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BREWING BUBBLES IN SHANGHAI, TOKYO, AND LONDON
“There is a bubble growing. Investors should be concerned about the risks,” said Cheng Siwei, vice-chairman of China’s National People’s Congress in a January 31st interview with the Financial Times. “But in a bull market, people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing. But that is their risk and their choice,” Cheng warned.
In what might develop into the third biggest stock market bubble in history, ranked alongside Japan’s Nikkei-225 of 1986-89, and the Nasdaq’s 1999-2000 bull run, the Shanghai Composite “A” share Index, restricted mainly to Chinese nationals, has posted a 140% gain over the past 12-months, after soaring 46% in Q4 2006 alone. And without deliberate market intervention, the A-share market could inflate into a Nasdaq-like bubble. How Beijing decides to deal with the Shanghai bubble can have a great impact on the outlook for the Chinese economy, global commodity markets, and exporters in the region from Australia, Hong Kong, Japan, and Korea. Will Beijing try to prick the bubble and set-off a steep correction, or carefully calibrate a series of tightening measures to take some steam out of the market and simply flatten it out?
Sometimes, markets can boomerang on central banks and torpedo the most carefully designed strategies. Therefore, jawboning is usually the first act of official intervention in the market place, because it is cost free and does not change underlying market conditions. Siwei’s remarks did trigger a 15% pullback from January’s peak, as traders locked in profits from sky-high valuations, figuring that official warnings might turn into concrete steps to cool down the market. Then on February 9th, the People’s Bank of China (PBoC) tried to keep the market off balance, by warning that it would use a number of tools to keep flush liquidity conditions in check. The Shanghai “A” share index fell 2.5% to an intra-day low of 2,541, within minutes of the PBoC’s threats, but then put in a reversal bottom, and closed 2.3% higher on the day. One week later, on February 15th, the “A” share index jumped more than 3% to an all-time closing high of 2,993. On the smaller Shenzhen market, three new IPOs soared into orbit, suggesting that the Chinese stampede into stocks has not run its course. The PBoC put its verbal threats into action on February 16th, when it lifted bank reserve ratios 0.5% to 10%.
The PBoC prints yuan in exchange for foreign currency flowing into the country, and until Beijing abandons its crawling peg of the dollar-yuan exchange rate, the M2 money supply growth rate will remain very high. Hot money will continue to flow in Shanghai stocks, feeding the bubble frenzy. The 5h hike in bank reserve ratios since June has only slowed the annual growth rate of China’s M2 money supply from an explosive 19.1% to a robust 15.9% rate last month. So far, the PBoC’s open market operations to drain liquidity have only put a floor under Shanghai money market yields rather than pushing them up. The PBoC plays a clever shell game, but is still pegging its 7-day repo rate in a range of 1.50% to 2%, which encourages speculation in stocks. Until the PBoC lifts interest rates high enough to discourage borrowing, it will not be able to contain the robust growth of the money supply. Therefore, an interest rate hike seems inevitable, as reserve ratio adjustments and open market operations have failed in curbing liquidity and lending.
Is the Shanghai stock market in a bubble?
It is popular to call a market that triples in value within less than two years, a bubble, but seen from a different angle, the spectacular resurrection of Shanghai “A” share index might have corrected a grossly undervalued position, into closer alignment with the global benchmark MSCI All-World Index (see charts), which closed at all-time highs of 1500 last week, up 100% from its low in March 2003. From 2001 thru 2005, China’s economy and the Shanghai “A” share market spent much of time moving in opposite directions. China was emerging as the world’s leading manufacturing power, yet the Shanghai A share index, lost half of its value, sliding from a high of 2200 to below 1000 on June 6, 2005.
The overhang of massive blocks of government-owned shares in the listed State-owned enterprises was responsible for much of the decline. The threat that Beijing would one day flood the market with NTS shares helped send the mainland share indexes to six-year lows in 2005. On June 6, 2005 the Shanghai stock index dropped to below 1000. Two days later, however, the Shanghai and Shenzhen stock exchanges jumped by more than 8%. Beijing announced a new policy to reform the split structure of mainland shares, which took into consideration the rights of holders of exchange traded shares, who bear the risk of decline in share prices when state owned shares are dumped on the market. Thus, the black cloud hanging over the Shanghai and Shenzen markets was gradually removed in 2006, and share values were unleashed from artificially low levels, and quickly caught up with other inflated world markets.
But what disturbs Chinese government officials are signs of a speculative bubble in the stock market. Investors opened 50,000 retail brokerage accounts a day in December and mutual funds raised a record 389 billion yuan ($50 billion) last year, quadruple the 2005 amount. January turnover was five times early 2006 levels. Beijing is now ordering banks to prevent retail borrowing for stock investments. China’s stock markets are dominated by retail investors, who hold 60% of the total trading shares. By comparison, in Hong Kong, which lists a number of mainland Chinese companies, institutional investors account for 70% of daily transactions.
The Chinese stock market has now become the most expensive in Asia, trading at 40 times 2005 earnings, compared to 16 in Hong Kong. If 2006 corporate results fail to meet strong expectations, Chinese investors could easily dump inflated stocks, and send the overall market into a tailspin. Might Beijing tighten its grip on monetary policy too far in an effort to contain high-flying Shanghai red-chips, even at the risk of triggering a deeper slowdown in the Chinese economy? If history is any guide to the future, the PBoC could control its economy, with a series of small rises instead of infrequent, bigger changes. China should also continue with a gradualist approach to yuan appreciation, and let the currency strengthen by about 5% a year. But would that be fast enough to fend off a protectionist bent U.S. Congress?
Déjà vu in Tokyo. A stock market bubble emerges from cheap yen.
Is it possible for central banks to devalue their economies to prosperity? Tokyo’s financial warlords have the tonic for whatever ails the Japanese economy – a cheap yen. The Japanese yen’s real trade-weighted value hit a 21-year low in January energizing its export-driven economy by making Japanese goods cheaper than European and Korean goods, and propelling its exports to a record high in 2006. Tokyo has pursued a weak yen policy for the past few years by pressuring the BoJ to keep its overnight interest rate near 0%, and forcing the central bank to monetize about half of its budget deficit. Super low interest rates have weakened the yen and helped to boost the local stock indexes. Tokyo’s broad equity market, the Topix, touched a 15-year high and the Nikkei-225 is near its highest since May 2000. The two indexes have risen more than 6% and 4% year-to-date, outperforming a number of emerging markets, putting them on a par with high-flying European stock markets.
Foreign investors have pumped ¥9.1 trillion ($76.2 billion) into Japanese stocks and equities over the past three months, and have received timely batches of good news from Tokyo apparatchniks. Japan’s economy grew at a 4.8% annualized clip in the last three months of 2006, the strongest pace in 3-years. It is a big stretch of the imagination to believe that Japan’s economy has suddenly vaulted into first place from last place, to become the locomotive for the G-7 industrial nations. But after-all, these are the same government apparatchniks that rejigged Japan’s consumer price index in August, shaving two-thirds off the inflation statistics, to handcuff the BoJ from any further rate hikes.
Tokyo boosted its stock market gauges thru manipulation of economic data and abnormally low interest rates that weakened the yen to 21-year lows. But now, Tokyo’s schemes are running into opposition from its top trading partners, who are crying foul play, and demand the BoJ lift its interest rates to levels that reflect its $4.7 trillion economy, the world’s second largest. Last year, Japan racked up a ¥18.6 trillion ($160 billion) current account surplus, while the eurozone suffered a €16.8 billion ($21.5 billion) deficit. Yet the power of the “yen carry” trade was able to swim against the tide of these trade imbalances, by pushing the euro 12% higher against the yen last year.
While Japan is a small market for European exporters, eurozone finance ministers understand that its exporters will suffer in world markets because of cheap competition from Japan in addition to cut-throat competition from China. With the European Central Bank poised to lift its repo rate in the months ahead, the euro is bound to go higher against the yen, without similar baby-step rate hikes by the BoJ, thus worsening the bi-lateral trade imbalance. ECB chief Jean “Tricky” Trichet has expressed his frustration with Tokyo warlords and their cheap yen scheme. “We believe that the Japanese economy is on a sustainable economic path and that exchange rates should reflect these economic fundamentals,” Trichet said after Japan released its stellar GDP report.
Central bankers and finance ministers from the G7 industrial powers, that account for 65% of global GDP, warned currency traders on February 10th, that they could get burned by betting in one direction against the yen. A week earlier, Chicago futures speculators had built-up record short positions against the yen for a third straight week. The large short position left Chicago speculators vulnerable to a minor shake-out from G-7 jawboning. The dollar tumbled 2% to 119-yen, before rebounding to 120.85-yen a few days later. Jawboning ran its course, but the fundamentals of the carry trade have not changed. With the yen’s trade-weighted value against a basket of foreign currencies sinking to a 21-year low, and Tokyo gold climbing to a 21-year high, the Bank of Japan was backed into a corner, and voted 8-1 to hike its overnight loan rate a quarter-point to 0.50%, its highest level in a decade. But the euro remains resilient.
By dumping the yen after the BoJ rate hike to 0.50%, traders ruled that the central bank’s action was “too little, too late” to reverse its long term trend. The BoJ must face a thicket of political wrangling with Tokyo warlords, before it can raise rates again. Tokyo gold traders track the euro’s performance against the yen for direction, and are not duped by Tokyo’s phony claim that consumer prices are only 0.1% higher from a year ago. As long as Tokyo pursues a cheap yen policy, Tokyo gold stays on an uptrend. Would the BoJ continue to hike its interest rates to combat the gold bugs and prevent a bubble from emerging in the Topix index?
