QE2: "No Cure But It Eased Symptoms"

The Wall Street Journal published the results of its monthly survey of economists.  The consensus forecast is for modest growth in GDP, 2.3%, and employment, 2.2 million jobs to lower the unemployment rate to 8.2% by this time next year.  A  number of potential risks are mentioned (spiking oil prices, increase in unemployment), but three potential tornadoes are ignored.  Greece is holding a yard sale to try to hold off foreclosure.  The U.S is reworking its budget (flying coach instead of business, cutting back to basic cable) in hopes increasing the line of credit.  And the Fed has been very clear that there is no plan for QE3. (The economists were decidedly unimpressed with the results of QE2!)

So this is where we stand:  sluggish growth and stubborn unemployment for the next 18 months with no expectation of any policy changes.

Inland Western Valuation

Inland Western filed an 8-K on June 20 announcing management's estimation of a $6.95 per share valuation.  This is an increase of $0.10 per share over the valuation announced last January.  Both of these figures  were developed by management.  No third party appraisals were conducted.

The valuations appear to be on the high side.  While doing a financial analysis earlier this year, I was able to estimate the real estate portfolio's Net Operating Income at $433 million.  Applying a (somewhat arbitrary) 7.5% cap rate (RealtyRates.com reports a national average of about 8.3% for anchored shopping centers), would indicate that the directly held real estate is worth about $5.8 billion, or about $100 million more than carrying value on the December 31, 2010, balance sheet.  Subtracting the liabilities provides shareholders equity of $2.4 billion or approximately $5.00 per share.  On the other hand, I calculated Funds from Operations (FFO) of $153 million or $0.32 per share.  The May issue of REIT Watch, a statistical publication of NAREIT, estimates the Price/ FFO of shopping center REITs at 16.75.  This would indicate a share value of $5.36.  Mind you, neither of these rise to the thoroughness of an appraisal, but at least you have the methodology to assess for yourself.

One very important source of information available to management to which I do not have access is a sense of the actual market acceptance of the shares of Inland Western.  Inland Western announced its IPO filing on February 14, 2011, and named four book-running offering managers.  Surely, these investment banks have been willing to advise management on its share value estimation, so as to avoid disappointment on opening day.  Still, $6.95 seems like a significant premium to just over $5.00 per share.

Special Thanks to the Rational Realist

No More Hybrid Advisors?

Todd J Pack, President and Chief Operating Officer of Financial Advisors of America LLC, has contributed a piece to Investment News on how the regulatory environment is making the hybrid advisor model unwieldy for the advisor and burdensome for the broker-dealer.  It appears that FINRA and state regulators are going to be enforcing "private securities transaction" oversight rules on broker-dealers whose reps who conduct asset management business under their own RIAs.  This outcome has been developing for 15 years, as FINRA has been putting pressure on BDs to assume the oversight responsibility "voluntarily."  Along with a number of related issues, including exorbitant state review fees, the viability of the business model on the broker dealer's part is diminishing.  Advisors should prepare to make the decision on which side of the fence they are going to conduct their business.

Rob Arnott's Inflation Protected Portfolio

Market Watch has an interview with Rob Arnott, founder of Research Affiliates, about his economic outlook and his portfolios allocation.  Arnott says the "3-D Hurricane" - a combination of deficits, debt, and demographics - is setting the U.S. economy up for a slow growth environment that is likely to b e accompanied by the inflation of deliberate debasement of the dollar.  His ideas for portfolio protection:

1. Rethink Asset Allocation - A traditional 60/40 allocation will disappoint.  Diverting some of the equity allocation to inflation hedge is cheap insurance.  Given the specific recommendations, I can understand this suggestion.  However, given that inflation is a covert transfer of wealth from lenders to borrowers, I would be inclined to reduce the fixed income allocation.
2. TIPS - Bonds tied to inflation should perform "decently" in an inflationary environment, and that is what an investor needs.  He cites the 1.8% spread available on the 30-year TIPS as comparable to what has been available to long Treasuries over the past ten years.  What isn't mentioned is that this spread is about the smallest it has been since the Treasury started issuing TIPS.  Purely defensive.
3. Commodities - With a nod to the drawbacks of commodity investments - volatility, prices reflecting expected inflation, speculation-driven prices - Arnott reminds us that commodities are an effective hedge against unexpected inflation.  While this could be argued at the stretched prices we have seen last year and earlier this year, the recent pullback of prices in the agricultural and energy sectors signal that this could again be an effective inflation defense.
4. Emerging Markets - Representing 40% of world GDP and only 10% of world debt,  emerging markets, both debt and equity, emerging markets have three factors in their favor: high growth, low leverage, and commodity exposure.  It could easily be argued that emerging market exposure in the equity portion of a portfolio is sufficient inflation hedge that no other is needed.
5. High Yield Bonds - As a fixed income instrument, junk bonds would not be expected to be a very good inflation hedge.  Arnott makes the argument that inflation improves the nominal performance of the issuer, potentially improving the credit quality of the bond.  On the other hand, this low growth economy that he forecasts could create struggles for companies of dubious credit.  Be wary.

