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Thursday, January 31, 2008

Outlook for the Nikkei

The Nikkei in the short term has upside to 14120 pts at which point I see it retracing. I dont see the Nikkei rallying as high as 14420 pt resistance in the short term given the current market climate. The Nikkei remains significantly above its recent low of 12600 pts. I think that low will be re-tested, and the market might yet fall as low as 12120 pts in response to financial news abroad. Likely such a market fall would be predicated on questions of financial impropriety, eg. option incentives, particularly in the hedge funds and derivatives trading arena.

Andrew Sheldon

Dow Jones set to rally to 13,000pts

The Dow Jones is set to rally to major resistance at 13,000 pts, though I dont find that point very secure footing, and I think it will close the day back at 12,850 pts. The fall to 11,650 pts was rapid, and after some trepidation, I think the rise will be technical trading more than fundamentals, so the move should be completed by the end of next week. In the medium term I see just more consolidation for the next few months.
The upside is presented by corporate reporting suggesting that the market remains resilient. The reality though is that asset prices are falling and costs are rising. Not a recipe for earnings growth. The Fed cut might give people confidence in the short term, but its not going to revive the market for very long. But inflationary pressures will take time to materialise, so I see consolidation in the near-term. The threat of a financial failure remains, likely associated with 'netting out of derivatives contracts'. This was the practice of rogue trader Jérôme Kerviel and I would suggest that the 'options incentive' that permeates dealing desks also extends to senior management. For this reason, in an environment where the 'players are rewarded on the upside' but not penalised on the downside, you are going to see CEOs retiring on their payouts and traders retiring. Who will be holding the broken eggs? Dismayed investors. There is a good chance of financial failures. So where is that likely to take the market? Well certainly back to 11,650 pts. The next support is 10,000 pts. I dont see any evidence for that size drop yet, but there remains a big risk hanging over the market. I suspect there will be 'regulated disclosure' though this period. But that I mean the Fed and other central banks will be in discussions with financial institutions to determine the state of the market. Will there be any surprises?
Andrew Sheldon

Monday, January 28, 2008

SocGen 'one of the better managers' ???

I was amazed yesterday when I saw on Bloomberg a fund manager commented on the Societe General loss of $US4.9 billion by a rogue trader. He said that this is nothing for SocGen. Its actually surprising because they are one of the better managed financial institutions, suggesting that this was a one-off.
I dont know about you - but the idea that one of the better managed derivatives players is lossing $US4.9 billion - thats reason for concern. That is one trader. The market is painting this situation as unique because this rogue trader had a history in the trading & backoffice areas, so was able to identify a loophole to cover his trades.
That is a nonsensical argument to me because:
1. It strikes me as well-known that the industry tends to monitors net positions
2. This guy took larger positions to offset his losses in an attempt to par back losses, and covered his losses with new positions to make them look ok on a net basis. I see no reason why that cannot happen at an institutional level, nor why the loophole would not be identified from office conversation.
I have long made the point that the fact that institutions only look at their net positions is a reason for great concern, though my focus is on the differing credit-worthiness of counterparties. It makes you wonder how many other traders are covering up at this point.
Andrew Sheldon

The real cause of inflation

It never ceases to amaze me how ill-conceived the public, media, even economists conception of inflation is. If you believe the rhetoric inflation is caused by an excess of consumption, that if your economy is growing too strong, then you get prices increasing because producers are unable to supply product. This never happens actually. You will find that economies in the long run are always able to meet demand. The reason for this is because of:
1. The almost universal availability of substitutes - If any product becomes scarce and prices rise, buyers are inclined to buy a similar product that serves the same purchase.
2. The pricing mechanism - Price rises in any single product will rise and in the process discourage consumption, or at least defer it until prices fall, or the person's capacity to buy improves through their increasing income or debt raising capacity.

A global economy offers even greater capacity to reduce inflation because there is greater possibility of substitution or competition, but it does have to overcome the added transport and marketing cost of selling that output, and thats a long-run commercial decision.

