This is the second post in a series covering my investment strategy for 2009 and beyond. The first post dealt with my macroeconmic view. This post will cover my investing ideas for the year. And in the final post, I will outline my investment ideas and list my watchlist of specific stocks/bonds/etc I'm attracted to.
It is important that you not blindly follow anything I do. My stockpicking has been terrible and you should simply consider anything I say as ideas that you should accept or dismiss. I may change my mind at any point. All of this is obvious but I think my readership has gone up and I don't want any newbies losing their life savings. Not a pretty sight if I started getting mentioned in the same breath as Bernie Madoff ;)
Views Going Into 2009
As one may sense from my macro outlook, I disagree with the consensus view of a strong recovery in the later part of the year. There is a possibility of a rally in the markets but it is difficult to see it being sustained. Remember, sucker's rallies may be the most dangerous of all. People, including me, tend to be overconfident on a sucker rally and commit way too much capital.
My feeling for the next few years is that the economy will be in a long slump, but not a depression, with low growth. I think the stock market may stay in a bear market for many years. However, this is a highly attractive time for stockpickers!!! (Traders will also have potential of doing well.) I remember seeing many newbies and amateurs aspiring to be the next Buffett, complaining that Buffett had it easy in the markets of the 60's and 70's--LOL only a newbie would call the 70's easy--since valuations were very low and wished we had the same type of market. Well, these guys & gals got their wish. It's make or break time for stockpickers like me and probably most reading this.
Investing Stance (as of January 2009)
This is not all-encompassing and only covers some areas that interest me...
Specific stock ideas coming in a future post...
- December (2)
- November (1)
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- Investment Outlook I: 2009
- Some items of interest for the last week of Januar...
- US GDP comes in stronger than expected; Canadian o...
- World Economic Forum at Davos turning into a joke
- Opinion: US should not label China a manipulator
- Government slowly gaining control over banks
- Miscellaneous articles for this snowy day... at le...
- Crude oil contango dissapearing
- Morgan Stanley economist Stephen Roach still beari...
- Macro Outlook I
- The ugly situation facing Dow Chemical due to thei...
- Chinese economic statistics over the last 8 years
- Jeremy Grantham January 2009 Quarterly Letter
- Did gold do well during the deflationary period in...
- Miscellaneous Articles for the week ending January...
- Astrologers not too bullish on stocks
- Story of 2009: China
- Russian Ruble completely disintegrating
- Barack Obama: A historic presidency
- Opinion: Good Riddance To The Worst US President S...
- Bank of Canada cuts rates to 1%
- The end of modern private banking...at least in th...
- 2008... Oh, What A Year... First Ever Turtle Award...
- What happens when Cushing fills up?
- Market signals not very accurate when it comes to ...
- Thoughts on the banking crisis... oil... dumb idea...
- Bond market still pointing towards deflation
- Buffett's 1998 comments still apply to Japan... Pl...
- End of an era: Apple CEO Steve Job resigns for hea...
- Infrastructure stimlus looks like a bad plan
- Nortel files for bankruptcy
- FinancialSense interview with Louis-Vincent Gave
- Super contango in oil may hurt oil bulls
- Some quick thoughts...
- Special situation: Unwinding of Sprott Molybdenum ...
- Articles for the second week of 2009
- Is the market cheap based on short-term P/E?
- Sears beats consensus earnings estimates
- Bank of England cuts rates to all-time low
- Graham-Dodd 10-year P/E still not low enough
- Thought: Can the Treasury bond bear bus get any mo...
- Satyam... Enron of India
- Marc Faber 2009 Outlook
- Another big M&A deal blows up
- Articles for the first week of 2009
- 2008 Asset returns
- 2008 Portfolio Performance
- December (56)
- November (58)
- October (63)
- September (65)
- August (35)
- July (42)
- June (48)
- May (19)
- April (32)
- March (35)
- February (25)
- January (39)
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About This Blog
- Sivaram Velauthapillai
This is the second post in a series covering my investment strategy for 2009 and beyond. The first post dealt with my macroeconmic view. This post will cover my investing ideas for the year. And in the final post, I will outline my investment ideas and list my watchlist of specific stocks/bonds/etc I'm attracted to.
January ended in the red, and I don't believe it technical analysis but some technicians say the negative January means there is a high chance of the year being negative. This goes against other views that suggest that the market rallies sharply after major crashes (happened in 1930, 1975, and 1988.) Whatever happens, it's starting out on an interesting note with the US$ still showing strength while gold may be entering a speculative stage. Anyway, here are some articles you may find interesting, in no particular order...
It looks like the 4th quarter US GDP number came in at -3.8%, which is better than the -5.4% consensus expectation. Even with the stronger-than-expected number, the US stock market is off slightly (down around 0.5%) right now. Although the number was much better than expected, it's still pretty weak and some think the worst will be first and second quarters of this year.
The Canadian November GDP change--Canada reports monthly numbers--is weaker than consensus. GDP seems to have declined 0.7% in November versus around -0.4% expected by consensus.
All these numbers may be revised later but this goes to show how blindly listening to economists is not a good technique.
(This is sort of a political post)
Well, I guess it is only fitting that the World Economic Forum at Davos, attended mainly by senior bankers and senior government officials, marks the current malaise the world economy when fighting words and denials erupts into the public sphere.
The forum seems to have gotten off to a rough start even before it started when several key players in the current financial crisis were nowhere to be found. It seems that only one senior American banker, Jamie Dimond of JP Morgan, showed up, while the CEOs of other banks don't seem to have made an effort to trek over there, although John Thain of Merrill Lynch was planning to attend before being shown the door. Not to be outdone, the Brazilian president, Luiz Inacio Lula, skipped the WEF for the competing, some claim anti-capitalist, activist-driven World Social Forum in the Amazon:
Brazilian President Luiz Inacio Lula da Silva is shunning the World Economic Forum in Davos this week and the chance to hobnob with business leaders and 41 heads of state. Instead, he’ll join more than 100,000 activists from around the world at an anti-capitalist jamboree in the Amazon.
Going back to the Davos forum, we have some public fighting between the Turkish Prime Minister and Israeli President over the invasion of Gaza by Israel recently:
The packed audience, which included U.S. President Barack Obama's close adviser Valerie Jarrett, appeared stunned as Turkish Prime Minister Recep Tayyip Erdogan and Israeli President Shimon Peres raised their voices and traded accusations.
Peres was passionate in his defence of Israel's three-week offensive against Hamas militants, launched in reaction to eight years of rocket fire aimed at Israeli territory. As he spoke, Peres often turned toward Erdogan, who in his remarks had criticized the Israeli blockade of Gaza, saying it was an "open air prison, isolated from the rest of the world" and referred to the Palestinian death toll of about 1,300, more than half of those civilians. Thirteen Israelis also died.
"Why did they fire rockets? There was no siege against Gaza," Peres said, his voice rising in emotion. "Why did they fight us, what did they want? There was never a day of starvation in Gaza."
The heated debate with Israel and Turkey at the centre was significant because of the key role Turkey has played as a moderator between Israel and Syria. Erdogan appeared to express a sense of disappointment when he recounted how he had met with the Israeli Prime Minister Ehud Olmert days before the offensive, and believed they were close to reaching terms for a face-to-face meeting with Syrian leaders.
Obama's new Mideast envoy, George Mitchell, will be in Turkey for talks Sunday.
Obama administration has to somehow keep the Isreali-Palestinian problem from getting out of control. Given the collapsing US economy, the last thing American officials probably want to hear is word of escalating problems in the Middle East.
