said sell gold. At a conference last October, I said, 'Sell down to your core position, maybe around 4% of your portfolio.' But gold is in a potential bubble, like a lot of other commodities. There has been a tremendous amount of money piling into commodities and precious metals on the prospect of a devaluing dollar.

The problem with the devaluing of the dollar is that there's no other currency to replace it. The Japanese are in worse shape than we are, and the Europeans are in worse shape than the Japanese are, and so there's nothing to replace it. So this is kind of like the Roman Empire. Or, we are in the eighth inning, and we have plenty of time to rectify our problems -- if we just get started. But if we keep wasting our time, then we are going to go by the wayside. There is no competitor to the dollar; that's the reason it isn't going to be debased. And if the dollar recovers, then gold won't do well.

Thanks, John. 

Birth Death Adjustment

Take away the Birth/Death adjustment of 206,000 and the Real NFP is: -150,000. This is the biggest monthly B/D adjustment in over a year. And if as all the pundit claimed last month, demanding the McDonalds addition of 62,000 janitorial, part-time jobs be added to the May number, the economy really lost over 200,000 in May. Time to price in QE 666?

Operation Twist Redux?

Yes, they could.

It is no secret that to a deflationist like David Rosenberg bond yields have to go lower... Much lower. With the 10 Year flirting with a 2 handle one would think he would be content. Alas no. In fact, as he suggests in his piece from today, Rosie is convinced that the next iteration of QE will be nothing short of a redux of the 1961 initiative to kill the gold spike known as "Operation Twist" (recently dissected by the San Fran Fed). Incidentally it was the same Fed that compared QE2 to Operation Twist. It is only logical that Rosie would then suggest that QE3 would be nothing short of a complete clearing of the 10 Year bond in the market via the Fed in order to anchor expectations that the 10 Year rate would never go up (or reasonably "never") in the biggest gamble of all: that the Fed will attempt to both control its balance sheet and target Long-Term interest rates, a mission doomed to fail...But not like that will prevent the Fed from setting off on such a mission, especially following today's official confirmation of the Housing Double Dip (someone page Jim Cramer). As Rosie says: "Now it is doubtful that the Fed would ever target the long bond. In fact, the Fed may even want it to be higher in yield to ease the pressure on radically underfunded pension funds. While the Fed can either target its balance sheet, which it has been doing with these QE measures, or target interest rates, it cannot do both at the same time. So the next 'QE' will not be called 'QE' but rather something else — maybe Operation Twist 2 (OT2 — you heard it here first). The Fed would buy up all the 10-year notes needed to clear the market at the target "price" (yield). So depending on supply conditions and demand from the private sector, the Fed would basically lose control of its balance sheet, but if in return this policy is the one that blazes the trail for a turnaround in the housing sector and a durable revival in the economy, so be it." And keeping in mind that the true unspoken reason for Operation Twist 1 was to terminate the outflow of gold from the US to foreign bank vaults, we find ourselves agreeing with Rosie that an insane idea such as OT2 is precisely what the Fed would do to avoid a recurrence of the 1961 gold exodus (and attempt to give housing one last failed boost). As many birds would be killed with one stone, the only downside, that of a complete balance sheet implosion following OT2, certainly seems quite acceptable to a central bank now officially run by sociopaths.

Chicago PMI

Drops to 56 and change. Still expansionary, but the biggest drop since October 2008.

When the Fed speaks of a "continued moderate rate of expansion", the operative word is "moderate".

More GDP

Click on graph for larger image in graph gallery.

The dashed line is the current growth rate. Growth in Q1 at 1.8% annualized was below trend growth (around 3.1%) - and very weak for a recovery, especially with all the slack in the system.

GDP revision commentary

Key Take-Aways:

1) Headline GDP--Unrevised at +1.8%, But Important Compositional Revisions
2) Surprising Downward Revision to PCE, Points to Weaker Aggregate Demand
3) Upward Revision to Inventories Points to Lower Inventory Building Ahead
4) Net GDP Revision Points to a Slower Trajectory of Growth than Apparent Earlier

The Second Estimate of Q1-11 GDP revealed a 1.8% rate of gain unchanged from the 1.8% per the Advance release. While the headline Q1 GDP rate of change was unchanged from the Advance estimate there were important compositional revisions, which in combination point to a slower trajectory of growth than appears to be on track prior to this rlease. In other words, we are a bit disappointed with these data.

Guess who is most embarassed by this data. Hint: not Goldman.

For all of 2011 the FOMC anticipates growth of 3.1% to 3.3%, implying a growth rate of around 3-1/2% to 3-3/4% over the balance of the year. This now appears to be a bit optimistic. It now appears as if Q2-11 may post a gain of about 3%. For the FOMC's forecast to be realized we would need 4% growth in the second half.

Counterpoint on China - FYI.

