Consumer Deception at a Young Age

In an era where accounting fraud is now official government policy, and a CEO , Corzine, who oversaw the theft of billions won’t face prosecution, it is no surprise that deceptive practices have extended to almost every level of our corporate world.

So, let’s imagine a company in a challenging retail environment that wanted to issue coupons (so that customers would think they were getting a bonus at the check-out counter), but also wished to ensure that virtually none of these coupons would actually be used. 

In such a world, we’d get something like this:

This coupon was issued on July 20. Note that it is not effective for nearly a month; and many customers would lose this small piece of paper before then.

And even if the customer retained the coupon that long, the fine print excludes almost anything in the store that the customer would want to buy. 

Sigh.

How Much Trading is “High Frequency?”

After Knight Capital’s meltdown, inquiring minds have asked how much of today’s stock market volume consists of computers trading with each other versus actual investors trading stocks they intend to hold longer than a few microseconds.

The following chart plots the average daily volume of S&P 500 shares traded since 1950.

Trading didn’t begin to ramp up until the beginning of the dot.com bubble in 1995-96, a phenomenon accompanied by the day-trading craze of the late 1990s.

The bust that followed slowed trading somewhat, but growth in the average number of shares traded accelerated in 2005 and reached a peak in 2009.

For daily fluctuations, see the following chart (source Yahoo Finance), which plots individual day volume along with the 20 day moving average.

Even after the dot.com implosion, volumes rarely reached 2 million/day until 2005.  However, trading volumes have declined by 31% since their 2009 peak.

Retail investors appear to be abandoning the stock market at a rapid pace (chart from Ritholtz.com).

If the retail investor leaves, who remains?

The machines.

Lapdogs Unite – HSBC Version

Earlier this week, a Senate investigative committee released a scathing 330 page report (click here for the link to the full PDF) describing HSBC’s laundering of money for Mexican drug lords, Iran, the Taliban and other assorted malefactors.

Inquiring minds may ask, “How did this happen?” 

The answer, as the recent Economist describes, is quite simple: 

The [Senate] report describes a constant struggle for resources by a compliance department vainly attempting to monitor a vast and expanding number of transactions and regulations in the face of efforts by executives to tamp down costs.

One employee who pushed hard for more resources to address festering problems was apparently sacked because of her efforts. Another, cited in 2009 by the bank’s primary regulator, the Office of the Comptroller of the Currency (OCC), as being unqualified, was promoted.

As with so many other aspects of our current financial mess, regulators were aware of a multiplicity of problems, yet did nothing.

HSBC’s compliance problems were hardly an internal secret. They were flagged numerous times by regulators, but the bank received only the mildest of sanctions in exchange for promises to do better. Senators Levin and Tom Coburn, the two senior members of the committee, slammed the OCC for serving as an ineffectual industry “lapdog”.

Lapdogs and yes-men rewarded; honest employees punished.  The story of our financial times.

Oh, by the way, “we’re sorry and won’t let it happen again.”

Right.

Food Inflation and $2 per Day

While the inflation vs deflation debate continues to rage over the likely trajectory of the US economy, the price of food is rising rapidly – a fact that would be apparent even to Helicopter Ben if he ever went to the grocery store.

I buy a fairly regular basket of goods, and the prices for these have increased by 15-20% since the first of this year.  Fortunately, this is more of an inconvenience than problem; but what about people – especially in the developing world – for whom an increase in food prices means genuine hardship?

More importantly, how many of these people are there, and what are the implications for the political stability in their countries?

Let’s look at three charts, which take the 20 most populous countries (excluding the four developed nations on the list – US, Russia, Japan and Germany) and base “poverty” on an income of less than $2 per day (on a purchasing power parity basis).   Poverty data is derived from the World Bank and the CIA World Factbook.

Countries are ranked in order of overall population, except that I’ve grouped the Indian subcontinent (India, Pakistan, Bangladesh) together.

From a raw numerical perspective, India has the highest number of people living in absolute poverty, with China a distant #2.

On a percentage basis, the Indian subcontinent and the African nations rank the highest in terms of poverty.

India’s economy is slowing, as is China’s.  The leadership structures of both counties know this, and are well aware of how many of their own citizens are living perilously close to the edge – and the social instability that will result from even small increases in food prices.

Has Helicopter Ben considered this side effect as he prints money to bail out the banksters?

Most likely not.

Finland’s European Math

Yesterday, Italian Prime Minister Mario Monti denounced unnamed “northern” EU states for taking positions that contributed to spikes in borrowing costs for Italy and Spain.

One of these states was Finland, whose Finance Minister, Jutta Urpilainen, stated that:

“Collective responsibility for other countries’ debt, economics and risks; this is not what we should be prepared for.”

Urpilainen wasn’t just expressing the normal distaste of the profligate by the prudent.  Regardless of intention, Finland cannot bail out Italy or Spain, even if it wanted to.  Simple math explains why.