Not to be outdone, Vladimir Putin, the Russian Prime Minister, puts down Michael Dell, the CEO and founder of Dell, the computer company (Thanks to Crossing Wall Street for original mention):
At the official opening ceremony of the World Economic Forum in Davos, Putin, now Russian Prime Minister, delivered a 40-minute speech touching on everything from why the dollar should not be the sole reserve currency to how the world needed to enter into a smart energy partnership with Russia. Then it was time for questions. First up: Dell. He praised Russia's technical and scientific prowess, and then asked: "How can we help" you to expand IT in Russia.
Big mistake. Russia has been allergic to offers of aid from the West ever since hundreds of overpaid consultants arrived in Moscow after the collapse of Communism, in 1991, and proceeded to hand out an array of advice that proved, at times, useless or dangerous.
Putin's withering reply to Dell: "We don't need help. We are not invalids. We don't have limited mental capacity." The slapdown took many of the people in the audience by surprise. Putin then went on to outline some of the steps the Russian government has taken to wire up the country, including remote villages in Siberia. And, in a final dig at Dell, he talked about how Russian scientists were rightly respected not for their hardware, but for their software. The implication: Any old fool can build a PC outfit.
I was initially thinking that there might have been a translation erro but I think Putin is fluent in Russian, English, and German, so I doubt he misunderstood the question. Maybe the economic crisis is getting to Putin; or maybe not. Maybe Russians and Americans will never get along.
And finally, it seems that the only bank CEO that seems to have shown up is partly blaming regulators for the problems. Yes, Jamie Dimon, seems to think regulators are at fault, although he may have a hard time pulling that excuse on any bank shareholder, nearly all of them with massive losses:
At a panel on leadership yesterday morning before hosting a reception with champagne and canapés at the Hotel Europe Piano Bar, JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon expressed frustration at those who seek to pin all the blame on bankers.
“I take full blame for all the American banks and all the things they did,” said Dimon, 52, the only CEO of a major U.S. financial institution to attend the conference this year, adding that he knows that’s what people want to hear.
Regulators, he said, should share some of the blame.
“God knows, some really stupid things were done by American banks,” Dimon said. “To policy makers, I say where were they? They approved all these banks.”
Stephen Green, chairman of London-based HSBC Holdings Plc, also criticized regulators at a panel about capitalism on Wednesday. Green, 60, a Church of England lay minister who has written a book about reconciling a life in banking with his belief in God, called for “an overhaul of the regulatory environment.” He also talked about the need for self-regulation, saying that “no amount of rules is going to enforce good behavior.”
At a press conference on Jan. 28, he dodged the question of personal responsibility, saying only that “the banking industry” has “something to apologize for.”
HSBC and JP Morgan have not suffered grave losses--at least so far--so they have a greater case for blaming the regulators. But it still goes to show how bankers still don't realize the monumental mistakes they have made, and are unwilling to accept some serious responsibility. Perhaps the greatest arrogance is this private equity fellow from Carlyle:
One Davos regular, Washington-based Carlyle Group’s managing director David Rubenstein, said he thinks a key issues at this year’s gathering is “who is at fault.” Yet Rubenstein, who was saying at Davos two years ago that the outlook for leveraged buyouts was “very robust,” says responsibility shouldn’t be tied only to him or his industry.
“There are six billion people on the face of the earth, and probably about five billion participated in what went on,” Rubenstein said in an interview. “Everybody participated in some way or shape or form.”
The difference that seems to have escaped David Rubenstein, of course, is that the 5 billion people weren't responsible for the trillions of losses. Most of the losses are attributable to a few individuals and a few financial institutions. Trying to blame the average homebuyer or the average low-level banker is nothing more than pure arrogance and a blame-shifting exercise.
I suspect that David Rubenstein will be a bit more humble in an year or two. I think it was Jeremy Grantham (or maybe George Soros?) who said that the losses in private equity haven't shown up yet but will in a few years. Private equity has long lockup periods and will only start showing losses over several years. Unlike hedge funds, mutual funds, and investors like you and me, the assets owned by private equity are illiquid and don't generally have a daily price. It is possible that many private equity buyouts in the last 3 to 5 years will be worth exactly zero in 2 years. I am not predicting it but it is quite possible that Carlyle will be among those groups posting massive losses within a few years (as a side note, I would avoid investing in private equity unless you are making a distress investment or know that the assets the firm has are good.)
Obama administration should avoid labelling China as a manipulator. It is something that is being decided upon.
Contrary to some who think that China is not manipulating its currency, I am of the opinion that it is clearly manipulating its currency. However, it isn't a one-way street, and China actually pays a price for this. It should also be noted that America's loss in manufacturing has little to do with the currency manipulation. America's peak in manufacturing, believe it or not, was somewhere in the 1940's and it has been declining ever since (I'm referring to manufacturing as a share of world production; in terms of raw production, USA probably has higher manufactured output now than at any time.) Clearly, American manufacturing started going down before China even showed up on the scene.
In any case, speaking as a largely free-market guy (but not as free market oriented as libertarians or most on the right,) the currency peg has to go. It distorts everything and messes things up for everyone, including the manipulating party. I mean, just look at Japan. The artifically low Yen has resulted in excessive export-oriented industry development. Japan is facing a brutal collapse in their industry and the Yen is still likely undervalued (although it will probably be forced down due to central bank intervention.) If Japan hadn't manipulated its currency, it's possible that they might have a stronger local, consumption-oriented, economy.
To those who are surprised by Treasury secretary Geithner's hard line against China last week, one needs to keep in mind that the Obama administration will take a harder line against China due to their ideological stance (left-leaning parties are more protectionist.) I think it is an inappropriate time to be flexing the weapons of trade. I strongly urge the US government, not that I have any impact on them whatsoever, to avoid labelling China as a manipulator.
If Obama wants to do it, he should do so if and only if China de-values its currency. Then, in such a case, the world opinion will be on USA's side and some global consensus can be reached on China. Otherwise, Obama is going to end up lost and alone like George Bush was with his Iraqi war (unless your idea of friends is, of course, the 'coalation of the willing'.)
The question on the mind of many is whether huge swaths of the Western banking system is going to end up being nationalized. The huge outlays, ranging from purchasing preferred shares to offering credit insurance, sometimes in quantities seemingly larger than the market cap of such banks, seems to imply that the government owns the banks. Well, it's becoming clear slowly that the government is taking over control.
Perhaps the most symbolic is the cancellation of an airplane order by Citigroup after the Obama administration made a call:
On Monday an official of the Treasury Department called an official of Citigroup, recipient of $45 billion in TARP funds, and complained about the company's new $50 million dollar,12-seater corporate jet from a French company.
The official "told them to fix it," a source with knowledge about the call tells ABC News.
Citigroup this morning released the following statement: "We have no intent to take delivery of any new aircraft."
There is no way such a thing would have happened under "normal circumstances." Politicians often criticize but executives generally ignore them. But not this time.
Whether this is a good or bad is a lengthy debate. Some, such as one of my regular readers, ContrarianDutch, is concerned with the rise of nationalization. I can see his concern. After all, it won't be too long before the government calls on these banks, if the economy deteriorates much further, to continue lending to consumers and corporations even if the risk increases. Fannie Mae and Freddie Mac have, recently, started expanding their mortgage operations after policymakers called for them to do so. The shares are still publicly traded but the orders are coming from the government. Similarly, Citigroup and others may end up with the same fate.
I think I know what the next controversial thing the government will tackle: compensation. It would not surprise me if Citigroup brass, not to mention the other banks, receive another phone call from the Treasury discussing government dissatisfaction with the seemingly large bonuses paid while the banks are posting losses or very small profits.
Most of the readers here probably won't agree with me but I don't necessarily see anything wrong with what is happening. First, though, make no mistake: I don't like what is happening! The fact that the government is taking over these megabanks means that the banks will be inefficient and will crowd out the private sector somewhat. But, the reason I'm more toleranat is because, if governments are spending, not just a few million here and there, but tens to hundreads of billions propping up these banks--nearly all of them would be bankrupt otherwise, at least on our "friendly" mark to market basis--why shouldn't taxpayers own them?