Why Jim Chanos is Wrong on China

Submitted by madhedgefundtrader on 05/25/2011 09:47 -0400

• Australia
 
• Bear Market
 
• Exchange Traded Fund
 
• Gross Domestic Product
• Japan
 
• Jim Chanos
 
• Real estate
 
• Reality
 
• Yuan
 

Hedge fund titan, Jim Chanos, is well known for his extremely bearish views on China. He says that the cracks are spreading on the façade, real estate sales are falling, and that the economic engine is starting to sputter.

This will be bad news for the rest of us, as China imports 50%-80% of the world’s commodities. Commodity exporting countries will be especially hard hit, like Canada, Australia, and parts of the US. Modern China has only seen a bull market, and he doubts their ability to manage a true crisis.

There is a widespread misperception that the government will step in and provide any bailouts that will be needed. The domestic Chinese banking system has in fact already been bailed out two times. The harsh reality is that while Chinese companies are selling billions of dollars’ worth of new stock issues in the US through IPO’s, a privileged elite is getting their money out of the country as rapidly as they can.

Jim says that he already has short positions in the Middle Kingdom that are profitable. There is no way that even a wrinkle in a market of this size is without global implications, and on that point Jim is right.

However, I think that Jim, who confesses to having never visited China, is missing the broader long term picture here. China has literally been building a Rome a day, the ancient kind, and the modern size every two weeks. In a year, it builds the equivalent of the entire housing stock of Spain, and in 15 years the equivalent for all of Europe.

While a lot of apartment buildings have been built, the country is rapidly creating the middle class to fill them. Even allowing for a pull back from its current blistering 10% per annum GDP growth rate, urban disposable income per person is expected to grow by 2.5 times to $7,500 by 2020. Over the same time frame, some 160 million are expected to move from the hinterlands to urban areas. Rising standard of livings mean that residential floor space per person will jump from 270 square feet to 369 square feet, still tiny by Western standards. That is a lot of housing demand.

China has already taken steps to head off a housing crisis, unlike the US. The People’s Bank of China has raised bank reserve requirements five times this year, now close to 20%, taking them to among the most stringent levels in the world. That is almost Canadian in its conservatism. Many banks are now demanding cash deposits of 40%, well over the official requirement of 30%. The government is in effect forcing the banks to deleverage before hard times hit. Too bad they didn’t think of that here.

I think China still has several good years ahead of it, and I am going to pile into the stock ETF (FXI) and the Yuan ETF (CYB) as soon as the current bout of “RISK OFF” selling exhausts itself. The country’s real challenge arises when its demographic pyramid starts to invert in about five years, the result of a then 35 year old “one child” policy, when too many single children have to start supporting two retiring parents. When that happened in Japan, a 21 year bear market followed.

To see the data, charts, and graphs that support this research piece, as well as more iconoclastic and out-of-consensus analysis, please visit me at www.madhedgefundtrader.com . There, you will find the conventional wisdom mercilessly flailed and tortured daily, and my last two years of research reports available for free. You can also listen to me on Hedge Fund Radio by clicking on “This Week on Hedge Fund Radio” in the upper right corner of my home page.

MLPs

Master Limited Partnerships   Y. Siegel
Credit Suisse Take on MLPs: NGLs - From Supply Glut to Supply Shortage 212 325 8462
NGL Update Call with Industry Expert Peter Fasullo from En*Vantage: Key takeaways: 1) "The NGL business has never been so good". NGL prices are firm, frac spreads are at record levels and the growth in NGL production is being more than matched by robust petrochemical demand. 2) NGLs extraction is expected to grow by 500,000 bpd (23%) between now and 2015-2020. 3) Ethane extraction (excluding Marcellus) should grow even faster over this time frame. 4) Ethane demand is increasing because it is a cheaper feedstock for ethylene steam crackers. 5) Ethane demand is likely to grow by another 100,000 bpd over the next two years as the ethylene industry converts more furnaces and debottlenecks. 6) Canada is likely to import as much as 90,000 bpd of ethane over the next 10 years. 7) At least 85,000 bpd of Marcellus ethane will be required in the Gulf Coast to satisfy demand. 8) Short-term, planned and unplanned ethylene plant downtime can impact NGL fundamentals. Please contact your Credit Suisse salesperson for a copy of the slides and transcript.

Our Take: We also hold a positive outlook for NGLs and the MLPs that will benefit from building the requisite NGL infrastructure. The following MLPs within our universe have significant NGL exposure. EPD, ETE/ETP, DPM and NGLS are rated Outperform, TRGP and OKS are rated Neutral.

Our Take on EPD's Sale of ETE Units: ETE represents a non-core holding for EPD and we would expect EPD to continue to exit its remaining ownership of 34.5 million units. We maintain our Outperform rating on ETE. Although EPD's sale may create a perceived overhang on ETE's units, we view ETE's leverage to distribution growth and increasing units outstanding at ETP will drive strong distribution growth (9.9% 3-year CAGR).

