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Wednesday, August 31, 2005

EuroZone - breakup on the cards

The EuroZone like Japan has languished as it struggles with national reform and regional integration. Integrating regions with entrenched regional identities was always going to be difficult, particularly when these countries have very different identities. My forecast is that the EuroZone is going to suffer a breakup based on values. I can see several blocks, namely:
  1. Northern countries: Germany, France, Netherlands, Sweden, Austria, Finland
  2. Southern EU countries: Spain, Portugal, Italy, Greece
  3. EU Tigers: Poland, Czech Republic, Hungary need not separate, as they might closely allign themselves with the Northern EU countries.

These countries can still integrate at a certain level such as trade tariffs, but they will not integrate on currency & interest rate policy or public spending priorities. A the moment, the saving countries (France & Germany) dont need higher interest rates, but the other countries do. EU monetary growth is 4x faster than economic growth - thus monetary policy is too easy.

Australia - Progress Report

The Australian economy has long been recognised as a `commodities play` because of its reliance on mineral & agricultural exports, but in fact the economy is considerably stronger than that precisely because of that dependence. If global demand for commodities subsides the $A declines and offshore commodity revenues (priced in $US terms) are preserved. Better still - the country benefits from increased tourism. The housing markets tend to suffer from higher interest rates as the Reserve Bank of Australia attempts to stabilise the economy. The economic paradigm has changed recently though.

Political Organisation
Australia has a stable democracy. The encumbent Prime Minister John Howard is the longest serving PM since his mentor Bob Menzies held power in the 1950s and 1960s. Both leaders led their conservative Liberal Party to successive election victories. Both leaders oversaw periods of economic prosperity, but in Howard`s case, it was largely by default, with no meaningful opposition.

The Howard government has however been disciplined in reducing the huge public deficit accumulated under the Labor Party in the 1980s. The debt has been reduced from $168billion to just $28bil, and that is likely to be a bottom given the desire to retain a liquid bond market.

My belief is that the Australian government will attempt to expand its immigration program to lift subdued domestic demand in future, as well as provide marginal support to nation-building infrastructure programs. In the process it hopes to stimulate new investment in under-funded infrastructure, as well as reducing debt in per capita terms.

Economic Activity
The Australian economy has been one of the fastest growing OECD countries over the last decade - largely as a result of labour market reform, privatisation of key state-owned enterprises and subsidies to the housing sector, in addition to falls in interest rates. The late 1990s and early 200os were particularly strong as mineral export prices & volumes improved and housing prices took off. In the last 3years, China largely accounted for the bulk of the incremental demand, and that demand will evaporate in future when the US & Chinese property markets fall.

Improvements in Australia`s terms of trade have been matched by increasing imports from China, which have helped to keep domestic inflation low, as the $A has rallied from $US0.48 t0 $US0.80, and since fallen to $US0.76. During the 1995-04 property boom, housing prices rose by an average of 250%(?), going from 3x annual average incomes to 9x, as prices rose with incomes and their capacity to borrow (new jobs & lower interest rates). The concern is that the bursting of the US housing market by high oil prices & excessive household debt will undermine global economic activity. We can thus expect a much lower $A and higher interest rates, which will take a huge hit on the Australia property market.
There remains considerable optimism about the health of the global economy. Iron ore & coal annual contract prices are up 50%, and such companies along with the oil companies are sparking an investment boom in WA and NT. These investments will take 2-4 years of construction. Investment in other areas is less active because mineral prices in Australia have not risen greatly in $A terms because of the strength in the $A. The positive is that as mineral prices fall, so will the $A. Just gold prices in $A terms will perform very well.

Equity Markets & Corporate Earnings
Australian equities posted solid earnings in 2004-5, and the minerals sector which renegotiated annual contract prices in Mar'05, will see stronger earnings this year, and those contract prices are likely to be preserved in coming years if the $US weakens.
The broader market is not likely to repeat its strong 2004 growth since high household debts and rising interest rates are likely to undermine retail sales. Inflation initially can be expected to boost earnings since the value of capital will boost balance sheets, whilst corporations are able to pass on costs. Corporates have resorted to boosting dividend pay-out ratios (DPRs) from 77% in 2004 to 80% in 2005. Two companies going against the broad trend:
  1. BHP Billiton has the made the lowest dividend payout ratio of 23% in years as it embarks on a $6bil capital expenditure program to boost output. This trend is evident across the resources sector, with Div Payout Ratio (DPR) in the resources sector falling from 49% to 31% between 2004-05, suggesting resource companies will have some nice profit/dividend growth in future, whilst the broader market is stretching itself. Clearly they are hoping the market will react to stronger metal prices in the short term and higher dividend yields (DPRs) as the commodity prices correct.
  2. Telstra: The new CEO of Telstra has disclosed that the company has under-funded capital expenditure by $2-3billion over 3-5 years to boost earnings, whilst at the same time delaying the adoption of ADSL at $30/month. Under-investment in the past (reflected by 14% line faults) means higher investment in the future, so lower earnings, and likely squeeze on margins, particularly if the Fed govt proceeds with a break up of Telstra. Lower dividends, particularly since the payout ratio from earnings is very high.
    Telstra’s dividend of 40c per share was based on a pay-out ratio of 93% (up from 75%) - suggesting they retained only 7% of earnings for capex. Its intention is of course to boost the share price for the privatisation, whilst not disclosing the capital investment required to maintain services. Telstra had to borrow $550mil from its Special (share premium) Reserve to fund this dividend, and the same for the special 2006 dividend.

