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THE SYMBIOSIS TRAP
A year ago, the macro debate was dominated by concerns over mounting global imbalances. Our 2005 outlook piece, modestly entitled “How to Fix the World”, probed in great detail the coming rebalancing of a lopsided world economy. The passage of time has not treated this outcome kindly. Global imbalances have continued to mount, but few seem to care these days. I suspect that 2006 will be a year when that ambivalence is shattered.
The broad consensus of financial market participants has come to the conclusion that there is a new symbiosis between America’s record-setting external deficit and those willing to fund it. China is typically singled out as the most willing participant in the “symbiosis trade” – the arrangement whereby the U.S. buys goods made in China in exchange for China’s willingness to buy bonds printed in Washington. On the surface, this seems like a terrific deal for both – providing American consumers with the interest rate subsidy needed to sustain wealth – and debt-dependent spending and helping China limit an appreciation in its currency that might otherwise hamper its export prowess.
Because this implicit contract has enabled China to keep its currency tightly aligned with the U.S. dollar, many have also referred to the new symbiosis as a “Bretton Woods II” regime – the modern-day sequel to the dollar-based international financial architecture that was adopted in the aftermath of World War II. Advocates of this view conclude that since it is in both parties’ best interests to perpetuate the symbiosis, there is no reason why it should change. With net foreign purchases of long-term U.S. securities averaging $114 billion in September and October 2005, the latest facts are certainly not getting in the way of that logic.
I worry, however, that the sustainability of the symbiosis trade is predicated on a very dangerous ex post rationalization of global imbalances. As was the case in the midst of recent bubbles in equities, bonds, credit, and property, there are important kernels of truth to the notion of a new international symbiosis. The increased trade and capital flows that stem from the cross-border connectivity of globalization create a growing sense of co-dependence in the global economy. The U.S. dollar’s role as a reserve currency adds confidence to the notion of an expanded dollar bloc. But at the end of the day, I do not believe that this arrangement is either desirable or sustainable from the perspective of either of the two main protagonists in the new symbiosis – China or the U.S.
China’s problems stem in large part from excess foreign exchange reserve accumulation. Lacking a well-developed domestic debt market, China can only sterilize a portion of these purchases; the rest leaks back into its domestic financial system – leading to excess liquidity and concomitant asset bubbles. With an estimated 70% of its reserves in the form of dollar-denominated assets, the mark-to-market costs of a significant further depreciation of the dollar would represent a major fiscal blow to the Chinese economy. And this perceived symbiosis begats an ever-widening bilateral trade imbalance between the U.S. and China that only heightens the risks of trade frictions between the two nations.
The risks are equally disturbing from America’s point of view. Foreign purchases of dollar-denominated assets represent the functional equivalent of a subsidy to U.S. interest rates, thus asset markets enjoy artificial valuation support. The result is a surge in housing values that many Americans now perceive to be a new and permanent source of saving. This, in turn, has had a profound impact in reshaping saving and spending strategies of U.S. consumers. In essence, the income-based consumption models of yesteryear have been replaced by asset-driven frameworks. The result is unprecedented consumer vulnerability on both the saving and debt fronts.
“So what!” retorts the symbiosis crowd. As long as the world is willing to finance America’s saving shortfall, goes the argument, there is no reason to worry about sustainability. This, in my view, is the essence of the “symbiosis trap”. The consensus has been lulled into a false sense of security – believing that imbalances will remain a non-issue for the global economy and world financial markets. That view could well be tested in 2006. For starters, global imbalances are likely to go from bad to worse over the next 12-18 months, pushing tensions in both the U.S. and China ever closer to the breaking point. In the case of the U.S., pressures are likely to intensify on two fronts: the housing market and the savings front. America will be upping the ante in terms of what it expects from China and the rest of the world in order to sustain the symbiosis trade. Such an outcome could put increasingly acute pressure on an already unbalanced Chinese economy.
The case for global rebalancing was dealt a tough blow in 2005. The dollar’s surprising appreciation led many to believe that financial markets are perfectly capable of coping with massive external imbalances. In my view, that coping mechanism has led to a false sense of complacency that could well be tested in 2006. In particular, a further deterioration of global imbalances – more likely than not over the next year – could well have adverse consequences for already-extended U.S. and Chinese economies. The result could be a sharp decline in the dollar and related upward pressures on U.S. real interest rates – developments that would take generally complacent investors by surprise. I have long been wary of new theories that spring up to explain away old problems. That was the problem with the so-called new paradigm thinking of the late 1990s. And it could well be the ultimate peril of the symbiosis trap.Link here.
EU ORDERS OFF-BALANCE-SHEET DISCLOSURES
The European Union is requiring listed companies to disclose off-balance-sheet transactions and provide more information about their corporate-governance practices. The new rules, proposed by the European Commission in October 2004, are partly in response to accounting scandals at Enron and Parmalat. Both companies have been accused of hiding their crumbling financial positions in hard-to-decipher off-balance-sheet vehicles. Under the new rules, listed companies must disclose all off-balance-sheet arrangements – including related financial impacts – in notes to the annual and consolidated accounts. Companies must also publish an annual corporate-governance statement. In addition, listed companies must provide more information on “unusual transactions”, including, e.g., arrangements with the spouse of a board member.Link here.
ONE SMALL STEP FOR PENSIONS
The Financial Accounting Standards Board further addressed its widely anticipated project on defined benefit pension and other postretirement plans. The first phase of the two-phase project is intended primarily to improve financial reporting by requiring that the overfunded or underfunded status of postretirement benefit plans be recognized on the balance sheet rather than in footnotes, the prevailing practice today. “Pensions tend to be complex and the accounting that we’ve had has been complex,” says FASB board member Michael Crooch. “My personal hope is that we’ll be able to simplify the accounting.”
The only real disagreement among board members related to the treatment of unrecognized prior service costs, from plan amendments that increase benefits, and credits, from plan amendments that reduce benefits. “Some people thought that that [unrecognized costs and credits] ought to be in the second phase rather than the first,” explains Crooch.Link here.
FUTURE COULD BE ON THE ROAD TO GOLD
Pierre Lassonde, president of Newmont Mining, told me gold had nowhere to go but up. That was August 2003, when gold hit what was then a high of $375 an ounce. Last Monday, the price of spot gold hit a 25-year high of $528.40 on the New York Mercantile Exchange. The price has since slipped back to about $507. This is in line with Lassonde’s predictions this year. In September, he said gold would hit $525 by early 2006. On November 28, as gold crossed the $500 mark, Lassonde predicted gold would hit $1,000 in the next five to seven years. “The gold market is hot, and it is going to get hotter,” Lassonde said in a recent interview.
Lassonde, of course, could be dismissed as a gold bug. He is the author of Gold Book: The Complete Investment Guide to Precious Metals. And as a gold- company executive, he has a substantial portion of his net worth tied up in gold. Still, his reasoning is compelling. He says demand will continue to outstrip supply as gold recovers from a prolonged bear market. Gold prices peaked at $850 an ounce in 1980 and fell to nearly $250 in 1999. During that time, gold production declined. Today, mining companies, including Denver-based Newmont, are playing catch-up. And it takes years to get gold mines up and running. Demand for gold is expanding with economic growth in China and India. As these nations prosper, their consumers buy more gold in the form of jewelry or religious statues. Also, unlike Westerners, many Easterners view gold as a traditional store of wealth. Chinese citizens were not allowed to buy gold at market prices until 2002. This new freedom is also boosting prices.
Americans, too, now have more ways to buy gold. In 2004, for instance, an exchange-traded fund called StreetTracks Gold Shares became available to individual investors for the first time. The fund, which trades under the symbol GLD, is backed by a trust that holds gold. As money pours into the fund, it buys more gold. Despite gold’s recent rise, there are plenty of naysayers. “It’s had a nice run over the last 24 months, but gold is easily the single worst investment of the last 25 years,” said Jeff Thredgold, an economist with Vectra Bank Colorado. “At these levels, I would call it fool’s gold.”
Peter Schiff, president of Euro Pacific Capital Inc. in Darien, Connecticut, has been sending me emails since 2003, predicting a long-term bull market for gold. His bright outlook for gold is based on his dark predictions for the U.S. economy. Schiff points to a nation with an $8 trillion federal debt, propped-up home prices and profligate consumer spending. He said he believes that rising gold prices are a reaction to rising inflation, soaring interest rates and a fear that the dollar will eventually collapse. He says other world currencies are likely to fall as well. Inflation is “going to go through the roof, and no one is going to want to hold any of these currencies,” he said. “They’re going to want gold.” Mainstream economists say the nation’s debt load is manageable, given the size of the U.S. economy, and that inflation is in check. But what if all this conventional thinking is wrong? “Look at all the nonsense that relatively intelligent people believed in the late 1990s about the stock market and the Internet,” said Schiff. “There were all these economists. Some of them had Nobel Prizes. But they believed in nonsense.” Gold, he says, will cut through the nonsense.Link here.
