The US & Chinese equity market outlook for late 2015 into 2016

In my last post on 18th August 2015 I forecast that the US and China were destined to enter recession. The reason for saying so is the subject of this article, however it needs to be acknowledged that the recession is destined to be 'short-lived', or simply a 'crisis of confidence'. There is no reason to expect mass employment, or foreclosures. The problem will simply be an absence of spending and falling asset prices. The reason for the falling prices will simply be:

1. The inability of the Fed to convince the investing public that there is destined to be a recovery soon
2. The fact that the market thinks asset prices are over-priced
3. The difficulty of resorting to more stimulus at this time - again - given that the first stimulus didn't fix what ails the economy
4. The fact the equity/property boom have been long-winded - worthy of a break

Having wrote that article, the US and Chinese markets collapsed. Now we are at a point where the Chinese and US markets are about to turn - the question is - which way? The fact is that there is hardly any recognition that the US is at a weak point. US business inventories are weak, confidence is poor. No one is spending money, and Obama wants to look good. Are we going to see any big spending initiatives at this point? I don't think so. He cannot serve another term, so we can expect that it could only be a new president who would do that. We can therefore expect confidence to be poor until the middle of next year. That's effectively at least a short 9-month recession. Mind you, given the US people appear set to elect a maverick, then you might conclude that is reason for more investor 'unease'. It is nevertheless good to see. It is however destabilising. 

Look at this chart - this is what the Chinese market is about to do - fall to 2500 points. I show in the first chart that 2500pts is support. This is not a crisis market, so its not going to 2000pts in my opinion. You can see the flag structure in the 2nd chart below. 

The US market however is the more important market. It is overpriced because of the very low prevailing interest rates. Interest rates are not going to rise; asset prices are going to fall, and that will scare some people, having fallen already. The US Dow Jones is going to 14,000 pts, as you can see in the following graphic.

As you can see the market is already half way to its support level of 14,000pts. In fact, I think it will find more support at 15,000pts, and finally at 14,000pts. We can probably count on a Xmas rally, and then a March-May 2016 sell-off as the election looms in November 2016. The implication is that after the recovery off the 14,000pt support, 2016 is going to be a very flat year for equities. Its hard to say with 2017 given that it will depend on the capacity of the leader to build a consensus.

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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

Outlook for China's equity markets

The Shanghai Composite index appears to be in a free-fall. I have just signed off on an article on our sister website 'Critical Media Group', where I describe the outlook for Chinese equity markets.

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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

The prospects of global recession heightened in the Dec-2015 quarter

The Dow Jones is coming under pressure at a time when market pundits are being told to expect a market recovery. What's new? There have been numerous opportunities for equity markets to go into a tailspin, but on each occasion asset prices (equities, property and bonds) have tended to rise. The elusive recovery to date could be attributed to:

• The strong equity markets
• The housing market recovery
• Low unemployment
• Low interest rates

The problem of course is that these indicators are not convincing for the following reasons. Basically there is little economic activity going on in Western economics, and that is even undermining growth in the emerging markets that rely on their exports to the West. 

Equity markets

The following chart shows that the Dow Jones is close to challenging its support levels. It has of course been sold off before, only to recover...So we might ask what is different this time?

Source: 4-Traders.com

The problem is apparent in the following chart. The market has had a huge 'unprecedented' rally in terms of its longevity. Even if you were positive about the outlook, you might question the sustainability of this rally, given the expectation of rising rates. Looking at the following chart it seems reasonable to expect a 'good retracement' to at least the 14,000pts level. The reason why we might not expect more than that is simply that, there is every reason to expect a recovery in the real economy because:

1. Interest rates remain very low - so there is scope for the market to accept some increase in rates
2. Higher rates would actually encourage more spending because the incentive to pay off one's liabilities will be lower. The problem is that the Fed would not raise rates if there was any prospect of sinking equity & property markets. 
3. There are no signs of inflation

Source: Google Finance

Based on the chart above, there is good reason to expect a 'sell-off' in Sept-2015 on the prospect of rising rates, but also for other reasons:

1. The 'dead-cat' bounce in China's equity markets, suggests a lack of confidence there
2. Ominous signs of political instability in the USA, with elections looming in 2016
3. The prospects of a currency war, that can only undermine confidence in political leaders. This is the surest sign of no demand. 

