From the viewpoint of rescuing banks, the plan looks like a failure. It will accelerate price discovery of loans, which may cause the balance sheets of weak banks to actually deteriorate rather than improve. Banks will not tender their loans for sale if they know that the loans will fetch prices lower than their marked down value. The bad loans will stay on the books of the bad banks. What will come off the books of the banks are the good loans, those that are likely to perform well, but have been lumped together with the bad apples and now are stuck on the balance sheets of the good banks. By getting those loans off their balance sheets, the good banks will be able to do what they do well, assess credit risks and make more loans to good risks. The net effect will be an extension of credit to the economy, but in an intelligent manner, by making use of the expertise of the good bankers.

Under this plan, two groups will make out like bandits. The first group are the good banks which will be able to securitize and unload their good loans onto the markets, enabling them to make more loans. The second group are the investors in those securitized loans, who will be getting a huge government-sponsored loan on intrinsically profitable loans, leveraging their profit many times. To me, this is a refreshing change. Rather then rewarding the bad bankers who could not differentiate good credit risks from bad ones, and rewarding investors who relied on leverage to obtain eye-popping gains, the government is finally rewarding the good bankers who knew good from bad risks, and the conservative investors who did not rely on leverage and kept their powder dry.

Part of the reason why the plan has been so roundly criticized by bloggers is that the favored solution has been outright nationalization. The previous solution of extending government guarantees to loans on the books of the banks has a negative effect on the economy. It does not make the banks in question healthy enough to lend again. Instead, it is effectively a tax on the good banks to throw at the bad banks, since the bad banks are in business only because of the government guarantees. Nationalization is a possible way out of the impasse. Certainly, a nationalized bank can be made lend again, relying on the balance sheet of the government. However, this is also a tax on the good banks, because depositors and investors will prefer dealing with the government over private parties. The new Geithner plan suggests a third way out that avoids nationalization and is economically beneficial. Pump so much money into the good banks that they can now take over the bad banks. Although a bank such as Citigroup (and perhaps Bank of America) looks too large to be sold to any group, if the current plan manages to pump enough money into the good banks, there is hope that a conglomerate of the good banks can absorb a sufficient portion of Citigroup’s assets to finally solve the problem. It may seem unlikely now, but then again, mega-banks such as Wachovia, Merrill Lynch and Wachovia once looked too big to be taken over too.

The final criticism of the current Geithner plan is that it is too punitive on the taxpayer, who stand to lose too much. However, the bad loans have already been made and the losses have already been incurred. When the decision was made that bad banks cannot be allowed to collapse, it is just a matter of determining the combination of parties who should be made to shoulder the losses. Due to the magnitude of the losses, realistically speaking, the taxpayer has to shoulder the lion’s share. The only question is what mechanism to use to shift the losses onto the taxpayer. We can extend government guarantees to loans, nationalize banks, or pay private investors to absorb the losses. It seems to me that the last way is the only way which rewards the good guys, and are the least objectionable.

Losses suffered by the banks can be apportioned among the following stakeholders : taxpayers, bank management, shareholders, debt-holders, and depositors. For taxpayers and depositors, the answer is clear cut. Taxpayers will shoulder the majority of the losses because the government is the only entity with sufficient funds to fill the hole. Depositors should not sustain any losses whatsoever because they were not at fault, and sharing losses with depositors will cause an immediate bank run on all banks. As for management, while the public overwhelmingly favors punishing management, perhaps by firing current management and clawing back compensation paid to past management, the actual financial impact on the banking crisis will be negligible regardless of the course of action. The money that can be recouped from management is miniscule compared to the scope of the problem. The last two classes of stakeholders poses the most acute moral questions. Are shareholders responsible for the crisis because of the pressure they exerted on management for profits? Should debt-holders have performed better due diligence before lending money to banks? Should they be completely wiped out to reinstate moral hazard, or will completely crushing them scare private investors away from bank stock and debt at the precise time when banks need capital? There are no easy or correct answers to these questions, as they are essentially value judgements. Nevertheless, serious debate about these questions should be undertaken.

