As will be explored in this post, a major determinant of large capitalization banking stocks is the direction of housing prices.
US centered large cap banking stocks appear undervalued by many measures in late April, 2012. Citigroup is selling at 0.53 net book value and approximately 0.66 net tangible book value, Bank of America is selling at 0.41 net book and approximately 0.50 net tangible book value, and even the generally well respected JP Morgan is selling at 0.91 net book value.
In comparison, in southern Europe, banking stocks are currently in a declining trend, but appear even more compelling to from a valuation standpoint, at first glace: Italy's largest bank, Unicredit is selling at 0.11 net book value (falling over 30% in one day in January 2012), Spain's Banco Santander is selling at 0.59 net book value (falling approximately 25% from march 2012 to April 2012) - even as Banco Santander has a compelling market position in one of the hottest emerging markets, Brazil.
The first step to analyzing large capitalization banking stocks is to note that the earnings power of the banking franchises - potentially massive due to the incredible size of the bank's balance sheets -- can be completely diluted to the current shareholder by loan losses. This is to say, if there are loan losses of sufficient size, then the loss taken by the bank will result low equity to asset ratios (as the loss flows to equity) which necessitates the bank to raise more capital. As the share price tends to plummet with high realized loan losses, the bank will have to sell very high numbers of shares to bring capital ratios back to acceptable levels.
So one could say that there are three main factors should be discussed in order to analyze current banking valuation for the shareholder:
1. Earnings power of the banking franchises,
2. Current required write downs from loan losses and
3. Potential future increases for loan losses (or, alternatively, reversal of estimates for loan losses) in future time periods.
On point 3 above, the major determining factor of additional losses beyond current estimates are the direction of housing prices. This is to say, if housing prices go up, then it is possible that current estimates of loan losses on the books will be lower, significantly adding to shareholder value.
The previous post in this blog has argued that housing prices are a larger contributor to GDP than commonly calculated by economists, and therefore will impact not just real estate but other commercial activity and loans, without government and central bank stimulus. Note that, as Warren Buffett stated in bis assessment of investment in banking, realized write downs may be "gained back" if assets recover in value (assuming banks have already taken the full loss, then any gain above that loss will add to earnings). That is to say, if the asset prices of problem loans increases, a firm may "write up" its problem assets, in the most optimistic scenario.
In the third part of this post, housing prices are theorized to be driven in the first stage up by "a large scale injection of money" into the economy by one or more of the following forces: large scale investment from positive views of future growth of the economy, additional earnings from exports, and/or monetary expansion.
It is assessed that in the US only large scale investment is moderately possible over the next few years based on computer technology or some other potentially now-unrealized technology (always possible in an innovative economy such as the US, that a new technology can appear over a short time span, such as the Internet in the mid 1990's, or the automobile in the 1910 to 1920's, etc), therefore the recovery in housing prices and the recover in banking stocks is tepid at best.
Bank of America Analyzed as an Example of Value in the Large Cap US Banking Stock Universe:
Bank of America is one of the largest mega-banks in the world, ranked as the number #3 banking institution worldwide in terms of total assets at the end of 2010 with approximately $2.1 Trillion of assets.
The simplifying assumption here is that the earnings power of BofA can be expressed as a net interest margin plus fee income as a percentage of total assets. Many analysts will estimate the earnings power of a bank by its divisions -- depending on how the bank divides its reportable segments into real estate lending, commercial lending, trading, credit card services, trading, investment banking etc -- then add up this earnings power on a segment by segment basis. A difficulty of using a segment approach is that such an approach takes emphasis off total loan losses, and treats the divisions as fully separable. I have read one analysis that stated card services, for example, would be worth by itself "more that the entire market capitalization of Bank of America." (and therefore BofA is a buy since the other divisions must be worth at least zero). However, in reality the Bank cannot spin off the credit card division as an entirely separate company: credit card holders will be deposit holders of the bank, deposits are used for funding of all divisions of the bank, if the bank losses depositors then credit card market share will go down.
So one could say, credit cards will report through the entire banking operation which must absorb credit losses. One could say, that each segment will be linked to the overall operations and asset levels of the Bank as a whole, although in different ways for example the trading division will be linked by the borrowing credit of the bank through the acquisition of trading assets, etc for the other segments of the bank. (with the possible exception of the investment bank, which could be potentially separated out from the overall bank).
At the end of 2011, a full $311Bn of BofA's total assets were invested in debt securities (secondary market, a low interest rate) and $120Bn were in cash and equivalents -- the rest were in commercial and real estate loans of $900Bn, trading assets ($176Bn, perhaps a majority from the trading division at the acquired Merrill Lynch) and reserves deposited at the Federal Reserve, which earns a small interest margin, and other assets such as property and equipment. The vast majority of assets are therefore accruing income (one could say, of course, why otherwise would these be "assets"?) the tricky part is assigning fee income to the balance sheet.
In 2011, the total net interest income of BofA was approximately $45Bn - representing a slight net interest margin of only approximately 50 bps on interest bearing assets. Fee Service and fee income was higher at approximately $58Bn before loan losses, with the majority of fees coming from credit card, deposit account, brokerage and investment banking fees. One could say , again that the majority of fee and service income is linked to total assets (with the possible exception of investment banking fee income).
All personal and other expenses were approximately $60Bn in 2011 for BofA, and tax rates are assumed to remain constant at 38%.
If one assumes that interest rate conditions remain similar going forward for at least the next couple of years then net interest and fee income appears to be approximately 50 bps total, then the revenue power of Bank of America is approximately $120Bn ($2Trillion times 0.60%), minus $60Bn in expenses to yield $40Bn in pre-tax income, and $24.8Bn in net income.
Note! This net interest spread of only 50 bps total on both interest and fee income is very, very low -- most banks report net interest margins in normal times in excess of 200 bps and certain banks, such as WestAmerica in Northern California have net interest margins of over 400 bps. If, conceivably, BofA could get their overall retun on assets around 200 bps then the earnings power would be massive, around $210Billion of net income per year (before loan losses). This is the power of having $2Trillion of assets, potentially -- and this is the hope that many analysts point to when they state BofA is undervalued -- however there are several complicating factors.
Potential Loan Losses at Bank of America:
BofA's real estate portfolio consisted of approximately $83Bn of home residential and equity loans with Loan to Values above 100% at December 31, 2011, and $47Bn (not indicated if included in the above 100% LTV category above) of home loans with FICO scores of less than 620, according to page 186 of their 2011 10-K. An additional $11.5Bn of credit card balances are outstanding to consumers with FICO scores of less than 620. At total of approximately $94BN-$130Bn of loans in the real estate and credit card category appear at risk if housing prices and the economy continue to deteriorate.
Of course, not the entire amount of the potentially problem loans would be written off, but some percentage, and my point is that this percentage would increase with continued declining house prices and a (however likely) potentiality of a double dip recession.
BofA has a combined approximately $24.5Bn of "receivable criticized" commercial loans according to page 186 of their 2011 10-k. Again, the full amount will likely not be written off in future years, but some percentage depending on the strength of the economy.
Some percentage of the approximately $70Bn of goodwill from the acquisitions of Merrill Lynch and Countrywide should be written off, if the economy and house prices deteriorates further.
What have other analysts estimated as the potential credit losses at Bank of America? Current CEO of the publication the BusinessInsider, Henry Blodget estimated loan and goodwill loans of between $100Bn and $200Bn, citing certain percentages of of home equity, commercial and goodwill to be written down, citing various sources, including bloggers and bank analysts, including a hedge fund which was short BofA stock. The analysis seems to have gotten under the skin of the Bank, as the Bank issued a statement denying Blodget's article within 24 hours of it being published in late August.
I am not going to speculate whether or not Blodget's analysis is correct or not, but rather that the ultimate credit loss by Bank of America, and by extension many of the large cap banking stocks, will be driven by the direction of house prices and, as house prices impact GDP to a larger extent than commonly supposed by economists and analysts. It should be noted that Warren Buffett, in stating his reasons for his purchase of $5Bn worth of preferred shares in Bank of America in late August, stated that he thought that housing prices were going to improve thereby giving a boost to the economy on Buffett's appearance on Charlie Rose. It is to housing prices that we now turn.
Thesis: Housing Prices Cycles Theorized to be Driven by "Macro-Scale Injections of Money into the Economy
A huge number of studies have looked at housing prices, mainly from the standpoint of supply and demand. Factors that impact demand are household income, and by extension employment rates and population growth, availability and interest charged on mortgage financing, cultural dimensions of housing demand (whether the population prefers houses to apartments, number of occupants per unit, etc). Supply is calculated by the existing housing stock and additions to the housing stock provided by surveys of homebuilders, economists and government officials.
One observation -- that does not appear to be in most of the existing studies on house prices -- is that household income levels and growth will be impacted, in part, by a relation with housing prices, in a self-reinforcing manner. As housing appreciates in price, the economy will strengthen and more people will be employed and earn income, which can then be used to purchase housing. Economists disagree on the exact magnitude of the relations between housing prices and GDP and household income, but mainly agree that a relation does exist.
A self reinforcing relation can also occur with financing and housing, in so far that financing will be more available and lower cost in a period of steadily rising house prices, all other factors equal, which supports house prices and vis-versa. The opposite can occur in a period of declining house prices -- financing is more difficult to get and at higher cost driving down demand for housing and therefore housing prices.
The "Chicken and Egg" Problem in Determining Housing Prices and Demand Factors:
As such, as the forecast for household income will depend in part on housing prices, we have a "chicken and egg" problem in forecasting house prices. This is to ask: what first causes housing prices to appreciate, in the first stage, is it disposable income rising first or housing prices rising first? Once housing prices establish an upward trend (for some reason) then they will impact household income, but in the first time period, what drives up disposable income or does disposable income go up first or housing prices go up first?
Well, it seems using common sense, in the first stage disposable, income will go up, which then goes towards supporting housing prices then house prices can "self-reinforce" disposable income.
The author of this post would propose that in order to get the housing price cycle started upwards -- and, critically to stop house price declines from continuing -- that some large "macro-injection" of money into the economy is needed, to increase disposable income and therefore begin the housing price-reinforcement cycle.
Three Types of Macro-Injections to Begin Housing Price Appreciation Cycles:
An excellent chart of the long term (since 1890) prices of houses in both the United States and Australia is presented here. Data is from Nigel Stapledon in Australia and Robert Shiller in the US, and is inflation adjusted. One can see a few interesting trends, house prices in both countries were relatively flat from 1890 to 1945, then increased dramatically from 1946 to 1950 as the solders came back from WW2, and a wave of optimism swept both countries (the Japanese defeated for Australia, the Germans and Japanese defeated for the US). Investment in the United States took off from 1950 to the late 1960's, (data to be provided) driven by business optimism in the US.
An interesting divergence in the housing prices of both countries appears in the 1970's -- the US's house prices kept up with (high) inflation, while Australia's house prices increased at a significantly higher rate -- an increase in Australia of approximately 50% from 1970 to 1975 while the US housing prices remained flat.
It is theorized that Australia benefited from the increase in metal and coal prices during this period while the United States did not to the same degree, which drove housing prices higher in Australia verses the US.
House prices remained relatively flat in both countries indexed to inflation through 1980 to 2000 then took off way above trend from 2000 to 2006 in the US and from 2000 to 2010 for Australia. It is proposed here that the driver of house prices was different in the two countries -- in the US it was "an injection of money" from loose monetary policy (interest rates declining from 6% levels in 1999 to 1% levels in 2002) while in Australia the injection of money stemmed from export earnings.