Housing market recovery

Judging by the following chart of new housing starts in the US, you could be forgiven for thinking the strong growth in construction is a 'good sign'. The reality is however is that:

• Current levels of housing construction only offset the 'pent-up demand' for new housing that arose after the global financial crisis. 
• There is no 'fundamentals' which would support the persistence of this trend, as I will show next.

Source: Federal Reserve

Looking at this chart and the absence of fundamentals to support it, it is easy to conclude that the USA is about to enter another recession, and that housing starts are destined to dip down soon. Might the Fed arrest this prospect with another QE program. The problem is the lack of jobs to justify it. You can put credit into the banking sector, but in the absence of 'real spending', it will just end up in already over-priced asset markets. If the Fed resorts to QE, it would probably also raise rates, and prompt more liquidity to enter the derivatives market 'short'. That would not help confidence in the real economy.

Low unemployment myth

The myth is being perpetuated that the unemployment rate is low, and that it has fallen over the last 7 years since the global financial crisis. In fact, we have simply seen a lot of Americans, as in other countries, live off their equity, and simply stop looking for work. I'm way ahead of these people because I left the workforce 15 years ago to simply live off investments. I was motivated by the decline in Western values; but others were mostly motivated by the decline in opportunities, i.e. retrenchments. The problem of course is that we have four types of people in the market place:

1. Families spending like there is no tomorrow because they have kids and little savings
2. Subsistence lifestylers living frugally - mostly these are skilled people leaving themselves flexible
3. Subsistence welfare recipients - mostly these are 'estranged' unskilled people, or skilled people in vocations that society does not value. Sometimes they are just people who don't readily integrate into society, i.e. libertarians, white supremacists, atheists, disabled or convicted felons for drug use. 
4. Skilled people who have seen a rapid rise in incomes - Even these people are not spending because they are rapidly paying off their homes

You can see from this 'anecdotal survey' of Americans that the only people spending are working families; whilst everyone else in 'economizing', whether because they are struggling, cautious or opportunistically paying down debt on their significant liabilities. This explains why spending is subdued, and why it will not increase until:

• There is a recovery in the 'real economy to justify a rise in interest rates by over 100bp beyond Sept-2015
• Quantitative easing in order to stimulate the US market

I am actually expecting the Fed to pursue both of these courses of action. So-called reference to a 'liquidity crunch' is nonsense. The reality is that there is a 'wage gap' between Western society and Emerging Markets. This will take time to resolve, however Western governments have done the exact opposite of what they need to have done in order to solve the problem. Far from increasing productivity, they have reduced it. Far from reducing waste; they have taken it to new levels with more intrusive 'distortionary' laws. This is why I support Donald Trump. He's not a political hack, he talks about reducing waste, and unlike Rand Paul, he resonates like a conservative, so he is plausibly electable.

It is therefore important to appreciate that 'low unemployment' is a 'dirty white lie' that is in fact a long term decline in the US workforce participation. You could argue that too many people have simply left the workforce, or 2-income families have become one, or full-time workers have become part-time, that more children are staying at home until their 50s, or more people are packing into ever-smaller apartments. Of course there are more Americans on welfare programs. But the greater reality is that they are simply living minimalist lives. This is actually one of the reasons why governments have shifted to taxing consumption, as well as expanding their powers to intrude into foreign bank accounts, as more people 'live abroad'.

Source: US Bureau of Labor Statistics

Why would this rate be falling if unemployment is falling. People have simply stopped looking for work. Not everyone of course. It is also fair to say that a lot of people are 'under-employed'.

