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MAKE SURE YOU GET THIS ONE RIGHT
85% of investment returns are a result of asset class allocations and only 15% come from actually picking investment within the asset class. Getting the big picture right is critical. So ... do we face deflation or inflation?
Another guest columnist on John Mauldin’s Outside the Box column: Niels Jensen from Absolute Return Partners. Mauldin trots out the statistic that 85% of investment returns are a result of asset class allocations; only 15% come from one’s choice of investment within the asset class. We have seen slightly different statistical breakdowns in the past but the order of magnitude was the same. Contrary to what one might conclude from all the shouting, your big decision vis a vis equities, e.g., is (1) in or out and (2) stock subgroup exposure.
Jensen says that the “make or break” decision which will effectively determine returns over the next many years is in the answer to the question: Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation? Yes, good question. And the answer is not clear. If it were everyone would have already piled into the appropriate assets.
Jensen’ attempt at an answer: “I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now.”
So how does one invest during a deflation. Unfortunately nothing does that well consistently, as the example of Japan the past 20 years teaches us. The early ‘80s buy-and-hold approach will not work. You will have to be willing to trade in and out.
Of course even if you buy the deflation scenario you will want to hedge your bet with some inflation hedges – gold and other commodities, commodity-related stocks and selected property. Forecasts are dangerous, especially when they concern the future.
There are those who sweat over every decision, worrying about how it will affect their lives and investments. Then there is the school of thought that we should focus on the big decisions. I am of the latter school.
85% of investment returns are a result of asset class allocations and only 15% come from actually picking investment within the asset class. Getting the big picture right is critical. In this week’s Outside the Box we look at a very well written essay about the biggest of all question in front of us today. Do we face deflation or inflation?
This OTB is by my good friends and business partners in London, Niels Jensen and his team at Absolute Return Partners. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work here and contact them at email@example.com.
“You can’t beat deflation in a credit-based system.” ~~ Robert Prechter
As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you will not have to get more than a handful of key decisions correct – everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.
Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those “make or break” decisions which will effectively determine returns over the next many years. The question is a very simple one:
Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?
Unfortunately, the answer is less straightforward. There is no question that, in a cash-based economy, printing money (or “quantitative easing” as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?
For a good cut out how the modern credit-based system of “money” creation – and destruction – works, see the post “Fiat World Mathematical Model” from Mike “Mish” Shedlock.
A Story within the Story
Following the collapse of the biggest credit bubble in history, there has been no shortage of finger-pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the center of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.
If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either do not understand the world of finance or you do not want to understand. Shame on those who fall for cheap tactics.
A crisis of this magnitude does not suddenly fade into obscurity.
Let us begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterized the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that “less bad” does not necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude does not suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.
Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.
Higher corporate earnings volatility will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. The next decade is therefore not likely to be a “buy and hold” market.
This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a “buy and hold” market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.
So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.
Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to rebuild its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people’s problems than your own. A little bit like raising children, I suppose.
Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.
For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.
We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.
This is illustrated in chart 3 which measures the growth in the U.S. monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.
Cumulative credit destruction is far less than amount spend on monetary and fiscal stimulous.
There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the U.S. alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.
If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.
I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won’t rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 5)?
Contrary to common belief, rising commodity prices can in fact be deflationary.
Good question – counterintuitive answer:
Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to reallocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.
A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money did not go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest “must have” amongst the super-rich in the Middle East.
I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now.
For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.
So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.
Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.
Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry’s leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. “Get long and get loud” it is called; it is widely practiced and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.
The main point: The inflation vs. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come.
The point I really want to make is that the inflation vs. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.
If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple – with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.
All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favored outcome if you look at it from the government’s point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.
THE GREAT REFLATION EXPERIMENT
Holding well above average liquidity, in spite of the paltry returns, is sensible for most people whose pockets are not deep enough to absorb another hit to their net worth.
Doug Noland is not the only one to observe that we are in a great reflation operation, or “experiment” as the former head of the publisher of the estimable Bank Credit Analyst, Tony Boeckh, expresses it. Noland tends to look at events in real time. Boeckh has a longer view, seeing this latest episode as yet another one in the “debt super cycle” long-running soap opera. Here he provides some very useful history in the bargain, with some investment advice to boot.
The advice: Bonds of maturity 0-5 years for immediate liquidity needs. And as a hedge against the biggest risk, a U.S. dollar crisis: high-quality U.S. equities that have a majority of their earnings and assets in hard-currency countries, gold and related assets, and non-dollar assets in the “best-managed” countries.
The question we have been focused on for some time now is whether we end up with inflation, or deflation, and what that endgame looks like. It is one of the most important questions an investor must ask today, and getting the answer right is critical. This week, we have a guest writer who takes on the topic of the great experiment the Fed is now waging, which he calls The Great Reflation Experiment.
One of my favorite sources of information for decades has been and remains the Bank Credit Analyst. It has a long and storied reputation. One of their enduring themes has been the debt super cycle. Investors who have paid attention to it have been served well. I am taking a little R&R this weekend, but I have arranged for my friend Tony Boeckh to stand in for me. Tony was chairman, chief executive, and editor-in-chief of Montreal-based BCA Research, publisher of the highly regarded Bank Credit Analyst up until he retired in 2002. He still likes to write from time to time, and we are lucky enough to have him give us his views on where we are in the economic cycles. Gentle reader, we are all graced to learn from one of the great economists and analysts of our times. Pay attention. Central bankers do. You can read his extensive bio [here] and I will tell you how to get his letter free of charge at the end of this letter. And, he told me to mention that his son Rob is now helping him write, so there is a double byline here. Now, let’s just jump in.
By Tony Boeckh and Rob Boeckh
Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.
The Crash of 2008/9 should be seen as yet another consequence of long-term, persistent U.S. inflationary policies. Inflation does not stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult. Reflation has occurred after each major correction, and this one is proving no exception. Return to discipline in the current environment would be too painful and dangerous. Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.
Policymakers, money managers, and most forecasters have argued that the crash was a “black swan” event, meaning that it had an extremely low probability of occurrence. That is grossly misleading, as it implies that the crash was so far beyond the realm of normal probabilities that it was unreasonable to expect anyone to have foreseen it. That argument has been used to justify the widespread complacency that prevailed in the years leading up to the crash. Policymakers are still failing to recognize the systemic causes of the crash and seem to believe that enhanced regulation will prevent history from repeating. While it is true that regulators were asleep at the switch or looking the other way, they were not the cause.
The Debt Super Cycle
The real culprit is the U.S. debt super cycle, which has operated for decades, mostly in a remarkably benign manner. The inflationary implications of the twin deficits (current account and fiscal), as well as the steady increase in private debt, have been moderated by the integration of emerging markets into the global economy. The massive increase in industrial output from China, India, and others has enabled persistent credit inflation in the U.S. to occur with virtually no consequence to date (other than periodic asset price bubbles and shakeouts). How long the disinflationary impact of emerging-market productivity growth will persist and how long these nations will continue loading up on Treasuries, will be instrumental in determining the course that the Great Reflation will take.
Tougher regulation is surely appropriate, but it will not stop the next inflationary run-up unless the system is fixed. In the final analysis, newly minted money and credit must find a home somewhere.
Some Background on U.S. Inflation
Inflation, to be properly understood, should be defined as a persistent expansion of money and credit that substantially exceeds the growth requirements of the economy. As a consequence of excessive monetary expansion, prices rise. Which prices go up and at what rate depends on a number of factors. Sometimes it is the prices of goods and services that are the most visible symptom of inflationary pressures. That was the case in the 1970s when the Consumer Price Index (CPI) hit a peak rate of 14% per annum. Sometimes it is the prices of assets such as homes, office buildings, stocks, or bonds that reflect the inflationary pressure, as we have seen in more recent years.
When inflation becomes pervasive, and other conditions are supportive, it can engulf a whole industry. We saw this in the financial sector in the period leading up to the crash. The supporting conditions or “displacements,” to use the terminology of Professor Kindleberger [author of Manias, Panics & Crashes], were financial innovation, deregulation, and obscene profits and salaries. These drew millions of bees to the honey. All great manias are accompanied by malfeasance, in this case the biggest Ponzi scheme in history and many other lesser ones. It is relatively easy to steal when prices are rising and greed is pervasive. Overspending and a general lack of prudence always become widespread when a mania infects the general public. Rational people can do incredibly stupid things collectively when there is mass hysteria.