2005 WAS A BANNER YEAR FOR CORPORATE BUYOUTS
Buyout firms are wrapping up one of their busiest years ever, shaking up the managements of hundreds of companies and setting up 2006 as a year for many companies to be restructured, fixed up and sold. Private-equity firms, consortiums and investors have bought 1,119 companies this year for $135.7 billion, says Dealogic. That is the busiest year for such deals since at least 1990, says Thomson Financial. Many targets have been household names such as Hertz, Toys ‘R’ Us, Neiman Marcus, La Quinta and Dunkin’ Brands, the owner of Dunkin’ Donuts. The targets keep getting bigger as more pension funds, institutions and wealthy individuals hand money to private-equity firms. “So much money needs to be put to work,” says Allen Stern, managing director at Imperial Capital. Private-equity investors “rather than give the money back, they must look for deals.”
“Interest rates are low, and real estate prices are high. Borrowed money is cheap and easy to raise to finance big deals,” says Kevin O’Mara, partner at Cadwalader Wickersham & Taft. In some cases, target companies’ real estate holdings are being used as collateral for loans or sold after deals close to raise cash, says Susan Schnabel, partner at DLJ Merchant Banking. Most industry experts expect next year to be just as busy. It could be the year many private-equity investors cash out of their holdings by selling them to larger private-equity firms, big companies or to the public as IPOs, says William Means, managing partner of Merion Investment Partners. “2006 will be a great year for exits.”Link here.
“IT’S OVER” … THUS BEGAN YET ANOTHER CONVERSATION ABOUT REAL ESTATE
The man speaking was a real estate developer and investor from Florida. The man listening was a writer from Maryland. The man recording the conversation was your editor. “I have been trying to sell my house for two months,” responded the man from the Old Line state. “About 20 people looked at it, but not a single person made an offer.”
“You’re going to have to lower your price,” said the Sunshine State (Maryland) man. “People still think they can get bubble prices for their property. But it’s over. I mean, the bubble is over.” Prices may not crash, opined the developer, but the bubble-rate rises are finished. We knew they would come to an end someday. If our friend is right, the precise day was the 16th of December 2005. Why that day? We do not know. Perhaps it was the 13th rate increase from the Fed; it had an unlucky sound to it. Maybe it was the spike in the price of gold. Or maybe it was nothing at all. When things need to be tipped over, there are always points when they will be. Maybe the tipping point for U.S. real estate prices came last week. Maybe it will come next week. But what will happen?
To this question we have no better answer than anyone else. We notice that the tipping point for bubble gains has already come and gone in both Britain and Australia. Both economies seemed to count on further bubble gains in order to keep going. But when the gains ceased … the economies kept going anyway. That is the part that puzzles us. We saw the bankruptcies and foreclosures coming. What we did not see coming was so much nothing. That is, we saw the economies of all three Anglo-Saxon countries – Britain, Australia, and America – dangerously dependent on house price increases. When house prices stopped rising, we expected a lot more trouble than has so far revealed itself. We have not been to Australia for many years, but our people on the ground tell us that things seem perfectly normal. If the end of the world has come, it is news to the Aussies. They are still spending money. The economy is still expanding. No worries, mate. Likewise, in Britain, there is no sign of calamity.
So, dear reader, there is life after the real estate bubble after all. What kind of life remains to be seen.Link here.
Housing market: Room for improvement?
If a plasma television, brand-new washer and dryer, and/or deluxe fitness center are on your wish list this Holiday, now there is a way to get all three for free: just buy a house. In case you had not noticed, cobwebs and icicles are forming on FOR SALE signs across the nation as the U.S. housing market goes from “You had me at hello,” to “Show me the money honey.” A December 1 Washington Post drives the point you know where:
“Homebuilders everywhere are making a greater effort to attract buyers, offering incentives… to try to maintain the brisk sales of the past five years. People are taking more time to make a decision and shopping around longer. There is an increased competition among sellers” to get their homes off the market. And how bout some of these carrots: One of the country’s largest homebuilders is enticing its customers with reduced closing costs, finished basements, exclusive landscape packages, top brand appliances, and $95,000 in design-center options – all on the house.
With the number of unsold homes in October rising to the highest level in 19 years, we cannot say we blame them. As for what the housing market should make of the dramatic shift from bidding wars TO bargaining chips – the mainstream “experts” offer these words of wisdom: After a long period of one side feverishly wooing the other, we now have a “healthy” and “mutual” courtship. Apparently, the December 20 housing start data revealing a 5.3% rise in the construction of new homes for October offered just enough support to keep this idea alive. In the words of the chief strategist from Dow Jones MarketWatch: “We’ve had some mixed signals from the sector but on the whole, the data suggests it keeps rolling along.” Or: “Housing once again shows its strength – the zombie market that just won’t die.”
It is official. Bullish enthusiasm for the future of housing has now reached the point where the public willingly accepts a walking cadaver over a rosy-cheeked market, so long as its still walking. And nothing reflects the depth of their faith like this December 20 Dow Jones Market Watch detail: The biggest portion of holiday money this year will be spent on NOT gifts, NOT travel, YES home improvement. “US consumers plan to spend an average $628 on improving their house, up 84% from the amount spent in 2003 this time. It’s likely consumers’ drive to beautify their home is connected to rising house values in recent years. There’s a belief that ‘I can spend on my home and get the money back.’”
Considering the incentives brokers and builders are offering, these days the best way to improve a home is to buy one. Think about it, though. Consumers are basing their “belief” in the housing market on “mixed signals” and government data that is, for starters, “subject to large samplings and other statistical errors,” not to mention the fact that it takes up to five months for a new trend to be established in housing starts. So explains the small, fine, print at the bottom of those articles celebrating the rise in October housing starts.
Call us crazy, but we prefer objective analysis of the housing market that calls the changes in trend BEFORE they happen. As we said this past March, the next phase of the housing market is set to start and will be accompanied by the following changes: “Demand wavers, supply spikes higher and sellers hold out for higher prices and sell at lower prices.” Sound familiar?Elliott Wave International December 20 lead article.
Should you invest in real estate?
We all know that property values never go down. Right? After the stock experience of 2000-2001, people are saying, “Maybe stocks can come down for a few months from time to time, but real estate will not; real estate never has.” They are saying it because real estate is the last thing still soaring at the top of the Great Asset Mania, but it, too, will fall in conjunction with a deflationary depression. Property values collapsed along with the depression of the 1930s. Few know that many values associated with property – such as rents – continued to fall through most of the 1940s, even after stocks had recovered substantially.
The worst thing about real estate is its lack of liquidity during a bear market. At least in the stock market, when your stock is down 60% and you realize you have made a horrendous mistake, you can call your broker and get out (unless you are a mutual fund, insurance company or other institution with millions of shares, in which case, you are stuck). With real estate, you cannot pick up the phone and sell. You need to find a buyer for your house in order to sell it. In a depression, buyers just go away. Mom and Pop move in with the kids, or the kids move in with Mom and Pop. People start living in their offices or moving their offices into their living quarters. Businesses close down. In time, there is a massive glut of real estate.
In the initial states of a depression, sellers cling to an illusion about what their property is really worth. They keep a high list price on their house, reflecting what it was worth last year. I know people who are doing that now. This stubbornness leads to a drop in sales volume. At some point, a few owners cave in and sell at much lower prices. Then others are forced to drop their prices, too. What is the potential buyer’s psychology at that point? “Well, gee, property prices have been coming down. Why should I rush? I’ll wait till they come down further.” The further they come down, the more the buyer wants to wait. It is a downward spiral.Link here.
“I started selling these lots much too cheap,” began a neighbor in Nicaragua …
“I was letting these beachfront lots go for $30,000 to $50,000. But that was before this big boom in America got underway. I built condos on the ocean, too, and sold them for $150,000. That was only three years ago … no, only two years ago. But I resold one of them last week for $279,000.” Property buyers in Nicaragua – as in Florida and California – seem to have spent too much time in the sun. They have become feverish.
“Even the ‘B’ lots – you know, those that aren’t on the beach – are selling. We’re almost out of them. And I’m amazed they would sell at all. It’s low land. And when it rains, the whole place is underwater. My tractors got stuck three times during this last rainy season. But the strangest thing was this guy who wanted to buy one of the back lots. He came during the rainy season, so I didn’t want to show it to him. Because it was under about a foot of water. Luis came to me and said he wanted to borrow the tractor. I asked what for. He told me the client wanted to see the back lot. We could only get in there on the tractor … and even then I was afraid it would get stuck. But he got on the tractor and went to look at the lot and bought it.”
People occasionally make a mistake and buy a lot that is underwater. Sometimes they get conned or swindled and end up with a waterlogged lot. But a real bubble market turns swindlers into honest men. They can tell the truth and still make a sale; the customer swindles himself. The bubble may be over in North America, Australia and Britain. But new trends reach the tropics slowly, as if by steam packet. For now, developers in Latin America are selling condos, houses and underwater lots without hardly trying.
And perhaps the buyers are not such fools, after all. Your editor bought a parcel down the coast a few months ago. The price was exorbitant by Nicaragua standards. But compared to the rest of the world, it was a bargain. Even $279,000 for an ocean front condo would leave change in a Miami-based buyer’s pocket. And, of course, other costs are lower too – cleaning, gardening, and dining out. Everyday that our family spends in London costs a fortune. We cannot go out to dinner without spending at least $100 … usually more. We take a taxi across town and easily pay $40. A cup of coffee and a croissant sets us back $15.
