New Answers On DB, GM, Private Equity Stocks, And More

I’ve decided to make this Q&A a regular feature

Last week the S&P 500 leaped nearly 2% and the Dow closed above 17000 for the second week in a row. I sent you an alert over the weekend explaining that this is really a bear market rally and we shouldn’t expect these highs to last. Predictably, readers have a lot of questions about the behavior of stocks right now – as well as about NIRP, MLPs, shady private equity practices, and other skullduggery.

This economy is circling the drain, and I’m happy to explain why.

Here’s what you wanted to know…

Stocks:

Q: Are you still negative on DB? They recently purchased back their bonds, but I am reading that this may be considered a sign of weakness. Are they still worth buying a put on here? ~Marcel G.

A: DB has not solved its problems. Rather than buying back debt it should be raising more equity and fixing its internal problems with financial controls. It should also radically reduce the size of its derivatives book. I don’t think the sell-off is over.

Q: Does the private equity meltdown mean we should get out of stocks like KKR? ~Fred E.

A: I expect the private equity stocks to drop another 20-40% before bottoming. They will then offer good value. They are well-positioned to take advantage of the credit market downturn to make new investments. If you can hold them for the long term I think they will rise sharply when the credit markets recover but for now they are dead money.

Q: Hello Michael, General Motors has posted excellent results and has a good dividend. Management seems to be making very sound, shareholder-friendly decisions. Why does the stock not respond more favorably? ~Aaron Y.

A: A lot of very smart people have lost money on GM. I think the poor stock performance is due to concerns about management’s ability to lead the company. There have been too many scandals and problems to give investors confidence. It is a cheap stock (as is Ford) but it just seems to have a problem gaining the confidence of investors. What’s more, auto sales are up because of record auto lending right now – and in February, subprime car loan defaults reached their highest level in nearly 20 years. The car industry is a shaky one to be in right now.

Currencies/Commodities:

Q: Isn’t the strong dollar actually a good thing(for small businesses and the working class)? A strong dollar and low commodity prices puts the power back in the hands of the people. That would be further enhanced by an actual interest rate that would return some wealth to our savings. The BEST way to reduce the debt burden of the world economies is to quit borrowing money for useless things we cannot afford, reduce spending, and get off our bums and work. Please correct me where I go wrong here. ~Carroll O.

A: You are 100% correct that the best way to reduce the debt burden is to reduce borrowing and create higher economic growth through hard work and better economic policies. But a strong dollar depresses commodity prices (because commodities trade in dollars and a strong dollar makes it more expensive for non-US dollar holders to buy them) and hurts corporate earnings in the US because many companies earn a lot of their revenue in other currencies.

Q: In your previous posting, you covered problems with central banks in Europe, in Japan and in China, as well as the Fed. You mentioned dollars and the Yuan as well as the Euro. No mention was made of Great Britain, Sterling, London or the Bank of England. Does that mean that there will be less impact across the pond when the meltdown comes, or are you already considering the United Kingdom as dead, buried and finished? ~ Louis F.

A: The UK is no longer a significant economy in the world system. I am well aware that Sterling has dropped in value against the US dollar, but the main effects of that will be felt in the UK. The currencies that matter the most are the US dollar, Euro, Yen and Yuan. Everyone else is a minor player.

Q: Are there any investment tools (besides gold) that are really safe in the event of a market crash?

~Pia C.

A: If the market crashes, the best things to own are cash, gold and US Treasuries. Everything else will lose value.

MLP Problems:

Q: Aren’t you painting MLPs with a broad brush? Just because SOME MLPs are debt laden and present a poor value proposition, doesn’t mean ALL MLP’s can be painted with the same colors. You have to do a little digging, but when the majority of take-or-pay customers have strong credit ratings, the risk is mitigated substantially. ~Pat G.

A: The point of my article was that MLPs have structural problems that render them potentially unattractive if the underlying businesses encounter problems. Those problems include adverse tax consequences for partners in MLPs that have to write-off some of their debt, creating “forgiveness of indebtedness” income for partners without any cash distribution to pay the taxes. In addition, many midstream MLPs are discovering that their customers and contracts are not as solid as they thought. Last week, a New York bankruptcy judge ruled that bankrupt Sabine Oil & Gas can reject pipeline contracts, something that could spread throughout the industry if conditions don’t improve. You are correct that it is necessary to analyze each MLP on its own terms, but investors are likely to encounter more problems before the energy markets recover.