Takeaways from the AGA Conference: Last week we attended the American Gas Association Financial Forum in Orlando. We had one-on-one/small group meetings with eight companies including CNP, NI, AGL, UGI, SE, MDU, TRP and ENB. Common themes included the continued growth opportunity tied to shale and unconventional resource plays, weakness in natural gas storage fundamentals and the importance of MLPs to energy infrastructure investment. See the full report for key takeaways.

Gross Processing Margins Down Slightly: Margins closed the week at $1.00/gal, down from $1.02/gal the previous week, driven by lower crude oil and NGL prices.

MLPs Up Last Week: The Alerian and Cushing 30 MLP Indices closed the week up 1.4% and 1.1% respectively vs. loss of 0.8% and loss of 0.3% for the Russell 2000 and S&P 500 indices.

Ford Meetings

Begin forwarded message:

From: "Michaeli, Itay "
Date: May 25, 2011 6:59:05 EDT
To: undisclosed-recipients:;
Subject: F: Takeaways from Management Meetings; Reiterate Buy

Key Points:
 
What's New? — We recently visited Ford’s headquarters where we met with members of senior management. We walked away with increased comfort around key issues and reiterate our recently upgraded Buy rating ($18 target).
 
Key Takeaways — Management appeared constructive regarding industry pricing discipline, and noted that its own recent price increases were received well. Although management reminded us that 2011 price momentum could slow after a stellar Q1, an affirmation of the overall price-discipline strategy, May pricing checks and Ford's product cadence point to a continued favorable environment. On costs, management indicated that internal structural cost forecasting has proven itself reliable (limited cost creeps) and that the recent commodity pullback has been a welcome development.
 
Progress Towards Investment Grade— A restoration of investment grade ratings was a key thesis behind our recent upgrade of Ford shares. Though management understandably could not provide a timetable for an upgrade, we sensed that our late-2011/early-2012 timetable resonated as a reasonable base case. Management pointed to the benefits from removing collateral packages and widening the funding sources at Ford Motor Credit, which we think would improve long-term growth prospects. An historical analysis of crossover situations points to a favorable re-rating potential (see Figures 1 & 2) for the shares, particularly given Ford’s captive finance position.
 
Reiterate Buy, Potential Catalysts Ahead — Ford is hosting an investor day on June 7 in New York. We believe management may provide additional medium-term parameters around key metrics. While we don't view out-year consensus estimates as conservative, a reassuring margin outlook should be sufficient to revive sentiment in the shares at the currently low 4.0x 2011E EBITDAP multiple (~10% FCF yield) and amidst industry pricing strength.  The upcoming UAW negotiation will also be a focal point, with the focus on whether Ford is able to narrow the remaining modest cost gap with domestic competitors (even at an upfront cost).
 
Please click on the following link for access to the full report: https://www.citigroupgeo.com/pdf/SNA81019.pdf
 
_______________________________
Itay Michaeli
Autos & Auto Parts
Equity/Debt Research
Citi Investment Research
(212) 816-4557
itay.michaeli@citi.com 
 
"We Value Your Feedback! The Institutional Investor Poll matters to our Analysts. If you value our work, we would appreciate your recognition. Please visit www.institutionalinvestor.com/rankingassistance to request a ballot."
 
 
For important disclosures regarding Citi Investment Research & Analysis ("CIRA"), including with respect to any issuers mentioned herein, please refer to the CIRA disclosure website at https://www.citigroupgeo.com/geopublic/Disclosures/disclosure.html. 
 
 
 
 

Gold man's read on the NFP for April

Results from the household survey were disappointing. Total household employment fell by 190k, and the unemployment rate rose to 9.0% (8.96% unrounded) from 8.8% previously. Results were somewhat better after adjusting for methodological consistency with the nonfarm payroll data; on this basis the household survey measure of employment would have increased by 50k. However, the labor force participation rate was unchanged during the month, indicating that the rise in the unemployment rate reflected job losses rather than an influx of persons into the labor force. While the news was discouraging, it follows four months of declining unemployment, and the level of the unemployment rate remains down 1.1 percentage points from its peak. The employment-to-population ratio fell slightly to 58.4% from 58.5% previously.

Services ISM, yuk

The April ISM Non-manufacturing index was at 52.8%, down from 57.3% in March. The employment index indicated slower expansion in April at 51.9%, down from 53.7% in March. Note: Above 50 indicates expansion, below 50 contraction. 

Click on graph for larger image in graph gallery.

This graph shows the ISM non-manufacturing index (started in January 2008) and the ISM non-manufacturing employment diffusion index.

From the Institute for Supply Management: April 2011 Non-Manufacturing ISM Report On 

Is Buffett's Teflon Finally Wearing Out

Is Warren Buffett’s Teflon finally wearing off?