Excess business inventories

There are however also other 'demand indicators' that are used to justify the premise that the US economy is recovering, such as new vehicle sales, which are at "record levels". There is other evidence however to suggest that not all is well in the US economy, namely:

• US inventory levels - see the ominous signs of recession below
• Vehicles in the US are a 'necessity' unlike Japan. The issue is not 'car ownership' but car cost. Moreover the credit terms for new cars have never been easier, and anyway delaying the purchase has a reason to jump into the market....they have been saving for 7 years.
• Judging by the statistics belong, vehicle sales are at 'break-neck' rates, so I'd expect a fall in coming months.

Source: Trading View & Federal Reserve; trend analysis by Andrew Sheldon

Source: US Bureau of Economic Analysis & Federal Reserve of St Louis

In conclusion, there are strong reasons to be cautious about the outlook for the next few years. There are also compelling reasons to appreciate that the current crop of conservative and democratic politicians have no intent to reform goverrnment. Only politicians like Rand Paul and Donald Trump are likely to make those tough decisions to cut costs, that will restore the US economy to health. Note the following:

• Stock and bond prices - the tendency for stock indices to fall every 7 years (2001, 2008 and now 2015??)
• Excess inventory levels - a precursor to recession
• Prospect of a modest interest rate increase - not so significant as only 25bp probable
• Election concerns diminishing confidence in the next year

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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

The market upside is looking a little 'tentative' in the short run

Asset prices are relatively high. In such times, you have to question when or what can undermine them, and what will not. The reality is that the stimulus of the previous few years has meant that conditions are rip for economic growth. There is however considerable concern about the sustainability of that growth given that a lot of the past growth was fuelled by debt finance in the West. You might wonder however why we cannot expect more of the same. The reason is that there is considerable concern about the prospects of higher interest rates. The reality is that there is no reason for central banks to raise interest rates more than modestly to end the 'ultra-easy' monetary policy. The reason not to do that is simply that the economy is not strong enough. Those fears are however positive in some respects because 'fearful' mortgagees are rapidly paying off their debts, and that is of course preparing the way for another cycle of spending moving forward

For these reasons, you can expect a sustained growth in the global economy, on the basis that:
1. The fundamentals are good, i.e. Asia and other emerging markets keep getting richer, with strong rates of economic growth, income growth, high rates of urbanisation, strong population growth. Its all good.
2. Interest rates are ultra-low, so moving back to neutral policy will not greatly affect spending since that nominal rise in interest rates will only be taken when it won't hurt spending. i.e. The Fed will wait for signs of an overheated market before it raises raises, to establish a sustainable growth outlook
3. There is no sign of inflation simply because there is no wages pressure. Moreover there will not be wages inflation for another 15 years or more, i.e. There will be no wages spiral for over a decade. So we don't need to worry about 'cost-of-living' inflation.
4. There is every reason to expect asset inflation. This process has been well-entrained since 2000. Ultra-easy interest rates have been around for a long time. The Fed and the Western governments were not interested in sustainable economic policy, they were interested in running the economy as 'fast or as hard as they could get away with', without paying the consequences. This might strike people as sensible. i.e. Its actually the same policy as applied on the Titanic. Now, do they understand the global economy so well? Well, you'd have to wonder. They simply can't know what can thwart it. The greatest threat would have been SARS. But they might well get away with it. In any respect, the fundamentals are good. So whilst you can expect bursting equity and property markets, you can expect them to rebuild or recover in the current market. You should however look to trade these positions however to maximise wealth. This means using 6mth or shorter charts to pick entries and exit points.

On that note, looking at the following charts for the Dow Jones, we can see that:
1. The long term trend for the market is at its highs, and that it has downside to 15,000 points. I'd even expect it to go to support at 14,810 points.
2. The short term 6 month trend has seen the market rise back above the Moving Average. We will be interested to see evidence that this trend continues. Certainly the 176 point rise today is a positive lead.
We should not however overlook the fact that the market is getting peakish, and there is a need for a little short term scepticism if we are going to trade this market efficiently.