The 'demand-based inflation' enthusiasts would have you believe that greater wealth creation is creating that demand across the whole economy. Some dont even bother to explain it - its just there 'suddenly'. But thats nonsense because the increase in wealth is due to expansion of economic output. It also does not account for the 'late' arrival of inflation. We have had 13 years of low inflation despite strong economic development. If you think that is a good thing consider that during the Industrial Revolution, under a gold-standard, there was no inflation. Price variable was essentially stable.

The reality though is that we have had inflation over the last 18-odd years, its just that the CPI is designed not to measure it. This is because the CPI measures only the increase in prices in products that are important to the poor. But the inflationary phenomena is a monetary phenomena caused by excess supply of money relative to the amount of goods & services in production. Now since the wealthy hold the bulk of the money and people want to make more, the bulk of this money flows into business & personal investments such as factories, property and stocks, not into household consumption. The implication is that this money is in a sense sterilising the inflation such that price rises dont flow through to basic goods and services. At some point asset prices become overpriced, and are sold down. This process will eventually lead to bankruptcies, whether because interest rates are raised to address inflation or just because of default because the factory sales fell, or the home owner lost their job.
Andrew Sheldon

Wednesday, January 23, 2008

The best performing markets for 2008

I think the best performing Asia Pacific markets in 2008 - in order of performance - are likely to be Vietnam, the Philippines and China.

China is getting pricey, but Vietnam is just opening up, and although the country will suffer from a softening US and global market, its growing from a small base and offers considerable savings to investors trying to reduce costs. This market has overcome its lack of policy change, and is starting to allign itself with western regulatory practices.
Unfortunately the poorly developed capital market remains an obstacle.

The Philippines has for a long time been a laggard in the global competition for capital. I am expecting that to change for several reasons:
1. Continued inflows of remittances because of a weaker USD
2. Continued strength in food (commodity) prices offsetting a stronger peso
3. Subdued impact of high oil prices because of the stronger peso
4. Subdued inflationary pressures because of the stronger peso
5. The adoption of a petrol tax will help to support domestic demand as well as improving local infrastructure
6. Buoyant gold and copper prices - the principal mineral exportas
7. Continued support for local property market
8. Continued demand for call centres & the associated investment/capital inflows
9. The Philippines I think will benefit somewhat from a growing local dynamism as a result of enhanced regional integration. The ASEAN efforts to deregulate air travel I think has the potential to enhance tourism inflows. 'Though tourism still remains poorly supported at grassroots levels.

There will come a time when the peso will come under pressure from the large capital inflows, particularly since the Philippines fails to address its poor productivity. There is a poor work ethic here based on a social fabric of entitlement and disempowerment than undermines personal initiative and opportunity.
The biggest obstacle in this market is the poor disclosure standards and the lack of data disclosure.

The Shanghai Stock Exchange (SSE) Index has pulled back as a result of a weaker global and US outtlook, but I can see this market trading higher in the next 12 months because there is no end to the shift in productive capacity from the west to east. A slow down will cease alot of new investment,but it will not undermine the substitution of high cost manufacturing capacity for cheaper capacity in China, nor will it prevent growth in other markets. I see modest gains in 2008, which will see it test its previous highs.

Andrew Sheldon

Equity market commentary

Dow Jones Industrial Average (DJIA)
As predicted in my previous blog the Dow Jones Industrial Average fell back to 11,650 pts, in fact it bottomed at 11,644 pts, but one seldom picks the exact bottom. More impressive is the volatility in the market.
the market fell some 600 points to get to that mark, then it rose 900 pts to close 299 points higher. Wow
Of course such trading volatility reflects technical trading strategies more than fundamentals. The marker was in a state of uncertainty, and it needed a 'firm peg' to cling to. The 11,650 level was a very firm support for a scared market. Expect the market to rally from here. You can expect some re-ratings under the headlines "Economy stronger than expected", "Profit upgrades" and just general market buoyancy due to bargain hunting. In the medium term (6mths), I see the market going for another rally, though I think it will have some difficulty breaking 13,000 pts. Broad market stocks will effectively consolidate, whilst people will be piling into resource stocks. Gold and silver stocks will particularly shine. Why? Well gold has risen from $660/oz to $900/oz over the last year, but with commodity currencies even weaker, the gold price in $A terms for instance is over $1000/oz. So earnings potential has more than doubled. Gold stocks were over-sold because of the falling confidence of foreigners selling $A denominated assets, but expect that money to pile back in. I do see some trepidation though because of the household debt over-hang in Australia. But I dont see a $US0.66 exchange rate as predicted by a major investment bank. Not for a while yet.

