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HOUSE PRICES MIGHT NOT FALL OFF A CLIFF
The Optimist has not yet heard any rumors about the Fed being able to prevent the unwinding of the housing bubble once it begins, so he is happy to have this opportunity to start one. Consider that refinancing mortgages to provide cash back for spending is a major pillar on which the consumers’ ability to spend rests. A serious problem with consumers’ cash flow in this housing bubble could be disastrous for the economy. Even a simple decline in house prices could begin an avalanche of foreclosures because many house buyers are drastically over extended. A significant downturn in the prices of real estate would have a very damaging effect on the economy. The fed is likely to exercise its powers to protect the economy, even if that requires putting a floor under real estate prices.
All of the readers who agree completely with the Optimist are certain that house prices have inflated a massive bubble. The Optimist is not aware of any historical precedent for a housing bubble of this magnitude, so he cannot show you the awful results after a similar bubble encountered a sharp pinpoint. The Optimist can, however, share with you the learning experience of a lifetime he was fortunate enough to have survived in Houston. More than 20 years ago, the Houston economy was as hot as a car parked in the broiling summer sun at noon in Houston. Then, in 1986, crude oil fired a bullet through the Houston real estate bubble. In a few short months, the price of crude oil plummeted from $30 to $10. People who had put 20% down on the purchase of their dream home in 1985 were suddenly deep in the red only a few months later as house prices in Houston plunged 50%. The word “foreclosure” did not adequately describe the traumatic financial carnage as people all across the city simply walked away from entire neighborhoods of recently constructed homes.
It is unimaginable that the Fed would permit a comparable economic devastation throughout the entire nation if they have the means to avoid it. Some pessimistic people may think that the Fed is powerless to prevent the housing bubble from collapsing, and thereby thrusting the nation into a deep depression. The Optimist offers a more positive possibility. The Optimist is quite content to agree that inflation must rise, and that long term rates must eventually rise with inflation. When rising long term rates begin to threaten the housing bubble, however, the Optimist offers the positive view that the Fed, working through its friendly subsidiary banks, will find new ways to prevent the housing market from imploding.
Even though the Optimist previously slew the Worry About Deflation dragon, that multi headed Hydra continues to pop up in web sites everywhere. Those sites argue variations of (A) there is already much too much debt (astoundingly true); (B) the economy is weak from loss of solid manufacturing jobs (sadly true); (C) low cost foreign labor will prevent the US economy from adding the dependable jobs that are needed for sustained growth (frustratingly true); (D) a perpetually weak economy cannot afford to pay the escalating debt service costs (frighteningly true); (E) the trade, current account, and budget deficits all add crushing new debt at an ever faster rate (unbelievably true); (F) the combined weight of all these negatives makes a depression unavoidable (inevitably true); and (G) therefore there will be deflation (probably false).
Those who correctly foresee the coming depression persist in remembering the Great Depression of the 1930’s. That was a dreadful time in America, and deflation acted to make the pain far worse than it otherwise might have been. It was not possible then to have a depression without deflation because legal tender was gold and silver. Even after FDR confiscated gold from Americans, the dollar was still convertible to gold overseas. Because money in the 1930’s was gold and silver, deflation was an unpreventable economic reaction to the financial excesses of the 1920’s. Compare and contrast the 1930’s with now. Even though a depression is just as inevitable over the coming years as it was 75 years ago, deflation is now optional. The Optimist can offer no guarantees, of course, but he is grateful that he has the opportunity to bet that politicians will always opt for the relatively easy and less painful path of inflation than the sure political and economic death of falling into a deflationary depression. The stagflation and rising misery index of the 1970’s will show the direction in which our present economy will move into the future.
The Optimist has argued that the Fed will not permit the housing bubble to collapse, and will not tolerate deflation. Does that mean houses are good investments? No! Even as the fires of inflation burn ever hotter, the economy continues to cool as it slides toward depression. The profit outlook for stocks is bleak. Without growing profits, the rise in stock prices will be sluggish at best. Similarly, as more Americans lose their jobs, the number of greater fools who bid up house prices will dwindle. Stocks and houses will also find it difficult to advance against the strong headwinds of higher long term interest rates and rising taxes. The Optimist guesses that the prices of stocks and houses will rise over the next decade, but at a rate which is much less than inflation. If that guess is correct, then a chart of the inflation adjusted prices of stocks and houses should soon peak and begin a slow descent into the future. That inflation adjusted chart is where the proponents of deflation will find what they seek. Even though the nominal prices will stay steady or climb slowly, the true values will inexorably decline due to the loss of purchasing power caused by inflation.
The prices of precious metals, in contrast, will not only advance with inflation, but will likely rise faster as the price compression of the last two decades is released. The Optimist is grateful that he has several ways he can invest his wealth in precious metals.Link here.
The brilliant Hyman Minsky viewed Capitalism as “a dynamic, evolving system… Nowhere is this dynamism more evident than in its financial structure.” He saw long periods of stability as breeding grounds for increasingly destabilizing behavior. Economic agents progressively reach for profits, risk and leverage, in the process constructing more fragile debt structures. When he died in 1996 he had spent much of his life hypothesizing as to whether the financial backdrop could reach a sufficiently fragile state where “It” (a depression) could happen again. If only he had lived another decade.
I have proposed a “Minskian” evolution from Money Manager Capitalism to “Financial Arbitrage Capitalism”. Command over the Credit system – hence the “capitalist economy” – has shifted away from “corporate boardrooms” and “institutional investors” to investment bankers, derivative players, and the “leveraged speculating community”. Moreover – and in a momentous departure from Minsky’s era – the consumer loan has become the locus for system Credit creation, supplanting business borrowing to finance capital investment. Thinking Minsky, one can confidently suggest that such historic financial system change provides monumental implications for the nature of both economic development and system stability.
The current environment is remarkable in so many ways. For one, many knowledgeable and seasoned analysts speak today of a “secular decline in volatility.” After the global tumult experienced during the second half of the nineties and the first few years of the new millennium, there is now expectation that we have commenced a period of financial and economic stability (confirmed by economic resiliency and minimal marketplace risk premiums and “implied volatilities”). Yet, Thinking Minsky, the extraordinary advance in risk-taking and debt that transpired over the past decade is much more consistent with mounting financial fragility and system instability. Indeed, one can make a strong “Minskian” case for the progression over the past decade to a perilous state of Systemic Ponzi Finance. What gives?
Minsky was keenly focused on how central bank validation of speculative practices guaranteed a more precarious inflationary boom. Never has such excess been “validated” and on such a global scale. Financial Arbitrage Capitalism, with its fixation on asset-based lending, leveraged speculation, U.S. consumption and massive Credit inflation, has taken the world by storm. Finance has evolved from vulnerable and less than “robust” to exceedingly “fragile” on a global scale, although this fragility is masked by robust housing inflation, ballooning central bank balance sheets, and overly-abundant global liquidity. Until rising rates, a dollar crisis, or some other major development exposes the acute frailty inherent in Historic Systemic Ponzi Finance, we should be on guard for fascinating developments. $60 crude is indicative of the swapping of inflating global monetary units for less abundant real things with inherent value and inflating market prices. This could prove contagious. And while the Japanese were content to trade our IOUs for Pebble Beach, Los Angeles office buildings, movie studios, and other overvalued properties, the Chinese are keen on energy, commodities, capital equipment and other resources.
