Pirate Equity Already Pillaging 2007 – Our Advice, Buy Gold

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Can anyone tell us what the entire U.S. monetary establishment was doing in China over the weekend, and why the price of gold fell?

If the U.S. sells nuclear plants to China (through Westinghouse) does that mean the Chinese won’t dump their $1 trillion in U.S. bonds and crash the dollar?

How long will it take Shane Warne to take Adrian Pietersen’s wicket today at the WACA? Chew on that…and while you’re at, think a little further into the future…to the day when all global stock markets are integrated.

Someday in the not-too-distant future-if things keep going they way they are- there will be a global exchange, open for business every 86,400 seconds of every day, 365 days a year. Traders and investors will be able to buy and sell anything at any time, all the time. Want to go long London-listed zinc futures from Melbourne? No problem.

Scratching our balding head and sipping coffee this more, we puzzled out what the emergence of global uber-market might mean right here and right now. If all global exchanges converge into one giant digital bazaar, will this bring us the academically-celebrated but completely non-existent efficient market, where every stock and bond is always perfectly priced to reflect every bit of known information?

That’s too big an idea for even our own ambitious brain. So we dialed back and asked a simpler question: how much further can this stock market circus go? We figure the answer is about 20%. And it could make 2007 a year to remember. Pirate equity holds the key.

Why 20%? Private equity firms typically pay a premium for publicly listed companies of between 15-20% of going market value. This premium (made up of borrowed money) entices the boards of the firms to be acquired to go along with the scheme. It’s an instant increase in the market value of the firm.

A 20% premium on the Dow (from its current level of 12,416) is another 2,400 points. That would put the Dow at around 14,900, which we can safely call 15,000. A 20% on the increase on the ASX gives you another 1,111 points on top of Friday’s 5,557 level, giving the index a devilish total of 6,668.

Or take the Wilshire 5,000, an index that roughly equates to the market value of all the publicly listed companies in the U.S. It’s the total market cap of the U.S. market. We’ve posted a chart of the Wilshire…well because it’s fascinating. The index closed Friday with a value of 14,347, which equates to about $14.3 trillion in total market value.

Yet that’s not a record. In early 2000, the index topped out at $14,751. That means to reach a new record by the end of this year, markets would have ad another $400 billion value, somewhere in the stock market. Now $400 billion may seem like a lot of money to you and me. What could you get for $400 billion on the stock market? Well, about the only company you couldn’t buy outright is ExxonMobil (NYSE: XOM), which currently goes for about $450 billion. But if you’ve been nice, for $400 billion, Santa is likely to give you anything you want.

What if the entire market sported a 20% premium to its current value? Twenty percent of $14.3 trillion is $2.86 trillion. Again $2.86 trillion might seem like a lot of money to the average investor. And frankly, $2.86 trillion IS a lot of money. According to the World Bank’s own figures from 2005, only two countries had a GDP higher than $2.86 trillion. Japan’s GDP was $4.5 trillion that year and America’s was $12.4. Germany came in third with a GDP of $2.7, with China at $2.2. Australia, punching above its population weight, came in 15th at US$700.

So if global stock markets were valued at 20% of their current total, they would have to create the equivalent of another entire German economy. When you put it that way, it sounds like a big ask. But maybe not as big as it first appears.

We’ve posted another chart here that shows the total growth of the derivatives market since 1990. If you were looking at the chart this very moment, we’re sure you’d be astonished, as astonished as we were. While the Wilshire chart shows the disappearance of nearly $7 trillion on shareholder value from the equity markets starting in 2000 (the dot.com bubble bursting), the derivatives chart shows nearly the exact opposite. Beginning in the 2001, the notional value of all derivates was nearly $40 trillion-about equal to total global GDP. Today, that figure is nearly three times as high at over $120 trillion.

So you see, creating an addition $2.7 trillion stock market value is not that hard after all. It simply requires an enormous amount of debt. And unfortunately, you’re about to see corporate Australia, along with the rest of the world, follow the lead of private equity and load up on debt.

“Companies are preparing to increase their debt levels, and even let their credit ratings slip below investment grade, as they feel the heat from cashed-up private equity predators and begin to mimic their strategies,” says Joanne Gray in today’s AFR. Increasing debt may be one way to fend-off unwanted advances. But the strategy strikes us as counter-productive for shareholders. If you want to avoid being robbed in a dark alley, you don’t go dressing up like a tramp and staying in the alley. You clean yourself up and find a new neighbourhood.