Regardless of whether you agree with my view or take the opposite position, I think we should all prepare for a market environment where huge swaths of the banking establishment is owned by the government (or at least is heavily influenced by it.) Investing in banks would be, in my opinion, somewhat akin to investing in some industrial companies in the 40's when they were essentially controlled by the government for the war effort. Perhaps we are facing a war, of the economic kind, and governments are forced to control the banking system.
I have painted a somewhat gloomy picture, at least if you are a free market type--I hope all of us are, even if the degree differs amongst us--and does not want the government dictating the financial matters; but it will only manifest itself if the economies of the world deteriorate significantly. The consensus right now is for the economy to recover by the second half of this year. If that's true, no need to worry much. Not only will asset prices, especially real estate and bonds, stop declining, banks will start posting strong profits off the positive sloping yield curve. John Hampton at Bronte Capital blog speculates that American banks will earn around $400 billion pre-tax so things can stabilize... but if the economy deteriorates much further, that's when the government will try to use all its tools to get lending going.
- Bond yield spreads high but not raw bond yields (Accrued Interest): This is a point I have made in the past and is worth keeping in mind if you are looking at bonds. Many analysts claim that corporate bond yields are trading more attractively than during the Great Depression. This is only true if you look at spreads. In contrast, if you look at raw yields, they are not necessarily that high. I think the junk bonds are worth considering but the rest of the corporate bonds do not look attractive.
- ConocoPhilips posts massive $31.8 billion non-cash loss (The Globe & Mail): This was supposedly announced before and most of it arises from writing down goodwill related to its Burlington Resources acquisition a few years ago. Talk about a terrible deal for shareholders (unless oil&gas prices rally or something.) Book value was around $93 billion (tangible was $63 billion) and it is going to get cut in third.
- Rio Tinto considering big stock sale to pay down debt (MarketWatch): They say that bubbles are often marked by huge takeovers near the top (incidentally profitting investment bankers and short-term traders, including arbitrageurs, while potentially hurting everyone else, including long-term shareholders, employees, and creditors.) Well, a good sign of the commodities bubble was the takeover of Canadian giant Alcan by the commodities giant Rio Tinto. Rio Tinto is now considering issues shares to pay off the debt. Needless to say, as is almost always the case when management makes mistakes, the shares will be issued at multi-year low prices.
- Marc Faber actually recommends some technology stocks (Seeking Alpha): I mentioned a few weeks ago how Marc Faber actually recommended some technology stocks--possibly the first time in many years. In the Barron's 2009 roundtable, he maintains his view and recommends some large-cap tech stocks. This is quite an interesting bet and one that I'm leaning towards. Tech has been out of favour for almost 8 years--ignoring some high flyers like Apple or Google--and is a good contrarian area to look... As for Marc Faber's main strategy, it seems that he favours betting on the re-flation trade. He is going heavily into all sorts of cyclicals. Faber's view is essentially the consensus view, with even the FedRes expecting growth in the later part of the year (although the FedRes is not predicting asset prices ;) ). I don't share the same view and would avoid them. But do keep in mind that some of Faber's investing is short-term trading based on technical analysis. In contrast, I do not use technical analysis at all and am more longer-term oriented (except special situations and the like.)
Bloomberg is reporting that the arbitrageurs trying to profit from the oil contago are starting to unload some of their cargo:
Royal Dutch Shell Plc sold more than 1 million barrels of crude stored off the U.K. and a vessel hired by Citigroup Inc.’s Phibro LLC left its anchorage in Scotland for the U.S. as the incentive to keep oil in tankers disappears.
Shell sold two 600,000-barrel cargoes of North Sea Forties crude for delivery in mid-February at Scapa Flow near Scotland’s Orkney Islands to oil trader Vitol Group, the companies said. The oil, already on board the supertanker Oliva, has been anchored off the U.K. coast since at least December, according to Bloomberg vessel tracking data.
Oil companies and traders have stored as much as 80 million barrels of crude on tankers as the so-called contango, a market where buyers pay more for supplies later in the year than now, allowed them to profit from storing crude. The incentive to store oil on vessels is shrinking as the spread between 1st- and 12th-month crude narrows to about $12 a barrel from $17 in early December.
I'm not sure if the above story played a role but oil was down almost 8% today. Marketwatch speculates that there are concerns over demand destruction and excess supply:
Crude-oil futures dropped 9% Tuesday, as another set of U.S. economic reports unleashed fresh worries that persistent economic weakness will spell further erosion in energy demand.
Also pushing oil lower, analysts predicted that new data will show U.S. crude inventories have risen for a fifth straight week and reached the highest level seen in 17 months.
Falling for a second session, crude oil for March delivery closed down $4.15, or 9.1%, at $41.58 a barrel on the New York Mercantile Exchange. The percentage loss was the biggest since Jan. 7.
As always, the media has no clue what is driving these price changes--no one else does either--so the speculation may or may not be true. It wasn't even an year ago when the media often speculated that oil prices were rising due to concerns over supply shortages, while those in the industry, such as the Saudi oil minister, kept saying that he has enough oil to sell to anyone that wants it.
I was speculating late last year that this would lower the futures price and that is what seems to have happened, although not quite in the manner I imagined. I thought the futures curve will shift down, along with the spot price. Right now, it looks like the spot price has risen while the futures curve has fallen slightly. Perhaps the spot price will fall once these arbitrageurs sell the oil but I may be wrong.
The above chart is the same one I used in late December, except I have updated it with the current futures curve. The futures curve has shifted down slightly, while the spot price has risen significantly. You can see the market marking down the price by looking at one of the futures contracts. Below, I have reproduced from barchart.com, the distant, very thinly traded, Dec 2017 contract:
The year has not been kind to the popular crude oil ETF, USO, investors. Assuming that no sizeable dividend was paid this year, it looks like the price has deviated significantly from the crude oil price.
I'm not too familiar with USO and not sure what it tracks, but assuming it tracks the same thing as the WTIC plotted at stockcharts.com, a gap is starting to develop. I wonder if this is the loss from rolling over the futures contract. So far it's shaping up to be a very volatile year in the world of oil.
Economists are often wrong. They tend to be early with their gloomy predictions, and they tend to be late with their bullish views. For example, Paul Krugman was calling for the real estate bust back in 2005 if I recall but nothing really happened until 2007. The same with Stephen Roach, who was warning about commodities bubble and the trade imbalance back in 2005, while nothing happened until 2008. So, if you are going to listen to them, keep that in mind.
Bloomberg interviewed Stephen Roach recently and he is quite bearish. For what it's worth, he has always been bearish for the most part over the last 3 or 4 years but it seems that his view hasn't changed much. He says all of Asia is in recession or slowing materially. He does not agree with the view floating around in Wall Street that China will lead us out of this mess. He reiterates his view that the US economy is going to face serious issues and a Japan-like lost decade is not out of the question, although he doesn't know if it'll be a decade or shorter.
The segment also has Mario Gabelli, who says he likes some Hong Kong stocks, which are trading below cash. I haven't done much work but I think it is better to look at Hong Kong stocks than Japanese stocks. Japanese companies are not shareholder-friendly and have very low ROE but if Hong Kong stocks are trading near or below book value, I would rather pick them. One should, still, watch out for potential problems in China. Chinese companies probably also have less transparency and higher corruption so discount them heavily. Just remember that there is no need to rush. Missing the bottom is fine if the upside is large.
"The only function of economic forecasting is to make astrology look respectable."-- John Kenneth Galbraith
Making forecasts is never good for one's reputation; but given how my reputation is close to zero or possibly negative, I probably don't lose much by making them ;) This will be my main outlook for the year and the future in general. There will be another post where I will lay out my investment plan for the year (since I am macro-oriented, my investments are mainly driven by my macro view, except for risk arbitrage, distress investing, and such.)