According to the CIA World Factbook, Finland’s population is 5.3 million.  Were Finland a US metropolitan statistical area, it would rank only #10 – behind Atlanta and just ahead of Boston.

Finland’s GDP is $271 billion ($197 billion at purchasing power parity).  More importantly, Finland’s central government tax revenues add up to $136.2 billion. 

So far, Spain has asked for a bailout of 100 billion Euros ($125 billion) – an amount equal to 92% of Finland’s total government revenues for 2011.  Spain’s ultimate bailout number will surely be higher.  Add Italy to the mix and the equation becomes insoluble.

Finland  will not bail out Spain or Italy because it could not do so without impoverishing its own population.   What is mathematically impossible will not happen.

A River of Doubt

While the NASDAQ fell nearly 2% today, shares of Amazon continue to levitate in the stratosphere. The question for investors is how likely is this to continue?

The company’s SEC filings make the case for caution.

At the end of today’s trading, Amazon closed at $220.07, giving it a P/E ratio of 181.73 (source:  Yahoo Finance).   A P/E above 50 – at least in the ancient days before the dot.com bubble and QEs 1 through 75 – used to signify either 1) a company on the cusp of explosive growth; or 2) a beaten-down cyclical on the verge of an upswing.

Amazon, however, fits neither of these categories.  Instead, the market appears  to be confusing high growth in revenues with growth in profits, which is another story entirely.

Consider the following chart (data from SEC Edgar for AMZN and WMT):

From 2007-09, Amazon had similar net margins to Walmart even though Walmart’s operating margins were higher.

However, in the last two fiscal years, Amazon’s margins have fallen off the cliff.  Yahoo Finance reports a trailing 12 month profit margin of a mere 1.09%, and AMZN’s latest 10Q states a net margin of only 0.99%.

This trend is likely to be exacerbated by state efforts to force Amazon to collect sales taxes (which begins in Texas starting July 1, 2012).

Now, let’s assume that Amazon could get its margins back up to Walmart levels.  What would that do to Amazon’s P/E ratio?

Consider the following chart for the effect on AMZN’s earnings:

This looks impressive, but Walmart trades at a PE of 14.69 (as of 6/25/12).

Let’s look at a few other numbers:

According to Yahoo Finance (which closely matches the numbers calculated from Amazon’s 10K and 10Q filings), AMZN’s trailing twelve month (TTM) diluted EPS is $1.21 per share.

Using Walmart’s TTM net margin of 3.52% would give Amazon a diluted EPS of $4.02 per share.

If Amazon had achieved this, AMZN’s P/E today would be a mere 54.7 (and compare to Apple’s P/E of 13.91).

On the other hand, if the market began to value AMZN according to its profitability, and not its revenue growth (in other words, like Walmart), the stock could be priced as follows:

Assume Amazon with Walmart margins and a Walmart P/E ($4.02 * 14.69) = $59.05

Assume Amazon with AMZN margins and a Walmart P/E ($1.21 * 14.69) = $17.77.

In other words, AMZN appears to resemble the coyote in the old roadrunner cartoons.  Wiley E has run off the cliff, but keeps running in levitation for a while before he finally looks down and plummets.

As always, though, the question is timing.

Disclosure:  I am short Amazon via puts.

Also note:  this is a discussion forum, and is not an offer of investment advice.  This is merely one data point, so do not take a position in AMZN without doing your own research first!

An Economy on Foot

A few days ago, I had planned to have lunch with a former colleague.  When I called that morning to confirm the place and time, he asked that I go by his apartment to pick him up, rather than meet at the restaurant.

“Car in the shop?”  I asked.

Um, no.

Instead, the car was gone.  The lease had expired and he didn’t have the means either to buy the car outright or to lease a similar luxury vehicle.

My friend’s tale is illustrative of the economy writ large.

There comes a time when those who would like to take on more debt (or utilize other contrivances – like car leasing – to live a “higher” lifestyle than their incomes would otherwise allow) simply have no more capacity to do so, while those who do have the ability to incur additional debt have the good sense not to.

But the overhang remains, and will take years to work through.  Changes to the bankruptcy laws in 2005 – in conjunction with the non-dischargeability of student loans, the fastest growing category of consumer debt – will simply make this process more drawn-out and painful.

Meanwhile, my friend faces two unpalatable choices:

1) admit that his former lifestyle is gone, and drive an inexpensive used car until he has rebuilt his capital base; or

2) scrape together enough cash to lease a new luxury car in the hopes that his income (and the economy) will grow enough to bail him out of this debt-ridden folly.

So far, as a country, we’ve chosen Option #2.  But that path leads to ruin, and a person – and a nation – eventually on foot, without any car at all.

A Few Bad Apples?

In a response to yesterday’s post about Jamie Dimon and Old Testament justice, reader Howard brought up an excellent point – one that illustrates what is probably the most fundamental question we face as a society:  were the excesses that led to the Global Financial Crisis the result of a few “bad apples,” or do we confront a deeper-rooted and more systemic institutional rot? 