But here, our wallets mildew from lack of use. There is nowhere to go … scarcely a thing to buy … and nothing to do that costs money. We can play in the surf … ride horses … sunbathe … play tennis … read … write … doze … none of it costs much money. We probably save $50 a day just by being here. In a month, we have saved nearly $1,500 – about enough to cover airfare.Link here.
HEDGE FUND CLIPS CLIENTS
Centrix Capital Management, a $700 million Colorado-based hedge fund, is limiting customer withdrawals from its main portfolio. Centrix took the unusual step to keep institutional investors from fleeing the fund after it was hit with hundreds of millions of dollars in client redemptions. Ordinarily, hedge funds just sell positions to raise money to pay their clients back. Centrix, however, packages sub-prime auto loans for its investors. Because those loans are private and held to maturity, there is no market in which to trade them to more willing buyers. Centrix has gone from about $700 million in assets to $442 million, according to Hedgefund.net.
“The cash we generate [from principal and interest payments] is the only cash we have,” said Centrix chief investment officer Clark Gates. The fund has had to ration withdrawals because, Gates said, “we don’t have liquidity in these loans.” He described the sudden rush for the doors as “a result of two of our larger investors needing to raise cash at once, for their own reasons.” Gates declined to name the investors who sought to redeem simultaneously.
Centrix is owned by Centrix Financial, one of the largest issuers of auto loans to people with less than stellar credit ratings and has had interest payments to its portfolio of high-yield loans hurt by Hurricane Wilma, Gates said. The loans themselves are insured so even in default, the fund should stand to get its principal back. One potential investor in Centrix said he was scared away from the fund because it had posted its October or November performance numbers yet. In August, in the wake of Wilma, the fund dropped 1.03%, its first monthly loss since opening last year. So far this year, the fund is up 4.80%. Gates declined to comment on the performance figures.
Several hedge funds specializing in buying asset-backed loans said that Centrix had approached them to potentially purchase a portion of the portfolio to raise cash. Gates declined to comment on this, but did say that one of the options the fund has is to pay its investors back “in kind” with the loans within the portfolio.Link here.
SAVINGS ACCOUNTS LOW ON INVESTMENT LADDER
OK, America, it is time to wake up that sleepy money and move it! I am speaking about money sitting in bank savings accounts and other moldy places. In truth, if you examine your banker, he would probably make a good stand-in for the Grinch, who believes money is worth 20% or more (plus whatever fees he can tack on) if he is selling it to you, but your money is worth next to nothing when you deposit it. I say this having searched the pathetic offers most banks are making for our cash and savings these days. Here is a comparison based on national averages.
Here are two recommendations. If you know money will not be needed for two to five years, invest it accordingly in longer-term Treasury securities. You will increase your yield substantially. If you have a good deal of money, this would be a good time to establish a Treasury ladder, owning securities that mature in one, two, three, four and five years. You will collect over 4% and have minimal interest rate risk. If you know money will not be needed for at least five years, consider putting it in I Savings Bonds. These will earn at a 6.73% annual rate until May. Those purchased between now and then will earn at 1% plus the trailing rate of inflation. The interest will accumulate tax-deferred, you will have inflation protection, and inflation needs to average only 2.89% a year to beat the 3.89% yield on the average bank CD.Link here.
SWISS RE SAYS 2005 DISASTERS COST INSURERS RECORD $80 BILLION
Insurers had their costliest year ever in 2005, racking up an estimated $80 billion in losses amid catastrophes including Hurricane Katrina, according to Swiss Reinsurance Co. “The full scale of the catastrophes in 2005 has not yet been fully assessed, but the trend toward very high losses appears to be continuing,” Swiss Re, the worl’qs second-largest reinsurer, said in a copy of a preliminary study.
Katrina, which struck the U.S. Gulf Coast and New Orleans on August 29, resulted in an estimated $45 billion in insured losses, according to the study. More than 112,000 people have died in disasters this year, with at least 90% of those in Asia. They included more than 87,000 people killed by an earthquake that struck Pakistan and India October 8. An earthquake in Indonesia’s Sumatra Island in March killed over 2,600 people. “The high death toll from these events is due to the high seismicity, but also to poor building standards in the regions affected,” Swiss Re said in the study, written by Aurelia Zanetti, Clarence Wong and Thomas Holzheu.Link here.
8 PREDICTIONS FOR TECH, INCLUDING WHY YAHOO’S EXPANSION OF SEARCH WILL HURT GOOGLE
Anything and everything Google is at the height of fashion right now. With a market capitalization of $127 billion, every move that the company makes – like the advertising deal an obsessed press says it will announce with Time Warner’s AOL unit – gets a lot of attention in the press. But what goes up must come down – especially in technology, the most volatile industry the world has ever seen. Yes, I love Google, but my first prediction is that a year from now we will not think that the search company is the invincible behemoth that we do now.
One reason for this a new concept known as “community-powered search”. Yahoo is forging an early lead over Google in this fast-evolving technology with its acquisition last week of del.icio.us. Del.icio.us operates on principles similar to the popular MySpace. But whereas that social network site helps members find dates, form groups, and share music picks, del.icio.us helps members find hot information – websites that others have found useful. Soon we will see a new form of results, like “What Others Liked”, on all search engines. It is how Amazon tells its customers what others have bought, except that these search results involve information. In many cases, community-powered searches will let members find what they are looking for more quickly than they would on a purely computerized type of web search, which Google does so superbly. Yahoo was already introducing community-based searches with My Web 2.0. Of course, Google is surely working on its own alternatives.
My second prediction is that Amazon will re-emerge as one of the web’s most powerful properties, and provide increased competition for Google in 2006. Amazon has done a nice job grabbing more and more commerce dollars, but it has bigger ambitions, and a savvy tech strategy. My third prediction is that telcos will become more powerful Internet service providers. My fourth prediction is that Apple is likely to introduce a cell phone next year. I say this only because one of the consumer technology problems that most begs to be solved is the MP3+cell phone combination.
Here are the rest of my tech predictions for 2006: 1.) TV viewing on cell phones will become routine – everywhere, that is, but in the U.S. 2.) AMD keeps kicking Intel’s butt. 3.) Microsoft’s big software launches next year – the Vista operating system and the next version of Office – will not generate much excitement. 4.) Cisco may be the big-company investment of the year. This company’s stock has flat-lined for 18 months, but every single trend that matters involves more bits flowing through more Internet-protocol pipes. Cisco remains so dominant in the business of building Internet-protocol infrastructure that its earnings growth could wow investors in 2006. Juniper, another network equipment manufacturer, will not do badly either.Link here.
AMID INQUIRY, CHIEF OF ITALY’S CENTRAL BANK RESIGNS
It was a drama that engrossed Italy’s political and financial circles. Antonio Fazio, the governor of the Bank of Italy, was at the center of a storm over efforts by foreign banks to buy an Italian bank. His late-night phone calls were wiretapped. Even his wife’s conversations with a top Italian bank executive were tapped. And yet for six months he still refused calls from the prime minister and others to step down. Until Monday. Mr. Fazio, who had lifetime tenure since his appointment to the post in 1993, had become one of the most powerful officials in Europe. An esteemed economist, he enjoyed a good reputation during his first decade running an institution considered above Italy’s political fray.
But his standing – and that of the central bank both inside and outside Italy – began a steep descent in July, when the Italian press began publishing the text of conversations that had been wiretapped. Those phone calls suggested that Mr. Fazio had been trying to help an Italian suitor outmaneuver a foreign one in the takeover of Banca Antonveneta. The scandal surrounding Mr. Fazio revolved around several traditional Italian fault lines, from corruption to the carte blanche power and influence that the country’s institutions appear to wield, without being held accountable. As Mr. Fazio was a faithful churchgoer, even the influence of the Roman Catholic Church played a role.
The reputation of the Bank of Italy is not likely to immediately recover with Mr. Fazio’s resignation. His departure comes at a time when the nation itself is mired in serious economic problems that have sapped trust in its leaders. The EU’s executive commission said that a legal action it had filed against Italy over the bank takeover remained in place. Prime Minister Silvio Berlusconi is scheduled to meet today with his cabinet to discuss a law that would strip away some of the nearly unlimited powers that bank governors now have – powers that seemed to prolong the crisis over Mr. Fazio.
Mr. Fazio, who is 69, managed for months to fend off nearly unanimous calls to resign, but he found himself in a precarious situation last week, after prosecutors began investigating him for insider trading. The Italian press also reported that Mr. Fazio and his family had accepted thousands of dollars in gifts from the head of an Italian bank, which the Bank of Italy was responsible for regulating, that was also bidding for Banca Antonveneta. Mr. Fazio’s political support seemed to wear away, as displeasure mounted at the European Central Bank and as the Italian finance minister developed legislation to depose him. Finally, on Monday, the Bank of Italy released a statement announcing his resignation.Link here.
“I’VE GOT A STOCK HERE THAT COULD REALLY EXCEL.”
If you have been reading this column for a while, you have most likely found our views different from what you normally see in the mainstream financial media. You may be curious about how we do our analysis and come up with our conclusions … so here is a quick peek at our know-how. The unorthodox economic and social perspectives we present here are based on the Elliott Wave Principle. Its main hypothesis – and the hardest one to swallow – is that mass human behavior is patterned. And since it is patterned, it is predictable.
