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Sunday, December 02, 2007

A sign of China’s ascension to global supremacy – NOT!

The media likes stories of suspense, intrigue and conspiracy, at least that’s what you could conclude from the latest article by the UK Telegraph “China wins from credit crunch fallout” (29/11/2007) according to the Special investigation by Telgraph staff Peter Koenig, Gordon Rayner, Katherine Griffiths, James Quinn, Mark Kleinman, Edmund Conway, Jonathan Sibun, Philip Aldrick, Andrew Porter, Robert Winnett, James Kirkup and Iain Dey. Original source: Rarely does one get the chance to attend a lynching, so let me be the first to invite you.
The article says that “China may in the end be the biggest winners from the credit crisis”. Take it as fact – no one benefits from a credit crisis, unless you are talking about the opportunists who buy up cheap assets in the aftermath. Yet this article would suggest that Chinese central bankers are astute investors by assembling a cash reserve of $US1.3 trillion at a time of financial crisis. But consider this – they have been assembling this reserve for the last decade, earning on average 2% and to top it off, they are over-exposed to a falling currency. In the same 10 year period US fund managers have been earning 20% on global equities, including China’s.
Notwithstanding that its nice to have a pile of cash at a time of currency, most central banks have a diversified portfolio. Any hint that China was going to sell its portfolio of US bonds would precipitate a collapse in bond prices. So far from being an opportunity, its really a prison sentence. The idea that this decision has “hasten the transfer of economic power from Europe and the US to Asia”, the reality is that it has slowed it. China’s savings are under-invested.
Having said that, there is no question that China is a force to be reckoned with. Not because of its astute investing, but rather because it’s a huge population of poor people, with a pretty good worth ethic. China set its strategy more than a decade ago, so you can’t argue its astute for cashing up for the ‘sub-prime crisis’ because the strategy predates it. You can’t even argue that China “has deliberately insulated itself against the boom and bust cycles of the capitalist West by building up the greatest cash fortune ever assembled” because it has participated in the boom in 2 respects:
1. Chinese investors are even more exposed to the property market because of the huge gains there. The difference of course is that relatively few Chinese can afford property, and that property fundamentals are stronger there, but I doubt they are secure from falling housing prices and higher interest rates, particularly since currently rates are subsidized.
2. Chinese people are exposed to the US property market through its export-orientated economy. The final demand for a lot of Chinese-made products is the USA and the EU, which is now impacted by weak Asian currencies.

The truth is that China is challenging the USA and EU but only by virtue of its cheap labour. Strangely it not the Chinese singing the praises of China, it’s the western media. It reminds me of the Cold War, when Russia was built up as a threat to western supremacy. The greenhouse issue has a similar stench attached to it. A stench that sells newspapers, creates fear, creates a story.
China will benefit from an market correction not because of its huge cash reserves, but because it has amongst the lowest unit labour costs in the world. When excess capacity is being closed, Chinese capacity will be amongst the capacity remaining open. But don’t forget – all remaining capacity (including the Chinese) will suffer the impact of subdued demand. All factories will experience lower prices, low profits. In fact the event might even force the Chinese government to end its support of the USD.
If the Chinese were canny investors they would have invested in global resource companies about a decade ago, and precious metals at least 5 years ago. On the contrary it has just started doing that. That is despite western media talking up the opportunities in resources for 2 decades. The ascension of China and India was predicated on their liberalization. It has a simple law of cause and effect. So there is nothing new in the idea that Asia has growing prosperity, and thus growing influence in global politics.
Yet if you listen to the Telgegraph, they make it sound like China is engaged in a clandestine act to take over the world. Makes you wonder whether the western media functions as the Dept of Western Propaganda. If you want a conspiracy theory, I would see more merit in that. We often hear that China is the ‘bad guy’ for buying USD, but the reality is that the US government wouldn’t have it any other way. They afterall want their deficit funded, and the presence of Chinese money keeps US debt cheap and available in abundance.
The reason why China had little exposure to the ‘sub prime crisis’ was because the $1.3 trillion is forex reserves, which are invested in highly liquid assets, not commercial debt, so no surprise that the Chinese didn’t invest there, no central bank does. It was only recently that Chinese fund managers (insurance companies) have been allowed to invest abroad. So there was little opportunity if they even wanted to.
The suggestion that “China's capital walls had largely insulated the country's banking sector from the crises elsewhere” is also not true, it was their well-understood lack of exposure. And the fact remains that China is still part of the global economy exposed to lower prices.
Even the suggestion that “we have seen a flight [of money] to East Asia in recent months” is incorrect because it suggests that Asia remains a bastion of strength. Funds will return to East Asia because the Japanese carry trade is being wound back by rising credit spreads. That is why the Japanese currency is stronger, but the rest of Asia, not particularly strong. Where it is strong, it has more to do with the weak USD.
It is true that the Asian debt crisis in Thailand, Indonesia, Malaysia and South Korea was precipitated by high debts and inadequate forex reserves, but that has not been the rationale for the build up in China’s US treasury holdings. Certainly China is stronger today because it always had the stronger fundamentals, but then Indonesia, Vietnam and India are stronger still.
The notion that China having the world’s biggest company PetroChina, is some sort of symbol of China’s ascension is folly, as really the fact that these developing countries have such big coporations is really a legacy of their government-sponsored monopoly policy, thus they are more a legacy of old, rather than new.

