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TRADERS ASK YOURSELF: HOW MUCH CAN I SCREW UP TODAY?
I read a book on trading many years ago that said before every trading day begins, you must ask yourself: How badly can I screw up my account today? This sounded a bit blunt to me. And it seemed like an odd way to start your morning. But I have found this simple approach is a great way to focus on the key element that will determines long-term success in any asset market, whether that be stocks, bonds, commodities, currencies, and even real estate. This key element is risk.
When you think of risk, you probably think of things such as brewing emerging market crises, potential time-bomb of derivatives, an overvalued stock market, a U.S.-China trade war, and on and on into infinitum. No doubt these are very important market risks. And these types of risks do generate fear and losses in the markets. But there is only so much you can do to hedge against these risks. It is much easier to control your individual account risk. Or in other words, how much you can afford to screw up your portfolio?
Obviously some of us can handle more investment risk than others. We can thank (the original) J.P. Morgan for the best single piece of advice about how to take on risk. J.P. Morgan had a friend who was worried about his stock holdings, so Morgan told him, “Sell down to your sleeping point.” If you are lying awake at night, worrying about your investments, then you are carrying too much risk. I have found the simple “screw up your account” mantra very useful for controlling my amount of risk. In fact, I have this phrase printed across the top of my “trade sheets” – the papers I use to record each of my trades, risk levels, and reasons for each trade.
This helps me because it forces me to define the level of risk BEFORE entering an investment position. It forces me to consider that factor. For many investors, it is easier to keep a degree of objectivity BEFORE entering a particular trade. After you place your trade, your objectivity can quickly evaporate. And it is replaced with something very dangerous – hope. Here is an example of what I do when defining my risk in a currency trade before I place my trades.
First, I look for key technical indicators in the market. I look for basic trend lines that tell me whether the dynamics of supply and demand have changed in the market. This tells me the price level which will prove my prospective trade wrong. At that price level, I will have to exit the market with a loss, no matter what – end of story. So before I even place the trade, I know what price to sell at to cut my losses, in case the markets do not go my way. I can always reenter the trade if it makes sense later. Once I have exited, I again regain that objectivity to better evaluate this particular trade.
There is an old market adage: Bull markets climb a wall of worry, while bear markets flow down a river of hope. It is natural to hope our losses will subside and be afraid our profits will go away. That is why we are tricked by the markets. When investing, you should use both fear and hope to your advantage. Defining risk beforehand helps you to know when to do that and drop a losing a trade. If you fear severe losses, then you will exit a trade to cut your losses before it is too late. Hope, on the other hand, can help you hold on to a winning trade long enough to turn a substantial profit.Link here.
CURRENCY TRADING: A GAME OF PROBABILITIES
Because I have seen some very strange things happen over the years that have drained more money from my trading account than I care to talk about (or let my wife know about), I approach the markets as a game of probabilities. As far as I am concerned, that is the only way to navigate the currency markets. What I mean by a game of probabilities is this: I do as much as I can when figuring my fundamental and technical analysis. I read and study all I can. And I do this with discipline, focus, and consistency. I do this to try to gain an edge.
But I know there is never such thing as 100% certainty. You can never have enough brain power or computing power to harness the mind of the market. That is because the players in the market do not make “rational” decisions all the time. When push comes to shove, the big moves in the market are driven by good old fear and greed, the base human emotions. The fear and greed and irrationality of millions of players cannot be modeled with much degree of certainty. That is a problem for economists and experts who believe they can create some type of Holy Grail model to forecast price action. They simply do not have the mathematics available yet to get their arms around irrationality in a modeling scenario, and there is no reason to think they will be able to factor in human emotions anytime soon.
“If you are going to use probability to model a financial market, you had better use the right kind of probability. Real markets are wild. Their price fluctuations can be hair-raising-far greater and more damaging than the mild variations of orthodox finance,” writes Benoit Mandelbrot in The Misbehavior of Markets. (Benoit Mandelbrot is the person who created fractal mathematics. He is a brilliant man, to say the least.) Bingo! “Real markets are wild.” So, does this mean we should be defeatist and believe we can never win? Absolutely not! But it does mean you need to develop a reliable system to help you recognize when it makes sense to trade. Or in other words, you need a system that pushes the probability of success in your favor. Here is what I do to help make currency trading decisions.
Yes, it is a lot of work. But this is my system that has evolved over the years. I am confident that if I do my homework and apply my system consistently, I will win over time. And the same system can work for you.Link here.
U.S. DOLLAR: BURIED ALIVE?
According to those people who conduct random polls, the 5th strangest phobia among Americans (directly below a fear of chopsticks) is that of being buried alive – of waking up inside the red velvet interior of a pine box to the rap of long-stemmed roses and shovels of dirt being tossed onto the top your coffin. For one of the world’s leading currencies, though, this thing of horror movies, this most irrational fear has become a dreadful reality.
Here is the gist. After the U.S. dollar plummeted 10.6% against the euro and 12% against the British Pound in 2006, every “expert” on and off of Wall Street agreed: the buck had fatally broken its greenback. As soon as 2007 began, so did the dollar’s requiem. “The dollar is in a death rattle,” reported one popular news source, alongside forecasts from both the S&P and Merrill Lynch of a respective 6.8% to 10% “further slide” in the currency’s value. “This isn’t a spooky tale of woe worthy of ‘Trilateral Conspiracy’ theories. It’s simply a matter of fact,” observed one January 14 Gwinnett Daily Post. “If there was a ‘Doomsday Clock’ to describe the threat of a currency crisis in the U.S., it’s hands would be in the 24th hour,” offered a similar site based out of Wall Street.
Everyone from Alan Greenspan to Bill Gates paid their respects to the deceased uptrend of the dollar, while U.S. Treasury Secretary Henry Paulson delivered a tear-jerking eulogy ensuring the world that the buck will be the last casualty of a warring financial landscape torn apart by outsourcing, exploding growth in China, and a burgeoning trade deficit. Paulson promised to “reinvigorate” the President’s “Working Group on Financial Markets”, (aka, Plunge Protection Team), increasing the number of meetings from once a quarter to once every six weeks, hoping to develop a plan that will prevent a dollar-provoked economic crisis.
And, in a final touching tribute, a January 17 New York Times article, “How to Catch A Falling Dollar?”, stood up to say – What the dollar could not achieve in life, it shall in death. It then offered these answers: Buy foreign bonds or CDs. Invest in European stocks, and developing and emerging markets. Lastly, stock up on domestic shares of American multinational corporations and stocks that earn a large part of their revenue abroad, e.g., 41% of the S&P 500’s revenue comes from international sources. The idea is simple. As the buck continues to fall, markets across the globe will rise. “A good bit of tailwind,” then occurs “when you transfer foreign profits back into U.S. dollars.” We should all be so honored when the time comes.
Problem is, that time has NOT come for the U.S. currency. Ever since the funeral dirge for the dollar has taken place in the mainstream, the dollar index has actually surged in a 6-week long rally from its early December low. Meaning the only thing that passed away during the buck’s burial was a major opportunity to the upside, one the November 30 Elliott Wave Financial Forecast anticipated in great detail: “The odds are high that the drumbeat of U.S. dollar bears is marking a significant intermediate term-low.” What other opportunities have the mainstream prematurely put to rest in peace?Elliott Wave International January 17 lead article.
THE ABSOLUTE WORST INVESTMENTS FOR 2007
Each year at this time I compile a list of the best and worst global investments for the next 12 months. I base my list of “low value” investments on absolute and relative values, current press coverage, and historical market returns. Typically, these securities have already enjoyed bull market advances. In many cases, these low value investments exhibit the characteristics of a “bubble”, or a speculative mania. Also, when the press is publishing stories on a nonstop basis about a certain market, you know the cliff is not far away. For 2007, the worst places to invest are:
LIKE A BROKEN RECORD: THE GLOBAL STOCK MARKET WILL DO PRETTY WELL IN 2007
I am starting to sound like a broken record. My 2007 forecast is for the global stock market, as measured by the Morgan Stanley World Index, to be up somewhere between 10% and 40%, while the S&P 500 will up but by a lesser amount. By either measure the stock market will trounce both bonds and cash. The problem: This was precisely my last year’s forecast.