This assertion goes against most mainstream economic theories, which claim that markets are random and unpredictable. The dominant theory among these is the efficient market hypothesis. First proposed in the 1960s, it states that the price of market securities is always “efficient”,i.e., correct, because investors are all rational beings that make decisions upon rational considerations. Therefore, prices can never be too high or too low – they are always “just right”. You can see why this view of the financial markets is so appealing. Every person considers him or herself a rational individual who makes decisions independently, free of any emotional influences. No one wants to admit that – yes, $450 for a share of Google, or $545 for an ounce of gold, or $700,000 for a one-bedroom condo may be “too high, but everybody’s buying them.” And under the efficient market hypothesis, the price is never “too high”. It cannot be. Which is a very comforting thought.
Elliott Wave Principle says that prices are inefficient, because they are a function of psychology. Individuals can be quite rational, but groups and crowds are not; they are emotional. The actions of one individual are unpredictable, but when we find ourselves in a collective environment – a sports stadium, for example – our actions lose their individuality. When 50,000 fans watch the same football bouncing around the field, collective psychology takes over, behavioral patterns emerge, and the fans act predictably. When their team scores the fans go wild, and when the tables turn they get angry and depressed.
In the financial markets – which are nothing but large crowds of investors buying and selling – mass emotions swing from one extreme to the other in exactly the same way. When millions of investors watch the price of the same security bounce around, collective psychology takes over individuals’ rational impulses. That is why most investors simply end up copying the actions of others, regardless of whether or not it is rational to do so. This cartoon has been around for years, but it illustrates this point perfectly:
First Trader: “I’ve got a stock here that could really excel.”
Crowd: “Really excel?” – “Excel?” – “Sell?” – “Sell, sell, sell!”
Second Trader: “This is madness! I can’t take this any more! Good bye!”
Crowd: “Good bye?” – “Bye?” – “Buy, buy, buy!”Link here.
SEASON’S SWEETEST TREAT, 28 YEARS IN THE MAKING
Whether or not we are witnessing a “War on Christmas” this year, certain sweeter traditions are likely to persist unscathed. Candy canes, spiced cider and Claxton fruit cakes will surely change hands and may even warm some hearts. Yet when it comes to commodities, the sweetest gift of the winter season is an opportunity that has little to do with the holidays – it is one you will rarely see in any year. In short, sugar prices show a stellar setup, the likes of which this soft commodity has not seen in three decades. What is more, our forecast will not lose its flavor for a while. Long after all the candy canes have disappeared, sugar prices should show a lasting and persistent trend. When you check out our labeled price chart that reaches all the way back to 1972, you will understand why. As Futures Junctures editor Jeffrey Kennedy explains, a truly huge “Contracting Triangle” pattern has finally come to a close.
To make sugar’s long story short, prices remain close to a reversal point that this market will not see again for quite a while. And the big trend’s nearest price target is 80% away from current levels. If you want a good idea of how long it should take to reach that point, just zoom in on more recent price action. The latest weekly price data reveals two relevant facts. The first is obvious to anyone paying attention – sugar prices have nearly tripled in the past two years. Yet what is only clear from an Elliott wave perspective is more interesting to those interested in future moves: The wave pattern traced out by that advance suggests we may see sugar’s last surge easily surpassed by what is yet to come.Link here.
“Fireworks” show to put Times Square to shame.
A little more than a week from now, millions will watch the ball drop over Times Square’s New Year’s celebration. But by that time, they may already be late for the financial fireworks show that is about to start across town at the New York Board of Trade. Coffee may well wind up one of the best opportunities of 2006, but the move that the mainstream media will point to half a year from now has actually already begun. The wave pattern traced out by coffee prices has foreshadowed a massive thrust for months, and our senior commodities analyst Jeffrey Kennedy has been closely monitoring it at each step along the way.
As Thursday’s Daily Futures Junctures points out, that thrust is finally poised to arrive: “Now that a five-wave [move] in wave one and an ensuing, three-wave [move] in wave two have occurred, the fireworks & should just now be getting underway.” Put simply, third wave thrusts like the one we expect to see in coffee are typically the most impressive moves in any wave sequence. Price gaps often occur one after another, and as Bob Prechter explains in Elliott Wave Principle, “third waves usually generate the greatest volume and price movement and the trend at this point is unmistakable.”Link here.
We inquired. … You replied. Last week, we asked you, the Rude Awakening readers, to identify gold mining companies that you believed would be attractive takeover candidates. You responded with a flood of emails. Specifically, we requested “mid-sized gold companies that YOU believe would be attractive acquisition targets for a larger gold or resource company. The suggested stock must have a market capitalization greater than $250 million. No small caps, please. And obviously, no inside information, please. We will examine the submissions that we receive over the few days and will provide a sampling of the best ideas in the December 20th issue of the Rude Awakening.”
In total, the Rude readership identified 25 different gold mining stocks, only four of which received multiple nominations. Hence, no identifiable theme emerged from the selections, except perhaps that Aussie readers responded more enthusiastically than their North American counterparts! Australia-based Oxiana Limited garnered the most nominations. Another Australia-based gold company, Bendigo Mining, picked up an enthusiastic endorsement. A little bit closer to home, Vancouver-based Northern Orion, picked up multiple nominations from the Rude readership, as did several other Canadian mining companies. The list below features a sampling of these recommendations.
Lastly, one of the more unusual ideas that we received would not qualify as a likely takeover play. Nor would it be large enough to make the $250 million cutoff, but we will mention it just the same. “Lion Selection (LSG.AX) in Australia is a Development Fund, which means it has no capital gains tax in Australia,” a reader explained. “It invests in what it sees as the most prospective gold (and other) plays around the world. It has some really promising plays in the portfolio.” In other words, Lion Development invests in the sorts of companies that COULD become takeover targets. It acquires stakes in both listed and unlisted shares of small- and medium-sized mining and exploration companies. The companies in its portfolio operate in Australia, Africa and Southeast Asia. Since the market capitalization of Lion Selection is only $150 million, the companies in its portfolio would be even smaller still. Nevertheless, it has managed to invest in companies that have attracted larger buyers. Less than two weeks ago, IAMGold made a bid for Gallery Gold, of which Lion Selection is the largest shareholder. Since we know almost nothing about the rest of Lio’qs portfolio, we cannot vouch for the stock. But we do find the company’s structure somewhat interesting.Link here (scroll down to piece by Eric J. Fry).
WHERE DO WE GO FROM HERE?
“I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crisis rather than a policy foresight that will force change.” – Paul Volker
How long can the United States continue with an ever rising trade deficit? How far can debt rise? Will it end, as Paul Volker, former Chairman of the Fed stated above, in a financial crisis? Will it end as a soft depression as Bill Bonner suggests or is it, as the team at GaveKal projects, different this time?
Over the next 10 to 12 years, we will see three recessions that will slowly move the average price-to-earnings ratio of stocks to historic lows. Rising oil and energy prices will be a main culprit of both the slowdown in the economy and an increase in inflation. Ever-increasing monetary inflation will, in fact, trigger a huge increase in all commodity prices, as well as a decline in bonds. Asset inflation will show up in the housing markets as home values continue to skyrocket. The dollar will continue to weaken against major foreign currencies. The current war will become increasingly unpopular, and the next administration will be forced to withdraw troops, under the guise of declaring victory. The American voting public will be split as never before, with major patterns in voting habits making a generational change. The newspapers will continue to write about how an Asian country will dominate the world economically in less than a few decades. Following this period of malaise, there will be an amazing cycle of new technical innovation that will spark yet another major bull market. The new technologies will change the world in ways that simply cannot now be imagined and will lead to whole new industries, putting amazing new power and abilities into the hands of individuals and governments.
The preceding scenario would, in fact, all come to pass. Except that the year was 1970 and not today. The forces that have changed the world in the decades following 1970 were only written about in science fiction and a few obscure books and journals. Who dreamed of the Internet in 1970? Who could envision that the Berlin Wall would come down in 1989? That Japan would not, in fact, dominate the world of economics and overwhelm the U.S.? Or that the China of Mao would become a capitalistic growth machine and that the USSR would break up? In the 1970s, the mood of the country was decidedly negative. Japan was eroding our manufacturing base and unemployment was increasing. Reagan spoke of the Misery Index in his race against Jimmy Carter, which was a combination of inflation and unemployment. And yet it all changed. In fact, the one constant in the modern world is that the pace of change is accelerating.
In the late 70’s and early 80’s, there was a concerted sense of doom and gloom pervading the markets. Many urged that we stock food and emergency supplies, buy gold and silver and sell stocks. Millions of jobs went offshore never to return. “Where,” many asked, “would the jobs of the future come from?” America was in decline. The correct answer then, as it is today, was “I don’t know from where they jobs will come, but they will.” And come they did, as American entrepreneurs created whole new industries. But that was then. Where are the economic miracles today that will save us from ourselves? Does the massive debt we are accumulating; both internally and abroad, matter? I do not believe that we can borrow our way to prosperity. Ultimately, there will be a rebalancing. But I do not think it will lead to a depression, soft or otherwise. It will be Muddle Through. And after that period of rebalancing, I think we will see another great boom, probably starting in the middle of the next decade.