Next steps in this post (as it is becoming very lengthy) is to determine the amount of additional capital needed as a percentage of GDP and/or the housing stock to supply continuation of housing price increases.
Thursday, April 26, 2012
Monday, April 16, 2012
How do House Prices Impact GDP?
Why are the US economy and stock markets are doing reasonably well, while housing prices are doing poorly? Something here feels "amiss."
Housing prices are currently declining in most areas of the United States, in Australia and New Zealand, in select Chinese cities and in southern Europe. Spain's house prices are forecasted to decline a further 20% after falling by 20% from their peak in 2007. This has lead Citigroup chief economist Willem Buiter to label in early April 2012 the economic situation in Spain as "dire." The forecast for housing prices is uncertain, with Goldman Sachs revising in January 2012 their estimate for the return of appreciating house prices from mid 2012 to the end of 2013.
Review of Existing Approaches to Modeling House Prices and GDP:
Economists have re answered the question of house prices and the economy by correlating house prices with consumer spending, by regression analysis through estimates of the wealth effect. In these models, increases in housing prices make the home owner feel more wealthy, thereby impelling the home owner will spend more of this wealth per year. The increase in consumption per year per dollar of increases in home prices is estimated by several economists (from Cambell and Cocco, Federal Reserve, 2011 to Case, Quigly and Shiller, 2003, among others) to between 3.5 cents to up to 18 cents per year per $1 of house price appreciation\, based on regression analysis of housing wealth to consumption over varying time periods.
Can one say, that with a 30% decline in house prices in the United States from their peak in 2006, consumption would be approximately 8% lower due to a 10% tendency per dollar of house price change? (peak housing wealth of approximately $28Trillion, loss of approximately $9Trillion of housing wealth, 10% lower per dollar of consumption). The results of the economists cited above would appear to say yes, with several caveats:
--> The data only shows past data in which house prices went up unabated for 60 or more years, therefore the models may break down in periods of lower year on year house prices.
--> Further the exact mechanism of house prices on consumption and the economy is not stated in detail: housing is treated as a normal asset without unusual attributes, even as housing comprises approximately two-thirds of the median American's net worth.
--> Lastly, the additional consumption due to housing is treated as the excess of consumption year to year over net disposable income in several models, even as increased spending from housing would result in higher income so would be difficult to separate out: as people spend more due to higher housing prices, this higher spending becomes other businesses' net income, leading to higher disposable income through a multiplier effect, making the cause and effect of higher disposable income due to higher consumer spending from higher house prices difficult to determine.
Home Ownership as a For-Profit Business:
A way to model house price declines on the economy and stock market is proposed here: home ownership in the economy allows individuals to become, in effect, "business owners to themselves." This is to say, appreciating house prices allow home-owning individuals to become successful profit owners (or "capitalists" in a traditional economic sense). Instead of rent paid to another property owner, rent and debt repayment are effectively repaid for a homeowner to himself or herself, with the home price appreciation as a "profit." An unusual situation indeed, but consider: an appreciating home allows individuals to realize gains on their home owning "business" over time, while a declining home market reverses this situation, and in effect produces a loss-making enterprise on home owning individuals.
For further background on this idea, consider that Net National Income -- which according to GDP accounting must approximately equal Gross Domestic Product -- without government and net exports consists of salaries and wages plus corporate profits. For money spend on goods or services, the company or individual selling the service or product must pay for materials, energy, transport, etc - which goes as costs to other companies if the costs are materials -- or to workers if the costs are salaries. This series of payments goes on until all income from sales can ultimately be divided into either wages and salaries or profits. Note that corporate profits have traditionally stayed around one-third of net national income.
Housing ownership moves most home owning wages and salaried individuals from being fully in the category of a) deriving income from mainly salaries and wages to ---> b) deriving income from in part from salaries and wages and in part from "corporate" (sole-proprietorship home ownership) profits.
Appreciating house prices mean that home-owning individuals have a substantial, profitable business supplementing their salaried income, while declining house prices means that individuals have a loss-making enterprise, subtracting from their income.
From 1992 to 2006, aggregate housing wealth in constant 2005 dollars increased from approximately $12.5 Trillion to $28.5 Trillion, accordihttp://www.blogger.com/img/blank.gifng data from the federal reserve. The average yearly increase was therefore approximately $1.14 Trillion per year. The question is, how much of this increase contributed to consumption?
Table 1: Household Wealth, Consumption and Housing Price Appreciation in the United States from 1950 to 2008:
According to Haurin and Rosenthal of Ohio State University (2006), a survey of 4,000 home owners found that households took on an additional 15 cents of debt per dollar of home price appreciation to finance consumer expenditures. Assuming here a range of 10 to 25 cents per dollar of home price appreciation/depreciation leading to initial increases/declines in consumer spending, creased spending from housing contributed through a ripple-through effect (a spending multiplier of .10 based on a marginal propensity to consume of .90 - a savings rate of 10%) 11% to 29% of GDP.
If the spending multiplier says consistent through a housing downturn, a similar decline in GDP should have been experienced. The reasons why such a downturn did not occur is likely due to the unprecedented actions of the US Government through stimulus spending and actions on the part of the Federal Reserve to support asset markets.
Note that the loss' or gain's impact from home price appreciation/decline on GDP can be treated with the spending multiplier, if the income or income decline ripples through the economy. Other economists do not touch upon the multiplier, but as consumer spending from house price gains ends up as sales of products and services, which ends up as income for other business to be spent, and so on and so forth, likely there will be a ripple through effect from additional consumer spending.
So one could say, yes housing does impact the economy through consumer spending (as economists have traditionally modeled), but now we can make an estimate utilizing a profit/loss estimate from published data and a multiplier estimate (not solely relying on regressions of past data which could have flaws due to the fact that housing has appreciated for the past 70 years before 2007).
Secondary Effects of Home Price Declines:
Further, secondary effects of declining home prices means that non-real estate related businesses are impacted due to lower effective real income. In any community, a percentage of GDP is represented by local stores, grocery, automotive, convenience, clothing, food retail etc which depends on the consumer spending of the individuals living in that community. One could say that declining house prices can one of the following: produce either 1) a situation of a multiple equilibrium (where economic activity can stabilize at a significantly lower level that less income is available for purchase of goods and services). Oil markets, for example, are considered to have multiple equilibrium by several economists -- at $20 in the 1990's or near $100 per barrel currently -- due to he relative power of the oil producers with spare capacity (OPEC).
2) Declining home prices could produce a "vicious spiral" in which lower home prices continuously reinforce lower income (lower home prices --> lower consumer spending --> lower sales for community business --> lower income for workers in the community --> lower amount of money available for home mortgage payments --> lower home prices ---> etc) At one one economist (Mark Zandi) as expressed concern that declining home prices may be a downward spiral for economies.
Conclusion:
If one models home ownership as a business with a certain level of profits or losses "marked to market" per year in an accounting sense, then with any level of spending multiplier it becomes clear that housing is a significant contributor to the US economy. It is estimated in this post that the contribution to GDP from housing is between 11% and 28% per annum of total GDP. This intuitively makes sense, in so far that housing represents approximately two thirds of the median household's net worth, and represents over $23 Trillion in aggregate value, in an economy with a GDP of approximately $14.5Trillion.
The impact of the decline of house prices - 30% from their peak over a 5 year period (with continued declines in the near future at least) -- could modeled as an approximate $1.8 Trillion loss of housing wealth per year in aggregate, which could be realized by home owners at between 10%-25% per year, with a multiplier of 10 would have resulted in a reduction of GDP of between 12% and 31%. So far, this reduction in GDP has not occurred, due to the unprecedented actions of the Federal Government and the Federal Reserve. However, if housing prices do not begin to recover before the end of current stimulus programs, it is possible GDP could once again decline due to the reduction of consumer spending and total income due to lower housing wealth.
Housing prices are currently declining in most areas of the United States, in Australia and New Zealand, in select Chinese cities and in southern Europe. Spain's house prices are forecasted to decline a further 20% after falling by 20% from their peak in 2007. This has lead Citigroup chief economist Willem Buiter to label in early April 2012 the economic situation in Spain as "dire." The forecast for housing prices is uncertain, with Goldman Sachs revising in January 2012 their estimate for the return of appreciating house prices from mid 2012 to the end of 2013.
Review of Existing Approaches to Modeling House Prices and GDP:
Economists have re answered the question of house prices and the economy by correlating house prices with consumer spending, by regression analysis through estimates of the wealth effect. In these models, increases in housing prices make the home owner feel more wealthy, thereby impelling the home owner will spend more of this wealth per year. The increase in consumption per year per dollar of increases in home prices is estimated by several economists (from Cambell and Cocco, Federal Reserve, 2011 to Case, Quigly and Shiller, 2003, among others) to between 3.5 cents to up to 18 cents per year per $1 of house price appreciation\, based on regression analysis of housing wealth to consumption over varying time periods.
Can one say, that with a 30% decline in house prices in the United States from their peak in 2006, consumption would be approximately 8% lower due to a 10% tendency per dollar of house price change? (peak housing wealth of approximately $28Trillion, loss of approximately $9Trillion of housing wealth, 10% lower per dollar of consumption). The results of the economists cited above would appear to say yes, with several caveats:
--> The data only shows past data in which house prices went up unabated for 60 or more years, therefore the models may break down in periods of lower year on year house prices.
--> Further the exact mechanism of house prices on consumption and the economy is not stated in detail: housing is treated as a normal asset without unusual attributes, even as housing comprises approximately two-thirds of the median American's net worth.
--> Lastly, the additional consumption due to housing is treated as the excess of consumption year to year over net disposable income in several models, even as increased spending from housing would result in higher income so would be difficult to separate out: as people spend more due to higher housing prices, this higher spending becomes other businesses' net income, leading to higher disposable income through a multiplier effect, making the cause and effect of higher disposable income due to higher consumer spending from higher house prices difficult to determine.
Home Ownership as a For-Profit Business:
A way to model house price declines on the economy and stock market is proposed here: home ownership in the economy allows individuals to become, in effect, "business owners to themselves." This is to say, appreciating house prices allow home-owning individuals to become successful profit owners (or "capitalists" in a traditional economic sense). Instead of rent paid to another property owner, rent and debt repayment are effectively repaid for a homeowner to himself or herself, with the home price appreciation as a "profit." An unusual situation indeed, but consider: an appreciating home allows individuals to realize gains on their home owning "business" over time, while a declining home market reverses this situation, and in effect produces a loss-making enterprise on home owning individuals.
For further background on this idea, consider that Net National Income -- which according to GDP accounting must approximately equal Gross Domestic Product -- without government and net exports consists of salaries and wages plus corporate profits. For money spend on goods or services, the company or individual selling the service or product must pay for materials, energy, transport, etc - which goes as costs to other companies if the costs are materials -- or to workers if the costs are salaries. This series of payments goes on until all income from sales can ultimately be divided into either wages and salaries or profits. Note that corporate profits have traditionally stayed around one-third of net national income.
Housing ownership moves most home owning wages and salaried individuals from being fully in the category of a) deriving income from mainly salaries and wages to ---> b) deriving income from in part from salaries and wages and in part from "corporate" (sole-proprietorship home ownership) profits.
Appreciating house prices mean that home-owning individuals have a substantial, profitable business supplementing their salaried income, while declining house prices means that individuals have a loss-making enterprise, subtracting from their income.
From 1992 to 2006, aggregate housing wealth in constant 2005 dollars increased from approximately $12.5 Trillion to $28.5 Trillion, accordihttp://www.blogger.com/img/blank.gifng data from the federal reserve. The average yearly increase was therefore approximately $1.14 Trillion per year. The question is, how much of this increase contributed to consumption?