In 2006 the World was up 20.1% (including dividends). The S&P 500 was up 15.8%. The 10-year bond delivered a total return of 2.4%, and cash was boring. It was what I initially envisioned as a good to great year – better than most folks expected. And that is just what I see now. Some of the same forces are driving stocks. By a yardstick that I consider very important, namely the spread between bond yields and stock earnings yields (the inverse of the P/E ratio), global stocks are 75% too cheap. The S&P 500 should earn $90 before nonrecurring items this year, which comes to 6.4% of the index’s price of 1414. Compare that with a 10-year bond yield of 4.6%. Historically, the equity yield is below the bond yield. In 2000 this relationship was reversed: Stocks had an earnings yield of 3.5%, while the bond yielded 6.5%.
The discount on stocks will not all get made up in one year. But a chunk of it may. We still cling to skeptical sentiment we learned to embrace between 2001 and 2003. But this spread between low-yielding bonds and high-yielding equities is driving both cash-based stock buybacks and debt-financed takeovers of companies by competitors or private equity players. Until that gap gets closed the bull market will live on. We also have not had a negative third year of a President’s term since 1939. And only two single-digit positive years. Third years are sweet. The question is how sweet.
Each year starts Forbes requires its stock-picking columnists to deliver a retrospective on the previous year’s recommendations. My prior 10 years’ report cards are detailed in an appendix of my book The Only Three Questions That Count. My columns did 11.7% annually for that decade versus 6.8% for the S&P tracker. I lagged the S&P in only 1997 and 2002. For 2006 I recommended 54 stocks. My picks returned 15.7%, versus 8.7% for the S&P 500 tracker. In 2006 I did well primarily because my picks had a slight value bias in a year when value beat growth and because they included foreign stocks in a year when the dollar was weak. Someday I will have to return to leaning primarily on U.S. stocks, as I was doing in the late 1990s, but that day has not come yet. This year, once again, foreign stocks should do better than U.S. ones. Quite apart from what happens to the dollar, foreign stocks will be helped by their low starting valuations. The expected 2007 earnings yield on the MSWI is 7.6%, a whopping 3.6% spread over the 10-year, GDP-weighted global long-term government bond rate – twice that for U.S. equities.Link here.
WHERE ARE WALDO AND SAFE CORPORATE BONDS?
My first column last year was headlined “Long and Optimistic”. I was quite nervous about this forecast. As it turned out, my view should have been even longer and even more optimistic, for 2006 was quite a year. Astonishingly, not a single significant equity market finished down. The two worst showings were Japan’s market, up a modest 6.9%, and Korea’s, up 4%. The vast majority of markets increased by somewhere between 12% and 30%, a sweeping success for the bulls. Helping feed the stock surge, of course, is the current bout of merger mania. The stocks I wrote about last year climbed 18.4%, after subtracting 1% in hypothetical trading costs. Equal investments made in the S&P 500 at the same times would have climbed 9.4%.
My big advice for 2007 is to be ultracareful about buying corporate bonds, whether investment grade or not. Why? Private equity buyers, who tend to load too much debt on their acquisitions, hurting the credit quality of existing bonds. The private equity investors are hell-bent on gobbling up anything, large or small, often by joining forces with other leveraged buyout funds. Such alliances, known as club deals, have produced acquisitions of huge companies on the order of hospital chain HCA, real estate power Equity Office Properties and media empire Clear Channel Communications. Even behemoths like Home Depot, with a market cap of $82 billion, become plausible fodder for the takeover gristmill.
The fuel that feeds this frenzy is abundant credit. To finance private equity deals many banks, bond funds, insurers, pension plans and foreign investors are happy to make loans and buy bonds at yields that are not much higher than what safe Treasurys throw off. LBO bids today are debt intensive, with debt running to eight or nine times operating income (earnings before interest, taxes, depreciation and amortization). Five years ago the ratio was typically a far less risky five to six times. Before abundant credit became the order of the day, buyers of corporate bonds were protected by a bulwark of covenants that forbade overleveraging the balance sheet and other sins. No more. Bond issuers lately no longer need to plug covenants into their issues for them to attract buyers.
With any company potentially in play, the bondholders are vulnerable. As soon as an LBO deal is announced, the bonds of the target company often plunge in price. The HCA bonds due 2015 sold at par before the buyout offer. Now they trade at 85 cents on the dollar. In this climate finding a good corporate bond reminds me of the popular children’s book, Where’s Waldo? Released in 1987, the book contains dense illustrations wherein the child is supposed to find the Waldo character hidden in the jumble. If you insist on buying corporate paper, you must look really hard to find Waldo, the rare corporate debt that offers fair reward for the risk of default.
A good example is Realogy (NYSE: H), the largest residential real estate broker in the U.S., spun off from the Cendant conglomerate. In mid-December private equity group Apollo Management announced a $9 billion bid for Realogy. But the impact on Realogy’s $1.2 billion in bonds issued just two months before was a price increase, because Realogy’s notes have excellent and atypical covenant protections: change of control puts and coupon step-ups for any ratings downgrade. Bondholders have the choice of either putting the bonds back to the company at par or receiving a higher coupon. If corporate bond investors demanded such covenants as a matter of routine, they would put a real damper on the LBO mania. At least the bond buyers would not be the easy victims.Link here.
Wall Street’s darling, Goldilocks, whose economy is neither too hot nor too cold, but just right for optimistic investors, is back. Inflation is under control, earnings are still strong, the outlook is for solid growth. That is why we are in the second-longest rally since 1929, at four years, three months and counting.
Market momentum pushed the Dow Jones industrial average above 12,000 in October and juiced 22 record highs before year-end. Small caps have been stellar. In Q4 2006 their benchmark, the Russell 2000, jumped 9%. That was essentially a year’s worth of performance in three months. Aftertax corporate profits, as a share of GDP, have risen to their highest level since 1929. This could be an odd coincidence. It is certainly a worrisome year for comparison.
Investors Intelligence, which polls Street sentiment, reported recently that 60% felt bullish and were convinced the economy is just right. The run has lulled investors into a false sense of security. After all, Goldilocks was no saint. She broke into someone else’s cottage, stole their porridge and busted Baby Bear’s chair. As a contrarian, I have always related better to the bears. They are the ones who recognized something was not quite right. That is how I feel as we start the new year.
A correction is inevitable. I am anticipating at least a 10% market drop sometime this year. Why? Earnings expectations are overly optimistic. After increasing 20% in 2005 and 15% last year, Wall Street is still banking on 10% earnings growth for 2007, double the historical average. But economic expansion is projected to slow to 2.5% in 2007, down from 3.3% in 2006. The smart money knows it is not possible for corporate profits to outpace the underlying economy for very long.
This is a time to be conservative. So I am sticking with quality companies – the slow-and-steady Eddies with the sturdy franchises, deep economic moats (protecting them from competition) and robust cash flows that enable them to hold firm in a slowing economy. My approach to value investing is not for the impatient. Some of my contrarian plays take a while to work out. My long-term strategy has done well for me. That said, 2006 was a tough year for my column. The stocks I wrote about advanced 4% since their initial 2006 mentions (after deducting a hypothetical 1% for trading costs) compared to 9% for investments made (with no trading costs) in the S&P 500 at the same times.Link here.
MONEY MANAGERS BUY LARGE CAPS, SELL SHORT TO SEEK STOCK SHELTER
After six months when stocks in almost every region and industry rallied, some money managers in the U.S. and Europe are driving with one foot tapping the brake. Their strategies include investing in the biggest companies, on the premise that they will weather an economic slowdown more smoothly than the smaller companies that led global stock markets higher during the past four years. Managers also are cutting allocations to equities and even selling borrowed stock on the view it will decline. “We’ve had fantastic conditions for making money,” said Rupert Della-Porta, who oversees $5 billion as head of U.S. equities at F&C Asset Management in London. “Can that keep going? I’d be more wary of riskier asset classes.”
Now investors are becoming more cautious, according to a UBS AG index of investors’ risk appetite. From mid-December to early January, the index had its biggest decline since stocks slumped in May and June, said Jennifer Delaney, a strategist at UBS. The gauge tracks changes in stock-market volatility and differences in yields between corporate and government bonds, among other statistics.
Della-Porta has been buying shares of Altria Group (formerly Philip Morris), the world's biggest tobacco producer, and Hewlett-Packard, the largest personal computer maker. The companies have market values of $185.3 billion and $118.4 billion, respectively. He has cut holdings of smaller companies in the past year, including jeweler Tiffany & Co. and Allegheny Technologies, a maker of specialty metals. The companies have market capitalizations of $5.4 billion and $9.1 billion.