The origins of post-war inflation go back to the late 1950s and early 1960s, though some would take it back much further. In the 1960s, the U.S. dollar started to come under pressure as a result of U.S. inflationary policy and foreign central banks’ ebbing confidence in their large and growing dollar reserve holdings. The U.S. responded with controls and government intervention in a number of areas: gold convertibility, the U.S. Treasury bond market, the Interest Equalization Tax, and, ultimately, intervention on wages and prices. These moves clearly flagged to the world that external discipline would be subjugated to domestic employment and growth concerns. The policy was formalized when the U.S. terminated the link between gold and the dollar in August 1971, essentially floating the dollar and setting the U.S. on a course of sustained inflation. Of course, the dollar floated down, which, among other things, triggered the massive rise in general prices in the 1970s.
The next episode of credit inflation began in the 1980s, paradoxically triggered by the success of Paul Volcker’s move to break the spiral of rising general price inflation through very tight money. He succeeded famously, and the CPI headed sharply lower along with interest rates, setting the stage for the massive U.S. debt binge and the series of asset bubbles that followed. It was easy for the Federal Reserve to pursue expansionary credit policies while inflation and interest rates were falling.
The Great Reflation Experiment of 2009
Private sector credit, the flipside of debt, maintained a stable trend relative to GDP from 1964 to 1982 (Charts 1 and 2). After that, the ratio of debt to GDP rose rapidly for the 25 years leading up to the crash, and is continuing to rise. The current reading has debt close to 180% of GDP, about double the level of the early 1980s. The magnitude and length of this rise is probably unprecedented in the history of the world. Even the credit inflation that was the prelude to the 1929 crash and the Great Depression only lasted five or six years.
Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were clearly on track to be much worse than the post-1929 experience. The pervasiveness of leverage – from banks to consumers to supposedly blue-chip companies – and the illusion of stability in the system, were fostered through the 25 years that this credit bubble has grown, basically uninterrupted. The speed and magnitude of the bailouts and stimulus – the end of which we will not see for a long time – aborted the meltdown. However, the story is far from over.
The Great Reflation Experiment ultimately has two components. The first is a rise in federal government deficits, debt, and contingent liabilities. The second is an expansion of the Federal Reserve’s balance sheet. Both are unprecedented since World War II. U.S. federal government debt is likely to reach close to 100% of GDP over the next 8 to 10 years, according to the Congressional Budget Office (CBO) and supported by our own calculations (Chart 3). Anemic growth, falling tax revenue, increased government spending, and bailouts of indigent states, households, businesses, along with an aging population, will all undermine public finances to a degree never before seen in peacetime. According to CBO data, government debt could reach 300% of GDP by 2050 as contingent liabilities are converted into actual government expenditures. This massive peacetime deterioration in public finances will have grave consequences for living standards and asset markets, particularly in the longer run.
The Fed is in a very difficult position. Its room to maneuver is either small or nonexistent, and the markets understand this.
In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole in the economy that has been caused by the sharp increase in household savings. Further out, government deficits will put upward pressure on interest rates. However, much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest-rate shock. Therefore, the Federal Reserve will have to monetize much of the rise in government debt, making it extremely difficult to unwind the explosion in the Fed’s balance sheet and consequent rise in bank reserves – the fuel that could be used to ignite another money and credit explosion.
The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or nonexistent, and the markets understand this. That is why there is a sharp divergence between those worried about price inflation and those fearing a lengthy depression.
Implications for Investors
Investors are also in an extraordinarily difficult predicament. From the peak in 2007, household wealth declined by about $14 trillion, over 20%, to the first quarter of 2009. Tens of millions of people had come to rely on rising house and stock prices to give them a standard of living that could not be attained from regular income alone (Chart 4). They stopped saving and borrowed aggressively and imprudently against their assets and future income, some to live better, some to speculate, and many to do both. That game is over.
Pensions have been devastated and people’s appetite for risk has declined dramatically. The return on safe liquid assets ranges from 0.60% to 1.20%, depending on term and withdrawal penalties. Reasonable-quality bonds with a 5-year maturity provide about 4%. Bonds with longer maturities have higher yields but are vulnerable to price erosion if inflationary expectations heat up. As for equities, people now understand that blue chip stocks carry huge risk. GE, once considered the ultimate “bullet-proof” stock, dropped 83% in the panic, and Citigroup lost 98%. Revelations of massive fraud schemes have further damaged trust and confidence in markets.
An increase in price inflation as reflected in the CPI is a long way off. Western economies will remain depressed for years, and China will also be important in keeping inflation down.
Against this backdrop we offer a few thoughts. First, an increase in price inflation as reflected in the CPI is a long way off. The degree of excess capacity in the world is probably the greatest since the 1930s, although excess capacity does get scrapped during recessions. Western economies will remain depressed for years, and China will also be important in keeping inflation down. Its capital investment is larger than the U.S.’s in absolute terms. It is currently 40% of GDP and growing at 30% per annum. Profit margins in China will probably get squeezed, which, together with the huge amount of underemployed labor, means that the Chinese will keep driving their export machine at full throttle, continuing to flood the world with high-quality, inexpensive goods. Therefore, investors who need income are probably safe holding reasonably high-quality bonds in the 5-year maturity range. A bond ladder is a very useful tool for most people. Holdings are staggered over, say, a 5-year time frame, and maturing bonds are invested back into 5-year bonds, keeping the portfolio structure in the zero-to-5-year range. In this way, some protection against a future rise in price inflation and falling bond prices can be achieved.
Investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.
Second, massive monetary stimulus is good for asset prices in the near term (e.g. stocks, bonds, houses, commodities) in a world of very weak price inflation and a soft economy. That is true as long as the economy does not fall apart again, which is very unlikely given all the stimulus present and more to come if needed. Therefore, investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.
There is a major risk to our relative near-term optimism, and that is the U.S. dollar. Foreign central banks hold $2.64 trillion, overwhelmingly the largest component of world reserves. The U.S. role as the main reserve currency country is compromised by its persistent inflationary policies and current account deficits, a subject high on the agenda at the recent G-8 meeting in Italy and referred to frequently by China, Russia, Brazil, and others. Foreign central banks fear a large drop in the dollar, which would cause them potentially huge losses on their reserve holdings. They do not want more dollars, and yet they do not want to lose competitive advantage by seeing their currencies go up against the dollar. To preserve their competitive position, they have to buy more when the dollar is under pressure. On the other hand, since the 1930s the U.S. has never subjugated domestic concerns to external discipline. Officials may talk of a strong-dollar policy, but their actions always speak differently. Their attitude towards foreign central banks is, “We didn’t ask you to buy the dollars.” The U.S. has typically seen such buying as currency manipulation to gain an unfair trade advantage.
The most important central banks will continue to hold their noses and buy the dollar to keep it from falling too sharply. However, this is an unstable situation, and the dollar must fall over time. Investors need to diversify away from this risk. There are three obvious ways.
The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers once described it, “a balance of financial terror.” The most important central banks will continue to hold their noses and buy the dollar to keep it from falling too sharply. However, this is a fragile, unstable situation, and the dollar must fall over time. Investors need to diversify away from this risk. There are three obvious ways.
The first is investing in high-quality U.S. equities that have a majority of their earnings and assets in hard-currency countries.
The second is investing in gold and related assets. Gold will probably remain in a tug of war for some time. On the negative side, it is faced with nonexistent global price inflation, even deflation, and a sharp decline in jewelry demand. On the positive side, concerns over U.S. monetary and fiscal debauchery will almost certainly heat up. As the odds of the latter increase, gold will be a major beneficiary, and investors should have a healthy insurance position in this asset class.