Once it has been decided how to divide the losses, many mechanisms exist to do so. Outright nationalization will completely wipe out shareholders, with the option of also causing pain on debt-holders should the government choose not to honor unsecured debt. An aggregator bank that purchases bad debt at prices far above market prices will essentially preserve both shareholders and debt-holders at the expense of taxpayers. Alternatively, the aggregator bank can demand a large haircut to acquire the bad debt, essentially socking it to both shareholders and debt-holders, or demand warrants or senior debt, which will again harm shareholders and debt-holders respectively. The possibilities and variations are almost endless. My gut feeling is that the Obama administration will go with the aggregator bank approach, because that is the most flexible, allowing the government to purchase various amounts of debt and inflict various levels of pain on stakeholders.

Inflation occurs when the monetary base grows faster than the amount of goods and services in the economy. Deficit spending, applied to boost consumption, will result in inflation because the amount of goods and services in the economy is unchanged while the monetary base is increased. On the other hand, deficit spending applied to boost production will increase the amount of goods and services, and is not necessarily inflationary. It is true that traditional Keynesian macroeconomics theory calls for the use of deficit spending to boost “aggregate demand”, but I am convinced that the theory thus applied will fail, as Japan has illustrated with its failed fiscal policy to boost consumption in the 1990s. The only thing that pro-consumption fiscal policy has going for it is its speed of effect; it is easy to boost consumption quickly, it is much harder to boost production quickly. However, the infrastructure projects currently envisioned by the Obama administration is in many ways the best of both worlds. Infrastructure improvements take time to impact production levels, but their immediate effect is to employ large numbers of people who will boost demand right now, when prices are falling due to deflation. Hopefully, by the time the economy recovers to the point that inflation is a concern, the productive nature of the infrastructure investments will kick in and help limit inflation. Also, boosting domestic production will reduce US reliance on imports, which will make it less important if foreign countries stop buying US bonds. Lastly, the Fed can print money to buy up any amount of Treasuries dumped in the open market, sharply limiting any effects on the interest rate, and can in fact substitute for any drop in foreign demand for US bonds. In general, the media should pay less attention on the total amount of stimulus spending, and more attention on how the money will be spent.

How can the stimulus money be productively spent? Three major areas occur to me, energy infrastructure, internet infrastructure, and education. Currently, US cities along the coasts burn oil and coal to generate electricity, while further inland, electricity can be generated cheaply from renewable resources such as wind generators and dams, prompting energy-intensive industries such as data centers and aluminum and steel mini-mills to relocate to those locations. Electricity transmission lines are regulated and maintained at a state level in piecemeal fashion by the electricity producers themselves, who understandably are not going to commission the construction of inter-state transmission lines which will disrupt their local monopoly. The government can step in to construct a cohesive national electricity transmission network, which will equilibrate electricity prices throughout the US, and probably reduce America’s reliance on imported oil for electricity generation. A similar failure of market forces is occurring in internet infrastructure, where the US lags many other countries in broadband penetration. Lastly, education is a silver bullet which, in addition to adding to human capital, has many beneficial social benefits such as lowering the crime rate and facilitating better political decisions. Unfortunately, an unnecessarily large number of young Americans drop out of the education system every year, and in general, Americans are under-educated, especially in math and sciences, to the point that the US computer and biotechnology industries require a large influx of highly trained foreigners annually for them to function. A lot can be done to change this situation. Many countries require teachers to pass stringent exams and be licensed. In return for a large increase in pay, American teachers should be required to pass both written and practical licensing exams, similar to the licensing process that medical doctors go through. Statistical tracking of student achievement should be vastly expanded and standardized at the federal level, so as to properly measure the ability of teachers and the improvement of students. A new initiative to expand educational research among social scientists should be considered. Schools should be safe and palatial, with facilities to accommodate students who need a refuge from their turbulent family life after school hours. Meals should be provided free and on a need-blind basis. While I realize that many of the proposals above are not politically realistic, the achievement of at least some of them will go a long way towards boosting the future productivity of the USA.