The Private Equity Shuffle:

Q: Why does a lender participate in a ” dividend deal?” With the reduction of elimination of the skin in the game of the private equity organization and the pending substantial reduction in strength of the company serving as collateral, how can a responsible lender put up the money? ~Sara M.

A: Wall Street is all about making money without caring about how it makes money. That means that large Wall Street banks that earn big fees from private equity firms will rarely turn away an opportunity to sell more debt for them even if the debt is not being used for productive purposes. The bigger question is why investors buy these deals and the reason is that they have short memories. Further, many investors are required to put money to work once they raise it and take what is available in the market. I have always avoided investing in dividend deals for the reasons stated in your question.

Q: Is there a parallel process (similar to these shady private equity practices) that governments engage in? What is it called? Because governments who can’t pay their debts will also be doing the “finance shuffle,” won’t they? ~Mike F.

A: All governments are engaged in a massive exercise in Ponzi finance whereby they borrow from the future to pay the bills of today. That is why governments are going bankrupt – they can never catch up to the promises they have made to spend money. The only way to pay back all of this debt is by devaluing their currencies, creating inflation or defaulting (they could also grow their economies but it is too late for that because too much debt has been created). Ponzi finance is why investors should buy gold – to protect against the destruction of paper money.

Fed Skullduggery:

Q: Newcomer to the newsletter and really think it is fantastic. I have a question I hope you will address soon. How will NIRP affect the high risk derivatives game that banks have jammed themselves into? With balance sheets of 2-3 trillion but yet gambling 52 trillion per bank in derivatives… how does that work when NIRP kicks in? ~Alex W.

A: NIRP is creating anomalies in the credit markets. For example, both the Japanese Yen and Euro strengthened after the most recent moves to lower interest rates into negative territory and do more QE in both regions. NIRP is therefore creating unexpected volatility in the currency and credit markets that could stress derivative contracts and lead to losses among investors and the banks that take the other side of their derivatives trades. The biggest risk with derivatives is that a large bank such as Deutsche Bank could fail and be unable to perform its obligations under the $60 trillion of derivatives on its balance sheet, which would hurt all of the other parties to those contracts. In such an event, governments would have to come in and back the failing bank in order to avoid a catastrophe. We saw this happen with AIG in 2008 and it could happen again with several European banks that are in bad shape.

Q: Michael, your insight is truly remarkable. I’ve only been following you for a few months and have learned so much. Question: you predict a super crash in June of this year. What if the Fed does another round of quantitative easing this time using the so-called helicopter money that Ben Bernanke talked about in the past in which the government will spend the money on infrastructure projects to spur economic activity? Can this be a sufficient countermeasure to blunt the effects of a super crash in the market? Thank you. ~James V.

A: The Fed and other central banks will do whatever they can to prevent a crash. The European Central Bank just announced last week further moves to lower interest rates farther below zero and to buy back more debt to try to prop up the weak European economy. The Bank of Japan is doing the same thing. My view is that central banks are out of ammunition and that markets will sell off once they admit that printing more money (all of which is debt) is not the way to cure a debt crisis. We need fiscal policy reform (tax reform, regulatory reform, labor policy reform) to take over the policy mantle from central banks and stimulate higher growth.

Q: Is it possible to artificially extend a credit cycle indefinitely? I certainly agree with your arguments but I don’t feel comfortable with the “end of the credit cycle” argument. They can extend it for ever and ever if they want. And I have the impression that it’s exactly what they are doing. ~Tony P.

A: They cannot extend it forever but they can extend it for a while more. There is already more than $200 trillion of debt outstanding in the world. The global economy does not generate enough income to service or repay that debt. The best case is that paper currencies will continue to be debauched (though the US dollar will remain the best of the bunch), which will lead to higher prices for financial assets. At some point debt has to be repaid or the borrower defaults and that applies to governments as well as corporations and individuals. Right now low interest rates are delaying the process but eventually the piper must be repaid.