Single-Family Home Foreclosure Data

Financial Advisor magazine has a May 26 article based on a press release from RealtyTrac.  It details the market share of home sales represented by distressed (bank owned, scheduled for auction, or in default) properties during the first quarter of 2011.  Just over a quarter of the properties that were sold to third parties were in a distressed situation, and sold at an average price about a quarter lower than the average non-distressed property.  Distressed sales have slowed since the previous quarter and the year earlier period, while the pricing is stable.  Current inventory of 1.9 million homes represents a three year supply at current sales rates.

Two factors are likely driving the slow liquidation.  First, foreclosure sales are being closed for all cash.  Selling banks are unwilling to close a sale except for all cash, because they are working to improve the asset quality pf their balance sheets.  Second, mortgage money is not scarce, especially for purchases of bank REO.  The dearth of financing reduces the number of potential buyers and the capital available.

The second factor is a regulatory environment that is encouraging the slow liquidation of the distressed properties.  Default periods are extended to allow for investigation of restructuring the mortgage.  Foreclosure periods are extended to ensure the proper procedures are followed.  REO is held on the books long to avoid taking the writedown of capital.  It is an intricate dance of Extend and Pretend, meant to give banks time to work through their asset quality issues that arose in the real estate bubble.

Three years of supply suggests at least two more years of soft home prices.  There is no telling ow much overhang remains just this side of default.  Until this inventory has been paired to something closer to six months, the economic engine of home building will remain moribund.

Are You Ready For QE3?

The Wall Street Journal hosted a video debate between Brad DeLong, an economics professor at University of California Berkeley, and Jim  Grant of Grant's Interest Rate Observer.  The subject was the prudence of another round of monetary easing, or QE3.

Jim Grant bases his recommendation on the ineffectiveness of the first two rounds of monetary easing, and the observation that interventions and manipulations are often met with unintended consequences.  He notes that large cash balances have been amassed, but that these balances are not purchasing goods.  He notes a fear of inflation in general and asset bubbles in particular

Professor DeLong's argument begins with a appeal to the Milton Friedman's reputation.  He claims that QE3 is what Dr. Friedman would prescribe, based on Friedman's work relative to the Great Depression and the lost decade in Japan.  DeLong sees no asset bubbles, and expects "NEGATIVE headline inflation" (my emphasis) before the end of the year.

My take is that QE3 would be more detrimental than helpful.  We are seeing signs of bubble pricing in certain ares: gold, Treasury Notes, oil.  The inflationary effects of these bubbles are being masked by the deflationary forces working in other sectors: housing, industrial capacity.  There is a sea of liquidity waiting to be unleashed when the economic, regulatory, and taxation conditions are favorable.  It's probably better for the country to go ahead and take its medicine, get labor and capital reallocated, and then move forward.

The Impact of the National Debt

The Wall Street Journal published this quote from Lawrence B. Lindsey:

"Right now, thanks in large part to Federal Reserve policy, Uncle Sam can borrow at an average cost of just 2.5 percent. The average borrowing cost over the last three decades was 5.7 percent. Our debt is now $14 trillion and scheduled to grow to $25 trillion by the end of the decade. If interest rates normalize over that period the added interest costs in 2021 alone will be $800 billion—more than 20 times the mere $37 billion in budget cuts that tore up Congress in March. It would take virtually all of the cuts in the Ryan budget just to cover that added interest, much less to start bringing down the national debt. Unfortunately, the Fed is now in a fiscal box. A normalization of interest rates would break the Treasury. Hence, a normalization of rates really can't happen—we're stuck in a world in which the Fed must keep rates artificially low in order to prevent a budget disaster."

 How terrifying! Either normalizing monetary policy will swamp the federal budget with interest payments, or the country will look to the Fed to debase our currency sufficiently that we don't default on our debt.  Neither scenario allows for economic growth, but the growth we have experienced over the past three years is less than the average cost of the federal debt.  This underscores how important it is to address our federal budget deficit.