Thinking Minsky, he was keen to have policymakers recognize the “flaw” in Capitalism. I am more inclined to underscore Capitalism’s “vulnerabilities”. However, the critical flaw in Financial Arbitrage Capitalism is that speculation and leveraging excess begets greater excess, with the marketplace woefully incapable of self-adjustment and central banks unwilling to risk reining in The Powerful Speculator Class. And while the leveraged speculating community may be indefinitely satisfied to expand leveraged holdings of increasingly suspect and fragile U.S. (“Ponzi”) mortgage securities and instruments, the rest of the world surely is not. Moreover, the risks associated with a higher cost of finance may have been taken out of the equation, but this only elevates the key issue of how overly abundant cheap finance is utilized in regards to economic development. A prolonged period of Systemic Ponzi Finance – with all the associated weakened debt structures and global financial and economic fragilities – ensures that “It” can happen again.Link here (scroll down to last article/heading on page).
There is good growth and bad growth. The former is well supported by internal income generation and saving. The latter is driven by asset bubbles and debt. The U.S., in my opinion, has been on a bad-growth binge for nearly a decade, but especially over the past five years. In a U.S.-centric global economy, that means the rest of the world has also become overly dependent on bad growth as the sustenance of a false prosperity. The endgame is all about the transition from bad growth back to good growth. The key question is under what conditions that transition occurs.
With a saving-short U.S. economy now hooked on an increasingly frothy property market, risks of the ultimate post-bubble shakeout are mounting. That is because, unlike the equity bubble of the late 1990s, the housing bubble has been built on a mountain of debt. The history of asset bubbles tells us they almost always last for longer than we think. That was true with the dot-com mania and is most assuredly the case today. The bursting of bubbles remains a great mystery. Macro offers two leading possibilities – rising interest rates or a shortfall of income growth. In my days as a bond bear, I used to think that rising interest rates would wean America from the excesses of asset bubbles once and for all – not just piercing the housing bubble but also triggering an unwinding of “carry trades” that stoke ever-frothy fixed income markets. As a newly converted bond bull, I now believe the imminent threat of such a possibility has receded. While that buys time, it does so with one more slug of bad growth. By dodging the interest-rate bullet, the debt-intensive Asset Economy may well get another lease on life – making for an ever more treacherous endgame.
The Fed is the swing factor in this outcome. And so far, it has swung its support repeatedly in favor the multiple bubbles of the Asset Economy. The Fed remains steadfast in its insistence that all is well because it is on a “measured” path toward policy normalization. While this week’s widely expected 25 b.p. tightening may add some credence to that impression, it will be the policy statement that tells us if the central bank’s commitment is wavering. The latest musings of Fedspeak are more ambiguous than usual. Steeped in denial, the Fed is trying to deflect attention away from its role in this sad state of affairs – choosing, instead, to focus the debate on the so-called interest rate conundrum. The central bank can only do so much, goes the plea – it is up to the markets to do the rest. So far, with the federal funds rate basically at zero in real terms when judged by forward-looking inflationary expectations, the Fed has hardly done much at all. But that has not stopped Alan Greenspan from going on at length in considering and then dismissing many of the factors that may account for this puzzle. Interestingly enough, the excess policy accommodation of the Fed has been conveniently left out of this discourse. It may well be that the real conundrum lies with the Federal Reserve, itself.
Despite all the special circumstances that the Fed has offered as explanation for the current yield-curve flattening, I suspect that this pro-growth central bank will do everything in its power to prevent the yield curve from inverting. Largely for those reasons, I suspect the U.S. interest rate climate is likely to remain surprisingly benign and, therefore, supportive of yet another wave of debt-intensive asset inflation. As a result, the housing and bond bubbles could well continue to expand, allowing asset-dependent American consumers to keep on spending. U.S. economic growth, in that climate, may well remain surprisingly firm – even in the face of $60 oil. All this would be a textbook example of another period of “bad growth” – the last thing an unbalanced U.S. and global economy needs. The bear case for rates that I now support is likely to come later rather than sooner – and off lower levels of longer-term rates than I had previously thought possible. Because of that hiatus, there is little to stop the Asset Economy for the time being.
Meanwhile, the excesses in the U.S. property market are now starting to display all the classic symptoms of a mania. It is not just the growing profusion of exotic financing schemes – the interest-only and negative-amortization mortgage loans that have become the rage in the hottest of real estate markets. Equally worrisome is evidence that “asset flipping” is now reaching Ponzi-like proportions. The latest rage is www.condoflip.com – a website dedicated to creating an electronic market whereby “buyers of preconstruction condos resell or assign those condos to new buyers.” Debuting in Miami, expansion is set shortly for Las Vegas, Los Angeles, Dallas, Chicago, and New York. If you hurry, you may even be able to own a “Condo-Flip” franchise of your own. Five years later, this is nothing more than a reincarnation of the day-traders of the dot-com era.
As former Fed Chairman Paul Volcker noted recently, the saddest thing of all is that no one in a position of responsibility wants to put an end to this madness. Congress is focused on fiscal profligacy and China bashing. The White House is fixated on “transformational politics”. The Fed remains steeped in denial. And the rest of the U.S.-centric world is begging for another spin around the track. Sadly, bad growth begets more bad growth – until it is too late. Following this week’s likely rate hike, the U.S. central bank will have only 325 b.p. in its arsenal – literally half the ammo it had five years ago when the first bubble popped. With the aftershocks of the property bubble likely to be far more worrisome than those of the equity bubble, this time the Fed may be ill equipped to face what is shaping up to be an increasingly treacherous endgame.Link here.
EVEN WITH NO BUBBLE, HOUSING COULD BE TROUBLE
When Fed Chairman Alan Greenspan and his central banker colleagues hold their two-day midyear meeting on monetary policy this week, America’s booming housing market will be very much on their minds. It is certainly on the minds of economists participating in MSNBC.com’s semi-annual roundtable, who describe the continuing housing boom as the biggest economic surprise of the year so far. Whether or not prices have reached “bubble” levels in the most overheated urban areas, the housing market would hardly have to collapse to cause heavy economic damage, several of our panelists warn.
“The reality is, you do not need home prices to go down – all you need is for housing prices to stop going up,” said David Rosenberg, chief North American economist for Merrill Lynch. He calculates a flattening of housing prices could trim U.S. economic growth, currently running about 3.5% a year, by a full percentage point. Rosenberg figures that over the past five years rising home values have added $4 trillion to the nation’s net worth, or 70% of the total rise in household wealth in that time frame. That “wealth effect” probably has translated to about $50 billion in additional consumer spending a year, adding half-a-percentage point to growth every year. “A lot of the economy’s fortunes hinge on the housing market, and yet it doesn’t look like it’s all that stable to me,” Rosenberg said. “The last leg has been fueled by a mountain of leverage and a lot of speculation.”
Ethan Harris, chief U.S. economist at Lehman Bros., agrees that the economy could suffer even if the housing bubble gently deflates rather than collapsing in a Nasdaq-like implosion.Link here.
Fed has few options in trying to cool housing.
In congressional testimony this month, Greenspan said he saw no national bubble but acknowledged “signs of froth in some local markets where home prices seem to have risen to unsustainable levels.” Other Fed officials, including Gov. Susan Bies, have been warning in recent weeks that some lenders need to pay more attention to the quality of borrowers and housing projects they are financing.
But beyond such “jawboning”, it is far from clear exactly what the Fed can or should do. The central bank has been raising short-term interest rates steadily since June 30, 2004, pushing the overnight federal funds rate from a historically low 1% to the current 3%. This week, on the first anniversary of the tightening cycle, the Fed is expected to nudge the benchmark a quarter-point higher for a ninth time, raising it to 3.25%. Yet such short-term rates have only limited impact on the housing market, which is driven more by interest rates on 15- and 30-year mortgages. Those long-term rates are set by global bond markets that are largely beyond the Fed’s control. And long-term rates have been moving steadily lower over the past year, even as short-term rates have moved higher. The average 30-year mortgage, for example, is currently being booked at 5.57%, compared with 6.25% a year ago, according to mortgage giant Freddie Mac.