Housing Market
Recent housing figures (July'05) suggest households are taking comfort in the persistence of housing prices, interest rates and strong labour market. The consequence has been a strong recovery in the housing refurbishment market. The consequence of this is likely to be a lift in interest rates by 0.25%, particularly as inflationary pressures are high.

Strong inflation has yet to register in the CPI figures, but it seems likely in coming quarters as:

  1. Wages rise: Wages rose 7.4% annualised in the Jun’05 qtr.
  2. Employment: The labour market remains tight with the unemployment rate still at 5%.
  3. Purchasing Power Index: The PPI, a measure of producers cost variability has increased due to higher fuel & material costs.

The Forex Market
The $A can be expected to trade higher due to the strong momentum in the housing market. Australia will also benefit from strong terms of trade as the recently negotiated mineral export contract prices still have some time (9mths) to run. A lift in interest rates will only help the $A remain high, but in6mths time it will come off strongly as commodity prices fall.

China - Progress report

This is a review of the Chinese economy which I will update as snippets of information become available. It will initially be a conceptual overview, but I will add statistical evidence for my views (from other sources) as I integrate them.

Since the 1990s the Chinese economy has expanded with increasing momentum as western companies gained increasing evidence that the Chinese government was adopting pro-market reforms. Despite a decade of very strong growth, the Chinese economy is still relatively small and export-orientated. With a population of 1.3billion - there is considerable potential for market expansion, but thats only as long as western companies have confidence in the stability of the region.
There is strong evidence to suggest stability will be maintained. Citizens in the poor rural western provinces are prone to move to the east coast - the centre of investment - rather than protest against the disparity between city & rural incomes. The problem however emerges in future - when China`s export-based industries can no longer expand and those millions of rural farmers migrating to the cities cannot get a job. They might be joined by homeowners unhappy with the collapse of the property bubble. Will they resort to protests? This seems likely, but with a 10mil strong military force, the Chinese government is well-positioned to suppress it.

Political Organisation
China is a country in transition from a communist regime to a market economy. That is a long path requiring a change in values - foremost in government, but since the government has the power, it usually takes much longer for market participants to assert their individuality. The Communist Party has moved from its hard-core socialist values. Today the Communist Party is different because free markets have demonstrated their practicality, foremost to party leaders at local & provincial levels, who are able to earn significant bribes for state approvals and licences. The argument is often made that China does not permit democracy because people don`t have the right to form opposing political parties. True. But the party is no longer an ideological entity it once was, rather an political organisation in which various factions fight for power. There is some value in this. We don`t see the appeals to populism evident in western democracies which undermines political integrity in favour of short term expediency. China is playing catch-up, economically and philosophically. Participating in a market economy implicitly changes values. People develop a sense of ambition, their own autonomy and values, and when they have achieved a level of comfort, they seek to express themselves.
There are alot of expatriate Chinese in Australia, Canada and the USA, which will similarly play an important role changing values in China.

Chinese economy
The Chinese economy is booming - largely because its cheap labour, potential market and technical skills make it a compelling proposition for western investment. The country is appealing for raw material processing, assembly, but increasingly companies are shifting all their manufacturing capacity there. The country is growing so rapidly that there are severe capacity bottlenecks on infrastructure and raw materials, leading to slowing productivity and higher prices. For these reasons some companies are reluctant to make China the centre the focus of their manufacturing.

China is undergoing a boom in foreign & domestic investment, but most of the activity relates to just 3 sectors:
  1. Property: Higher incomes earned by Chinese people, mainly working in foreign JV companies or those offering technical skills or self-employed successful business people are fuelling a property boom. In addition, expatriate Chinese are reinvesting in Chinese real estate.
  2. Export industries: There is a huge influx of foreign investment in factories, assembly & processing plants.
  3. Infrastructure: All this activity is stimulating a demand for basic services, eg. Power, roads, highways, railways, gas, water & sewage reticulation systems, etc.

The consequence of these activities is that fixed capital investment accounted for 50% of GDP in 2004. This causes an immense disparity between income capacity and spending. The problem with this is that capital spending is servicing export markets, making the Chinese economy highly vulnerable to a slump in global activity. The problem is that there is a serious risk of a slump because:

  1. Asian countries have adopted japan-style mercantilist policies at the expense of western interests, as well as the well-being of their own people.
  2. The United States has propelled its economy by adopting an overly-stimulatory monetary policy that has sparked a property boom on top of an equity boom. This has placed US finances in jeopardy, requiring higher interest rates and undermining its currency.

Japan - Progress Report

The Japanese economy is regarded as holding considerable promise, but there is a pre-qualifier - substantial reform.