Meanwhile, Japan’s interest rates remain abnormally low and far out of alignment with the rest of the world, and the “yen carry” trade lives on. An estimated $330 billion is invested the yen carry trade worldwide. What can weaken the euro against the yen, if Tokyo warlords will not allow the BoJ to lift interest rates to normal levels? “We believe that a weak yen is a reflection of Japanese government policy,” said Rep’s Charles Rangel, Barney Franks, John Dingell and Sander Levin. “We urge the Japanese government to reverse their weak yen policy through concrete action. Japan should be selling the massive reserves it has accumulated, thereby changing the imbalances with the dollar and the Euro.” Tokyo could quietly sell some of its $874 billion of foreign exchange reserves, mostly held in U.S. dollars and euros, on the open market to put a lid on the “yen carry” trade. Tokyo could use the proceeds to pay down some of the 35-trillion yen in short-term debt it acquired in 2003-04, when it intervened on a grand scale, to support the dollar between 104 and 110-yen.
The Bank of England confesses its sins.
It was the monetary equivalent of “shock and awe”. The BoE delivered a nasty New Year surprise on January 11th, its third quarter-point rise in interest rates in six months. Bank governor Mervyn King and his colleagues had been expected to push up rates in February, but by ambushing the markets with a January move to 5.25%, they may have hoped to make more of an impact. “The risks to inflation now appear more to the upside,” the BoE explained. But London’s FTSE-100 all but shrugged off the rate hike. It suffered a 30-point fall just after the announcement, but then closed the day 70 points higher.
It was not so long ago that even a hint of an interest rate hike sent traders scurrying for the hills. So clearly, like everything else, the markets are putting a positive spin on what would normally have been a nasty surprise. The fact is that interest rates have been too low for too long, and few traders take the BoE seriously. But bringing the UK economy back into balance will unfortunately require a lot more discomfort than the slap delivered by Mervyn King and his chums last month.
For the past four years, the BoE pursued the most radical monetary policy among the G7 central banks, pumping up its money supply to inflate British home prices and the local stock markets. But after the UK M4 money supply expanded by 0.9% in January to stand 13% higher from a year earlier, the BoE issued an unusual confession of its past sins. “Investors are likely to take advantage of this ample liquidity and the associated easy credit to purchase other assets, driving risk premiums down and asset prices up,” the BoE told parliament’s Treasury Committee on February 20th. “In due course, those higher asset prices may be expected to feed through into higher demand for goods and prices, putting upward pressure on the general price level,” the BoE concluded. Still, there are plenty of signs of complacency.
Years of monetary abuse by the BoE are finally coming home to roost. In order to get a handle on the explosive M4 growth, the BoE would probably have to hike its base rate by at least 75 basis points to 6%, far above the 5.25% U.S. fed funds rate, which could put more upward pressure on the British pound against the yen and dollar. But a stronger British pound could widen the UK’s trade deficit with the rest of the world, after it notched its largest annual trade gap on record last year.
The massive deterioration in the UK trade balance has been accompanied by the British pound’s rise to 235-yen, it is highest in 14-years. British manufacturers will find it hard to compete with their Japanese competitors, who enjoy a cheap yen and super low interest rates at home. If the BoE aims to tackle M4 by lifting its base rate, without similar rate hikes by the BoJ, it could wreck further damage on Britain’s export sector.
How far would the BoE go to contain its money supply and prevent the emergence of asset bubbles? “British interest rates will probably need to rise one more time to keep inflation on track to hit its 2% target,” the Bank of England signaled on February 14th. Yet one week later, the BoE ratcheted up its hawkish rhetoric by focusing on the explosive growth of M4. Lately, BoE chief King has shown a penchant for the big surprise, outflanking his counterpart Jean “Tricky” Trichet, so stay tuned.Link here.
THE WORLD DROPS ITS GUARD
A new level of complacency has set in. It is not just a financial-market thing – extremely tight spreads on risky assets and sharply reduced volatility in major equity and bond markets. It is also an outgrowth of the increasingly cavalier attitude of policy makers. That is true not only of central banks but also by the global authorities charged with managing the world financial architecture. Meanwhile, by flirting with the perils of protectionism, politicians are ignoring some of the most painfully important lessons from history. After four fat years, convictions are deep that nothing can derail a Teflon-like global economy. That is the time to worry the most.
I am especially concerned about a new lax attitude that has crept into the mindset of the so-called stewards of globalization – namely, the IMF and the broad collection of G-7 finance ministers. Last spring, in an uncharacteristically bullish lapse. I was especially encouraged that the Wise Men had finally woken up to the perils of ever-mounting global imbalances – namely, the widening disparity between America’s gaping current account deficit and large and growing surpluses in China, Japan, Germany, and the major oil producers. With great fanfare at the April 2006 G-7 and IMF meetings, institutional support was thrown behind a new framework of multilateral surveillance and consultation – in my view, materially raising the odds of an orderly, or benign, rebalancing of an unbalanced world.
Unfortunately, the multilateral approach is now rapidly losing momentum. With the global economy and world financial markets turning in yet another good year, suddenly, the urgency to act is now seen as less critical by the stewards of globalization. Complacency has claimed an important victim – thereby undermining the major rationale for my bullish change of heart on the global prognosis. Meanwhile, central banks – basking in the warm glow of success on the inflation-targeting front – are pouring more and more fuel on the global risk binge. The Federal Reserve seems to settling for a long winter’s nap, likely to keep monetary policy on hold through at least the end of this year, according to our U.S. team. An inflation-targeting Bank of Japan seems to be of a similar mindset, mainly because of the distinct possibility of a minor deflationary relapse. A one-party Japan has little tolerance for central bank independence, especially in light of a still very fragile state of affairs. That leaves the European Central Bank as the only one of the three major central banks that is likely to make any type of a policy adjustment in 2007. But should the view that the European economy will continues to surprise on the upside be drawn into question for any reason – hardly a trivial possibility – the risks are that the ECB policy path could quickly tip to the downside.
There is nothing wrong with this picture from a strict inflation-targeting perspective. But that is just my point. At low levels of inflation, and persistent risks of deflation in Japan, inflation targeting produces an exceptionally low level of nominal interest rates. That, in turn, continues to fuel the great liquidity binge that underpins an extraordinary degree of risk taking still evident in world financial markets. Central banks have circled the wagons in taking an agnostic position on this state of affairs. As a former senior central banker put it to me indignantly the other day, “Who are we to judge the state of markets?” That is indicative of what I believe is a very narrow perspective of the role and purpose of central banking. Most importantly, it relegates financial stability to a secondary consideration at precisely the time when financial globalization and innovation could be inherently destabilizing.
The orthodox view of modern-day central banking is premised on the belief that hitting the narrow target of CPI-based price stability is sufficient to address anything else that might come along. Never mind that this approach has produced a most unfortunate string of asset bubbles – first equities, now property, and next those that may well be bubbling up to the surface in the form of a tightly correlated compression of spreads on a host of risky assets. Never mind the explosion of worldwide derivatives, whose notional value has now reached some $440 trillion – over nine times the size of the global economy. Central bankers will tell you that the liquidity and risk-distribution benefits of derivatives far outweigh the lack of transparency and limited information they have on the incidence and concentration of counter-party risk. Never mind the power of the carry trade, which has been given a new lease on life by the politically-compromised Bank of Japan. Never mind the potential “canary in the coal mine” that may well be evident in America’s sub-prime mortgage market. All in all, increasingly complacent central banks are telling us that these concerns are not actionable issues for monetary policy. That could well be a blunder of tragic proportions.
A similar complacency is evident on the political front. As the pendulum of economic power in the developed world has swung from labor to capital, the pendulum of political power is now swinging from the right to the left. As pro-labor politicians now move into action, trade protectionism is increasingly getting the nod as a legitimate policy response. Nowhere is this more evident than in Washington D.C. I have spent a good deal of time in there the past couple of weeks and sense that Congress’s anti-China sentiment is most assuredly intensifying. I have taken the other side in the debate at several forums in Washington – but to little or no avail. This takes complacency to an even more worrisome level. U.S. politicians feel completely justified in ignoring some of the most painful lessons of history. And, ironically, the broad consensus of investors feels equally justified in ignoring the possibility of a protectionist outcome. Such an inconsistency is yet another example of a world in denial.
I have been relatively constructive on the global outlook over the past 10 months. The call did not work out all that badly. That was then. New and worrisome political forces are coming into play at precisely the time when the stewards of globalization have gone back into hibernation. Meanwhile, central banks are refusing to take away the proverbial punchbowl when the party is getting better and better – instead, egging on the risk-takers when risky assets are priced for all but the absence of risk.
Enough is enough. From where I sit, it no longer makes sense to maintain an optimistic prognosis of the world. This is more of a structural call than a cyclical view. I remain agnostic on the near-term outlook, and certainly concede that the Goldilocks-type mindset currently prevailing could put more froth into the markets. But complacency is building to dangerous levels ... always one of the greatest pitfalls for financial markets. And yet that is precisely the risk today, as investors, policymakers, and politicians all seem to have dropped their guard at the same point in time. The odds have shifted back toward a more bearish endgame. I have a gnawing feeling we will look back on the current period with great regret.Link here.