After key lieutenant resigns under cloud, some asking if it’s time for Buffett to go

By Ben Berkowitz

NEW YORK — Aside from maybe the odd cheeseburger stain on his tie, nothing much sticks to Warren Buffett.

Whether his underlings are convicted of helping insurance companies inflate results or a major company he helps oversee is sanctioned for accounting shenanigans, his admirers don't seem to care. Or at least, they haven't historically.

But with a key Buffett lieutenant resigning under a cloud recently, some sophisticated investors are no longer willing to overlook the obvious. For all the shareholders who still consider Buffett the epitome of American capitalism, there are others who wonder whether the time may be near for Buffett to take a graceful bow and exit the stage.

Some will clamor for that this weekend, when 40,000 of his shareholders prepare to descend on Nebraska for the annual meeting of Berkshire Hathaway, the ice-cream-to-insurance conglomerate he runs with absolute authority.

"I want to hear more about Sokol, I want to hear more about how they're going to outperform the markets. I want to hear about what (Buffett's recent) trip to India leads us to believe about how the money is going to be invested in the future," said Michael Yoshikami, chief executive of wealth management firm YCMNET Advisors and a widely quoted Berkshire shareholder.

Investor disappointment reflects not just the revelation that David Sokol, once Buffett's presumed successor as chief executive, bought stock in a company he then pushed Buffett to acquire. It is also because of Berkshire's lackluster performance recently, and questions about the firm's ability to thrive after its octogenarian chairman and chief executive moves on.

Berkshire Hathaway has grown exponentially over decades, but many investors question how it can possibly do as well in the future. With the dozens of companies that Berkshire Hathaway owns having had relatively little oversight for years (by Buffett's own proud admission), some wonder how much earnings power Berkshire actually has and whether future earnings can be as strong as past.

"Obviously Berkshire has intrinsic value but now I have to question that intrinsic value," said Janet Tavakoli, an expert on derivatives and author of "Dear Mr. Buffett," a 2009 book laden with fulsome praise for the legendary investor. Tavakoli, like many others, has revised her thinking sharply in the intervening years.

Yet she, like so many others, added an important caveat about Buffett: "(His) brand is so powerful you are reluctant to question."

Sokol affair
By now the details of Sokol affair have been told many times. Citigroup bankers pitched a long list of companies to Buffett's presumed successor, and he told them he thought Lubrizol Corp, which makes lubricants and other chemicals, might make a good acquisition target. He started buying up shares for his own account, and after building up a $10 million position he pushed Buffett to buy the company.

As Buffett put it, Sokol made only a "passing" mention that he owned some Lubrizol shares.

Sokol made about $3 million on the trade, perhaps at Buffett's expense. Buffett has been called to task for how he handled the matter. In a letter to investors, he announced Sokol's resignation, explained the stock issue and offered a grant of absolution: "Neither Dave nor I feel his Lubrizol purchases were in any way unlawful," he wrote.

Less than three weeks later, the first shareholder suit was filed, accusing Berkshire's board of breaching its fiduciary responsibility. More are expected, particularly from bigger firms with a track record of winning large settlements for shareholders.

Governance experts say Buffett blamed the sin but not the sinner.

"The response wasn't as strident as ... I would have hoped for in suggesting that personal stock transactions that are related to corporate stock transactions are problematic and not the sort of thing that the company thinks is a good idea," said Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware.

"And I would hope in these situations that you would be pretty tough on that in your response."

Some of Buffett's biggest investors also say he should have chastised Sokol or told him to sell his stock. What is murkier, however, is the question of whether Buffett actually did anything wrong from a legal standpoint.

"There's a lot of very problematic behavior here that doesn't easily find an explanation, so the question remains, what in fact was going on here?" said Harvey Pitt, chief executive of Kalorama Partners and the former chairman of the U.S. Securities and Exchange Commission.

"Why would somebody be allowed and be deemed to have acted properly in profiting to the tune of $3 million based on his privileged position at the company?," Pitt added.

It wasn't the first time that Buffett has been close to people behaving questionably. But few of his investors have cared, and the damage to his reputation seemed slight if at all.

In 2008, for example, the government won convictions of four executives from his reinsurance business for helping other insurers inflate their results. The nearly uniform reaction from legions of Buffett fans around the world: yawn.

And in 2005, the SEC sanctioned the Coca-Cola Co, whose audit committee Buffett sat on, for inflating earnings. His admirers barely batted an eyelash.

'That's my guy'
Buffett, of course, benefits mightily from his folksy image. After all, it's tough to imagine how someone who drives himself to work and stops at McDonald’s for a bite on the way home can also be guilty of high crimes of finance.