Morgan Stanley Capital International’s World Index has risen 17% in the past six months, and nine of its 10 industry groups have advanced. Only energy shares fell. In Europe, 17 of 18 groups climbed in the Dow Jones Stoxx 600 Index, with oil and gas companies again the outliers. All 10 industries in the MSCI Asia-Pacific Index have gained in the past six months. In the U.S., only energy and transportation stocks fell among 24 groups in the S&P 500 Index.
Morley Fund Management, with the equivalent of $319 billion in assets, has a small “overweight” in stocks compared with amounts dictated by its benchmarks. The allocation has been pared to less than half of what it was in 2006. “The value of equities has declined as prices have gone up,” said Adrian Jarvis, head of investment strategy for the London-based firm. “And bond yields have gone up, so relative value has shrunk accordingly.” The U.S. 10-year Treasury note yields 4.78%, up from 4.43% on December 4.
Bond yields have been rising in part because the U.S. Federal Reserve has signaled it is in no rush to reduce its benchmark interest rate, said David F. Cooley, a managing director at Collateral Investment Management, a hedge fund in Cleveland. Fed officials’ “predominant concern” is rising prices, according to minutes of their December 12 policy meeting. “News that the Federal Reserve is more concerned about inflation has shaken everybody’s temperature up,” said Cooley. “One of the things that helped establish a nice run in the equity markets was the rally in bonds; that’s now coming off.” Cooley’s fund has more money betting on stock declines than it does wagering on a market rise.
The views of Della-Porta, Jarvis and Cooley do not reflect the thinking of people spinning doomsday scenarios. Instead, the money managers are concerned that global stock markets may have risen too far, too fast.Link here.
THE TECHNICAL CHARACTERISTICS OF THE U.S. REAL ESTATE MANIA
Normal markets propel themselves via a chaotic feedback system. Price movements are driven by behavior which in turn drives behavior. The market inhales and exhales, moves up, then moves down, retracing part of its gain. We see this in the progress and regress of Elliott Waves.
This price “respiration” vanishes when markets are not normal, as is clear from studying a chart of asset manias. You notice fewer and briefer setbacks. The usual tools of analysis do not work. In a stock market mania, for instance, prices blow through calculated levels of resistance that the former bull market would have respected. In some markets, technicians might characterize the final move of a mania as parabolic – a period when the price graph becomes considerably steeper toward the peak. Technically, a mania arises out of a long-term bull market that once exhibited the normal pattern of ebb and flow, but changes into virtually a non-stop rise that appears as a steep line on a graph.
Manias have duration. Some famous manias lasted two years, the 1920’s stock run-up was about eight years, the Japanese stock market experience was 15 years, and the U.S. stock market’s mania covered 1982-2000, about 18 years. Manias have extent. Manias raise asset prices by multiples. From its low in 1982 until its 2000 high, the Dow’s price multiplied by 15x. The multiple for tulip bulbs in the 1630’s was considerably more. U.S. house prices have been ascending at least since the start of this data series in 1963. Are any of the technical characteristics of a mania evident in this graph?
The national housing market has certainly been in a long bull run. The arrows on the graph point to the most protracted flat-to-down periods of the long-term upward trend. Some regions of the country endured substantially longer and more painful housing bear markets, thus contributing amplitude to these national-scale corrections. But on that national level, the recovery times from these corrections have been relatively quick. There are a few down times in very recent years, but the dips are brief.
Note the three red trend lines. Prices broke away from the first trend line in 1992. The second trend line highlights the slightly steeper slope that started around 1994 and terminated in 2002. Finally, the third even steeper trend line started in 2002 and lasts until it was decisively broken in the first half of 2006. Thus another of the technical conditions that characterize this market as a mania is clear, namely increasingly steeper trends. Manias accelerate in arithmetic terms.
The graph shows duration. If one counts the start of the mania from 1982 it has lasted 25 years, from 1971 ... 36 years. When we examine the behavioral aspects of a mania and the steps that turn a bull market into a mania, we could make a case that some aspects go back to the Great Depression – over 70 years – and even longer than that. And then there is extent. In nominal terms, the median house price was $25,000 in 1971, and poked through $250,000 in 2006, a 10-fold multiple.
It is practically impossible to call the top of a mania, but other measures of the asset market potentially flag when a decline is imminent. With stocks, for example, the Advance/Decline line typically falls, so the final advance rests on fewer and fewer stocks. In the housing market, existing home sales seasonally adjusted topped out June 2005, and inventory, described in terms of the number of months it takes to sell it, has been climbing since January 2005. So by some measures of housing market strength, the jig is up. These weakening indicators do not guarantee a decline of course, but these indicators would need to weaken before a price decline develops.
Relatively quick recovery from setbacks, shallow quick dips in very recent years, increasingly steeper trend lines, duration, extent, other measures that have warned of a weakening trend – it looks like our national housing market has been in a mania from a technical perspective, and that the mania is in the process of unwinding.Link here.
REAL ESTATE WILL UNDERPERFORM INFLATION FOR DECADES
The census.gov web site clearly indicates (PDF) that while general prices throughout the economy tripled between 1915 and 1965, from 30.4 to 94.5, rents (the most reliable indicator in the absence of price data) only doubled, from 49.6 to 94.9. This means that if you had bought in 1915 and sold in 1965, you would have lost 33% in purchasing power. Obviously, actual results varied with about half of actual returns even lower and half higher. An interesting side note is that over the period of 1915 to 1965, housing costs appreciated in price by an average of only 1.32% per year, or negative 0.8% a year after inflation.
The Census data contradict the absurd fantasy that house prices are a wonderful investment and always provide consistent inflation-beating returns. In fact, in the last century they often underperformed inflation for many decades at a time. There are many legitimate reasons to buy real estate, e.g., stability of schools and neighbors, freedom from capricious landlords, certain tax advantages, and (if) mortgage payments that save money every month by being less than the rental of the same unit. If the last 100 years are any indication of the future, expectations of future price appreciation are not a legitimate reason to buy real estate. A large percentage of the current buyers in the real estate boom of the 2000s are buying based on future price appreciation. Unfortunately, this means that the real estate boom of the 2000s is largely based on a myth. As real estate prices return to levels justified by the legitimate reasons, prices will fall in inflation-adjusted terms.
Combining the census data for 1914-1970 with data sets from Freddie Mac for the years 1970-2006, this figure is obtained. The chart indicates that real housing prices in the mid-1990s were about 25% below prices in the mid-1920s. The old adage of our grandparents that “housing is a depreciating asset” was true for a very long time. The 1914 peak in inflation-adjusted terms was only exceeded for the first time in 2005.
Even if you do not believe price statistics, evidence can be gathered with just the two eyes for evidence of the real estate fall in the years following the peak in 1914-1933. In free-market economies, as land prices get higher, buildings get taller. Higher construction costs are offset by lower land costs. Most major cities in the U.S. had tall buildings built between 1914 and 1933 during the real estate boom of that time frame. After the tallest building was built, it typically took about 41 years for the real estate prices to return to levels that would justify buildings of similar height. And that understates the time to return to a previous peak because of technological improvement that lower construction costs and thereby making it more feasible to build a building of given height. Assuming the tall building indicator is off by between 50% and 200% due to technology improvements, the 41 years indicated is probably closer to 60 to 120 years for a peak real estate market to exceed its prior peak. This is consistent with the data showing 1914 real estate prices were not exceeded in inflation-adjusted terms until 2005 – or 91 years later.Link here.
THE LOST CONTINENT OF LATIN AMERICA
Venezuela’s nationalization of the telephone company CANTV and the electric utility Electricidad de Caracas have demonstrated once again how insecure are property rights, not just in Venezuela, but in Latin America as a whole. Latin Americans pay for their disdainful attitude to those rights, in every paycheck they get, because the lack of secure property rights is a major cause of the continent’s pathetic productivity growth.
There is one great way, long term productivity growth, to distinguish between countries that are growing rapidly for the long term and those which are just enjoying high commodity prices or a cyclical boom and will relapse thereafter. Productivity growth tells you whether the local economy is just having a good year or whether its growth is fundamental, enabling it to change its place among the countries of the world, and over the long run enter an altogether higher league. If next year you can make more stuff with the same number of people, working for the same number of hours, you will get richer.