“Advisers said many companies planned to take on more debt to lower their cost of capital, because it was cheaper to borrow than to sell shares and pay dividends,” the article continues. But what are the companies going to do with new capital? Why borrow simply for the sake of borrowing? It seems like a very American thing to do, to spend money you don’t have for the sole reason that some moron is willing to lend to you.

By the way, the moron isn’t really a moron, it’s just that he has no risk. He’s not the ultimate lender. Once he’s made the loan to you, he packages up the loan and sells at a “receivable” or bond to a long-line of insurance companies, pension funds, and institutions willing to own collateralized debt. At that point, the risk of making a bad loan is distributed across the economy…and everyone owns a little piece of it. This, we are told, makes the world’s financial market safer. Instead of bad-loan risk being limited to the lending institution, it’s “disaggregated into the wider economy. Of course by this point, no one is exercising any discretion in making the loans in the first place, which eventually results in a lot of mis-allocated capital and asset bubbles…but that comes later in the story.

There are some commentators advancing the notion that there is more to the pirate equity onslaught than old fashioned gearing, greed, and guile. Like certain members of the U.S. Federal Reserve (Richard Fisher and Ben Bernanke), some believe that U.S. and British capitalists are just better at being capitalists than anyone else in the world. It is a new class of capitalists, they claim, which explains why the capital returns on investments in U.S. financial assets are consistently higher than returns on capital invested in emerging markets.

What is it these new capitalist pirate equity men are doing different than the people who own and operate public companies? “Private equity owners sit right on top of the companies they own. They handpick executives, sit on the board, and immerse themselves in the details of the business. The laser-like focus on an eventual exit, and the ability to take quick decisions and invest for growth, married with a greater appetite for debt, as in many cases allowed private equity to generate superior returns.”

It is not hard to take quick decisions. Buy! Sell! Fire! Hire! Cut off his head! Bury the body! Full speed ahead! It is harder, we suggest, to make the right decision on how to use scarce capital (assuming capital were scarce). Do the pirate equiteers really know how to more effectively deploy capital to produce better returns more quickly? Maybe some of them do. But all of them?

“Private equity is shaping up as a big test for corporate Australia. There are those who see it as a bubble that will burst. But the smartest companies accept that there is a lot to learn from this new class of asset managers, which are here to stay.”

Here to stay? A new class of asset managers? How about an old class of over-paid fraudsters. Michael Lewis, who made obscene money himself trading bonds for Lehman Brothers during the junk bond boom of the 1980’s, has correctly identified what private equity really is: a way to screw shareholders and help the undeservedly rich get undeservedly richer.

Writing at Bloomberg today, Lewis says, “The upper class is now serviced by a vast and growing industry, loosely called Private Equity…The job of the private- equity investor is again, speaking loosely to exploit the idiocy of the ordinary investor, and the corporate executives and mutual-fund managers who purport to serve him. Private Equity Intelligence says this year private-equity firms have raised $300 billion, up from $283 billion for all of last year which is up from an ignorable $10 billion or so 10 years ago.”

“In effect, the smartest, best-connected money has separated itself from the rest of the stock market, and has gone into business trading against that market. It seeks to buy from the stock market cheap, and sell to the stock market dear, and if you need evidence that this is impossible you need only look to the returns on private equity, which have been running three times the returns of the public stock market,” says Lewis.

In effect, the insiders have re-rigged the game of investing so that you always lose. Private equity is for insiders only. The rest of us get the table scraps. Those scraps might be somewhat nourishing over the next few years, as the cheap money flood pushes markets to nominally higher levels. But it would be a grave and financially disastrous mistake to mistake this rush to higher levels for real wealth building.

The stock market may make new highs this year or early next year. And it may keep making them for all of 2007. It may even keep going for a few years. But keep in mind what our friend Dr. Marc Faber said this summer, “If the Dow goes to 36,000 then an ounce of gold will go to say $3,600, or maybe it will go to $10,000. In other words, you produce nominal gains in the stock market but against gold it continues to deflate.”

Gold, you might think after Friday’s beating, is hardly the best refuge against a rampaging index. After all, don’t you want be with the rampaging index instead of against it?

A lot of people wanted to be with Internet stocks in 1999. They were shamed into them, humiliated by the meager returns of value investing and the effortless riches of people who knew nothing about investing but were getting rich anyway.

Well guess what buttercup? Those times are back. If you have a taste for risk and can gamble with your life’s savings, now is the time to risk your fortune. Otherwise, we would look to buy gold on the dips.

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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