A Plan for Social Security

Read a terrific interview in Barron’s yesterday with Joe Rosenberg, Chief Investment Strategist at Loews, a New York conglomerate controlled by the Tisch family. The point blank question was for his views on the government bond market. Response: “I see no value whatsoever. With the two-year Treasury yielding under 2%, you might as well keep your money in cash or go out and enjoy it, because you are not getting a return on an after-tax basis.”

Ok, that was a lay up, but the fact is, I’ve seen NBA players miss lay ups. The response to the next question was even better.

Ques: You have some ideas on social security?

Answer: “If the government thinks it can fund Social Security with 4% government bonds, it’s dreaming. It’s a great time to start funding Social Security with stocks. The government ought to take advantage of the low yield on Treasuries be selling debt at 3% or 4% and buying the S&P 500, which has an earnings yield of 7%. Large corporations and states fund their pensions with equity. Why shouldn’t the federal government?”

Now you have to appreciate a guy who has a strong opinion. I couldn’t agree with him more, especially since I am a 40 year old working stiff who thinks the likelihood of the social security trust fund solvent in 25 years is a thousand to one long shot at best.

Plus, we have a smart guy talking about the earnings yield of the stock market! We’ve opined in these pages in the past about the attractiveness of stocks over bonds when comparing the earnings yield. Joe talks about a 2% treasury on the short end of the curve, but we’ve discussed a 3.65% 10-year Treasury as having little value, especially relative to the S&P 500.

Joe makes a strong argument for long term equity investing, and reinforces the notion that now is not a time to panic out, but to stay committed to your long term wealth accumulation plan. In fact, he argues that the present environment is one of opportunity versus risk, and the winning trade will be in equities, and not fixed income.

Speaking off opportunity, the cover story of this week’s Barron’s issue (titled: Giddyup) was a spotlight on Wells Fargo Bank and why Warren Buffett had purchased additional shares recently and how his stake had grown to 9+%. Here again, we have a large institutional type investor buying shares of a financial stock, when almost universally, we read about the terminal condition of banks and consumer oriented companies. Why would smart money man Warren Buffett invest in a so-called near death bank stock? Incidentally, one of Joe Rosenberg’s “picks” discussed in his article was about a bullish bet on Target (TGT), a stock in another massively out of favor sector. So we have two credible individuals buying shares in unappealing sectors at the moment, are you willing to bet against them?

Re-Testing the Low - Is it Necessary?

There is chatter about a re-test of the January 22, 2008 lows. Mark Hulbert writes a nice article about the re-test theory and how many practitioners believe it. His analysis found that many newsletter writers are unwilling to declare the lows are in for the year, and how that is good! Hulbert is taking a contrary view here, in the sense that since his research points to many don't believe a low is in and a re-test is necessary - which translates into these very same newsletters are then, by definition, bearish to slightly bearish, and invested accordingly. If you are expecting lower prices, then you are either short, in cash, or hedged to a certain degree. Therefore, your opinion can change two ways, one from bearish to bullish, or from bearish to depressionary.

My take, we are in a global boom, and the odds of depression are very low. Therefore, the direction of those bearish is more likely to change to bullish, or at least a move to neutrality. Therefore, the next trades for those particular investors presently expecting lower prices are to either buy back their short positions, or to invest their cash in long positions. In some sense, this creates a sort of backstop for the market, since other evidence supports other broad groups of investors presently in bearish modes as well.

A Busted Deal or an Opportunity?

Penn National Gaming (PENN) offers a unique investment opportunity at current prices. They have a private equity buy-out on the table for $67.00 per share at something called a "fully financed" transaction led by Fortress Investment Group (FIG) and Deutsche Bank AG (DB). The terms of the deal are such that Penn shareholders will receive $67.00 in cash for each share of Company common stock they own. If the merger is not consummated by June 15, 2008, the per share merger consideration will be increased by $0.0149 per day. There is also a provision that pays Penn $200mm if the deal falls through.