To tell you the truth, regardless of how bad you are at it, I think forecasts are actually a good thought exercise if you are macro-inclined. If, however, you are bottom-up then avoiding forecasts is a good idea (in this case, forecasts, which are nothing more than guesses, will adversely cloud your view.) Before I started my blog, I used to write yearly forecasts on some of the forums I was posting on. My forecasts have a poor track record but interestingly, quite a number of key ones have come true. Unfortunately, it took much longer than I thought and hence I didn't profit much from them (sometimes lost some money too.)
Thoughts On The Past
A few of the big calls that took far longer than I thought but still came true to a large degree were my bearish view of commodities, my bullish view of US$ and bullish view of US government bonds. I had also been bearish on emerging markets, especially the high flyers such as China and India, and it seems to have been a good move to avoid them (although if you were really early, you probably made more money that I would in my whole lifetime!) If anything, I get the feeling that I am too early and hence need to extend my time frame. So, moving forward, I am going to extend my calls. Instead of trying to come up with yearly events, it's better to think of them as long-term multi-year events.
An important thing to keep in mind is that macro forecasts are not simply an attempt to make money. Rather, they are also an attempt to avoid losing money.
Note that I may change my mind on anything I say, as new information becomes available. I am unsure of certain key themes, such as the commodities bubble, and may change my mind on them. The important thing is to develop your world view while absorbing market data. If the situation on the ground changes, you should change your view as well.
There are two parts to this post. In this post I will outline my macro views. In a subsequent post, I will cover my investment plan, including specific investments that are worth following or investing in. Except for some quick points, I am not justifying my macro views since it takes way too long.
I should also note that I will mostly talk about USA but view the rest of the world as being somewhat similar, in a crude sense of course. I follow the view that says all asset markets are closely related and definitely do not buy the de-coupling theory. For instance, many investors don't realize that the European stock markets collapsed before the American one in the 1920's. The inter-linkage between economies back then is far less than now yet asset prices were influenced by the US. Interest rates also move with each other, even though each country has its own economy and government policies. Presently, the linkage is even stronger given the greater amount of international trade.
If you are macro-oriented, your goal is to either invest ahead of everyone or avoid potential problems. That's the whole point of injecting macro into investment plans.
Weak Economic Growth
My view is that the world will be in a slump for 5+ years. I don't expect to see a worldwide depression or anything severe, but I do see low growth for many years. Developed countries will likely see below-potential (3% is roughly the potential of USA) growth while developing countries will likely fluctuate wildly based on political problems arising from weak economic growth. Jeremy Grantham forecasts growth of 2% for the G7 and that is how I'm looking at it as well.
My feeling is that we will see low inflation along with periods of mild deflation (some countries may see high inflation due to political actions.) [note: irrational political actions, such as tariffs, trade embargoes, etc, can alter this so watch for that.] The difficulty will be figuring out if any bouts of collapsing prices is good deflation (declining prices due to productivity/technology/etc) or the bad kind (decline due to slump in demand or wealth destruction.) Right now it's deflation of the bad kind but it'll become difficult to distinguish in the future. In particular, I think it is going to be difficult, if China shows deflationary results, to tell if China is seeing bad deflation or good deflation.
Given how the core problem in the developed world is debt, the paradox of thrift ensures that we won't get a quick recovery. Everyone needs to save but doing so at the same time is bad for the economy.
Weak Asset Prices
I think the world economy will do ok but asset prices will struggle. My guess is that the current period for investors will resemble the late 1930's to 1940's (without the war--hopefully.) Treasury bond yields were very low in the 40's (around 2% for 10 year bonds if I recall) and corporate profits actually kept increasing throughout this period. Yet stock prices didn't really go up much (although if you bought a low such as in 1932 or 1942, you saw gains of 50% or so.)
There are a couple of reasons why I don't see the start of a bull market in stocks right now. Firstly, according to John Napier (I'm planning to buy his book soon,) the worst bear markets--he looked at the 4 big ones--last around 14 years. The current one can be shorter but if you are conservative, assuming that the bear market started in 2000, you have to assume that there may be another 6 years left.
Secondly, regardless of how long a bear market lasts, nearly all of them overshoot on the downside. The reason seems to be psychological, partly arising from massive losses suffered by prior investors. Stocks right now are attractive but not extremely cheap (as in 1982 or 1974 or 1932 or 1942.) So it is more than likely that valuations will decline further (this is almost a certainty if bond yields rise significantly due to a crisis.) However, do keep in mind that this may mean that prices stay flat while earnings catch up.
It is likely that the market will fluctuate in a wide range so traders and stockpickers will probably do really well.
It is important to remember that, for all practical purposes, the bottom in the bear market may be set long before before the "start" of a bull market. That is, technical investors consider the start of a bull market from the point of the absolute bottom. But, in practice, an investor may suffer for a long period after the bottom is in. The classic example is the 70's. The absolute bottom was set in 1974 but unless you picked off that bottom exactly, it was an inflationary nightmware for most investors for the next 8 years. For all intensive purposes, the start of the bull market was in 1982, even though the bottom was back in 1974. Similarly, depending on the index you are looking at, the bottom was set in 1932 but it really wasn't a bull market until the late 40's. The implication of this thinking is that, even if you think the bottom was set in October 2008 (it may not be,) we may still face a rough period for many years.
Collapse Of Mercantilism
We are probably witnessing the beginning of the end of mercantilism. I think the US$-peg by many in Asia or Middle East will break within 5 years. China will gradually move away from the peg while some others alter their pegs more quickly (actually, we have already seen quite a few switch to a peg based on a basket of currencies and we will see more of this.) The problem for the pegged countries is that they may see big inflation problems if growth picks up slightly while USA pursues deflationary policies.
One should also be prepared for adverse trade disputes, capping off with a big trade war. I hope it never comes to this but it won't be a shock. The potentially big conflicts are:
- China vs USA: This is a huge problem. China is artificially maintaining a low currency by pegging their currency to the US$ (in a free market, the Renmembi would rise as China prospers and capital flows into the country.) China does this in order to develop its manufacturing-oriented economy. Exporters in USA are disadvantaged by this, although importers benefit. However, the resulting current account deficit in the US is unsustainable and many American nationalists do not look favourably upon this relationship. The Obama administration will be more protectionist, like most left-leaning parties of the world, and will likely take a really tough line than the Bush administration ever did. Obama campaigned on it, although it wasn't high on the list, and we saw Tim Geithner, the new Treasury Secretary, send a signal to China recently by publicly calling out China on its mercantilist policies. I don't think anything serious will happen unless China de-values its currency. Yes, contrary to market consensus expecting the Renmembi to rise, China may actually de-value it if it faces economic problems and wants to boost manufacturing further. Investors should pay keep an eye out on this situation.
- Potential problems in Europe: I think there is a moderate risk of serious trade disputes and policy disagreements developing in Europe. We already have some countries like Spain expecting 16% unemployment and seeking lax monetary and fiscal policy, while others such as Germany pushing for a stricter policy. The collapse in the pound and potentially further weakening, which helps British competitiveness, may also ruffle some feathers in mainland Europe (would you rather take a vacation to France or a 30%-cheaper Britain?.)
- East Asia vs China: A low risk right now but if East Asian countries, most of them built on an export-oriented economy, devalue their currencies, I suspect China is not going to take it too kindly. There could be some disagreements if East Asian countries become more competitive than some Chinese regions.
- OPEC oil price control: This is a very low probability event, at least in my eyes. If we face high inflation--I'm not expecting high inflation so that's why I say it's low probability--it is possible that some oil-importing countries may retaliate against OPEC for its price control of oil.
So those are some events to think about, especially if you are a global investor. Imagine if you overload on emerging market stocks and some dispute arises.