SUBPRIME TITANIC HITS ICEBERG: WALL STREET ABANDONS SHIP
On April 14, 1912, the mighty Titanic hit an iceberg and the ship’s fate was sealed in just over 2 hours and 40 minutes. The boat’s structural design and weight made sinking inevitable and swift. Over 1,500 lives were lost, along with personal fortunes amounting to over $600 Million in 1912 dollars. [Ed: About $12 billion in 2007 dollars.]
Icebergs are interesting because only about 10% of the ice is visible above water. Seeing an iceberg in the distance is any Captain’s worse nightmare and the iceberg that took down the Titanic was no exception. The famous ocean liner could not maneuver around the massive iceberg quickly enough to avoid hitting it.
This tragic story reminds me of some of the subprime mortgage lending problems that actually began a few years ago. Indeed, we have been watching this iceberg for three years now, and investing accordingly. Anyone aware of the fraud and foolish underwriting that has been ongoing in mortgage origination should be honest enough to admit we have only seen the “tip of the iceberg” so far, and mortgage lending is heading straight towards a massive piece of ice. The subprime market is overloaded with bad loans that have effectively smashed holes into the hull of this financial ship. Best estimates are that half of all subprime mortgages had no income verification. This is no small problem! How can a clerk at McDonald’s (who claims to earn $10,000 a month on his mortgage application) be approved for a 100% mortgage loan on a speculative property? Do you really believe that this marginal borrower – who happened to be approved for a loan with a fraudulent appraisal – will be able to refinance now that housing prices are falling?
What happens when the loan goes bad? Mortgage companies make lots of money writing “iffy” loans as long as Wall Street can package and sell the securities (and risk) into the capital market. The securitization mortgage business relies on trusting the mortgage brokers and bankers, who make representations on aspects of loans and borrower quality. For a few glorious years, rising property prices allowed a borrower to avoid default by rolling a loan (headed to default) into a new larger loan. Now, as subprime defaults are picking up, the lenders are taking a closer look and sending all kinds of bad loans back to the mortgage companies that originally made the reps and warranties, but failed to weed out the fraudulent applications. So, while a lot of subprime lenders made a bundle writing bad loans, now they are being asked to give the money back! This tsunami of fraud is enough to crush the lenders. Market reports show that at least 21 sizeable subprime lenders have already shut down or filed bankruptcy, and the head of Countrywide Financial estimates that as many as 20 to 30 small mortgage originators are failing every day!
Between reps and warranties and widening mortgage credit spreads, most subprime lenders will end up closing down or heading to Federal Bankruptcy Court. Even mortgage firms with limited exposure to subprime loans could fail. Even if a mortgage company survives, it will now have to dramatically raise interest rates to borrowers and put in place sound loan underwriting. So, how does a lending market go from insane back to a sane? (This would be a market that would require a solid down payment, an appraisal based on an honest valuation, and an applicant with verifiable income who can prove they can really afford the monthly payment for a number of years.) It doesn’t.
Over the past six years, home ownership nationwide increased from 66% of the working population, to almost 70%. Indeed, loans were extended to borrowers who could not afford to rent because they could not come up with the security deposit. Yet, with a liar loan on income, and a “piggyback second” to 100% of LTV, they became lucky homeowners. Only now, however, they are not so lucky.
2007 is a new year and the mortgage world has changed. Credit underwriting is getting more like old-time religion. Do not expect that housing prices will bail out the lenders. In markets where prices are failing like a stone, lenders will be dangerously exposed to serious losses. With all the liar loans, coupled with adjustable-rate mortgages that are scheduled to adjust upward within the next 12 to 18 months, I estimate there will be well over $1 trillion in mortgages that cannot be refinanced, until the incomes of wage earners rise significantly. Many homeowners will be trapped in a house they cannot sell or take equity out of. Mortgage companies, home builders, and real estate agents have already begun seeking new lines of work.
At the moment, the symptoms of bad loans in the mortgage market are a little bit like noticing rats. You may manage to catch a few, but when it comes to rats and mortgage fraud, if you see one, you know there are a 100 or more you did not see. It should be no surprise to learn that Wall Street and the hedge funds have quietly begun abandoning ship. The Titanic was designed to hold 32 lifeboats, though only 20 were on board. The esthetic of the ocean liner (too many boats were unattractive) was more important than the safety of the passengers. Only 705 passengers survived because they were lucky enough to get in a lifeboat. I cannot help but wonder how many investors will survive if they do not grab the first lifeboat.Link here.
Any outstanding arrest warrants?
In retrospect, it is clear that home prices did not go up because the supply lagged the demand. Instead, prices went up because the demand was artificial. I need not regurgitate how absurdly overpriced home values became in recent years. I also assume that, even more recently, you are aware prices are down and foreclosures are up. The trend has turned. And the early evidence suggests that the trend is already turning the hardest against mortgage holders who were in that artificially created wave of demand.
It may seem quaint now, but there really was a time when it was not easy to become a homeowner. You needed 20% down, a good credit record, stable employment history, etc. But when the frenzy peaked in 2006, all you needed to do is say that there were no outstanding felony arrest warrants out there with your name on it – not that the lender would ask. That is what created the artificial demand. The prevailing psychology among lenders was “Can Do!”
Fast forward a few months, and, as a story in the Wall Street Journal notes, “Now there are signs that the pain is spreading upward.” “Upward” means into the category of borrowers know as “Alt-A” – the apparently middle category of risk, between “prime” or low risk, and “subprime”. Alt-A borrowers made up some 16% of mortgage originations in 2006. What is more, this “middle” category sounds like the risks were not especially well-defined – it included some of the low-doc/no-doc loans, and speculators who were buying properties in order to flip them.
Since the subprime market accounted for 24% of mortgage originations in 2006, that means 40% of the mortgage loans last year were of the “anything can happen” variety. The WSJ story also noted that, wethat the default rate for Alt-A mortgages has doubled in the past 14 months.” Stay tuned.Link here.
WORTHY INDICTMENTS IN THE SUB-PRIME MORTGAGE DEBACLE
Last Friday, the market today decided that the subprime meltdown matters – at least a little. The Bank index, after reaching a record high earlier in the week, dropped almost 1%. The Broker/Dealers were hit for about 2%. Stocks concentrated in the so-called “prime” mortgage business – including Fannie, Freddie, Countrywide, and MGIC all traded lower. Even credit insurers MBIA and Ambac declined better than 1%. Meanwhile, Treasury prices rallied sharply, generally pushing narrow spreads somewhat wider. The dollar index dropped back below 84, and gold shot briefly above $688.
The bulls would retort, “But the S&P 500 declined only 0.36% and NASDAQ 0.39%. The broader market was up strongly on the week.” And, curiously, the Morgan Stanley Cyclical index closed the day higher, with only small declines for the Morgan Stanley Retail Index and the S&P Supercomposite Restaurants Index. Financials may have been a worry, but the consumer was not. And technology stocks were generally unchanged to higher. The market is not yet inclined to connect the dots of subprime woes spreading to the prime mortgage market, in the process creating a meaningful tightening of credit conditions for the consumer economy as a whole. That would be expecting too much from an over-liquefied market undoubting of Goldilocks, the power of contemporary finance, and the capabilities of the Fed. After all, with the exception of subprime, U.S. and global credit systems remain firing away on all cylinders. Worries about the general economic impact of mortgage problems are assuaged by lower market yields and the prospect of a more generous Fed.
Yet the market now has good reason to ponder subprime’s financial contagion effects. News from NovaStar confirmed that profitability has vanished across the board for the mono-line subprime originators. An ensuing industry liquidity crisis is feeding a self-reinforcing markdown of distressed loans and originator retained portfolios, with negative ramifications for subprime ABS and securitizations. At the minimum, the specter of rapidly tightening subprime credit conditions is beginning to foment heightened uncertainty throughout the mortgage finance super-industry. The derivatives market for hedging subprime exposure has badly dislocated, but there are few willing providers (think panic buying of flood insurance during torrential rains and rapidly rising waters).
It may take some time before mortgage tumult expands to the point of significantly impacting the general economy. However, recognition that the unfolding subprime debacle is an indictment of contemporary Wall Street finance should be more immediate. The almighty Wall Street securitization and distribution machines were directly responsible for millions borrowing more than they could reasonably be expected to ever repay. The issue was never that it did not make sense for an individual borrower to bury himself in debt to participate in an obvious bubble. Instead, it was all about whether scores of such loans could be pooled together and structured in a fashion that ensured that holders made above-market returns for awhile ... and, later, with the eventual blow-up, that risks had been spread sufficiently so that nobody suffered too big a hit. We will wait to see how effectively risk was dispersed and how well related Credit “insurance” markets function. And let us see to what extent Wall Street can simply pack up its gear and move it on over to the next nascent Bubble.
As for the Fed, they were happy to take a hands-off approach as long as most subprime risk was seen to be disintermediated away from the banking system. The subprime debacle is certainly an indictment of Federal Reserve policy. The Greenspan Fed knowingly fueled the mortgage finance bubble (post-tech bubble “mop-up” reflation). Worse yet, I am convinced that Mr. Greenspan promoted variable-rate mortgages to the masses as part of a strategy to extricate banks and GSEs from potentially catastrophic interest-rate risk associated with normalizing rates after an extended period of ultra-accommodation. The sophisticated were certainly forewarned and well positioned to profit immensely from Fed (telegraphed) policies, while so many less fortunate destroyed themselves financially at the grimy hands of housing bubbles and “teaser-rate”, “option-ARM”, negative amortization and zero-down mortgages.