How can the stimulus money be mis-spent? The Obama administration is unlikely to use another tax rebate to boost consumption. Japan’s experience with issuing shopping vouchers to citizens has shown that when companies recognize that the demand boost is a temporary phenomenon, they do not hire people or expand production. Another tax rebate is likely to be saved, or be used to buy imported goods, and hence will not stimulate the US economy by much. A more likely scenario is a government subsidy for house purchases or refinancing, perhaps by issuing government backed housing loans at a below-market interest rate. This development would be troubling to me, as I frown on consumption-boosting stimulus efforts. In my opinion, the government should not be trying to influence consumption patterns through its policies. US politicians seem to have a penchant for promoting house ownership, believing that somehow this will give people a stake in the economy and help them save up for the future. In practice, owning a house makes little sense for someone who may move in a couple of years, as the transaction costs involved are huge and will likely eat up any capital gains. In fact, excessively high home ownership levels make it difficult for people to move to where jobs are, making the labor market more inflexible. Businesses routinely operate with long-term operating leases on buildings and properties without the need to own them outright, even though it can be argued that a business is more likely to have a permanent presence in a certain location compared to a person. Still, the government will be sorely tempted to try and stabilize the balance sheets of banks and the psyche of the American public through targeted inflation of housing values.

In short, there is good deficit spending, and bad deficit spending. The US government should concentrate on getting the most productive bang-for-the-buck with the stimulus money, and immediately start all currently feasible productive infrastructure projects. Everything else is just noise, including predictions of pending inflationary doom and reactions of foreign governments. If the government invests the stimulus money correctly, the other side-effects will sort themselves out.

To find out where we’re headed, its important to see where we are today. The US economy has begun to shrink at an annual rate of 0.3%, and unemployment has edged up to 6.1%. Inflation is running at 4%, but will fall in the near future as the price of oil and other commodities have plunged in the face of weak global demand. Similarly, US exports, which had been growing by 15% until recently, will probably decline as world demand decreases. Government mistakes in the form of allowing Lehman to fail has sparked a financial crisis which is only now coming under control. The Fed has aggressively lowered interest rates down to 1%, and the Treasury has injected capital into banks, but banks are not lending at any price, since there is spare capacity in nearly every business sector, and banks do not know how high default rates will rise, and therefore prefer to keep the excess capital in case they need it in the future. Massive deleveraging and capital flight to cash on a global scale have sparked economic crises in multiple countries, further threatening global demand.

The key now is in boosting demand. Without adequate demand, there will be spare capacity in the economy, with excess resources going unused (spare land going unused, spare labor in the form of a high unemployment rate, and spare capital in the form of cash sitting in bank accounts and under mattresses). Monetary stimulus has reached its limit; it is time for the federal government to step up with fiscal stimulus to boost demand. This stimulus should be channeled towards productive purposes (e.g. building wind farms to wean the US off oil imports, building a national broadband system etc.) instead of more consumption (e.g. shopping vouchers for citizens). During the 1980s, the Japanese government issued multiple tax credits and started many “bridge-to-nowhere” infrastructure projects in trying to jump-start the Japanese economy from a deflationary spiral, but they failed because people saw that these measures all had a temporary effect which would fade once the extra one-time demand ceased, and resisted investing in new factories. Only when it is clear that the new measures will result in permanent new demand (e.g. by shifting demand for foreign oil into demand for domestic wind power, resulting in permanent new jobs in the US) will the private sector be willing to invest its own capital into the economy.

What will happen in the future? In the worst case scenario, the US may endure a Japan-style lost decade. The Fed cuts rates to zero without increasing lending, and deflation causes people to avoid taking on debt (which costs more to repay in a deflationary environment) and to defer consumption (goods get cheaper with time). The economy stabilizes at a level of lower consumption, with 15-20% unemployment rate and lower living standards, and the stock market stays depressed. In the best case scenario, the US government incurs large deficits to spur productive investments in infrastructure, education and technology. It pays for this deficit by issuing Treasury bonds on a large scale, and the Fed holds the interest rate of these bonds at a measly 1% by buying up excess bonds on the open market (i.e. by printing money). Foreigner creditors take a look at the deteriorating balance sheet of the US government and the burgeoning inflation, and decide that rather than hold Treasury bonds that are losing value, they would rather buy USD-denominated assets, such as stocks and real estate. The housing and stock markets recover, and US consumers feel richer again and start spending. The increasing inflation discourages people from holding cash, and demand recovers.