Nikkei-225 (Japan)
The markets have been very volatile of late. The Nikkei is falling c
lose to a major support, so seems likely to rally from that point. The bottom I see as around 12,100 pts, though the market has until now fallen to just 12,550 pts. I suggest that there is scope for further weakness, but I think this support will hold. It will take time for confidence to be restored, and after traders take profits today, the market will all once again, but a base will be established. As you can see from the chart to the left, the 12, 100 support is a strong support.

The All Ordinaries Index (Australia)
The Australian All Ordinaries Index - has also followed the general volatility and malaise experienced in other markets. The index fell to 5243 points - exceeding my expectations by 50-odd points, but nevertheless recovered to close at 5549 pts. As a consequence the index has found the support of a major support level, and recovered quickly. In coming days I expect some consolidation after profit taking.
I dont expect a great outlook for the broader market, but I do expect confidence to be buoyant in the mining/resource sector because of:
1. Resilience of metal prices - strength in gold/copper prices
2. Weakness in the $A
3. Prospect of Chinese investment in the sector - maybe even a few Indian, Swiss investors
4. The long term prospects for the sector

See My Speculators Dream and Blue Chip Equities blogs for suggested market buys.

Andrew Sheldon

Thursday, January 17, 2008

ASX likely to pull back to 5300 pts

The ASX market is following the global trend and is experiencing a considerable global pull-back. The rationale for this pull-back is:
1. Rising interest rates to crimp inflation
2. Prospect of softer commodity prices
3. Reassessment of risk premiums - demand for higher yields to offset lack of asset growth and
On the positive side, we can expect the following:
1. Strong Chinese investment in Australian mining companies. The Chinese will be passive investors, not operators, so these will be corporate deals. Expect them to buy convertible notes and equity. I dont see corporate takeovers. I see them making deals with project sponsors. But these deals will help these stocks, so this is the market that will yield opportunites in future.
2. Tight metal markets
3. Weaker AUD and Chinese investment will support capital inflows, as USD-based commodity export revenues will help.
4. Australia has pretty full employment so the impact of any slump looks less worrisome. But then markets always fall from highs.
5. Government debt is very low so the goverment has the capacity to spend on ports, railways, dams, etc.
6. Prospect of higher export volumes to offset price erosion in the long term
7. Mineral markets are pretty tight so commodity prices are likely to remain pretty bouyant considering
8. Agricultural exports will eventually recover - so thats an added source of export revenues
All this is reason to think that the ASX will not sink too far. There will be pain at the lower end of the property market. eg. Debt liquidations, but matters are not too bad for the Australian market. But they will be oversold because the US market is featuring as the issue of the day.
So I am expecting a pull back in the ASX to 5300 pts, and that the broader retail, banking, markets will be hurt more than mining stocks, Woolworths, etc.

