Monday, December 27, 2010


The Dallas Fed Manufacturing Index for December dropped to 12.8 from 16 in November.

There was a good two-year U.S. note auction (2 basis points below expectations with a reasonable bid to cover.)

"Never make predictions, especially about the future."

-- Casey Stengel

In an excellent essay published over the past week, GMO'S James Montier makes note of the consistent weakness embodied in consensus forecasts.

Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. Even a cursory glance at Exhibit 4 reveals that economists are simply useless when it comes to forecasting. They have missed every recession in the last four decades! And it isn't just growth that economists can't forecast: it's also inflation, bond yields, and pretty much everything else. If we add greater uncertainty, as refl ected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!

For 2011, consensus estimates for economic growth, corporate profits, stock price targets and interest rates are grouped in an extraordinarily tight range. I have chosen to use Goldman Sachs' forecasts as a proxy for the consensus.

Here are Goldman Sachs' principal views of expected economic growth, corporate profits, inflation, interest rates and stock market performance:

* 2011 GDP up 3.4% (global GDP up 4.7%);
* 2011 S&P 500 operating profits of $94 a share;
* year-end S&P 500 price target at 1,450 (a gain of about 15%) ;
* 2011 inflation of 0.5%; and
* the 2011 closing yield on the U.S.10-year Treasury note at 3.75%.

Looking beyond 2011, it appears that the consensus further expects that the domestic economy is well on its way toward delivering a smooth and self-sustaining and normal historical recovery that (from start to finish) should last about four years. The clustering of that consensus suggests that any short- or intermediate-term variant outcomes could be destabilizing to the markets, both to the upside and to the downside.

"Those who cannot remember the past are condemned to repeat it."

-- George Santayana

Looking at history, there was no better example of misplaced optimism than in the period leading up to the Great Decession of 2008-2009, providing a vivid reminder of the poor forecasting ability and investment risks associated with the crowd's baseline expectations and the value of a surprise list that deviates from that consensus.

Only the remnants anticipated anything near the magnitude of the fall in the world's economies and capital markets, despite what appeared to be clear and accumulating evidence of economic uncertainty and growing credit risks (and abuses). The analysis of multi-decade charts and economic series convinced most (along with other conclusions) that home prices were incapable of ever dropping, that derivatives and no-/low-document mortgage loans were safe, that there was no level of leverage (institutional and individual) too high and that rating agencies were responsible in their analysis. Importantly, they also failed to see the signposts of an imminent deterioration in business and consumer confidence that was to result in the deepest economic and credit crisis since the early 1930s.

From my perch, many of those who are now expressing the most extreme levels of optimism were the most wrong-footed two years ago and experienced not inconsequential pain in the last investment cycle. (Perhaps the recovery in equities was so swift in time and sizeable in magnitude that memories simply have been erased to the risks that are still omnipresent today.)

Back then and, to a lesser degree, today, many investors appear similar to victims of Plato's allegory of the cave, a parable about the difficulty of people who exist in a world shaped by false perceptions to contemplate truths that contradict their beliefs. This is why so many investors were blindsided by the last downturn and, from my perch, continue to remain conditioned to wearing rose-colored glasses.

In the famous simile of the cave, Plato compares men to prisoners in a cave who are bound and can look in only one direction. They have a fire behind them and see on a wall the shadows of themselves and of objects behind them. Since they see nothing but the shadows, they regard those shadows as real and are not aware of the objects. Finally one of the prisoners escapes and comes from the cave into the light of the sun. For the first time, he sees real things and realizes that he had been deceived hitherto by the shadows. For the first time, he knows the truth and thinks only with sorrow of his long life in the darkness.

-- Werner Heisenberg, Physics and Philosophy

I'm wondering if one of the most notable takeover deals in 2011 might be MSFT launching a tender for YHOO at $21.50 a share. With the company in play, NWS might follow with a competing and higher bid. The private equity community then may join the fray. I'm thinking MSFT ultimately prevails and pays $24 a share for YHOO.

Currently, Yahoo! is universally viewed as a dysfunctional company, and few expect that Microsoft has an interest in the company. But a deal could be profitable and advantageous (more critical mass and immediate exposure to the rapidly growing Chinese market) to Microsoft:

* Microsoft is hemorrhaging cash in its Internet operations (estimated $2.5 billion of losses in the last 12 months). Yahoo! will immediately contribute $1.25 billion-plus of cash flow. (Applying a normal multiple, 6x to 9x creates $8.5 billion of value to Microsoft from Yahoo!'s current earnings before interest, taxes, depreciation and amortization).

* Yahoo! boasts net cash of $3.4 billion.

* Yahoo!'s public holdings total $9.5 billion of value ( and Yahoo! Japan).

* Yahoo!'s private holdings total $6.0 billion.

Yahoo owns 40% of private AliBaba through two assets:

1. A call option on Chinese search via Microsoft joint venture. Based on the value of Baidu, if Yahoo gets a 10% share of $50 billion Chinese search market the value is $5 billion - the value to Yahoo is about $1 billion for each 10% of search share (40% of 50%).

2. 40% of AliPay. This is the elephant in the room. Current AliPay payments are about two thirds of PayPal, but the company is growing much faster than PayPal and its market potential is far greater. PayPal is currently worth $18 billion - making AliPay valued at $12 billion. Yahoo!'s 40% is worth $5 billion now but will easily be $10 billion in three years.

By means of background, on Feb. 1, 2008, Microsoft offered $31 a share, or $45 billion, to acquire Yahoo! in an unsolicited bid that included a combination of stock and cash. At that time, Yahoo!'s shares stood at $19 a share, and Microsoft was trading at $32 a share. (Today Microsoft trades at $27 a share, and Yahoo! trades at $16 a share.)

Yahoo! rejected the bid, claiming that it "substantially undervalued" the company and was not in the interest of its shareholders. In January 2009, Carol Bartz replaced Yahoo! cofounder Jerry Yang, and six months later Microsoft and Yahoo! entered into a search joint venture.

I'm also thinking there is a peaceful regime change in Iran.

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