It may seem like heresy to advocate for higher inflation, since inflation works against savers and investors (like myself), and benefits debtors (like the idiots who took out loans they could not afford). However, on a macroeconomic basis, it is reality that the US is a country with a negative savings rate, and that we have depended on foreign countries to fund our consumption for nearly a decade. I see moderate inflation as a fair way to spread the pain between debtors and creditors, who share responsibility for past excesses and the current situation. Inflation erodes the value of the huge pile of Treasuries held by foreign creditors, causing them pain, and also makes future consumption more expensive, causing US consumers pain. In the short term, the US loses a chunk of its productive assets to the hands of foreign government as the price for past consumption, and in return the US economy regains its footing and continues to be the most innovative economy in the world, generating new productive assets (ideas, companies, technology) at a rapid clip.

The key to an economic recovery therefore now rests almost entirely upon government policy (as well as policies by foreign governments). This is the key reason why stock markets are so volatile at this time; the current administration is genetically opposed to government intervention and vaciliates from policy to policy, while the capabilities of the future government is not yet clear. At no time in recent history has government leadership been as important as it is today.

The latest panic in the credit markets, caused in my opinion by the mis-steps of the Treasury, has considerably darkened the prospects for the recovery of the US economy. Bond investors are by nature extremely risk-averse, and any uncertainty will cause panic; Paulson, with his years of experience in the financial world, should have known this. Now, US companies and banks have effectively lost the ability to issue bonds and incur additional debt. New initiatives for growth will go unfunded. Companies with existing debt which need to be refinanced will likely be unable to do so, and will go bankrupt. Banks will seize every opportunity to terminate credit lines to preserve their own capital. All this adds up to more people being laid off, the economy sliding further into recession, and a massive decline in the stock market.

Investors who had made ill-considered investments in risky subprime mortgages should not be rescued. However, the government has failed to clearly specify its criteria for rescue, and has chosen to haphazardly mount rescues on an ad-hoc basis. As a result, otherwise sound bonds, such as those backed by student loans and commercial bonds, have also became risky in the short term as bond holders flee the entire bond market. In other words, the government has failed to contain the crisis to the subprime mortgage sector, and contagion of healthy bonds has begun. In order to salvage the situation, the government needs to formulate a clear industry-wide criteria for rescues. In addition, the Fed must apply monetary stimulus and tolerate a short-term period of increased inflation, which will stimulate exports, reduce the current account deficit, and hasten the bottoming of housing prices (in real terms).

This investment thesis may appear to be a rather risky one at first glance. After all, economic growth has slowed dramatically in the US and Europe, and as the Asian economies are heavily weighted towards export to the Western economies, there is widespread consensus that these economies will also slow. However, in recent years, a middle class has emerged in the Asian economies, especially in China. Despite the recent drop in the Chinese stock and real estate markets, the newly-minted middle class still has wealth unimaginable just a generation ago. To combat an impending slowdown due to the malaise in the western economies, the Chinese government is likely to attempt to stoke consumerism among the middle class to boost domestic demand, to promote the development of a more service-based economy, as well as to move up the value chain in the goods it produces. All these trends will boost demands for computers. In fact, I see computers as the single most productive investment that can be made by the Chinese economy. Rather than hold onto depreciating US Treasuries and bonds, the Chinese government can embark on a program to massively upgrade the technological and educational infrastructure of the country. In order to give birth to the future Googles and Microsofts, China needs an educated and technologically savvy population. Even among the middle class, only 20-30% of households now own a computer. In support of this view, Lenovo has recently announced that its quarterly profit has risen 65%, driven mainly by demand in China and the emerging economies.

