Any Port in a Storm

We turn to the markets first today with a note from Citigroup (NYSE: C) that it is time to be fearful rather than greedy. It leads us to the thought experiment that, ahem, it may be a better time to buy a house than it is to buy stocks. Personally, we are considering both, wondering which will give us more peace of mind at night (and which will hold its value the most in the next five years.)

“The market is getting expensive again,” writes Adrian Blundell-Wignall, Citigroup’s direct of equity strategy writes, “but the money is pouring into the equity market at rates that we have now revised significantly higher. There are signs of excessive complacency about economic performance, and the cheering on of private equity deals, etc that worry us.”

There’s so much money pouring into the stock market from superannuation, private equity, and other credit sources that we often think the best strategy for making some real money is to dash off a business plan on the back of a napkin from Café Babylon next door and go public. We don’t mind selling shares in our self. We share our self every day, for free! Why not make some money out of it?

Wignall continues, “Inflows into (local) managed funds could be as high as $79 billion this year and $92 billion next year. Changes in super rules in the run up to 30 June 2007 as well as the creation of the Future Fund are responsible. Compared to like issuance, there will be massive excess cash coming into the market in both years, and asset managers will benefit strongly (more than we previously thought)."

Riding the wave of new highs gives some investors a sense of complacency and self-satisfaction. It gives us vertigo. It reminds us of falling off a surfboard on our maiden voyage here nearly four years ago. We were tossed around like a used dishtowel in the washing machine of currents underneath the surface and ended up with a lungful of sea water and nose full of sand. If it weren’t for the fact that we were such a strong swimmer—and in only about 50 centimeters of water—we’re certain we would have drowned. That is the bad kind of liquidity.

"Moral hazard problems associated with private equity and the ready availability of liquidity, both here and globally, are driving up equity prices beyond reasonable returns, primarily in the Industrials. Greed has become a factor and comparisons with elements of the late 1980s come to mind. The current period has some worrying characteristics in common with the late 80s and the LBO debacle.”

Ahh. Here we come to the heart of the matter, which Wignall finds rotten and corrupt. If he were writing about politicians, we’d agree unreservedly and with enthusiasm. But we are not so sure that pirate equity is, at its heart, a greedy and negative phenomenon. We are open to arguments as we learn more about it. For example, a Bloomberg story by David Glovin tells us that “Kohlberg Kravis Roberts and Co.  and The Carlyle Group... are among 13 private equity firms accused in a class-action lawsuit of rigging the market to take companies private.”

This sounds vaguely like a school-yard skirmish to us. Private equity is the big bully, taking the best toys on the playground and going home to play with them behind closed doors. “Investors in the target company,” the suit claims, “are deprived of the full economic value of their holdings and ‘squeezed out’ at artificially low valuations.”

Just who is entitled to the full economic value of a firm’s cash flow? Employees? Capitalists? Bondholders? Shareholders?

Have the dread pirate equiteers really done anything illegal? We can’t see that they have. They have merely found a way to more directly benefit from distressed or under-priced assets than the “average” investor.

Isn’t this what the stock market is all about, after all? Aren’t we all trying to find some advantage which lets us buy a good stock at a discount and own before everyone else? IN this war of all-against-all there are only two kinds of investors in the stock market, the winners and the losers.

We would rather figure out how to do what the pirate equity people are doing than going to the courts and the lawyers for a remedy, like a petulant child. This stock market is not a school yard and the courts are not the hall monitor or Principal. Investment markets have risk and don’t guarantee reward. They are not insured savings accounts.

They are for serious adults, not a society full of investors with childish expectations, expecting Big Brother or the Nanny State to institute equality where none rightfully belongs. At least, that is our first, ill-considered impression of the whole thing. But what do we know? We were always a teacher’s pet in school… and big enough that no one picked on us for our runny nose, mismatched socks, and later, our stylish pocket protector.

Our main point is that the markets are always animated by fear and greed. Today is no different. The task, as Warren Buffett puts it, is to be “fearful when others are greedy and greedy when others are fearful.” Easier said than done, but this is true of most things in life worth doing, like losing weight, making money, or taking private yoga lessons from a supermodel.

Our instinct tells us to avoid most stocks and look for shelter, literally (considering we are being evicted from our rental property.) Any port in a storm. And we have a liquidity storm brewing. The question is whether the tide is coming in or going out.

Wignall continues, “On the basis of present information about issuance and M&A deals, we estimate excess cash in the Aussie equity market of $ 24 billion in 2006 and almost $ 35 billion for 2007. This is very bullish for the equity market. The figures for inflows into managed funds more generally have moved into record territory this year and look set to beat that easily in 2007. Global $ liquidity is also a great lead indicator of commodity prices. It is consistent with a top in the commodity cycle in 2007, but not a collapse.

Caution, exuberance ahead! "The market could continue to rise on this exuberance, in the absence of a shock of some form, even as the fundamentals are slowly undermined. Back in 1986, the market continued to rise with liquidity, fraud, LBOs in one of the worst examples of greed driving deals and market participants convincing themselves that it was all ok.

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