Muddle Through will not necessarily be fun. The 70’s were times of Muddle Through. Few would willingly revisit those economic times. And things changed dramatically from 1970 until 1990, and even faster after that. I think the next period of change will happen at a much faster pace. But free markets and entrepreneurs adapt to new conditions. That is what happened in the 70’s and 80’s and 90’s, and what will happen in the future financial crisis that Volker speaks of. And I believe he is right. There will be a series of crises. But I think we have had a number of crises over the past 35 years and somehow we seem not only to survive, but also prosper.
The argument that Bonner, Marc Faber, Steve Roach et al make is that the United States is living off of the kindness of strangers. It is the savings of the rest of the world, and primarily Asia, which finances our massive trade deficit. I argue that it works both ways, as they have become dependent upon the U.S. consumer to buy their products and keep their factories humming. It is this symbiotic relationship that has allowed the U.S. to run such massive deficits without a collapse of the dollar. [However, see “The Symbiosis Trap”, the lead article on this page.]
So, do trade deficits matter? Yes, in the long run, but probably not next year or the year after that. And they primarily matter to currency valuations. Please note that currencies fluctuated up and down 30% or more in the 80’s and 90’s and the large majority of the country did not notice. Has Europe wilted because the euro is down 40% or so? So “matter” is a relative term. But it should be positive for the gold bug crowd. Because it is in the best interest of all parties concerned, the U.S. trade deficit is going to last a lot longer than most people think. The Asian countries hope that they can create their own consumer classes and slowly wean themselves from the U.S. consumer, allowing the dollar to fall gradually.
Gradually is probably not in the cards. It will be in fits and starts, with some long rallies to scare the dollar bears, like we have seen recently. I hope Volker is wrong. It would be a nice world if policy could manage a smooth transition. I strongly suspect he is right. It will be a series of financial crises that will push the dollar lower coupled with a Muddle Through Economy. During these crises and recessions, we will see consumer spending slow and savings increase which together will bring down the deficit.Link here (scroll down to piece by John Mauldin).
World imbalances: Economics, physics, philosophy?
Don’t hold your breath waiting for the stormy end feared for global economic imbalances in 2006, but do not lose sight of them either. That is the ambiguous message from economists who, after three years of constant debate, are no closer to consensus on the threat posed by record U.S. international deficits and the counterbalancing stockpile of Asian foreign currency reserves.
This year only muddied the water for many. A year ago, most agreed that further dollar weakness was a likely result of a U.S. current account shortfall closing in on $800 billion – or more than 6% of GDP. With the U.S. needing to attract nearly $3 billion of new net foreign investment every working day just to balance its books, they reckoned a lower dollar would be needed keep U.S. assets cheap enough to be tempting. But currency markets contrived to ignore the script. Focused more with the U.S. Federal Reserve’s small but relentless interest-rate rises, the dollar gained more than 10% against a broad basket of world currencies as inflows of capital to U.S. assets seemingly grew unabated.
So has a crisis been averted or just postponed? Or, as some economists now wonder, is the threat actually an illusion? Richard Berner, chief U.S. economist at Morgan Stanley, reckons it is all about context. This year’s growth, inflation and policy environment were all pretty benign for cross-border investors and financial markets, and stability ruled. “Those benign circumstances may now be changing,” he said, adding that the increasingly worrying U.S. budget and inflation outlook may be key determinants for 2006. But investors have heard dire warnings before and are now fed an almost daily diet of new interpretations and fresh angles on the nature of and risk from these imbalances. …Link here.
Do fundamentals not matter any more?
With one half of the world’s forex traders on Christmas vacations and the other half schlepping to work across the Brooklyn Bridge, currency markets are in the never-never land. Of course, not everyone is away this week – after all, currency rates are still moving, so someone must be trading. But the markets are jumping around a lot more than usual, without any clear direction or regard for economic news. For example, on Monday, December 21, the U.S. third-quarter growth estimate was revised lower. Bad for the dollar, right? You wish. Immediately after the news release, the USD started rallying, gaining some 70 pips on the EUR in a matter of two hours.
Not that the news matters that much for the forex markets on any other day, but this time of year, it matters less than ever. A week before Christmas, it is the remaining few hard-core forex traders who seem to have the markets cornered. Cornered, yes – for now. This lull will be over as soon as the rest of the traders are back to their desks on January 3. And whether you are a scalper or a position speculator, you cannot help but wonder: What does the next year hold for the buck and other majors?
There is a lot of talk about the coming “dollar collapse” due to the “deteriorating fundamentals”. It is hard to see, though, why this collapse has not already occurred, because fundamentally-speaking, 2005 was no picnic for the dollar. The same problems that plagued it in December 2004 – when EURUSD stood at $1.36 – are haunting the greenback today, when the rate is at $1.18. In fact, some of the problems – like the U.S. budget and trade deficits – have only gotten worse in 2005. And yet, the dollar has rallied all year long. Was it one of those “technically-driven” rallies? You could say that, because there sure ain’t no fundamental explanation for it. And do not bet that next year will be any different. The forex markets will always go where they want to go – that is, where traders’ mass emotions take them.Link here.
BIG MOMENTS IN FINANCIAL HISTORY … LIKE NOW?
People are famous for saying big things at big moments in financial history. “It is obvious that we are through with business cycles…” was such a declaration, made by the head of the NYSE in September 1929. A similar gem appeared some 70 years later (July 1998), from a professor of economics in the Wall Street Journal. He humbly affirmed that, “This expansion will run forever,” and for good measure he banished future recessions: “We don’t want one, we don’t need one, we won’t have one. … Our policy team will keep it from happening. … The market won’t melt down.”
That is cute, yet these expressions of prevailing psychology do have their extreme opposites. Near the end of the Great Depression, the famous Austrian economist Joseph (“creative destruction”) Schumpeter called Kondratieff’s cycle theory “the single most important tool in economic forecasting.” Similar respect for cycles and technical analysis thrived in the late 1970s and early ‘80s, after the long bear market in stocks had mocked the idea that uptrends are the normal state of affairs.
These observations amount to a lot more than a history review. In our day, academics and money managers are the commentators of choice in the business pages and on financial TV. What does this mean? And why have so many Wall Street firms reduced or eliminated their technical analysis departments? The context to what is happening now can and will inform you of what should happen next.Link here.
SIZE MATTERS AND CHINA JUST GOT MUCH BIGGER
China’s bean counters came across something extraordinary while going over a few numbers: a statistical error the size of Austria. Once corrected, China’s economy turned out to be $285 billion, or 17%, larger than previously estimated. While that does not alter the economy’s basic structure or make China’s 1.3 billion people richer overnight, the discovery is a sign of the profound changes taking place in the world economy.
In a single stroke China now appears a whole lot wealthier – something its trading partners are not likely to miss. That probably increases the odds that tensions between China and the U.S., Japan and the EU will rise in 2006. Think about it: Within its borders, China has found an economy roughly the size of Austria’s or Indonesia’s. The difference is equal to the combined annual output of Argentina, Venezuela and Ecuador. Now that is a revision!
For Chinese officials, the news is both wonderful and terrible. First, the good news. An economy few central bankers, economists and pundits thought about three years ago just leapfrogged over the U.K., France and Italy to become the world’s fourth largest. Not only does that make the Group of Seven nations look less relevant than ever, it also boosts China’s global clout overnight. “More usefully, the change improves most of China’s economic health ratios,” said Stephen Green, Shanghai-based senior economist at Standard Chartered.
When it comes to economic development, size really does matter. China’s newly discovered output provides a bigger base from which to deal with the burden of Mao-era government-run enterprises. The addition to China’s economic pie also could raise its credit rating as the ratio of bad loans to gross domestic product is recalculated. Anyone who has made the most cursory of visits to China in the past two years has probably sensed officials there were underestimating the economy. Eastern coastal cities feel like they are growing at least twice the official 9.4% annual rate. It is hardly surprising, for example, that China has been underestimating the output of its service economy. Its relatively small size has long been “one of the perennial puzzles” of China’s economic rise, Green said.
All this will make China appear less reliant on foreign investment. Today, what economists call gross fixed capital formation is about 46% of GDP. Since much of China’s newly found output is in non-investment activities, that ratio could drop toward the neighborhood of more developed economies such as Japan, South Korea, Hong Kong and Singapore. The bad news is how the rest of the world is sure to view China’s newly discovered prosperity. At a minimum, calls for China to revalue its currency will intensify. So may calls for officials in Beijing to step up protection of intellectual property and improve human rights. Until now, China argued that its economy was too fragile to withstand a rising yuan. That argument will be harder to make now that its economy is pushing the $2 trillion mark.
Yesterday’s revision does not mean China’s challenges have suddenly disappeared. It still needs to create hundreds of millions of jobs to maintain social stability. It also needs to improve the quality of its companies, foster better stock markets and create a bond market. China’s state-run banks are still awash in bad loans. Even so, China’s revision is an omen of things to come: an economy that alters the global pecking order sooner rather than later.Link here.
That blur? It is China, moving up in the pack.
Many economists have long suspected that official government statistics here provided only a shadow of reality. With China’s announcemen that its economy was considerably bigger than previously estimated, economists and financial prognosticators are scrambling to rethink their assessment of China’s rise and its role on the world stage. China’s new figures suggest that it probably has passed France, Italy and Britain to become the world’s fourth-largest economy.