Table 1: Household Wealth, Consumption and Housing Price Appreciation in the United States from 1950 to 2008:
According to Haurin and Rosenthal of Ohio State University (2006), a survey of 4,000 home owners found that households took on an additional 15 cents of debt per dollar of home price appreciation to finance consumer expenditures. Assuming here a range of 10 to 25 cents per dollar of home price appreciation/depreciation leading to initial increases/declines in consumer spending, creased spending from housing contributed through a ripple-through effect (a spending multiplier of .10 based on a marginal propensity to consume of .90 - a savings rate of 10%) 11% to 29% of GDP.
If the spending multiplier says consistent through a housing downturn, a similar decline in GDP should have been experienced. The reasons why such a downturn did not occur is likely due to the unprecedented actions of the US Government through stimulus spending and actions on the part of the Federal Reserve to support asset markets.
Note that the loss' or gain's impact from home price appreciation/decline on GDP can be treated with the spending multiplier, if the income or income decline ripples through the economy. Other economists do not touch upon the multiplier, but as consumer spending from house price gains ends up as sales of products and services, which ends up as income for other business to be spent, and so on and so forth, likely there will be a ripple through effect from additional consumer spending.
So one could say, yes housing does impact the economy through consumer spending (as economists have traditionally modeled), but now we can make an estimate utilizing a profit/loss estimate from published data and a multiplier estimate (not solely relying on regressions of past data which could have flaws due to the fact that housing has appreciated for the past 70 years before 2007).
Secondary Effects of Home Price Declines:
Further, secondary effects of declining home prices means that non-real estate related businesses are impacted due to lower effective real income. In any community, a percentage of GDP is represented by local stores, grocery, automotive, convenience, clothing, food retail etc which depends on the consumer spending of the individuals living in that community. One could say that declining house prices can one of the following: produce either 1) a situation of a multiple equilibrium (where economic activity can stabilize at a significantly lower level that less income is available for purchase of goods and services). Oil markets, for example, are considered to have multiple equilibrium by several economists -- at $20 in the 1990's or near $100 per barrel currently -- due to he relative power of the oil producers with spare capacity (OPEC).
2) Declining home prices could produce a "vicious spiral" in which lower home prices continuously reinforce lower income (lower home prices --> lower consumer spending --> lower sales for community business --> lower income for workers in the community --> lower amount of money available for home mortgage payments --> lower home prices ---> etc) At one one economist (Mark Zandi) as expressed concern that declining home prices may be a downward spiral for economies.
Conclusion:
If one models home ownership as a business with a certain level of profits or losses "marked to market" per year in an accounting sense, then with any level of spending multiplier it becomes clear that housing is a significant contributor to the US economy. It is estimated in this post that the contribution to GDP from housing is between 11% and 28% per annum of total GDP. This intuitively makes sense, in so far that housing represents approximately two thirds of the median household's net worth, and represents over $23 Trillion in aggregate value, in an economy with a GDP of approximately $14.5Trillion.
The impact of the decline of house prices - 30% from their peak over a 5 year period (with continued declines in the near future at least) -- could modeled as an approximate $1.8 Trillion loss of housing wealth per year in aggregate, which could be realized by home owners at between 10%-25% per year, with a multiplier of 10 would have resulted in a reduction of GDP of between 12% and 31%. So far, this reduction in GDP has not occurred, due to the unprecedented actions of the Federal Government and the Federal Reserve. However, if housing prices do not begin to recover before the end of current stimulus programs, it is possible GDP could once again decline due to the reduction of consumer spending and total income due to lower housing wealth.
Thursday, February 23, 2012
How Central Banks Worldwide are Supporting Stock and Commodity Markets
In my opinion the markets are being driven higher, to a large degree by quantitative easing. This is going to be a bit lengthy, hold on (tried to make brief but it's a bit of a difficult subject).
The original exploration of monetary policy, according to Nobel prize winning economist Robert Lucas in his 1995 Nobel Prize Lecture, was David Hume's "On Money" in the late 18th century. Hume asked, "what would happen if the money supply doubled overnight?" (Hume proposed an angel would come in at night and put 10 pounds equally into everyone's pocket). Well, Hume states, clearly this is impossible!
It is only possible to increase the money supply by distributing new money through certain agents first, in Hume's time this would have been Spain, the "conquistadors" taking gold from the new world, bringing it back to Spain, hiring tailors, buying grain, housing -- the price increase from the new gold would flow first to sectors that serviced the conquistadors, then onward until prices go up overall approximately by the amount of the new gold. (tailors take the gold from the conquistadors, buy more food and housing in the second time period, food producers use that gold in the third time period to buy other items, on and on, prices going up each time period until equilibrium)
So it's important to trace the flow of money when new money is "introduced" or "printed." Prices will go up in the time order that the money flows through acquisition of assets, according to Hume.
The US Federal Reserve is currently doing $600Bn of Operation Twist, which was preceded by $2.7Tr of QE1 and QE2. The ECB did Euro800Bn of QE primarily to buy southern EU governmental debt, the Central Bank of Switzerland did approx SF100Bn buying back Swiss Francs in September, Bank of Japan, Bank of England, Central Bank of China, even the Central Banks of Brazil and Chile and Norway (I don't know why Norway needs to do QE, as the Norwegian economy appears very strong) -- and many others -- did major easing programs.
The central banks will (although there is a slight variation in the first round in 2008 and 2009 for the Fed and BofEngland, used mainly reserves from member banks) create the money with a keystroke to buy the assets - government bonds, some cases MBS, currency from a list of major banks, Fed has I believe 29 major banks.
The major banks will buy, in the first round (I believe) with the newly printed money more highly rated fixed income assets, (providing the un-intuitive effect of interest rates declining during economic crises), but (I think) will in the second time period lend out margin loans (repurchase agreements) to funds, for the purchase of buying stocks, bonds and commodities.
Repurchase lending is considered very safe for the banks, in fact, repurchase lending bounced back extremely quickly during the crisis in October 2008 (only one week of uncertainty in funding according to Annaly Capital, an investor in agency MBS, then all the funding Annaly could need by the fourth week of October 08 (Annaly is leveraged between 7 to 10 to one, debt to equity, buys MBS with repurchase or margin loans from banks).
One can see that the total assets under management for the total fund management industry have now gone significantly higher than the peak in August of 2008. This does not mean that 100% of the new money comes from margin loans from major banks -- but certainly a lot of it is -- I'm actually looking for the data here, overall repurchase loans (hard to find).
Concluding, adding up the different QE programs I believe in the $4-5Trillion range, this drives down interest rates in first time period and then boosts stocks and commodities in the second time period (gas prices, food prices to follow soon - is following now), as banks undertake repurchase lending on a large scale.
I read through the reasoning for the QE by the Federal Reserve economists, not sure if it is the "correct" road but certainly it is the playbook they are going to now. (source papers are Paul Krugman's "It's Baaack" (2002) and papers by Eggertson, and other papers on the "Zero bound" -- the Central banks will fight deflation at all costs since they view deflation as devastating for the economy: quantitative easing is the main weapon against deflation when interest rates are low.
Oddly, however, in these papers to my reading the economists do not trace the newly printed money from the banks to other assets on a time period by time period basis, but appear to assume inflation increases in all sectors all at once (clearly impossible unless there is Hume's Angel, alive today although dead two centuries ago :) The models the economists use do not make use of time sequences for price appreciation (this is to say the models have a lot of complex math in them, but it is assuming one move to a final end state, turing a blind eye to intermediate states).
One more point: the central banks are terrified of sovereign defaults leading to major bank collapses, so QE supports the banks by getting these problem debts off the books and also supports the price of these problem assets.
So the final conclusion, is that one really need to watch the Federal Reserve and the worldwide Central Banks to determine the direction of the market. So far things look ok until June 2012, (Operation Twist good until then) but if the Central Banks stop easing, watch out. Overall in my opinion, it's a weird market currently, in so far that the Fed and other Central Banks haven't done large scale QE in 60 years, with the small exception of Japan in 2001, but actually if you read before WW2, the Fed and Central Bank in Europe were extraordinarily active in supporting banks, governmental debt during periods of wars and crisis -- it's incredible sort of a lost history. (I'll save this for another post).
The original exploration of monetary policy, according to Nobel prize winning economist Robert Lucas in his 1995 Nobel Prize Lecture, was David Hume's "On Money" in the late 18th century. Hume asked, "what would happen if the money supply doubled overnight?" (Hume proposed an angel would come in at night and put 10 pounds equally into everyone's pocket). Well, Hume states, clearly this is impossible!
It is only possible to increase the money supply by distributing new money through certain agents first, in Hume's time this would have been Spain, the "conquistadors" taking gold from the new world, bringing it back to Spain, hiring tailors, buying grain, housing -- the price increase from the new gold would flow first to sectors that serviced the conquistadors, then onward until prices go up overall approximately by the amount of the new gold. (tailors take the gold from the conquistadors, buy more food and housing in the second time period, food producers use that gold in the third time period to buy other items, on and on, prices going up each time period until equilibrium)
So it's important to trace the flow of money when new money is "introduced" or "printed." Prices will go up in the time order that the money flows through acquisition of assets, according to Hume.
The US Federal Reserve is currently doing $600Bn of Operation Twist, which was preceded by $2.7Tr of QE1 and QE2. The ECB did Euro800Bn of QE primarily to buy southern EU governmental debt, the Central Bank of Switzerland did approx SF100Bn buying back Swiss Francs in September, Bank of Japan, Bank of England, Central Bank of China, even the Central Banks of Brazil and Chile and Norway (I don't know why Norway needs to do QE, as the Norwegian economy appears very strong) -- and many others -- did major easing programs.
The central banks will (although there is a slight variation in the first round in 2008 and 2009 for the Fed and BofEngland, used mainly reserves from member banks) create the money with a keystroke to buy the assets - government bonds, some cases MBS, currency from a list of major banks, Fed has I believe 29 major banks.
The major banks will buy, in the first round (I believe) with the newly printed money more highly rated fixed income assets, (providing the un-intuitive effect of interest rates declining during economic crises), but (I think) will in the second time period lend out margin loans (repurchase agreements) to funds, for the purchase of buying stocks, bonds and commodities.
Repurchase lending is considered very safe for the banks, in fact, repurchase lending bounced back extremely quickly during the crisis in October 2008 (only one week of uncertainty in funding according to Annaly Capital, an investor in agency MBS, then all the funding Annaly could need by the fourth week of October 08 (Annaly is leveraged between 7 to 10 to one, debt to equity, buys MBS with repurchase or margin loans from banks).
One can see that the total assets under management for the total fund management industry have now gone significantly higher than the peak in August of 2008. This does not mean that 100% of the new money comes from margin loans from major banks -- but certainly a lot of it is -- I'm actually looking for the data here, overall repurchase loans (hard to find).
Concluding, adding up the different QE programs I believe in the $4-5Trillion range, this drives down interest rates in first time period and then boosts stocks and commodities in the second time period (gas prices, food prices to follow soon - is following now), as banks undertake repurchase lending on a large scale.
I read through the reasoning for the QE by the Federal Reserve economists, not sure if it is the "correct" road but certainly it is the playbook they are going to now. (source papers are Paul Krugman's "It's Baaack" (2002) and papers by Eggertson, and other papers on the "Zero bound" -- the Central banks will fight deflation at all costs since they view deflation as devastating for the economy: quantitative easing is the main weapon against deflation when interest rates are low.