Political System
Japan has a western-style democratic institution in name only. Institutions are a facade in Japan. There is a legal system to protect civil rights, but no one uses it. Many marriages are dysfunctional, but there are few divorces. Most have a job, but can`t justify it.
Nevertheless, the political process is increasingly becoming more like the west. Historically political power has been retained by the Liberal Democratic Party (LDP), which has won all but one election (1994-5?) since the US Occupation. Within the LDP faction leaders held most of the power because of their capacity to generate campaign funds. Money has always meant power, and in Japan this has meant considerable misallocation of postal savings & tax receipts into dubious public works programs. Corruption was an accepted part of politics until the late 1990s. Adoption of the Political Funds Control Law was however discouraged corruption, and thus weakened the power base of faction leaders. Faction heads unable to find a leader to ignite a party lagging in the polls, chose a 'lone wolf' in Junichi Koizumi. To their surprise, Koizumi has emerged as a populist leader and a reformer. His popularity gave him the power in the recent Sept 2005 election to oust the old faction MPs who opposed his reform agenda (Postal Savings Proivatisation Bill), and replace them with popular public figures with no political history. The strategy worked, and Koizumi was able to swing more votes, and thus a mandate for his reform agenda. At the same time, he was able to introduce women MPs into the parliament and unify the party behind him, as well as increase their power.

Its apparent that Koizumi has learned a great deal from US politics - whether under the instruction of US political analysts or his own minders. He danced with Richard Gere, appeased conservatives by visiting the controversial Yasokuni Shrine honouring Japanese soldiers, published his own Elvis hits, named his website after his hair style and expediently (before an election) appointed a string of women to his party, in the hope of drawing alot of support from women for his pro-reform agenda, since few young Japanese women vote.

During the last 4 years Koizumi has been unable to convince LDP faction leaders of his reform agenda. Some opposed it outright, others had their own schemes. He responsed by ousting those opponents, replacing them with outsiders whose popularity was tied to his, and made the Postal Reform Bill the focus of this election. In the wake of the election, the factions are cosiderably weakened. Ryutaro Hashimoto, the Ryotaro 'Hashimoto faction' leader has retired, and another faction leader - Shizuka Kamei - has been purged, while their factions have lost 15 and 12 lower house seats respectively to Koizumi's benefit. Both leaders opposed his Postal Reform Bill. He got his `reform mandate`, meaning that the government will in its next term of government be able to achieve a great deal. The big issues are:
  1. Social Security Reform: The social security system costs are rising by a modest Y500 billion per year due to the country's aging population. In 2004 social security expenditure rose by 0.8% to Y84.27 trillion.
  2. Health Insurance System: Every year the health insurance system has a funding shortfall of Y300 billion covered by the government.
  3. Pension System: The number of aging baby boomers retiring will increase greatly after 2007. Pension, nursing & medical costs accounted for Y59.3trillion (70.4%), with just Y3.16trillion spent on children, family support (including child rearing & child birth benefits), equal to 3.8%. Pension benefits amounted to 53% of payments in 2003 and medical benefits 31.6%.
  4. Bureaucracy: The public service is over-paid by up to 20%, and in need of cut backs. Japan Post is one of the worst offenders.
  5. Public sector debt: A great deal is made of the public sector debt (150%of GDP), however it could quickly be slashed by a series of privatisations, whether its NTT, Japan Post, Japan Airlines, Tokyo Electric, Tokyo Gas, airports or other government-owned infrastructure. The government can also resort to printing money. Importantly this public sector debt is mostly owed to Japanese citizens, so a new tax would just redirect the burden to a more prosperous sector of the economy.

Substantitive reform is needed in these areas, and its mostly likely that the consumption tax will be increased from 5% to 10%. But the public sector represents just 25% of the economy. Koizumi will need to pass significant reforms in the private sector to boost productivities and incomes, otherwise a higher consumption tax will just undermine consumption. In Koizumi's favour is the fact that the real estate market is priced on 'attractive yields' and foreign investors are keen to invest in Japan given their over-priced domestic markets and the possibility of reform in Japan. Facing a sanguine foreign export market, domestic economic growth will require income growth - wich will drive spending and the housing market to underpin confidence. With so much money swashing around, there is little chance that softer foreign markets will undermine that.

The government is attempting to get its budget under control. It has postponed an increase in the GST until domestic spending recovers. Public debt serving costs rose 11.1% in 2004-5, whilst grants to local governments are up 4.7%. The Japanese government proposes to cut 10% of civil servants in coming years.

The election result left the LDP with 296 seats (excluding former LDP members who ran as independents in opposition to the Postal Savings Reform), DPJ 113 seats, New Komeito Party 31 seats, Japan Communist Party 9 seats, Social Democrat Party 7 seats, Independents 18 seats, with a total of 480 seats contested. Its thus apparent that the LDP can adopt its 'reform mandate' without the support of its Coalition members - the New Komeito, and some of those former-LDP might reform the party. The LDP only needed 269 seats to ensure the smooth passage of legislation through the Diet. The result gives the LDP a majority position in all Lower House committees. The LDP performed well in the urban areas of Tokyo, Chiba and Kanagawa, areas traditionally strong for the DPJ. The New Nippon Party won just 1 seat, showing that Japanese voters have little faith in 'new institutions', and that they vote for parties not candidates.