Some economists are even accelerating their timetables for when China may eclipse the U.S. as the world’s biggest economy. With the new figures offering a more expansive view of economic activity, some said China could overtake the U.S. as early as 2035, at least five years earlier than previous projections. “We now have a new snapshot of the Chinese economy,” said Hong Liang, an economist at Goldman Sachs. “This is not slightly bigger – it’s a significantly bigger economy.”
China said it revised its economic data after a yearlong nationwide economic census uncovered about $280 billion in hidden economic output last year. The new output was the equivalent of an economy the size of Turkey’s or Indonesia’s – or 40% the size of India’s economy. As a result, China’s GDP for last year is now estimated at nearly $2 trillion, not the previously reported $1.65 trillion. That translates into an adjusted increase of 17%, making China the 6th-largest economy in the world in 2004.
The U.S. economy is still far in front, with a value of about $11.7 trillion last year. And for all China’s fast growth and its rapid ascension to the major leagues among national economies, it remains a relatively poor country. Even with the expected revision, China’s output per person will climb to a little more than $1,700 this year. It ranked 134th in income per person in 2003, according to the World Bank. Economists say the new figures provide good news for China, suggesting that the economy is healthier, more diversified and more sustainable than previously believed.Link here.
THE NIKKEI: RAIDERS OF THE LOST ARKS
Recently, a friend of mine told me about the timing newsletter to which he subscribes. Evidently, it had recently recommended Japan as a great play. If extrapolating the past few months’ returns (see chart) is the only measure we use in selecting investments, then, indeed, we should all be piling into the Nikkei. While no one can state for sure what will happen to the Nikkei over the next few weeks or even months, a quick look at the macroeconomics picture tells us why this recent run-up is likely not signaling a turnaround for Japan.
What I would like to do is take us through the “Museum of Not-Too-Distant History” and examine the returns in the Nikkei. Do they point to the emergence of a “Japanese Ark,” with untold wealth for the investors who have found it, or will this ark spell “financial death” for those careless enough to touch it at the wrong time. Let us start out search by going to the section called the “Museum of Government Debt”. As we comb through the artifacts of the Japanese monetary system, we find out that this time it is different. Well, maybe not different but unprecedented in size. Yet, in some ways the story is the same. As we cross the hall to the “Museum of Foreign Investment Holdings” section, we see that Japan has been accumulating foreign exchange reserves for decades. So again, purchasing U.S. assets is not a new discovery ensuring a vibrant economic future for Japan.
If we walk to the next exhibit, we can look at Japan’s purchases of foreign exchange reserves from our own perspective. Here, we scan a small government document of 198 pages. After turning past the first hundred tables, we come to one called, Foreign Holdings of U.S. Long Term Securities, by Country, as of the Survey Dates. There, buried in a long list of country names, we find Japan. We notice two things. First, Japan’s Ministry of Finance has been increasing their purchases of long-term securities in the U.S. for a number of years. As well, we see that Japan’s purchases of U.S. assets have grown exponentially since the year 2000, and that Japan now has the largest amount of financial holdings of U.S. assets of any nation outside the U.S. The size and scope of these numbers is substantial. From 1984 to 2004, Japan’s long-term U.S. securities holdings grew 32-fold! And for those of you curious about the nation with second highest level of U.S. securities, China’s holdings have grown 18-fold from 1994 (the year they pegged the Renminbi to the U.S dollar) to 2004.
Now, where did Japan get the money to buy all of these U.S. long-term securities? The Bank of Japan (BOJ) has given trillions of yen to Japan’s Ministry of Finance (MOF), in exchange for MOF debt with virtually no yield. The MOF then invested those yen into U.S. dollar-denominated debt instruments such as government bonds and agency debt. This can be easily verified by looking at another portion of this same 198-page document we mentioned earlier. A few pages prior, it shows the dollar amounts of each type of securities each country owns. 76% of Japan’s holdings are comprised of U.S. government long-term and short-term debt and U.S. government agencies.
So, why has Japan’s Ministry of Finance bought our debt? Japan experienced a fantastically speculative bubble in its stock and real estate markets, which popped in 1989. Since then the Japan has experienced a protracted bear market with its concomitant economic perils. Japan does earn a return when they invest in U.S. debt, yet that is not their main objective. In the simplest of terms, Japan buys our debt to make Toyotas and Sonys more affordable for the U.S. consumer. In buying our debt, Japan keeps U.S. dollars out of circulation and, comparatively, more yen in circulation. Thus, with the law of supply and demand, the value of the yen is kept from rising against the dollar. As we depend on imports to keep our economy going, Japan, with little domestic demand, depends heavily on exports to keep their economy afloat.
So, how has it worked? Though Japan’s purchases of U.S. securities may have acted to keep more Japanese people employed, it does not take long to realize that this strategy has done little good for Japan’s markets. This chart from the “Museum of Japanese Financial History” reveals that the Nikkei has been trading near 15,800 in mid-December of 2005. While this is up 45% from May 2005, it is still 60% (23,177 points) lower than the Nikkei’s all time high of 38,915 in December of 1989. For those who still do not believe in long term bear markets, let me repeat that year. 1989! Japan’s policy has done little to benefit the Japanese real estate markets over the last 16 years.
I am a bit amused by those who think this time it is different, while Japan’s fundamental macroeconomic environment is little changed over the last 15 years. So, who is buying into the Nikkei? Though we cannot answer this question definitively, a closer look at the Japanese culture reveals who it is probably not. The Flow of funds data from the Bank of Japan shows that the household sector is indicating that high savings are still intact. Moreover, savings behavior of the household sector hardly changed during the 1990s. The sector saved and equivalent of around 7% of GDP at the peak of Japan’s asset-price bubble in 1990 and continues to do so. If the Japanese nationals were unwilling to reduce their savings to move money into the Nikkei at its peak, it seems unlikely that they would do so today. Their culture, unlike our own, is still deeply entrenched in the discipline of saving. On the other hand, many Americans have come to believe that asset appreciation is the same thing as savings. As the markets have largely increased since the early 1980s, we have seen a corresponding decrease in our personal savings rate. This is accentuated by the recent negative savings rate, which has spanned five months as of October.
So as all the bullish rhetoric comes out about the booming Nikkei, a word of caution is warranted. A look at the not-too-distant history of Japan tells us that little has changed. As various proponents of investing in the Nikkei extrapolate the potential earnings into the future, we do well to remember that extrapolating short-term trends can be very dangerous. As Jeremy Grantham notes, “The probable winning bet is not to extrapolate, but to expect a very mean reversal.”Link here.
QATAR FINDS A CURRENCY OF ITS OWN: NATURAL GAS
In a shift that has drawn historical comparisons to the ascent of Saudi Arabia’s oil industry several decades ago, Qatar has moved swiftly in recent years to develop its huge offshore natural gas reserves – once dismissed as practically worthless because of the difficulty of transporting gas to distant markets – while cementing strong military and economic ties with the U.S. Driven by an ambitious, reform-minded ruling elite, these moves have allowed Qatar to leap ahead of Russia and Iran, the only nations with larger reserves of natural gas, seizing new opportunities to export the fuel to markets in North America, southern Europe and the Far East.
Tankers laden with gas supercooled to liquid form already depart each day for Japan and South Korea from the northern port of Ras Laffan, not far from the American military’s main air operations center in the Arabian Peninsula. Soon the ships will start delivering their cargoes to ports in Texas and Louisiana in the most ambitious project to date to bring natural gas from the Middle East to American consumers. These plans, which would help transform the U.S. into the largest importer of liquefied natural gas, have created some unease at a time when American reliance on oil from the Middle East is still unabated. Even as OPEC tries to strengthen its grip on world oil markets, Qatar has moved to exert greater influence over the trade in natural gas through the creation of the Gas Exporting Countries Forum.
Qatar’s ability to emerge as the world’s leading producer and exporter of liquefied natural gas, with plans to produce 77 million tons of the fuel by the start of the next decade, depends on cooperation. It is working with Western energy companies and Asian shipping concerns in the construction of an immense industrial complex in Ras Laffan near the maritime border with Iran. It has been just a decade since the emir, Sheik Hamad bin Khalifa al-Thani, overthrew his father in a bloodless coup, strengthening ties with the U.S. and betting on an offshore natural gas reserve of 900 trillion cubic feet – the world’s largest purely natural gas reserve, called the North Field – that it shares with Iran. That shift gave Qatar, long a marginal oil producer, a commodity to help it escape the Saudi orbit and the wealth to plot its own path to prosperity.Link here.
BOOK OFFERS A GLIMPSE BEHIND THE HEDGE FUND CURTAIN
Ah, the grand life of the hedge fund manger … the annual paychecks in the tens, if not the hundreds, of millions, the mansions in Greenwich, Connecticut and the ski houses in Aspen. But there is another other side of the business, one examined by Barton Biggs, the former Morgan Stanley strategist and now a hedge fund manager himself, in a soon-to-be published book, Hedgehogging. In it, he writes about stressed-out managers struggling to maintain their lavish lifestyles even as their funds suffer losses. One manager, identified as “Ian”, would grind his teeth each night, according to an advance copy of the book; he shut his hedge fund down after only two years, crushed by losses of more than 16%. “The pressure of living so intimately, so intensely with his portfolio (and dying a little on the bad days) had become intolerable,” Biggs writes.