Sunday, November 18, 2007

Equities in recovery

The Dow Jones Industrial Average (DJIA) has reached a previous low at 13,000 points, but it would not surprise me if it goes lower overnight to at least touch a much firmer support level at 12,800 points (a prevous high). But from that point I expect the market to rally.

Now if we anticipate the DJIA to present good buying opportunities late in overnight trading, then we really need to be buying Australian equities today. The market has already opened higher, and I think like these buyers we should be taking our lead before the DJIA gives us the confidence that will die after opening tomorrow. The best stocks to buy are metals - gold and others severely cut down by offshore selling in recent weeks as metal prices and the Australia dollar came under pressure. As we can see the Australian All Ordinaries Index has hardly changed direction in the recent profit-taking, so there is still alot of confidence in the Australian market.

Tuesday, October 09, 2007

Dow rally signals buy!

The Dow was up 120 points overnight giving further confidence that the current trend is going to continue. Although the Dow had already breached its previous Apr'06 high, it was not very convincing. The overnight rise takes the Dow to a new high, signalling its going higher. That is further reason to jump into commodity stocks - particularly copper (off highs at $3.60/lb) but also gold.

Monday, October 01, 2007

Dow strikes new high!

The Dow Jones has struck a new high despite negative news by Citibank Group. Instead the market moved 191points higher to 14,11o on the back of a market belief that the Fed will support the market with further Fed rate cuts. I'm not so sure about that, though I dont see the Fed cooling that optimism for the foreseeable future. So I would be looking for Dow weakness over the next few days before I would be making a greater commitment to the market.
I dont see Americans supporting the property market just because the Fed is lower rates, or at least paused for it. There is a market overhang, a very real threat of inflation, and this market is slowing. I would be staying in gold and cash, though with copper at $3.72/lb, i am holding Matrix Metals, though it concerns me that they have not moved up yet. Am I being impatient again, or is the market worried about lower prices. Copper prices would have to fall $1/lb before this stock would be bad buying. Its a great story.

Wednesday, September 26, 2007

Markets due for correction

If the US Dow Jones Industrial Average and Australia's All Ordinaries Indices are any guide the market is due for a correction based on technicals.

Looking at the chart above we can see that the Dow is just off its previous highs, and seems somewhat reluctant to advance. The ASX below has already reached its previous all-time high, but it too seems to be marking time, as it waits for direction from the US market.

Based on these charts today was a good day to sell down your stocks until the market sets its direction. Of course such charts only provide an average guide of market direction, and one can expect the gold sector to respond better, although it will not be completely protected from any fall.

Sunday, September 02, 2007

Another sell opportunity

The US market was up 113 points on Friday on news that the US government would provide support for loan defaulters with a good credit history. I think such support misses the point because:
1. Interest rates will rise further - squeezing even more households
2. Not all sellers will be defaulters - but investors
3. We are looking at a recession - which means job losses
4. No matter what is negotiated, you can be assured the government is going to give defaulters just enough security to retain their homes, but thats not going to give them the confidence to keep spending.
5. There are still alot of 'no doc' loans which will be resetting at higher (+30%) interest rates over the next 18 months.

Thats all depressing news for the market and the domestic sector accounts for 60% of US consumption expenditure, so expect these factors to be a significant drag on business spending. The global economy remains strong...but for how much longer?

I still remain negative. The Dow was up 113 points on Friday, but that is a daily move inspired by Bush's mortagee support and Bernacke's 'dovish' comments about monetary policy. I still think the Fed is not going to raise rates. I think they want asset prices to cool to take inflationary pressures out of the market. Paradoxically that only happens if debt is liquidated - whether by default (in the housing sector) or higher interest rates parring back business loans or leveraged investments.

Technically the charts are telling us the same. The Dow went as high as 13,428 pts before it fell back to 13,357 points on Friday. Importantly, although it breached the previous high of 13,387 points, the market closed below this important resistance. Given that half of the gains were parred back, and the Dow closed below its resistance, I think we can expect the market to fall off big time on Tuesday (after a Monday Labor Day Holiday). So today and tomorrow are sell opportunities.