I'm looking for a market peak around 17,100-17,300 points; from which I think you can expect a substantial correction .The most logical correction would see a fall back to the 14810-15,000 point level. One already gets some sense that one's buying is getting 'sold into'. i.e. One gets the sense that for every order one places, there is a 'bigger player' getting out. This is most apparent in the less liquid stocks. Looking ahead, I'm expecting a very lucrative recovery from any sell-off. I'm expecting the next rally will offer a lot of profits based around a lot of Mergers & Acquisition (M&A) activity. This next rally I think will get consumer spending momentum going again.

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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

Rebuttal of Krugman's inflation critique

Paul Krugman is an annoying person. He is annoying because his entire modus operandi is attacking neo-conservative idiots on the right, whilst ignoring his own shortcomings. His short comings arise from his:
1. Gross ignorance about economics as a compartmentalised irrelevant economist
2. Engagement in straw arguments, or false dichotomies between left and right when the real game is the ascension of libertarianism.

Liberals love this game because it keeps them 'self-important'. The world will not miss Paul Krugman. He will fade into obscurity. But before he does, lest we be criticised for attacking the man without argument, let us focus on his arguments for asserting that there is no inflation, and that its not coming. Well, in truth, he is 'right'....yes 'right' in a sense, and wrong in a sense. There is bugger all 'cost-of-living' inflation. The problem with his arguments is:

1. Krugman does not understand inflation
Krugman thinks inflation is a 'cost-push' phenomenon caused by excess demand for goods and services. He thus celebrates the lack of demand for goods evident in the absence of evidence for inflation, measured empirically by CPI indices. The problem is that the 'goods and services' measured by the CPI are not exactly a useful basket, as some indices exclude the 'volatile' items in order to give a seasonal account. The greater issue however is the 'qualitative' adjustments governments make to inflation numbers, as they are not always comparing like items, i.e. A 286 computer in the 1980s bears no easy comparison to the modern computer. How do you account for the fact that you no longer need anti-virus software as an bundle of inflation costs. Finally, Krugman ignores the 'asset inflation' that exists in many countries. If these assets were to collapse, thanks to higher interest rates or correction to an impending asset bubble, then you would indeed expect inflation. The problem is 'not that the conservatives are wrong', but that their concerns are misplaced. i.e. Inflation is not in the short term from costs, but in unsustainable asset prices. The problem is that 'the problem' is concealed as a 'benefit' for some, because people in the cities like to see their property prices rise. Those buying late are happy as long as the correction in asset prices doesn't show. i.e. They are not concerned until there is a collapse, and even then they might not care if the collapse does not send them broke, precipitate the loss of their job, or their interest repayments does not exceed what they would otherwise have paid in rent.

2. Krugman cannot forecast inflation
Krugman is akin to the environmentalist who points at 'evidence' and decries how bad or wrong people are. He is a tragic soul who understands nothing. He has no credible analytical proscription for how the world works. This is why he cannot offer an explanation of the world; only criticism when others are wrong. He cannot tell us when inflation will appear; if it ever will, and he cannot offer an explanation of why. Firstly, we need to deal with what inflation is.

Inflation is a broad indicator of price movements relative to purchasing power; which is itself tied to the productive capacity of any economy and the supply and demand for money. 

The Austrian School is correct insofar as they regard there to be a relationship between the supply of money and the productive capacity of the economy. Their failure is to not convey an understanding of the dynamics that actually drive price movements. i.e. There is a tendency to speak 'broadly' (by definition) and not see the differentiated foundation for supply and demand in the economy. They fail to see that there are several pertinent factors, namely:
a. Wage restraint prompting an overweight investment in investments like productive property, productive capacity and securities that help finance that capacity, prompting an excess of savings over consumption, i.e. we see a deferment of spending. They fail to realise that this is caused by the autocrats of developing countries causing a pent up supply of labour, suddenly released in the 1980s. It will take us another 15-20 years to balance this global labour distortion, but the impact will be 'mass stimulus' to the global economy, the persistent of the 'super cycle', and low inflation. There will be no wages spiral, though we might expect some unionisation in Asia. There is however no culture of this, and Asia will need to compete with Africa, South Asia on labour costs.
b. Low interest rates prompting speculation in assets.