"Warren Buffett works very hard reflecting an image that 300 million Americans, six billion people around the world say, 'That's my guy. That's the way I'd like to be like.' And he works very hard at that -- not every week or every month, but every day. And I think by working hard at it every day, he drives that image hard into people's minds," said Robert Dilenschneider, a public relations executive who heads the Dilenschneider Group in New York.

The audience at the annual meeting is one of the tools he uses to burnish his reputation. There is no better financial television than footage of Buffett having an ice cream at (Berkshire-owned) Dairy Queen, with hordes of investors thronging him and hoping he might drop a stock tip on the floor with the crumbs of his vanilla cone.

It is hard to interrupt that storyline.

"With the cash that he was able to squeeze out of that dying textile business (Berkshire Hathaway) and astutely reallocating it year after year after year, the business grew from $18 a share to $120,000 a share," said Roger Lowenstein, author of a well-regarded 1995 Buffett biography and a number of other finance books.

"I have no doubt that he'll be regarded as the investor and probably the financier of the era. This incident sort of tells people that he's human."

Performance under fire
While many would agree with Lowenstein on Buffett's place in financial history, his returns of late have not necessarily matched his reputation.

Berkshire shares have only barely matched the S&P 500 since September 2008, the depths of the crisis and the time Buffett made some of his most lucrative bets, like buying Goldman preferred shares that threw off more than $15 a second in dividends.

Just this year, Berkshire has underperformed the S&P 500 by about 4 percent. Buffett has said returns will slow, so it does not necessarily come as a surprise.

There is expected to be less reluctance to question him this year in Omaha. Author Tavakoli said shareholder dissatisfaction was already palpable at the last meeting she attended in 2009, as Buffett went on about his bet on Wells Fargo and investors grumbled that he was not talking about the "crony capitalism" they saw behind the crisis-era bailouts.

"It seems as if Warren Buffett has sort of lost touch with the tone of the people who invest in Berkshire Hathaway and their sentiment," she said.

The Q&A session will again be moderated by financial journalists this year, so even if investors don't ask tough questions, reporters may. Words like "contentious" and even "raucous" are being thrown around. And yet, some investors still do not expect much.

"I don't expect any great revelations but what I want is not necessarily what I'm going to get," said YCMNET's Yoshikami.

Yet he still expects the annual meeting to be a "lovefest," given the overwhelming number of shareholders who flock to Omaha annually for nothing more than pearls of Buffett's wisdom (and perhaps some discount pearls from his jewelry business, one of a number of Buffett companies to offer steep shareholder discounts over the course of the weekend).

Yoshikami said that if Buffett gets away from the Sokol episode unscathed, it will be because he has banked sufficient goodwill with investors in the past.

"When you have an inventory of transparency that you can fall back on I think you get the benefit of the doubt," he said. "I think when you self-disclose enough and you have a reputation for self disclosing it buys you some reputation credits."

But no matter what Buffett says or does in Omaha, there is a growing realization that the old days have slipped by. Buffett and his partner, Charlie Munger, are aging, the questions about the future of the conglomerate are getting louder and people are recognizing, as they do, that all good things have to come to an end.

"The passage of time is hitting home. This year is the end of Berkshire as it used to be," said Alice Schroeder, a former stock analyst who wrote what many view as the definitive biography of Buffett.

"It will never be the same. Even if people think Buffett's not going to address all these issues and the questions won't be as tough as they should be, Berkshire as it used to be is over," Schroeder said.

WSJ: Pricing Power (CdeR)

By JOHN SHIPMAN And PAUL VIGNA

More companies that had resisted raising prices are conceding they have few alternatives with commodity costs continuing to climb on everything from steel to cocoa beans.

In the quarters following the recession, the ability to raise prices and make them stick re-appeared primarily at industrial companies selling to other businesses. Now, consumer-oriented companies that haven't been able to raise prices are running out of ways to hold the line on margins.

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The result is more retailers, construction-related and consumer-oriented companies are finding they must raise prices, even at the risk of undermining sales. Some vow to find new cost cuts but with little specificity. Airlines, which have had some post-recession success in raising prices by constraining capacity, appear to be reaching a limit on additional increases.

Auto-parts manufacturer Johnson Controls Inc. last week said it will boost its auto and marine battery prices by between 5% and 9%. Johnson Controls doesn't report its fiscal second quarter until April 25, but the company has already raised its profit forecast for the year and posted a 31% fiscal first quarter profit gain.

In contrast, parts retailer Genuine Parts Co., which owns Napa stores, said first-quarter gross profit slipped to 28.5% from 29.2%, due in part to "competitive" pricing pressures. Struggling to raise prices, the company is working to shave more costs, executives said Friday. Chief Financial Officer Jerry Nix said customers are "pushing back" on price increases.

Major airlines, which release calendar first quarter profits beginning next week, have had six significant price increases this year. However, their most recent efforts, including a bid this month to boost domestic fares by between $5 and $10 each way, unraveled.

