Lessons From Cyprus

The troubles in Cyprus may seem remote to many investors, and involve a small nation whose economy is not terribly influential to many businesses in other parts of the world, but the events unfolding there should be clearly understood by all participants in the "modern economy," no matter the level in which they participate in said economy.

The banking crisis in Cyprus provides a crystal-clear lens through which to examine some of the fundamental issues facing anyone forced to use fiat currency to obtain the goods and services they need to survive (which is to say, just about anyone reading this article).  Fiat currency means currency which is mandated by government decree (by "fiat," from the Latin verb meaning "Let there be," as in fiat lux: "Let there be light").  

Other forms of money have existed before fiat money -- forms of money which communities settled on to enable easier exchange of goods and services and to store value, whether in the form of pieces of gold or gigantic round stones with holes through their centers.  Because fiat systems are forced on the people by government dictate, and because that government then controls the supply of the money in a fiat system, the people participating in a fiat system are at the mercy of those controlling the supply of that money.

Most people know that the situation in Cyprus involves people standing in long lines at ATMs, hoping to withdraw money which they loaned to their banks, and that the banks are currently closed so that depositors cannot withdraw more money.  The reason that the banks are not allowing people to get their money back is that the banks are insolvent, and in most modern countries when banks become insolvent the government steps in to make sure that people can get their money back.  The problem in Cyprus stems from the fact that the government of Cyprus does not have the wherewithal to back up the banks (one troubled bank in particular, in this case).

Thus, the government of the Republic of Cyprus needed to turn elsewhere for help, first turning to Russia and then, as time dragged on and the government was unable to increase its income enough to meet its obligations, leading to a precipitous downgrade in its credit rating, Cyprus became a pariah whose debt  (bonds) could no longer be held in most investment funds, and its government had to turn to the European Financial Stability Facility for an emergency loan of ten billion euros.

Earlier this week, a loan was approved, after the initial proposed terms were rejected by the parliament of Cyprus.  Part of the stipulations of the final loan of ten billion euros from the International Monetary Fund included the "levying" (that is to say, "taking") of all the uninsured deposits at the failing bank, as well as the levying of 40% of all the uninsured deposits everywhere else on the island.  Uninsured deposits, in this case, means deposits of more than a hundred thousand euros (there is no explicit deposit insurance in eurozone banks, the way there is in the US, but there is an implicit assurance that deposits up to a hundred thousand euros are backed by the government; in the US, deposits are insured by the FDIC up to $250,000).

The idea that bank deposits could be seized by the government as part of the terms of a loan that government enters into because it is in dire financial straits itself obviously raises all kinds of emotional responses in those watching this crisis unfold, and the assurances that "most of" the big deposits are probably owned by shady characters from Russia (according to the press) does not change things.  After all, should honest depositors who have a lot of money see their funds levied just because other large depositors were involved in criminal activities?  Isn't that the same as punishing all the kids on the playground for the bad actions of a few of them*?

What observers of this train wreck need to understand is the fact that, while the seizing of assets in Cyprus arouses angry emotions because it is so blatant and arbitrary, and because 40% seems like such a shockingly-high figure, this same sort of money grab goes on in the vast majority of countries where fiat systems have been imposed.  It has been going on for years, and the "levying" usually amounts to a whole lot more than a simple 40% haircut.  Most governments are just a lot more careful to make it a lot less obvious.

We previously published an article discussing an American Institute for Economic Research (AIER) study entitled "A World of Persistent Inflation," in which we explained that when governments rack up a history of excessive expenditures (usually on wars or welfare or both), they can finance those expenditures by increasing taxation on their people (which is unpopular), or by increasing their borrowing through the issuance of bonds (which generally causes the rate of loans to go up, driving up the rates of borrowing on everything else, and which therefore also becomes unpopular after a while).  To artificially keep interest rates low, governments in charge of their own fiat currencies can mask the cost of their borrowing by printing more money -- inflating the currency.  The AIER study proves with extensive evidence that this last choice has been the overwhelming favorite of governments in charge of fiat currencies for the past seventy-plus years.

In the case of Cyprus, of course, the government could not really issue more bonds (their credit had been reduced to junk status), and the government could not print more money (they use the euro, so that option is closed to them, as it is for Greece, Italy, and the other eurozone countries, unless they decide to try to leave the euro).  Thus, what generally happens in a slow and stealthy way elsewhere just erupted to the surface in Cyprus like a big ugly boil for all the world to see.

But just because it isn't out in the open the way it is in Cyprus does not mean that other participants in fiat systems can breathe a sigh of relief, thankful that they do not have large portions of their wealth sitting in Cypriot banks.  As AIER has shown through their studies over the years, the inflating done by governments takes away the purchasing power of the currency that savers deposit just as surely as if those deposits were levied the way they are in Cyprus.  In fact, although a loss of 40% all at once is a heavy blow, the data AIER has been collecting since 1960 shows that the damage done by the inflation of fiat currencies over time has been far more devastating than any 40% levy (it varies by country and by currency).

This concept is one that all participants in the economy should understand very clearly.  It is one of the reasons why we have always advocated the allocation of some portion of one's wealth to the ownership of  the shares of well-run, innovative businesses, rather than simply "putting it in the bank."

* For a discussion of the morality of taking depositors' money, which the author explains really means "money loaned to highly-levered financial entities," see this article written by Austrian economist and former money manager Detlev Schlichter, published on March 20.

ORCL earnings miss

Equity markets today are reacting negatively to an earnings miss from Oracle, seen as a bellwether for enterprise IT spending.* 

While we are not shareholders of Oracle, we do invest in many other technology companies (see discussions in previous posts here and here for example), and we believe that the same tidal wave of increased data usage that we have been writing about for years will have a huge impact on businesses of all sizes.