Koizumi prior to the election claimed to have no plans beyond his contract expiry in Sept'06. Yet given his overwhelming support among LDP members and the wider public, it seems likely he will stay on to implement his reform agenda. Its likely his comments were made in the light of his stalled agenda. To date he has hardly achieved anything - so to date he's not leaving much of a legacy. Perhaps his greater influence has been to shift executive government from deal-making, consensus-building to image-driven, media-managed policy based on simple messages for the public. If Koizumi leaves, Deputy LDP Secretary General Shinzo Abe seems the most likely replacement. He's 50yo, hawkish on China & North Korea. He's popular with women despite his attitudes to sexual equality. He likes to visit the Yasukuni Shrine.

Japanese Economy
The Japanese economy has been subdued since 1991 (about 15 years) as the 1980s property bubble deflated leaving the Japanese banking system in tatters, and undermining personal incomes and domestic consumption. The export-orientated of the economy has remained surprisingly strong (despite a strong Yen)due to subdued domestic demand (for imports) and strong exports to a bouyant US and Chinese/Asian economies. In recent years, inconsistent growth in the Japanese economy has largely come from Japanese capital spending tied to cyclical fixed capital investment and Chinese/US-inpsired export demand and foreign earned income. Since 2004 the Japanese economy gained a little strength from a recovering property & construiction market (after 15years of decline averaging 9% per annum) . New investment was sparked by record low interest rates, increasing preparedness of banks to lend, and high yields on property. Already there are signs of oversupply of residential apartments in & around Tokyo, which is why a rise in household incomes is needed to sustain the economic recovery. This can only come with productivity-generating reform. High oil prices and softer US-Chinese markets will not help.

Japanese household spending fell 3.3% in July05 YoY , due to an average monthly fall in household income by 3.6% to Y572,399. At the moment the gains are patchy. Certain retail groups like furniture and clothing
have benefited from real declines in prices from Chinese imports. More progress is needed on retail reform and utilities to reduce the cost of living. The other retail sector to record strong growth (9.1%) was housing.

The financial system
The Japanese economy has stagnated for the last 13 years whilst households have seen their home equity eroded and backs have haemorraged under the weight of non-performing loans. The problem was that corporations & households were encouraged to debt finance capital expansion, and this spilled into household & public consumption, some of it frivilous spending on rural resorts, civil infrastructure, etc. In the last 13 years the banking sector has been reluctant to lend to households, while corporate demand for finance has been weak. Instead the Japanese banks have rebuilt their reserves by lending overseas to lifting margins. Now that asset prices have stabilised, Japanese banks are feeling more confident about lending. They have made considerable progress writing off bad loans to clean up their balance sheets, such that bad loans have fallen by 28% in the year to Mar'05 to Y24.9trillion ($US240 billion). This figure might however be treated as conservative. Regardless, it will take time for bank credit expansion to get into full swing. There is no doubt more progress can be made in the financial sector. Private banks in Japan trail other developed markets in productivity and innovation. It would not be surprising to see Koizumi allow foreign banks to enter the market, and privatising the Postal Savings & Insurance Scheme is the first step towards an improvement in the Japanese banking system. Privatising the Postal Savings Scheme would mean savings would no longer be channelled into public infrastructure projects, and its likely that interest rates would rise.

The Outlook for Japan
If the Japanese government is able to implement substantive reform, we might expect the government to print money to rein in the excessive public debt (150% of GDP). Most of this debt is held by Japanese institutions and investors at nominal interest rates. Such inflationary pressures would create a `money illusion` to rebuild confidence, whilst the government embarks on its reform program, which would deliver real savings for households.


Postal Savings Reform - the start of something bigger: PM Koizumi tried to sell off the post offices (Japan Post) but failed because LDP factions didnt like the impact on rural electorates where the post office is subsidised by generous rent & payments unrelated to turnover. There are some 19,000 privately run post offices in isolated rural areas those existence cannot be justified. Japan Post has been in the red since 1997, and 60% of its expenses are labour costs. This largesse will not change under the current proposed reforms, but will likely be revisited if he wins many seats. Having failed on that, he turned his attention to selling the Postal Savings scheme. This organisation controls Y340 trillion in pension & depositor savings, paying minimal interest. Even members of his own party oppose sale of this government cash-cow. Its because of non-discerning, conservative investors that interest rates in Japan are so low, so if the Postal Savings did not have a political purpose then interest rates would be higher, as they would be chasing higher returns in property, equities and overseas, rather than Japanese govt bonds. Foreigners are not interested in Japanese bonds, so interest rates will have to rise. Thats good for savers. PS: Japanese debt is public, and mostly held by Japanese institutions and individuals. Thus Koizumi need only increase tax or print money to repay it. I bet he will print money to stimulate the economy after he gets some reforms through. This will lift consumption, counter deflation and make everyone feel good about more reform. It will create jobs to replace those lost by reform. Go Koizumi!