Deflation Over Inflation
A huge call over the next few years is the inflation vs deflation decision. I thought this was a big issue in the last few years but I was wrong. This is an even bigger issue right now. Getting the direction wrong is going to result in a disaster of epic proportions.
Right now, my feeling is that the market consensus is for inflation, with some expecting high inflation down the road. The consensus seems to be that the market hit a bottom late last year and we may start the beginning of the bull market later this year. This thinking seems to come from the consensus economic view of stronger economic growth in the last part of this year. We even have some investors betting heavily on commodities expecting re-flation later in the year.
I am in the mild-deflation/disinflation camp. I think we will see bouts of deflation similar to how it was in Japan (but the situation will be much better than Japan.) It's too long to go into the reasons but to put it bluntly, I don't see how the $30 trillion or so losses in the world, most of which is still not recognized by banks and investors (i.e. fraudsters and ponzi schemes; and investment assets not need to be marked to market) can be "made up" anytime soon. Furthermore, are we really going to see investors jump back into equities and debt in the same manner? How many investors would be willing to contribute to equity capital of banks? How many would provide debt financing to corporations, not to mention private equity? How many citizens would be willing to pump a ton of money into stocks after seeing almost 50% vanishing within an year, while their homes, generally their biggest asset, also plunges 25%?
There is a high chance of USA following the path of Japan (but won't be as bad since USA is more capitalistic and has more diversified economy.) In Japan cash and bonds ruled, as they always do in deflation, and it's quite probable for bonds to outperform stocks for a few years.
Having said all that, one should consider where they might be wrong. I will consider the possibility of high inflation if central banks start monetizing assets in far greater amount than the amount destroyed. So far no sign of that. There is the thinking that the government will come and save the economy, a proposition I believe has been wrong all throughout time. Governments can cushion the blow but they can't reverse the losses. They won't create $30 trillion in wealth and make stock prices, bond prices, house prices, etc, go back to what they were in 2007.
One can also come up with a low probability high deflation case. We may see a sizeable threat of deflation if China implodes and starts dumping goods on the world markets. So, if you are making the high inflation case, then there is also a high deflation case. Both are remote in my eyes.
China Is The Main Story
China will be the most important macro story over the next few years. On the positive side, if the world economy recovers, it will partly be due to China. If China can increase its consumption then it can contribute to future growth, while America and others remain in a mild slump. On the negative, there is a possibility that China may implode. If China enters the situation USA faced in the 1930's, it may face a severe political crisis. This will be a disaster for everyone.
Bullish On US$; Bearish On Gold
I don't have strong conviction but my current view is to remain bullish on US$, a position I have maintained for several years--an incorrect call during that period. Unless the world recovers strongly, and quickly, US$ will see capital favour it. If I am wrong on the US$ call, I will pay a heavy price, as most Canadians who have invested in US stocks in the last decade know all too well.
It's not a strong view but I'm developing a bearish feeling for gold. It's likely too early but I don't see gold doing too well if we enter a long period of low growth and mild deflation... If we face the high inflation situation that some are expecting, we obviously will see gold skyrocket. But that's not my expectation.
Commodities Bull Market Likely Over
Too early to say but it is possible that the commodities bull market is over. The fact that prices are off so much--we are not just talking 20% or 30% but, more like 50% to 70%--seems to imply the end of one of the major bubbles in the last decade. However, different commodities have differing characteristics so it's possible for some of them to do well in 4 or 5 years. For instance, perhaps the bull market in oil and base metals is over but not in soft commodities.
Also, even if the bull market has ended, it does not mean that you won't see rallies of as much as 50%. Some may have hit bottom and rally. The difference, of course, is that you won't have the bull market in your favour as was the cast in the last 10 years. If you mistime things or pick wrong commodity, you will have difficulties.
Avoid Current Account Surplus Countries
This is totally contrarian and counterintuitive to some degree but countries that ran current account deficits will likely perform better than the surplus countries. This is one reason I am far more bullish on USA than many. I think it is possible that countries such as India may also perform better. I'm still bearish on India but less bearish than an year or two ago. A sizeable chunk of the current account deficit of such countries was due to high commodity prices, particularly oil, and if commodities enter a bear market, the deficit should shrink (we are seeing this in the US already.) I am also concerned that the present situation resembles the trade relationships in the 1920's and 1930's. Back then, current account surplus countries, such as USA, suffered far more than current account deficit countries, which was the case with most European countries.
Stock Market May Not Lead The Economy
I was listening to an interview by Russell Napier, the author of the Anatomy of a Bear, a book I'm planning to read, and he said that the stock market does not always lead the economy. It certainly didn't happen in some of the four key bear markets he looked at. I think the same thing is possible now. Given how almost everyone believes the market leads the economy, and hence are quick to jump into the markets in order to avoid missing the train, the contrarian in me says that this time will be more like the severe bear markets of the past than the mini-bears of the last two decades.
(If you do think the economy is going to recover, Napier says that autos and copper are two good indicators.)
Tags: investment plan
We had one major M&A deal blow up in Canada--the BCE deal--but it looks like the proposed buyout of Rohm & Haas by Dow Chemical might be the next big one--this time in America. Similar to the BCE deal, this one was cut near the peak of the cycle (in this case, the commodities cycle back in July.) If you ever want to know why arbitrage hedge funds are doing terribly, it's because of situations like this.
It's a good case study for arbitrageurs. This is an example of a deal, that seemed somewhat certain at that time, completely disintegrate within two months.
I never pursued this as a risk arbitrage play because (i) I didn't have enough free money, (ii) I am bearish on cyclicals and don't want to be holding any of them if the deal fell apart, and (iii) the deal is not a simple cash-only deal and I'm not skilled enough to properly hedge these deals by shorting, in this case, Dow Chemical. Never the less, the deal "looked" somewhat safe to me because it was a strategic bid. Financial bids, such as those from private equity or management, are very risky in this environment. But strategic deals should be safer. It looked like Dow genuinely wanted Rohm & Haas and it likely would benefit from a merger even if the fundamentals deteriorated slightly.
The deal looked like it was falling apart in December but Dow re-affirmed their intention to buy Rohm & Haas. Dow was considering financing a portion of the deal from proceeds from a joint venture with some Kuwaiti government units. Unfortunately for Dow, the Kuwaiti government backed out of the joint venture, with accusations from the opposition, what little exists in the Kuwaiti government, of corruption and various other irregularities. The deal has been on the ropes ever since.
Now it looks like Dow is going to have to cut its dividend--a dividend that it has maintained or raised since 1912. Although rare, this does go to show how dividend investors relying on historical trends such as 'companies that paid dividends consecutively for 20+ years' can end up investing into a questionable situation (this was also the case with a lot of dividend investors who went into financials two years ago.) If you are a dividend investor that is not heavily diversified (say picks less than 20 dividend stocks,) it is perhaps best to do analyze companies on a case by case basis. I'm not a dividend investor but I see many dividend investors spend a lot of time looking at the historical dividend trend and projecting that far into the future; instead, they should be looking at the company in question. Admittedly, management can go and do something stupid and ruin the dividend, which is what Dow management seems to have done, but a deeper analysis would still bring up issues pertaining to the business environment--such as how cyclical earnings are.
The M&A deal seems airtight, especially after Dow re-negotiated with Rohm & Haas in December, if I remember correctly. Rohm & Haas has filed a suit against Dow. The New York Times' Deal Professor goes over the situation and thinks Dow has bought itself a few months at best. Dow supposedly will have to pay $100 million per month to Rohm & Haas (but this may be negotiated away if a deal is cut.) The suit by Rohm & Haas includes new allegations that the Dow CEO tried to get the FTC to delay approval--a claim denied by Dow. Break-fee is $750 million if Dow walks away but it seems that Dow may have a hard time even satisfying the break-fee (I don't know how this works.)