“Unfortunately the Fed’s tools on monetary policy are not very precise,” said Diane Swonk, chief economist for Mesirow Financial. The Fed could raise short-term interest rates to 10% and “prick” the housing bubble, but that “would not necessarily be good for the rest of the economy, nor would it be prudent. The reality of it is they cannot target one industry when they are shaping monetary policy,” she said. “They can have a limited effect on the macro economy and that’s what they try to do, but they cannot target asset price bubbles.” She said the best way for the Fed to cool the housing market would be through regulatory action, ensuring that lenders impose higher thresholds before handing out loans that require no down payment and minimal monthly payments of interest only or less.Link here.
Dot-com bust holds lessons for housing.
Alan Greenspan sees signs of “froth” in some local housing markets, but says overall the nation does not appear to be in a housing bubble that could potentially burst. Such a sanguine prediction might do little to calm the nerves of anyone who remembers when the dot-com stock boom went bust five years ago and how that led to a marketwide bloodbath. Investors lost wealth they have yet to recover, and Wall Street’s collapse played a key role in pushing the economy into a recession. That is something for homeowners today to consider. It could be that even if there is not a housing bubble in their back yard, they may still get caught if demand slows elsewhere.
That “if” is the big unknown these days. Among economists, homeowners and market-watchers, there seems to be a wide range of opinions over whether the housing market has spun out of control. Recent data show the market accelerating rapidly. Home prices overall have jumped 12.5% during the 12 months ended in March. Sales of new homes in May climbed to the 2nd-highest level in history, providing further evidence that low mortgage rates continue to fuel a booming housing market. The “froth” shows up in pockets around the country where prices are soaring beyond the average. New research by Merrill Lynch looked at the housing markets in 52 large cities and found that 30 of them had signs of overheating.
Topping that list: Miami, where home prices have jumped 85% since 2001 and price-to-income levels are soaring. Six cities in California – San Diego, Riverside/San Bernardino, Los Angeles, San Francisco, San Jose and Sacramento – were also considered “white hot”. On average, home prices there have risen about 75% since early 2001, according to Merrill. More surprising, perhaps, are the price gains in Midwest markets like Milwaukee, Minneapolis and Cleveland. “House price bubbles in these Midwestern cities, where manufacturing is king and activity is on the decline, flashes even bigger warning flags, in our opinion,” said Sheryl King, the Merrill senior economist who wrote the report.
With those kind of examples, it is easy to see how comparisons to Wall Street’s technology heyday come to mind. Back in the late 1990s, the major market indexes soared; among the most extreme cases was the 5-fold gain in the tech-heavy Nasdaq composite index. That momentum boosted stock prices all around. When the tech bubble burst in early 2000, the plunge was crippling. The Nasdaq was among the hardest hit, but other broader market indexes also saw gains quickly disappear. Maybe some of what fueled the equity market’s boom then was that investors lived by what history showed, with stocks recovering losses if held long enough. What they seemed to forget was that stocks do not always quickly rebound.
The dot-com boom was fueled largely by momentum investing – a bet that hot stocks would continue to rise. The housing market seems to be working the same way. Should that momentum cool, that could put most at risk those investors who borrowed money to gamble on a quick, profitable flip of their properties.Link here.
Manhattan home prices hit new records.
The average price for residential property in Manhattan has topped $1.3 million for the first time, according to a Prudential Douglas Elliman survey which tracks condo and co-op apartment sales. The median sales price for a Manhattan apartment hit $775,000. Tight supply on the island means homeowners today pay an average $970 per square foot of Manhattan property compared to the $762 they shelled out per square foot at the same time last year, the survey results show.
The Upper East Side is the most expensive part of the city to buy, where a square foot of property costs nearly $1,000. The Upper West Side follows at $940, while about $900 will buy a square foot in downtown Manhattan. Uptown properties – primarily those north of Central Park – are the cheapest by region at $436 a square foot, but they are appreciating the fastest, with prices growing 45% from last year.Link here.
If housing bubble bursts, even non-bubble inflated Houston-area will feel gust.
The overheated housing markets on the East and West coasts may seem far removed from Houston, where home prices have been nearly flat over the past year, but the city would still be hurt if the bubble bursts. “There are lots of communities that think they are immune because their house prices are at reasonable levels,” said Barton Smith of the University of Houston’s Institute for Regional Forecasting. “But a bust in the Northeast or in California will affect places like Houston because it will be so significant that it will hurt the national economy.”
The Office of Federal Housing Enterprise Oversight, the agency that oversees Fannie Mae and Freddie Mac, reported that house prices rose across the country by 12.5% in the year that ended March 31, the biggest jump since 1979. By contrast, it found that prices rose by just 4.38% in the Houston area and by 3.77% across Texas – the lowest of any state.
Low interest rates have fueled home sales in Houston just like they have across the country. The city is adding 10,000 more new homes a year than it did during the boom years of the late 1970s and early ‘80s, Smith said. But prices have not been bid up as much as in the crowded coastal cities because builders in Houston have kept pace with demand. Geography is key. “The biggest thing that Dallas and Houston have going for them is the ability to deliver new land to the market,” said Chris Engle, vice president of AngelouEconomics of Austin. Relaxed government regulations, cheap labor and “a lot less opposition to sprawl” have also helped fuel the construction boom, he added. As a result, homes in Texas are relatively affordable. The median house price in Houston in May was $144,800, according to the Houston Association of Realtors, compared with $204,600 nationwide.
Although the Federal Reserve has said it is impossible to know if there is a housing bubble until it bursts, economists note that house prices in many markets have departed from fundamental measures such as income growth, supply of homes and rental income that properties can command. Housing busts are generally characterized by milder price drops than stock market crashes. This is because homeowners are loath to sell at prices they deem too low. But a housing correction today may in fact be steep, thanks to the explosion of risky mortgage debt in 2004. Owners with little or no equity in their homes may be forced to sell at low prices if rates rise and they cannot meet their mortgage payments.
In 2004, 20% of all conventional single-family home loans in Houston had adjustable rates, according to the Federal Housing Finance Board. This is triple the percentage than in 2003, although Houston hardly rivals places like San Diego, where adjustable-rate mortgages account for about 70% of loans. Houston foreclosure rates, which are now at levels not seen since 1991, show that many homeowners are struggling to meet mortgage payments. Across the nation, many people are borrowing against their homes to finance more spending. Others have piled on mortgage debt to gain a foothold in a hot housing market.
A collapse in house prices or a rise in interest rates would slow the national economy by reining in this willy-nilly spending and perhaps even setting off a round of foreclosures. This would be bad news for Houston. “We need the national economy to be healthy for our economy to be healthy,” Smith said.Link here.
SUCH IS THE POWER OF CERTAIN FAIRY TALES …
“Before the year is out, many money managers believe, the Fed will send a signal that it is ending its rate-increase program and maybe even preparing to cut rates. When that happens, they expect, stocks finally will break out of the doldrums they have endured for most of this year.” Not only is this quote not out of context – I asked myself why the well-known financial daily even ran the rest of the article this morning. Heck, the headline alone included 95% of the idea: “Investors Hope the Fed Will Come to the Rescue.” The plot of this story never changes. If the Fed does it, then “it” is good, and promises to rescue victimized investors.
Such is the power of certain fairy tales. Observers who think the Fed can move the markets apparently cannot muster enough critical thought to at least ASK if the Fed’s rate hike campaign started too soon and went too far. The economy supposedly turned up in 2002, yet the data shows it to be the most anemic “recovery” in decades. What is more, rates in the Treasury Note and Bond market have steadfastly refused to follow the Fed’s lead. As for those of us who reject the notion that the Fed moves markets, we are left to wonder: Did folks who believe “stocks go up when rates go down” take a two-year nap in 2001 & 2002, when the central bank cut the Fed funds rate 12 times, even as the stock market did this?