For these reasons, we can say that the global market place will be under low inflationary pressures for another 15-odd years. In that time, we can expect corresponding asset price bubbles. Its inflation, but not the type described by Krugman. He, like the Fed Reserve, like Alan Greenspan, are simply not looking at asset prices as a vulnerability. It is the prospect of asset price collapses that will demand further QE programs. These are forms of taxation rather that cost-of-living inflation. They are destined to recapitalise the value of money; but not cause the type of inflation spiral that is associated with cost-of-living inflation. In fact, the dearth of specialisation and economies of scale, along with productivity gains are destined to see costs under control. So that's the explanation and forecast.

3. Krugman offers no clarity over 'excess money'
Concerns about "excess money and a devalued dollar" is not a problem (as Krugman argues) because there is no such thing as excessive money. Even in the context of a 'balanced labour' market, the problem is not wage demands; the problem is that they able to be extorted from business by unionised labour. We are however under the illusion that unions are good, because they lead to better worker conditions. They don't. They take what business would have been forced to give (belatedly) or they extort that which business cannot afford to offer, so being forced to close business and go overseas, or go broke.
Krugman suggests that the USD is not weak, but in fact it is relative to hard currencies in Asia. He does not realise this because he selectively compares USD value with other major currencies, like the Yen and Euro, which are also weak, or those economies whose pricing is tied to the USD, whether its the managed 'mercantilist' currency regimes of Asia, or even the USD-denominated currencies of commodity producers like Australia, South Africa, Canada et al. It does not help that these countries borrow in USD. The implication is that all these currencies become immutably tied to the USD. The fact is that there is no country pursuing a 'productivity' based wealth strategy to prompt higher currencies. They are pursuing an 'economic stimulus' strategy, which attempts to create the illusion of wealth creation. Observe that households are working harder than ever, with two or more contributors to income, and they still struggle to live. Home prices are 10x average earnings in many cities. Unskilled labour is having a harder struggle still. This is the constituency that 'applaudes' Krugman's negativity, but he is unable to offer a solution. He can only knock down straw arguments.

It is true that many free marketers and conservatives have been expecting inflation. His argument is not entirely invalid; but this is not a man with much interest in truth; so much as disparaging counter-thesis to his own delusion.

In conclusion, we can expect more asset bubbles, with the prospect of more bail outs by government of banks or maybe creditors. We can expect no sign of inflation for more than a decade. We can expect those traditional indicators of inflation, the precious metals, like gold, silver, palladium and platinum to rise in price slowly, as they are among the cheapest assets. They will not however do as well as demand-based commodities in the short term, or as well as emerging market property. The reason being of course the low-yield on these asset classes. They will however be helped in time by the low yield on equities and property. This will take time to unfold. This is a super-cycle...so don't be tragic. Though it will be harsh times for unskilled workers in the West. They live in an over-priced, high cost markets, and without exployment opportunities in the third world, they are really between a rock and a hard place, with no preparedness to address their problem.

Asian property markets outperforming Japan Foreclosed Guide Philippines Property Guide
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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

Dow Jones - a great performer?

Reading the NZ Herald, you could be forgiven for thinking that the US economy has re-emerged 'transformed' from the global financial crisis. In the last few weeks, we heard that in the month of January, that the US deficit was positive for the first time in years. A seasonal aberration  however it did denote a positive trend. The problem with such news is that:
1. Asia is still growing and spending
2. Unites States is still saving, not spending, by paying down mortgages

The problem is two-fold:
1. Corporations are still strongly incentivised to take jobs offshore because emerging market wages are still very competitive
2. Once confidence returns, Americans will resume spending. This will create some 'domestic service' jobs, but it will also restore to some degree the spending which caused the problem in the first place.