Oddly, however, in these papers to my reading the economists do not trace the newly printed money from the banks to other assets on a time period by time period basis, but appear to assume inflation increases in all sectors all at once (clearly impossible unless there is Hume's Angel, alive today although dead two centuries ago :) The models the economists use do not make use of time sequences for price appreciation (this is to say the models have a lot of complex math in them, but it is assuming one move to a final end state, turing a blind eye to intermediate states).
One more point: the central banks are terrified of sovereign defaults leading to major bank collapses, so QE supports the banks by getting these problem debts off the books and also supports the price of these problem assets.
So the final conclusion, is that one really need to watch the Federal Reserve and the worldwide Central Banks to determine the direction of the market. So far things look ok until June 2012, (Operation Twist good until then) but if the Central Banks stop easing, watch out. Overall in my opinion, it's a weird market currently, in so far that the Fed and other Central Banks haven't done large scale QE in 60 years, with the small exception of Japan in 2001, but actually if you read before WW2, the Fed and Central Bank in Europe were extraordinarily active in supporting banks, governmental debt during periods of wars and crisis -- it's incredible sort of a lost history. (I'll save this for another post).
Friday, January 6, 2012
2011 and 2012 -- Years that the central banks drove markets
A very large factor in the overall market performance this last year has been the actions of the world central banks. Martin Feldstein, at NBER, stated that most of the stock market appreciation last year (2010) was due to the Fed's QE2. See: http://www.project-syndicate.org/commentary/feldstein33/English. According to Marty Feldstein, the income effect of the rising market made consumption go up temporarily increasing GDP.
In other words, the economy was extremely weak, which necessitated the worldwide QE programs, but the printing of money at the Fed made the market go up even as economic conditions deteriorated. So, one could say, the market would be a lot weaker if the central banks didn't step in, and, further if the weak economic conditions continue in 2012 (which, considering the weakness in southern Europe and potential weakness in China and unprecedented deficit spending in the US, is likely) central bank's actions will determine the fate of markets in 2012.
In 2011, the Fed finished up $600Bn of Quantitative Easing then went on a $400Bn Operation twist. Operation Twist lowered long term interest rates to even closer to nothing -- meaning bond prices appreciated. QE2 (coming after QE1 which totaled approx $2Tr) was meant to supply cash to financial institutions, with the intention that they lend this cash to the private sector.
It seems the money from the QE2 went directly from the financial institutions back to buying government bonds, as well as other high grade corporate bonds. Further, according to a paper by M Singh at the IMF, the largest component of the shadow banking system (money market funds, hedge funds, off balance sheet vehicles) is lending to hedge funds and other investment vehicles. So it seems some of this money was lent to these hedge funds and other investment vehicles, which put the money into investments such as stocks and commodities.
The Swiss Central Bank finished up an approximate $100Bn QE program in August buying Swiss Francs to lower the Swiss Franc, while the ECB had a Euro600Bn QE program in November.December to buy up southern EU debt.
Bank of Japan also did a large QE over approx $100Bn to lower the value of the yen this year.
What makes it stressful from an investor's standpoint, is that the central banks are very secretive and hush-hush -- Bernanke for example does not want the Fed audited publicly (and also secretly pushed for a new accounting rule at the Fed that subprime bonds at the Fed can never be marked down). The ECB didn't really announce it's buying program until a few days before -- in fact comments from the ECB made it sound as if the ECB was not going to buy southern EU debt.
So it total, this past year has been really stressful and unusual -- note the Federal Reserve and the ECB had never done any money printing (Quantitative Easing) in their respective institutions' histories. 2008-2011 for the Fed and 2011 for the ECB have been "groundbreaking" years, even as they have kept this information somewhat behind closed doors.
In other words, the economy was extremely weak, which necessitated the worldwide QE programs, but the printing of money at the Fed made the market go up even as economic conditions deteriorated. So, one could say, the market would be a lot weaker if the central banks didn't step in, and, further if the weak economic conditions continue in 2012 (which, considering the weakness in southern Europe and potential weakness in China and unprecedented deficit spending in the US, is likely) central bank's actions will determine the fate of markets in 2012.
In 2011, the Fed finished up $600Bn of Quantitative Easing then went on a $400Bn Operation twist. Operation Twist lowered long term interest rates to even closer to nothing -- meaning bond prices appreciated. QE2 (coming after QE1 which totaled approx $2Tr) was meant to supply cash to financial institutions, with the intention that they lend this cash to the private sector.
It seems the money from the QE2 went directly from the financial institutions back to buying government bonds, as well as other high grade corporate bonds. Further, according to a paper by M Singh at the IMF, the largest component of the shadow banking system (money market funds, hedge funds, off balance sheet vehicles) is lending to hedge funds and other investment vehicles. So it seems some of this money was lent to these hedge funds and other investment vehicles, which put the money into investments such as stocks and commodities.
The Swiss Central Bank finished up an approximate $100Bn QE program in August buying Swiss Francs to lower the Swiss Franc, while the ECB had a Euro600Bn QE program in November.December to buy up southern EU debt.
Bank of Japan also did a large QE over approx $100Bn to lower the value of the yen this year.
What makes it stressful from an investor's standpoint, is that the central banks are very secretive and hush-hush -- Bernanke for example does not want the Fed audited publicly (and also secretly pushed for a new accounting rule at the Fed that subprime bonds at the Fed can never be marked down). The ECB didn't really announce it's buying program until a few days before -- in fact comments from the ECB made it sound as if the ECB was not going to buy southern EU debt.
So it total, this past year has been really stressful and unusual -- note the Federal Reserve and the ECB had never done any money printing (Quantitative Easing) in their respective institutions' histories. 2008-2011 for the Fed and 2011 for the ECB have been "groundbreaking" years, even as they have kept this information somewhat behind closed doors.
Monday, October 10, 2011
Wealth and GDP
"Political Economy is defined as the science of wealth" wrote Francis Wayland in 1870 (Wayland was Yale University's first professor of Political Economy). Adam Smith wrote "An Inquiry into the Nature and Causes of Wealth of Nations" in 1776 inspired by a group of mainly French economists called the Physiocrats. The Physiocrats (who could probably be considered the first economists) proposed that all material wealth came from the development of land.
A question is: does the classical view of wealth production provide any insight into the modern conception of GDP and economic activity?
Wealth Defined by Classical Economists
Wealth from a Classical sense (classical economists are economists from the 1700's before the mid 20th century) was defined on a national level as, according to the classical economist Jean Baptiste Say (1821) in his Letters to Malthus on Political Economy. Say asked and answered a series of questions in these letters concerning wealth. Say defined Wealth as "Whatever has a value; gold, silver, land, merchandise..." and then defined Value as "[A product] having utility." Value was conceived of as mainly a product with "utility," and utility was viewed as having a both subjective and a non-subjective element in so far that, according to Say, utility drives value as "persons are then to be found who are in want of this thing (with utility); they desire to have it from those who produce it."
The subjective element of wealth -- wealth as defined that is deemed useful by potential customers in the classical economic tradition, to the extent that they will pay for that item -- is interesting in so far that wealth has to be something not already extremely abundant and/or provided by nature (classical economists asked "if I hold a glass of water, is this wealth? The accepted answer, after much debate was no, in so far that water is already in abundance).
Further wealth could hold significant value, but if this value was not recognized by consumers or if the necessary infrastructure was not in place to realize this value, then perhaps the item would not have value. One could think of, for example, petroleum oil in the 1800's, at first was considered a nuisance for agriculture and therefore did not represent wealth.
Alfred Marshall, John Maynard Keynes' mentor at Cambridge University, in the late 19th century proposed the concept of supply and demand curves for products summing up the idea of price (value) as the intersection between supply and demand for the product.
On a national scale, Jean Baptiste Say defined the "wealth of nations" as: "(A wealthy nation) in which many things of value, or more briefly, many values are to be found." But Jean Baptiste Say did not formalize a measurement system for quantifying a country's wealth -- this was not to be performed until the 1930's under the economist Simon Kuznets (to be examined below).
One last interesting point is that classical economists stated that wealth could only cocur with the legal right of private property: Jean Batiste Say asked in his Letters: "Can Riches Exist without property?" and answered "No, as richest represent property."
Classical Economists on How Wealth is Produced:
The next question is, according to classical economics, how is wealth produced? The production of items of value (note Say did not cover services in detail, or even conceive of services as a major portion of the economy) was split by Say into three separate activities in his Letters (1821):
1. "Cultivation," by which Say meant the production of resources and commodities, agriculture and mining and resource extraction -- Say began with this activity in so far Say was influenced by the Physiocrats, who stated that all value came from land.
2. Manufacturing -- the conversion of resources to a usable end product -- Say expanded and improved upon that all value came from land only by expanding value added to manufacturing.
3. Commerce -- the distribution of manufactured and processed products to the end customer. One can think of modern retail chains, grocery stores and online as falling under this designation of commerce.
Say noted that each of these three steps in the economy was necessary for the completion of the next step, in so far that manufacturing could not occur without cultivation or resource extraction and commerce could not occur without manufacturing or processing. Say did not discuss trade in detail -- whether one step could be outsourced to another country sustainably.
Two questions come to mind: first, would all new industries (from technological advances) since 1821 fit into these three steps in terms of producing value? And second, how would services fit into Say's 3 step framework?
Major advanced such as the cotton gin and steel industry, the Bessemer Steel Process, the steam engine would all fit in very well within Say's Framework. The textile industry, revolutionized by the cotton gin and the spinning jenny -- told resources in the form of raw cotton and manufactured these into clothes, then distributed these clothes to the end customer.
Industries invented in the 20th century such as the computer industry would also fit in, albeit with a more substantially available raw material (semiconductors are made from silicon -- sand, and also energy - from coal and natural gas) and an interesting "manufacturing" process, if one can view production of software or the "soul" of a computer as "manufacturing." (taking prewritten logic commands and constructing them to give instructions, on a silicon base). Technology consulting companies such as EDS could be viewed as providing both manufacturing (programming of local data processing for banks, for example) and commerce -- directly providing a service to the end customer.
One can see that much of our "service based" economy can be viewed as really either processing and/or commerce. Currently retail is classified as services and IT work is also classified as services in modern GDP accounting.
The modern finance industry, one could say is meant to assist the other segments of society. Warren Buffet has stated that the "raw material" of banks is "capital" by which they make loans (end product) in which the capital would not be dependent on physical raw materials (even software depends on silicon, but in modern banking money can be created by the central bank). I am not sure how to classify finance according to Say's three part system, but would lean towards finance supporting other industries, not as an industry in and of itself (one could also make this case with legal services).
The modern health care industry -- which accounts for upwards of 15% of US GDP -- does not exactly follow Say's threefold method -- more thought on this by the author is needed.
To sum up, classical economics was the study of wealth by which a country produced and distributed items of perceived utility, by a three step process of gathering resources by the land, processing these resources and then delivering these products to the end customer. We will next see how this view fits with modern GDP theory. Note that classical economics did not focus in any significant way on debt -- Say did mention national debts, but only in passing, and also did not focus on income distribution -- what would occur if a small percentage of the population owned most of the wealth? Say did not address this in detail, nor did Wayland or John Stuart Mill. ONe would have to wait for economists in the early 290th century such as John Maynard Keynes and Mickal Kaleci to discuss the distribution of wealth.