For this reason, I favour sitting on least until we get confirmation of market direction from the Fed and US government. I can't quantify the extent of the falls on Tuesday, but I suspect the Dow will fall be over 350 points. Basically I think the market will come to regard Bernacke's lack of disclosure as a 'market risk', even though he is actually trying to give the market some hope of a cut. This supports his desire for a 'smooth ride' but I think the markets will gradually anticipate his position.

I will offer some stock selections after the market confirms a trend or as soon as I take a position.

Thursday, August 30, 2007

Is there going to be a rate cut?

This Friday night the Fed chairman Ben Bernanke is due to give a speech outlining his monetary policy in the wake of the housing & loan crisis. This speech, addressed to central bankers around the world, is intended to shape market expectations to its scheduled Fed policy meeting on Sept 18th 2007. According to Yahoo "analysts are predicting the Fed will start cutting the federal funds rate at that time, delivering from two to four quarter-point reductions this year and early next year. The funds rate has been at 5.25 percent for more than a year".
I frankly doubt the Fed is considering such an easy monetary policy. Certainly such cuts would reduce borrowing costs for consumers and businesses and mitigate the payment shock faced by 2 million mortgage holders as their adjustable rate mortgages reset in coming months. But since when does the Fed act as a welfare agency? Consider the Fed response to the collapse of the Thai baht in 1997 that was the beginning of the Asian financial crisis. It took the Fed more than a year to respond with a rate cut in Sept'98. Alot of investors suffered in the meantime. People might argue that this was an Asian crisis, but the reality is that the Fed policy is to preserve 'sustained growth' and to do that it needs to consider the inflation consequences of its policy.
Yahoo also suggests "The Fed is seen as having the leeway to cut interest rates because inflation is easing". But the implication that inflation is a 'product demand' phenomena is wrong - its a monetary demand phenomena. Excessive growth in money supply relative to the productive capacity spells inflation in at least some segments of the market. The reason food prices were not running away in recent years whilst money supply was increasing is because financial assets like shares and property were growing appreciably. Now asset prices are falling, that liquidity has to go somewhere. Well we are not going to eat more because of falling house prices. But there will be a slowdown in investment, so wasted financial resources means economic stagnation while prices increase.
It seems more likely to conclude that the Fed on Aug. 17 was merely calming financial markets when it said the "downside risks to growth have increased appreciably". Some market pundits seem to be interpreting this as justification for a rate cut - that the Fed is now more worried about weak growth than inflation.

Concluding, I dont expect a cut in the Fed Funds Rate on Sept 18th 2007. Tomorrow I suspect Ben Bernacke might even correct the perception somewhat. So I expect a weak market next week (1st week Sept'07).

Wednesday, August 29, 2007

Day to sell!

Geez I hate re-writing posts...I pressed the button to send this post at 9:30AM this morning, but you didn't get it because of a power failure in the Philippines. Fifteen years ago alot of countries were having power failures...its incredible that the Philippines still has them. Which means:

1. I need to get a diesel generator and battery to stay powered.
2. I need to write blogs offline

Anyway, the big news is, today is a good day to sell your stocks. Why?

Because the technical analysis of the chart below - the Dow Jones Industrial Average - is following a downtrend. I must however say that the evidence is not conclusive. On the negative side, we already have a sucession of lower 'highs' suggesting a downtrend. The big drop in the market on Weds was a clue that the market was staying in the downtrend. On the bullish side, overnight (their Weds) the Dow had a very strong rally (240 points), all the more impressive because it closed at a high. But it didnt break the psychologically important Weds high, so thats not good. So its difficult to read which way th market is going, but I can tell you that the next 2 days the Dow is going to move in one of 2 ways:

1. Upside: It could have a very solid rally tomorrow to break out of the downtrend. I would be looking for a 250 point move higher.

2. Downside: It could have a modest fall of 50-80 points on their Thurs, followed by a much bigger fall (confirming the downtrend) on Friday.

I personally look to the fundamentals to make that decision for me, and I see two sets of news in the short term which will drive the market:

1. Earnings: The positive side is that companies will be reporting some positive earnings.

2. Debt worries: The market will be concerned about the negative fall-out from the housing problems in the market. I can see a succession of bad news. For example, the failure of hedge funds, loan defaults, lower consumer confidence, lower retail sales, etc.