The focus of this NZ Herald article however was the strength of the Dow Jones. The problem with the Dow Jones as a measure of financial well-being is:
1. The US has greatly depreciated in the time since it bottomed; and some of those economies to which it trades, have therefore been impacted. The USD has likely bottomed I would suggest to you. Its at an all-time low against the Philippine Peso.
2. The Dow has benefited from a significant amount of monetary stimulus by the Federal Reserve
3. Interest rates are very low - so of course equities will out-perform the bond market.

The issue is whether yields are attractive; whether the stimulus will be sustained. Investors apparently think it will be; or are they going to capitulate in coming days, and send the Dow crashing back down? Time will tell. There is no reason to say that Americans will not resume spending at some time. There is every reason to think that the softer currency and immigration will not effectively recapitalise the nation, that higher taxes a nd restored activity will result in a budget surplus as well as more jobs. The question is whether confidence has returned. We'll see.

Is the time to 'invest in stocks' destined to come after a doubling in the market? Apparently Robert Pavlik, chief market strategist at Banyan Partners, thinks so. We are told that these equity price gains can be sustained because earnings have risen drastically. Well, we need to factor in whether:
1. Those earnings came from consolidation gains - taking over the competition - remembering that corporations entered the recession cashed up
2. Higher prices due to weaker US
3. These earnings can be sustained if there is an increase in taxes

The implication is that now is a great time for American Filipinos to move their savings to the Philippines if they are looking to retiring there, or simply to paid off any investments in property there. The USD is I suggest going to be stronger from herein, or at least after that support is reached.

Asian property markets outperforming Japan Foreclosed Guide Philippines Property Guide
Profit from mining with Global Mining Investing eBook

Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

Australia in great shape - better without Gillard

In the last week there has been a raft of news confirming our views of the last year that Australia will weather the current global economic storm very well. In fact it always does. Any collapse in commodity prices is accompanied by a collapse in the $A. The current scenario is even better. We can see from several announcements that Australia's trade surplus is not just good, but excellent. Its at record levels - see article 1 and article 2 to that effect.

Australia is benefiting from a combination of factors:

1. Higher export volumes of minerals - particularly gold, iron ore and coal I suspect, maybe alumina.

2. Higher export prices - for this year anyway - so expect trade surpluses of another $3bil per month, rising to $3.8bil in 9 months, before they fall back to $3billion.

3. Strong population growth. Did you know immigration numbers have doubled from 140,000 to 300,000 between 2007 and 2010. Its part of the stimulus.

4. Business investment in mining and energy is strong - despite the tax applied by Gillard - which destroyed our credibility. There is already a lot of work in progress, so it will take a few years for our loss of credibility to show up in stats. In the meantime, the govt will need to beg for the forgiveness of foreign investors.

5. Chinese stimulus in the wake of the 2008 Sichuan earthquake and more recent Chinese government stimulus of RMR 4 trillion is going to benefit Australia. You can almost expect $500 billion of that money to make its way to Australia in terms of mineral purchases and mine investments. In reality, it might come from a different pot, but its all good. Except for Labor. They go to purgatory.

If you want to profit from mining buy a mining stock - don't encourage government parasitism.

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Andrew Sheldon www.sheldonthinks.com

Australian market outlook - May 2010

You may have read that the Australian housing market is in for an 'implosion'. Read this article in The Australian. I disagree with this analysis by a US investment banker.

The guy who emailed me this story also made the point:

"Is the Australian house market a bubble? The Australian money supply (M3) has gone up 10% per year, the last 10 years. It is not an issue of if, but when".

Here are the reasons why I think there will be no collapse. But I do expect higher interest rates, and I do not expect much growth (if any) in prices. Yields need to rebuild in property.

