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The Sherman Act

October 19, 2009


Good morning. A positive week for the market last week, even with a down Friday due to a couple of rocky earnings reports. The SPY closed at 108.89, up 1.5% for the week, bringing the total rally in the SPY from the March low to 62.3%. Friday there was positive earnings from Google, but not so positive from IBM, GE, and Bank of America. In fact, BAC still seems to be writing off some loans in the consumer sector and will continue to have some problems in that area for a while. The question is, how much of even a positive earnings announcement is already anticipated in the price? For example, IBM had net profit growth of 14% on revenue declines of 6.9% as they continued to concentrate on cutting costs. In fact their gross profit margin increased to 45.1%, resulting from a combination of cost cutting and greater relative growth in their high margin Services and Software segments. On this news the stock fell $6.34 (or 5%) on Friday, sort of begging the question of why? It might have something to do with the fact that the stock had already rallied 84% from its 11/21/08 $69.50 low, and 22% from the $99.50 level on 7/9/09. Sometimes the good (or bad) news is already in the price.

It is interesting that those firms continuing to do well in this environment, like IBM, INTC, and Google, continue to do so by having continuing pricing power in fairly non-competitive areas. Gross margins like Google reported, 62.8%, in an economic time when workers have little or no competitive advantage and the company has few competitors should be watched carefully from an anti-trust standpoint. I am certainly not in the camp that says profit is a bad thing, but any attempt by a would-be monopolist like Google or INTC to gain further market share through acquisition should be (and I know in this world I am probably trying to swim against a rushing stream) strongly discouraged. In fact, there was a time when the market share (81% of fourth quarter microprocessor revenue) of INTC in computer chips would be looked at with an eye towards a break up.

Unfortunately, we continue to stay (and will for an extended period of time) locked into a very strong political overtone to both business and the market. As reported this weekend in various sources the Obama administration is both shocked and concerned with the incredible opposition by the very financial firms (banks and others) that were bailed out to any new regulatory rules that would affect their business. Why are they so shocked? The hubris of these people (I am talking the Goldman’s and JPM’s of the world) has been shown to know no bounds. There are basically two sorts of economic systems (with a lot of iterations in the middle). One says that we are better off in a competitive system where individual people have a huge buffet of economic choices, and that the competition for these people’s business will drive innovation and quality in the private sector in a way not possible by a huge bureaucracy of rules and regulations and people trying to anticipate needs and wants. The second is just that, a hugely inefficient group trying to determine needs, wants, and trends and trying to determine what and how much is produced, and how it is priced. I am not trying to do Economics 101 in one paragraph, but that is basically the choice.

I do not think that there is much doubt that System A (with some inherent flaws) in more efficient than System B by a huge amount. To a large extent the predominance of a competitive system is what has created the economic miracle that is the U.S economy. We seem, however, to be morphing into some sort of third system. It is not new, really, that some have tried to “corner” an industry to the extent that they have pricing power far in excess of what a competitive system will allow. Clearly the Rockefellers and Carnegies figured this out long before me, that if you can control the normal competitive response to a high margin industry (namely, people will see the potential and enter the industry), either through laws you force through or by buying out the competition you will do better than you should. The real sweet spot is to somehow be a monopolist or oligarch in a supposed competitive economic system without the normal rules and oversight inherent in a socialistic type system. Like I said, this is not new, and the response to this type of thing were anti-trust laws, namely the Sherman and Clayton Acts.

It is a simple economic fact that virtually any business (given the degree of concentration in the space) is worth more to a competitor than to a third party. Take the simple case of a small town with two restaurants that currently compete. Restaurant B is not worth as much to me, assuming continued competition with A, as it would be to the owners of restaurant A, who might be able to nudge prices up without a competitive response if they owned both. Imagine how much more they would be worth if the combined owners could somehow talk the town governors into no new restaurants or liquor licenses for the next ten years. The Sherman Act was very clear, as Sec. 2 says “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce …. shall be deemed guilty of a felony.” They were not kidding, a felony. That is because they knew how valuable these less than competitive industries would be.

Why are we so stunned? I, for one, have been astounded by the lack of anticipation of how incredibly economically powerful the remaining four large Commercial Banks and few Investment Banks (especially now that they can do both) will be. I also know that they would want to be totally unfettered to use this power, and will use whatever means at their disposal (legal or other) to maintain this position. The Obama Administration is in a very serious fight, and even if they are waging it properly (which I doubt) they are probably outgunned. I can only imagine the lobbying interests and the promise of jobs and other stuff to staffers that will guarantee the status quo, even for a while. The general population senses something wrong, mainly because these people get paid too much, but really have no idea of how important going forward this fight is. Even the least astute among us does not believe that the average employee at Goldman or wherever would do as well if the competition was a little more robust. I think all would agree that the mergers in banks leaving the top four Banks with 64% of the credit card business in 2008 is probably not good for card holders, or maybe the economy as a whole. I am surely not shocked rates and fees are up, and these Banks are resisting any attempt to regulate them or make the industry more competitive.

Other than being a concerned citizen, why should you or I care? How does it affect our portfolios? It means that we have to be on the news and the potential political interaction between companies and pending legislation or rules way more that we had to historically. When we see Morgan Stanley buying out their warrants from the government early, and on seemingly favorable terms, we need to at least think about others getting a break on terms on their deals with the government. One problem with that is that the government has been very inconsistent in its dealings with the individual firms, obviously treating GS and AIG a lot different than Bear or Lehman. The quick out given MS might not apply to Citi, maybe because of mood or public sentiment at the time. Maybe AIG will get a chance to renegotiate the terms yet again, of a few years from now make a quiet deal when all if forgotten, maybe not. Makes trading tough. I really do feel that the industry has the Obama group on the defensive, it would seem inconsistent (although probably proper) to give massive amounts of money to a group to save them, then regulate them to the point where they cannot pay you back. The point may be that they actually need the returns normally associated with a monopoly to have even a chance to pay you back, causing a real conundrum. Do you now allow these Banks to stick it to the population to “make” the money needed to pay back the population whose money you just gave away? Tough problem.

I know I mentioned this last week, but I think, and some of you have seen the proof in your accounts, that we need to be long this financial group (not huge, but some). I think the Obama group loses this regulatory battle, unfortunately, and we need to be on the winning side (much as we hate it). Other than that, I continue to try and resist taking huge long positions in the market in the new world of falling dollar, rising market. I will stay a little long, I do want to participate if the rally continues, but I am worried. All these earnings numbers appear to be good only because they have been talked down so much, and are coming in the face of stock prices that have already inflated in anticipation. I am also continuing to look for a way to get most of us long, or longer, in the oil complex, but right now the volatility is increasing going out, and I will not initiate a trade with the volatility edge against us. Maybe we will get a chance this week.

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