I also dont think the Fed will lower interest rates because of a fear of inflation, or if they do it will be just 0.25%. The reason I expect no increase is because they didnt do it when it counted most, so why would they do it later. The Fed never cared about asset prices on the upside, why are they going to care on the downside. Its not going to support the already falling housing market, it would support higher consumer prices (meaning inflation), so they are not going to lower rates...I

So I believe the market is going down. The question is - will it make new lows, or just return to its previous low at 12,800 points. The media would have us believe that market PERs are reasonable, but there is going to be alot of downgrading to those revenue models given the evaporating consumer confidence, so at the very least there is reason for weakness. But I think it will take bad inflation figures or a financial failure to get the market to fall to around 11600-11800 level, or a recession, but a recession will take time to unfold. A financial collapse of a hedge fund will unravel the market. The Fed can boost the liquidity of the banking system, starving off a run on banks, but it cannot raise investor or consumer confidence without lowering interest rates...and I doubt that will happen.

Monday, August 27, 2007

Moment of truth for Dow, All Ords

Anyone trying to gauge whether equity markets are going to continue their upward movement should be taking a close look at the main indices over the next few days. I focus on the Dow Jones Industrial Average (DJIA) and the All Ordinaries (Australian ASX) because the US leads the global market and the All Ords is sensitive to the global outlook for commodity stocks.
Looking first at the Dow, its apparent to me that the index is at a critical point where it could go either way. It might shrug off the negative news in the housing sector. At this point in time 2AM Eastern Standard Time (Sydney) the US market is down 44points, though it appears to be holding.

The ASX is at a similar turning point with the index surging over the last week to over 6200 points, not far off its high of around 6400 points. I personally dont see the ASX breaking its current resistance, even though the index finished just off its daily high. I think the index will face selling tomorrow, but I will wait for direction from the market because there are alot of 'political wills' that want this market to go higher. Notwithstanding the uncertainty, the volatility is making great trading conditions.

The gold index is poised for similar direction from the markets. We are still waiting for a break out on the up or downside. I actually think gold will fall off, along with equity markets, with $US550/oz my target.

We might know if I am wrong or right tomorrow, but it might otherwise take a day or two.

Friday, August 24, 2007


The amazing aspect of this financial crisis was that the financial sector actually fared quite well compared to others sectors. Partly this reality can be attributed to concerns about sub-prime exposure earlier in the year and partly to the fact that the energy & raw material sectors had performed the best before the crisis. As a consequence, in the year to date financial stocks fared the worst on the S&P500, falling 7.2%, but in the month of the crisis they fell only 5.25% compared to a 6.8% fell for the broader S&P500 Index or the 10.5% ($2.2 trillion) during the 4 week crisis, compared to a loss of $5.8 trillion between Mar-2000 to Oct-2002, which was accompanied by a short recession. The implication is thus given the health of US balance sheets a subdued US economy, but not a recession.
Given that this was a financial (sub-prime) crisis you might have expected the losses to have been largely restricted to the financial sector. But it was not just a case of investors worrying about non-disclosed non-performing loans, the sell-off reflected a deeper problem.

The rationale for the equity sell off
The rationale for the sell off lies in the nature of the crisis itself. The panic arose when the sub-prime mortgage-backed security holders realised that they couldn't sell or price their exposure in the market so that they could sell them. This forced these investors to raise capital, and by the time the problem had hit the market, their financiers were demanding margin calls. This forced sub-prime security holders to sell their quality assets to cover their illiquid positions. Hedge funds and others were thus forced to sell everything as markets continued to fall, so a snow-balling liquidity problem emerged, which was only stalled when the central banks and bargain hunters moved back in the market.
Clearly there was a ‘flight to quality’ which resulted in a stronger USD. Surprisingly the panic resulted in even low-risk investments like municipal bonds and hospital stocks being sold off, whilst quality smaller stocks fared even worse, particularly those stocks exposed to the discretionary consumer, energy and raw materials sectors. The sell off was not totally irrational, given that during a credit crunch small stocks have the greatest difficulty raising capital – whether as loans or equity. Thus its understandable that the Russell 2000, a small-cap index, should fall more than the S&P500 or Dow Jones Industrial Average (DJIA). But the extent of the fall should highlight the systematic risks inherit in the market.
Individual investors added their share of panic to the market as they were not immediately in a position to know the extent or ramifications of the crisis. All 10 sectors of the S&P 500 fell between 2.6% (for consumer staples) to 12.76% (for the energy & raw materials sector). The reason of course is that investors perceived this crisis as signalling a downtrend in the economy and a softening in retail sales and commodities demand. Its interesting that the contagion was even worse in commodity producing countries like Australia, South Africa and Canada, which experienced plummeting currencies that would only preserved their local dollar earnings, even though commodity prices did not fare so bad.
But there is another reason why certain high-yielding currencies were signalled out – the carry trade. The yen carry trade involved Japanese financial institutions placing their low-yield institutional funds in higher yielding commodity markets. When there is a loss of confidence in Australia and other countries, the Japanese unwind those currency trades, resulting in a rapid drop in the $A and NZD. The worst performers were the smaller, less liquid stocks. But we must remember that the smaller stocks were trading at significant premiums prior to the crisis so they were always more vulnerable to a correction.