The evidence here on Latin America is quite clear. The Groningen Group’s Total Economy Database has statistics including productivity growth (GDP per person-hour) on a comparable basis for a number of economies. Wealthy countries, such as the U.S., the EU or Japan mostly have productivity growth in the 1.5%-2% per annum range over the last 20 years, with Germany being a little below this since 1990 because of the costs of reunification and the U.S. a little higher since 1995 because of the huge amounts of capital that have been hurled at the economy. Some countries, notably in Asia, and restructuring Eastern Europe, have productivity growth higher than this. Estonia, Slovakia, South Korea and Taiwan have particularly stellar records of prolonged productivity growth. Generally, you would expect poorer countries to have faster productivity growth than rich countries, because the “catch-up effect” allows them to increase productivity to the rich countries’ level.
Latin America, on the other hand, has a productivity record consistently worse than any other in the database (Groningen does not have productivity data for Africa). Chile is a marginal exception, with productivity growth of 2.4% per annum in 1985-2005, presumably the result of Augusto Pinochet’s economic reforms (while merely middle-of-the-pack as a human rights abuser, Pinochet was in a class of his own as an economic manager). However even in Chile, backsliding has been apparent since 1998, with the advent of an openly Socialist government in 2000 being accompanied by the reduction in productivity growth to a sluggish 1% per annum. Elsewhere in Latin America, the story is worse. In spite of its economic reform programs, Brazil has managed only 1.0% per annum in the last 20 years. Argentina, also around 1% after 1980, reverted to negative productivity growth in the middle 1990s, and has been negative over the last decade, while Colombia, whose productivity grew at 0.6% in 1985-2005, has seen a slowdown since 2000.
Most disgraceful of all have been the performances of Mexico and Venezuela. Mexico’s labor productivity peaked in 1980, and is still more than 10% below its 1980 level, having seen almost no recovery in the last decade. Venezuela’s labor productivity peaked as long ago as 1970, and it is now fully 43% below that level. Productivity has declined by a rapid 2.2% per annum under Chavez, but it declined by 1.5% per annum year after year for the 28 years from 1970-1998. Venezuela had democratic governments, and whatever the electorate asked for, productivity and therefore living standards inexorably declined. High oil prices, low oil prices, it made no difference, Venezuela kept on becoming steadily more incompetent at supporting itself. It is always asking a lot of an electorate to postpone short term gratification for long term goals, but frankly by 1998 the Venezuelan electorate had some excuse for irresponsibility. Since Latin American productivity growth is so poor, significant economic growth occurs only through population growth or a rise in commodity prices. The continent slips further down the international league tables, being overtaken first by the emerging Asian tigers, recently by Eastern Europe, and shortly by China and India.
Lack of secure property rights is certainly one explanation for Latin America’s poor economic record. If property rights are insecure, even on a long term view, the required rate of return for foreign and domestic investors increases, and capital flees to Miami. Individual defaults, such as those in Argentina, land expropriations, as in Bolivia, or random and unjustified nationalizations, as in Venezuela, cause risk premiums to rise across the continent. Investors recognize correctly that there is no sharp dividing line between the governments. Lack of investment resources thus becomes a problem for the entire continent, forcing productivity growth to low or even negative levels.
Lack of property rights is however insufficient as an explanation for poor productivity growth. It begs the question of why do Latin American electorates vote for governments that fail to protect property rights? The insecurity of property rights is so chronic that there must be some explanation explanation beyond mere circumstance. Culture may be part of the explanation, but one of the worst productivity performances is exhibited by Argentina, which is 97% ethnically European. One factor that certainly seems to apply is education deficiencies. The Latin American have comparably lower literacy rates, 97.2% for Argentina and 86-93% for the others, vs. 98.6% for Bulgaria and 99%+ for Poland and Slovakia. Tapid population increase makes education very expensive, and, as we see in Latin America, makes it miss a significant percentage of young people, mostly those brought up in large poor families in shanty-towns or the deep countryside.
With rapid population growth and inadequate resources for education and infrastructure, it is little wonder that Latin America has among the highest inequality in the world. Society is unable to provide the rapidly increasing population with enough resources to sustain a stable home and working life, so inevitably a seething underclass is created. In turn, if the society is democratic, that underclass regards the system as irretrievably hostile, and so follows the siren song of radical populists or guerilla movements. Pproperty rights, particularly those of foreigners or the remote “rich” are regarded as fair game for expropriation. It is not an accident that “land reform” is primarily a Latin American problem, as is hyperinflation wiping out middle class savings, as increasingly is expropriation of foreign investment.Link here.
BIG MUTUAL FUNDS GET AN UNJUSTIFIED PASS IN HOME DEPOT SEVERANCE PAY SCANDAL
Thank heavens for the outrage over the scandal at Home Depot (NYSE: HD). It is about time American investors got angry about the way their pockets are being picked by corporate executives. But the people who should be right at the center of the scandal are not the executives who are taking the loot or even the directors who gave it to them. It is the managers of some of America’s biggest mutual funds, including Vanguard and Fidelity. Instead, so far, they are getting a pass.
In case you have spent the last two weeks in a cave, Home Depot has found itself at the center of a storm after revealing it is paying former chairman and chief executive Bob Nardelli $210 million in severance pay. We can dismiss the claim that this sort of windfall has any business or economic rationale. Home Depot stock actually declined during Nardelli’s six years in charge. During the biggest real estate boom in American history. Investors in Lowe’s, the company’s chief competitor, tripled their money over the same period. Profits rose a lot faster, too.
The biggest canard going around is that these executive windfalls must be OK because they are somehow the outcome of an efficient “market” for executive “talent”. Never mind the questionable use of the word “talent”. The real flaw? An efficient market needs buyers and sellers who are both motivated to get the best price. In the case of CEO pay, those “selling” executive labor, namely the executives themselves, are certainly motivated. Bob Nardelli did not really do anything wrong. He just asked for, and received, a massive amount of money. Who would not?
The problem lies with those on the other side of the trade. The people hiring the executives. The people who are involved in the negotiations, namely the directors, are not particularly motivated. They do not get paid very much, at least by heavy-hitter standards. And it is not their money that is involved. No wonder they just outsource the calculations to “consultants” whose biggest interest is in keeping the executive class happy. Meanwhile, the people who are motivated to get the best price, the shareholders, are not really involved. Which is why attention should turn to those who are supposed to represent them. Mutual fund managers have a fiduciary responsibility to their investors. Letting someone lift some of their clients’ cash in this way would be like a bank manager forgetting to lock up when he goes home.
Fidelity alone has about 5% of Home Depot stock. If it started taking a serious stand against outsized executive pay, the practice would stop. Simple as that. Instead, most fund managers have an abysmal record in this matter. They tend to just wave the executive pay reports through each year. Consider the key HD stockholders’ meeting last year, when a rebel shareholder finally forced the issue of Nardelli’s pay package. How did HD’s 10 biggest mutual fund investors voted at the meeting? Five of those funds were controlled by Fidelity and Vanguard. Those funds backed up Nardelli and the board on all the key issues, including the reelection of directors. So did American Funds’ Washington Mutual fund fund. Bill Miller’s Legg Mason Value Trustfund straddled the fence, voting to reelect the directors, but backing shareholder proposals to rein in executive pay and assert better corporate governance.
Out of the top 10 funds, just three stood up to the board. So let us give a cheer for Grantham, Mayo and Van Otterloo’s fund GMO U.S. Quality Equity II fund, Putnam’s Fund for Growth & Income fund, and the T. Rowe Price Equity Income fund fund. Why did the rebels get so little support from the big guns? Vanguard and Fidelity do not say. But a Fidelity spokesman argued that the company was already taking a more activist stance on the issue of executive pay, and voted against half of all stock compensation plans that came up for a vote last year. So why did they back Nardelli’s deal at Home Depot?
Congressman Barney Frank (D-Massachusetts), chairman of the House Financial Services Committee, wants to take steps to try to stop these absurd windfalls. What we do not want is a blizzard of new regulations and big government setting pay levels. His proposal to force companies to disclose executive pay more fully in advance, and to make sure shareholders get to vote on it, has a lot of merit. Although there is plenty of “disclosure” now, it is buried in the proxy statements. Frank could make sure that each proxy statement discloses the total amount, in clear English, that the top executives stand to make. The other proposal being kicked around – allowing shareholders to “claw back” excessive severance after the fact – goes too far. There is the principle of contract involved.