If that is what a rescuer does, I would hate to cross paths with a real villain. Investors who think they qualify for “victim” status simply because the market goes against them will remain blind to the real enemy, namely their own emotions. Don’t be locked into believing that stock market opportunities come only when prices move in one direction. Do you really want to depend on some policymaker to come to your rescue?Link here.
THE SELL-OFF IN STOCKS: FOOD FOR THOUGHT
On June 17, the Dow Jones Industrial Average soared to a 3-month high after seeing 7 straight sessions in a row to the upside – a feat unequaled in over two years. The winning streak also erased the S&P 500’s yearly losses to date. The conventional wisdom offered a feast of fundamentals for traders to chew on to justify the rise: A “less-than-expected rise in first-time filings for U.S. jobless claims” – AND – a “blowout number on the University of Michigan confidence report” – AND – the “fastest rise in durable good orders in 14 months” – AND – a 3.3% surge in the price of oil to over $58 a barrel, in the sense that stocks were able to “shrug off” the bounce in oil prices. The June 17 consensus: “Economic growth will provide a reasonable catalyst for the market from here.” (AP)
Cata-listlessness, maybe: In the week that followed, blue-chip stocks suffered a 5-session losing streak, including back-to-back triple digit losses that took the DJIA 325 points below its June 17 high. By Friday, June 24, the major averages were down some 4.5% for the year. And here, the eating of words began in earnest, starting and ending with this June 24 explanation for the fall: “Economic data isn’t positive enough – or broad enough – to make a dent in investors’ pessimism over the future effects of higher crude oil prices.” (Fox News)
Doggie bag, anyone? The problem is, conventional economics sees only what is directly in front of it, with no regard to the past or future. Our analysts do the opposite. We keep our eyes peeled to the Elliott wave pattern in prices, gauging how such forms influenced stocks in the past AND, therefore, how they will likely affect the market in times to come.Elliott Wave International June 27 lead article.
STOCK BUYBACKS: THEY’RE BAAACK
In case you had not heard, the stock buyback is back, with a capital “B”. Technically speaking, in the first quarter of 2005, company buybacks in the S&P 500 index leaped by 91% vs. the same period last year. Put another way, in the first three months of the year, companies doubled their spending on share reacquisition from $43 billion in Q1 of 2004 to $82 billion in Q1 of 2005. (AP June 27) You may even have received a letter in the mail requesting your attendance at the next shareholder meeting, as buybacks require the approval of shareholding investors.
And as far as Wall Street is concerned, those kinds of letters should be taken with an entire seashore of über-bullish salt. Anyway you taste it, buybacks occur when a company believes its stock is undervalued. They either hold the repurchased shares and thus reduce the number available on the open market, and hopefully raising its price… OR, they redistribute the shares among employees and executives in the form of stock options, bonus incentives, pension plans, and the like – in essence suggesting the shares will appreciate faster than cash held in a bank.
It is an old practice, in a very different time. Briefly, stock buybacks took the financial world by storm in the early 90’s, after a 1993 legislative act made the whole thing legal. Back then, though, in the raging bull market and New Economy, companies had the balance sheets to back up glowing forecasts for future gains. Yet today’s buybacks are often an effort to boost the value of a failing company’s fledgling stock NOW, with the idea that it is only a matter of time before things turn up and shares reach their rightfully higher level.
What we have today are buybacks based NOT on hard-core facts but rather on HOPE. And really, who can blame them? As the June 2005 Elliott Wave Financial Forecast observes: “Company officers are part of the market’s psychological fabric just like everyone else.”Elliott Wave International June 28 lead article.
A BOOMING CHINESE EXPORT
Last year, China exported 504 million pairs of socks, 73 million cell phones … and 30 million tourists. Tourists have become one of the country’s leading “exports”. Wanderlust, it seems, is but one of the many by-products of the flourishing Chinese economy. As Chinese tourism grows, many of the world’s leisure companies will enjoy what could be a very, very long boom. Two years ago, for the first time, outbound Chinese tourists outnumbered their Japanese counterparts. By 2020, the World Tourism Organization predicts Chinese will be taking about 100 million trips a year – placing them fourth on the list of the world’s most frequent travelers behind the U.S., Germany and Japan. And by 2035, the Chinese will likely become the world’s leading globetrotters. Between now and then, many companies stand to benefit, especially those operating in and around China itself.
The growing swarms of Chinese travelers are changing the face of tourism worldwide. For starters, many hoteliers have learned to apply Feng Shui concepts to room layouts, to serve “congee” [a rice porridge] on breakfast buffets alongside eggs and bacon and to avoid placing their Chinese guests on the “unlucky” fourth floor. But Chinese tourists are also changing the economics of global tourism. “It is not just the sheer number of potential travelers that is making this group attractive, but also their spending power,” Eurobiz magazine relates. Down in Australia, the Chinese already top the list of big-spending tourists.
“All across the Pacific,” the New York Times reports, “officials are vying to net the elusive, wealthy Chinese tourist, seen as the big-spending successor to the Arab tourists of the 1970’s, fueled by oil dollars, and the brandaholic Japanese shoppers of the 80’s and 90’s. The Chinese now dominate or account for a large slice of foreign tourism in Hong Kong, Macau, Singapore, Taiwan, Malaysia, Thailand, Vietnam and Indonesia.” We suspect, therefore, that hotel and leisure companies throughout the Pacific Rim will reap the bulk of the Chinese tourism bounty. Last fall, colleague Christopher Mayer identified one such company: Orient Express Hotels (NYSE: OEH). It would be a stretch, however, to label OEH a pure “China play”, since only about one quarter of the company’s revenues derive from the Pacific Rim. Meanwhile, Shangri-La Asia Ltd. (Hong Kong: 69), a much more focused play on Chinese tourism, has gained “only” 45% since last fall, vs. OEH’s almost 100%. Shangri-La’s share price, at 20 times estimated earnings, reflects much of the company’s near-term growth prospects. But we suspect the stock has not yet “priced in” its prospective earnings of 2035.Link here.
CHINA EXPORTS CARS IN A SIGN OF AN ECONOMY RISING TO RIVAL U.S.’S
GUANGZHOU, China – A line of Chinese-made cars began rolling onto a ship here Friday, bound for Europe. The cars, made at a gleaming new Honda factory on the outskirts of this sprawling city near Hong Kong, signal the latest move by China to follow Japan and South Korea in building itself into a global competitor in one of the cornerstones of the industrial economy. China’s debut as an auto exporter, small as it may be for now, foretells a broader challenge to a half-century of American economic and political ascendance. The nation’s manufacturing companies are building wealth at a remarkable rate, using some of that money to buy assets abroad. And China has been scouring the world to acquire energy resources, with the bid to buy an American oil company only the latest overture.
Indeed, fierce domestic competition and a faster accumulation of financial assets are laying the groundwork for the arc of China’s rise to be far greater than Japan’s. “It’s going to be like the Arabs in the 70’s and the Japanese in the 80’s – we were worried they’d buy everything,” said William Belchere, the chief Asia economist for Macquarie Securities in Hong Kong. But unlike those previous challenges, which soon faded, “longer term,” he added, China will “be a much bigger force.”
China’s economy has risen rapidly with foreign expertise and investment. The Guangzhou airport here has a terminal designed by an American company, boarding gates supplied by a Danish company, and an air traffic control tower engineered by a company from Singapore. The resulting bilateral corporate tango – in contrast to the confrontations reminiscent of the 1980’s and early 1990’s when Japanese capital poured into the U.S. – means that China has many American corporate comrades, who have a stake in helping generate its growth.