What can we say about the meltdown?
1. There is no question that markets are unstable, and for this reason markets are in need of greater information. This is a financial crisis, not an economic crisis. The problems started in the sub-prime credit market, investors panicked masse, leaving the Fed merely trying to prevent a self-fulfilling prophecy.
2. The sub-prime crisis took on a global magnitude as a result of European and Asian bank exposure to property foreclosures in the US market, giving investors reason to think the crisis was bigger. In reality the risks were distributed more widely.
3. The confidence problem emerges because the financial industry has created an array of new debt instruments that are hard to price, particularly in times of uncertainty. Really they were attempting to make products commodities (securities) which were never really commodities. Because these products don’t offer the same level of transparency as simpler instruments, in bad times the liquidity evaporates and the result is a market crisis. The problem was this crisis arose in one of the biggest credit markets, even though it represents just a small fraction of it. The problem was inadequate disclosure to reassure markets.
4. The crisis does however highlight a poor capacity of credit rating agencies to quantify risk, or a preparedness of the agencies to overlook certain risks for the sake of profits. The situation is reminiscent of the auditing fiasco a decade ago when the major auditing companies came under attack for conflict of interests. The credit rating agencies or investors needed to understand the nature of the instruments they were trading – they didn’t. The risk assessment was just not adequate.

What can we say about the Fed response?
The European Central Bank, the Federal Reserve and other central banks acted quickly to pumped hundreds of billions of dollars into the world's banking system, the largest injection since the 9/11 tragedy, when the Fed injected $334 billion into the markets between 12-19th Sept 2001. The actions by the Fed were an appropriate step towards restoring confidence in the banking system. Nevertheless:
1. Liquidity is only a short term measure. If the markets experience another shake out it will be because of further bad news lacking perspective. This just might give us a double-bottom entry into the market.
2. The Fed decided not to cut interest rates on the 7th Aug 2007, insisting that inflation was the greater threat to the economy - not credit disruptions. This is a sign that the Fed has a more realistic assessment of the problem.
3. The Federal Reserve will need to lower the Fed rate if they want to soften the impact of the sub-prime crisis.
I believe the Fed will NOT lower interest rates because of the greater concern about inflation, and its clear that a market anticipation of such a cut might undermine the market at a later date. I think at some point the market will conclude that the global economy is in good shape, even if the US market will be subdued for several years. It also makes no sense for the Fed to ease credit conditions for financial institutions since the financial institutions are only going to tighten credit conditions upon consumers.

What is likely to be the short term impact?
We can expect that there will be several short term impacts:
1. Credit growth will slow as banks lending activities take a hit, and their profits will tank for 2007. And credit growth is likely to fall longer term as interest rates rise. We can expect the banks to focus on their wealth management divisions as we experience a recovery in broad market equities.
2. Markets are in good condition: Investors need to place the current financial problems in perspective. The credit risk in the USA will affect only a small portion of the USA market, so the ramifications for the global economy are quite small. The global economic fundamentals are excellent. Equity market valuations are reasonable, interest rates are still relatively low, employment growth is strong, and global economic growth is booming.
Some of the selling is not unwarranted in those sectors exposed to the US property and financial markets, as well as US-based retailers who will face some exposure to lower consumer spending as US household mortgage payments rise.

So is there a long term crisis brewing in the long term?
As the dust settles it is clear that there is a short term and longer term problem. The central banks injection of liquidity was an appropriate response to the short term panic, so the immediate threat has been addressed. There is however the threat of more bad news, though it is likely to be tempered. Franklin Roosevelt once said that "the only thing we have to fear is fear itself". He made this assertion upon shutting down the nation's banks in 1933 as he assumed the Presidency. The good news is that the Fed will use this opportunity to assess the risk rating procedures of banks and credit agencies, to avert a similar flight of confidence in future.
There are 2 concerns for the Fed:
1. Inflation: The Fed, along with other central banks, are worried about inflation. This is a global problem of much greater global ramifications than a segment of the US property market.
2.. Weak property markets: We must remember that the sub-prime crisis is a problem for poor households as well as aspirational property investors in the USA. Regardless the weakness in the US property market will affect spending there, but we must remember that US households don’t look at their house values in a way which would affect their psyche, at least until it results in higher mortgage payments, and so far interest rate increases have been subdued.