Global Economics 101

The way information is packaged today its very hard for people to develop or maintain an understanding of global economic activity or its sustainability. These are important issues to us all because we all hold assets, or depend on economic cycles to sustain our livelihoods. The problem is that university studies are lectured ideas detached from reality, novices get analysis of raw data divorced from any global context, or their personal investment objectives. Even the professionals have a hard time coming to terms with all the information, and maintaining a realistic perspective. Its not just a challenge to understand trends, but harden still is determining when trends will change. This is particularly important when markets are subject to sudden moves, ie. stockmarket crashes.

The Circular Flow of Income
The first task in studying the global economy is to focus on what is important. The answer to this in simple terms is to understand what is maintaining current economic activity, and what will sustain it. The answer to this is:
  1. Investment: Fixed capital spending is mostly undertaken by businesses (factories, etc), households (small businesses & homes) and governments. Small businesses are generally less important because of their difficulty raising finance, though there are medium sized companies with an earnings history or assets which have no problem. Governments similarly have no problem raising funds, however most of their expenditure is recurrent expenses, and not of a capital nature. Government (public) spending is generally less productive to the economy, and certainly harder to measure the benefits because they are provided as `public goods`.
  2. Savings: Savings refers to more passive forms of investing retained wealth such as bank deposits, fixed income securities, bonds, etc. These instruments are packed by intermediaries such as exchanges, merchant banks and fund managers.
  3. Final Consumption: This refers to retail consumption of finished goods & services by households. There are 2 types: Non-discretionary spending is the consumption which is less sensitive to changes in wealth or economic activity. eg. Food, utilities are considered inelastic sectors because we always need food, water, power, etc. Discretionary spending tends to be on luxury
Real Wealth and `Money Illusion`
Real wealth is nothing more than a market perception of the capitalised value of an income stream, whether it pertains to vacant land, your job, a car, house or factory. Your wealth is often assessed by market prices because things - whether tangible (physical) things or intangibles (like goodwill or intellectual property) have value in use or exchange.
Real wealth can continue to grow as long as real income in the economic system continues to grow. Growth in incomes sustains more spending, growth in asset prices and higher levels of debt accumulation. Such growth is only undermined by a deterioration in the quality (productivity) of investment such that new investment is unable to sustain growth in final consumption.

Cause of Economic Cycles
The global economy has been in one of the strongest periods in the modern era. Economic cycles tend to be initiated by 2 sources of stimulus:
  1. Government stimulus in the form of public spending, whether debt-financed or funded from tax receipts or printing money.
  2. Lower interest rates: In most western markets short term interest rates on deposits and loans are determined by a country`s central bank. Depending on demand for funds, these rates impact on long term bond rates as well.
  3. Private fixed investment by businesses: Businesses only invest in fixed capital in anticipation of increased consumer demand, because their inventories are low or because investment in technology offers superior returns in the long run.

Generally an economic cycle cannot start until the causes of recession/depression have been overcome, namely a collapse in asset values (property & equities), surplus production capacity or excess inventories. The duration of any recession will depend on the size of the excesses, the industry extent of the over-capacity and surplus inventories. Inventories can clear in months, but with a collapse in consumption, it can take years for excess capacity to clear. Fortunately not all production capacity is equal, thus rationalisation (ie. the closure of high cost factories) can often allow new investment sooner than was permitted when unions and governments gave industry protection. Markets are now much more responsive to market signals, so they recover much more quickly. There are however markets which are slow to clear because of government interference in the economy, eg. Japan has suffered a 13yr recession because of lack of financial disclosure, government propping up failed businesses and lack of reform to such practices. Such practices merely replace productive investment with unproductive types. Poor businesses have to fail to create opportunities for the successes.

Efficient Market Hypothesis
The global economy is only as efficient as human management systems and human nature permit. The limits of human endeavour are not a constant, but a growing sum since our capacity to do more grows with increased sophistication, technology, understanding and cooperation. Management systems are critical. The most important management systems pertain to the way organisations are structured, whether public enterprises or private corporations, and even the way individuals organise their lives to achieve productive goals. As long as a management system is generating more value to themselves or others with fewer resources (money, time or labour), then wealth is being produced. The formal economy recognises such productive endeavour through the money economy, whereas 1000s of years ago it was achieved inefficiently through the barter economy.

In so far as there are still management systems operating under sub-optimal conditions, there will remain a great deal of capacity for the global economy to grow. Consider the opportunities:

  1. Poverty & war: There are countries in which governments don`t have the freedom for outside investors to introduce organisational & financial resources to improve them.
  2. Collectivism: There are countries which continue to operate sub-optimally under tyrannical rule (with fear as the standard) and entrenched social values which seek to preserve the vested interests of those in power at the expense of those who don`t know better. eg. Poor, uneducated people clutching at straws. Sometimes even wealthy ones. Another example of this is protection of industry - where its a virtue to protect the weak, as opposed to defending victims of injustice. eg. Trade tariffs, quotas, subsidies all lead to higher costs in sum. It does however serve narrow vested interests who retain political power.
  3. Knowledge: There are people and organisation executives who don`t have the access or awareness of best management practices. This extends back to childhood education for many people, and it might yet extend to their children. Individuals need formalised systems as much as companies to overcome bad habits, to preserve control.
  4. Sense of life: There is a crisis of confidence in many societies because of entrenched values. Societies have a dominant value system, and experiences reinforce either a positive (proactive) or negative (safe, reactionary) system of values. It takes great leaders to result in either value system dominating - whether Thomas Jefferson (USA) or President Castro (Cuba).
The importance of perspective lies in understanding the significance of any factor on the total system. Having recognised that investment, savings and consumption undermine economic activity, its important to appreciate where its happening.