Third, most foreign currencies will also benefit from these fears, and hence investors can also protect themselves by diversifying into non-dollar assets in the best-managed countries. Some of these are emerging markets like China, which are liquid, in surplus, fiscally stable, and still growing well in spite of the global economic downturn. If and when the world economy begins to recover, and should price inflation stay low, asset bubbles are likely to recur. Where and when is always hard to tell in advance. Good prospects are in emerging-market equities, commodities, and commodity-oriented countries.
Note that Doug Noland warns above that China is now riding its own credit bubble-tiger. Timing is critical.
So, to sum up, in the next six to 12 months we look for a weak but recovering U.S. economy, a continued deflationary price environment, pretty good asset and commodity markets, and continued narrowing of credit spreads. This view is based on the assumption that the new money created has to go somewhere, a stable to modestly falling dollar, and an anemic world economic recovery next year.
The investment world is likely to remain very unstable in the face of the difficult longer-run problems discussed above. Investors, whether they like it or not, are in the forecasting game, and forecasting is all about time lags.
A buy and hold strategy has been bad advice for the past 10 years. The S&P is down 45% from its peak in early 2000. The investment world is likely to remain very unstable in the face of the difficult longer-run problems discussed above. Investors, whether they like it or not, are in the forecasting game, and forecasting is all about time lags. The exceptional circumstances of the current environment make any assessment of time lags extraordinarily difficult, and mistakes will continue to be costly. For that reason, holding well above average liquidity, in spite of the paltry returns, is sensible for most people whose pockets are not deep enough to absorb another hit to their net worth. They are in the unfortunate position of having to wait until the air clears a bit and more aggressive action can be taken with higher confidence. Warren Buffet has properly reminded us on numerous occasions that a price has to be paid for waiting for such a time, but then most of us are not as rich as he is. ...
I want to thank Tony and Rob for writing this week’s letter. You can go to their website and see some of their recent letters, or send an email to firstname.lastname@example.org and get put on their regular list for the free letter.
FACETS OF BUBBLE ANALYSIS
Bubbles are a credit phenomenon, of which inflating assets prices are only one consequence.
We think PrudentBear.com’s Doug Noland has pretty well fingered the most important factor behind today’s financial markets: the ongoing “government finance bubble” which has emerged from the destruction of the mortgage finance bubble. Governments are engaged in a massive substitution of government debt for imploding private debt in an effort to keep total system credit from deflating. The success, for lack of a better term, of the strategy so far is reflected in reflating financial asset prices and some signs of slowing declines in the economy.
But how long can this reflation scheme continue? Eventually people will notice that debt is being issued willy-nilly with no hope of it ever being repaid other than by issuing more debt or “printing” money. This type of belated recognition brought on the crisis in confidence that ended the mortgage finance bubble with a bang. It will not even take some critical mass of individuals to panic – just a foreign central bank or two – and now the consequences will be even more catastrophic: When everyone loses their confidence in government debt, what else is left?
So are we looking at Argentina ca. 2001 on a grand scale – with the only issue being timing (mania highs are extraordinarily hard to call)? We are all duly warned, but as the lead posting in this Digest cogently argues, deflation is perhaps a better bet for the next several years. The interface of that trend with the government finance bubble will almost certainly make for exciting times.
A couple years back I received an email from a unimpressed reader with the following message: “Doug, when you are a hammer everything looks like a nail.” He was referring to my thesis back then that bubbles had sprung loose from the U.S. credit system and had begun propagating around the world.
Months back I posited that a government finance bubble had emerged from the smoking ashes of the Wall Street/mortgage finance bubble. I understand why some might see me as a dreary hammer out searching for nails. All the same, the backdrop merits further discussion of facets of bubble analysis.
Analysts should downplay asset prices while focusing keenly on underlying credit and speculative dynamics.
Many see bubbles in terms of an unsustainable overvaluation of asset prices. And many would view today’s “post-bubble” landscape and find my ongoing bubble premise borderline ridiculous. But I have always viewed bubbles as a credit phenomenon. Inflating assets prices are actually only one of many consequences of an overexpansion of credit. Rapid asset inflation is almost a sure sign of underlying credit excess, though analysts should downplay asset prices while focusing keenly on underlying credit and speculative dynamics. Huge credit growth, market price distortions (especially the under-pricing of risk), highly speculative markets, and prolonged asset inflation are inevitably indicative of some underlying monetary/credit disorder.
The problem today is that central bankers for years ignored a historic expansion of credit and the resulting monetary disorder. Now policymakers have jumped farther into the uncharted waters of unconstrained credit expansion.
I want policymakers out of the business of targeting or tinkering with the asset markets and market yields. Instead, the focus should be on creating a backdrop of stable money and credit. The problem today is that central bankers for years ignored a historic expansion of credit (much of it directed to the asset markets) and the resulting monetary disorder. Now, to avert systemic implosion central bankers at home and abroad have resorted to unprecedented measures to expand credit and intervene in the markets’ pricing of credit. Instead of a movement toward constructing a more stable global credit system and backdrop, policymakers have instead jumped farther into the uncharted waters of unconstrained credit expansion. Such a backdrop is ultra-conducive for ongoing speculation, bubbles, and general disorder.
Credit is inherently self-reinforcing – both on the upswing and downswing. An unlimited supply of credit will tend to satisfy rising demand at a lower price.
Again, bubbles are first and foremost a credit phenomenon. Fundamental to the nature of credit, expansion generally fosters more expansion. Credit excess begets only greater credit excess. And credit excess notoriously begets speculative excesses. Importantly, credit is inherently self-reinforcing – both on the upswing and downswing. In today’s “system” of unrestrained credit, rising demand for borrowings does not dictate an increasing price for this credit. Indeed, an unlimited supply of credit will tend to satisfy rising demand at a lower price. And this gets right to the heart of a huge bubble – and policymaking – dilemma.
The breakdown of U.S. discipline – and the resulting massive dollar devaluation – has unleashed domestic credit systems from China to Brazil.
The bottom line is that unrestrained credit is inherently unstable, and few seem to appreciate the unique nature of today’s unfettered global credit environment. There is no international gold monetary regime for which to discipline lenders, central banks, governments or economies. The dollar reserve system self-destructed over decades of undisciplined credit expansion. And the breakdown of U.S. discipline – and the resulting massive dollar devaluation – has unleashed domestic credit systems from China to Brazil. Never have “developing” credit systems (and currencies) enjoyed such freedom to inflate financial claims.
The massive intrusion of the Treasury and Federal Reserve into the marketplace has only further distorted the pricing of finance throughout our economy.
It is with this backdrop in mind that I contemplate the likelihood that we have entered an especially dangerous period of credit excess and attendant bubbles. Fundamentally, the massive intrusion of the Treasury and Federal Reserve into the marketplace has only further distorted the pricing of finance throughout our economy – as well as globally. Despite record debt issuance, the market will lend the Treasury 3-month money at about 11 basis points. Two-year borrowings come at cost of about 100 bps. The price of Treasury notes and bonds inflates in spite of enormous deficits as far as the eye can see. Moreover, the marketplace is happy to lend to Fannie and Freddie at only a slight premium to the U.S. Treasury, with the prices of their obligations inflating in the face of these institutions’ ongoing financial implosions. Today’s price distortions go right to the heart of system “money.”
The government is quietly accumulating dangerous credit and interest rate risk in its ongoing mortgage operations.
Fannie Mae’s Book of Business (mortgage holdings and MBS guaranteed) jumped $43.9 billion during June to $3.194 trillion. This was the biggest growth since December 2007. Freddie’s Book of Business increased $12.2 billion last month. According to Bloomberg’s issuance tally, the GSEs (Fannie, Freddie and Ginnie) issued $168 billion of MBS in July, down somewhat from June’s huge $236 billion and May’s $212 billion. At $1.102 trillion, year-to-date agency MBS issuance has already almost matched 2008 and 2007. The government is quietly accumulating dangerous credit and interest rate risk in its ongoing mortgage operations.
A market trapped in bubble dynamics had lost is capacity for adjustment and self-regulation.