Modern Gross Domestic Product Defined
Classical economics did not provide a substaniative calculation procedure to determine the size of the overall economy -- before the invention of the gross domestic product methodology in the 1930's economic activity was roughly gauged by production of key outputs such as steel and/or by the unemployment rate. Modern conceptions of gross domestic product are generally based on theories of the early 20th century economist Simon Kuznets: consumption is calculated by utilizing the formula Consumption = income - savings (income both salaried and capital gains and profits can be obtained by tax records). GDP is then calculated by the formula GDP = net domestic consumption = C + I + G + (X-M), which theoretically equals net domestic income (aggregate salaries plus capital gains and profits) which also theoretically equals net domestic product (aggregate hours worked times productivity). The fact that the three equations for GDP must equal each other is the reason, according to Kuznets, that GDP account is refered to as the "National Accounts" (similar to the accounts, balance sheet, cash flow and income statement of a business).
Gross Domestic Product calculations do not focus on the conception of wealth as utility per say. One could conceive of an economy mainly driven by the production and sale of tulips at a very high price, which would result in high sale prices and therefore high salaries and therefore high GDP. However this economy would soon collapse -- once consumers realized tulips are plentiful and don't have much intrinsic utility (cannot be eaten, made clothes out of, etc).
GDP calculations do not give too much indication as to the utility of GDP -- not to say that classical economics provided significant insight into the economy as utility, but at least classical economics would indicate the citizen to consider the functionality of goods produced. Modern economics reports one number, GDP, without much discussion of its underlying "value." An economy producing very high amounts of "intrinsic utility" items, such as food in a period of food, energy, clothing and transport, in a period of surplus of these items (meaning the items sell at a low price) mean that the GDP calculation for this economy would be low, despite the high "real" living standards and relatively high sustainability.
There is a sense Modern GDP accounting has well known shortcomings -- it does not typically (except for certain countries like Norway) account for resource base depletion, GDP only accounts for economic activity in constant currency (so if the currency depreciates by a significant margin it is unclear if GDP is really declining), related to resources the sustainability of GDP is not indicated, nor is the overall debt level of the economy. GDP also does not measure the distribution of wealth in the overall economy -- it seems a country would be "richer" overall if more of its citizens enjoyed a wider range of its products.
It seems that the production of goods and services in Say's three economic productivity dimensions that have higher "utility" that satisfies "needs" -- clothing, shelter, nutrition,
A question is: does the classical view of wealth production provide any insight into the modern conception of GDP and economic activity?
Wealth Defined by Classical Economists
Wealth from a Classical sense (classical economists are economists from the 1700's before the mid 20th century) was defined on a national level as, according to the classical economist Jean Baptiste Say (1821) in his Letters to Malthus on Political Economy. Say asked and answered a series of questions in these letters concerning wealth. Say defined Wealth as "Whatever has a value; gold, silver, land, merchandise..." and then defined Value as "[A product] having utility." Value was conceived of as mainly a product with "utility," and utility was viewed as having a both subjective and a non-subjective element in so far that, according to Say, utility drives value as "persons are then to be found who are in want of this thing (with utility); they desire to have it from those who produce it."
The subjective element of wealth -- wealth as defined that is deemed useful by potential customers in the classical economic tradition, to the extent that they will pay for that item -- is interesting in so far that wealth has to be something not already extremely abundant and/or provided by nature (classical economists asked "if I hold a glass of water, is this wealth? The accepted answer, after much debate was no, in so far that water is already in abundance).
Further wealth could hold significant value, but if this value was not recognized by consumers or if the necessary infrastructure was not in place to realize this value, then perhaps the item would not have value. One could think of, for example, petroleum oil in the 1800's, at first was considered a nuisance for agriculture and therefore did not represent wealth.
Alfred Marshall, John Maynard Keynes' mentor at Cambridge University, in the late 19th century proposed the concept of supply and demand curves for products summing up the idea of price (value) as the intersection between supply and demand for the product.
On a national scale, Jean Baptiste Say defined the "wealth of nations" as: "(A wealthy nation) in which many things of value, or more briefly, many values are to be found." But Jean Baptiste Say did not formalize a measurement system for quantifying a country's wealth -- this was not to be performed until the 1930's under the economist Simon Kuznets (to be examined below).
One last interesting point is that classical economists stated that wealth could only cocur with the legal right of private property: Jean Batiste Say asked in his Letters: "Can Riches Exist without property?" and answered "No, as richest represent property."
Classical Economists on How Wealth is Produced:
The next question is, according to classical economics, how is wealth produced? The production of items of value (note Say did not cover services in detail, or even conceive of services as a major portion of the economy) was split by Say into three separate activities in his Letters (1821):
1. "Cultivation," by which Say meant the production of resources and commodities, agriculture and mining and resource extraction -- Say began with this activity in so far Say was influenced by the Physiocrats, who stated that all value came from land.
2. Manufacturing -- the conversion of resources to a usable end product -- Say expanded and improved upon that all value came from land only by expanding value added to manufacturing.
3. Commerce -- the distribution of manufactured and processed products to the end customer. One can think of modern retail chains, grocery stores and online as falling under this designation of commerce.
Say noted that each of these three steps in the economy was necessary for the completion of the next step, in so far that manufacturing could not occur without cultivation or resource extraction and commerce could not occur without manufacturing or processing. Say did not discuss trade in detail -- whether one step could be outsourced to another country sustainably.
Two questions come to mind: first, would all new industries (from technological advances) since 1821 fit into these three steps in terms of producing value? And second, how would services fit into Say's 3 step framework?
Major advanced such as the cotton gin and steel industry, the Bessemer Steel Process, the steam engine would all fit in very well within Say's Framework. The textile industry, revolutionized by the cotton gin and the spinning jenny -- told resources in the form of raw cotton and manufactured these into clothes, then distributed these clothes to the end customer.
Industries invented in the 20th century such as the computer industry would also fit in, albeit with a more substantially available raw material (semiconductors are made from silicon -- sand, and also energy - from coal and natural gas) and an interesting "manufacturing" process, if one can view production of software or the "soul" of a computer as "manufacturing." (taking prewritten logic commands and constructing them to give instructions, on a silicon base). Technology consulting companies such as EDS could be viewed as providing both manufacturing (programming of local data processing for banks, for example) and commerce -- directly providing a service to the end customer.
One can see that much of our "service based" economy can be viewed as really either processing and/or commerce. Currently retail is classified as services and IT work is also classified as services in modern GDP accounting.
The modern finance industry, one could say is meant to assist the other segments of society. Warren Buffet has stated that the "raw material" of banks is "capital" by which they make loans (end product) in which the capital would not be dependent on physical raw materials (even software depends on silicon, but in modern banking money can be created by the central bank). I am not sure how to classify finance according to Say's three part system, but would lean towards finance supporting other industries, not as an industry in and of itself (one could also make this case with legal services).
The modern health care industry -- which accounts for upwards of 15% of US GDP -- does not exactly follow Say's threefold method -- more thought on this by the author is needed.
To sum up, classical economics was the study of wealth by which a country produced and distributed items of perceived utility, by a three step process of gathering resources by the land, processing these resources and then delivering these products to the end customer. We will next see how this view fits with modern GDP theory. Note that classical economics did not focus in any significant way on debt -- Say did mention national debts, but only in passing, and also did not focus on income distribution -- what would occur if a small percentage of the population owned most of the wealth? Say did not address this in detail, nor did Wayland or John Stuart Mill. ONe would have to wait for economists in the early 290th century such as John Maynard Keynes and Mickal Kaleci to discuss the distribution of wealth.
Modern Gross Domestic Product Defined
Classical economics did not provide a substaniative calculation procedure to determine the size of the overall economy -- before the invention of the gross domestic product methodology in the 1930's economic activity was roughly gauged by production of key outputs such as steel and/or by the unemployment rate. Modern conceptions of gross domestic product are generally based on theories of the early 20th century economist Simon Kuznets: consumption is calculated by utilizing the formula Consumption = income - savings (income both salaried and capital gains and profits can be obtained by tax records). GDP is then calculated by the formula GDP = net domestic consumption = C + I + G + (X-M), which theoretically equals net domestic income (aggregate salaries plus capital gains and profits) which also theoretically equals net domestic product (aggregate hours worked times productivity). The fact that the three equations for GDP must equal each other is the reason, according to Kuznets, that GDP account is refered to as the "National Accounts" (similar to the accounts, balance sheet, cash flow and income statement of a business).
Gross Domestic Product calculations do not focus on the conception of wealth as utility per say. One could conceive of an economy mainly driven by the production and sale of tulips at a very high price, which would result in high sale prices and therefore high salaries and therefore high GDP. However this economy would soon collapse -- once consumers realized tulips are plentiful and don't have much intrinsic utility (cannot be eaten, made clothes out of, etc).
GDP calculations do not give too much indication as to the utility of GDP -- not to say that classical economics provided significant insight into the economy as utility, but at least classical economics would indicate the citizen to consider the functionality of goods produced. Modern economics reports one number, GDP, without much discussion of its underlying "value." An economy producing very high amounts of "intrinsic utility" items, such as food in a period of food, energy, clothing and transport, in a period of surplus of these items (meaning the items sell at a low price) mean that the GDP calculation for this economy would be low, despite the high "real" living standards and relatively high sustainability.
There is a sense Modern GDP accounting has well known shortcomings -- it does not typically (except for certain countries like Norway) account for resource base depletion, GDP only accounts for economic activity in constant currency (so if the currency depreciates by a significant margin it is unclear if GDP is really declining), related to resources the sustainability of GDP is not indicated, nor is the overall debt level of the economy. GDP also does not measure the distribution of wealth in the overall economy -- it seems a country would be "richer" overall if more of its citizens enjoyed a wider range of its products.
It seems that the production of goods and services in Say's three economic productivity dimensions that have higher "utility" that satisfies "needs" -- clothing, shelter, nutrition,
Friday, October 7, 2011
What Will Happen When Greece Defaults?
Greece will likely not be able to pay back the full value of its debt, due to the fact that Greek debt to GDP is 140%. Many market commentators are stating that a Greece default will not cause a significant move in the markets ("Greece is only 3% of EU GDP" or "A full meltdown is very unlikely but the market must price in this very unlikely event")
These commentaries do not perform a cause and effect analysis -- meaning, what would occur in the case of a Greek default, if one takes into account the impact on banking institutions, and national economic activity, in a step by step, sequential analysis? Such an analysis shows that significant problems occur with a Greek default for the EU and world economy and markets.
If Greece defaults, then the value of its bonds will drop by 50-80%. Note that the average sovereign default since 1980 according to Moody's has seen net losses of between 50-60%, but Greece is has significantly more debt than the average default, so losses would likely be higher.
Greek Banks would be insolvent:
This default in turn would cause the major banks of Greece (which in turn hold Greek sovereign debt) to go bankrupt. As the Greek government cannot guarantee the deposits of the Greek banks, the deposits of these institutions would be wiped out.
Significant Declines in Greek GDP:
What would happen to Greece's gdp? Many large banks go bankrupt in Russia in 1998 (although not in Argentina to the same extent in 2002-2003, as Argentina limited the amount of funds deposit holders could withdraw) as Russia defaulted on its debt in that year. Russia's GDP fell approximately 50% from 1992 to 1996, then recovered somewhat from 1996 to 1998 but then declined a further 15% fro 1998 to 2000. Argentina's gdp declined approximately 15% from 2002 to 2004. Both countries began to recover when their currency declined significantly and the export market (as both Russia and Argentina are major commodity exporters) picked up.
Greece's GDP would likely fall more than 15%. The world economy is more fragile currently, so a recovery in two years may not occur, through an export led recovery, so the slump would likely last for several years. The issue of leaving the Euro would have to be addressed -- instituting a new currency in a very difficult economic environment would be problematic.