Another trader is stung by losses after moving into a Greenwich estate with $20,000 trees, a two-story screening room and a wine cellar that holds 5,000 bottles. “The straws were mounting on the camel’s back even as dark clouds were gathering,” Biggs writes. With losses approaching 30%, the manager has a breakdown and refused to get out of bed, so his wife goes in and abruptly shuts the fund. The book, which will be published in two weeks, offers a rare peek inside a world that thrives on secrecy and the promise of outsized returns.
A mystique has developed around hedge fund managers, who have become Wall Street’s biggest clients and challenge some of the biggest companies – witness Carl Icahn and Time Warner. The perception is that hedge fund managers are swimming in money, spending tens of millions of dollars on the choicest artwork and real estate. Yet the average investor understands very little about how hedge funds – lightly regulated private investment partnerships – operate and how they make money. The book is a return to Biggs’s role as a Wall Street commentator, harkening back to his days at Morgan Stanley when his literate essays on the markets were well circulated among investors.Link here.
INFLATION MONSTER CAPTURED (DEFLATION MONSTER STILL AT LARGE)
I am pleased to report that the inflation monster has been captured and placed in a jar. This stunning announcement, as well as an accompanying video detailing the highlights, was made by the European Central Bank, in cooperation with the national central banks of the euro area. Along with the announcement, the ECB has produced an information kit on inflation entitled “Price stability: why is it important for you?” It is targeted at young teenagers and teachers in all the official languages of the EU. Here is proof.
The ECB’s eight minute video is actually somewhat entertaining so I recommend that everyone click on this link take a look. Even though it is entertaining, it sure flops as an educational tool unless of course the goal is self-serving propaganda by the ECB, for the ECB. Unfortunately, the video does not explain that the real source of inflation is printing of money by the central bank itself. Nor does it explain why 2% is such a good inflation target. Finally it does not explain how prices across the board can be contained by broad brushed practices like setting of short-term interest rates. Those things were not explained simply because they cannot be explained.
Why should inflation be targeted at 2%, not 1% or 3%? Why should any inflation be targeted at all? Even if it were for some reason smart to target prices, can prices really be measured accurately? What do central banks do to overcome lag effects of monetary tightening and loosening? Is this just blind faith that “we know neutral when we see it?” The problem is targeting prices in the first place. Sometimes, money flows into houses and stock and bonds, instead of goods and services. Sometimes, productivity improvements mask inflation. Sometimes falling commodity prices mask inflation. Of course, I am talking about “real inflation” as measured by increases in money supply, as opposed to hedonically adjusted price inflation, as seen through the eyes of central bankers.
The last paragraph is exactly what made a fool out of Greenspan. In the mid-to-late-1990s, “real inflation” (a rampant increase in money supply) was masked by productivity improvements, falling oil prices, and falling prices of goods from Asia. Greenspan called it a “productivity miracle”. It was a “miracle”, indeed. Rampant increases in money supply fueled the 2000 stock market bubble and spawned nonsensical talk about “new paradigms”. Then, in the sheer “after-the-bubble-pops” panic adjustments that he likes to make, Greenspan refused to allow a recession to run its course. Instead, he slashed interest rates to 1%, fueling the biggest housing bubble the world has ever seen. Here we are three short years later, now facing a “new paradigm” in housing, with debt levels far worse at both consumer and governmental levels. Greenspan will soon be gone, and Bernanke is next to bat, waiting in the on-deck circle. Like the ECB, Bernanke wants to set price inflation targets of 2%. I have some advice for him: It simply cannot work.
I almost forgot to mention that the ECB claims to have “the deflation monster” bottled up as well. I guess we will see, but I think they are hopelessly wrong. The ECB points out “deflation monster” problems when, in fact, deflation is both a blessing as well as the natural state of affairs. Rising productivity is “price deflationary”: More goods are produced faster by fewer people. Prices naturally decline as a result. Look at how few farmers today produce more grain than 100 times as many farmers did not that long ago. Corn prices fell to 1943 levels a couple weeks ago. Is that a problem? For whom? It is only a problem because the U.S. and European central banks blow countless billions of dollars every year on price crop supports. It is a total waste of money.
If deflation is such a good thing, why do central banks fear it? One answer is because deflation is debt’s worst enemy. If asset prices and wages fall, people cannot possibly ever pay back what they owe. Banks and credit card companies do not seem to like that state of affairs. Is that a problem with deflation? No, that is a problem created by reckless lending, easy credit, and the endless cheerleading on CNBC every time consumer spending rises and people sink heavier into debt.
The second answer is because inflation benefits those who receive money first. The government and banks are at the very top of the list. The former benefits via automatic tax increases not indexed to inflation (especially property taxes), the latter simply because banks are first in line to receive money from the Fed at rates no one else sees. By the time lending standards drop so that the masses have access to credit, the boom is well under way. By the time credit is granted to anyone that can fog a mirror, the boom is nearly over. Those buying assets late in the game will eventually be crushed by those selling assets who got in early. Simply put, inflation eventually becomes a moral hazard.
We are now at or close to the pivot point. The pivot point (or tipping point, if you prefer) is when consumers cannot or will not take on any more debt and/or corporations simply are unwilling or unable to extend more credit. I have been writing about various tipping points for some time now, and we seem to be hitting those tipping points simultaneously in many areas: jobs, housing, consumer spending, and credit expansion. The malinvestments of the have-it-now, me-too ownership society are about to be unwound. The central banks have put off the inevitable deflationary credit crunch, while making it worse along the way.
There are many who think true deflation (decrease in money supply) cannot happen under a fiat system. I disagree, but perhaps the point is moot. Money supply itself actually never contracted in Japan. Instead, it grew very slowly for quite some time. However, bank credit outstanding contracted for 60 months in a row. Clearly, there was a credit contraction. How did money supply still manage to grow? Fiscal deficits were ramped up immensely, roads to nowhere were built, and the Bank of Japan monetized all of it. In addition, money velocity plummeted. The net effect of the credit contraction on prices was clearly what one would nowadays call “deflationary”. Prices across a broad range of assets and goods and services fell. Indeed, practically everything fell but government bonds. Perhaps a practical way to think of deflation under a fiat system is the destruction of credit/debt that exceeds growth in money supply.
Regardless of social and economic differences, I fully expect the U.S. to follow in the footsteps of Japan. Although a central bank might be able to sustain a certain amount of inflation by resorting to extreme measures, it cannot stop a credit contraction in the private sector. Nor will a central bank bail out consumers at the expense of themselves and other creditors. The Fed, like the BOJ, will stop short of destroying itself and its power.
Life would be so much simpler if central banks everywhere would stop trying to micromanage both prices and economic cycles. Quite simply, they are trying to achieve nirvana when nirvana cannot possibly be measured, nor can nirvana be achieved in the first place with the policies they have in place. Yes, we will still have economic cycles if central banks do those things, but the cyclical peaks and valleys would not be as exaggerated as they are now. It seems as if we have learned nothing from the Great Depression or the more recent experience of Japan. I fear we may get a second chance.Link here (scroll down to piece by Mike Shedlock).
HOW TO INVEST IN SQUIRRELS
For 26 years, the symbol for Ralph Wanger’s small-cap Acorn Fund – which averaged 17% from 1970 to 1996 – was a squirrel. Seems odd at first. But after thinking about it, it makes perfect sense. Squirrels, like good small-cap companies, are nimble, efficient and adaptable. They are quick to avoid danger. They can thrive in small niches that most do not even know to look in. And if they do get into trouble, they can outmaneuver their larger predators. “You don’t see many three-hundred-pound squirrels in the park,” Wanger remarked in his classic book, A Zebra in Lion Country. Squirrels that are slow and overweight could not survive in the wild. And the same goes for over-leveraged and stodgy companies.
So how can you determine if a company is innovative and progessive, rather than stodgy and fat? One of the best ways is to examine a company’s return on invested capital (ROIC). A company’s ROIC numerically answers questions like: Is it a good business? Is it innovative and progressive? Does it manage and invest its own capital to generate a high rate of return for its shareholders? Or does it waste its earnings on frivolous projects that yield very low (even negative) returns? E.g., if a company spends $1 million to build a new manufacturing plant and is able to crank out $500,000 in new earnings, its ROIC is 50%. That is a very effective use of company capital. In two years the new manufacturing plant would be paid off and the company’s earnings will be much higher than they were before.
Conversely, if a rival company spends $1 million to open a similar manufacturing plant across town and only manages to eke out $25,000 in new earnings, its return on its investment would only be 2.5%. That is terrible. The company could have made more money by putting its $1 million in a safe CD or government bond! It wasted the shareholder’s money. As an investor, you want to invest in companies that generate a higher return on invested capital versus a lower ROIC.