To be fair to Chase, any organization with 160,000 employees scattered across the globe will have its share of rogues.  This is the inevitable consequence of the law of large numbers, and is just as true of institutions – such as the US military – that are held in high esteem as it is of those that are not.  Also, I am certain that the vast majority of Chase (or other bank) employees are  honest people just trying to do their jobs as best they can.

But how, we must ask, if it is a matter of only a few bad apples did we wind up with the crisis we have - a world of massive and unpayable debts, widespread lending and foreclosure fraud, and trillions of bank liabilities being transferred onto the backs of future taxpayers?

In a saying attributed to Benjamin Franklin, “fish rot at the head.”

While no one will find a smoking gun memo from Dimon (or any other bank CEO) instructing employees to make loans to people without any prospect of repayment in the absence of house price appreciation of 20%+ per annum into perpetuity, those loans were made – in the millions.

The CEO sets the tone of the organization and decides which behaviors will be rewarded.  “Making the numbers” results in promotion, and despite all the corporate-speak of “mission, vision and values,” those who exercise values at the expense of numbers usually find themselves seeking employment elsewhere.

A recent article in the Economist sheds some additional light on this subject, exploring “why people lie and cheat and what it means for business.” Dan Ariely, a social psychologist who has spent yeaars studying cheating, concluded that the vast majority people are prone to cheating, and – interestingly – are more willing to cheat on other people’s behalf than on their own.” 

This, by the way, is the view of Charlie Munger, who has also decried the current “ethic” on Wall Street as “anything that won’t send you to prison is OK.”  (cited from his book Poor Charlie’s Almanack).

Taking these factors in combination:  1) enormous pressure from the CEO to “make the numbers;” 2) a natural human propensity to cheat (“after all everyone else is”); and 3) a prevailing business ethic that sleaze is OK as long as it does not degenerate into outright criminality, and it is no surprise that we have landed in the sorry and indebted state that we are in.

And I’ll add a fourth factor:  the curse of false accounting – “mark to make-believe” and “extend and pretend.”

Dimon’s defenders cite Chase’s supposedly fortress-like balance sheet.  But the price of Chase’s stock makes it clear that investors do not believe the stated numbers.  Chase’s price to book ratio is 0.74.  Citibank and Bank of America’s P/B ratios are 0.46 and 0.41 respectively – which means that if the book values of these institutions are accurate, dollar bills are on sale for less than 50 cents.

But no one with any serious money is taking this bet.

That is because they suspect that TBTF balance sheets resemble Enron’s (in spirit if not in degree).  Assets (like mortgages and derivative contracts) have nowhere near the values that are recorded in the books, and liabilities are most likely under-stated or hidden through various stratagems.

The highest ranks of CEOs, auditing firms, and even the Treasury and Federal Reserve have gone along with this.

But that doesn’t make it right, and will not shield us from the consequences when it all comes crashing down.

Jamie Dimon and Old Testament Justice

In his testimony before the banker-owned Senate Banking Committee, JP Morgan Chase CEO Jamie Dimon professed to apologize for the bank’s $3 billion (and counting) trading loss.  He also made the comment that the government should have the authority to shut down “big, dumb banks” with “Old Testament punishment.”

Let’s look at an example of such Old Testament justice.   The Book of 2 Kings, Chapters 9 and 10, describe the final days of the Israelite king Ahab.  After Ahab’s death in battle, a warlord named Jehu decided to take the kingdom for himself.  2 Kings describes what followed:

He [Jehu] looked up at the window and called out, “who is on my side?”  Two or three eunuchs said they were, so Jehu commanded them to throw Ahab’s wife, Jezebel, out the upper story window.

“So they threw her down and some of her blood spattered the wall and the horses as they trampled her underfoot.”

Jehu then “went in to eat and drink,” but apparently decided that a queen deserved a decent burial after all.

“But when they went out to bury her, they found nothing except her skull and her hands.”  The city’s stray dogs had devoured the rest.

Later, Ahab’s relatives, all his “chief men,” his priests, and his close friends met similar ends – most of whom had their heads “placed in piles at the entrance to the city gate.”

Be careful what you ask for, Jamie.

Under your watch, JP Morgan Chase wrongfully foreclosed on the homes of US service personnel fighting in Iraq and Afghanistan.  Your bank also bribed officials in Jefferson County (Birmingham), Alabama in one of the nation’s most expensive municipal finance scandals.

True Old Testament justice would prove as kind to you as it was to Jezebel and the rest of Ahab’s family – though putting such an event on pay-per-view could perhaps put a sizable dent in the US federal budget deficit.

US Bank Exposure to Euro Debt Doubles

In a chart that should surprise no one who is actually paying attention, Bloomberg points out that US bank exposure to Euro area debt has doubled in the last four years and now exceeds $600 billion.

Should anyone have reason to believe that the US banking system can remain “decoupled” from the European morass?

I think not.