The flaw in Greenspan/Bernanke inflationism has always been that it further empowers the flourishing booms in Wall Street “structured finance”, leveraged speculation and asset inflation, generally. The Federal Reserve and their apologists couched the “debate” in terms of some dire risk of “deflation”. We were instructed that expansionary policies were required to elevate the general price level to a much less risky 2% or so – as if once it got there they would, or could, turn down the inflationary spigots.
Greenspan/Bernanke inflationism’s consequences.
The principal consequence – the actual inflation fostered by inflationist monetary policies – has been massive credit and speculative excess, along with resulting dependency. Deluding conventional analysts, the impact on the so-called “general” price level has been token. But the effect on the financial and economic structure – what really matters and is conspicuously indicated by our disastrous current account deficits – has been momentous. Subprime mortgage finance today provides an instructive microcosm of the degree to which securitization-based finance, derivatives, and leveraged speculation foster egregious credit excesses that contort price signals in both the Financial and Economic Spheres. The boom was fun and games while it lasted, but the bust will be an utter mess.
I will take Fed officials’ recent words at face value, that they actually are focused on inflation risk, and I found interesting Dallas Fed President Richard Fisher’s comment that “globalization is helping less in inflation fighting.” His comments were, however, followed a few hours later by dovish San Francisco Fed President Janet Yellen, stating the Fed “should not take” the risk of raising rates. The markets will likely rubberneck at subprime carnage and take Yellen’s comments as indicative of the true sentiments harbored by many on the FOMC – including its chairman. The prevailing analysis will be that the Fed talks tough on inflation but can be expected to quickly rationalize away inflation risks at the first whiff of systemic stress.
For some time the markets have presumed that the Fed would not actually ratchet rates to the point of tightening financial conditions. This was a safe bet, recognizing the predominant role encompassing asset inflation, leveraged speculation, and Ponzi-like finance had come to play in sustaining our financial and economic booms. The Fed had become hostage to the markets and the powerful leveraged speculating community, and would be forced to back off come the first sign of trouble.
Ponzi finance rules.
It is a defining characteristic of current U.S. financial and economic booms that they are dependent upon enormous and uninterrupted credit and speculative excess. Wall Street and the U.S. financial sector create and disseminate the requisite liquidity/purchasing power. Not the Fed. The Fed does retain the power to impose its will on the Financial Sphere – enticing expansion with the carrot of financial profits or by exacting restraint with its blunt instrument of threatening financial loss. As we have witnessed, telegraphed baby (carrot) steps have been perfectly in accord with ballooning Financial Sphere profits. At this point, the Fed does not even dare remove the vegetable platter (modern-day version of the “punch bowl”).
As I am writing, I see that KKR is bidding for TXU Energy. While credit conditions tighten in subprime, they could not be looser throughout corporate finance. Indeed, the M&A boom, and the corporate debt bubble generally, could additionally benefit from lower rates (or at least no Fed tightening) and the marginal flow of speculative finance from mortgages to corporates. And here we see the Fed’s dilemma: Not only is there no general price level to manipulate, the heart of the credit system is locked in aggressively financing one asset bubble after another. Bubble (“Ponzi”) finance is not reconcilable with moderation.
The upshot is monetary disorder and resulting price instability that seem to worsen by the week. A New York Times article last week highlighted the recent resurgence in the local housing market. Meanwhile, condo markets in Miami, Las Vegas, Washington (D.C.) and elsewhere appear nothing short of unfolding debacles. Following in the footsteps of energy properties, farm prices are shooting higher. At the same time, homebuilders are canceling options on and liquidating billions worth of land held for residential development. Most housing markets are posting moderate price declines, while Sam Zell speaks of upper single-digit and perhaps even double-digit residential rent increases nationally this year. The residential construction boom goes bust, yet this provides only greater firepower for the non-residential (echo) boom. Same dysfunctional financial infrastructure – just a new target. Meanwhile, some key labor markets are demonstrating acute wage pressures, as workers in many industries do not even keep up with the rising cost of living.
The Fed is not in control of any “general price level” and they certainly are not in command of credit bubble and speculative asset market boom and bust dynamics. And there is no interest rate that could today rectify the Bubble Dilemma. In the old banking system, Fed tightening would reduce both liquidity and industry loan portfolio profitability, thereby inducing a general system tightening. Today, waning financial profits in one asset class simply induces greater lending, securitizing and speculating elsewhere (one boom and bust leads naturally to the next). And I will further hypothesize that the more protracted the global credit boom, the less reliant the world becomes on the U.S. economy and credit excess. This has important implications for prospective U.S. and global inflation, dynamics increasingly outside the purview of our policymakers.
I would not go rambling on about the Fed’s lack of control if grossly inflated asset markets were not so convinced of the polar opposite. Perhaps the greatest indictment should be reserved for highly over-liquefied and speculative marketplaces.Link here (scroll down).
WILL HONG KONG SHANGHAI BANK BE THE NEW CREDIT ANSTALT?
Arguably the biggest story from last week was that Hong Kong Shanghai Bank (HSBC) one of the world’s largest banks, has taken a $10.6 billion hit on U.S. consumer loans, specifically in the subprime mortgage arena. (Forget for a moment, what happened to smaller concerns like New Century Financial or NovaStar.) These problems are not only bad in and of themselves, but in their potential effects on the global economic system. That is because the bank has ties to China through its original namesake, and to Britain and the U.S., through the acquisition of Britain’s Midland bank and America’s Household International.
Like Austria’s Credit Anstalt bank in relation to Germany in 1931, HSBC is located barely outside of China, but with important indirect ties to that country. (The bank’s traditional area of strength has not been in China per se, but rather in lending to companies that do business in China.) And HSBC’s links to the U.S. go far beyond what Credit Anstalt boasted. Besides being one of the largest banks around, HSBC represents a connection between the world’s two most important economies like perhaps no other bank in the world. Thus, a problem in one country could be transmitted through HSBC via a weakening of the bank, to a curtailment of its role vis-à-vis the other country.
The danger arises because the world’s two big economic bubbles are U.S. consumer spending and Chinese capital spending. HSBC’s recent problems were tied to the former. So far, I have not heard of issues for the bank in connection with the latter. Even so, the fact that HSBC is having major problems at one end of the spectrum has to be unsettling.
At the risk of a slight digression, one knows that the U. S. consumer lending market is on its last legs when lenders like Bank of America considers illegal immigrants a hot market for its loan products, because everything better has already been mined. HSBC, through Household International, was on the horns of the same dilemma. And some think that Chinese capital spending may be in similar straits. Columnist Jim Jubak’s article “Time is Running Out on China’s Economic Boom” rightly points out that “the current spate of growth has been built on non-renewable human, environmental, and capital resources,” which is to say that it is soon likely to regress to the global mean as Japan’s economic miracle did in the 1980s. And such a regression, while normal for the U.S., would represent a hard landing for China.
The collapse of the Credit Anstalt Bank, with its ripple effect on Germany, was probabl more responsible than events stateside for the length and severity of the Great Depression of the 1930s. (And it ended Weimar Germany’s experiment with democracy, bringing about the rise of Adolf Hitler and national socialism.) That was because of its impact on the already-shaky economies of a whole continent, Europe. China is now the largest international holder of U.S. dollars. The end of the Chinese economic miracle would have grave consequences for the U.S., as well as for the rest of Asia. Hence I take little comfort in the presumed ability of the Fed to ward off the crisis. And because its importance is even greater in Asia than in the U.S., HSBC could have a major role in bringing the Chinese miracle to an end.
These remarks may seem to contradict my “constructive” investment posture for 2007. The reason I am not a full fledged bear right now is because historically, most of the nation’s financial crises have originated in the corporate or international, rather than U.S. consumer, sector. (My investments are tilted in favor of industrial, capital goods, and international stocks, and away from U.S. consumer goods and financials.) The non-consumer-dependent areas are quite healthy for now. I believe the resident bear when he characterizes the (consumer) subprime mortgage and securitization markets as a “fungus”, but I do not (yet!) believe that it will have national or global ramifications. Even so, this posture is probably skating on thin ice. And if I hear that HSBC has major problems with industrial exposures, perhaps to China’s troubled state-owned enterprises, my days as a chicken-bull will be numbered.Link here.
HOW THE FED LOST CONTROL OF MONEY SUPPLY
The world is awash in money. This money has flown into all asset classes, from stocks to bonds, from real estate to commodities. In a world priced for perfection, should we enjoy the boom or prepare for a bust? Let us listen to Wall Street’s [and Deep Throat’s] adage and “follow the money”.
After the tech bubble burst in 2000, policy makers in the U.S. and Asia set a train in motion they have now lost control over. In an effort to preserve U.S. consumer spending, the Federal Reserve lowered interest rates. The Administration lowered taxes. And Asian policymakers kept their currencies artificially weak to subsidize exports to American consumers.