Other Southern EU Banks at Risk:
Deposits in other southern European Union countries would be at risk, in so far that account holders in Italy, Portugal, Spain and Ireland would see Greek banks default, then attempt to transfer their deposits to safe havens, whether northern European banks. Italian, Portuguese, Irish and Spanish banks would be at risk from direct losses from holdings of Greek bonds (total outstanding Greek debt is over $400Bn, held mainly by European banks). As the southern EU governments are already highly levered, it is not likely that they would have the ability to raise funds to bank stop losses in their banking systems.
Southern EU Countries GDP at risk of significant decline:
Southern EU banking insolvency would be a significant risk, which could drive declines in Southern EU gdp.
French and German banks with exposure to Greek debt would be at risk:
Deutsche Bank and the major French banks have significant exposure to Greek debt, which would mean significant losses at these banks, and likely a need for government assistance. As both France and Germany have debt to GDP ratios in the 80% range, further payments to their banks would likely move their respective debt to GDP levels to close to 90%, which is the cut-off range (according to Harvard economics professors Kenneth Rogoff and Carmen Reinhart) for markets funding debt to GDP without significant issues (although this 90% cut off grade has received some criticism as being too arbitrary, however 90% likely does not leave too much room for further debt financed growth or assistance).
Certain Hedge funds will likely go insolvent and will likely have to liquidate, driving stock values down:
In the October 2008 crash, according to the book "The Quants" many large quantitative and macro hedge funds which were levered had to panic sell in order to meet investor redemptions. With the unprecedented volatility in the markets from a Greek debt, some larger hedge funds would have to liquidate, driving asset prices down.
Mutual Funds would see higher redemptions, causing selling to drive the market down:
Most mutual funds have been bullish through this crisis and have encouraged their investors to hold through the long term. Mutual funds had record low levels of cash in July and many have seen significant declines in equity values since that time. Further the average mutual fund investor is likely an aging baby boomer who is nearing retirement. All these factors point to higher redemptions.
Pension Fund Values would decline, leading to unrest:
Pension funds as a whole are more heavily invested in equities, due to the fact that they can assume a higher rate of return on equities (more in the range of 8-9%) verses bonds (in the range of 4-6%). The projected value of the pension plan is highly dependent on the projected return on plan assets. With panicked selling, pension plans would see the value of their assets decline significantly.
Safe Haven Assets would increase in value:
Safe haven assets are likely the US dollar, the Swiss Franc, potentially precious metals (however precious metals are held by hedge funds, which would likely liquidate in the short term).
Government Bailouts of Banking Institutions would be even more unpopular with the public, worsening the banking crisis.
The public of many countries is already upset with the banking bailouts of 2008 and 2009, and would not be in any mood for continued bailouts. This would complicate efforts to shore up bank balance sheets, making the banking crisis worse than otherwise would be. As banking crises have a "cumulative" character - the farther they are allowed to fester, the more the public panics and withdraws funds, potentially causing and worsening a bank run -- the unpopularity of bailouts can only worsen events for the banking system.
Recovery for Southern Europe would be more protracted, due to a weaker than normal world economy and therefore export market:
Both the United States and China are currently slowing -- China is attempting (successfully) to slow housing and infrastructure spending, however this means that commodity demand from China is slowing. This, in turn, impacts the major regions more dependent on commodity export: Latin America, the Middle East, Russia, Australia. This means that the EU will have a more difficult time utilizing exports to dig itself out of crisis.
What can be done to avoid a Greek Default?
As this analysis shows that a Greek default would be extremely problematic for the EU and world economy as well as stock markets, the question is, what can be done to avoid a Greek Default?
Either the EU, or another institution such as the IMF, should come in and guarantee Greek debt so that banks are assured of receiving 90%+ of their full value of their bonds. If the full value of Greek bonds are more or less assured, the chain of events described above will not occur.
However, likely the sovereign debt of the other Southern EU states, Italy, Spain, Portugal as well as Ireland needs to be backstopped as well in order to stop potential defaults of these countries, which in turn would cause banking crises moving to economic to market crises.
What would be the amount of funds needed to guarantee Greek and Southern EU debt?
Something in the range of 50-80% of Greek Debt would be needed to fully backstop this debt, meaning funding in the range of $200Bn to $360Bn. This is likely at the highest range for France and Germany combined to fund. Germany's debt to GDP is 80%, and German GDP is $3.33 Trillion, meaning that Germany can afford $333Bn before it moves to 90% debt to GDP (the danger zone, according to Rogoff and Reinhart). France's debt to GDP is also approximately 80%, and France's GDP is approximately $2.65 Trillion, meaning France could contribute $265Bn before reaching 90% debt to gdp.
Both France and Germany would therefore be seriously strained to provide a backstop to Greek debt, and the UK (also at 80% debt to GDP) is not in the Eurozone, and would likely significantly resist paying for Greek debt. Other countries with relatively low debt to gdp such as Finland (48% debt to GDP) only have smaller GDP levels (Finland's GDP is approximately $222Bn). Of course, Southern EU countries such as Spain and Italy cannot provide funding to Greece, in so far that their debt to GDP levels are already too high and the markets would likely not support these countries issuing more debt.
The problem is that not only Greek debt needs to be guaranteed, but also Italy, Spanish, Portuguese and Irish debt needs to be guaranteed. Italy currently has a debt to gdp of 119% with total debt outstanding in the $2.5Trillion range. In order to get this debt down to a manageable 80%, total funds would be needed of approximately $700Bn. All in all, the total backstop for Europe to guarantee all its "in danger" countries would likely be over $1Trillion.
Overall, it appears unlikely that France and Germany or a combination of other European countries can backstop $1trillion.
Can the IMF provide funding to Europe?
The current lending capacity of the IMF is approximately $400Bn -- so the lending capacity of the IMF would have to be increased. To get to $1Trillion, the United States (which contributes 17% to the overall IMF funding capacity) would have to increase $106Bn, which is possible, but politically unlikely. Other countries, such as Japan (which contributes 6% to the IMF budget) would have a difficult time raising funds to contribute to a vastly increased IMF lending capacity. Overall it appears the IMF will have a very difficult time guaranteeing EU debt alone.
Can a combination of IMF and the EU Guarantee Southern EU Soveriegn Debt?
This is possible, but would require the IMF taking the lead, as it is difficult to see how the northern EU states and France could guarantee more than $400Bn, while over $1 Trillion would likely be needed. An increased funding capacity to $500-$700Bn for the IMF is more possible -- meaning additional funding by $200 to $300Bn. This would require close cooperation between the IMF and the EU, which appears very difficult currently, politically. But financially, it is possible although difficult.
Conclusion: Greek Default and Southern EU Sovereign Defaults Very Possible -- if not likely -- without joint EU -IMF Bailouts
Currently as of the beginning of October, it does not look as if there is the political will to get the EU and IMF coordinating on a combined, increased bailout package, which would require significant additional funding (read: additional taxes) for the EU from France and Germany and increased funding for the IMF (read additional taxes for IMF member countries). The likelihood of this occurring is very difficult to say, but cannot be considered "the most likely outcome" meaning that the probability is higher for less than a needed guarantee for southern EU debt materializing in the future.
These commentaries do not perform a cause and effect analysis -- meaning, what would occur in the case of a Greek default, if one takes into account the impact on banking institutions, and national economic activity, in a step by step, sequential analysis? Such an analysis shows that significant problems occur with a Greek default for the EU and world economy and markets.
If Greece defaults, then the value of its bonds will drop by 50-80%. Note that the average sovereign default since 1980 according to Moody's has seen net losses of between 50-60%, but Greece is has significantly more debt than the average default, so losses would likely be higher.
Greek Banks would be insolvent:
This default in turn would cause the major banks of Greece (which in turn hold Greek sovereign debt) to go bankrupt. As the Greek government cannot guarantee the deposits of the Greek banks, the deposits of these institutions would be wiped out.
Significant Declines in Greek GDP:
What would happen to Greece's gdp? Many large banks go bankrupt in Russia in 1998 (although not in Argentina to the same extent in 2002-2003, as Argentina limited the amount of funds deposit holders could withdraw) as Russia defaulted on its debt in that year. Russia's GDP fell approximately 50% from 1992 to 1996, then recovered somewhat from 1996 to 1998 but then declined a further 15% fro 1998 to 2000. Argentina's gdp declined approximately 15% from 2002 to 2004. Both countries began to recover when their currency declined significantly and the export market (as both Russia and Argentina are major commodity exporters) picked up.
Greece's GDP would likely fall more than 15%. The world economy is more fragile currently, so a recovery in two years may not occur, through an export led recovery, so the slump would likely last for several years. The issue of leaving the Euro would have to be addressed -- instituting a new currency in a very difficult economic environment would be problematic.
Other Southern EU Banks at Risk:
Deposits in other southern European Union countries would be at risk, in so far that account holders in Italy, Portugal, Spain and Ireland would see Greek banks default, then attempt to transfer their deposits to safe havens, whether northern European banks. Italian, Portuguese, Irish and Spanish banks would be at risk from direct losses from holdings of Greek bonds (total outstanding Greek debt is over $400Bn, held mainly by European banks). As the southern EU governments are already highly levered, it is not likely that they would have the ability to raise funds to bank stop losses in their banking systems.
Southern EU Countries GDP at risk of significant decline:
Southern EU banking insolvency would be a significant risk, which could drive declines in Southern EU gdp.
French and German banks with exposure to Greek debt would be at risk:
Deutsche Bank and the major French banks have significant exposure to Greek debt, which would mean significant losses at these banks, and likely a need for government assistance. As both France and Germany have debt to GDP ratios in the 80% range, further payments to their banks would likely move their respective debt to GDP levels to close to 90%, which is the cut-off range (according to Harvard economics professors Kenneth Rogoff and Carmen Reinhart) for markets funding debt to GDP without significant issues (although this 90% cut off grade has received some criticism as being too arbitrary, however 90% likely does not leave too much room for further debt financed growth or assistance).
Certain Hedge funds will likely go insolvent and will likely have to liquidate, driving stock values down:
In the October 2008 crash, according to the book "The Quants" many large quantitative and macro hedge funds which were levered had to panic sell in order to meet investor redemptions. With the unprecedented volatility in the markets from a Greek debt, some larger hedge funds would have to liquidate, driving asset prices down.
Mutual Funds would see higher redemptions, causing selling to drive the market down:
Most mutual funds have been bullish through this crisis and have encouraged their investors to hold through the long term. Mutual funds had record low levels of cash in July and many have seen significant declines in equity values since that time. Further the average mutual fund investor is likely an aging baby boomer who is nearing retirement. All these factors point to higher redemptions.
Pension Fund Values would decline, leading to unrest:
Pension funds as a whole are more heavily invested in equities, due to the fact that they can assume a higher rate of return on equities (more in the range of 8-9%) verses bonds (in the range of 4-6%). The projected value of the pension plan is highly dependent on the projected return on plan assets. With panicked selling, pension plans would see the value of their assets decline significantly.
Safe Haven Assets would increase in value:
Safe haven assets are likely the US dollar, the Swiss Franc, potentially precious metals (however precious metals are held by hedge funds, which would likely liquidate in the short term).
Government Bailouts of Banking Institutions would be even more unpopular with the public, worsening the banking crisis.
The public of many countries is already upset with the banking bailouts of 2008 and 2009, and would not be in any mood for continued bailouts. This would complicate efforts to shore up bank balance sheets, making the banking crisis worse than otherwise would be. As banking crises have a "cumulative" character - the farther they are allowed to fester, the more the public panics and withdraws funds, potentially causing and worsening a bank run -- the unpopularity of bailouts can only worsen events for the banking system.