The Street is reacting to Oracle's miss by punishing the company's stock (down over nine percent today so far) and the stocks of many other companies involved in the "unstoppable wave" of data, but we believe this reaction is overblown.  This is especially true in light of the fact that some of the revenue issue at Oracle was likely driven by company-specific changes taking place at Oracle, which deserve to be evaluated over a longer period of time than a single quarter or even a few quarters.

The bigger picture for investors is the importance of seeing through the sensationalist tendencies of the financial media, and the inevitable over-reactions of the market (which tends to react first and ask questions later), and to focus on getting to the real story underneath the headlines on any given day.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Oracle (ORCL).

"I figured I was the only one who knew the truth."

Legendary basketball center and power forward Moses Malone, who played in both the ABA and the NBA (he was the MVP of the NBA three times, including twice in a row in the '81-'82 and '82-'83 seasons) once said: 

I didn't pay attention to the things people said about me.  I didn't want to know what they were saying, because I figured I was the only one who knew the truth.1

This statement strikes us as one that is critically important in many spheres of life -- not only in sports but in investing as well.  

In the world of investing, there will be times when an investor may feel as though he or she is "the only one who knows the truth."  While it is probably not advisable to pay no attention to critical opinions about an investment, it is extremely important to realize that there will always be critical opinions, and it is extremely important to be able to determine when, like Moses Malone, one needs to have the confidence to proceed even if (especially if!) he or she is the only one who seems to know the truth at any given point in time.

While the subject does not always get much coverage in the "financial media," investors should realize that there are traders who make a living by purposely driving stocks down (typically by "shorting" the stock, among other strategies), and who may float negative stories in order to assist in driving stocks down for their own profit (and to the detriment of those companies and the investors who are "long" those stocks).  

We are not suggesting that shorting in and of itself is nefarious -- in fact, we believe it is a valid trading strategy and serves to keep the managements of companies disciplined.  Short sellers are often the first to uncover mismanagement or impropriety and act on it, providing a valuable check to market prices.  We have written about this in the past (see here and here).

However, some short sellers and research firms which cater to short-selling hedge funds will craft carefully-written articles which paint legitimate accounting practices as underhanded forms of "cooking the books," with pages and pages of examples full of accounting jargon to back up their case, which can take days to sort through.  When a story like this comes out, big investment firms that hold those stocks will often sell first and sort through the esoteric accounting allegations later, especially if the story is accompanied by a rush of selling.

To further exacerbate the impact of these hit pieces, and to help start the mini-panic in the stock, some short sellers may engage in the illegal (but difficult to stop) practice of "naked short selling," which is discussed in this Bloomberg News special report, which was nominated for an Emmy award for broadcasts which first aired between June 2006 and June 2007.

When such critics are at their most vicious, an investor in a stock under such an attack may watch a dramatic drop in the price, sometimes in a single day and sometimes over an extended period.  In the words of another great quotation, by American patriot Thomas Paine, "These are the times that try men's souls."  An investor in such a situation then has some hard work to do, to determine whether the criticism is valid, or whether those who are selling in a panic are wrong.  

That there are investment firms out there who specialize in making money by producing negative reports that will drive down a stock in order to make money is evident from the facts presented in a case between Overstock.com and two different investment-related firms, which took place between 2005 and 2009.2  In that case, Overstock alleged that a hedge fund colluded with a paid research firm to publish negative reports about Overstock.  

This discussion of some of the evidence presented in the court cases indicates that the research firm may have altered the reports to make them more negative at the request of their customers (who were often hedge funds shorting a stock), and that the hedge-fund customers of the negative research firm would even ask the research firm "not to disseminate the report to the public for a specified time period so they could obtain their position in the targeted company’s stock prior to the public receiving the information."

According to the testimony presented in the court cases, it also appears that the research firm would keep track of what they called "blow ups," defined as a stock-price drop of 20% or more in a single day, or 25% or more in a single week, and advertise their successful "blow ups" to potential or existing customers.

Both naked short-selling and deliberately misrepresenting the facts about a public company are illegal.  However, both practices are very difficult to prove, and therefore very difficult to shut down.  "Failures to deliver" can happen because of clerical errors, and in fact they do happen every day, without deliberate naked shorting involved (for more detail on this subject, watch the Bloomberg special report, or research the subject further on your own).  Also, when a story is published on an investment news website which portrays arcane (but legitimate) accounting practices as being nefarious or illegal, it is very difficult to prove that the story was intentionally trying to mislead -- it is very easy to argue that the author thought something was wrong, and was using protected free speech to call attention to what they mistakenly thought was bad accounting.

The court cases between Overstock and their adversaries were ultimately settled out of court.  However, the information which surfaced during the cases should be understood by investors who choose to allocate capital to a company in the public markets.  In this world, there will always be those with differing opinions, and there will sometimes be those who hold malicious opinions or who, for whatever reason, are actively involved in tearing someone or something down with their words.

A player in professional sports is familiar with such criticisms.  In fact, during one's career, it is sometimes said that a player's "stock" is going up or going down.  When critics were trying to tear down Moses Malone's personal "stock" as a player, he chose not to listen, figuring that even if he was the only one who knew the truth, he was going to eventually prove the critics wrong.  Today he is considered one of the fifty best NBA players ever to have played the game.

Investors who venture out into the often-brutal world of the public markets should learn a lesson from this basketball legend.

1.  Quotation from The Edge, by Howard Ferguson (1983), page 7-13.

2.  At the time of publication, the principals of Taylor Frigon Capital Management did not own any securities issued by Overstock.com (OSTK), nor did they during any of the proceedings discussed in this post.