A great deal of focus is given to China`s economic ascension, but consider that its only a processing & assembly plant for western consumers. Still very little consumption occurs in China because the population is still very poor, even with a population of 1.3 billion. It remains a great promise for the future though, but also a great risk. ?? Might China invest abroad.

Wednesday, August 24, 2005

Historical Economic cycles

The global economy has undergone a number of important expansions over history. In recent history, these included:
  1. 1904-1929: This period ended with the Great Depression (25 years).
  2. 1947-1974: This period was ended with the early 1970s oil crisis (27 years).
  3. 1982-2003+: The current cycle has yet to reach an end (21 years to date).
expansion has undergone 3 major sub-rallies:
  1. 1st cycle: This lastest from 1982 to 1990. It was ended by higher oil prices and inflation.
  2. 2nd cycle: This latest from 1992 to 2000. It was ended by the dot-com crash.
  3. 3rd cycle: This started in May 2003.

These cycles are often said to be driven by technology, but really they are being driven by monetary credit cycles. Only in `easy monetary conditions` do a range of technologies get funded. These cycles collapse only when the stimulus which sustained them can no longer be sustained. Slowing productivity gives way to higher inflation. The opening up of China & other 3rd world markets have extended this cycle by keeping inflationary pressures subdued.

We do need however to recognise that whilst inflationary pressures have been minimised as industrial capacity has shifted from developed countries to developing countries, this cycle has been stifled by lack of reform in the EU and Japan - the 2nd and 3rd largest markets, and ultimately 2 of the 3 major consumers of producer country products. With US consumer capacity max`ed out, the capacity of these 2 economies to carry the burden is poor. This has to be inflationary, particularly when combined with monetary policy.

Despite the loss of jobs in western markets, US employment is fully employed. To some extent there are early retirees as wealth explodes, whilst a great many workers are migrating into the service sector.

There is some expectation China & other developing economies will extend this cycle, but what of the developed countries - Japan and EU - which are stifling it. Japan is at least showing signs of reform, but it will take time.

Investment & Tax Strategies - Australia

There are a great many financial planners and accountants recommending diversification and `buy and hold` strategies. Their argument is that broad equity indices have grown in real terms of XX% per annum over the last 20 years. There is no disputing those facts, but several points need to be made:
  1. These long term yields depend upon your period of observation
  2. Current equities are at record PE ratios - due for a tumble

There is no question that humans are not omniscient, and thus should diversify, but you get to a point where you can only watch and understand so many markets, so it might be a better decision to monitor a particular set of markets more closely than more markets. This also guards against an unforeseen `systematic risk`. A systematic risk is a concealed risk that a market might fall because of falls in other markets. In the last 20 years, the US and other western governments have greatly increased money supply, credit growth, fuelling an asset bubble, starting with the bubble in Sept 2000, and more recently property & broader equity bubbles. We are thus due for a huge fall in equities and property markets which will quash consumer & business spending.

In 1928, investors taking positions in the market would have had to wait until the 1940s to recoup their capital. Quite apart from the desire to conserve capital, there is a huge opportunity cost in taking unnecessary, ill-timed investments.

Technical analysis offers investors some simple tools for understanding investment timing - when to buy and sell. There is no point investing in markets if there is evidence its in a long term downtrend -unless you are trading for short term profits. It makes more sense to identify growth markets.

When asset values are artificially inflated by `easy monetary policy` it makes sense to invest in real assets - as opposed to `paper-inflated` financial assets like equities, property. The real assets are commodities (food, precious & industrial metals, energy). The best real assets are those that are not impacted by weaker global demand - thus gold and food make the greatest sense. Go for the more profitable equities market if the yields (PERs) are not inflated by bullish market conditions.

Risk Management
There is a perception that investors can protect their position with derivatives, but these instruments are voodoo, since there is no escaping the existence of a counterparty to any `unlimited` risk which is limited by the counter-party. Someone is wearing the exposure, and given the extent of derivative contracts outstanding relative to the physical market, there is huge potential for derivatives to destroy financial markets. In a crash or unexpected market move, there is every likelihood that derivatives will offer little or no protection, and the market is too large for any central bank to prop up. Furthermore, its your managed funds that are at risk.
There are only a few guidelines for risk management:
  1. Avoid systematic risks
  2. Avoid investing more than you can afford to loose.
  3. Use technicals to pick entry & exit points. ie. If the market is telling you that

Risk is often inversely correlated with returns, but in fact we all have a different perception of risk, and a different understanding of markets. Understanding market fundamentals is a full-time job. My advice is try to identify analysts that pick market trends more consistently. You dont normally find them in newspapers, or among financial journalists. I recommend:

  1. Morgan Stanley GEP Digests Archives
  2. Kitco essay contributors
  3. The Conference Board
  4. Max Walsh `the Bulletin`

Most get issues of timing wrong, which is why fundamentals commentary should help you identify the opportunity, but charts should tell you when to buy and sell.