Memo to Congressman Frank: There is an easier way. Mutual fund managers absolutely loathe being embarrassed in public. If the congressman really wants to crack down on these pay deals, he should slap subpoenas on every single fund manager who controlled shares in Home Depot over the past six years and voted to approve Nardelli’s pay. He can throw in those who backed other outrageous pay deals – like the $200 million that Hank McKinnell got when they kicked him out of Pfizer and the $500 million that Lee Raymond had in his pocket when he walked away from ExxonMobil. Frank can start with the folks at Fidelity, probably the most powerful fund management company in America, and certainly one of the most powerful companies in his home state of Massachusetts. He should drag the managers and the fund trustees down to Washington, D.C., to explain themselves before the cameras. And he should do it again, every year, until they learn to be more careful with their shareholders’ money.Link here.
The rain falls on the rich and the poor alike. That is symmetry. But after the rain lands, the rich receive a much larger share of the water than the poor. That is asymmetry. Indeed, some of the rich funnel as much water as possible toward their own personal reservoirs ... even though they have more than enough water already. That is greed. And some of the rich drain the wells of their neighbors and clients to water their golf courses. That is Wall Street.
Greed is one reason why brokerage stocks might be dangerous stocks to own at their current lofty valuations. No automatic connection exists between greed and poor stock market performance. But bad things just seem to happen to the common shareholders of companies that greedy managements oversee. Names like Enron, Tyco and Worldcom come to mind. In this context, names like Merrill Lynch and Morgan Stanley do not yet come to mind. But the big brokerage firms of Wall Street have veered perilously close to the shoals of excessive greed.Link here.
SHAREHOLDERS WANT CASH NOW
Forget about capital spending, debt repayment, funding pensions, and stuff like that.
Investor demands for companies to hand back cash to their shareholders have reached new highs, according to a Merrill Lynch poll of fund managers. More than 50% of investors want cash returned – via dividends, share buy-backs or cash acquisitions – rather than used for capital spending, debt repayment or pension top-ups, the survey found. The poll showed that a record 53% of fund managers want cash returned, up from 44% a month ago. Some 60% of respondents said they felt company balance sheets were underleveraged, while 46% believed pay-out ratios were too low.
“Investors are urging companies to return cash to shareholders as never before. They perceive corporate cashflow to be very stable, very strong and unlikely to be derailed,” said David Bowers, consultant to Merrill Lynch. Mr. Bowers said there was huge pressure on companies to issue debt and use the proceeds to improve returns on equity, such as through share buy-backs. This was partly because corporate credit was so cheap and cash-flow so strong. However, it also reflected the pressures being exerted by private equity buyers. Investor preference for cash-backs over capital spending could also reflect worries about slower U.S. economic growth, with fund managers reluctant to see any expansion of capacity going into a downturn.Link here.
THE RETURN OF THE DUST BOWL
A darkness blacker than night is how it was often described. At least one could pierce the black veil of night. Not so with this kind of darkness. It was opaque. People were afraid. It was only mid-morning. They had never seen anything like it. If you ventured outside into the cold and biting wind, sand would get in your nose and mouth and ears. You would hurry back inside and cough up black. While inside, people soaked sheets and towels. They would try to stuff them around windowsills and doorframes. But choking dust still filtered in. It spread out in little ripples on the floor and seeped through windowsills. It was November 11, 1933, Armistice Day, South Dakota.
When it was finally over, families would stumble out of their farmhouses and peer out at a new surrealist landscape. The fields were gone. The trees were no more. Just mounds of sand and eddies of dust swirling in the light autumn breeze. There were no roads. No tractors or machinery, no fences. All of it laid buried in sand. The great Black Blizzard of 1933 destroyed acres of farmland stretching from the Texas Panhandle all through the Great Plains and clear to the Canadian border. The following day, the skies darkened over Chicago. A steady stream of filth fell on the city like snow. Even people as far east as Albany, N.Y., could see the menacing dark clouds roll their way across the horizon.
Yet 1933 was “only a prelude to disaster,” as Frederick Lewis Allen wrote in his panorama of the 1930s, Since Yesterday. In 1934 and 1935, the dust storms destroyed thousands and thousands of acres of farmland. The lives of more than half a million Americans changed forever. Many hit the road, forced to wander like refugees in their own land. Most headed west, looking for a new start.
The Dust Bowl was a seminal event in American history. Unlike a natural disaster such as a hurricane, “There was a long story of human error behind it,” as Allen wrote. After World War I, there was a great demand for wheat. Mechanized farming also became common. Farmers tore up the sod that covered the plains and farms expanded. Production soared. The Plains were a region of high winds and light rainfall. Yet the 1920s were pretty forgiving in terms of drought. But in the 1930s, we had some real drought in these places. The combination of drought and desiccated farmland would create the epic dust storms. “Retribution for the very human error of breaking the sod of the Plains had come in full measure,” Allen wrote.
I recently spent some time looking over pictures of the aftermath of these blizzards. They are incredible and simply hard to believe. Yet I see how something like this could happen again. Except this time, it will be bigger. And it will happen in China. Plumes of dust emanating from northern China have already hit the U.S. mainland. As Lester Brown, author of Outgrowing the Earth, explains, “With little vegetation remaining in parts of northern and western China, the strong winds of late winter and early spring can remove literally millions of tons of topsoil in a single day – soil that can take centuries to replace.” These dust storms are so strong that they can peel the paint off cars. They often force the closure of schools, airports and stores – as far away as South Korea and Japan.
As with the Great Plains, northern China is dry and farmed intensely. Already, China’s farmland is turning to desert at an alarming rate. Chinese farmers struggle to meet the demands of the Chinese people. It is not so much the basic demand for food as it is a change in the mix of what people eat. In richer countries, people eat more meat, as well as fruits and vegetables, and less cereals and grains. Meat is incredibly expensive to produce, because raising the necessary livestock requires large amounts of grain. A typical 1,200-pound beef steer could consume enough grain to feed more than 10 average-sized adults for an entire year.
There is limited arable land in northern China, so the Chinese rely more on fertilizers to boost yield. Currently, fertilizer use in China is more than three times the global average. China’s ability to produce the fertilizers it needs – in particular, potassium and phosphate – is limited, and thus is one of the largest importers of these fertilizers. This is one of the reasons companies such as Agrium (AGU: NYSE) thrive today. So you have chunks of Chinese farmland turning into desert every year. You have got limited water resources in a dry region. Already you have got dust storms that kick up plumes of dust that travel thousands of miles. All of this is reminiscent of the U.S. in the 1930s.
We all have a stake in what happens in China. If China relied on the rest of the world for even 20% of its grain needs, there would be an incredible strain on the world’s grain producers. Many of the challenges China faces exist in the world at large already. Grain production per person is falling worldwide. So is cropland acreage per person. We are also approaching the limits of what fertilizers can do in terms of boosting crop yields. Plus, strong demand for biofuels – like ethanol – now competes with food demand.
The investment conclusion from all this seems to be that we are in a long bull market for grains. Expect the prices of corn and wheat to keep rising. Expect the price of meat to rise. It also seems that fertilizer producers, such as Agrium, should continue to do well. Other ancillary ideas also come to mind – shippers of dry goods (i.e., grains) and manufacturers of farm equipment. My recommendation of irrigation equipment maker Lindsay Co. is up 40% since June. The potential for another 1930s-style Dust Bowl only adds to the power and durability of these trends.Link here.
In case you are on the Atkins Diet of commodity trading, you may have missed the fact that the really big gains of late have been in the Grains. To wit: On January 16, March corn prices soared above $4 per bushel for the time in the history of the Chicago Board of Trade, while wheat prices rocketed to their loftiest level in 10 years. Talk about Carbo-high-drates.
Right away, the mainstream “experts” pawned wheat’s move off on corn, calling the former’s rise a “knockoff” rally. “Corn rules,” observes a January 17 Associated Press. “Whither corn, whence the rest of the grains.” As for why corn doth climb o’er mountains so high – this January 16 DJ MarketWatch says: A January 16 US Department of Agriculture report cut its estimate on corn supplies for the end of the latest crop year by almost 20%. “The crop report remains shocking in its short and long-term implications, catching the entire grain trading world off guard.” A same-day Bloomberg offers, “The shrinking size of the corn pile is absolutely huge and cannot continue without astounding high prices developing.”