Ok, the background on Penn Natl Gaming: PENN is the 4th largest casino operator in the U.S. They have annual revenues of approximately $2.5billion. They have a focus on slot machine entertainment. The Company operates nineteen facilities in fifteen jurisdictions, including Colorado, Florida, Illinois, Indiana, Iowa, Louisiana, Maine, Mississippi, Missouri, New Jersey, New Mexico, Ohio, Pennsylvania, West Virginia, and Ontario. In aggregate, Penn National’s operated facilities feature over 23,000 slot machines, approximately 400 table games, over 1,731 hotel rooms and approximately 805,000 square feet of gaming floor space. In the past week, they opened a brand new facility called Hollywood Casino in Harrisburg, Pennsylvania to rave reviews.

The ques: Why is the stock trading for $49 when there is a deal that is set to be consummated in June at $67? One word...debt, well maybe two words, credit crisis. Fortress, Deutsche Bank, and another private equity firm in on this leveraged buyout, Centerbridge Partners, must have the capability to obtain financing, and the ability to off-load some of the debt to third party investors. This is the nature of the LBO - the tool is to finance a takeover by raising large amounts of debt at competitive prices. If pricing is unfavorable, then it becomes harder to justify the Return on Investment (ROI). The market is placing a legitimate amount of skepticism on the deal getting done.

However, here are some things to consider:

This past weekend, Peter Carlino, Chairman and CEO of PENN, was interviewed on site at the opening of the Hollywood Casino in Harrisburg. He was asked point blank to comment on the progression of the transaction. Answer: "To my knowledge, very well....This is a fully financed transaction, like Harrahs. We had locked-in financing from the outset. Financing with virtually no escape from the banks."

Note, Carlino mentions the Harrahs deal, which was recently completed in January. That was a $17billion purchase (significantly larger than the Penn offer) by Apollo Group and Texas Pacific Group (TPG) and banks in on the deal were Bank of America and Deutsche Bank.

Note, Deutsche Bank announced earnings a week ago, and lo and behold, they did not report any write-downs related to sub-prime or other mortgages. Last October, they did report $2.2 billion in write-downs, but the latest report mentions strong risk management exercised during the overall credit crisis. CEO Josef Ackermann was quoted, "Unlike many of our competitors, we are in very good shape and at times like these, when financial markets are more risk-averse, we are set to gain from a flight to quality." The banks ability to dodge the subprime crisis also allowed it to raise their dividend 13%, which is unusual relative to some other banking institutions doing the exact opposite.

Here's a re-cap: Fortress (and others) offer $67.00 per share for Penn (a premium of 37% over today's price). The bond market swoons on sub prime and other related problems. In the meantime, the board agrees to sell, and PENN shareholders approve the deal. Fortress agrees to pay $200mm if they back out. Harrahs Entertainment, the largest casino operator in the US, gets taken out in a private deal for $17billion in January 2008. One of the banks assisting the Harrahs package is Deutsche Bank. They had trouble selling some of the junk bonds, but the deal got done. Fast forward to June 2008, will the debt market get better? Will the "locked-in fully financed" deal get done? Is this a speculative risk worth taking? Would I be comfortable holding PENN if the deal does not take place? You be the judge.

Good Luck.

What Do We Know?

AIG (American Intl Group) is in the news today, off -11% or so as its auditors have called into question the value of some Credit Default Swaps (CDS's) listed on their Dec 31st balance sheet. The iShares Financial Sector ETF (IYF) is down -1.8% today, but still up +9% from its lows three weeks ago! One might ask: How is that possible? If there is blood in the streets, and another large financial firm is on the tape with more credit crunch news, why are financials up 9% from their lows? AIG is approx 4.6% of this particular ETF, by the way. Retailers and financials, some of the hardest hit sectors in the economy, are exhibiting short-term strength. We will continue to watch closely, as they could be signaling a change in market leadership.