Food sellers are among the few retailers hoping for inflation to bail them out of declining pricing power. Grocery store operator Supervalu Inc., which last year struggled with food deflation, reported lower fiscal fourth-quarter profit last week. Chief Executive Craig Herkert said that the company did see a "modest amount" of inflation in the quarter and was "successful in passing it through to retail prices."

The Federal Reserve said last week "manufacturers generally [are] finding less resistance to price increases than either retail or construction (where weak demand was a limiting factor)." Fed branches in Richmond, Va., and San Francisco, for instance, noted strong competition and lukewarm demand are limiting local retailers' ability to raise prices.

For companies that have balked at raising prices so far, falling profits are leaving them little room to maneuver. "Firms that are seeing input costs jump are likely worrying that if they pass through those increases they will lose sales as consumers cut back to pay for gasoline," wrote economist Joel Naroff of Naroff Economic Advisors. "But the constant drum beat of rising costs has to be affecting earnings."

For instance, toy makers Hasbro Inc. and Mattel Inc. each have said they are raising prices in the face of rising costs. Hasbro last week reported profit fell 71% on flat revenue while Mattel's net dropped 33% amid higher expenses.

Hasbro Chief Operating Officer David Hargreaves said Thursday that the company hasn't had any pushback from retailers after raising prices earlier this year. Retailers understand commodity costs are increasing, he said, and "I think they accept that the prices need to go up a bit to cover these costs."

But resistance to price increases can hurt sales. Revenues at United Forest Products Inc., which makes a variety of housing-related wood products, fell 1.5% and the company reported a $3.7 million loss.

Chief Executive Michael Glenn said in an effort to increase sales "some of our operations simply took ... business priced at levels that were unacceptable." United Forest added fuel surcharges late in the quarter to counter rising diesel costs, but it has been "a little bit of a battle" to get customers to accept them, he said.

BRCM upgraded at Oppenheimer on valuation.

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Distressing Home Sales Gap

Another update ... this graph shows existing home sales (left axis) and new home sales (right axis) through February. This graph starts in 1994, but the relationship has been fairly steady back to the '60s. Then along came the housing bubble and bust, and the "distressing gap" appeared (due mostly to distressed sales).

Click on graph for larger image in graph gallery.

The gap is due mostly to the flood of distressed sales. This has kept existing home sales elevated, and depressed new home sales since builders can't compete with the low prices of all the foreclosed properties. 

Mauldin, QE2 - Posted so it will be archived

This is in addition to the email just sent out, same thing, but I thought to post it here in case you wish to refer to it in the future.