So what is an investor to do?
BUY! BUY! BUY! The recent collapse in equity prices was an over-reaction sparked by institutional demands for liquidity. The global reach of the sell-off was really a manifestation of foreign institutional exposure. Clearly the best buys are those sectors that suffered the most during the sell off, so:
Commodity based currencies are going to benefit from retention or recommittals to the carry trade
Commodity (raw material & energy) stocks are likely to recoup the losses they experienced over recent weeks
Small cap stocks that we particularly punished are likely to experience the best recoveries.
There are already signs that this is occurring. The Yen was weak last weak, as Japanese fund managers re-entered forex markets to buy AUD and NZ. The commodity sectors were the strongest sectors of the economy – particularly the smaller quality stocks like Matrix Metals – up 40%.

Tuesday, August 14, 2007

Re: Rebound in sight

The Dow Jones Industrial Average (DJIA) has fallen from its peak of 14,000pts to 13,028pts, a decline of 7%. Today it fell 207pts. Fund managers would have us believe all is well, but the reality is there is alot of problems confronting the market with excessive indebtedness. Having said that I think the market is not far off bargain hunting. I suspect Wall Street will be down on Thurs and mid-Friday is when the bargain hunters will be re-entering the market, so I will be bargain hunting Friday in anticipation of a strong US market on Friday when it opens, and thus strong followup on Tuesday, and I will be looking to take profits on Wednesday. Why? I think the market will rally, but I think there is more bad news ahead. And I think the market will want to consolidate before to heads up again.
So hopefully you are all cashed up. I was a little late getting out of the market, though when I did, I almost liquidated everything, so I could re-enter the market. I was caught by surprise, when the DJIA broke 13,500pts I thought it was going higher, and though it weakened I thought it was looking at a 13,500pt support. But when it broke 13,300pts I knew we were looking at a further falls. I am very sensitive to falls because of the nature of the stocks I buy. So the bad news is - I lost 15%. The good news though is that I should pick up 30% on the recovery in just the first week.
I think its important to note the strategy of the Fed at this point. Its leaving interest rates steady (that is retaining an easy monetary policy) whilst responding to a falling asset market by pumping up bank liquidity. There are 2 aspects this nonsensical policy:
1. Neutral monetary result: The Fed is taking with one hand and giving with the other. Although the Fed is currently keeping the Fed rate on hold, there is no question that it will raise interest rates in future. But the reality is that the increases will lag inflation. Why? Thats the taking. Next its giving the banking system the capacity to borrow money so they dont need to raise interest rates, well at least by not as much. Who benefits from that? Well since its households are highly indebted, its the cashed-up companies that will benefit.
2. Desicrating Robin Hood's grave: Well I never believed in the notion that Robin Hood was taking from the rich and giving to the poor, as landowners were paying taxes as well. A more realistic scenario today and during Robin Hood's time is that governments allign themselves with certain interest groups. So basically governments screw everyone, just they need tax from 'discretionary' business so they screw them less. Afterall they have more choice than salarymen to move offshore. But recognise that the essence of their policy is to 'take from the poor and giving to the rich'. Errol Flynn (aka Robin Hood) will be turning in his grave. The interesting thing is that governments that profess to be big on welfare are not opposed to a policy which actually supports the mass transfer of wealth from the poor to the rich. Think about it! Sure everyone lost money in the fallout of this correction, but the poor lost all savings, so they have no capacity to buy back. Those assets will be bought back by the wealthy. The wealthy might have even hedged with derivatives. The poor will be scared off even if they could afford to raise a few thousand to benefit.

I have shown two scenarios on the chart - a more favourable 'green outlook' and a more pessemistic 'purple outlook'. The rationale is that I think the market will rally from 13,800pts, however 12,000pts is a stronger support. But I think it can only get to 12,000pts if there is a plethora of bad news. In any respect I think the spec end of the market that carried the greater burden will recover quickly, then profit-taking will set in. So I dont see the market going to 12,000pts in a hurry. But if a few financial institutions fail it could be a very different story. But even if that were the case, expect the Fed and other central banks to step in to save the market.