These policies have lead to one of the longest booms in consumer spending ever - U.S. consumer growth has not been negative since the early 1990s. However, it was credit expansion, rather than increased purchasing power, that has fueled the growth. Until about a year ago, consumers took advantage of abnormally low interest rates to print their own money by taking equity out of their homes. This source of money is drying up as home prices no longer rise and sub-prime lenders (those providing loans to financially weak consumers) are facing difficulties. Financially stronger homeowners have not yet been affected as the interest rates they pay have stayed abnormally low. In recent weeks, these rates have ticked up significantly, and we may see the next and more severe round of pressure being exerted on the housing market. In this phase, we will see monetary contraction: money that has subsidized not only the real estate market, but also consumer spending, stocks, bonds and commodities may dissipate.
Why is it that asset prices have continued to soar despite the stall in home prices? Consumers have not been the only source of money creation. Corporate America is cash flow positive, but corporate CEOs seem to prefer to invest abroad. A massive source of money supply growth is purely of financial nature. Volatility in major markets was at or near record lows last year. With volatility low, risk premiums are low. When risk premiums are low, investors have an incentive to employ more leverage and still be within their risk comfort zone. What may seem like an abstract concept has propelled financial markets to the stratosphere.
Two groups that have been most aggressive at taking advantage of this are hedge funds and the issuers of credit derivatives. For example, Citadel Investment Group, a manager of hedge funds, had $5.5 billion in interest expense on assets of only $13 billion. The hedge fund group routinely borrows as much as $100 billion. Note that this is only the leverage visible on the financial reports; the instruments invested in may themselves carry yet further leverage.
The world of credit derivatives has also seen explosive growth. European Central Bank (ECB) president Trichet at the World Economic Forum in Davos warned that the explosion of credit derivatives are a risk to the stability of financial markets. Specifically, he complained that the market under-prices their inherent risks. With risk premiums at record lows, issuers of credit derivatives can borrow money at or near the Fed Funds rate. And that in turn means that we do not need the Fed to print money, anyone can. That is precisely what has been happening. But more often than not, credit derivatives contain risks that only the issuer properly understands.
A year ago, the Fed stopped publishing M3, a broad measure of money supply. Just because you lose control of something does not mean you should not monitor it anymore. Of the major central banks around the world, only the ECB takes an active interest in money supply. Why does the Fed not intervene and try to stem excesses in the credit industry? Because if the Fed were to do something about the spiraling credit expansion in the derivatives markets, the imposed tightening would quite likely hurt the consumer. Typically, a recession would not scare the Fed, but globalization has put the fear of deflation in Fed chairman Bernanke. Tight credit could cause a collapse in the housing market and in consumer spending. A great boom would turn into a great bust.
The fear also spills over to the U.S. dollar. As a result of the current account deficit foreigners must purchase in excess of over $2 billion U.S. dollar denominated assets every single day, just to keep the dollar from falling. As the U.S. economy slows, foreigners may be more inclined to invest some of their money elsewhere. The rising price of gold reflects that many investors believe that the Fed rather see a continuation of monetary expansion than allowing a severe contraction. Fed chairman Bernanke has also made it clear in his publications that he favors monetary stimulus at the expense of the dollar to mitigate hardship on the population at large.
Market forces will try to bring this credit expansion to a halt. While a crisis scenario with an imploding hedge fund causing ripple effects through the financial sector is possible and likely, we do not need a crisis for the party to end. All we need is increased volatility which we have already seen in the commodities and bond markets. The equity and currency markets have also indicated volatility may be on its way back. As volatility increases, speculators are likely to pare down their leverage. The economic slowdown induced merely by an increase in volatility may be sufficient to encourage the Fed to ease monetary policy once again. Any easing in this context will, in our assessment, have negative implications for the dollar.
Investors interested in taking some chips off the table to prepare for potential turbulence in the financial markets may want to evaluate whether gold or a basket of hard currencies are suitable ways to add diversification to their portfolios. We manage at hard currency fund that seeks to profit from a potential decline in the dollar. Learn more about the fund here.Link here.
ACADEMY AWARDS FOR THE REAL WORLD
BOOM TIMES FOR U.S. EQUITIES DUE TO SHARE SHRINKAGE?
Charles Biderman cobbled together a nice little property empire in the 1970s – six shopping centers, two office buildings and two apartment buildings – only to watch in horror as real estate went into the tank. Although he figured the property’s value was $30 million, well above his $20 million in debt, his panicked lenders would not cut him the least bit of slack. He filed for bankruptcy protection and soon lost everything. Real estate rebounded, but it did him no good. From that scarring experience, Biderman took this insight: “I discovered that price is a function of liquidity, having nothing to do with value.”
Looking for a second act in the early 1990s, Biderman applied his hard-won lesson to stocks. A Harvard Business School graduate, he was familiar with traditional methods of valuing stocks, looking at their P/E ratios and estimating future cash flows. But what about the overall market’s liquidity? Why not look at changes in the supply and demand for stocks? Biderman believes that when stocks are in short supply, from buybacks or private-equity buyouts or whatever, their relative scarcity will push up prices. Conversely, when the market is flooded with new supply, from IPOs or exercised stock options, then the abundance brings a decrease in prices.
This was a simple yet controversial idea. How can the supply of publicly traded equity be limited? If the prices of shares go too high, suppliers can manufacture more. Corporations are free to sell equity and use the proceeds to retire debt. Or to put the money in the bank, as Google did after a $2 billion secondary offering last year. And yet there is the intriguing possibility that Biderman’s theory might work, at least in the short term, if corporate treasurers are restrained by inertia or swept along by a Wall Street fad like buying in shares.
Biderman decided to build his own measure of the total supply of stocks from the ground up. He combed through company filings and surveyed mutual funds on inflows and outflows. His equity retirement numbers are close to those published by the Federal Reserve, but available sooner. 12 years later, he says, he can show a rough inverse relationship between market performance and changes in the quantity of equity available. The shrinking of the stock pool from 2004 on saw advances in the S&P 500 each year. The same held true for 1995 through 1999. The 2000–02 net increase in the stock supply coincided with a vicious bear market. In December 1999 he issued a sell signal in his regular letter to clients, citing planned stock offerings and the end of insider lockups that were about to flood the market with shares.
His sole slipup came in 2003, when the new supply of equity remained positive, and he stayed with his bearish prognosis. (The S&P was up 28% that year, including dividends.) A rumpled fellow who started out as a journalist at Barron’s, Biderman, 60, exudes a true believer’s passion about his discoveries. “I’m a gambler, and if you’re a gambler, you want an edge,” he says. “No one’s ever looked at supply and demand to play the market. This is our edge.”
The company Biderman founded, Trimtabs, has made a nice business selling its liquidity data to mutual funds and hedge funds for between $15,000 and $150,000 a year. More recently it has opened up its own fund for private clients, seeking to repeat its past success at calling market turns. (Following Trimtabs calls to buy S&P Index funds in bullish times and going to cash in bearish periods, Biderman says his fund would have yielded 104% since 1998, versus 48% for holding the S&P the entire time.)
Annette Vissing-Jorgensen, a Northwestern University finance prof, recently published a paper analyzing the effects of supply and demand on bond prices. She found a broadly similar effect to Biderman’s, and says his logic makes sense as applied to stocks – because Biderman’s approach is consistent with more traditional ways of valuing firms. “In those models, the discount rate [the number used to translate future earnings into current dollars] is going to be determined by the supply and demand of capital,” she says.
So what are Biderman’s supply signals telling him about today’s market? An unequivocal message: There has never been a better time to be a bull. “So the housing market is soft, so the legacy automakers are tanking. Who cares?” says Biderman. The recent boom in leveraged buyouts has sopped up huge chunks of public equity. The equity shrinkage since 2004 may be only a few percentage points of the $19.9 trillion in U.S. market value outstanding, but it is enough to affect investors, Biderman argues.
A measure of skepticism is warranted with the stock-supply theory. Biderman’s supply figure does not include dividends, which are interchangeable with share buybacks. Does it matter to the liquidity of either Microsoft or its shareholders whether it pays a $32.6 billion dividend or buys back shares of that value? Yet in the Biderman analysis, the latter creates a shrinking in the supply of equity but the former does not. Another weak point in the theory is that it overlooks where the buyout capital is coming from. Blackstone gets capital from pension funds. Blackstone’s buying puts an upward pressure on stock prices. But those same dollars were taken out of the pocket that otherwise would have paid for publicly traded shares. Why would moving the investment dollars from one pocket to another boost share prices? Biderman says its wrong to assume all private equity investments replace public stock holdings and, more important, that private equity funds use leverage to greatly magnify the impact of every dollar of equity they receive.
There are two ways to play the scarcity thesis. One is to aim narrowly. On the assumption that investors tend to keep sector allocations fairly steady from year to year, buy into sectors where equity retirement is most pronounced (see table). One such is the materials sector, where the takeover of Phelps Dodge by Freeport-McMoRan has already shrunk the public equity supply and a buyout of Alcoa for cash is a distinct possibility. Rather than try to cherry-pick companies, you could buy an exchange-traded fund that encompasses the entire category, such as the Materials Select Sector SPDR. By the same token, avoid energy shares, where no big buyouts are occurring and new issues are aborning to get in on what likely will be a long-term trend of high energy prices. The stock supply here has shrunk, but by a minuscule amount, far less than the shrinkage in the overall market.