During the Wall Street/mortgage finance bubble, seemingly no amount of credit creation and debt issuance would place upward pressure on the cost of borrowings (or reduced the price of the underlying debt instruments). Importantly, the bigger this bubble inflated the more confident the savvy market operators became that an inevitable crisis would force policymakers to explicitly back GSE obligations and aggressively slash interest rates. Market yields remained artificially low and increasingly detached from escalating risks. Fundamentally, a market trapped in bubble dynamics had lost is capacity for adjustment and self-regulation.
Today’s mispricing of government finance reinforces the market’s perception that U.S. policymakers will successfully reflate the economy. This bubble distortion, then, fosters a problematic explosion of government debt issuance – and a most dangerous case “Ponzi finance.”
The massive expansion of GSE obligations, coupled with a speculative marketplace’s anticipation of yet another major government-induced reflation, severely distorted the marketplace and provided the bedrock for a historic mortgage finance bubble. Today, the government’s intrusion into the marketplace is greater than ever. The markets readily accommodate a couple $trillion of annual issuance – as if the U.S. economy and credit system were on solid footing. And I would argue that today’s mispricing of government finance reinforces the market’s perception that U.S. policymakers will successfully reflate the economy. This bubble distortion, then, fosters a problematic explosion of government debt issuance – and a most dangerous case Minskian “Ponzi finance.”
There are a number of reasons why the government finance bubble is even more dangerous than the Wall Street/mortgage finance bubble.
There are a number of reasons why the government finance bubble is even more dangerous than the Wall Street/mortgage finance bubble. First of all, the $2 trillion or so of “government” issuance over the past year is greater than the $1.4 trillion peak total mortgage credit growth during 2005 and 2006. I would expect another $2 trillion next year and the year after. Government debt enjoys the attribute of “moneyness” in the marketplace to a much greater capacity than mortgage securities did during the boom. The risks associated with debasing this “moneyness” are momentous. And there is, as well, the dynamic where the greater the government finance bubble inflates the more convinced the marketplace becomes that the Federal Reserve will do everything within its power to accommodate the debt markets (ultra-loose monetary conditions for the duration). And destabilizing speculation can return to all markets ...
The government finance bubble is a global dynamic. There were pertinent bubble-related comments out of China this week:
July 30 – Dow Jones (J.R. Wu): “China’s central bank will emphasize market-based systems, rather than administrative controls, in guiding the appropriate growth of credit, People’s Bank of China Vice Governor Su Ning said. The statement ... came just hours after Chinese shares posted their biggest one-day percentage fall in over eight months on fears that loan growth may start to pull back ... ‘We should pay attention to the use of market-oriented means – rather than controlling the size – and flexibly use various monetary policy tools to guide the appropriate growth of credit,’ Su said. ... He said ‘the mind and action’ of all financial institutions should ‘be as one’ with the government’s goal, and financial institutions should properly handle the relationship between supporting the economy’s development and preventing financial risks. Su’s comments appeared to signal the PBOC was not about to set loan curbs in the second half of this year to cool explosive lending growth, as it did in 2008 when it used the blunt tool of loan quotas for banks to hold down inflationary pressures that were building at the time. ... But Su said the central bank will resolutely maintain its moderately loose monetary policy. He said the foundation for China’s economic recovery is not firm yet and many uncertain factors still exist in both the external and domestic environment.”
Similar to the Federal Reserve, Chinese authorities are increasingly held hostage to bubble dynamics.
Similar to the Federal Reserve, I see Chinese authorities increasingly held hostage to bubble dynamics. I found it fascinating that a top People’s Bank of China official would mention emphasizing “market-based systems” for guiding credit growth. I suspect this may be a most inopportune time to begin relying on market mechanisms. As we have witnessed, market-based processes can be particularly unreliable credit regulators after bubbles have reached an overheated state. It is my view that only decisive action by Chinese policymakers will at this point have much impact at restraining excess. Central to the analysis of unfolding precarious bubble dynamics is my view that few, if any, policymakers anywhere around world will be willing to act decisively to tighten credit conditions and address increasingly speculative financial markets.
“BUBBLE-MANIA” IN SHANGHAI SPREADS TO GLOBAL MARKETS
Gary “SirChartsAlot” Dorsch is tracking China’s gargantuan reflation effort, which has shown up in the dramatic recovery in the Shanghai red chips – more than doubling from last November’s lows – and the major rallies off their lows of many industrial commodities, including oil.
Dorsch notes that the liquidity that is been unleashed into the global banking system will ultimately play havoc with accelerating inflation. Central banks have demonstrated zero proclivity to preempt such inflation by withdrawing liquidity early, instead inflating bubbles to dangerous proportions. Ergo, this cannot come to a good end. [See “The Coming China Meltdown” in this week’s W.I.L. Offshore News Digest: “Looks like a bubble to me, and bound to end in tears,” says Martin Hutchinson. “In a Western economy, one would be sure of it. So why should we think China is different?”]
In the mean time, the major emerging “BRICK” country stock markets – Brazil, Russia, India and China, joined by Korea – are recovering even more vigorously than their developed country counterparts. And their economies are expanding while the old-line developed economies are still vigorously contracting. However bubble driven this is – which is plenty – does this presage the long forecast “decoupling” between the emerging and more developed G-7 economies? The evolution in that direction goes in fits and starts. Most telling will be the recovery after the next crash.
The S&P 500 Index, a global bellwether for the world stock markets, extended its best 5-month winning streak since 1938, by advancing through the psychological 1,000-level, and is up nearly 50% from its 12-year low set on March 10th. The S&P 500 gained 7.4% in July, its best monthly performance since 1997, even as average earnings per-share tumbled -32% and sales slid -16% from a year ago.
Industrial commodities, often viewed as barometers for global economic trends, have also moved sharply higher. So far this year, copper has soared by +96%, nickel is up 62%, and zinc is +50% higher. China, which buys 2/3 of the world’s seaborne iron ore shipments, boosted imports 30% in the first 7-months of this year to 353-million tons, lifting its spot price to $91/ton, up from $60 per ton in February. Crude oil rose above $71/barrel this week, doubling in value since December.
While G-7 economies imploded, China engaged in the most ambitious stimulus plan the world has ever seen, to rescue its juggernaut economy from the brink of social disaster and unrest.
In hindsight, while the “Group of Seven” (G-7) economies in North America, Europe, and Japan, were experiencing the most severe economic contractions since the Great Depression of the 1930s, coupled with unemployment rates ratcheting upward to multi-decade highs, the emerging economic giant – China, was demonstrating its prowess, with the most ambitious stimulus plan the world has ever seen, to rescue its juggernaut economy from the brink of social disaster and unrest.
In a little more than 9 months, the pendulum of investor sentiment in Asia has swung from the extreme of terrifying panic and fear to hope and unbridled greed.
In a little more than 9 months, the pendulum of investor sentiment in Asia has swung from the extreme of terrifying panic and fear, to the opposite side of the emotional spectrum – hope and unbridled greed. The Shanghai stock market index has surged +90% this year, owing its good fortune to 1.2 trillion [USD] of bank loans clandestinely funneled into the stock market by brokerage firms, leaving it awash with yuan and lifting share prices above what economic reality can support.
China’s ruling Politburo is demonstrating to the world, its command and control over its stock market and economy. Over past few-years, Beijing has proven its ability to either massively deflate a stock market bubble, as seen in 2008, and the wizardry to re-inflate a stock market bubble this year. Beijing is following the Greenspan-Bernanke blueprints – turning to massive money printing to re-inflate bubbles in asset markets, in order to jump start an economy from the doldrums, or in this latest case, from the grip of the Great Recession.
A relatively healthy banking system enabled the Chinese central bank to work its magic. China’s M2 money supply is growing at a record +28.5% annualized rate, and the money supply surge is coinciding with big rallies in stocks and property, spilling over into neighboring Hong Kong. State-controlled Chinese banks extended 7.4 trillion yuan ($1.2 trillion) of new loans in the first half of this year, equal to 25% of China’s entire economy – helping to fuel a powerful Shanghai red-chip rally.
One of the beneficiaries of the explosive growth of the Chinese money supply is the Shanghai gold market, which is trading near 6,600 yuan/ounce, and is also tracking powerful rallies in industrial commodities. China is poised overtake India as the world’s top gold consumer this year, and there is speculation that Beijing will quietly buy the gold which the IMF wants to sell in the years ahead.