I don't think too many would be interested in taking risk arbitrage positions in this deal but, if you are contemplating it, be very cautious. If the deal collapses and Dow only has to pay $750 million, shares of Rohm & Haas can collapse anywhere from 30% to 60%! It can be hedged (say by buying put options) but the cost is likely to be too high.
Happy Chinese New Year to all! The astrologers, in true fashion of hedging their bets and proclaiming some vague results--kind of reminds me of Wall Street portfolio strategists :)--are expecting a rough year. One unskilled in astrology might be forgiven for thinking that the ox--this is the year of the ox by the way--is somehow related to a bull and hence portends to a bull market. Apparently not. At least that's how I'm reading the situation. I should note that I'm neither an astrologer nor a very good investor so take that for what it's worth ;)...
So, let's check out some Chinese statistics as a New Year arrives in China...
China is potentially one of the top stories of the year. One can argue it was already the story in the last decade but a lot of that was hype and obscured by the bull market in, practically, every single asset--except US$ and Yen, of course. The real story is if it can survive a severe world recession without an implosion of the political system. Let's take a look at how some key ecoomic statistics look, compared to the past 8 years. I am reproducing some charts from an HSBC report below (source: China Economic Spotlight: Not all gloomy, by Hu Hongbin and Ma Xiaoping. January 22, 2009. HSBC)
For what it's worth, the HSBC economists think China will bounce back in the second half of this year. As is the case with the consensus view in America, the thinking is based on the view that the government stimulus will prevent any major collapse. I, however, am more bearish and am far more cautious. I think my negativity is not necessarily based on economic numbers but is, instead, driving by my concern for the political system. A lot of economists and investors only put passing effort into considering political events but I believe they are a big part during economic slowdowns.
(For those not familiar, IP stands for industrial production, RMB is renmembi, and FAI is fixed asset investment.)
GDP & Electricity Production
Chinese GDP numbers are likely manipulated heavily by the government (as is the norm in most totalitarian countries.) It also likely under-represents rural areas. I have no proof of this but am just guessing based on the view that developing countries don't spend the same resources as developed countries. For example, I'm sure the census in China is far less accurate than in Canada or USA. In any case, as long as the government manipulates the numbers in a consistent manner, they can be a rough guide.
Chinese GDP numbers are based on year-over-year numbers, whereas it's mostly annualized quarter-over-quarter numbers in America and most other places, so the drop-off is far worse than it seems. There was essentially zero growth in the 4th quarter, compared to 3rd quarter. One needs to wait and see how 1st quarter numbers shape up. In the US, the first quarter is starting off to a rough start with massive job cuts, annoucements of huge profit declines (this may reflect what happened in 4Q but I suspect management actually looks forward to 1Q and 2Q), and continuous losses from financial institutions (latest was American Express, which reported steep decline in profit due to high losses on credit card loans, although the number was close to consensus estimate.) If you assume that one well-paying job loss results in 2 or 3 indirect job losses, which are almost always not covered by the media, then you can see how much consumption can drop off as the year progresses. China is not driven by the consumer as America and most of the developed world is. But, nevertheless, its economy can continue to deteriorate.
The Chinese GDP growth rate is also close to the widely estimated figure of 7% needed to minimize unrest. I personally don't believe in that number but if things continue to deteriorate, political problems will arise. We already have some protests and riots in some European countries--such as Greece--and China is far more vulnerable. Totalitarian systems are efficient and seem great when things are going well. But they can undergo an epic collapse when the situation deteriorates. For instance, if the economy deteriorates further or if some adverse outcome occurs (say China loses a huge chunk of its reserves due to US$ decline,) then the population will blame the government. To make matters worse, the population will blame the government even if it's not the government's fault. In a more democratic government, population blames the government as well, but everyone knows that they voted for the politicians. So everyone feels somewhat like it's their fault. It is more likely that the party in power is thrown out or some policy is changed, rather than the whole political apparatus being called into question. In contrast, Chinese may call the whole system into question. I am not a fan of totalitarian systems and would like to see them switch but it is more preferable to do that in a slow manner than in the thick of an economic collapse.
Some rely on electricity production--electricity is heavily used by industries--as a better measure of economic activity in China. The GDP can be manipulated more easily than the electricity numbers. I think the industrial production also a good indicator of economic activity. Both IP and electricity production have completely collapsed. Given the steep decline, these measures may have hit a bottom. The question is how long it will take them to recover.
Exports/Imports & Loan Growth
Nothing surprising with imports/exports, with both of them collapsing in the latter part of the year. It should be noted that imports have collapsed more than exports so China actually "benefitted" somewhat from this deterioration. This means, so far, that the cost is being borne by what China imports: commodities and semi-finished products. Commodity exporting countries, such as Brazil and Australia, have taken huge hits; so have the semi-finished-product exporters, such as Thailand, Indonesia, Korea, etc.
The HSBC analysts cite the loan growth as a positive sign in China. IANAE and am not clear on how significant this is.
Fixed Assets & CPI
China is trying to keep the economy humming along by maintaing high fixed asset investment (this would include things like shopping malls, roads, railroads, factories, water treatment plants, etc.) Contrary to the opinion of some, I am of the opinion that fixed asset infrastructure, which is a big portion of FAI, in China is in a bubble. I have quoted, on and off, some stories in the past about brand-new shopping malls being empty or real estate being unaffordable. But if China wanted to keep economic growth going, spending on fixed assets may be ok. It's really a waste of money but it prevents a collapse of society.
The first chart also shows that real estate has clearly entered a correction. I would guess that this may the start of a long correction in real estate, similar to the stock market in China (do keep in mind that the stock market in China is nothing like developed country stock markets, and is more akin to a casino like the US stock market in the 1800's, with rumours driving prices and insider trading being rampant.) My impression, from what little I know of China, is that real estate is likely in a bubble in the coastal urban cities, but is not in a bubble in the interior. So, when I say Chinese real estate has entered a correction, I am primarily referring to coastal areas (I suspect most economic measures capture the coastal areas more than the interior.)
As far as inflation is concerned, the CPI and PPI numbers have fallen off a cliff. Some inflationists seem to think that China will see high inflation in the future but that seems unlikely--unless the government devalues the currency far more than needed. From my understanding of China, it has faced bouts of mild deflation all throughout the 80's and 90's. You can sort of see this in the chart with negative CPI in the late 90's and even early 2000's. My guess is that the mild deflation faced by China in the 80's and 90's is of the "good deflation" type. Namely, deflation due to productivity gains. Although it's too early to say for sure, the current deflation is likely the "bad deflation" which arises due to collapse in demand (or overcapacity if you want to think in terms of production.)
Anyway that's a quick look at some key economic numbers from China over the last decade or so. Hope it was useful to some of you...
Thanks to Todd Sullivan's ValuePlays for bringing Jeremy Grantham's 4Q letter to my attention. It's a good read. Grantham is considered by some to be a value investor but, unlike most value investors, he is a top-down, macro-focused, strategist. At least that's my impression of him. I recommend this letter to anyone, including non-macro-oriented investors since it gives an overview of the size of the problem.
Jeremy Grantham has been critical of many policymakers and so-called leaders and he is critical of Obama's Treasury team as well. In any case, the most valuable thing for me is his quantification of potential losses in America, and how they compare to Japan. I had been trying to figure out how the US situation compares to Japan and Grantham finally provides his estimate. The bad news is that there will be huge losses; the good news is that it looks better than Japan. I personally felt before that the losses would be better than Japan since Japanese real estate and stocks were wildy overvalued like nothing I have ever seen or heard of in my limited reading (people always keep referring to the South Sea bubble and the Mississippi bubbles but the Japan one looks much larger--I still need to do read up more though.) Jeremy Grantham doesn't cover it, but my feeling is that the picture in some parts of Europe will be ugly--far worse than what America is facing.