We will let that slide ... NOT. Fact is, even with the USDA’s downsize, the 2006/07 figure is still the 3rd largest corn crop in U.S. history. But, interjects the popular press, the current inventory of corn will not be able to satisfy the [widely expected to become, but not as yet] insatiable demand for ethanol – the “real driver of corn’s spike.” (Anyone. Anywhere.) Oh yes, the ever-growing craze for m-ethanol. Certainly by now we have all heard about it. We have all read about it. But few of us have actually seen it taking place in the real world. In March 2006 the Chicago Board of Trade launched the very first ethanol futures contract. Now, on January 16, 2007, when corn prices experienced their rise to record highs, 456,877 contracts traded. On that same day, a grand total of seven contracts traded in ethanol. Not to mention the obvious fact that the alleged hunger for ethanol has come at a time when crude oil has suffered a 6-month long, 25% selloff to 20-month lows.
Even if we did entertain the idea that ethanol demand will eventually outpace the supply of corn, the fact remains that consumption of corn has exceeded crop size for six out of the last seven years, none of which have witnessed prices surging as they are today. The seeds of corn’s rally were NOT “planted at the start of 2007” – as a January 17 DJ MarketWatch has suggested. One look at a price chart of the grain and it is clear that the uptrend in corn took off in late September 2006, with prices surging over 50% since. The question now is: how high are these grains set to fly?Elliott Wave International January 18 lead article.
What is ahead for stocks and the economy in 2007? Setting aside unknown elements like major terrorist attacks or natural disasters, I believe six phenomena are shaping the investment climate this year. The world is awash in financial liquidity mainly due to rising house values, the negative U.S. corporate financing gap, and the American balance of payments deficit. Inflation remains low despite higher energy prices. As a result, investment returns are low. Speculation remains rampant despite the 2000-2002 bear market. So, investors are accepting more risks to achieve expected returns. And then there is the insatiable U.S. consumer, who, thanks to the booming housing market, continues to spend freely.
In this climate, I foresee 12 investment themes, seven of which are likely to unfold in 2007 while four will probably work but maybe not until next year:
NOMINAL GDP GROWTH AND ASSET PRICES LINKED, OR NOT?
Bloomberg’s Tom Keene: “(Pimco’s) Bill (Gross), your note every month is always interesting. This last one is one of my favorites. As you know, I am a big fan of nominal GDP – this, folks, is real GDP plus inflation. It is the “animal spirits” that’s out there. You say be careful, Bill Gross. It looks real good to me, Bill. I see 6% year-over-year nominal. You say that is going to end?”
Bill Gross: “I think almost assuredly, because of oil prices. I am not suggesting it end because of real growth going down – that is the Goldilocks scenario in which we have 2% plus or minus real growth. With oil prices doing what they are doing – if they hold in the $55 range – gosh, we are going to see CPI prints y-o-y over the next three or four months of 0.5% or 1.0% and that means nominal GDP is down in the 3% range.”
Tom Keene: “And the important distinction here is you have two moving parts: GDP and inflation. So you have got roughly four outcomes: They both go up, they both go down, or they split the difference. You are suggesting – your focus – is more on the inflation part of nominal GDP or are you looking equally at the growth dynamics?”
Bill Gross: “Ultimately, the inflation component affects the real growth component. To the extent that you have nominal GDP – in my forecast 3 to 3.5%, that is really not enough growth in terms of the economy itself to support asset prices at existing levels. And so, declining assets prices ultimately factor into eventually lower real growth. But that is not for mid-2007 but perhaps for later in the year.
“... When you realize that the average cost of debt in the bond market – and therefore in the economy and this includes mortgages – it is about 5.5%. If you can only grow your wealth and service that debt at 3.5% rate, then that has serious implications. When you go back to 1965, Merrill [Lynch] did this study – in terms of asset prices during periods of time when nominal growth grew less than 4%. Risk assets have been negative in terms of their appreciation and actually bonds have done pretty well. The question becomes why has that not happened yet, and I think we are simply in a period of time where there are leads and lags that are much like the leads and lags of Federal Reserve policy.”
Tom Keene: “Where will the 10-year yield be 12 months from now?”
Bill Gross: “I think around 4.5%, and that is not a dramatic bull market. We are at 4.75% now and that would imply a point and a half of price appreciation on top of that yield, so maybe a 6% total return. But we are definitely moving into a period of time during which bonds begin to do better. Obviously, in the last month or two they have not, and risk assets – typified by equities – have done just the reverse. But I think we are beginning to get into a period in which this tightening effect will move things in the opposite direction.”
I chose to highlight part of this interview because it touched upon a few key financial issues – in a year where I expect to analytically fixate on finance. I find Mr. Gross’s focus on low Nominal GDP and the related “tightening effect” quite interesting. And Mr. Keene’s view that Nominal GDP represents “animal spirits” is also worthy of contemplation.
My bias at this point would be to downplay the rapid moderation in Nominal GDP – or at least question the germaneness of traditional analysis. I do not see slower growth as the consequence of tightened credit. I have a much different focus, believing instead that the widening divergence between slowing GDP and continued robust system credit growth is evidence of loose (and likely loosening) financial conditions. As I have been noting for some time, the housing-driven Economic Sphere moderation has provided a powerful catalyst for accelerated Financial Sphere expansion.
Sure, a decent case can be made that recent declines in housing, oil, and commodities are indicative of Mr. Gross’s unfolding tightening process. But what if the downturns in housing and oil are not at all related to restrictive finance, but are instead the upshot of the dynamics of ongoing highly liquefied and speculative markets? Markets do fluctuate, and there is certainly ample evidence elsewhere to support the view of ongoing ultra-loose financial conditions. And to what extent do lower energy prices stoke bubbles elsewhere? Faltering U.S. housing bubbles promoted the surge in global M&A.
For things to get really interesting, contemplate for a moment the possibility that moderating housing markets, oil prices, and nominal GDP are indicative – not of tightened finance but instead – of dramatic price volatility associated with hyper credit inflation-induced monetary disorder. After all, late-stage credit bubbles are masters of price distortions. There is today a distinct possibility that analysts have been fooled into inflation and credit bubble complacency.
Not without justification, Mr. Gross believes that our current rate of “wealth” expansion is problematic when it comes to servicing our economy’s 5.5% “cost of debt”. Well, to begin with, in no way do I subscribe to the view that nominal GDP is an accurate reflection of real wealth creation in our economy. With $900 billion Current Account deficits and asset-based debt outstanding at multiples of nominal GDP, we do not in reality service our “cost of debt” with real wealth creation. Instead, we “monetize” our mounting interest costs by creating only more debt. This illusory economic miracle works wonderously until debt holders decide to change their rules of engagement.
The key metric for sustaining the asset markets is not GDP as much as it is total system credit growth – of which there is today plenty. Traditionally, credit created in the process of financing real business investment and economic output was the prevailing source of liquidity, fueling both the economy and asset markets. GDP was closely tied to monetary conditions. Today, asset and securities-based finance is the key system monetary mechanism – often operating with a dynamic of their own. Real GDP and “output” inflation will capture varying effects of rampant credit inflation, although much of the created purchasing power/liquidity will impose unequal and divergent influences primarily on various asset prices and markets.
Today, Tom Keane’s “animal spirits” – profit-seeking behavior – find their primary outlet in the expansive Financial Sphere, where the men and woman of the leveraged speculating community and Wall Street finance today dictate system behavior to a profoundly greater extent than does real business investment. Moderating nominal GDP has provided a boon to finance – an impetus to only greater credit bubble excesses and risks.
I propose that this is the key dynamic explaining why risk assets have generally been notably robust (escalating bubbles) in the face of what one would typically have expected to be a problematic U.S. economic slowdown. Focusing on nominal GDP, Mr. Gross believes the Fed now has much greater flexibility to commence the next easing cycle. Yet, if slower growth has indeed provoked only greater financial excess, i.e., looser financial conditions, the upshot might instead be pressure on the Fed to resume the “tightening cycle”. The Bank of England this week decided as much and sent its message loud and clear.