Dow Jones - on target for 11,650pts

The Dow Jones Index (DJIA) fell 306pts overnight to 12,159. I see the market falling further, and I dare say it will find support at the 12,000 psychological support, even though it will be temporarily broken in day trading. In the medium term I think the market will fall to 11,650 pts before we see stability. So events are unfolding as expected.
People might look at this chart and think the US equity market is way off-trend, so has a much greater fall to return to reasonable value. Since 1995 the US equity market has sustained a much higher rate of index growth. I think we have to appreciate that this higher growth rate was due to the capacity of companies to borrow, to use greater leverage, and to expand earnings, but this has been at the expense of unlisted and foreign companies. We have been through a period of global consolidation, and the USA has reinforced itself as the global head office for globalised business.
Having said that companies are using derivatives to manage their risk, and whilst that is fine for the operating companies, it leave the risk of a financial institution (counter-party) failure since they have the unlimited risk exposure. You might think that they have protective cover as well, and that its not the total exposure that counts, but the net exposure. Whilst this is true - the problem is that not all counter-parties have equal risk attached to them. The concern is that if there is excess concentration of risk then we can expect failures, and some institutions will have greater risk than others. The market will collapse without second guessing as the risks are not quantifiable, we can expect markets to react HARSHLY to any news of a financial institution failure. The bigger the institution, the bigger the collapse. We know that the size of the derivatives market has taken off over the last 10 years and that there is a high level of concentration in certain markets. In some markets the derivative market dwarfs the size of the physical market by 3x. This leaves the prospect of thousands of banks failing. The implication is massive debt liquidation, huge excesses of capacity, deflation. Thats not good for gold. Gold is only attractive if debt remains stable. Anyway people will sell gold to cover losses elsewhere, so reason for caution.
Rest assured that greedy deceitful CEOs are likely to retire before the problems occur. I guess they were cashing in their stock options last year. My guess is that they have already bought their yacht and spend Xma in the Carribean. Some of them might even have changed their citizenship to the Cuba. But thats not to say they are living there. They go where the current takes them. :)

Monday, January 07, 2008

Weaker global economic outlook

There are signs finally that the US market is starting to tank. It wasn't easy to dismiss that fact that the sub-prime loans debacle was going to cause the global economy to tank since there is a raft of new loans re-setting their fix rates to market rates each month. There was even talk that prime loans were also of a dubious quality. Quite apart from the loan obligations there was also the threat of falling property prices in the USA, and the impact further falls would have.

There is now evidence that the US economy is slowing with jobs growth in November a paultry 18,000, compared to the days of 100-200,000 at the peak of economic activity. The blame can be placed upon the property market woes and more importantly the high oil price - now hanging around $US95-100/barrel. You could argue that the employment rate remained largely unchanged at 138.5 million - but markets are looking for evidence of the future outlook, as they adjust their expectations, expect some significant falls.
The unemployment rate rose from 4.7% in Nov-07 to 5% for Dec-07, with most job losses occurring in the construction, manufacturing and retailing sectors. Another important indicator - the Institute for Supply Management's (ISM) index of factory activity fell to 47.7%, down 3.1% from Nov-07. Now a figure under 50% is taken as a sign that we are facing recession. No surprise then that the S&P500 index last week fell 4.5% to 1411.63, the biggest fall in 5 months. Meanwhile the Dow Jones Industrial Average fall 4.2% to 12, 800.18, losing 256 points on Friday.
This should not come as a surprise as some 6-8mths ago I forecast the market would go sideways for the next 5 years, maybe even longer. We'll see...
Its noteworthy that market pundits are expecting the Fed to drop interest rates. I am not so confident about that, but I would not be projecting an interest rate rise. I am expecting a 'steady' with a 25% chance of a fall. I think the markets have it wrong.
Regardless of who has it right or wrong - there is a significant risk being carried by investors. These times are unprecedented. Generally when markets are carrying a unprecedented risk, they sell on the side of caution. The risk is of course that the derivatives market poses a huge under-regulated risk to the broader market. The risk is not too different from the risks in the equity markets prior to the Great Depression. The difference is that this time the risk is concentrated in a few investment banks.

Based on the chart above we are looking at the Dow falling from 12,800 pts today to 11,650 pts in the next few months - this support is the prior resistance set at the time of the 2000 dot-com bubble. Frankly I think there is every reason to believe that the market can fall back to base trend as - unlike before - the inflationary pressures are muh higher, so the Fed hasn't the power to support asset prices that it previously had.

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