The End of QE2? The Fed committed to buying $600 billion of Treasuries between the beginning of QE2 in November and the end of June. June is 3 months away. What will happen when that buying goes away? The hope when QE2 kicked off was that it would be enough to get the economy rolling, so that further stimulus would not be deemed necessary. We’ll survey how that is working out, with a quick look at some recent data, and then we go back and see what happened the last time the Fed stopped quantitative easing. First, the guy on the street is getting squeezed. Real US consumer spending slowed in January and looks like it did only marginally better in February. The Fed argues that inflation is mild, as they prefer to look at “core” inflation (inflation without considering food and energy). If you look at it that way, they are right. And in normal times, I can kind of see why we strip out energy and food, as they are very volatile price points and can move a lot from month to month. But that argument gets a lot weaker when your main policy, that of significant quantitative easing, is perhaps CAUSING the rise in food and energy (as well as weakening the dollar)! If the Fed policy is at least contributing to the cause of total inflation, arguing that food and energy don’t count doesn’t hold water. Let’s look at the following chart from economy.com. In particular, notice the rise in the last three months since the beginning of QE2. Inflation is running at over 5% on an annualized basis. Companies like Kimberly (diapers, etc.), Colgate, P&G, and others all announced 5-7% price increases this week. These are companies that provide staples we all buy. Those prices matter. Even Wal-Mart will have to pass those increases on. To say that food and energy don’t matter misses the point. These items have real economic impact. As my friend David Rosenberg wrote this morning: “In February, there was no inflation at all in average weekly wage-based earnings but there was 0.5% inflation in consumer prices, meaning that real work-related income was crushed 0.5% and has now deflated in each of the past four months and in five of the past six months, during which it has contracted at a 2.3% annual rate. Once the effects of fiscal stimuli wear off, this negative income trend will show through in a much more visible slowing in real consumer spending that we doubt the markets have fully discounted. So far, what has happened in equities has been treated as a financial event – just wait until the economic event follows suit. And it’s not only fiscal stimulus that is soon to subside. We still have that 86% correlation over the past two years between movements in the Fed balance sheet and the direction of the S&P 500 – this too will come home to roost before long, whether or not we end up seeing a resolution to the crises in Japan, Libya or Bahrain.” He goes on to give us this chart: How’s that QE2 thingy working for you, Mr./Ms. Average Worker? Prices up, income down? And remember, most workers got the equivalent of a 2% pay hike with the temporary boost in Social Security, which goes away at the end of the year (and without which the economy and consumer spending would be even worse!). Maybe that’s why New York Fed Chief William Dudley got heckled this week. (Courtesy of the Agora 5 Minute Forecast:) “Dudley – a 21-year vet of Goldman Sachs – stepped out of his bubble to explain Fed policy to real people in Queens. “It might not have been the first time Dudley attempted to gain the trust of the hoi polloi, but we’re pretty sure it’ll be the last. The details here were reported widely. We divined the scene from a Reuters report. “First Dudley swore up and down that inflation was no problem. ‘When was the last time, sir,’ came a reply from the audience, ‘that you went grocery shopping?’” “Dudley boldly proceeded to explain the concept of ‘core CPI’ – the cost-of-living measure designed for people who don’t eat or consume energy. Heh, we know firsthand how well that goes over… “Then in a brilliant stroke, he pointed to Apple’s shiny new iPad 2 to illustrate his point. ‘Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful,’ he gamely explained. ‘You have to look at the prices of all things.’ “‘I can’t eat an iPad,’ someone yelled from the crowd.” Ouch. (For the record, I do go to the grocery store and Wal-Mart and Home Depot, as well as other less frugal venues.) And core inflation may soon be under pressure. There were two articles yesterday, one from Yahoo and the other on Bloomberg. Both related to rising pressure on rental costs. (My recent lease renewal increase was significantly above core CPI!) (From http://realestate.yahoo.com/promo/rents-could-rise-10-in-some-cities.html) “Already, rental vacancy rates have dipped below the 10% mark, where they had been lodged for most of the past three years. ‘The demand for rental housing has already started to increase,’ said Peggy Alford, president of Rent.com… By 2012, she predicts the vacancy rate will hover at a mere 5%. And with fewer units on the market, prices will explode.” Look at this graph showing their projections: Here’s what to pay attention to. Notice that since 2002 (or thereabouts) rental costs have been flat, and down of late (inflation-adjusted). If Rent.com projections are anywhere close, we could see a rise in rents of 15% by the end of 2012. Let’s remember that 23% of the CPI and 40% of core CPI is Owner Equivalent Rent. If they are right, that adds about 3% to total CPI and 6% to core CPI! Will the Fed be telling us to focus on core inflation in 12-18 months? And those prices will start to show up steadily. “This is a sharp change from the recession, when many Americans couldn't afford to live on their own. More than 1.2 million young adults moved back in with their parents from 2005 to 2010, said Lesley Deutch of John Burns Real Estate Consulting. Many others doubled up together. “As a result, landlords had to reduce prices and offer big incentives to snag renters. Now that the recession is easing, many of these young people are ready to find new digs, mostly as renters, not owners. Plus, the foreclosure crisis continues unabated, and the millions losing their homes are looking for new places to live.” Producer Prices Up 35-40% in the Last Six Months Then let’s look at business. The Producer Price Index was out this week, and it was way up – 1.6% for the month, or an annualized 20%+. Even if you look at the last year, it was up a real 5.8%. That is inflation in the pipeline. Look at this chart from economy.com. Notice the trend since QE2 was announced in August and implemented in November. I won’t bore you with the details, but for those interested, go to www.bloomberg.com and search for “Japan supply issues” and further on “semiconductors.” It is clear that, at least for a while, prices of electronics and tools are going to rise as one company after another is shutting its production lines down in Japan. Auto manufacturing plants in the US will have to close soon, as critical parts from Japan are not going to be forthcoming. Flat screen TVs? The iPad 2 I keep trying to find? All sorts of companies are going to get their costs squeezed even further. Remember, the above PPI numbers are from before the Japanese earthquake and tsunami and nuclear disaster. (I was in Tokyo less than two weeks ago. I can’t imagine the stress and anguish going on there. The scope of the disaster is just shattering. I encourage my readers to go to http://american.redcross.org and donate directly to their Japanese fund or the charity of your choice. A few details from Japan, though, gleaned from here and there. Sony alone makes 10% of the world’s laptop batteries. Japan is responsible for 30% of global flash memory, 20% of semi-conductors, and 40% of electronic components. The point is that the Fed has created real pressure in the price pipeline, primarily on basic commodities and energy. “Crude” goods, which is basically materials before there is any value added, are up 28% from a year ago and pushing an annualized 35-40% for the last six months. Those costs are filtering in to final finished products. And when you add in the supply-related problems from the recent disaster? It is not a pretty picture for profits. Let’s go back and look at a graph from friend Vitaliy Katsenelson, from a few weeks ago. It points out that corporate profits are back close to all-time highs as a percentage of GDP. As the brilliant Jeremy Grantham says, and I am paraphrasing, corporate profits are among the most mean-reverting of all statistics. And this makes sense unless capitalism is broke. High profits entice competitors to come in and take market share by selling for less. If corporate profits went back (mean-reverted) to their longer-term average, P/E ratios would be close to 24 at today’s prices. Corporations have some room to absorb some price increases, but at the expense of the bottom line. What Happens When We Come to the End of QE2? We have only one instance where the Fed cut back on quantitative easing, and that was last year. It is a data set of one, but it is all we have. So, let’s look at what happened. As noted by several sources (but I am looking at Rosie’s list right now), the Fed let its balance sheet contract by some 12% from late April to late August. Quoting: “Now over that interval ... “The S&P 500 sagged from 1,217 to 1,064…. The S&P 600 small caps fell from 394 to 330…. The best performing equity sectors were telecom services, utilities, consumer staples, and health care. In other words — the defensives. The worst performers were financials, tech, energy, and consumer discretionary…. Baa spreads widened +56bps from 237bps to 296bps… CRB futures dropped from 279 to 267…. Oil went from $84.30 a barrel to $75.20…. The VIX index jumped from 16.6 to 24.5…. The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5…. Gold was the commodity that bucked the trend as it acted as a refuge at a time of intensifying economic and financial uncertainty — to $1,235 an ounce from $1,140 and even with a more stable-to-strong U.S. dollar too…. The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…” What will happen this time around? Is the economy strong enough to grow on its own without stimulus, or strong enough that the Fed will be reluctant to continue with QE3? My friends at Macroeconomic Advisors have reduced their first-quarter GDP projection to 2.5%. Morgan Stanley has dropped theirs from 4.5% less than six weeks ago to 2.9% today. That is a huge drop in a short time for a forecasting model. Forecasts at other economic shops are being slashed as well. States and local governments, as I have continuously noted, are cutting more than 1% of GDP from their budgets as I write. That translates into real-world pressure on the GDP (even if it’stemporary, which I believe it to be, we live in the present). I am not ready to use the “R” word, but Muddle Through could show up with a true vengeance this summer, with higher inflation and slower growth. I lived through the ’70s, and frankly, I would just as soon not go see that movie again. The danger here is that the Fed (Bernanke) watches the economy slow and decides we need another round of quantitative easing. I have resisted that idea but, as I have noted, sometimes we need to think about the unthinkable. And thus, I come to the end of the letter with a brief note on a very worrisome conversation I had yesterday with Martin Barnes, editor of the esteemed Bank Credit Analyst. Martin is one of the people I call when I want to know what the Fed might do. I guess I was looking for assurance that the Fed would not do QE3. I did not get it. “Look, John” (insert Scottish brogue as I paraphrase), “if the Fed sees the economy rolling over into recession they will put their mandate for employment ahead of their mandate for stable prices.” “But that would mean higher inflation in the face of a slow economy.” “And?” he shot back. “That would just be the price of trying to increase employment, in their minds.” “But at some point you have to bring out your inner Volker!” I intoned. “What about the future?” The conversation continued, but I never got my warm and fuzzy assurances. For the record, another round of QE, unless there is a true liquidity crisis (and the last QE did not qualify!), would be a disaster, at least from the cheap seats where I sit. There are all sorts of inflationary and stagflationary consequences, none of which I like.