China, economists and Asia experts say, does not face some of the inherent limitations that ultimately stymied Japan and led to economic stagnation there over the last 14 years. With its giant population, China is developing a large and diverse economy, creating an almost Darwinian competition for a domestic market that has extremely low-cost companies ready to export inexpensive goods around the globe. “The economy is much more flexible, adaptable than Japan’s,” said Liang Hong, an economist in Hong Kong for Goldman Sachs. “Being a continental economy is an advantage because it has competition within.”
To be sure, China is still at an earlier stage of development than was Japan when its economic rise became a national obsession in the U.S. In the 1980’s and early 1990’s, Japanese companies claimed a sizable chunk of the American car market and purchased Rockefeller Center and the Pebble Beach golf course. The bid by the China National Offshore Oil Corporation for Unocal has raised worries among some politicians in Washington. That $18.5 billion bid comes as America’s trade deficit with China is ratcheting ever higher and the dollar is getting support from rising inflows of Chinese capital, which also helps support low interest rates.
More disconcerting to others in Washington is China’s growing ability to finance any political and military ambitions. But China’s economic rise also faces many obstacles. Its banks have huge portfolios of nonperforming loans that have not yet become a crippling problem because of rapid growth, but that could, as in Japan, make a recession someday even harder to combat.Link here.
IS IT TOO LATE TO INVEST OVERSEAS? (NO)
Every once in a while, a university or think tank releases a study suggesting just how insular Americans are. Only 7% of Americans own passports, according to a recent survey, and as recently as three years ago, just 13% of Americans between 18 and 24 years of age could find Iraq on a map. When it comes to stocks, however, Americans seem to be coming around to the notion that their investment horizons do not end with Microsoft, General Electric, and eBay. Over the past year, some investors have steered a disproportionate share of their assets to funds that invest overseas. Performance-chasing is no doubt partly to blame. After all, the MSCI EAFE Index, which is composed of the largest stocks from developing countries outside of the U.S., is in the middle of its 5th consecutive year of outperformance over the S&P 500 Index. But it is also highly likely that some U.S. investors have woken up to the idea that their portfolios have too much of a home-market bias.
There is also a fundamental argument for staking more of your portfolio overseas, according to three top managers who appeared at Morningstar’s Investment Conference last week. Jeffrey Everett, chief investment officer of Templeton Global Equity Group and lead manager of Templeton World and Templeton Foreign; Sarah Arkle, CIO of British money-management firm Threadneedle, which oversees AXP Threadneedle Global Equity; and Bill Fries, lead manager of Thornburg International Value and the 2003 Morningstar International Fund Manager of the Year, painted an optimistic picture for overseas markets. What is more, all three, who have the freedom to invest both domestically and abroad, repeatedly dismissed the widely held suspicion that foreign stocks are somehow inherently riskier than domestic equities.
Although he prefaced his remarks by saying that investors should maintain a healthy mix of U.S. and non-U.S. stocks, Fries argued that international markets offer an expanding set of opportunities: By ignoring foreign stocks, investors are not only losing out on currency diversification but also exclude themselves from a host of global industry leaders, such as Japanese automakers Toyota and Honda. A number of smaller obscure companies that have plenty of room to grow exist overseas, too, he said, adding that as foreign economies prosper and gravitate more toward free-market capitalism, one should expect an increasing amount of privately held firms – both small and large – to come to market. Everett echoed those remarks, making a reasonable assertion that sparse Wall Street research coverage has created a unique chance for managers to unearth off-the-radar foreign small- and mid-cap firms.
Everett, who has long been underweight in U.S. stocks in his global offering, Templeton World, added that while the U.K. and continental Europe might be growing at a slower pace than the U.S., both regions are still home to a host of high-quality companies with globally diversified revenue streams, such as GlaxoSmithKline. Arkle agreed. Although her team at Threadneedle has been slowly increasing its exposure to U.S. equities over the past year, the firm’s funds remain overweight in non-U.S. stocks relative to the MSCI EAFE World Index. In addition, valuations are generally more compelling overseas than in the U.S., the panel concluded. Price/earnings multiples for foreign stocks may have caught up with those of U.S. counterparts. But across most industries, the most-attractive bargains reside outside of the U.S., they said.Link here.
GM, FORD LOSE BY TREATING SUPPLIERS AS ADVERSARIES
Top executives at General Motors and Ford cannot be surprised by a new survey showing what they know to be all too true: Many of their suppliers cannot stand doing business with them. If that sounds like a big hurdle for Detroit as it tries to rebound from financial setbacks and market-share losses, it is also something the bosses can fix if they want. They will need humility, since GM, Ford and DaimlerChrysler AG’s Chrysler Group – the Detroit-based U.S. automakers – once again must study at the feet of Toyota and Honda, whose supplier relationships are the envy of the industry.
Toyota will be happy to explain, for the umpteenth time, that suppliers must be treated as valued partners, almost as family members, with the goal a mutual regard for the other’s welfare. The simmering animosity between the U.S. automakers and their suppliers is highlighted in a survey released last month by a Detroit-area professor, documenting what automakers and suppliers acknowledge under their breath. Suppliers are wary of publicly criticizing automakers for fear of losing a contract or customer.Link here.
When you visit foreign countries, it takes you out of your comfort zone. Other people have different customs. The food is different. Often the language is different. Making yourself uncomfortable causes you to see things you would not otherwise see. It changes your perspective. It is also a way of showing yourself that what once seemed too challenging to attempt is actually not as hard as it looks. But what does it mean to make yourself uncomfortable as investors? There are three answers to this question.
First, it means being bold enough to think unconventionally. You recognize that the world is always changing and that what worked yesterday may not work tomorrow. You are willing to try new approaches to achieve your investment goals. Second, it means using all the tools at your disposal. This can sometimes be even more difficult than allowing yourself to think differently. Most of us are lazy. We would do as little as possible to achieve our investment goals, if we could get away with it. Finally, you have to be willing to ask the questions no one else wants to ask. In the investment world, thinking about the future can be a dangerous game. You cannot predict the future. If you invest your money based on faulty predictions, you could easily lose it. Yet the investor’s greatest challenge is to figure out what price to pay today for future earnings that are unpredictable. The further you go into the future, the harder it is to tell what tomorrow will bring and what you should be willing to pay for it today.
But the stock market looks ahead, not behind. And so we have to look ahead, too, to try to see what is coming, if not in the earnings picture, then at least in the bigger picture. You are going to be investing in a stock market driven by geopolitical events as much as earnings, probably for the rest of your investment life. That means trying to decipher what events like war in the Middle East or high personal debt levels in America might mean for the stock market. It is also possible to look into the future and make some intelligent speculations on what might happen. Using options on index funds and exchange-traded funds is one way that modern investors can insure themselves against large, macroeconomic risks. It is not foolproof insurance. And it is not without risk. But in a dangerous and uncomfortable world, it is one practical way to begin putting the tools at your disposal to work.
In a speech I gave in Chicago in 2004, I made the case for $100 a barrel oil to 150 options investors. They were shocked, skeptical, and intrigued, by turns. I told them that event-driven investment moves – the kind where an external event shocks markets and causes a big move up or down in a sector or the whole market – are nearly impossible to predict. But strategic foresight can help you prepare for some of them. One of the largest geopolitical events looming on the horizon today is a potential conflict with Iran. Iran is a charter member of President George W. Bush’s Axis of Evil. Iran is near the top of the president’s foreign policy agenda for his second term. At stake is whether Iran will become a nuclear power. It is not clear how this would change the world. What is clear is that the mullahs who run Iran have a strategic vision of their own. To investors, what ought to be even clearer is what the consequences of a war with Iran would mean: $100 oil.