A recent study by Bin Jiang and Timothy Koller of McKinsey Global Institute found that from 1963-2004, the average ROIC for all publicly traded companies (excluding financial companies) with sales of at least $200 million was nearly 10% – on average a company will earn 10% in every dollar it invests. But that “average” return varies widely from industry to industry. As you can see from the chart below, pharmaceutical companies tend to have a higher ROIC than utilities companies. Software companies have a higher ROIC than energy companies. And health care equipment companies tend to have a more robust ROIC than consumer service companies. So for the purposes of using ROIC as an investment tool (or screener), it is essential to compare individual companies to their peers versus the market in general.
Note that the average ROIC across all industries over the last 10 years is higher than in the last 40 years. And the industries leading the way are the pharmaceutical/biotech, household and healthcare services industries. So it should come as no surprise that those industries have outperformed the overall market in 2005. Meanwhile the consumers services, food, transportation and telecom services industries all have lower returns on invested capital compared to their 40-year averages. You want to guess how they performed this year? Not too well. Clearly, companies that earn a higher return on their own investments are companies you want to have in your portfolio. They are the ones that can adapt, innovate and manage their operations better than competitors. So as we get ready to start a New Year, where are the best companies hiding right now?
To begin answering that question, I created a list of all the companies in the stock market with an ROIC of at least 30%. After excluding all financial companies (like the McKinsey study did), I came up with 165 companies. Here are some observations I made after studying the list. Of the 165 companies, seven were from the textile industry, seven were from the steel and oil industry, seven were from the oil and refining industry, and 17 came from the business services and software services industries. So if you are looking for industries to focus on right now, those are four I would start with.
And after drilling down even further, I noticed that 87 of the 165 best-run companies on the market were small caps with a market cap of $1 billion or less, 51 were mid-caps with a market cap between $1-5 billion, and 27 were large caps with a market cap above $5 billion. Translation: over half of the well-run, innovative and adaptable companies on the market right now are in the small-cap universe. They are everywhere – just like those wily squirrels that Wanger loved so much. “The squirrel is an interesting animal,” said Wanger in a 2000 interview. “It’s not the strongest or smartest animal in the forest, but it is a very successful animal. There are squirrels in every country, because they are adaptable and opportunistic. For a small-stock manager, that’s a good symbol. Tigers are brave and beautiful, but they’re nearly extinct. And bulls are strong and powerful, but they wind up as a beef patty between slices of bread. But squirrels are all over the place.”Link here (scroll down to piece by James Boric).
NOT SEXY, BUT A JUICY STORY ANYWAY
Copper is not sexy enough to rank among the “precious” metals, yet it has been at the center of a juicy financial story over the past month. The tale includes all the makings of a good movie plot – including government intrigue, a huge rally, an immense gamble, hundreds of millions of dollars lost, plus a savvy trader who first went missing, then did not exist, then reportedly wound up in state custody, where he may or may not be helping to sort out the mess.
The short version is: A successful trader named Liu Quibing worked for a Chinese government agency that stockpiles commodities – such as copper – which the country needs in massive amounts to industrialize. For at least the past year, China has actively schemed to keep down the price of commodities it needs, and even said publicly that it would try to deflate copper prices. Mr. Liu, in turn, started shorting hundreds of thousands of tons of copper on the London Metal Exchange (LME). He did this either on his own or with the approval of people higher up the food chain, depending on which version you find more plausible; Liu Quibing disappeared from view sometime in October/November.
Now, Mr. Liu did not begin his massive short play until this past spring, when copper was near 150 (or about two-thirds of the way into the rally that carried prices from 60 to 212). Still, the initial reports about Mr. Liu said prices had gone up because other copper traders knew where he was and what he was doing; but, as prices continued higher still, more recent stories said the rise was due to other traders NOT knowing where Mr. Liu was or what he was doing.
The moral of the story? I do not have a moral to tell; maybe you will get one if Mr. Liu is lucky enough to live and surface, otherwise, we will have to wait for the movie to make something up. I do know the facts, which are as true in this case as in every other such scandal: 1) All efforts to manipulate major financial markets always fail, and 2) Breaking accounts of the story always make it sound like the scheme made the market go up, down, or sideways, depending.Link here.
NEW YORK TRANSIT STRIKE REFLECTS WIDER PENSION CONCERNS
New York’s bitter three-day transit strike is over, but the two sides remain at odds over an issue that increasingly is being faced by millions of workers in a broad range of industries: pension security. “It’s a very common situation with a unique dimension,” said Harley Shaiken, a labor economist and professor at the University of California at Berkeley. “The common part of it is that millions of workers are very apprehensive and deeply disturbed and often very angry about what is happening to their pensions.”
Transit union leaders ordered workers to return to work Thursday as talks aimed at seeking a permanent settlement continued with pensions still a central issue. Pensions and associated health-care costs for retired workers also are a principal factor in this year’s landmark bankruptcy of auto-parts maker Delphi, financial problems at General Motors and the turmoil that has sent eight airlines into bankruptcy protection.
Ironically the two sides in the New York transit strike did not seem to be all that far apart on pensions when workers walked off the job. Initially the Metropolitan Transit Authority wanted to reduce pensions by raising the retirement age to 62 from 55. Just hours before a strike deadline the authority withdrew that demand, offering to leave the pension system unchanged for current transit workers. Instead the MTA wanted all new workers to contribute 6% of their wages toward pensions, up from the 2% that current workers pay. The proposal, which was rejected by the union and triggered the walkout, would have saved the authority a mere $20 million over three years, according to The New York Times.Link here.
BONUS FEVER ON LONDON’S WALL STREET
At the end of a prosperous year in London’s financial district, pubs like the New Moon are enjoying high customer traffic. At pubs, restaurants and office parties in the City, London’s Wall Street, all the talk has been on the bonuses that are being lavished on bankers and traders. London is at the center of an expansion in European deals, helped by inflows of cash from private equity shops, the Middle East and Russia, and a rush of foreign listings on the London exchange. As a result, many bankers here are hoping that this is the year when their year-end bonuses, which have traditionally lagged those of their counterparts across the Atlantic, rise to a comparable level. “London and New York have been coming closer and closer together over the last few years,” said Carl Sjostrom, a partner in KPMG’s executive compensation practice. “New York is a bigger market, but there have been some fantastically lucrative areas in Europe as of late.”Link here.
SHORT SELLING: INTELLECTUALLY HONEST, ETHICAL AND LOYAL
If you believe that war is simply the opposite of peace, then you might also believe that short-selling is simply the opposite of long-side investing. But, in fact, you would be completely wrong on both counts. War has no opposite and neither does short-selling. The opposite of peace is discord. War, on the other hand, is a catastrophic event that is wholly OTHER than peace or discord or any other human condition. It has no opposite, and neither does short-selling, although warfare might be its closest synonym. In fact, short-selling is guerilla warfare. And if you understand how to fight a short-seller’s war, you will become very well-equipped to win at the relatively peaceful activity of long-side investing.
Earlier this month, your editor was privileged to attend the 20th Anniversary party of Kynikos Associates, the investment firm headed by renowned short-seller James Chanos. To commemorate the occasion, Chanos rented out a chic Upper East Side eatery and filled it full of friends, colleagues and kindred spirits of various sorts. Many of the kindred spirits in attendance were also professional short-sellers, or at least professional skeptics (like James Grant, editor of Grant’s Interest Rate Observer). They nodded knowingly throughout the pre-dinner presentation, as Chanos’s right-hand man recounted the many triumphs of Kynikos’s 20-year history, the prescient short-sale of Enron being its most celebrated triumph.
But Chanos was not merely “the man who called Enron”, he was also the man who called Tyco and Conseco and Boston Chicken and Coleco and many, many other troubled companies of the last two decades. On this night, the attendees smiled and chuckled over these short-selling “war stories” But they would never forget the war itself, or the pain it inflicted on their professional – and sometimes personal – lives. They seemed to remember all too well the difficulty of selling short throughout the go-go 1990s. Even your editor, himself a former short-seller of no particular repute, remembers vividly the agony of short-selling throughout that bullish decade.
Short-selling is agonizing on every level, even successful short-selling, of which the practitioners are few. It usually requires arduous research, well-seasoned experience, fortitude, patience … and deep pockets. “Markets can remain irrational longer than you can remain solvent,” as John Maynard Keynes once observed. Throughout his career, therefore, Chanos has battled tirelessly to achieve his many successes. He has battled against prevailing market trends, against public opinion, against entrenched Wall Street interests and against almost every other possible obstacle to investment success. But such is the life that short-sellers chose … or that they are cursed to endure. In particular, every short-seller wages war against the popular (and powerful) delusions of the day, as expressed in the incessant, sycophantic cover stories that decorate America’s leading business magazines.
Unfortunately for short-sellers, a company’s fall from corporate superstardom to ignominy or bankruptcy or criminal investigations, or all of the above can take a VERY long time. And it is no simple task to short a stock that your research says is woefully flawed, even while all of Wall Street tells you that you are dead wrong, and an idiot besides. But Chanos has mastered the art of short-selling as well as anyone. And as I listened to his brief speech at the anniversary party, I thought I learned some of the key the reasons why. “When we founded Kynikos 20 years ago,” Chanos explained to the roomful of friends and peers, “we wanted to create a firm that was intellectually honest, ethical and loyal. And I think we’ve done that.” Intellectually honest, ethical and loyal. Hmmmm. That is exactly it! These exact three qualities represent everything that Wall Street is not.Link here (scroll down to piece by Eric J. Fry).
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