Shanghai traders are betting that Beijing will opt to blow even bigger bubbles in asset markets.
China, the world’s biggest gold mining nation, is seeking to boost gold output by 3% to 290 tons this year, far less than the 400 tons it consumed last year. Thus, China could become an even bigger importer of the yellow metal in the months ahead, helping to cushion inevitable corrections in the gold market. Given the tradeoff between expanding growth and fighting asset-price inflation, Shanghai traders are betting that Beijing will opt to blow even bigger bubbles in asset markets.
Industrial Commodities Eyeing Shanghai
China’s super-easy monetary policy is designed to offset the damage to its export-dependent regions, which are suffering from the collapse in global trade. Beijing is also spending 4 trillion yuan on infrastructure projects, equal to roughly 15% of its economic output per year, to create jobs and stoke economic growth. So it was of great interest to global traders, when the Shanghai red-chips suddenly plunged -5% on July 29th, the biggest daily loss in 8 months, on rumors that Beijing would curb bank lending in the second half of this year.
The Shanghai index is prone to sudden shakeouts, with the index trading at 35 times earnings, and Shenzhen’s small-cap shares trading at 45 times earnings. The Shanghai red-chip index has evolved into the locomotive for key industrial commodities, such as crude oil, base metals, and rubber. Industrial commodities rebounded from a nasty one-day shakeout on July 29th, after the People’s Bank of China wasted little time, in denying rumors swirling in the media that is was considering the idea of enforcing quotas on bank loans.
The prospects for Chinese corporate earnings growth are of critical importance, with the Shanghai stock index flying higher in bubble territory. Large-scale industrial companies in 22 Chinese provinces saw their profits decline -21.2% in the first half to 894.14 billion yuan, but the decline rate was less from the first quarter’s 32% slide, and nowadays, “less bad,” means signs of recovery.
The most optimistic scenario calls for Chinese industrial profits to rebound to an annualized growth rate of +30% in the 4th quarter, due to the government’s massive stimulus. China’s Bank of Communications predicts the economy’s growth rate will to accelerate to a pace of +9% in the Q3 and +9.8% in Q4. China’s crude steel output would surely top 500 million tons this year, equaling 40% of the world’s total production.
Korea Joins Alignment of B-R-I-C-K
Upbeat markets in China are helping underpin the BRIC nations, including Brazil, India, and Russia, which have the four best performing stock markets this year. Brazil’s Bovespa Index is up 79%, India’s Sensex Index is up 63%, and Russia’s RTS Index has gained 62-percent. The S&P 500 by comparison, is up 9.4% this year, while Japan’s Nikkei-225 index is up 7.5%.
With growing appetites for risky assets, global investors have rushed to snatch up Korean Kospi shares.
One could add Korea to the alignment of B-R-I-C-K stars, since the Kospi Index has rebounded by 72% above its November low, emerging as the most favored market among global investors. With growing appetites for risky assets, global investors have rushed to snatch up Korean Kospi shares, particularly those in the information technology (IT) and the auto sectors. Foreigners were net buyers of $4.7 billion of Korean stocks in July, much larger than net purchases of $2.6 billion of stocks in Taiwan, $1.9 billion shares in India, and $1.3 billion in South African shares.
“Money has no motherland, financiers are without patriotism and without decency – their sole object is gain,” observed Napoleon Bonaparte. Highlighting the fickle nature of speculators – foreigners bought a record $18 billion of Korean securities in Q2 of this year, or 24 times more than $750 million the previous quarter. In the 3rd and 4th quarters of 2008, foreigners sold $17.9 billion and $17.4 billion, respectively, at the height of the global financial turmoil.
In a world where G-7 central banks are pegging rates at record low levels, it does not take much imagination to envision them underwriting rallies in the emerging currencies.
Foreign buying of Korean equities knocked the U.S. dollar 28% lower against the Korean won, and the Japanese yen has tumbled 20% to 12.8 won, since March 10th, when global stock markets bottomed out. “Carry traders” are active in Seoul, and profiting from a stronger won. In a world where G-7 central banks are pegging rates at record low levels, it does not take much imagination to envision the Federal Reserve, the ECB, and the Bank of Japan underwriting rallies in the emerging currencies of Brazil, Russia, India, and Korea, just as Tokyo pumped massive liquidity straight into New Zealand and Australian dollars during its flirtation with the hallucinogenic drug – “Quantitative Easing” (QE) between 2001 and 2006.
Virtuous Cycle Swings in the Kremlin’s favor
The resilience of China’s economy has rekindled the decoupling debate, which hinges on the premise that the emerging economies in Brazil, Russia, India, China, (BRIC) can grow in spite of a declining G-7 economies. The so-called BRIC countries accounted for half of global growth in 2008 – China alone accounted for a quarter, and Brazil, India, and Russia combined equaled another quarter. Furthermore, the IMF notes that BRIC “accounted for more than 90% of the rise in consumption of energy products and metals, and 80% of grains since 2002.”
The virtuous cycle of events are now swinging back in the Kremlin’s favor, as global speculators flock back into hard-hit resource shares trading in Moscow. Russia’s central bank cut its main interest rates for the 4th time in less than 3 months, after Moscow said the local economy contracted an annual 10.2% in the January-May period. Bank Rossii lowered the refinancing rate a half-point to 11% following on initial reduction on April 24th and two further cuts on May 13th and June 5th.
The Russian rouble has rebounded 16% against the U.S. dollar, since the first quarter, as Urals blend crude oil rebounded towards $70 a barrel, and base metals surged higher, boosting demand for Russia’s currency, a world leader in commodity exports.Russia is the world’s 2nd-largest oil exporter behind Saudi Arabia, and supplies a quarter of Europe’s natural gas needs. Russia is also the world’s largest nickel and palladium miner, the second largest platinum miner, and the 4th-largest iron ore miner, behind Brazil, Australia, and India.
After reaching a record high of $597 billion last August, Moscow’s foreign currency reserves were dramatically depleted in the 2nd half of 2008, as the central bank spent more than $200 billion supporting the Russian rouble and bolstering the capital position of domestic banks. This year’s rebound in Urals blend crude oil has improved the Kremlin’s coffers, to the tune of $404 billion today. China, the world’s 2nd-largest oil guzzler, imported 3.83 million barrels per day in July, or 25% more than a year earlier, the fastest pace in nearly two years.
The BRIC nations are rethinking how their U.S. dollar currency reserves are managed, underlining a power shift from the United States.
The BRIC nations are rethinking how their U.S. dollar currency reserves are managed, underlining a power shift from the United States, which spawned the global financial crisis. Russian chief Dmitry Medvedev has repeatedly questioned the U.S. dollar’s future as a global reserve currency. China is allowing companies in its southern provinces of Yunnan and Guangxi to use yuan to settle cross-border trade with Hong Kong and Southeast Asia to reduce exposure to the U.S. dollar.
India Weathers the “Great Recession”
Reserve Bank of India chief Duvvuri Subbarao says India’s modest dependence on exports will help Asia’s 3rd-largest economy, to weather the “Great Recession” and even stage a modest recovery later this year. Even during the depths of the October massacre in the Bombay Sensex Index, India managed to maintain a 5.3% growth rate in Q4, and India’s banking system had virtually no exposure to any kind of toxic asset, manufactured in the United States.
India’s factory output contracted by a slim 0.25% in January, the first decline this decade, and export earnings had fallen for six straight months. In January exports were 16% lower from a year earlier tumbling to $12.3 billion. So the Reserve Bank of India (RBI) scrambled to rescue the Bombay stock market, by slashing its lending rates six times from September thru April, by a total of 425 basis points.
The Indian Sensex index began to decouple from Wall Street and Tokyo in early May, after it rallied 14% for its biggest weekly gain since 1992, when Indian Prime Minister Manmohan Singh won a second term. Bombay stocks soared with enthusiasm at the prospect that Singh’s new government, shorn of Communists, would privatize up to $20 billion of state-owned assets, increase foreign investment in highly profitable crown jewel companies, begin deregulation of banking and financial services, and gut restrictions on the closing of factories.