I doubt the Fed buys into the bond market’s story. Understandably, the Fed is cautious when it comes to analysis professing underlying U.S. (bubble) economy weakness. Much of the economy is booming and labor markets are generally tight. And a better case can be made that the recent mild inflation reports are more indicative of unusual price volatility than a sustainable trend. I will change my tune when Financial Sphere, credit and income growth trends reverse. The Fed lost flexibility last year when the Financial Sphere was determined to “front run” the Fed’s easing cycle – creating a problematic backdrop of excessive global financial leveraging, speculation and destabilizing liquidity. This rampant bubble environment has the Fed both fearing that it would, if it eased, exacerbate excess and, if it tightened, risk bursting bubbles. Sinking oil prices, rising market yields, and highly speculative risk markets create a volatile mix to begin the New Year.Link here (scroll down to last heading in the left/content column).
LOW VOLATILITY DOES NOT EQUAL LOW CREDIT RISK
Credit creation appears to be a self-reinforcing process (what some call a “positive feedback loop”). The added availability of credit results in an increase in asset purchasing power (driving asset values higher). The higher asset values in turn result in an increased “willingness” to lend and to borrow, which in turn results in more borrowing ... and so forth. The process continues in one direction – upward – until an extraneous variable changes dramatically in a way that negatively impacts this “willingness”.
Those extraneous variables as they pertain respectively to the lender (supply) and the borrower (demand) are the yield curve and the level of interest rates. It would appear that the negative yield curve is the decisive factor at the present time. Once the credit creation process is reversed, then the big problem is that the process is also self-reinforcing in the opposite direction. Less credit results in lower asset values which result in even less credit. This is effectively a deflationary process (a la Japan).
The extension of credit is essentially psychological at its core. Credit represents in its essence the willingness of one person to borrow money and the willingness of another person to lend money. All of our measurements of credit and credit growth are actually measurements of this “willingness”, if you will. The less fear that people feel, the more willing they are to borrow – and vice-versa. And likewise this is the same for the lender. If some type of economic dislocation were to occur, this could potentially result in a tremendous increase in the “level of fear”, which in turn will be reflected in a plunge in credit creation. Knowing what we know about people’s tendency to behave in crowds, it is the foremost priority of the government to reassure people about the current state of affairs and keep fears at bay.
The current level of complacency has been reflected in the record low levels of stock market volatility indicators such as the VIX. Some people such as economist Hyman Minsky have noted that it is precisely when people are most complacent that economic and financial market risk are at the most dangerous point. The current public complacency has been so great that some have made humour of this prevailing perception through the tombstone heading “RIP: The Death of Risk”.
Our financial markets have innovated products, such as asset-backed securities and derivatives, that essentially enable the sharing of risk among many parties instead of just one. While that risk is reduced for a single party, the total level of risk across the entire system is completely unchanged – it is only redistributed. The perception of risk reduction encourages people to extend more and more credit, which results in the risk level for the entire system to keep escalating, even though this may not be evident to the single party engaging in one credit transaction. This risk redistribution mechanism is fatally flawed because of two key elements.
The first flawed element pertains to derivatives in that they hinge on one party assuming the obligation to pay the counter-party in the event that the value of the underlying asset changes in value (counter-party default risk). The widespread adoption of derivatives usage has ensured that a vast network of interlocking counter-party relationships has been established worldwide. The financial collapse of a single major participant could bring down the whole system, because they will default on their derivatives obligations, which will in turn bring about the financial collapse of their counter-parties (and so on), resulting in a domino effect. The likelihood of this scenario occurring will increase as a function of volatility in the financial markets.
The value of underlying assets underpinning derivatives contracts is estimated to exceed $200 trillion and is still rapidly growing. We can safely assume that a small percentage of that amount would represent the value of counter-party financial obligations. Even if that percentage were as low as 1%, this would represent a value of $2 trillion, which by itself is a staggering number. That number will swell up into a value of several trillion more than that should financial market volatility increase.
There is one new category of derivative that appears to be particularly problematic. That being what we call the credit derivative. This instrument entails someone selling credit protection on the debts of a corporation in exchange for a premium paid. We can call this credit insurance if you will. The problem with this type of derivative is that the notional underlying value is 100% at risk, for if the company defaults on its debts, the “losing” derivatives counter-party will be required to pay the entire amount of the notional value of the derivatives contract (rather than a small percentage as is the case with most other types of derivatives). What that means is when statistics of total credit derivatives contracts outstanding are disclosed amounting to several trillion dollars, it is literally the entire value of that which is at risk.
The overwhelmingly predominant use of derivatives – roughly 90% of all contracts – today is for the purpose of protecting against changes in interest rates. When attempting to ascertain what kind of event would place the derivatives system under particular stress, it would appear that it would likely be an interest rate dislocation in the bond market. Foreigners currently own in excess of 50% of all outstanding tradable U.S. Treasury securities on the market. As we have observed repeatedly and with remarkable consistency with countries dependent on external borrowing in the past, when foreign investors start to lose confidence in the borrowing country’s economy, this has resulted in a “snowball” effect, whereby each foreign investor tries to anticipate the other one in trying to time the withdraw of their capital from the borrowing country. The outcome has generally been sharply rising interest rates simultaneously accompanied by a sharp decline in the value of the borrowing country’s currency.
The second flawed element of our risk redistribution mechanism pertains to asset-backed securities in that they are dependent on credit rating agencies to measure the credit risk for the lender (investor) and assign a credit rating to the security. In the past, the fear of credit loss ensured that the lending bank was very diligent in assessing credit risk. This responsibility has now been delegated to a credit rating agency who does not face any financial loss if the borrower defaults. They do not have the same incentive to be as diligent in assessing credit risk as the bank used to be when it was “on the hook”. Their incentive may very well be quite the opposite, given that their revenues are derived from the borrowers – which pay them fees to assign a credit rating so that they may issue the securities. As a result, there is no built-in restraint mechanism in place for this new age credit creation machine as it were.
The situation is analogous to a vehicle that has an accelerator but no brakes. If people were to drive such a vehicle, what can we surmise would be the eventual outcome? As a society, we are now collectively driving in this “vehicle” and will eventually suffer the consequences of doing so.Link here.
EASY MONEY PROMPTS ASIA CENTRAL BANKS TO TAYLOR POLICIES TO STOP ASSET BUBBLES
Asian central banks are using tailored policies to combat the threat from a flood of easy money, keen to avoid interest rate rises given that headline inflation and economic growth are expected to ease. Many economies are awash in easy funds as central banks buy dollars generated by regional balance of payments surpluses which otherwise would push up the value of their local currencies.
To deal with the nagging problem, China and India have forced commercial banks to park more money with the central bank. South Korea and China are encouraging locals to invest more abroad, while Thailand has adopted more severe measures by placing curbs on foreign money entering the country. “I think policy makers are looking for more direct means and direct tools to try to control liquidity,” said Rob Subbaraman, senior economist with Lehman Brothers in Hong Kong. “The problem with raising interest rates is that it affects the overall economy, so maybe it’s not the appropriate policy given that inflation is so low and generally there is a concern about the export outlook.”
The cash flowing into banking systems has led to a surge in lending that central banks fear could find its way into the property or stock markets, sparking asset bubbles. “Consumer inflation is likely to stay benign in the region, but the main concern is that serious asset-price inflation may occur,” said Wang Qing, economist at Bank of America in Hong Kong.
China’s central bank has raised reserve requirements, or the amount banks have to deposit with the authority, four times in seven months to curb growth in fixed-asset investment and property. The Chinese Academy of Social Science, a top government think-tank, has urged Beijing to rein in the property sector to prevent a real estate bubble of the sort that crippled Japan’s economy in the 1990s, the Xinhua news agency said last week. Tim Condon, an economist at ING in Singapore, said China would probably have to raise reserve requirements again.
The rush of money into financial systems is becoming more of a priority for many central banks. “Liquidity has become more of an issue for China than inflation and even the Philippines is concerned about rapid money supply,” Subbaraman said. The Bank of Korea raised the reserve ratio on banks’ short-term deposits in November to try to stabilize real estate prices. The Reserve Bank of India, frustrated by the failure of successive interest rate rises to put a brake on the bank credit fanning a property boom, changed tack in December by raising bank reserve ratios.