Any economist worth his or her pocket protector will tell you that $100 oil is not economically sustainable. The world simply could not afford to pay $100 for a barrel of oil – for a sustained period of time. It would create a world of oil haves and have-nots, and might even precipitate oil wars between nations desperately competing over a scarce and expensive natural resource. But that does not mean it could not happen anyway – at least for a few days or weeks.
You do not have to be Dr. Strangelove to envision what the Iranian strategy might be against the U.S. economy. I say economy and not military. The nature of an Iranian counterattack would mostly likely be to strike against U.S. economic interests. And what greater interest than oil? After all, it is much easier to drive the price of oil to $100 a barrel and instigate a political firestorm in Washington, D.C., than it is to defend against American strategic bombers and precision-guided munitions. Iran knows that America and all of Europe and Japan are addicted to oil. Much of that oil comes from the Persian Gulf and must physically pass through the Strait of Hormuz to get to its final destinations. By choking off the supply of oil at this strategic point, Iran could exert enormous pressure on the United States, which would itself be pressured by those who desperately count on Middle East oil and want no part of America’s quarrel with Iran.
With such a potentially high economic price to pay for a war with Iran, I have been told by some strategic investors that the U.S. would never risk it. But here is a question to make you uncomfortable: If it is plain for all to see that the way to America’s weakness is through interrupting the flow of oil from the Persian Gulf, is it not just a matter of time until someone tries it? Instead of fighting a war conventionally, why not try economic warfare, attacking what makes a country strong to begin with – its economy? In total economic warfare, you attack a country’s access to natural resources or its currency. By attacking its economy, you indirectly weaken its ability to attack you militarily. If not Iran, then perhaps al Qaeda? And if not at the Strait of Hormuz, then perhaps at the Saudi oil refinery of Ras Tanura, one of the world’s biggest and most productive?Link here (scroll down to piece by Dan Denning).
LEARNING MORE ABOUT OIL
There is no doubt that energy is a problem, oil in particular, but it is one that can be managed. It is obvious that the world has ample oil and there would be no problem where it not for the dishonesty and incompetence of the corporate world that specializes in petroleum, the genuinely outstanding dishonesty and incompetence of governments everywhere, and the truly remarkable behavior of environmentalists desperate to create difficult problems or problems for which there is no solution. There are good odds we face a dismal future so long as we acquiesce in government interference in markets; oil being a striking example. There are even stronger odds that we will exacerbate this dismal picture so long as foreign policy decisions, including those of energy, are resolved by sending fleets and armies around the world and bombing civilians indiscriminately.
If U.S. oil production continues its 30-year decline there is nothing wrong with importing more oil. In a trading world it is foolish to attempt to be self-sufficient, and not buy goods where they are the cheapest. But the forecast of a decline is not necessarily true. Jim Saunders, in a letter criticizing my belief in the availability of oil, makes a serious charge when he claims that inorganic energy sources are considered to be “fringe” science. This ignores that using this “fringe” science Russia has gone from being nearly out of oil 50 years ago to producing on a par with Saudi Arabia and ourselves today. They call it the modern Russian-Ukrainian abyssal theory and see basement rock below the earth’s crust as the source of petroleum. The Russians have long since shown that the conventional wisdom, in this case the belief that oil is produced from the detritus of plants and microscopic animals, is questionable if not actually wrong. His “fringe” science comment makes him sound very much like someone stuck on a Kuhnian paradigm, unable to accept new ideas.
It works for the Russians; they claim it will work anywhere. The trick is to not to be too concerned about sedimentary rock and to seek out drill sites where the earth’s crust is thinnest. It is expensive and since our oil companies have ample reserves today, they are reluctant to spend money now for future benefit, and so long as they remain hung up on the false theory of biotic oil they see no point to it. Our government, in collaboration with big oil (it keeps the price up) and attempting to please environmentalists, appears to be sitting on vast oil fields in the Beaufort Sea. The Gull Island field alone is estimated to contain resources as large as those of Saudi Arabia, probably of abiotic oil that has already migrated upward (upwelling is the expression oil people use), but no one is permitted to explore it, to find out.
It is clear that if we accept the abiotic (inorganic) theory, stick to free market principles and establish the unhampered market as best we can, energy sufficiency can be established worldwide. The oil is there. All it needs is technology and the will to use it.Link here.
Oil is where you find it.
In the past two decades, oil exploration has evolved from drilling the “bumps”, to utilizing the theory of plate tectonics to help reformulate an overarching strategy for the search. In the modern world of petroleum exploration, plate tectonics provides useful models to explain the nature of ancient deposition environments, burial of sediments, subsidence of basins, thermal histories of rock masses, hydrocarbon generation, deformation of structures, uplift of mountain masses, and eventual erosion and exposure.
In the present, just as in the past, oil is exactly where you find it. And that is why we are going to discuss the Maritime provinces of eastern Canada, where the St. Lawrence River spills out into its eponymous gulf. Specifically, we are going to take a bird’s-eye view of current exploration efforts in and around Nova Scotia, New Brunswick, and Prince Edward Island, as well as the southeastern part of Quebec. Formally, the entire area is called the Acadian region.
Who, figuratively at least, are the next Col. Drakes of the coming oil boom in eastern Canada? There are a number of oil-exploration firms heavily involved in the Anticosti and Magdalen basins. They have been conducting seismic work, performing ground mapping, leasing up the best acreage of prime oil patch, and drilling test holes “out yonder, where the wildcats live”, to coin a phrase. When the big-time drilling starts in the next few years, you will either be in on the action or on the outside looking in.Link here (scroll down to piece by Byron King).
HOW GOOD ARE HEDGE FUNDS?
A trillion dollars rides on that question, not an easy one to answer, because hedge funds are by their nature secretive. Secretiveness is to some degree mandated by law; these unregulated investment partnerships are not permitted to advertise. No doubt the dark mystery associated with them adds to their allure.
The genre is delivering decent performance, to judge from various published statistics on average results. Hennessee Group, which helps rich people find the best ones, tracks 880 hedge funds in an unweighted index that was up 8.3% last year. A joint venture of Credit Suisse First Boston and Tremont Capital Management, which places money with hedge funds, calculates a 2004 return of 9.6% on an asset-weighted index of 400 names. Okay, the S&P 500 did 10.9% last year. But to be fair to the hedge guys, they will typically underperform in a good year because of all the hedging they do. Also, the index numbers are net of fees. Before fees, which by tradition among hedge funds are rapacious, the managers are perhaps beating the market.
Before investors send another $1 trillion to these would-be Paul Tudor Joneses, however, they ought to ponder the fact that both the 8.3% and the 9.6% are unobtainable returns. They include claimed results from stock pickers who are not taking new clients. Suppose you want to buy an index of hedge funds with real money. You have to find what is called an investable index. Standard & Poor’s has one, with 41 hedge funds in it. To be included, a fund must agree to take real cash and hand back the profits. The manager, that is, has to put your money where his mouth is.
It is astonishing what having real money on hand does to the performance of a hedge fund. The S&P Hedge Fund Index was up only 3.9% last year. A plausible explanation lies in the very elusiveness of these exotic investment vehicles. The manager can prove that he was a genius last year. But just when you hand him a check, his strategy stops working. Why not buy a plain old mutual fund? You can even get one that hedges.Link here.
Hedge funds conclude a wild quarter.
Hedge funds – those famously publicity-shy investment pools targeted at wealthy individuals, institutions, and increasingly, public pension plans – were the talk of Wall Street in the second quarter, when rumors of a major fund’s collapse raced through financial markets. The rumors of the mystery fund’s demise were greatly exaggerated. But in the ensuing media feeding frenzy, a simple question went mostly overlooked: How are hedge funds doing?