Then there is the big-picture play, which follows a line of thinking that has been advanced in these pages by columnist Kenneth L. Fisher in the past year. His argument goes like this: A worldwide glut of savings has depressed interest rates. Big investors are taking advantage of cheap debt capital by buying equity: corporations buying their own shares, corporations buying other corporations for cash, and outfits like Blackstone buying corporations with debt. Fisher foresees a continuation of this trend. (See article summary from W.I.L. Finance Digest of two weeks ago, here.) He is bullish on equities, too.Link here.
Insatiable investment funds in hot pursuit of huge prey.
The widely anticipated takeover of a Texas energy giant by Texas Pacific Group and Kohlberg Kravis Roberts for more than $30 billion showcases the insatiable appetite and deep pockets of private investment funds. According to The New York Times, the board of TXU Corp. could agree to a buyout valued at between $30 billion and $45 billion, if debt of roughly $12 billion dollars is included in the calculation.
The deal would set a new record for private equity funds, after Blackstone’s recent purchase of real estate manager Equity Office Properties Trust for $39 billion, including $16 billion in debt. The Blackstone deal and other such private equity takeovers sizzled to a world record in 2006 of nearly $600 billion – of which $353 billion were in the U.S. This was a 70% jump from $350 billion in 2005, according to market researcher Dealogic. Private money accounts for more than 17% of global mergers and acquisitions, compared with only 4.0% in 2000, Dealogic says. Thanks to these funds, global mergers and acquisitions were expected to have climbed to a record $3.70 trillion in 2006, topping the $3.32 trillion attained in 2000 at the height of the Internet boom, according to Dealogic.
By contrast, the more “classic” types of operations – strategic takeovers by one company of another – were losing momentum. Driving the appetite for takeovers are coffers awash in cash. “I have never seen a time like this when money is so available and so global,” Henry Kravis was quoted as saying in an interview by The Wall Street Journal. WSJ, however, pointed out that the buyout of TXU, if confirmed, would face a series of regulatory hurdles. In that respect, it would be a good test of investment funds’ capacity, often controversial, to penetrate business sectors that are significantly regulated, the newspaper said.Link here.
A BAD HAND FOR BERNANKE
Will the gold market now fold, raise, or call his bluff?
Gold’s bull market continues, the noisy setbacks of “hot money” aside. And as the price keeps on rising, so more and more private investors – looking to put their money to work after 6 years of watching gold outperform stocks and bonds – are joining the search for information and advice on the metal. But plain facts about gold are just as hard to come by as they are when you are trading equities or bonds.
Falling for the #1 gold myth, for instance, would have cost you 14 cents in the dollar at today’s prices. It signaled “sell” back in October last year, and it signaled “sell” again on Tuesday this week, just before gold shot 3.5% higher in one session to reach levels last seen at the quarter-century peaks of May 2006. Listen to any pundit or metals analyst talking about the price of gold today, and chances are they will tell you to watch oil. Yet by mid-February, oil had failed to hold above $60 per barrel. Gold, on the other hand, stood nearly 10% higher from when oil’s bull market broke down last fall.
What link there is failed to hold firm even during the “commodity bull” that saw hedge funds pile into both oil and gold over the last half-decade or so. Crude oil first turned higher in 1999; gold did not get started until 2001. Oil’s major leg up began in 2002 and peaked in mid-2006; gold’s uptrend remains rock-solid today. More importantly for active gold traders, short-term fluctuations in the gold price have next-to-nothing to do with movements in oil. Compare gold with base metals, and it is the same story. And both the oil and base-metal correlations have varied massively over time. Going from 2006 into this year they ranged well above the historic norm. But the correlation still says other factors are more important than oil. Pundits who claim that gold is all about oil, make the classic mistake of confusing recent events for a law of nature.
It is not just recent history that creates misinformation in the gold market, however. The major newswires and leading newspapers cite gold as an “inflation hedge” every time they mention the metal. It is easy to see why. For along with bad German wine and the Bay City Rollers, the 1970s cursed the industrialized world with soaring inflation in the cost of living. Gold’s stellar run up to $850 per ounce came that same decade, ending with the all-time high hit in January 1980. Therefore gold must deliver its strongest returns when the cost of living is shooting higher. Right?
Wrong. Just look at the last quarter century. Consumer prices in the U.S., even on the U.S. government’s own [suspect] data, have doubled since 1982. Gold simply failed to keep pace. It has dropped 15% of its purchasing power over that time. At its lowest point, back in 2001, the loss of purchasing power for U.S. investors reached over 75%. How to square this fact with gold’s huge returns in the ‘70s? Perhaps gold only responds to rapid inflation, you might think – the nasty kind we got three decades ago, rather than the “mild” case our money has suffered since then.
Wrong again. Between 1980 and 1981, U.S. inflation ate 17 cents of the dollar’s purchasing power. The gold price dropped 40% over the same period. And look further back – even to when physical gold stored in government vaults helped support the dollar, just as it did all other major currencies – and you will find that gold has always made a poor hedge against rising prices. In the mid-70s, Professor Roy Jastram of the University of California at Berkeley found that gold had failed to keep pace with the cost of living during seven inflationary periods in Britain. His data ran across more than three centuries! In the U.S., Jastram identified six inflationary periods between 1808 and 1976. They saw the purchasing power of gold fall by more than one fifth on average. Only the final period in Jastram’s study, beginning in 1951, saw the metal gain value. It continued to gain purchasing power right up to that infamous top of $850. But from then on, it was downhill all the way until spring 2001.
What changed at the start of the 1980s? Two words: Paul Volcker. The key thing to watch is not the rate of inflation, not by itself. You need to watch the gap between Fed interest rates and inflation instead. Real interest rates paid on U.S. dollar accounts averaged just 0.01% between 1970 and 1979. That lack of decent returns made gold attractive on a relative basis. Actually, it only made gold less burdensome. Gold pays no interest, remember. Indeed, gold costs you to hold it, either by rolling forward futures contracts to maintain a paper position, or through storage and insurance fees on physical bullion. Yes, these costs can be vanishingly small today, thanks to ground-breaking gold investment services such as BullionVault.com for instance. But gold still fails to pay investors any kind of dividend. And the gap between inflation and interest rates has to reach absurd levels to make gold worth holding.
That is just what happened in the 1970s. It is what has happened in the 21st century so far as well. The real rate of interest, the gap between CPI inflation and the Fed’s official interest rate, has averaged just 0.47% since the start of 2000. Real rates during the 1990s stood almost four times as high - and gold fell by one third. Measured against CPI inflation, in fact, its purchasing power dropped by one half.
So what to make of the upturn in real dollar rates starting two years ago? By the end of 2006, U.S. rates adjusted for inflation had shot up to 4%. We last saw that level just before the Federal Reserve first unleashed the flood of liquidity and cheap money still drowning the world’s financial markets today. So the jump in CPI inflation reported this week really did drive that $23 jump in gold prices too.
But not because gold offers protection against higher consumer prices. Rather, the Labor Department’s data set a challenge to the Bernanke Fed: “Will you keep raising interest rates to defend the sollar, pay a decent return to U.S. savers, and crush the gold speculators like Paul Volcker did at the start of the 1980s? Or will you freeze – perhaps even cut – real rates to prop up the housing market, bond prices and the Dow like Alan Greenspan would urge?”
It is clear that Bernanke has been dealt a bad hand by the Maestro. But will the gold market now fold, raise, or call his bluff?Link here (scroll down to piece by Adrian Ash).
What is with all the over-reaction? So a $130 billion was lost in China’s market the other day. It is not like it was real money. The sympathetic corrections in other global markets were mostly occasions for profit taking by investors and traders nervous about eight months of good times. All those flashing lights and bells and whistles ... those just mean we are in a casino. There are other explanations. But we are not buying the theory that China’s crash indicates real concern about the sustainability of its boom. The China boom is happening in the real world. The China stock market boom is largely fictitious.
So is the whole current global asset boom model in jeopardy? No. There are three pillars to the global asset boom: Japan’s easy money, America’s free-spending ways, and China’s appetite for raw materials in order to make things. If this were a celebrity marriage threesome, what would we call it? Chimerican? Americhinan? Or how about ... Japanica! Japanica it is, the new name for the wobbly, triumvirate/mascot for the global super asset bubble. And for the record, since we are sure history is paying attention to every word we write, our bet is that this asset bubble has miles and miles to go before it sleeps. The unification of global stock exchanges looms in the not-too-distant future. This will facilitate even more rapid global capital flows, and bring even more investment products online for surplus savers, be they in Australia, China, or Amer ... er ... Japan.
Seriously, you can see where all this is headed, a super asset boom. And there is a simple reason for it. The Boomers (or Japanese and Chinese savers) are not ready to leave the gambling table just yet. They can’t. They do not have enough money to cash out their blue chips and call it a day. They are still making up for the tech wreck, and still wary of the durability of home price appreciation (and the liquidity in the housing market, which, at least in America, is dropping like a stone).
Was this week a wake up call for investors that markets are still risky? Of course. But investors already they knew that. They love risk. More importantly, they cannot afford not to take it. Day by day, we are inching closer to the time when the Boomers will have to liquidate. But it is not that time yet. So the money pours into the market, and the market itself grows larger and ever more integrated. You know what that means, right? The real liquidity crisis, when it comes (18-26 months down the road, we reckon) will be much larger, much more destructive, and impossible to contain. It will represent the end of the post-war, post-Bretton Woods experiment with asset inflation as a means to personal wealth-building. It will be nice to own some gold then, preferably a lot.