India’s factory sector, measured by the Purchasing Manager’s Index, held strongly at a reading of 55.3 in July, or 2 points higher than China’s, signaling a strong industrial recovery in the second half of this year. If the decoupling of China, India, Russia, and Brazil becomes a reality, it could be good for the developed G-7 nations, as growing wealth in BRIC nations could, in theory, increase demand for goods made in battered nations like Japan, Germany, and the United States.
A decoupling between the emerging BRICK nations and the more developed G-7 economies would mean a huge shift in the global financial markets, away from the traditional pattern of emerging markets dancing to the tune of G-7 economies.
A decoupling between the emerging BRICK nations and the more developed G-7 economies would mean a huge shift in the global financial markets, away from the traditional pattern of emerging markets dancing to the tune of G-7 economies, which still account for 60% of global GDP. Instead, increasing independence could lead to a greater sphere of influence of the emerging giants, led by Beijing.
“Bubbles” Bernanke follows in the footsteps of his mentor “Easy” Al Greenspan.
In the United States, Fed chief Bernanke is pumping a “bailout bubble” for Wall Street, similar to the policies of his mentor “Easy” Al Greenspan, who inflated the housing bubble, the subprime debt bubble, and the high-tech bubble. It is a never ending cycle of boom-and-busts of bubbles, engineered by central banks. The revival of the “Commodity Super Cycle,” might already be already in motion, and if a global economic recovery gains traction, soaring input costs, would begin to crimp the profit margins of the giant Asian industrialists.
All the liquidity that is been unleashed into the global banking system would play havoc with accelerating inflation. History shows that central banks will not preempt inflation by withdrawing liquidity early. Instead, the money printers tend to inflate bubbles to dangerous proportions. Add to the mix, the vast leverage of the U.S. dollar and Japanese yen carry trades, it is going to be a wild ride for the U.S. Treasury bond market, which is increasingly dependent upon the whims of BRICK.
MAKE A BID ON AND FOR eBAY
EBay is evolving into a business much more like Amazon – only with better margins. Its PayPal and Skype units are the icing on the cake.
An April posting, “The World’s Best Retailer,” summarized the many virtues of Amazon.com. As great a company as Amazon is, it was not a bargain then, and it is less of one now – near the top of its 52-week trading range.
EBay, on the other hand, trading at a little over 13 times 2010 earnings estimates looks like a buy candidate. The company is dominant in its online auction market. And its two major subsidiaries, PayPal and Skype are even more dominant in theirs – in neither case do we need to tell you what they do. Barron’s maintains that while eBay’s reputation as an online auctioneer of quirky items and occasional gems lingers, investors fail to “fully appreciate the global, multifaceted and increasingly profitable company that has replaced it.”
Why is eBay so cheap, if indeed it is? The company has been involved in a long campaign to turn around its core business, which had its problems when growth rates matured. Wall Street is justifiably leery of turnarounds; they always seem to take much longer than expected. EBay’s relatively new management says they are halfway through their turnaround.
The company’s record in reinvesting its ample free cash flow in acquisitions is mixed. PayPay and Skype look like they will work out, but others have not fared so well. Finally, like many technology and dot-com companies, eBay issues liberal amounts of stock options and uses liberal accounting in reporting their earnings-diluting effect. So earnings per share are overstated. Value buyers will want to adjust their buy target accordingly.
Bidders at auction often lose their nerve in the face of escalating prices. Investors contemplating a stake in eBay , which has rallied 52% this year – and 15% just in the past two weeks – might understand the phenomenon well. They, too, may be questioning whether the company and its shares are “worth it” at 21-and-change. They should stop worrying, and bid.
EBay, the online-commerce specialist, is worth its current price and perhaps as much as 30% more, as a long-promised turnaround in its core online-auction business finally begins to yield results. The company also produces copious cash flow, benefits from a stabilizing consumer economy, and owns a pair of fast-growing units – PayPal and Skype – whose gains have been obscured by the mature, but improving, auction business.
While eBay has had an impressive run, the stock (ticker: EBAY) remains more than 50% below its peak level of five years ago. Moreover, at just 14 times this year’s expected earnings of $1.51 a share, and around 13 times 2010 estimates of $1.62, the company trades at a 20% discount to the broad stock market, and looks like a bargain relative to similar e-commerce outfits such as Amazon.com (AMZN), which sport considerably higher price/earnings multiples.
Ever since John Donahoe was elevated early last year to replace Meg Whitman as chief executive, management has been promising eBay would find a way to cut costs and streamline its online marketplace to heighten its appeal to large sellers of fixed-price goods. In recent months, these efforts began delivering positive results.
“First real signs of a turnaround.”
The volume of total items sold in the latest quarter increased by 2.7%, reversing a 1.6% decline in the prior quarter, in what Stephen Ju, an analyst at RBC Capital Markets, calls the “first real signs of a turnaround.” Earnings and revenue in the quarter both were ahead of forecasts, improvements that likely mark the beginning of a lasting recovery.
Crucially, Donahoe’s focus on better accommodating large sellers of merchandise, such as mainstream retailers, has driven the proportion of fixed-price merchandise, as opposed to auctioned goods, to 51% of sales in the company’s marketplace segment, which rang up total revenue of nearly $5.6 billion in 2008. The growth rate of the auction business has been declining since the fourth quarter of 2008, highlighting the imperative to boost fixed-priced sales.
Majestic Research, which maintains a proprietary database to calculate e-commerce volumes, says total listings on eBay are up 17.3% year-to-year in the current quarter. Of the total, store-posted listings have soared 57.7%, while “core” listings from individuals have risen 11.2%.
Last week, eBay altered its listing rules to help top-rated large vendors win buyer traffic more easily, a move that drew predictable carping from small sellers but was otherwise roundly embraced.
Online retailing of fixed-price merchandise is no easy business, given powerful competitors from Amazon to the websites of bricks-and-mortar merchants. But by growing its fixed-price business, eBay wisely is declaring itself agnostic about how people use its platform to buy and sell goods.
In the past decade, eBay has gone from overhyped and overvalued to underloved and underpriced. At the peak of the dot-com bubble in early 2000, when the San Jose, California-based company barely was turning a profit, it had a market value of $30 billion. Today, its market value is $28 billion, supported by more than $2 billion a year of free cash flow.
Amazon fetches 50 times earnings, and even a terrestrial retailer like Target trades for a slight premium to eBay.
The mania of the late 1990s that inflated all things technology-related should not be expected or invited back for years, if ever. But even in these sober times, with the tech-heavy Nasdaq Composite still a shadow of its former self, Amazon fetches 50 times expected earnings. Even a terrestrial retailer like Target (TGT) trades for a slight premium to eBay.
The company image of an online auctioneer of quirky items and occasional gems is largely obsolete.
A whiff of the eBay of old – an online auctioneer of quirky items and occasional gems – still lingers. But the public, and particularly the investment community, does not fully appreciate the global, multifaceted and increasingly profitable company that has replaced it.
EBay may lack Amazon.com’s reputation as the go-to site for media products, not to mention a product like Amazon’s hot-selling electronic reader, the Kindle. Yet, it is evolving into a business much more like Amazon, only with far better margins.
Last year, eBay earned about $1.8 billion on $8.5 billion of revenue. Amazon netted $645 million on $19.2 billion of sales. Plus, in PayPal, an online-payments system, and Skype, an internet-communications service, eBay has two unappreciated businesses whose growth is far outstripping that of many other technology-based services.
To be sure, eBay is not the bargain it was at the market’s lows in March, when it traded below 10 a share. A pullback below 20 would not be surprising after the stock’s recent run-up – indeed, it might be welcomed by careful investors. Yet, eBay could trade up to the high-20s – a level last seen in the summer of 2008 – in the next year or so, as sales and earnings resume growing.
Ju, the RBC analyst, began recommending the stock following eBay’s latest earnings report. He says there is an upside tilt to sales trends in the marketplace segment, and that the “multiple has room to expand as [eBay] begins to string together additional signs of platform improvements.”