In the future, I see companies such as Dell, Intel and Nvidia as being more like Coke and McDonald’s, deriving the bulk of their profits from outside the United States. Already, Dell’s international sales has outstripped its domestic sales. Furthermore, even within the US, hardware and software upgrades cannot be indefinitely postponed. At some point, demand will recover. Here, again, timing is the bugbear. However, given the excellent financial positions of the companies I’ve chosen, I expect them to outlast even a protracted domestic recession.

This prompted me to think about investment strategies in a weakening US economy. Traditionally, one would retrench to defensive sectors like healthcare, staples and utilities. However, with the spiraling healthcare costs almost sure to provoke some kind of regulation, I find the healthcare sector too uncertain to invest in for now. Also, unlike previous recessions which were induced by short-term supply or demand shocks, this particular recession appears to be a secular one characterized by a what is probably going to be a long-term supply constraint of all major commodities, and would require the US consumer to adjust to a lower consumption of these commodities. Already, the oil refineries are losing money because they had been unable to pass on the price increases of crude oil in full to the consumer (see another NYT article to this effect). I think that in this climate, people may in fact reduce their consumption of electricity and gas, and so utilities is not such a sure bet either.

The sectors that I am optimistic about are international, technology, agricultural and commodity stocks. By international stocks, I don’t mean the companies that concentrate in the high growth economies of China and India (these economies are likely to slow in the near future from reduced US demand for their exports) but rather the truly international ones with a footprint in many countries, including European countries (which are better adapted to high oil prices). Companies that satisfy this criteria include McDonalds, Coca-Cola, Pepsi, and increasingly, Dell and Walmart. Also, the US has always led the world in computer technology, and still retains a very strong first-mover advantage, with all the most important hardware (Intel), software (Microsoft), and internet companies (Google) based here. The weakening US dollar is likely to bolster this sector where the US holds important advantages (though if the US government doesn’t loosen immigration laws soon, the US may squander that advantage). Lastly, the agricultural and commodity companies will finally see increasing profitability in the supply-constrained global economy.

As a whole, the portfolio is slightly up over the last 3 months, out-performing the S&P 500 index modestly. Commodity stocks (TX and MEOH) are up, and financial stocks (FMD) are down, in line with the performance of their respective sectors. Consumer goods stocks are mostly treading water. Of greatest concern to me are two stocks with a close to 20% loss, SAFM and CCIX. The commonality between these two stocks is that both carry rather high debt loads. Evidently, the market is concerned about companies with high debt loads in an uncertain economic climate. Compounding the problem is the lack of credit, which has caused LIBOR to soar to above 6% recently, and since the revolving credit facilities of most companies are tied to LIBOR, debt servicing costs are expected to rise. In the near-term, this means that I expect both SAFM and CCIX to take a hit to earnings due to increased interest expenditure. However, both companies command large market shares in their industries, have competent management with high insider ownership, and are pursuing rational business strategies. I continue to have faith in these companies, and feel that with their market positions and strong cash flows, it is unlikely that they will fail amidst a credit crunch. While some banks may make use of the current lack of liquidity to impose extortionary interest rates on company, in the long run, it harms their own interests if they raise interest rates to the point that fundamentally sound companies fail.

Overall, I am a little disappointed by the performance of the portfolio. I had expected a value-oriented portfolio to hold up relatively well during times of market stress, considering that most stocks were bought with huge margins of safety. Instead, portfolio performance has sunk to nearly risk-free return rates. I think the chief culprit is an outsized position in CCIX, which is probably overweighted relative to the merits of the other stocks in my portfolio (despite the underperformance of SAFM, I think that its position size is reasonable). I walk away from this analysis with several conclusions. Firstly, I should pay greater attention and establish hard rules regarding position sizes. While value investors have had a tradition of holding ultra-concentrated portfolios, for my personal portfolio, I feel that sacrificing some return for reduced volatility is worth it. Secondly, I should pay more attention to sector diversification. I’m thinking that 5 uncorrelated sectors each with 2 stocks would be appropriate. Lastly, the total and individual debt levels in the portfolio must be monitored. I think that at most I’ll hold 1-2 stocks with a debt to equity ratio above 0.5, striving for minimal debt in the rest of the holdings.