Note: The biggest holding of IYF is none other than Bank of America (BAC), which will be added to the Dow Jones Industrial Average next week!

AP Poll Says We are in a Recession

61% of the public believes the economy is in recession. Click here for the story. So, if the public knows, what does the stock market know? Isn't the stock market well ahead of broad public sentiment? A market strategist at Bear Stearns says, "Stocks don't do well because the economy or earnings are strong; they do well because the environment turns out better than expected." So, if the stock market and the general public know we are in recession, the challenge will be to figure out what's really anticipated, and therefore priced. This also means understanding the odds and resulting outcomes when things are better or worse than expected. Sounds like a challenging and dizzying game that gets repeated on a daily basis. Is there a Cray Supercomputer big and fast enough to help in our worthy cause?

Take retailers, for example. They are up more than 10% from their lows a few weeks ago. Is the consumer recession already priced, and a continued accommodative Fed will avert a real drawn out recession, and therefore, the worst is over for the retailers. Or, what if the drastic rate cuts in January caused short sellers to cover, only if momentarily, and the 10+% pop off the lows is temporary, as the economy nosedives into a severe recession, and it lasts longer than most expect? Things aren't so crystal clear now, are they?

All in all, the fact that sentiment surveys (including the one above from the AP) are so despondent is a good sign for the bulls. The one unique notion of this market is that you can't have universal agreement that the market is going to decline and it comes to fruition because when everyone is on one side of the ledger, the other outcome usually comes in. (Think New York Giants as heavy underdog, and the New England Patriots as huge favorites). The question is, what is unexpected? Think of the litany of reasons as to why we are in big trouble: economy is in recession, the sub prime mess is bad, the credit crunch will take time to mend, the dollar is weak and going to get weaker, the election will be a pitched battle, earnings will disappoint, budget deficits are going to get worse, etc etc...these stories have had more black ink spilt on them than necessary...so the astute investor knows they should spend their time seeking clues as to the surprise, the unexpected outcome, and its ramifications. That's what we'll be doing. Good luck and have a pleasant week.

Adverse Feedback Loop

Janet Yellen and other Federal Reserve officials made some interesting statements this week. I copied and pasted a paragraph from her speech below. The key point is her comment about a negative feedback loop. I do think there is something to be said about the psychology of the markets, as one does wonder about the constant drum beat about "how bad things are," and whether or not investors act on that information. If you are told on a daily basis that things are bad, whether the facts may show something completely different, you may begin to believe "the noise," as I like to call it. However, the cascade effect impacts us all - as folks talk themselves into thinking the economy is in recession - they react by unwinding their portfolios; this selling begets selling. I can see where the feedback loop gets stuck in reverse and the market, economy, and life in general can get mired in the negativity.


Speech to the Chartered Financial Analysts of Hawaii
Honolulu, Hawaii By Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco
February 7, 2008, 7:25 PM Hawaii Standard Time, 12:25 AM Eastern February 8

To sum it up, for the next few quarters, I see economic activity as weighed down by the housing slump and the negative factors now impacting consumer spending. It remains particularly vulnerable to the continuing turmoil in financial markets. My comments haven’t even touched on possible slowdowns in business investment in equipment and software and buildings. I see the growth risks as skewed to the downside for the near term. In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop—that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution. Indeed, an important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold.

Silver Compliments Gold Nicely

Why Gold?

Weak U.S. dollar

A commodity play

A budget deficit play

Inflation play

Supply/demand imbalances

A hedge to your proto-typical equity allocation

A traditionally non-correlated asset

Credit crunch, derivative mess, mortgage meltdown

Govt stimulus package

Fed easings, etc etc

Substitute the word SILVER for GOLD. Why put all of your eggs in one basket? The way to diversify into silver is through SLV - the streetTRACKS Silver Trust. The shares are consolidating recent gains, and pulling back off of new highs, so a decent entry point is at hand. Good Luck.