Managers and investors say that despite the occasionally wild ride and a tough April, when the dust settles after June, hedge funds probably finished the quarter, and the first half, about flat. That is because June looks like it was a much better month than had been expected for many funds. The June pickup is welcome news for an industry where business has gotten so tough that two big funds shut down in the first half of the year, and others are said to be considering cutting fees.
The real story now is not when we might see a blowup, but how long can the industry endure its current lackluster returns. With investors looking back wistfully to the double-digit average returns of the 1990s, and managers charging performance fees of 20% on top of 2% management fees, flat returns are not good news, especially for fund managers who often live the “eat what you kill” rule and sink lots of their own money into their funds. Still, some observers think the current environment is being blown out of proportion.
The best performers so far this year are equity hedge funds, particularly those that trade growth stocks, such as in the technology sector. Funds investing in high-yield bonds and the debt of troubled companies are also expected to be up for June.
The infamous 1998 collapse of LTCM, a highly leveraged hedge fund that blew up, sent shivers through financial markets worldwide. The New York Federal Reserve helped prevent a disaster when it organized a consortium of Wall Street firms to privately bail out the fund with a $3.5 billion cash infusion. Since that debacle, hedge funds have scaled back on borrowing to make investments, and the industry has mushroomed, with assets estimated at $900 billion to $1 trillion – roughly the size of the entire mutual fund industry in 1990. That year, hedge funds had about $40 billion in total assets. But hedge fund managers face a tough market now, with many stocks and bonds trading in tight bands, less volatility in general, and more competition.
“We are less concerned about hedge fund blow-ups. (But) in general, we expect the average hedge fund to underperform, on a risk adjusted basis, after fees,” said Larry Kochard, chief investment officer of the $680 million Georgetown University endowment fund. “There’s so much money and so many people competing with each other.” Kochard said he still wants to invest in hedge funds but will seek ones with niche strategies that stand apart from the pack.
Observers said some managers, cognizant that their hefty fees will not sit well with investors looking at low returns, may have to start scaling back on fees. But some managers, like superstar Jim Simons at Renaissance Technology Corp. can keep fees high, people in the business said.
Jeff Maillet, who runs the multi-strategy hedge fund Noble Asset Management in Chicago, said that some funds are getting more conservative as they seek to lure bigger pools of capital from pension funds and other more traditional investors. He said lower returns are partly from more mediocre managers getting into the business, as well as some managers being too careful, over-promising and under-delivering. “I like the way that (Julian) Robertson and (George) Soros operated – that’s the way hedge funds are supposed to be,” he said, referring to the industry’s most famous managers, who produced high-flying returns during their heydays in the 1990s. “They’re supposed to have hedge fund returns, not mutual fund returns with a big fee attached to it,” he said. “If you don’t want volatility, don’t talk to me.”Link here.
CHINA: WHY REVALUE WHEN YOU CAN GO ON A SHOPPING SPREE INSTEAD?
Give the Chinese credit: at least they are not using their substantial foreign exchange holdings to buy trophy properties in New York or golf courses in California, as the Japanese did during the 1980s. One might query the price they are paying, but at least there is a certain strategic logic for Beijing to acquire assets which will help to secure the country’s future voracious needs for natural resources, particularly energy.
With the opening up of China in the mid-1990s to foreign investors, its abundance of cheap labor, and the authorities’ encouragement of Chinese banks to lend more, have allowed the country to build infrastructure and capacity at a rapid pace. Unsurprisingly, China’s share of global trade has also grown rapidly. But over the next fifteen years, to improve living standards, the authorities plan to move 300 million workers from rural areas where they earn just over $1 a day, into the towns and cities where they could earn $4 1/2 dollars a day. So China is likely to add to its infrastructure at a rapid pace for many decades, both to house the workers, and to build the manufacturing plants for them to work in. One consequence of the rapid growth to date is that demand for electricity is now outstripping supply. Which explains the energy buying spree currently being sponsored by the Chinese government.
One thing is certain: China’s acquisition strategy is an economic counterpoint to America’s increasingly militaristic posture in the Middle and Far East. In both cases, the ultimate aim is to achieve energy security. As present and future superpowers, both Beijing and Washington are reluctant to accept import dependence for so vital a commodity as oil. Both are using their comparative assets: In Washington’s case, this means bullets, in the case of Beijing, dollars.
As its formidable pace of economic development accelerates, global policy makers are calling on Beijing to play a role commensurate with its increasing international economic status. It appears to be doing precisely that, although perhaps not in a manner sanctioned by Washington. Going on a shopping spree for natural resource based companies with its substantial dollar foreign exchange holdings may be no bad thing for China, although the strategy may well signal further conflict ahead with Washington given that this suggests a future clash of priorities between Washington and Beijing. In that regard, the reaction to the CNOOC attempted takeover is but a small bellwether of what lies ahead. But it probably beats the alternative.
True, the deals may end up costing billions, and there is also the politically sensitive job of allocating a certain proportion of foreign exchange reserves to the goal of recapitalizing China’s state banking system. Throwing bad money after good, one might say, but if any country can afford to waste money it is China, given the fact that the country’s foreign currency reserves are already almost as big as one year’s worth of imports. Although this strategy might not seem sensible for the medium term, measured against the prospect of an imminent currency revaluation, does it not make more sense to China to use this window of opportunity to secure as many strategic natural resource assets as possible?
What is the pay-off offered in the event of a revaluation of the currency, which might do nothing more than create further speculative instability? However high the prices paid for some of these assets, as a strategy it certainly appears to make more sense from Beijing’s perspective than, say, spending $800 million to buy Pebble Beach or even recycling money back into U.S. treasuries, where the risk of capital loss mounts every day. In that regard, China has absorbed the lessons of previous Asian buying sprees better than most. There may be a political price to pay for learning that lesson rather too well, but the CNOOC deal signals Beijing’s readiness to embrace that risk.Link here.
Chinese Road Rage
The only way you can profit from opportunities is to know as much about the risks as you can. It is ironic that at the moment of their apparent economic triumph, China’s Communists could be blindsided by the unintended consequences of globalization. But when you unleash the powerful human desire to be rich, the desire to be free is not far behind. But let me put it to your more simply: China’s Communist government will collapse within 10 years. This will be more than a little politically disruptive. And it could, briefly, rock the world’s financial and commodity markets. But the long-term bullish economic picture will not change. Asia is the greatest investment story of your lifetime. But the short-term political picture surely will change. And soon. Sound far-fetched? Wishful thinking? Think again…
“Thousands of people went on a rampage, smashing police cars, hurling rocks at paramilitary officers and attacking a police station in a disturbance that lasted several hours,” Times of London reporter Oliver August wrote from Beijing. “The incident, in Chizhou, Anhui province, was apparently triggered by a minor road accident, which prompted a brawl that quickly became a riot involving up to 10,000 people.” Only in China can a random act of road rage spark a riot with 10,000 angry people. China is the Texas of the world. In China, everything is bigger, including the road rage. The government is big, too. Yet it is barely big enough to contain the growing frustration of the people with pollution, corruption, and the obvious gap between those who have done very well in the new China, and those who have not. “The incident reflects a growing degree of dissatisfaction and distrust with authorities in China, which has repeatedly been expressed in social unrest,” August adds.
In The Bull Hunter, I ask whether economic success can be had without political freedom first. In 17th-century Britain, political freedom paved the way for private property, higher savings rates, investment, and Britain’s stunning global success. Must China follow the same path? Unlike some in Harry Potter, I cannot see the future. But there is an invisible tie between liberty and prosperity. You can have some of the latter without all of the former. However, it is going to be very hard for the Communists in Beijing to manage and plan for the needs of 1.2 billion teeming new capitalists. Frankly, no government in the world would be up to the task. For the kind of problems China faces, markets always work better than governments.