I’m not sure whether imposing the above restrictions on my stock holdings will make it so difficult to find new stock picks that investing becomes impossible. At least in the current climate, there are plenty of stocks at attractive valuation levels, so these conditions should not prove to be too onerous. In the near-term, I’ll probably seek to take my profits in my commodity stocks and rotate out of them when and if the market rebounds, and invest the proceeds in another sector. In line with these thoughts, I have recently bought a small position in VPHM, a pharmaceutical company. Normally, I avoid pharmaceuticals because they are too risky, but VPHM has an exceptional capital cushion, and pharmaceutical companies whether recessions well, since medical costs is probably the last expenses one can cut.

Why has the Chinese stock market bubble developed? This is mainly the fault of the Chinese central bankers. In the US, inflation is surprisingly tame despite despite the US waging a war and running huge budget and trade deficits. This is because the inflation is essentially being exported to China. When Chinese companies export to the US, the US dollars they earn have to be swapped for the yuan in China for domestic use. By pegging the yuan at artificially low levels to the US dollar, the Chinese central bank is forced to inject large amounts of its own currency into the Chinese economy. At the same time, the Chinese central bank pays a very low interest rate on its own bonds and bank deposits (presumably because it knows its own capital controls are leaky, and higher interest rates will serve to exert further upward pressure on the yuan), causing the Chinese public to seek better investment returns elsewhere. This has caused both real estate and stock market bubbles in China. By exporting cheap goods to the US, China has helped to control inflation in the US and stimulated its own economy to nearly full employment, at the cost of rampant inflation.

The simple fact is, when you peg your currency to another country’s currency, you lose control of your own monetary policy. Chinese monetary policy is now being controlled by the US Federal Bank, which has held interest rates at a level that is appropriate for the lukewarm US economy, but which is too low for the red-hot Chinese economy. Will the Chinese authorities be able to control their speculative bubbles and navigate the economy to a soft landing, or will they crash and burn like the Japanese did a decade ago? The Chinese government has mainly used regulatory measures to try and cool the speculative bubbles (increasing taxes, banning margin for stock investments etc), but is also moving towards real structural changes, such as pegging the yuan to a basket of currencies instead of just the US dollar, and allowing the yuan to gradually rise against the US dollar.

Are there any opportunities for the retail investor in this situation? Chinese capital controls mean that foreigners cannot directly hold the Chinese yuan or buy Chinese stocks. The only Chinese ETFs available today, FXI and PGJ, are based on Chinese ADRs and Hong Kong companies with a large exposure to the Chinese market respectively. These are US denominated assets, and are not highly correlated with the most overheated Shanghai stock market. FXI sports a PE ratio of around 16, and PGJ around 26. In comparison, the Shanghai Composite index has a PE of 45. Furthermore, when the Shanghai stock market dropped 6.5% on May 31, both ETFs were virtually unchanged. Even if one manages to circumvent the capital controls and get ahold of Chinese stocks, stocks cannot be shorted on Chinese stock exchanges, and the futures market is untested and may not be reliable in a stock market rout.

In my opinion, the only way to play this is by shorting companies with weak fundamentals listed in the US stock markets which depend substantially on Chinese consumers. A sharp fall in the Shanghai stock market will immediately curtail Chinese consumption. At this point, however, it is premature to predict a sharp fall in the Chinese stock market. With the Chinese Olympics coming in 2008, the economy is certain to receive a stimulus in the short-term, and widespread public perception is that the Chinese would not allow a severe correction and panic to set in before the Olympics has ended. Furthermore, the Chinese measures to cool the market still has a chance of working. Both the Nikkei and the Nasdaq indexes had PEs of more than 100 before they crashed. Ironically, the higher the Shanghai index climbs before the Olympics, the higher is the chance of a sharp correction after the Olympics. If the Shanghai index climbs above 7000 before the Olympics, I think that the chance of a sharp correction will become high enough for me to actively begin scouting for stocks to short. The end of the Olympics will have a small contraction effect on the local economy, and more importantly, is likely to cause a change in investor psychology, which may well cause the stock market bubble to pop if the Chinese authorities fail to control the bubble now.