The increases in the money supply have occurred because of huge capital inflows and investment, so matched by increases in productive capacity in mining. The outlook is for more mining investment in iron ore, coal, oil & gas. The outlook for commodity prices is rather good. Expect $300 billion of mining investment in the next 20 years.
Property prices are high because govt artificially keeps them high by restricting land releases, so they can keep taxes high, keep you working hard, and minimise the cost of local services, i.e. roads to nowhere, buses servicing no communities. High rates of immigration can be expected to assist with property demand. Where are all the NZ'ers going to go for a job. Sorry, you are right, they are all already there. :)
Many argue that China is a bubble, but again with huge capital inflows boosting labour productivity and productive capacity, I think there is fundamentally strength there. They are on an exponential growth path, along with India. I think this is one of those magical times where the world does REALLY WELL. Afterall 3 billion people have had their markets deregulated.
The US and EU are more of a basket case, so I think there will be a short term impact from those countries performing poorly and as he suggests 'boosting their money supply', but the long term looks good for Australia and the world, and govt spending will raise demand in the short term, as much as it might be inefficient expenditure.
I think markets will fall, and activity subdued only for the next few years...sideways more than anything. There was no huge capacity overhang when the US tanked, so the slack will be absorbed in a few years.

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Andrew Sheldon www.sheldonthinks.com

US Fed reaches deep for new levels of delusion

The latest headline “US Fed sees signs of economic upturn” by Rob Lever, SMH Online, 21st May 2009 has the US Fed recognising "tentative evidence" that the US economy is emerging from recession and could show modest growth in the second half of 2009. By way of our analysis, suggests a new low in US Fed delusion. How possibly could the US be looking at turning around when it’s just about to experience a re-setting of mortgage loans. Remember the sub-prime crisis. Well there is an equally large problem facing US mortgagees – the resetting of those ‘teaser’ interest rates to market rates. Now, I must concede that those interest rates are not going to reset at troublesome rates in the short turn, but with the Fed and central banks around the world pumping money into the banking system, the day is not too far away that we are going to experience some inflationary pressures. Just as governments have been stripping out costs to reduce taxation, now we are going to see consumers or households facing higher costs, higher inflation, partially for the sake of debt sustainability, and partly because there is so much paper money in the market which is not supported by current levels of economic activity.
The Fed revised its economic outlook to suggest US output would fall 1.3-2.0% over 2009, and that the worst declines may be over. Well that does not surprise me. If you are ‘high’ on economic stimulus there is no question people are going to feel good about a stabilisation of asset prices, but at some point inflation is going to take its toll on household’s purchasing power.
The notion that “there are improvements in financial and credit markets” only highlights the fact that the Fed and other central banks have been recapitalising the banks using taxpayer money, and rather then using the proceeds to lend to households, who are already indebted, the banks have been speculating in the securities markets, driving up security prices. This will come to an end at some point soon, and we will be looking at another volatile downtrend through 2009-2010 as interest rates move higher.
US economic output fell by 6.1% in the March quarter of 2009 after a 6.3% fall in Dec-08 quarter. They are serious hits to the market, but more will follow. There is at least some recognition that this is crisis is not over. The Fed projects unemployment to rise from 8.9% in 2008 (a 25-year high) to 9.2-9.6% in 2009.
The Fed expects inflation to hold at 0.6-0.9% in 2009. I have never believed in inflation numbers because you only have to look at how they define the concept. Any measure of inflation that does not consider all asset prices, excludes the most important components like securities, food and energy, is just trying to plan delusional games betting on Chinese deflationary impacts. A sudden loss of economic capacity is going to result in higher fixed costs to all production. There is no escaping that, though if you are selective in your inflationary analysis, you can of course opportunistically consider energy and asset prices, which have been falling...but not for much longer. The reality is – inflation as defined is manipulated, so give it no heart.
Now for those of your with a sense of humour. The Fed is forecasting “modest growth” of 2-3% in 2010. Wow, that is quite a turnaround. You might be inclined to believe that there is no reason why this market cannot just turnaround like it did in years past. Afterall as long as the Fed and other central banks shore up the banking system, what it to stop Western governments from sustaining this delusion for years to come. I think there are several issues which can stop them:
1. War
2. Pandemic
3. Debt levels
The international political environment is pretty tense, but there is probably little prospect of war or further substantial military action at this point since oil prices have fallen significantly. A pandemic is a threat to consumer spending, though I would suggest any threat is likely to be short lived. It might actually be expected to affect the financial system more than the real economy. My analysis is that it will cause short term financial volatility, which will probably knock a few more financial institutions out of the market, but that the market will recover from a bird/swine flu based pandemic. We will stock up on food, hide in our houses for a few weeks as it sweeps the world, and on that basis it will die out, and become a less virulent strain.
Debt levels remain the biggest obstacle to the sustainability of the current economy. Even if tax increases can be delayed a few years, it will only result in government debt being rising to the same levels of household debt. With many households already having lost a lot of equity in their homes in recent times, causing the biggest mass transfer of wealth (as a % of GDP) in history, who would expect a recovery? This at a time when governments are moving to consumption-based taxation. Who understands the logic of these people? Well of course its a desire for short term political power, and taking every expedient step to preserve it.
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Andrew Sheldon www.sheldonthinks.com