Recovery for Southern Europe would be more protracted, due to a weaker than normal world economy and therefore export market:
Both the United States and China are currently slowing -- China is attempting (successfully) to slow housing and infrastructure spending, however this means that commodity demand from China is slowing. This, in turn, impacts the major regions more dependent on commodity export: Latin America, the Middle East, Russia, Australia. This means that the EU will have a more difficult time utilizing exports to dig itself out of crisis.
What can be done to avoid a Greek Default?
As this analysis shows that a Greek default would be extremely problematic for the EU and world economy as well as stock markets, the question is, what can be done to avoid a Greek Default?
Either the EU, or another institution such as the IMF, should come in and guarantee Greek debt so that banks are assured of receiving 90%+ of their full value of their bonds. If the full value of Greek bonds are more or less assured, the chain of events described above will not occur.
However, likely the sovereign debt of the other Southern EU states, Italy, Spain, Portugal as well as Ireland needs to be backstopped as well in order to stop potential defaults of these countries, which in turn would cause banking crises moving to economic to market crises.
What would be the amount of funds needed to guarantee Greek and Southern EU debt?
Something in the range of 50-80% of Greek Debt would be needed to fully backstop this debt, meaning funding in the range of $200Bn to $360Bn. This is likely at the highest range for France and Germany combined to fund. Germany's debt to GDP is 80%, and German GDP is $3.33 Trillion, meaning that Germany can afford $333Bn before it moves to 90% debt to GDP (the danger zone, according to Rogoff and Reinhart). France's debt to GDP is also approximately 80%, and France's GDP is approximately $2.65 Trillion, meaning France could contribute $265Bn before reaching 90% debt to gdp.
Both France and Germany would therefore be seriously strained to provide a backstop to Greek debt, and the UK (also at 80% debt to GDP) is not in the Eurozone, and would likely significantly resist paying for Greek debt. Other countries with relatively low debt to gdp such as Finland (48% debt to GDP) only have smaller GDP levels (Finland's GDP is approximately $222Bn). Of course, Southern EU countries such as Spain and Italy cannot provide funding to Greece, in so far that their debt to GDP levels are already too high and the markets would likely not support these countries issuing more debt.
The problem is that not only Greek debt needs to be guaranteed, but also Italy, Spanish, Portuguese and Irish debt needs to be guaranteed. Italy currently has a debt to gdp of 119% with total debt outstanding in the $2.5Trillion range. In order to get this debt down to a manageable 80%, total funds would be needed of approximately $700Bn. All in all, the total backstop for Europe to guarantee all its "in danger" countries would likely be over $1Trillion.
Overall, it appears unlikely that France and Germany or a combination of other European countries can backstop $1trillion.
Can the IMF provide funding to Europe?
The current lending capacity of the IMF is approximately $400Bn -- so the lending capacity of the IMF would have to be increased. To get to $1Trillion, the United States (which contributes 17% to the overall IMF funding capacity) would have to increase $106Bn, which is possible, but politically unlikely. Other countries, such as Japan (which contributes 6% to the IMF budget) would have a difficult time raising funds to contribute to a vastly increased IMF lending capacity. Overall it appears the IMF will have a very difficult time guaranteeing EU debt alone.
Can a combination of IMF and the EU Guarantee Southern EU Soveriegn Debt?
This is possible, but would require the IMF taking the lead, as it is difficult to see how the northern EU states and France could guarantee more than $400Bn, while over $1 Trillion would likely be needed. An increased funding capacity to $500-$700Bn for the IMF is more possible -- meaning additional funding by $200 to $300Bn. This would require close cooperation between the IMF and the EU, which appears very difficult currently, politically. But financially, it is possible although difficult.
Conclusion: Greek Default and Southern EU Sovereign Defaults Very Possible -- if not likely -- without joint EU -IMF Bailouts
Currently as of the beginning of October, it does not look as if there is the political will to get the EU and IMF coordinating on a combined, increased bailout package, which would require significant additional funding (read: additional taxes) for the EU from France and Germany and increased funding for the IMF (read additional taxes for IMF member countries). The likelihood of this occurring is very difficult to say, but cannot be considered "the most likely outcome" meaning that the probability is higher for less than a needed guarantee for southern EU debt materializing in the future.
Thursday, October 6, 2011
Valuing Corning in an Extended Period of Lower Revenue Growth
Corning (NYSE: GLW), founded in 1851, has historically been at the forefront of glass production technology. Corning invented the glass process to produce light bulbs in the late 19th century, fiber optic cable in the 1970's, and liquid crystal displays (LCD's) in the 1990's to early 2000's.
Glass, which is produced from silicon (which in turn is made from sand) will likely be utilized in society far into the future, in so far that glass has certain suprior optic characteristics vis-a-vis plastics, a chief competitor material. Further, plastics are produced from more expensive hydrocarbons.
Corning, along with many downtrodden stocks in the current environment, is currently selling at a multi-year lows, at approximately $13, down from $22 in July and only moderately above the depths of the near $8 valuation at the bottom of the financial crisis. Corning's valuation represents 1x book value and approximately 6x historical earnings, with a net cash position of over $4.1Bn on Corning's balance sheet.
The question most relevant for investors is: at this current valuation is Corning significantly undervalued?
The answer to this question mainly lies with the direction of the High Definition television market. Corning's current profitability is highly dependent on its patented Fusion Process for liquid crystal display (LCD), which are used for high definition televisions and displays for computers and hand held devices. Corning, along with its 50% owned equity company Samsung Corning, has an estimated 83% market share in the manufacture of LCDs.
In the last quarter ended 6/30/11, Corning's LCD segment, along with equity earnings from Samsung Corning, comprised 90+% of operating income.
Corning's Profitability is Likely Significantly Higher in LCD's Produced for HD Televisions Verses for Computers and Hand Held Devices:
Corning in its 2010 Investor's Day estimated that approximately 60% of the volume (square feet) of this LCD glass was produced for HD televisions, and 40% by sq footage was produced for computers and hand held devices. Corning does not split out the relative profitability for computer and hand held display glass, however it is likely that Corning derives a higher percentage of its display earnings from HD Television glass, in so far that this glass is significantly thicker and represents a higher valued added product, in which screen resolution is significant competitive differentiator.
The Fusion Process Invention for LCD Marked an Incredible Turnaround for Corning in 2004:
Corning in the 1990's derived the majority of its income from the production of Fiber Optic fiber, where GLW had a market leading market share. In 1998, Corning derived 65% of its operating income from its telecommunications division, which mainly sold fiber optics. Interestingly, in 1998, Corning derived only 11.5% of its operating income from its information display segment, which at that time produced glass mainly for cathode ray tube televisions and computer monitors (this segment would by 2005 comprise the vast majority of Corning's profits through LCD technology).
Optic fiber sales collapsed in 2000 following the popping of the Internet bubble. Corning reported losses of $5.2Bn, $1.2Bn and a slight gain of approximately $200M in 2002, 2001 and 2000 respectively. In retrospect, it could be said that fiber optics worked TOO well, in so far that, according the publication The City of Light: The History of Fiber Optics by a medium sized, single fiber optic cable had enough capacity to carry ALL the phone calls in the United States simultaneously. One could say, Fiber Optics would be built once, then would not need to be rebuilt for 10 years or more -- a difficult market to build a sustainable business.
Are there Parallels Between Fiber Optics and LCD Technology in terms of the technology "working too well?" LCD's interestingly do not wear out at any sort of moderate pace -- most technological publications estimate that LCD screens will last decades -- 30,000 to 60,000 hours for the LCD screen to lose 50% of its display brightness, which, at a rate of 8 hours of use a day means a minimum of 10.6 years before the LCD needs to be replaced.
One could envision a scenario in which consumers buy one LCD television and do not replace this television for 15 or more years. Corning, in its 2010 annual investor meeting, estimated that 50% consumers would replaced their HD televisions every 6 years on average, but this data is speculative in so far that HD televisions have been introduced only since 2006 and therefore not many consumers have replaced their televisions for functional deterioration or any other reason.
HD televisions were introduced in 2006, and experienced rapid growth as consumers replaced their traditional cathode ray tube (CRT) sets with LCD and plasma televisions. In North America, Europe and Australia and New Zealand, initially the sales of HD televisions was likely buoyed by a strong housing market -- as one buys a new house, part of the improvements process likely involved buying a HD television for the living room (which could be viewed as an "investment" along with new floors, landscaping, furniture etc). All in all, HD televisions increased at an annual rate of over 30% from 2006 to 2008, driving HD televisions to a respectable 44% of all televisions in the United States (or slightly more than 1 HD television set per household in the US) by 2010. HD televisions represent 37% of all televisions in the EU-27 and 45% of all televisions in Japan. Even China reports HD television market share of total television units of 21% across all approximately 400 million households, even as according to the China's People Daily, the Chinese middle class (defined as households with income of at least 60,000 rmb or approximately $10,000 per annum) comprises 23% of the total population -- in other words nearly all of China's middle class as of the end of 2010 already owns an HD television set.
Will HD Televisions Units Sales Grow Significantly Going Forward?
At first glace, this question would be ridiculed by Corning and industry consultancies, which would reply of course! Corning has estimated that the total sq footage of HD televisions will increase at an annual rate of 21% in China and other emerging markets, with a total increase in HD television sales to 2014 across all areas of 12% (with only 4% growth in North America and Europe on an annual basis).
It is argued here that 1) HD television penetration in China likely will only grow at the rate of the overall Chinese middle class growth and 2) economic weakness in the US and Europe will mean flat to declining HD television unit sales in the near term.
The Chinese publication estimated at in July 2010 that the middle class would reach 48% of the total population from the current 23% by 2020, or a near doubling in 10 years. However, this implies that HD television sales will increase at only an approximate 7.2% per year -- and this under more optimistic economic growth forecasts for China of last year (in which growth rates of 8-10% were considered attainable for the next 10 years, currently China is more likely to achieve lower economic growth).
HD televisions do not appear to be any cheaper within China than in the US or Europe, with starting costs at around $US300 -- a newly minted middle class member of China with approximately $10,000 of annual income can afford this purchase but those with lower incomes likely will keep their old CRT televisions (currently China already has on average 1.1 televisions per household).
In the 4th quarter of 2008 and the first quarter of 2009, Corning's display segment reported significantly lower sales, total year on year sales declines of 50-58%, as North American and European consumers cut back on discretionary purchases. As Goldman Sachs has recently updated the forecast for a recession in the US to a 40% probability in 2012, and likely the odds of a recession in Europe are significantly higher (given the banking crises there) unit sales growth of HD televisions appears to be on a declining trend in the US and Europe for 2012 and the intermediate term.
Overall, Corning's 2010 investor day forecasts of 12% industry growth in HD television sales growth should be averaged to a rate that is significantly slower, and potentially (probably) slightly negative (mid single digit sales growth in China, declining sales growth in North America and Europe). The question is, can Corning remain profitable in these conditions?
Estimating Cornings' Display Segment Profitability with Mid-Single Digit HD Television Sales Declines:
In the 1st quarter of 2009, Corning's display segment actually reported a small profit (excluding Samsung Corning) of $38M despite 57% lower sales year on year -- however $37 of this profit was due to favorable exchange rates. Some of this moderate result was due to Corning idling LCD plants. Impressively, Samsung Corning only reported 13% lower year on year profit declines to $180M in the 1Q 09 -- mainly (appears, as Samsung Corning does not publish separate financial figures) due to continued growth in HD sales in China during 2008 and 2009 as the Chinese middle class bought new HD televisions.