For investors, that means that the real profits from China will begin after the Communists are swept aside. It will be possible, of course, to profit while the Communists are still in power. I call it “China profits without the China risk” in The Bull Hunter. But the biggest fortunes will be made when China is democratic and free. The Chinese people will get rich (not the government). And so will investors who are ready for that moment. It may be sooner than you think.Link here.
MR. MARKET’S SADISTIC TENDENCIES
Even though Mr. Market is capricious – bordering on sadistic - he often responds to persuasive “lobbying” from the real world. If, therefore, the real world convinces him that the global economy is slowing, he may respond by knocking a few more points off of the Dow Jones Industrial Average. Already this year, the major U.S. stock averages have struggled to keep their statistical heads above water. The Dow and the Nasdaq are both down about 5% for the year-to-date, while many economically sensitive indices like the Morgan Stanley Cyclical Index have dropped twice as much. Perhaps, therefore, Mr. Market is already responding to the prospect of impending economic weakness. All the classic leading indicators of future U.S. economic activity are heading in the direction that neither Alan Greenspan nor President Bush has authorized: Down.
The bond market, for one, argues persuasively that economic weakness looms. It has also convinced us. Not only are long-term interest rates probing all-time lows, but they are doing so at a time when short-term rates are climbing. These divergent trends are producing a “flattening yield curve”, which often augurs recession. Specifically, the difference (or spread) between the 10-year Treasury note and the fed funds rate, which reached a plump 359 basis points in the second quarter of 2004, has been narrowing ever since. (In other words, the yield curve has been flattening). As of yesterday, the spread had narrowed to less than 70 basis points.
“There is a strong correlation between a narrowing yield spread and a subsequent slowdown or decrease in final sales,” Comstock Partners notes. A slowdown in final sales is just another way of saying: Recession. We are not yet tempted to buy a 10-year Treasury note yielding 3.90%, but we are very tempted to believe the message that bond market is sending: the global economy is slowing down, perhaps quickly. The “Grande Dame” of economic indicators – the growth of the money supply – is also signaling economic weakness. Specifically, the monetary aggregate called MZM (money of zero maturity), which includes cash and cash-like assets, is showing year-over-year growth of almost zero percent. “For the past 40 years,” International Strategy and Investment explains, “every time MZM growth has been this low, the economy has either had a significant slowdown or recession. EVERY TIME.”
The growing signs of economic weakness lead bond fund manager, Bill Gross, to predict that the Federal Reserve will be LOWERING interest rates by December. Gross’s view remains a minority opinion for the moment, but we expect it to become a majority opinion sometime before Halloween. If Gross is correct, the economy and the stock market may be in much bigger trouble than most folks imagine. If, for example, the economic growth that most Wall Street analysts anticipate fails to materialize, the share price gains these analysts also anticipate would fail to materialize. Out in the real economy, a recession might inflict even more harm than usual, according to Gross, because the U.S. economy is poorly equipped for adversity. Since we have been relying so heavily upon asset inflation (mainly housing) to power our economy, the consequences of the approaching economic slowdown could be much more dire than in times past.
Unfortunately, an inverting yield curve and slowing employment growth often create a toxic effect on asset inflations. “The current, rather mild U.S. recovery has been driven by asset appreciation/consumption and not employment or cap-ex growth,” says Gross. “If, therefore, the asset-inflation well runs dry,” he warns, “the inevitable path of the U.S. economy will reflect slow growth at best.” In which case, long-term bonds might perform very well. Stocks might not. Quiet Mr. Gross! … Mr. market might hear you!Link here.
SO POWERFUL IN ONE MARKET, TOO WEAK IN ANOTHER?
The central bank’s decision to raise the Fed funds rate was a surprise to absolutely no one. So I am still waiting for someone – anyone – to tell me exactly how the stock market could fall “in reaction” to news that was not news. And if that someone – anyone – actually does solve this mystery, well, I have got a still bigger riddle: How can Mr. Greenspan & Co… a) Be powerful enough to make investors sell their stocks, yet simultaneously, b) Be too weak to make rates go higher in the broader interest rate market? What am I talking about? The answer is in this chart.
Especially note the data over the past year. As the Fed carried out its campaign to raise rates, the Bond Buyers index and the Fannie Mae proxy for 30 year mortgage rates FELL in that time; as for the Bank Rate Credit Monitor’s lowest credit card rate, I included it to show that even the rates which have gone up climbed at a slower pace than did the Fed. In truth, the stock market and the interest rate markets dwarf the Federal Reserve. The evidence makes a joke of anyone who thinks otherwise, even if the joke does masquerade as serious “news” on days like this one.Link here.
As the saying goes, there are lies, damned lies and statistics. One of the most blatant examples of government manipulation is the consumer price index. These data are stretched, smoothed and distorted in every conceivable way possible to dampen any sign of inflation. Here is an excerpt from Jim Puplava at Financialsense.com to give you the flavor: “The ‘core rate’ is a fictional concept designed to soothe the financial markets and distract them from the reality of rising inflation. The core rate does not exist anywhere in our economy. It is a fictional concept designed to obfuscate inflation.”
I could also rant and rave about the silliness of substituting “equivalent rents” for housing prices or excluding energy costs from inflation calculations or “hedonically adjusting” the price of a big-screen TV because the screen has 30% more pixels. Some may not understand why data manipulation is a big deal. The simple answer is that by pretending everything is OK now, we are guaranteed to make everything worse later. The federal government, in concert with Wall Street, is engaged in a long-standing fiction to convince us that all is well. Meanwhile, this false assurance leads us down a path of complacency, as the problem gets worse.
For the life of me, I cannot understand why anyone listens to what Greenspan says. As a forecaster, the man has one of the worst track records in history. How many times has he assured us that everything would be fine just before it blew up in our faces?Link here.
WHY DOES TREND FOLLOWING WORK?
Like the famous movie line from Cool Hand Luke, Trend Following has been hurt by a failure of communication. The skeptics have not been shown the facts. The evidence has not been forced upon them. Our entire web site (Turtletrader.com) solves that failure to communicate – for those receptive to the message. Why has Trend Following been the best style of trading for the past 30 years? Trend Following has worked in the past, excels today and will perform into the future for the simple reason: trends exist and they can be traded up and down for profit.
The world will always face constant change and no one can forecast a trend’s beginning or end until it becomes a matter of record, just like the weather. But if you have a basic strategy that is sound, you can take advantage of market changes to make money by capturing the bulk of a trend. Trend Following is based on good business principles. If your principles are designed to adapt, the changing world is not going to materially hurt you. It is the ability to adapt that allows Trend Following to continually pull profits from the marketplace.
Some people are skeptical. They come to this site seeking the magic bullet, the Holy Grail, the secret sauce – they miss the clear point. There are no secrets. There is only hard work. Big trends are like epidemics. Starting with only a few people, an epidemic can spread through a population as it multiplies again and again. Just like when a virus spreads, it doubles and doubles and doubles. It flows. It trends.
Extreme market trends can appear from out of nowhere moving either up or down. These trends often feed upon themselves and can quickly progress geometrically allowing the opportunity for huge profits if you traded the trend. However, people can have a hard time with this idea, because, like an epidemic, the end result often seems out of proportion to the cause. Instead of just riding the trend for profits, they seem more interested in understanding it. Instead of wanting to win, they want to be right.
In order to appreciate why market progressions or trends can be so powerfully rewarding, you must not expect proportionality. You need to prepare for the possibility that sometimes big market changes follow small events, and that sometimes that change can happen very quickly. Trend Following trading is designed to find and exploit those market trends long before they arrive on the radar screen of the masses.Link here.
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