Saturday, August 11, 2007

Inflationary outlook

Global markets have entered a new phase. Many pundits are suggesting that this market correction is short-lived, which is true in a sense, but lt this point mark the end of the easy money from property and equities, and lets poise to consider where we should be investing in future. For the last 15 years the global market has undergone a period of monetary expansion. I know you have heard about the wonders of technology and the impact of market liberalisation and productivity gains. But it gets to a point when all those factors are priced into the market and asset prices have no where to go but down. Consider these parameters:
1. Unemployment in western markets where the bulk of consumption occurs is tight
2. Productivity has fallen off considerably as asset prices have undermined consumption
3. Debt creation has reached its limits as wsterners become fully leveraged and home ownership rates have never been higher.
4. Interest rates are tightening after reaching their lows
5. Asset prices are falling from their peaks, giving people with high debts reason to pause
6. Inflation is feeding into the basic cost of living, particularly with high energy, food costs. The factor that has not readily been apparent to us has been monetary inflation, although we had witnessed the associated asset inflation. We were lead to believe that was due to higher incomes, growth in income and employment and easy money. But it was more than that. There was a shift in pricing from market prices to the consumers ability to pay, which itself reflected the ever-presence of easy money. Those days are now over. Inflation and debt liquidation will bring money supply back in sync with global output. We tend to talk about inflation and deflation as if they are univeral phenomena, but the reality is the nature and reason for price increases. Over the last 15 years we have seen strong equity and property prices, whilst in the last 5 years commodity prices have been strong. In future we are likely to see subdued asset prices and higher prices for basic commodities. At this juncture there seems to be 2 ways the market can go - each outcome depending on the governments attitude to inflation. It has a choice of achieving a market equilibrium by allowing prices to rise or credit to fall, but normally its some politically palletable combination. It can respond with:
1. Easier monetary policy: This would involve the Fed ignoring inflation and responding to falling asset prices with an injection of credit or paper money into commrcial banks to support credit growth. Of course this would result in run-away inflation culminating in choice 3.
2. Modest monetary policy: That assumes that the governments respond to higher prices with slightly higher interest rates. Despite the increases in nominal rates importantly the increases maintain cheap money in real terms. Eventually this results in negative real interest rates, but asset holders still benefit from higher prices, but only after loan defaulters have been squeezed out of the market. Governments take this approach because it shifts pain to the poor, whilst protecting the asset rich. This stratgy involves the economy working its way out of problems. The consequence is what might be referred to as a 'lost decade' of low returns that occurred in the late 1970s and early 1980s.
3. Tight monetary policy: This strategy involves staying above the curve, to rein in money supply, to force prices down by raising rates, ending credit expansion. This strategy causes a precipitous fall in markets, though once the correction has ended markets are able to build on a firm footing. It hurts everyone, but particularly the holders of assets.

So basically we are looking at 5 years of subdued growth and stable asset prices, or a precipitous shakeout of asset market and credit liquidation culminating in a rapid transition to economic growth, though a calamitous shift in wealth from those with asset or liability exposure to those with cash. The question is:
1. Does the Fed have the skills to maintain a flat market for 5 years?
2. Will global markets be exposed to exogenous factors that might impose instability, eg. bird flu?

Sunday, August 05, 2007

Market correction - Aug 2007

For anyone who has been following the sub-prime lending fiasco the failure of funds with exposure to the sub-prime market and stockmarket weakness comes as no surprise. Why:
1. The US market was at dangerously high levels of debt
2. Nominal US interest rates are still very low - making little allowance for current inflation, let alone increases
3. The risk-premium implied in current nominal interest rates is excessively low.
4. The ARM-type 'no doc' loans offered in the US were destined to result in failures. Offered at times when people cant remember bad times, and when interest rates were extraordinarily low. Rates are rising, and the 'concessionary rates' that baited lenders are about to reset.

Sub-Prime Lending Fiasco
There are 3 issues that can sink this market:
1. The prospect of a bird flu epidemic
2. Inflation taking off or market recognition that inflation is higher than we know
3. Debt liquidation

Bird flu
Well there is currently no sign that no sign that bird flu will turn into a pandemic. Its plausible that authorities have improved the levels of animal husbandry in China and other developing countries to an extent that it might be avoided. For now its 'all quiet on the eastern front', but I suspect work practices in Outer Mongolia are a little harder to administer, or people simply dont bother. The wild bird population is spreading the virus to these farflung areas. The question is whether a mutation arises which combines some of the bird flu virility issues with the communicability of the common flu.

I have long argued that inflation is a broad measure of price variance, and thats not what the 'core CPI' measures in western countries. This is political distortion. The exclusion of housing prices, energy prices, food prices for the sake of volatility is equally invalid. The inclusion of qualitative adjustments is a subjective distortion, and the inclusion of rent is a distortion too because rents are suppressed by the high levels of home buying. Clearly you can't have your cake and eat it...unless you are a bureaucratic manipulator. Its interesting to ponder why business accepts this state of affairs. My assessment is:
1. They have derivatives contracts to protect themselves
2. They benefit from the sustained growth in global consumption
At current nominal interest rates there is little adjustment for inflation, so the current Fed interest can be regarded as stimulatory...say 2.5% when a neutral (real) rate would be around 4-5%.