The global economic super cycle

These are interesting times. We are told that this is an inflationary cycle. True enough. But its not exactly clear just how significant this credit squeeze is. My personal opinion is that this is just a medium term correction, that within 18 months we are going to see a new period of credit growth. My reasons for believing this are that this 23-years growth period (1984-2007) has been too limited or regional. It was in Asia ('the tiger economies'), then it was the West, then the commodity countries. I am looking for a period when it is everywhere, when all markets are booming. I know that we will be at the top of the economic cycle when the developing countries are having property booms, when there is an excess of industrial capacity rather than a shortage. You might say that over-supplies start with shortages since they are what ignite all the new capacities. But this is what differs. This is a super-cycle where the bottlenecks run so deep that there is no chance for sufficient supply to meet demand. For this reason, I think the current credit squeeze is a period of debottlenecking. That the relaxed demand will see softer prices, particularly in assets, but it will be a period of rebalancing. Everyone is going to be relatively rich because of the huge productivity gains that are going to come from technological change.

My understanding is that this is one of those economic cycles that come around every century or so, the last being the 1880s through to the 1920s, when the world goes through a economic revolution of soughts. The Modern Era started in the Rennnaissance in the 1570s, with Leonardo Da Vinci and others. Invention of the printing press and global exploration driven by news ideas and technology. This is such a period with global inter-connectedness which will do the following:
1. Allow people in third world countries to catch up on technical skills faster than at any time in the past. Every day more & more of the information we need is on the internet and its going to grow. So how does one differentiate oneself? By having better, more useful, more insightful information.
2. The culmination of that trend is going to be global outsourcing of services. It will start with basic things like accounting, bookkeeping, technical support for call centres, but eventually it will include sales roles and project management.
3. This of course has to push a lot of productivity incentive upon the Western countries who need to stay relevant. The key is for the West to appreciate their strengths.
4. The globalisation of markets will change the way we relate. The distinctiveness between cultures will die. The market will become global. already markets are aligning. Sadly there is no competition between governments so it looks like they will align themselves in their common goal of screwing taxpayers.

The big feature of this credit expansion is that its going to move to Asia. The ASEAN region is currently creating a framework for economic integration which I believe is going to make this a region not just of savings to finance the West, but a region of conspicuous consumption. We are going to see more Indians and Chinese holidaying in the Philippines, Indonesia, whilst these countries reform to embrace the benefits of capital inflows. China and India will continue to rapidly urbanise their populations, with those new pools of labour providing part of the productivity gains, the rest coming from better organisation and technology. Organisation will mostly mean more outsourcing and specialisation.

So what are the implications for markets and commodities?

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Andrew Sheldon www.sheldonthinks.com

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.

Vietnam
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.

Philippines
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.

China
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.


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Andrew Sheldon www.sheldonthinks.com

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.

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: www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/11/28/ccrock128.xml. 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.

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).

BUY BUY BUY!!!

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%.

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.

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?

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.

Inflation

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 CNNMoney.com. 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 rest....so 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.