Something Does Not Compute!

Philly Fed Strongest Since 1984

"Greed, for lack of a better word.....is good" - Gordon Gecko

From the Philly Fed: March 2011 Business Outlook Survey

The survey's broadest measure of manufacturing conditions, the diffusion index of current activity, increased from 35.9 in February to 43.4 this month. This is the highest reading since January 1984. The demand for manufactured goods is showing continued strength: The new orders index increased 17 points this month, the sixth consecutive monthly increase.
...
Firms' responses continue to indicate overall improved labor market conditions. The current employment index fell back 5 points [to 18.2], but for the seventh consecutive month, the percentage of firms reporting an increase in employment (25 percent) is higher than the percentage reporting a decline (7 percent). Over twice as many firms reported a longer workweek (25 percent) than reported a shorter one (12 percent).

That is mostly good news. This was well above the consensus of 35.9.
The concern remains the pickup in both prices paid and received: 

Firms continue to report price increases for inputs as well as their own manufactured goods. The prices paid index declined 3 points this month but has still increased 51 points over the past six months. ... Thirty-two percent of firms reported higher prices of their own goods this month, compared with 29 percent in February.

Click on graph for larger image in graph gallery.

Here is a graph comparing the regional Fed surveys and the ISM manufacturing index. The dashed green line is an average of the NY Fed (Empire State) and Philly Fed surveys through March. The ISM and total Fed surveys are through February.

This early reading suggests the ISM index will be in the 60s again this month. Another very strong report.