The rally since March in eBay’s shares reflects growing confidence that the company’s sales trends are stabilizing after a rocky stretch, and that the improvements to the marketplace site instituted by Donahoe and his team are gaining traction. Donahoe, 49, joined eBay in 2005 to run the marketplace business, following a 20-year career as a consultant at Bain & Co., most recently as the firm’s CEO. His emphasis on operational efficiencies, return on capital and cash-flow deployment reflects this background, and will leave eBay better-positioned as the global economy improves.
Bob Swan, the company’s chief financial officer, describes eBay as a facilitator of “goods transfer.” Snow emphasizes that the e-commerce industry is relatively young; online sales represent just 6% to 7% of total retail sales, and are growing at a 15% annual rate. Approximately $60 billion of online transactions were made through PayPal last year, up 27% from a year earlier; the service’s total payment volume represented nearly 9% of global e-commerce, and 15% of U.S. transactions.
EBay aims to produce mid-single-digit percentage gains in earnings, and an aggregate $6 billion to $7 billion of free cash flow.
EBay’s stated objective is to build annual revenue – an estimated $8.5 billion this year – to between $10 billion and $12 billion by 2011. The company aims to produce mid-single-digit percentage gains in earnings, and an aggregate $6 billion to $7 billion of free cash flow. If investors believed it could meet those goals, its shares likely would be higher. Yet, these targets are achievable, especially as the economy picks up.
Stock options outstanding lead to systematic overstatement of profits.
Ebay, like many tech-related companies that liberally issue stock options, reports non-GAAP [generally accepted accounting principles] earnings results and forecasts. They exclude stock-based employee compensation and some goodwill amortization. Barron’s has long argued this leads to systematic overstatement of tech profitability, but it does nothing to change the valuation discount of eBay versus other, similar companies.
Last year, eBay’s marketplace unit contributed about 65% of total revenue, and 80% of operating income. PayPal accounted for 28% of revenue and 16% of income – proportions that have been growing with the unit’s sales and profits.
Skype the clear winner in internet calling – so much so that its name has become a verb.
Skype, which still chips in less than 10% of revenue, is growing by more than 420% a year. It has 481 million registered users, and is the clear winner in internet calling – so much so that its name has become a verb. EBay plans to spin off the unit through a stock offering early next year, in an acknowledgment that Skype is not symbiotic with the rest of the company. A spinoff, however, could spotlight Skype’s value, and simplify eBay’s business mix. Donahoe has said Skype could be valued at $2 billion or more in the public market.
These days, eBay is getting an increasing percentage of its business from abroad. Non-U.S. revenue accounted for 54% of total second-quarter sales of $2.1 billion. In countries such as England, Germany and Korea (where eBay acquired its largest competitor, GMarket), auction activity is several times as popular as in the U.S.
In stark contrast to a decade ago, and even five years ago, when aggressive-growth investors swarmed into eBay’s shares, the company’s stock now is largely in the hands of a more value-oriented crowd. Big holders, who have upped their positions this year, include Southeastern Asset Management and Dodge & Cox.
Sell-side analysts remain skeptical. Contrarians take note.
Sell-side analysts remain skeptical of eBay’s prospects. Only eight of the 32 analysts who cover the company recommend its shares, while three have Sell ratings. Even the putative bulls do not see much upside; none has a price target above 25. Contrarians, take note: Street sentiment in the face of a strongly performing stock and improving corporate performance often is a recipe for further investment gains.
In some respects, the analyst cadre remains overly focused on the company’s core auction business, using “gross merchandise volume” as the key measure of eBay’s results. The gross value of merchandise sold in the latest quarter at fixed prices, often from large retailers and manufacturers, surged 19% from a year earlier, adjusted for foreign-currency translation. That more than offset a 17% decline year-to-year in auction volume.
The most unique and valuable franchise within eBay – PayPal.
Yet this focus obscures the most unique and valuable franchise within eBay – PayPal, the secure online-“wallet” payment processor. PayPal handled $16.7 billon worth of transactions in the second quarter, up 19% year over year after currency adjustments. Its loss rates are microscopic. The proportion of eBay transactions consummated via PayPal has risen from 56.5% to 64.4% in the past year. The larger opportunity is signing up more third-party merchants, both sole proprietors and large retail chains.
EBay management is committed to doubling PayPal’s revenue in the next three years. Given that investors happily pay 23 times earnings for Visa International (V), whereas eBay, as a whole, trades for 14 times earnings, the likelihood that PayPal increasingly will contribute a higher percentage of company profits is another argument for eBay’s valuation to rise over time.
Christa Quarles, an analyst at Thomas Weisel Partners, values the PayPal business at a multiple of 13 times cash flow, nearly twice what she suggests the core eBay-marketplace business is worth.
Once Skype is carved out of eBay next year via an initial public offering, PayPal’s sway in driving company profits should become clearer to the Street.
A valid concern among some investors is eBay’s hit-and-miss acquisition record.
The Skype separation, a mere four years after its expensive and much-criticized acquisition by eBay, points to a valid concern among some investors: that eBay has a hit-and-miss record with acquisitions, which, after all, are a key use of all that lush free cash flow.
Shopping.com, acquired in 2005, was not exactly a boon to the bottom line. And when eBay bought Bill Me Later – a PayPal competitor that extends credit to riskier consumers – late last year, the deal was ill-timed, if strategically defensible.
EBay’s 2nd quarter e-commerce volume rose 2.7%, bolstered by greater sales of fixed-price goods.
Skype’s pretax margins run above 20%, hinting that its stock could get a generous reception once an IPO is executed.
Skype might never have meshed with the rest of eBay, but it has proved a category killer, with far more users for its telephony and video-conferencing services than its nearest competitors. Pretax profit margins in the Skype unit run above 20%, hinting that its stock could get a generous reception once an IPO is executed. There are some legal challenges to Skype’s technology, however, so investors must remain alert to headline risk on the way to the spinoff.
There have been consistent suggestions over time that eBay itself could become a takeover target by a large online player covetous of its traffic and network efficiencies. These, presumably, could be leveraged into greater advertising revenue if integrated into a Google (GOOG) or Microsoft (MSFT).
It is plausible, but hardly probable, given eBay’s relatively new top management, which by its own admission is only halfway through a long turnaround campaign. But the very things that make eBay so attractive as a hypothetical buyout target argue that investors should consider bidding for its shares as those promised results are delivered in the next couple of years.
SIX REASONS TO LIKE STOCKS
Wells Capital Management’s strategist, James Paulsen, likes stocks. He contends they are pretty cheap, at a current P/E of 15, and that with all the cost-cutting “corporate profits are spring-loaded to catapult higher even without strong economic growth.” Also, “There will certainly be a ton of buying power available once any bear conversion takes place.”
This last one amounts to the assertion that some of all the money and credit created of late will find its way into the market. That we will buy. We think that is what is behind the strong market action since March. But what happens when people realize that credit-creation is out of control? We suppose stocks may preserve their real value better than bonds.
We will return to a theme we have encapsulated in the advice: “Don’t bet cake in an attempt to win some icing.” If you can afford to lose the money, be our guest and engage in some intelligent speculations with it. If you cannot, capital preservation is the order of the day. Playing the stock market does not make our capital preservation playbook.
Tony Boeckh – chairman, chief executive, and editor-in-chief of Montreal-based BCA Research, publisher of the highly regarded Bank Credit Analyst, up until 2002 – and his son Bob eloquently expressed a similar sentiment (see above): “Holding well above average liquidity, in spite of the paltry returns, is sensible for most people whose pockets are not deep enough to absorb another hit to their net worth. They are in the unfortunate position of having to wait until the air clears a bit and more aggressive action can be taken with higher confidence.”
Moreover, we suspect if the market turns tail that Paulsen will suddenly come out with a list of reasons why the market will continue to fall. Markets make opinions.
Even after the stock market’s boffo performance in July, investors can be forgiven for feeling some trepidation, if not fear and loathing, about stocks.