With lower than expected growth over the near to intermediate term, it can be inferred (very roughly, based on Corning's historical ability to idle plant capacity) that Corning will eek out approximately low profits, in the $100M range per quarter. It does not appear that Samsung Corning will get the same boost from Chinese demand going forward into 2012 as it did in 2008 and 2009, but on the flip side, other region's declines of 50-58% in revenues is quite severe and not likely to be repeated. Total yearly profits therefore appear around $400M to $800M in the LCD division for intermediate term.
What Annual Earnings in a Slow Growth Environment would Corning's Other Division's Yield?
Corning's fiber optics group has reported relatively break even profits (with growth mainly dependent on infrastructure spending in China) and three interesting, but smaller groups -- specialty materials which includes Corning's Gorilla Glass and Biologic Glass, which includes high-tech glass for biotech laboratories (cells, test tubes, etc -- glass is non-reactive so has an advantage in these applications verses plastic). Corning's environmental technol0gies group produces glass for catalytic converters, and reported profits of $42 in 2010. Earnings were $60M for life sciences in 2010, and Gorilla Glass reported impressive sales growth but no profits in 2010. All in all, in appears Corning's other divisions can be counted on for around $100M in annual earnings in a slow economic growth environment in 2012.
Dow Corning Earnings:
Corning owns 50% of Dow Corning, which is a major producer of silicon and silicon based materials. Dow Corning is a large company in a period of world economic growth, with earnings approaching $800M for 2010. In a recessionary environment, Dow Corning broke even in 2008. With recessions more likely than not in 2012, Dow Corning appears to be set for low profits in 2012, barring significant governmental action.
Likely Earnings for Corning in a low Growth Environment:
Corning appears to be set for $600M in annual earnings without significant new product introductions ($400M approximately in their Display Segment and $100M per year in their other segments combined, and $100M for the 50% stake in Owens Corning). With a 14x multiple, $600M would command a market cap of $8400M (plus $4.1Bn of net cash) would be valued at $12.5Bn -- current entreprise value is $15.71Bn.
Corning would likely significantly disagree with this analysis, but such an analysis assumes significantly lower HD television sales growth and significantly lower replacement rates for HD televisions, based on a more challenged global economic enviornment. To the extent that Corning is accurate in forecasting close to double digit HD television sales growth going forward, Corning's long term value would be significantly higher.
Glass, which is produced from silicon (which in turn is made from sand) will likely be utilized in society far into the future, in so far that glass has certain suprior optic characteristics vis-a-vis plastics, a chief competitor material. Further, plastics are produced from more expensive hydrocarbons.
Corning, along with many downtrodden stocks in the current environment, is currently selling at a multi-year lows, at approximately $13, down from $22 in July and only moderately above the depths of the near $8 valuation at the bottom of the financial crisis. Corning's valuation represents 1x book value and approximately 6x historical earnings, with a net cash position of over $4.1Bn on Corning's balance sheet.
The question most relevant for investors is: at this current valuation is Corning significantly undervalued?
The answer to this question mainly lies with the direction of the High Definition television market. Corning's current profitability is highly dependent on its patented Fusion Process for liquid crystal display (LCD), which are used for high definition televisions and displays for computers and hand held devices. Corning, along with its 50% owned equity company Samsung Corning, has an estimated 83% market share in the manufacture of LCDs.
In the last quarter ended 6/30/11, Corning's LCD segment, along with equity earnings from Samsung Corning, comprised 90+% of operating income.
Corning's Profitability is Likely Significantly Higher in LCD's Produced for HD Televisions Verses for Computers and Hand Held Devices:
Corning in its 2010 Investor's Day estimated that approximately 60% of the volume (square feet) of this LCD glass was produced for HD televisions, and 40% by sq footage was produced for computers and hand held devices. Corning does not split out the relative profitability for computer and hand held display glass, however it is likely that Corning derives a higher percentage of its display earnings from HD Television glass, in so far that this glass is significantly thicker and represents a higher valued added product, in which screen resolution is significant competitive differentiator.
The Fusion Process Invention for LCD Marked an Incredible Turnaround for Corning in 2004:
Corning in the 1990's derived the majority of its income from the production of Fiber Optic fiber, where GLW had a market leading market share. In 1998, Corning derived 65% of its operating income from its telecommunications division, which mainly sold fiber optics. Interestingly, in 1998, Corning derived only 11.5% of its operating income from its information display segment, which at that time produced glass mainly for cathode ray tube televisions and computer monitors (this segment would by 2005 comprise the vast majority of Corning's profits through LCD technology).
Optic fiber sales collapsed in 2000 following the popping of the Internet bubble. Corning reported losses of $5.2Bn, $1.2Bn and a slight gain of approximately $200M in 2002, 2001 and 2000 respectively. In retrospect, it could be said that fiber optics worked TOO well, in so far that, according the publication The City of Light: The History of Fiber Optics by a medium sized, single fiber optic cable had enough capacity to carry ALL the phone calls in the United States simultaneously. One could say, Fiber Optics would be built once, then would not need to be rebuilt for 10 years or more -- a difficult market to build a sustainable business.
Are there Parallels Between Fiber Optics and LCD Technology in terms of the technology "working too well?" LCD's interestingly do not wear out at any sort of moderate pace -- most technological publications estimate that LCD screens will last decades -- 30,000 to 60,000 hours for the LCD screen to lose 50% of its display brightness, which, at a rate of 8 hours of use a day means a minimum of 10.6 years before the LCD needs to be replaced.
One could envision a scenario in which consumers buy one LCD television and do not replace this television for 15 or more years. Corning, in its 2010 annual investor meeting, estimated that 50% consumers would replaced their HD televisions every 6 years on average, but this data is speculative in so far that HD televisions have been introduced only since 2006 and therefore not many consumers have replaced their televisions for functional deterioration or any other reason.
HD televisions were introduced in 2006, and experienced rapid growth as consumers replaced their traditional cathode ray tube (CRT) sets with LCD and plasma televisions. In North America, Europe and Australia and New Zealand, initially the sales of HD televisions was likely buoyed by a strong housing market -- as one buys a new house, part of the improvements process likely involved buying a HD television for the living room (which could be viewed as an "investment" along with new floors, landscaping, furniture etc). All in all, HD televisions increased at an annual rate of over 30% from 2006 to 2008, driving HD televisions to a respectable 44% of all televisions in the United States (or slightly more than 1 HD television set per household in the US) by 2010. HD televisions represent 37% of all televisions in the EU-27 and 45% of all televisions in Japan. Even China reports HD television market share of total television units of 21% across all approximately 400 million households, even as according to the China's People Daily, the Chinese middle class (defined as households with income of at least 60,000 rmb or approximately $10,000 per annum) comprises 23% of the total population -- in other words nearly all of China's middle class as of the end of 2010 already owns an HD television set.
Will HD Televisions Units Sales Grow Significantly Going Forward?
At first glace, this question would be ridiculed by Corning and industry consultancies, which would reply of course! Corning has estimated that the total sq footage of HD televisions will increase at an annual rate of 21% in China and other emerging markets, with a total increase in HD television sales to 2014 across all areas of 12% (with only 4% growth in North America and Europe on an annual basis).
It is argued here that 1) HD television penetration in China likely will only grow at the rate of the overall Chinese middle class growth and 2) economic weakness in the US and Europe will mean flat to declining HD television unit sales in the near term.
The Chinese publication estimated at in July 2010 that the middle class would reach 48% of the total population from the current 23% by 2020, or a near doubling in 10 years. However, this implies that HD television sales will increase at only an approximate 7.2% per year -- and this under more optimistic economic growth forecasts for China of last year (in which growth rates of 8-10% were considered attainable for the next 10 years, currently China is more likely to achieve lower economic growth).
HD televisions do not appear to be any cheaper within China than in the US or Europe, with starting costs at around $US300 -- a newly minted middle class member of China with approximately $10,000 of annual income can afford this purchase but those with lower incomes likely will keep their old CRT televisions (currently China already has on average 1.1 televisions per household).
In the 4th quarter of 2008 and the first quarter of 2009, Corning's display segment reported significantly lower sales, total year on year sales declines of 50-58%, as North American and European consumers cut back on discretionary purchases. As Goldman Sachs has recently updated the forecast for a recession in the US to a 40% probability in 2012, and likely the odds of a recession in Europe are significantly higher (given the banking crises there) unit sales growth of HD televisions appears to be on a declining trend in the US and Europe for 2012 and the intermediate term.
Overall, Corning's 2010 investor day forecasts of 12% industry growth in HD television sales growth should be averaged to a rate that is significantly slower, and potentially (probably) slightly negative (mid single digit sales growth in China, declining sales growth in North America and Europe). The question is, can Corning remain profitable in these conditions?
Estimating Cornings' Display Segment Profitability with Mid-Single Digit HD Television Sales Declines:
In the 1st quarter of 2009, Corning's display segment actually reported a small profit (excluding Samsung Corning) of $38M despite 57% lower sales year on year -- however $37 of this profit was due to favorable exchange rates. Some of this moderate result was due to Corning idling LCD plants. Impressively, Samsung Corning only reported 13% lower year on year profit declines to $180M in the 1Q 09 -- mainly (appears, as Samsung Corning does not publish separate financial figures) due to continued growth in HD sales in China during 2008 and 2009 as the Chinese middle class bought new HD televisions.
With lower than expected growth over the near to intermediate term, it can be inferred (very roughly, based on Corning's historical ability to idle plant capacity) that Corning will eek out approximately low profits, in the $100M range per quarter. It does not appear that Samsung Corning will get the same boost from Chinese demand going forward into 2012 as it did in 2008 and 2009, but on the flip side, other region's declines of 50-58% in revenues is quite severe and not likely to be repeated. Total yearly profits therefore appear around $400M to $800M in the LCD division for intermediate term.
What Annual Earnings in a Slow Growth Environment would Corning's Other Division's Yield?
Corning's fiber optics group has reported relatively break even profits (with growth mainly dependent on infrastructure spending in China) and three interesting, but smaller groups -- specialty materials which includes Corning's Gorilla Glass and Biologic Glass, which includes high-tech glass for biotech laboratories (cells, test tubes, etc -- glass is non-reactive so has an advantage in these applications verses plastic). Corning's environmental technol0gies group produces glass for catalytic converters, and reported profits of $42 in 2010. Earnings were $60M for life sciences in 2010, and Gorilla Glass reported impressive sales growth but no profits in 2010. All in all, in appears Corning's other divisions can be counted on for around $100M in annual earnings in a slow economic growth environment in 2012.
Dow Corning Earnings:
Corning owns 50% of Dow Corning, which is a major producer of silicon and silicon based materials. Dow Corning is a large company in a period of world economic growth, with earnings approaching $800M for 2010. In a recessionary environment, Dow Corning broke even in 2008. With recessions more likely than not in 2012, Dow Corning appears to be set for low profits in 2012, barring significant governmental action.
Likely Earnings for Corning in a low Growth Environment:
Corning appears to be set for $600M in annual earnings without significant new product introductions ($400M approximately in their Display Segment and $100M per year in their other segments combined, and $100M for the 50% stake in Owens Corning). With a 14x multiple, $600M would command a market cap of $8400M (plus $4.1Bn of net cash) would be valued at $12.5Bn -- current entreprise value is $15.71Bn.
Corning would likely significantly disagree with this analysis, but such an analysis assumes significantly lower HD television sales growth and significantly lower replacement rates for HD televisions, based on a more challenged global economic enviornment. To the extent that Corning is accurate in forecasting close to double digit HD television sales growth going forward, Corning's long term value would be significantly higher.
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