Scope of American Losses
But let us look for a minute at the extent of the loss in perceived wealth that is the main shock to our economic system. If in real terms we assume write-downs of 50% in U.S. equities, 35% in U.S. housing, and 35% to 40% in commercial real estate, we will have had a total loss of about $20 trillion of perceived wealth from a peak total of about $50 trillion. This relates to a GDP of about $13 trillion, the annual value of all U.S. produced goods and services. These write-downs not only mean that we perceive ourselves as shockingly poorer, they also dramatically increase our real debt ratios.
...If we would like the same asset coverage of 50% that we had a year ago, we could support only $15 trillion or so of total debt. The remaining $10 trillion of debt would have been stranded as the tide went out! ... As always, now that it’s raining, bankers want back the umbrellas they lent us. At 40% of $30 trillion, ideal debt levels would be $12 trillion or so, almost exactly half of where they actually are today! It is obvious that the scale of write-downs that we have been reading about in recent months of $1 trillion to $2 trillion will not move our system anywhere near back to a healthy balance. To be successful, we really need to halve the level of private debt as a fraction of the underlying asset values. This implies that by hook or by crook, somewhere between $10 trillion and $15 trillion of debt will have to disappear.
I haven't published my macro outlook--I'll do it soon--but this humongous loss, some $10 trillion to $15 trillion, is what makes me dismiss all the rosy forecasts. The consensus seems to be that assets, most importantly stocks and real estate, will somehow start a bull market later in the year. A day doesn't go by without some analyst expecting oil to rally to $80, for housing to show strong recovery, and for consumer discretionary technology stocks to rally. I'm not sure how that is possible given that a big chunk of losses still haven't been absorbed. A short term rally, call it an Obama rally if you will, is possible; so is skilled stockpicking. But long-term bullish macro bets seem risky.
Given where we are today, there are only three ways to restore a balance between current private debt levels and our reduced, but much more realistic, asset values: we can bite the bullet and drastically write down debt (which, so far, seems unappealing to the authorities); we can, like Japan did, let the very long passage of time wear down debt levels as we save more and restore our consumer balance sheets; or we can inﬂate the heck out of our debt and reduce its real value. (In the interest of completeness I should mention that there can sometimes be a fourth possible way: to somehow re-inﬂate aggregate asset prices way above fair value again. After the tech bubble of 2000 Greenspan found a second major asset class ready and waiting – real estate – on which to work his wicked ways. This time there is no new major asset class available and, although Homo sapiens may not be very quick learners, we do not appear eager to burn our ﬁngers twice on the very same stove. As a society, we apparently need 15 to 20 years to forget our last burn. With so many ﬁnancial and economic problems reverberating around the world and with animal spirits so crushed, re-inﬂating equity or real estate prices way above fair value again in the next few years seems a forlorn hope if indeed it is possible at all.)
I concur with Grantham and think the fourth choice is unlikely, even though it must be said that a big chunk of market participants are expecting another bubble to be created soon, as if bubbles are the norm and possible after such a big credit bust. Grantham comments that he thinks that a bit of each of the three choices will be used. He seems to be in the inflation camp and expects the possibility of high inflation (I'm in the mild-deflation/disinflation camp and think high inflation is only likely if the authorities want it to occur.)
The Humongous Bubble In Japan
The Japanese had an even bigger problem in write-downs of “wealth” than we have now. They had to write down perceived wealth by an amount equal to a stunning three times GDP! Even in 1929, we had to write off amounts equal to only three quarters of a year’s GDP as the stock markets then were less developed and housing was decidedly pre-McMansion. This time in the U.S., however, we must write down perceived wealth or capital by almost precisely one and a half times GDP, worse than the Depression but happily much less than Japan.
...At about 4 to 1, the Japanese corporate sector went into the 1989 crunch with much higher leverage than the U.S. had ever seen. Remember too that their stock market, at 65 times earnings, was over three times our market’s recent highs and their land was at several multiples of ours. In 1989, Tokyo’s land per square foot was around ten times the value of Manhattan’s! So they had higher write-offs conﬂ icting with much higher corporate leverage. If they had rapidly marked their assets to market, the entire corporate Japan Inc. would have been under water. And since we know that around a quarter of Japan’s market – their Sonys and Toyotas – was solvent, we can deduce that the remaining three-quarters was shockingly under water, using the types of rules we are attempting to apply to ourselves now... Somehow or other, Japan absorbed the greatest deleveraging in human history without incurring a severe depression.
I knew that Japan had higher P/Es on stocks and wildly overvalued real estate; but, until I read this, I never knew that they had greater corporate leverage than America ever did. I wonder if part of the high leverage was due to commercial real estate holdings of corporations (real estate, commercial or not, tends to involve higher leverage.) My understanding is that it was popular for some Japanese corporations to speculate on real estate--sort of like how we heard stories a few years ago of Chinese companies speculating on the stock market--since they were making more money off that than in their operations.
Grantham is correct to point out that Japan actually managed to avoid a depression. They ran up their debt to some ridiculously high level in order to save themselves--but this is their World War (USA ran up the debt during WWII.) I see a lot of investors criticizing Japanese policymakers for taking their time but, as Grantham speculates, 2/3 of Japanese corporations may have been insolvent if they took a quick pill, as some liquidationists desire.
Having said that, I do feel that Japanese culture and government policies make things worse. They need to diversify their economy and make it more dynamic.
Although Japanese corporations were in much worse credit shape than ours are now, the reverse is true for consumers. Japanese individuals went into the 1989 event with a very high savings rate and very high accumulated savings. In contrast, our households go into our crunch borrowed to the hilt (or beyond) and painfully under-saved. So our job is to nurture our average people in the street and somehow restore the quality of their balance sheets, just as Japan (admittedly taking 15 uncomfortable years) did for its corporations.
This is something that the liquidationists and libertarian-type individuals such as Jim Grant and Jim Rogers never seem to address. Calling for a quick liquidation is all fine and dandy but given how 70% of the US economy is driven by the consumer, have any of them considered what would happen to the economy? The economy will completely implode if a big chunk of the consumers declare bankruptcy in a short period of time. A lot of extreme free market supporters never realize that politics and economics are intertwined. In fact, the concept of 'political economy' was quite common a hundread years ago. Perhaps this is probably why they never get elected to power in any country.
For many years, we used a 10-year forecast for asset class returns. In January 2002, we made our ﬁrst 7-year forecast, dated December 31, 2001. We moved from 10 to 7 years because research proved that it was closer to the average time for ﬁnancial series to mean revert.
I wondered why he uses 7 year forecasts rather than the convention 10-year ones but now I know...
Even with hindsight, if you value the market in 1974 using our current methodology it was very much cheaper than it is today at 950, which is what we calculate as almost precisely fair value.
...we suspect that cheaper prices are not just possible but probable, although admittedly far from certain...
Slowly and carefully invest your cash reserves into global equities, preferring high quality U.S. blue chips and emerging market equities. Imputed 7-year returns are moderately above normal and much above the average of the last 15 years. But be prepared for a decline to new lows this year or next, for that would be the most likely historical pattern, as markets love to overcorrect on the downside after major bubbles. 600 or below on the S&P 500 would be a more typical low than the 750 we reached for one day.
In ﬁxed income, risk ﬁnally seems to be attractively priced, in that most risk spreads seem attractively wide. Long government bond rates, though, seem much too low.
So, he thinks the market is currently close to fair value; but he thinks it can overshoot on the downside. This is similar to my view. Valuations are attractive but not exceptionally so (You can get the breakdown of his forecast from last year here.)
For the long term, research should be directed into portfolios that would resist both inﬂationary problems and potential dollar weakness. These are the two serious problems that we may have to face as a consequence of ﬂooding the global
ﬁnancial system with government bailouts and government debt.