Investors’ act irrationally in the presence of risk.
The incredible irony of what we have seen in the past few days is that most investors almost always do exactly the wrong thing, from a rational perspective, when confronted with “decisions under risk.” Human beings, under the duress of fast-moving global financial markets with dozens of virtually untrackable variables, are programmed by nature to do two things. First, they freeze, the way our ancestor used to when they saw a lion on the horizon. You can thank the amygdale, which takes control of the brain at these crucial times, pulling rank on the thoughtful frontal lobes that otherwise makes us distinct as primates. This temporary coup-de-brain is nature’s way of by-passing the frontal lobes to arrest our action before we do something stupid like running for our lives and attracting a lot of attention from other predators. Panic does not promote survival. It is this freeze in our musculature that gives us enough time to tense up our muscles and either fight, or flee.
The second thing human beings do when confronted with risk is seek the action which has the largest possible negative effect on them. Yes, you read that correctly. And here we apologize for getting a bit statistically geeky on you. But we are pretty sure you will not read this explanation for market behavior anywhere else. From a novelty perspective at least, it should be worth your time.
In 1979, Daniel Khaneman and Amos Tversky published the second most cited economics article in academic history, “Prospect Theory: An Analysis of Decision Under Risk”. The paper was a landmark in the understanding of human behavior because it pointed out the tawdry little lie at the heart of classical economic models about human behaviour, namely that people weigh risks with perfect information and then make rational decisions. Wrong! Homo economicus is a complete fiction.
Khaneman and Tversky showed that people make two kinds of decisions with respect to risk and reward, and that neither decision is rational. One the reward side, investors tend to overweight certain outcomes, choosing lower returns with higher probabilities over higher returns with lower probabilities. Or, most investors prefer the appearance of certain, predictable, single-digit returns from blue chip stocks or bonds than the higher but lower probability returns from say, small cap stocks or emerging market bonds. This suggests that capital preservation is psychologically (and financially) more important to investors, than capital growth. The difference today may be that investors – at least the retiring Boomers in the West who make up the bulk of the market – need big capital gains in the next few years to increase their retirement income. This may cause them to take more risk (to make up for past losses) than would ideally be appropriate at this stage in their investment career.
Investors seek losses!
What is really shocking from Kahneman and Tversky’s paper is how investors approach losses. Investors seek them. Or, as the paper puts it, “This analysis suggests that a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise. The well known observation that the tendency to bet on long shots increases in the course of the betting day provides some support for the hypothesis that a failure to adapt to losses or to attain an expected gain induces risk seeking.” And here we thought investors were seeking alpha, and that global risk premiums were converging toward zero. But no! What we are really seeing is more bets on long-shots. This is, in the paper’s own terms, a failure to adapt to the very risky world we invest in. So in the coming years, we can expect investors not to avoid wealth-destroying beahviors and investment decisions, but to greedily seek them out.
Tversky and Khaneman show that faced with a choice between a low-probability but high-magnitude loss on the one hand, and higher-probability but lower magnitude loss on the other hand, human beings tend to choose the higher magnitude loss with the lower probability. So if you were faced with the choice of a certain loss of $20 or the 30% probability of losing $60, you, if you were like most of the other featherless bipeds on the planet, would choose the 30% chance of losing $60. It does make sense with a weird kind of emotional logic. But when you apply this finding to the equity markets writ large on a global scale, reacting to one another in real-time, the result is stunning. It means you can expect to see people engage in riskier and riskier behaviour, nearly always choosing bigger losses over smaller losses.
Why choose a certain loss over a probably loss? Good question. But perhaps our notion of probable losses is wrong as well. Investors are operating under the assumption that larger losses in today’s markets are lower probability events. There is also a wide-spread believe that the larger the markets get and more integrated they become, the lower probability of really gut-wrenching losses. The problem with this academic theory is that it is exactly, emphatically, categorically, wrong.
Market crashes are more common than you think.
The theory we refer to is that market crashes are statistically rare and can be modeled on a bell curve, with a standard distribution of price movements. Most movements, in a classic bell curve, would be within one or two standard deviations of the mean. Or, in stock market terms, there would be only a few instances when the market produced dramatically above average or below average returns. Most returns would be rather mundane, and rather predictable. There would be few crashes and fewer still triple digit gains. But the evidence suggests otherwise.
“From 1916 to 2003,” Benoit Madelbrot writes in The Misbehaviour of Markets, “the daily index movements of the Dow Jones Industrial Average do not spread out on graph paper like a simple bell curve. The far edges flare too high: too many big changes. ... [I]ndex swings of more than 7 percent should come once every 300,000 years; in fact, the twentieth century saw forty-eight such days. Truly, a calamitous era that insists on flaunting all predictions. Or, perhaps, our assumptions are wrong.”
And what about this new era? When you combine Mandelbrot’s observation with Kahneman and Tversky, you get a picture of increased volatility and risk-seeking behavior. People, faced with more to lose, risk ever more. The only question now is how large the stakes will get. And our observation on that is that the global equity and asset pot has room to grow. Volatility has been ominously quiet the last few years. It may have returned this week through the backdoor in Shanghai.
But do not expect it to make investors more conservative and trigger a rally in fixed income and bonds. Rather, we may be seeing a whole new level of global speculation, an order of magnitude larger than anything that came before it. This game, the world series of speculation, is the end-game of the experiment with fiat money, money not backed by a real asset. But it would be a mistake, we think, to imagine that the end-game is now. The tragedy/comedy has at least one more act and a few years to go. And in that time, we recommend you pull up a chair, pop some corn (if you can afford it at today’s prices), and enjoy the spectacle.Link here (scroll down to piece by Dan Denning).
ONE [CLUELESS] EXTREME LEADS TO ANOTHER ...
Let us put it this way: One extreme will lead to another. And, multiple extremes will lead to another, and another, and another ... The failure to grasp this simple principle is why so much of the commentary has been so clueless regarding the Dow’s 400-point decline earlier this week. The “reasons” for that decline ranged from China (multiple sources) to Alan Greenspan (the New York Times) to the Drudge Report (ABC News). No matter how far-fetched it may be, external “causes” are what the financial press will report when the prices go down – any explanation will do, except the one that lets the market speak for itself.
What do I mean by “speak for itself”? Simple. The market speaks for itself when:
Psychology among market participants had reached an extreme going into this week. One extreme led to another. As the bullet points show, the extremes were multiple. It is reasonable to expect another, and another, ...Link here.
REVISIT FUNDAMENTALS WHEN THE MARKET PANICS
This week, the stock market flashed warnings that investors should fasten their seat belts and revisit fundamentals. The fundamentals underlying the broad market are weakening, so if you are invested in the stock market, you want to be in the right sectors.
Colleague Chris Mayer writes, “Diligence and discipline and selectivity are keys. ... [W]e do not invest in the market. We invest in specific opportunities in the market. Not the produce section, but specific avocados, onions, and melons. I view my Strategic Investment recommendations in a similar light. While my top-down approach differs a bit from Chris’s bottom-up approach, we share the goal of finding winning stocks for our readers. Macroeconomic analysis can increase the odds of finding them. If the produce section is consistently good, we want to look for opportunities there – and avoid the overripe beef in the meat department.
The Picture of Panic
The CBOE volatility index (VIX) indicates how volatile speculators expect the stock market to be in the future. More specifically, the CBOE defines the VIX as “a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.” When it is low, stock options are cheap, and when it spikes upward, stock options become expensive. During Wednesday’s meltdown, the VIX recorded one of the largest percentage spikes in its 14-year history (see chart). To what can we attribute such a move? Who is to blame?
Not very much has changed over the past week. Simply put, risk now matters. The market often chooses to ignore fundamentals until they suddenly matter. After nearly everyone has joined the bullish camp, the slightest defection back toward the bearish camp can produce the type of market action that we saw Wednesday. Markets go into a free fall when buyers sit on their hands, waiting for the plunge to stop.
For too long, the market has been caught up in such pointless distractions as anticipating the Fed’s next interest rate move or using the 3-week Northeast U.S. weather forecast to trade natural gas futures. While such distractions make nice stories for the financial media, they should not form the foundation of investment decisions. My advice is to take a good look at the fundamentals supporting the value of every stock you own. Then separate the wheat from the chaff. You want to buy and hold solid companies with favorable macroeconomic winds at their backs. And you want to avoid overpaying for these shares.
What would I define as “overpaying”? Here is where we delve into the art/science of security analysis. A stock may appear cheap if it has just delivered a few years’ worth of impressive earnings results. But it may, in fact, be expensive if a one-off economic event like the housing bubble temporarily boosted earnings. If earnings per share decline 50%, a 15 P/E stock immediately becomes a 30 P/E stock. Traders will punish this stock, likely pushing it back down to its typical 15 P/E range. Or below.
P/E ratios expand and contract during secular bull/bear markets.
How can we judge if the market is cheap or expensive when earnings fluctuate so wildly? One of the best ways to do this is to calculate the market’s price-to-peak-earnings (P/PE) ratio. The market as a whole is pretty well defined by the S&P 500, an index of the largest 500 stocks on U.S. exchanges. It is now trading at about 18 times peak earnings – quite expensive by historical measures. And peak earnings happen to be the earnings from the last 12 months, when conditions have hardly been better for Corporate America. Steve Saville, editor of The Speculative Investor, incorporates Austrian Economics-based analysis and advanced charting into his newsletter ideas. He was kind enough to allow me to reproduce this chart.