There is a ATO tax rule that saids if you buy stocks mainly for gains, you may attract the full income tax rate rather than the 50% concessional rate. Under Section 118-20 of the CGT rules, income tax rules take precedence over capital gains tax laws. Peter Bobbin, senior partner of Argyle Partnership saids `if investors buy stock mainly to make gains, they may attract the full income tax rate rather than just the 50% concessional capital gains tax rate`. Fortunately my investment strategy is not about making gains, in fact I don`t invest in alot of the companies I identify here. I invest only in those companies with whom I respect their objectives and management. So I leave the tax to all the `vulgar materialists`. eg. For instance last year I choose to make a loss even though charts said the market was in a long term decline.

`The common wisdom is that you get a capital gains tax concession if you sell shares after holding them for 12 months. But that is not true. You only get the 12mth CGT concession where you purchased the shares for the income they would generate, such as dividends` says Bobbins. The only way to avoid such nonsense is to incorporate.

Does anyone still believe tax is `well-intentioned` welfare redistribution? Are you tired of trying to jump through the ATO hoops and hurdles? FIGHT FOR REFORM - limit the unaccountable power of governments! The ATO is prepared to enforce this law - fighting in 2004 against a women who traded St George Bank shares.

The easiest solution is to document the reasons why you buy a share. If you intewnd to claim the concession, then your stated aim should be to generate income, not to make a capital gain. If you incorporate, then you are able to realise gains at the flat corporate tax rate.

Debt market outlook

Attached is a todays news report from Bloomberg - see My comments in bold brackets.
`Investors started to push bonds higher again in afternoon trading as crude oil and natural gas rose to records on concern a storm heading for Florida may threaten production platforms in the Gulf of Mexico`.``There is this underlying demand for fixed income which has restrained the increase in yields'' said Christopher Sullivan, chief investment officer at the United Nations Federal Credit Union in New York, which manages $2 billion in debt. [Doesn`t he have this around the wrong way. Aren`t the high yields attracting demand for US treasuries, pushing up bond prices, thus reducing yields. ie. Supply-demand. I`ll have his job].

The price of crude oil surged to $67.40 a barrel in New York, up 49percent from a year ago. [How many economists predicted that? Only a few]
Treasuries also benefited as the government sold $20 billion of two-year notes at a yield of 4.014 percent. A category of bidders that includes foreign central banks bought 44 percent of the debt, the most since September. There were $2.28 of bids for every $1 sold, compared with the$2.14 average for the previous 12 sales. [Not surprising that foreign bidders dominated given that US investors are still pooring money into real estate. So expect higher demand for white goods - durables, sustenance of the boom a bit longer, but those US treasury yields are now 4% - not1%, so the US deficit is going to rise greatly. The US is paying more for oil, its paying higher interest on its foreign-held deficit, and the demand for foreign-manufactured white goods will be up. So long as property prices are rising stronger than interest rate payments, US house holds might feel comforted by the high level of economic activity, at least until house prices fall. A few bad numbers could easily kill a Japanese recovery, starting with high oil prices. Mind you the Japanese don`t relyon cars nearly as much as the Americans. Chinese factors do. But oil is likely a bubble too, and like housing, it will go higher. Certainly to$US75, perhaps $US100/bbl if the US Fed start cutting interest rates prematurely to maintain activity. Lastly, US imports will rise (ie. higher deficit) because Americans are paying more for Chinese goods - thanks tothe US deficit. Since the US has no competitive advantage in the Chinese product fields, this does not give the US a competitive benefit...rather Indonesian might benefit over China].``The 4 percent coupon may have enticed some people looking to park moneyin the short end of the curve,'' or shorter- maturity debt, said Rick Klingman, head of U.S. Treasury trading in New York at ABN Amro Inc. The firm is one of the 22 primary dealers of U.S. government securities that are obligated to bid at Treasury auctions.The so-called yield curve may have flattened to the point where two year notes are attractive, Klingman said.Two-year yields rose to within 18 basis points of 10-year yields today,the narrowest since the start of 2001, reducing the incentive for investors to buy a longer-dated, and thus riskier, 10-year security. Thegap has shrunk from 211 basis points in June 2004 as investors pushed up short-term yields in response to the Federal Reserve's 10 interest-rate increases. [An inverted yield curve signals a recession. Every war in recent history has been associated with high oil prices and recession].

Durable Goods
HomesOrders for durable goods tumbled 4.9 percent in July, compared with a riseof 1.9 percent in June, the Commerce Department said. A decline of 1.5percent was expected, according to the median forecast in a survey by Bloomberg News.Later, a government report showed sales of new homes unexpectedly rose toa 1.410 million annual rate last month. A drop to 1.328 million from 1.324million was expected, according to the median estimate of economists surveyed by Bloomberg. [See comments above].
Some strategists predict the rally will be short-lived.Ten-year yields ``just don't make a lot of sense,'' given the Fed is goingto keep raising benchmark rates, said William Prophet, an interest-rate strategist in Stamford, Connecticut, at UBS Securities LLC. The securities are ``definitely rich,'' he said. Ten-year yields will probably rise to about 4.40 percent next month, said Prophet. [Unless demand for long bonds remain strong because of uncertainty, ie. fears of asset erosion].