Central banks are more confident now that inflation is set to ease because oil prices have tumbled about 30% from July’s record high. But falling oil prices have also helped push up trade surpluses in many export-orientated countries, exacerbating the problem of excess cash. Asia’s external surpluses are unlikely to ease this year in the absence of effective methods to tackle global economic imbalances, analysts say. Few economists believe China’s trade surplus, which jumped 74% last year to a record $177.5 billion, will narrow any time soon. South Korea’s commerce ministry predicted this month that the country’s 2007 trade surplus would be similar to 2006’s surplus. Asian holdings of foreign exchange reserves jumped by $448 billion in 2006 to $3.15 trillion, led by a 30% jump in holdings in China and India.
Central banks have been selling huge volumes of bills to “sterilize” the local currency released, but analysts say the operations would be overwhelmed as external surpluses soar and massive debt issuance could push up market interest rates.Link here.
THE GROWTH MACHINE
Stephen Roach questions his past cautionary calls, but is not ready to concede just yet.
After four years of booming global growth, I have argued that the world is due for a rest – not a hard landing but a marked slowdown from the strongest surge since the early 1970s. The verdict in the early days of 2007 is that I could well be wrong. For longer than I care to remember, my base case has argued that ever-mounting imbalances will ultimately crimp vigorous growth in global economy. While there can be no mistaking the imbalances of a U.S.-centric world, there can also be no mistaking the extraordinary resilience of the great global growth machine. Is it time for a new approach?
The debate over the sources of growth is as old as the economics profession itself. That debate has great relevance for global rebalancing – especially since it makes the important distinction between growth that is dependent on external or internal sources. In the end, only the latter strain of growth is self-sustaining. That raises one of the toughest problems of all for an unbalanced world: The demand side of the global economy has been dominated by the American consumer, where growth in recent years has been underpinned less and less by the traditional support of income generation and more and more by the wealth effects of an increasingly asset-dependent economy. As the balance shifts from income- to wealth-dependent growth, the risks of financial vulnerability can mount. That has certainly been the case in the U.S., with record levels of household sector indebtedness, sharply depressed domestic saving, and massive current account deficits.
Similar sustainability concerns pertain to the supply side of the global economy, increasingly dominated by China. In this case, the growth dynamic has been concentrated in China’s two most outward-looking sectors – fixed investment and exports, which collectively account for about 80% of Chinese GDP. The sustainability requirements of such an externally-led growth framework are very different from those of the demand-side model. The investment process has to be rational, with capital allocated in the right dosage to the right industries – avoiding both production bottlenecks and capacity overhangs that might jeopardize ongoing growth. The export process needs to match the needs and aspirations of China trading partners – without creating undue cross-border frictions.
My problem with sustainability of the current strain of global growth arises mainly out of the internal imbalances of the U.S. and Chinese economies. In recent years, America’s asset-dependent economy has been prone to periodic bubbles – first equities and now property. Post-bubble shakeouts crimp equity extraction from asset markets – putting pressure on income-short consumers to rebuild income-based saving rates. By contrast, China’s supply-led model has been funded, in large part, by a relatively undisciplined system of policy-directed bank lending. That underscores the risks of a misallocation of capital that could lead to excess supply and deflation. At the same time, China’s export-led dynamic is now eliciting a mounting protectionist backlash from both the U.S. and Europe. With growth risks tipping to the downside in both the U.S. and China, I have argued that slowing is inevitable for a two-engine global economy. Lacking in support from private consumer demand, the rest of the world is not nearly as decisive in shaping the global growth outcome.
Ultimately, the question of sustainability is an exercise in “equilibrium economics”. I have long argued that it is a bit like physics – that an unbalanced economy is akin to a system in disequilibrium that is especially vulnerable to periodic shocks. A slowing of global growth is a key implication of the rebalancing framework. But far from slowing, an increasingly unbalanced global economy just ended a fourth consecutive year of the strongest growth since the early 1970s. And so it turned out that an increasingly unbalanced world has not been nearly as vulnerable to shocks as I had thought would be the case.
I have been around this track long enough to know when it is game over for a big macro call. I must confess that my patience is definitely wearing thin. It has long been said that being early on market calls is the functional equivalent of being wrong. However, with many of the rebalancing tensions I have long been warning of now coming to the surface, I am not willing to concede on the analytics of the global rebalancing framework. I still believe it is a powerful way to understand the forces and risks that drive today’s unbalanced, yet increasingly interdependent, global economy.
But we live in a mark-to-market world, and it is not acceptable just to counsel patience in waiting for the big calls to break one way or another. We owe it to ourselves and our loyal followers to figure out why the consequences do not match up with the analytical conclusions of the framework. My own explanation has long pointed in the direction of the global liquidity cycle – especially the lack of interest rate pressures up and down the risk spectrum. Without a meaningful jolt to interest rates, the asset economy is able to keep cushioning the real economy from otherwise disruptive shocks. Yes, as many have pointed out, excess liquidity has become the all too convenient rationale for all that seems awry in financial markets. This may be one of those times when the crowd is correct.
If so, that conclusion does not bode well for a still unbalanced world. From tulips to dot-com, the cycle of fear and greed has all too often gone to extremes in asset markets. In an era of excess liquidity, asset bubbles are the norm – not the exception. In the past seven years, there has been an equity bubble, a housing bubble, and now a risk bubble. I am not convinced that financial globalization has progressed to the point where an increasingly asset-dependent global economy is now self-cushioning – essentially immune to the risks of post-bubble adjustments. However, the latest batch of data has certainly not broken my way. While that does not convince me I have the basic framework wrong, it certainly puts me on notice that the proverbial moment of truth could well be close at hand. If the great global growth machine does not start to slow by the end of this year, it will be high time to give up the ghost.Link here.
THE UNEASE BUBBLING IN TODAY’S BRAVE NEW FINANCIAL WORLD
Last week I received an e-mail that made chilling reading. The author claimed to be a senior banker suggesting that the explosion in structured finance could be exacerbating the current exuberance of the credit markets, by creating additional leverage. “Hi Gillian,” the message went. “I have been working in the leveraged credit and distressed debt sector for 20 years ... and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past.
“I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions ... with very limited capacity to withstand adverse credit events and market downturns.
“I am not sure what is worse, talking to market players who generally believe that ‘this time it’s different’, or to more seasoned players who ... privately acknowledge that there is a bubble waiting to burst but ... hope problems will not arise until after the next bonus round.”
He then relates the case of a typical hedge fund, two times levered. That looks modest until you realize it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralized debt obligations, which are nine times levered. “Thus every €1 million of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital – a 2% price decline in the CDO paper wipes out the capital supporting it.
“The degree of leverage at work ... is quite frankly frightening,” he concludes. “Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don’t even expect one.”
Since this message arrived via an anonymous email account, it might be a prank. But I doubt it. I have recently had numerous emails echoing the above points. And most of these come from named individuals, albeit ones who need to stay anonymous. There is, for example, a credit analyst at a bulge-bracket bank who worries that rating agencies are stoking up the structured credit boom, with dangerously little oversight. “[If you] take away the three anointed interpreters of ‘investment grade’, that market folds up shop. I wonder if your readers understand that ... and the non-trivial conflict of interest that these agencies sit on top of as publicly listed, for-profit companies?”
Then there is the (senior) asset manager who thinks leverage is proliferating because investors believe risk has been dispersed so well there will never be a crisis, though this proposition remains far from proven. “I have been involved in [these] markets since the early days,” he writes. “[But] I wonder if those who are newer to the game truly understand the impact of a down cycle?”
Another Wall Street banker fears that leverage is proliferating so fast, via new instruments, that it leaves policy officials powerless. “I hope that rational investors and asset prices cool off instead of collapse, like they did in Japan in the 1990s,” he writes. “But if they do, monetary policy will be useless.”
To be fair, amid this wave of anxiety I also received a couple of “soothing” comments. An analyst at JPMorgan, for example, kindly explained at length the benefits of the CDO boom: namely that these instruments help investors diversify portfolios, provide long-term financing for asset managers, and reallocate risk. “Longer term, there may well be a re-pricing of assets as the economy slows and credit risk increases,” he concludes. “But. there is a very strong case to be made that the CDO market has played a major role in driving down economic and market volatility over the past 10 years.”
Let us hope so. And certainly investors are behaving as if volatility is disappearing. But if there is any moral from my inbox, it is how much unease – and leverage – is bubbling, largely unseen, in today’s Brave New financial world. That is definitely worth shouting about, even amid the records now being set in the derivatives sector.Link here.
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