Steve dissected 80 years of market history into secular (long-term) bull and bear markets. Only instead of using indexes, he defines bull markets as periods of expanding P/E ratios and bear markets as periods of contracting P/E ratios. Market prices and earnings can move up together, down together, or independently of each other. But major peaks and valleys in the price-to-peak-earnings ratio provide reliable signals of change in the market’s long-term tide. The public’s fear of consumer-level inflation spiraled out of control in the 1970s. This period was pretty unique in financial market history. It demonstrated that investors are not willing to pay a high multiple of earnings in a high inflation environment. During the 1966-1982 bear market, earnings grew rather dramatically but the S&P went practically nowhere. The P/PE ratio compressed all the way down to about 8 by 1982. Who cares about earnings growth if it just keeps pace with the CPI?
I agree with Steve that we are in a secular bear market similar to the 1966-1982 market. While history never repeats exactly, it often rhymes. Going out on a limb, I expect the S&P 500 will fluctuate in a trading range between 1,000-1,500, while earnings grow enough to push the P/PE ratio back below 10. Note that during 1995-2000, the initial dividend yield started low and dividends did not grow much over the next five years, but returns were huge. Investors were willing to pay double the P/E ratio to get into stocks because they feared missing out on the biggest boom in history. These market returns were driven by speculation, not fundamentals, and the consequences were costly during 2000-2002.
A closer look reveals strength in energy earnings.
So which market sectors will remain attractive investments through a period of higher market volatility? You want to own companies that produce what consumers need and can afford without exotic financing arrangements. The energy sector provides a great starting point for your search.
Veteran economist Ed Yardeni produces great chart books. Here is one that provides us with a good perspective on how much energy sector earnings have contributed to overall S&P 500 earnings. Since the 2003 bottom, energy stocks in the S&P 500 have grown from 5% to 10% of the index’s market value. But this huge price move was supported by fundamentals. Energy’s share of total S&P 500 earnings grew from 6% to 13% over this time frame. This trend has plenty of room to run over the next decade because the bull market in energy stocks has not pushed them to overvalued levels. Many are worried that the commodity pricing environment cannot possibly get any better. But at 3% of the average family budget, gasoline is not prohibitively expensive. Neither are the other energy commodities. Gasoline prices could climb to 10% of the family budget without significantly altering demand.
If this were to happen, consumers would just cut 7% worth of discretionary or leisure spending to offset this price hike. Given the good probability of this occurring over the next 10 years, you want to own stocks whose earnings benefit from higher energy prices and avoid stocks whose earnings will be undercut by them.
Odds are good that the government will eventually throw a wrench into orderly free market gasoline pricing. Many in Congress think that consumers should not have to prepare for a long period of expensive gasoline. The U.S. Congress appears ready to fight on their behalf if this occurs. Venezuelan dictator Hugo Chavez is threatening fines and imprisonment for shopkeepers who hike prices above a government-mandated inflation limit. Congress is threating similar actions. But these sorts of price controls only prompt suppliers to start smuggling and black market operations. One way or another, the free market will ensure that goods like gasoline supplies will flow to consumers willing to pay the highest prices.
Liquidity from the free market may dry up.
“Liquidity” has become the new buzzword explaining why financial markets have remained tranquil and expensive. But the past few days of action in the stock and credit default swap markets hint that this wave of liquidity may be drying up.
A good parallel to the wave of liquidity was the IPO environment for tech stocks in 1999-2000. Companies with little chance of developing profitable business models were easily financed. Investors lined up around the block, desperate to buy ownership stakes. Near the peak of the Nasdaq, speculative demand for IPOs indicated that we were in a new era of easy financing for IPOs. Liquidity seemed abundant. But within months, it had vanished and every tech IPO over the next few years became difficult to finance. Subprime mortgage lenders are the IPO buyers of the housing bubble, and they have left the market completely or dramatically tightened lending standards.
Markets can seize up and go into free fall when a flood of free market financing dries up. So the Federal Reserve will attempt to rise to the rescue. Many believe that it will be powerless against the forces of deflation, but it is not smart to bet against central bankers’ ability to destroy the value of paper money. The Fed will act in concert with most central banks around the world to keep the inflation game going.
A large, increasing global debt load creates constant demand for the money and credit necessary to service it, and if the free market refuses to supply the money and credit, central banks will. The free market’s supply of credit dried up during the Great Depression and the Fed’s inflationary ability was hampered by early 20th-century banking and monetary policy restrictions. It was powerless to stop a cycle of defaults. The Fed’s 21st-century inflationary tool kit is far more potent and flexible. Deflation cannot happen when governments can create infinite quantities of money and credit at zero cost – and are insensitive about returns on investment, malinvestments, bubbles, and ever-growing trade deficits. But bailouts do not happen without consequences. The faster central bankers inflate their cur will want to have a full allocation of gold-related investments as insurance.
So the Fed and the federal government will attempt to magically protect us from both stock market crashes and gasoline shortages. After years of relative tranquility, stock market investors are due for some turbulence. If you are exposed to financial markets, it is not too late to reassess the fundamentals supporting the value of your investments. In the inflationary environment I expect, you will want to avoid holding long-term bonds and increase exposure to select precious metals, energy, and “old economy” infrastructure stocks and minimize exposure to consumer discretionary stocks. Companies vital to the production of developed and emerging market economy needs – energy, food, and water – will enjoy strengthened competitive positions.
Replacement values of the physical assets on their balance sheets will grow year after year, supporting their stocks’ values. An entrepreneur – assuming environmental permitting were even possible – could probably not construct an oil refinery for anything less than twice the cost of buying the portfolio of refineries offered by shares of Valero in the stock market. Conversely, what sorts of barriers to entry characterize an apparel retailing business? All you need is access to credit, low-cost clothing supplies, and a lease at the local shopping center. Companies that can deliver consistent, sustainable (i.e., not one-off, housing bubble-driven) earnings should assume market leadership positions in the near future.Link here.
NORMALLY FUNCTIONING MARKETS ARE EXACTLY WHAT WE SHOULD BE WORRIED ABOUT
“You can’t always get what you want, but ... you get what you need.” ~~ The Rolling Stones
“Bernanke’s words lift investor sentiment,” said the headline in the Financial Times article on the subject. The head of the U.S. central bank told investors that there was no cause for alarm, because the markets were working “well” and that they were functioning “normally”.
On this point, we have no doubt. It is normal for prices to rise to unrealistic levels. It is normal for a correction to follow, when they fall back down to more ordinary heights. It is normal even for asset prices to crash occasionally ... after having run up too far too fast. Our doubts arise when we consider the circumstances. Mr. Bernanke told investors that his economic forecasts were unchanged. His soothing words and professorial demeanor led them to believe that they had nothing to worry about. But a normal market is like a normal tornado. Both can whip things up and tip over the outhouse.
Let us turn to Zimbabwe for a little instruction and entertainment. You will recall our dictum: A normal correction is equal and opposite to the deception that precedes it. Thanks to the scheming of the Mugabe government, the prices of consumer items are soaring. The inflation rate was 600% a year ago. Now, it is 1,600%. Readers who want to keep up with the rate of inflation in Zimbabwe are invited to go to mukuru.com. According the figures on the website, the Zimbabwe dollar has lost 16% this week alone, and now sits about 10,000 to one against the U.S. model.
Meanwhile, Gideon Gono, Zimbabwe’s central bank chief, said that “new farmers” were the cause of the problem. These new farmers are unlike the old farmers in that they do not actually grow anything. This came about because the government decided to confiscate white farmers’ land – in the name of “justice” – and turn it over to political hacks and cronies. We only mention this to show how “normal” markets work. They tolerate fools and knaves for a very long time, but never forever.
But the nice thing about the markets is that the punishments tend to fit the crimes. The greater the deception and scheming, the harder the punishment. The farther out-of-the-ordinary prices go, the more they have to move to get back into the ordinary. The greedier investors become, the more they lose.
If the markets are really functioning as well as Ben Bernanke thinks, they will soon correct the foolish and absurd bubbles blown up by today’s excess liquidity. Even after the mini-collapse of this week, Chinese shares are up 34% this year. Investors, quoted in the Financial Times, say they are not worried. They expect to continue investing in the stock market and are confident they will make money. Little wonder, given that over the last 12 months, Chinese stocks are up more than 100%.
Stocks in Vietnam – another Marxist paradise – are up 51% this year, again after this week’s price slippage. Over the last year, they are up 200%. Again, reports tell us that speculators have no intention of getting off this gravy train until it comes to a full stop. Junk bond investors are just as bullish. Even after openly threatening default, Ecuadorian bonds still yield only 11%. And in the former Soviet republic of Latvia, real estate agents say property prices went up 40% between July and September of last year. GDP growth in that tiny Baltic nation hit 12% in 2006 – faster even than China.
All over the planet, people working in the money shuffling industry are making more money than they ever made before, financial assets are more expensive than they have ever been before, and more money and credit is being added than was ever added before. Normally, you would expect a correction.
Ben Bernanke tells investors to relax. Markets are functioning normally, he says. He might as well tell sinners not to fear because God is just. But that is what they should be worried about.Link here (scroll down to piece by Bill Bonner).
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