Tuesday, August 16, 2005

Crash update - Sept`05

There is no change from the previous posting on the market outlook. The prospect for a `softer` landing is declining with each day as US property prices march higher. The reality is that there can be no soft landing - why? Because
(1) The US has limited capacity to finance a soft landing given the size of the public deficit, the extent of household indebtedness. He`d have to lift taxes or print money to offer any largesse. Given the amount of money slushing around the US economy, the US is not weak, even in the wake of Hurricane Katrina, 10 consecutive rises in the Fed rate and higher oil prices. But the US has to fund its largesse, and the spirit of the US consumer will change as oil prices bight and inflation takes off. The US government can only respond by printing money, and this will cast doubt upon foreign government's strategy of buying US treasuries. With rising inflation, we can expect more Asian governments to shift to gold, not to mention individual investors. Expect a bright picture for gold.
(2) The US cant rely on a strong terms of trade like Australia to support equities & incomes when the property market comes off. Mind you the Australian market has further to fall, as all markets will fall with the collapse of the US market. Asian savings are unlikely to be spent on consumption given the surplus export capacity in those markets, and their fiscal conservatism. The US has accounted for 75% of global financing demands...thats not an easy vacuum to fill.

Rises in commodity prices are impressive, but look outside those markets which are easily traded with derivatives, eg. look aside from those COMEX & LME traded commodities to contract-based markets like iron ore, coal, tantalum, zircon. That`s where you will get a better idea of market fundamentals. Mind you most of the speculative money has gone into copper because its the most liquid commodity market. Next will be gold!!!

The following charts shows the state of the bond market. The first chart shows the interest rate differential or 'spread' between the long market bond rates and the shorter term rates, which are strongly influenced by the Fed-set rate. When the differential is small, there is little incentive for the short-term refinancing. When the differential goes negative, banks have no benefit from lending funds short term because they can get better long rates. This severely undermines economic activity leading to recession. The impact is particularly bad when interest rates are high, but regardless the impact is not positive given that rates appear to be on the rise and households are so heavily indebted.

The 2nd chart shows the differences between the various US treasury debt securities based on their maturity. Its apparent that there is a strong correlation between term rates. Its evident that the Fed has resorted to strong monetary stimulus to kickstart the US economy after the US internet-tech wreckage of 2000, when it drove the Fed rate well below market rates. From the chart its apparent that this is not the first time that the Fed (under Greenspan) has resorted to such stimulus. Perhaps that was the rationale for Greenspan's easy monetary policy - 'It worked last time, might it work again'. Well consider that the stimulus at the time resulted in the internet bubble, and that we are now at a more mature stage of the economic cycle.

Doesn't the downward trend in interest rates however suggest that we are still on an expansionist trend. I would suggest that is the appearance by virtue of monetary stimulus. Macroeconomic factors to me suggest that this cannot go on as long as Asian savings are channelled into the US market and mis-applied on household largesse.

The question is whether the US Federal Reserve will continue to lift the Fed rate to keep ahead of inflationary expectations. The answer is - It has no choice. But inflation can't be fought by lifting rates. That just curtails further lending and spending. There is still too much money sloshing around, and it can only be counter-acted by productive investment or the liquidation of loans. This requires a collapse of the housing market or debt repayments. Thats an unlikely trend given that the US savings rate is back below 1%. Expect a collapse in the US housing market like the collapse in the Dow/Nasdaq in 2000-1. Greenspan or his replacement might be inclined to ignore inflation and reduce rates, but its unlikely because Asian governments won't fund the US economy. They will be buying gold to counter their $US exposure. Since their export markets will be collapsing, and they will face domestic challenges stimulating domestic demand at home with infrastructure projects, expect them to start liquidating some of their US bond holdings. Expect a run on the $US, driving the $US to historic lows. Sadly there will be no export markets for the US to service given the over-capacity in the global marketplace. It will likely take about 3-4 years for the global economy to work through the excess capacity. The US government cannot expect to finance the malaise given its fiscal position and its reliance on Asian (45% holdings) treasury holdings. It will have to raise taxes and interest rates will also have to be higher.

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Investment Strategy

If you are investing for the long term, you still need an investment strategy. Dont be fooled by the rhetoric of fund managers. The reason they advise you to 'buy & hold' is because they dont want to compete with you in sell-offs. Markets and industrial sectors are cyclical, so they demand trading to get the best returns. Fund managers actually cant hope to match the performance of small investors (if you are half good) because they have to manage huge amounts of funds and charge you a fee besides.
MY ADVICE is (i) look at a range of market indices and decide upon what level of correction would give you the justification you need to get in & out of the market. It might be a 5-10% retracement or a break of trend. (ii) Diversify if you dont have an intimate knowledge of the company or management. More than 30% in one company is aggressive.

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