Up nearly 50% from the March lows, the Standard & Poor’s 500 certainly inspires a measure of vertigo after so furious a rally. Moreover, last Friday’s gross domestic product numbers show the all-important bulwark of economic growth, consumer spending, turned negative in the second quarter.
Even good news on the recession and housing fronts is invariably met with predictions that the pain is far from over and a second dip impends in the near future. Finally, employment and consumer confidence measures, albeit lagging indicators, still signal much gloom.
So we were intrigued by a report put out last week by Wells Capital Management’s strategist, James Paulsen, contending, in line with his generally sunny Minneapolis point of view, that investors not only should stay in stocks, especially if they are fortunate enough to be well-positioned, but also keep buying. His argument was distilled into six persuasive bullet points – all commonsensical enough, at least if one can blot out the trauma endured by investors during the worst financial and economic collapse of the post-World War II era.
First, one must ignore the 45% to 50% jump in the market averages since March. This was in fact something of an optical illusion, amplified by the percentage gain off momentary, panic lows. In fact, all the furious rally of recent months did was carry the stock market back to levels that existed before the September 2008 bankruptcy of Lehman Brothers, which unleashed the global financial-system meltdown.
At current levels, the market is still more than 1/3 lower than index highs. In fact, if one puts a 2-year chart into perspective, all the price action of the 9 months seems nothing more than a long bottoming process. Or, as Paulsen asserts in his report, “Equities may have lifted off of crisis lows, but a new bull rally based on and driven by a sustained economic recovery has not yet even started.”
Second, according to Paulsen, stocks are still cheap, signaled by their current price/earnings ratio of 15. Sure, that multiple is only about average over stock-market history. But when the ratio is adjusted for the current low level of inflation and slack competition from the low interest rates now extant, the valuation of the stock market is cheaper than at any time since the 1950s and remains in the lowest quartile of valuation since 1870.
Paulsen likewise contends many are also ignoring the “spectacular profit leverage” that corporations will enjoy once revenues turn up. Companies have cut inventories, payrolls and capital spending with an alacrity and vigor never before seen, in expectation of a coming global depression. Actual wage cuts have cropped up in many industries for the first time since the Great Depression. Productivity, or output per man hour, has risen even during the economic slide.
In other words, corporate profits are spring-loaded to catapult higher even without strong economic growth.
Also bullish is the fact that investor sentiment is in the dumpster. He calls it “dominance of doubt.”
Investors put little trust in bullish developments such as the much-maligned economic green shoots, the sharp narrowing in the yields of all manner of fixed-income instruments over Treasuries, or even corporations reporting better-than-anticipated earnings. This psychology could lead to huge upside price potential in stocks once the bears become converted, he argues.
There will certainly be a ton of buying power available once any bear conversion takes place. Cash holdings amounted to about 95% of the value of U.S. stocks at the end of the first quarter. Paulsen argues that given the current environment of inflation and interest rates, this ratio of cash to market cap should stand at around 50%. That would leave, by his reckoning, nearly $5 trillion of cash currently sitting on the sidelines available to push stocks markedly higher.
Last, Paulsen harks back to the old stock-market adage that one should not fight the Fed. Only in this case, investors timorously avoiding stocks are fighting not only the Fed but also Treasury, a pedal-to-the-metal fiscal policy, and central banks and governments all around the globe. All are working mightily to stimulate the global economy and bolster asset values.
Certainly the stock market figures to offer investors a bumpy ride. After all, financial markets exist to provide capital and not offer investors an anxiety-free road to riches. But if Paulsen is right – and we hope he is – then stocks these days merit accumulation and not disdain.
A “JUNK” RATING FOR AMBAC – TWO YEARS TOO LATE
An empirical fact of life is that the big ratings service agencies’ assessments are lagging rather than leading indicators of financial strength, at least when it comes to major downgrades. In virtually all the big collapses one would have been far better served by tracking the companies’ stock prices than tracking the ratings. The oligopolistic ratings service industry appears to retain its stature by virtue of institutional inertia.
Case in point: Ambac. The stock prices of Ambac and its fellow bond insurers fell off a cliff in 2007. Announcements of large writedowns proliferated. The uncertainties surrounding their financial viability have been well publicized ever since. Anyone looking at the leverage involved versus the low quality of the credit instruments “guaranteed” would have concluded that bankruptcy was a likely outcome. Yet only on July 31 of this year did Standard & Poor’s push Ambac into junk territory – a full two years late. A year earlier Moody’s downgraded Ambac and MBIA from Aaa, after their shares had fallen over 90%.
Oddly, many members of the mainstream financial media tagged along with the ratings agencies’ assessment, going along with the ratings agencies’ obsolete rankings. The people at Elliott Wave International, however, operating under the credit bubble framework, started warning that AAA credits were suspect in early 2007. And they noted in late 2007, following Ambac et al’s stock price declines, that the “credit crunch is climbing the quality ladder.”
It was basic common sense to deem companies with leveraged exposure to the credit bubble as suspect. That seems to have eluded the ratings agencies and the mainstream press.
In theory, credit-rating agencies are to companies what Kelley Blue Book is to cars. They reveal the “true value” of a firm’s securities after taking into account “wear and tear.” A higher grade indicates lesser risk and greater “resale price.” A lower one equals big risk and rapid depreciation.
In reality, however, this is not the case with credit-rating agencies. So often, a rating service will assign unit “X” a good-to-excellent grade – only to find it cast into the “JUNK”-yard soon after.
In his 2002 New York Times Business Bestseller Conquer the Crash, Elliott Wave International’s president Robert Prechter revealed the danger in judging a financial entity by its ratings cover. In his own words:
“The most widely utilized rating services are almost always woefully late in warning of problems within financial institutions. They often seem to get news about a company around the time that everyone else does. ... In several cases, a company can collapse before the standard rating services know what hit it.”
The name “Enron” might ring a bell. On November 30, 2001, the company maintained an “investment grade” rating. Four days later, it filed for the largest bankruptcy in U.S. history.
Flash ahead to today. On July 31, 2009, Standard & Poor’s rating service pushed the leading bond insurer Ambac into junk territory – TWO years TOO late. (“AAA” Spells “Trouble”: If the credit crisis is nearing its bottom, then why are the top-rated bond insurers seeing a wave of selling? It is the story we saw coming. Get the latest Financial Forecast Service today.)
Fact is, since the start of 2007, deep and obvious cracks such as slipping share prices, billions of dollars in write downs, and underperformance began to appear in Ambac’s foundation. Yet – the mainstream experts continued to keep their faith in the firm, while the raters continued to uphold its triple-A status. Here, the following news items from the time say plenty:
- July 2007: “[Ambac] had minimal exposure to subprime mortgages, and should fare better in terms of losses. Ultimately, it’s going to weather this.” (New York Times)
- December 2007: “The reaffirmation of Ambac’s Aaa rating should be a big positive for the shares.” (Bloomberg)
- February 2008: “Investors sent Ambac shares up amid hopes that the broad credit-market losses may soon subside. The Standard & Poor’s decision to keep the firms triple-A rating shows the strength of our capital base.” (AP)
Our team of analysts could not have disagreed more. First, the March 2007 Elliott Wave Financial Forecast alerted readers to the “extension” of the subprime debacle across the “depth and breadth” of the credit universe and wrote: “Ultimately the economy will turn down and AAA credits will follow the subprime line” on the [left side of] chart below.
Then, the November 2007 Elliott Wave Financial Forecast addressed the “mounting losses” at Ambac and MBIA and offered the right-hand illustration of how rapidly the “credit crunch is climbing the quality ladder.”
Only after the shares of Ambac and MBIA had plummeted 90%-PLUS did Moody’s Investors Service Inc. downgrade their Aaa status on June 19, 2008. If that is how the cream of the crop performs – I’d hate to see the crop.
Lumber Is a Stiff for Now
Economists preach visible economic recovery by year end, but lumber may not join the party until much later.
A wait-and-see approach may be the best course for the lumber and housing markets, because a recovery is shaping up to be a slow, drawn-out affair. Ashley Boeckholt, vice president of sales for lumber brokerage Bloch Lumber, says there still are too many existing houses to work through before lumber can make any kind of a sustained recovery.
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