Debt Liquidation
The other aspect of this market correction is the threat of credit liquidation. Just as global consumption has been fuelled by credit expansion, any contraction of credit growth (from higher interest rates) and even credit defaults (liquiation of existing outstanding loans) poses a significant threat to the market. There is a snowballing effect as well since we are likely to see higher interest rates and the resetting of ARM rates causing even more failures in the USA.
Consider the facts emerging today.
1. More than 2 million subprime adjustable rate mortgages (ARMs) are poised to reset at much higher rates in coming months according to Based on current proportions we might expect 5-10% of these to fail. But when you consider that these problems will cause weaker housing prices, we are looking at a significant problem.
2. Borrowers who took out ARM loans in 2004 and 2005 based on concessional rates for the first 1-3 years can expect their monthly mortgage payments to climb by 35% or more.
3. In October alone more than $50 billion in ARMs will reset - so there is alot more failures coming.
4. The threat is that as the number of subprime ARMs underwritten reached a high, the quality of loans was hitting a low. Since the lowest quality loans were made through to 2006, we migh expect the US property market to remain subdued until late 2008 I believe.
5. Another threat is the prospect of a huge increase in the sale of homes in the USA, as home owners drop out of the market. In 2005, about 40% of all purchases were for second homes and investment purposes. Expect alot of these owners to bail out, increasing the listing backlog and depressing prices.

So how bad is the problem?
Well its not good. According to AIG, the world's largest insurer and one of the biggest mortgage lenders, residential mortgage delinquencies and defaults are becoming increasingly common among borrowers in the category just above subprime. As it stands AIG has said that 10.8% of subprime mortgages were 60 days overdue, compared with 4.6% for loans just above subprime. What does this mean? Well I think it means 50% of the loans in the higher quality bracket might not be sound since at the same point in time, 50% of those loans are doubtful. that loans indicating that the threat to the mortgage market may be spreading.
AIG said delinquency rates for first mortgages had risen from a low of 3.08% in Jul'05 to 3.56% in Apr'07 and 3.98% in June'07. First mortgages represent 90 percent of AIG's domestic mortgage business, so its possible that the broader market is fairing better.

The good news is....
The good news is:
1. Equity markets have not woken up to the fact that more bad news is coming. This is not unxpected since we have become so accustomed to the good times
2. The good news is that whilst credit expansion has ballooned over the last 10 years, inflation has been greater than stated by the media-promoted statistics. The bad news is that there is still a significant correction required to bring markets back to equilibrium. Since money supply has grown so much more than output, prices and credit liquidation both have to rise to bring those markets back into equilibrium.
But the bad news is...if you own a property, you are about to loose a significant amount of money. Why?
1. Deflation will occur most in those markets where there was the greatest inflation.
2. Prices are set at the margin, so they will fall quickly as buyer interest evaporates. You wont have time to sell.

Equity Market Correction
Its hard to make informed decisions on these issues since the information to assess the market is not readily available. Up until a few weeks ago I was thinking that the market had enough momentum to keep growing, that the US housing market was turning around and the amount of money in the global economy would sustain a stronger market, with also the remote prospect of Fed stimulus in the form of lower rates. I was particularly heartened by the fact that copper inventories are very tight and copper and tin prices are very high. But thats a precarious position to hold as well.

From the market I gathered several points that prompted me to question my previously positive judgement:
1. Credit risk: The snowballing impact of the sub-prime loan. The news just keeps getting worse
2. Technical weakness: The failure of the Dow Jones Industrial Average (DJIA) to continue its uptrend
3. Affirmation of weakness: The fact that recent price action has suggested further weakness.
4. Commodity markets: I think the impact on commodity markets is lagging because of strike shocks to supply and because China is expanding inventories unaware of the market realities.

I was originally expecting a fall back to the 12,800-12,900 level in the Dow Jones, but I actually would not be surprised if we see a fall to 11,700 pts as its a much stronger support, particularly as I think there is more bad news looming.
Dont expect fund managers to spread news of an impending implosion - look at what the market is telling you. Understand that if you are a fund manager it takes time to unload stock. They dont want you thinking their is a meltdown, otherwise you will be jumping in queue ahead of them to unload your stock. So instead they tell investors 'all will be fine in the long run', 'nothing to worry about'. Of course in the long run the Dow Jones has risen exponentially for 100 years. But why would you want to wear a loss if you dont have to. So if you want to be ahead of the pack, you need to see trends before the you are ready to react when you see statistics that carries bad news.

Its seems likely that the Dow Jones is about to fall to its trend support of 12800-12900 points. Given that the collapse in the sub-prime market is a US phenomena, you might think this is a US-only phenomena. Well the rationale is that the US consumption has been fuelling the global economy, so a contraction there will have a significant impact on the global economy. I have recently become pessimistic on a US recovery until late 2008, and I see a short recession caused by the housing slump, with the prospect of an inflation-fuelled slum next year, which could make the forthcoming recession about 4-5 years long. I suspect it will take this long for the asset inflation to work its way out of the market and for production capacity to be re-adsorbed.

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