This is completely opposite my view. I don't feel that high inflation will be a problem. Admittedly it's a possibility but I'm not willing to build my portfolio based on that. I will change my bias towards inflation if China gets through this without any major implosion and we avoid major trade disputes.
Under the shock of massive deleveraging caused by the equally massive write-down of perceived global wealth, we expect the growth rate of GDP for the whole developed world to continue the slowing trend of the last 12 years as we outlined in April 2008. Since this recent shock overlaps with slowing population growth, it will soon be widely recognized that 2% real growth would be a realistic target for the G7, even after we recover from the current negative growth period. Emerging countries are, of course, a different story. They will probably recover more quickly, and will continue to grow at double (or better) the growth rate of developed countries.
I think it's fairly safe to assume that GDP growth will be much lower over the next 20 years than the last 20. Without the same leverage, developed countries like USA, Britain, et al, will slow down. Similarly, I doubt that China can grow at 10%+ in the future, or that Brazil can grow at the same high rates without a commodity bubble.
One of my potentially big macro bets this year (and beyond) is shorting gold. It's just an idea at this point, and I am likely early, but I don't find gold attractive. So, I've been researching and building my thesis. So far early indications are that gold is only worth shorting if it goes past $1000 to, say, $1500. I'm researching some theories I have and will post entries as I finalize them.
The first theory to test is if gold does indeed do poorly during deflationary periods. One of my reasons for considering a short of gold, apart from it doing so well in the last 10 years, is due to my belief that it isn't a good asset to own if we enter a long slump like the 30's and 40's. I'm not expecting a depression but I do think growth will be below potential (3% real growth is roughly the potential for USA.) Most of the world was on a gold standard during, or at least going into, the Great Depression. USA was also on the gold and silver standards during big chunk of the 1800's, including the late 1800's. More recently, USA was on a quasi-gold standard--US$ not redeemable in gold for Americans; but redeemable into gold for everyone else--until 1971 so it's difficult to read the situation during that period.
So I looked at Japan in the 90's to present, another famous deflationary period, to see how gold performed.
This chart is constructed by taking the gold price in US$ and adjusting it by the US$-Yen exchange rate. Ideally, one should just look at the market price of gold trading in Japan but I couldn't find data for that. My thought is that my method should roughly represent the actual Yen gold price in Japan (if we were in a pure free market it would, but given government restructions, arbitrage costs, etc, it may not.)
Before we look at the data, there are several things to keep in mind.
First of all, we are only looking at a single scenario which may or may not be reflective of future environments. Trying to form opinions based on one data point is dangerous but we have nothing else to look at since most of the developed world was on a gold standard or a quasi-gold standard until the 1970's (it wasn't a continuous gold standard but it was mostly a hard currency period, with silver standard being also popular in the distant past.)
Secondly, the BOJ intervened heavily during the 90's and 2000's to keep the Yen artificially down (to help Japanese exporters.) BOJ wasn't really successful but nevertheless, buying US$ and selling Yen would have had some impact, even if it was unpredictable. If anything, gold in terms of Yen should have risen due to the BOJ heavy buying of US$ during that period, yet that is not what we see.
I should also note that I'm plotting the average monthly prices, which isn't the same as the daily spot prices. I also estimated the December 2008 gold price from a different source since it wasn't available in the monthly series data I had.
Gold in Yen terms seems to have declined throughout the 90's. It also seems that gold in Yen declined more in the 90's (the gap between the US$ and Yen increases) so gold was not a good asset to hold in Japan at that time. Given how the BOJ was actually buying US$ and selling Yen (should be bullish for gold,) the decline in gold against the US$ gold leads me to conclude that gold was behaving poorly.
But it seems that gold in Yen terms is simply tracking gold in US$ terms. Gold in US$ hit a bubbly peak in 1980 and entered a 20 year bear market, and the gold in Yen was following a similar path. This either means that gold in Yen was being driven by the world gold price; or it means that gold was simply being driven by valuation and sentiment. If the latter point was the main reason, that is, gold in the 90's being driven by valuation and sentiment, then the decline in gold in Japan may not be due to deflation. The decline in the 90's in Japan could simply be due to the fact that gold was likely overvalued in 1980 and was in the process of correcting valuations.
So, overall, I have to say that this limited data implies that gold wasn't a good asset to own in Japan during the 90's. But the observations are inconclusive given how gold seemed to be largely impacted by the world--US$ gold and Yen gold tracked each other closely--than the deflation in Japan. The implication of all this--just based on one data point, mind you--is that, if one is going to short gold, they can't rely on the situation in USA alone. It is likely that gold is driven by the world price, which, in the last few decades, was largely dependent on the US but, in the future, it may or may not be influenced to the same degree by the US. Or, it is possible that gold is driven by valuation and not the actual economic scenario (i.e. if gold was undervalued now, it would rise regardless of what happens in the world.)
Some items you may find worthwhile...
- Leveraged or inverse ETFs are dangerous (Morningstar): I mentioned this before but this Morningstar article does a good job illustrating how inverse and/or leveraged ETFs can behave unexpectedly. We are talking about inverse ETFs posting negative returns while the actual index it shorts is down for the year. Very important to read if you are use inverse or leveraged ETFs. [further comment below]
- John Thain out at Bank of America (The Globe & Mail): This story has made its rounds but it wasn't a big surprise to see John Thain being fired by Ken Lewis. I have been critical of the John Thain situation, not because I have any opinion of his work, but for the fact that Merrill Lynch board of directors, and hence shareholders, paid him around $50 million (with potential of more than $100 million per year based on stock performance) simply for accepting the job at Merrill Lynch. It was hard to see what sort of job he would need to do to earn his pay (Of course, the fact that he didn't do a good job and the stock collapsed with massive losses for shareholders made the point moot in the end.) In any case, the firing is an interesting situation. Thain was perhaps disingeneous in keeping the massive losses at Merrill Lynch away from Ken Lewis; but he probably did a good job for the shareholders of Merrill Lynch in getting Bank of America to buy it out at a good premium without BAC ever realizing that Merrill Lynch was on the verge of posting a massive $15 billion loss.
- One analyst sees TSX P/E rise to 30.3 (National Post): It's obvious to anyone investing for a while but one should always keep in mind that the P/E ratio is more complicated than it seems. In some cases, a high P/E means valuations are low; while in other cases it's the opposite. A big chunk of the TSX is composed of cyclical sectors such as materials and energy, so its P/E will actually rise significantly during recessions. This is certainly the case in the last decade due to very high, unsustainable, earnings from commodity businesses.
- Warren Buffett PBS interview (ValuePlays): Nothing new per se but always good to hear Buffett's opinions...one of the great Americans of all time...will miss him when he's gone... (Recommended although nothing new)
- Jeff Matthews sees Berkshire posting its all-time large book value loss (Jeff Matthews Is Not Making This Up): Good write-up about Buffett picking up the Morningstar CEO of the year award...the thing, though, is that this will be Buffett's worse year of his investing career (in terms of book value loss.)
- Inside look at the worker environment at Zappos (Fortune): Some of you may have encountered Zappos!, which is an online retailer primarily dealing in shoes. Readers with an interest in entrepreneurship may want to read this article to see a laid-back work environment.
- Some don't see progress from Satyam scandal (Fortune): India is one of the most corrupt countries on earth--and I hate to say it because I come from that part of the world, albeit not from India. So a corporate fraud scandal is actually an opportunity to clean up the system. But this Fortune article implies that progress will be limited. The Satyam case seems to be theft on a grand scale--the criminal chief executive originally said that it was due to losses that were masked which seems to be a lie, especially given how the business process outsourcing industry actually has good profit margins--with family founders looting up to a billion dollars from shareholders through as many as 100 side businesses.
- Some Peter Schiff foreign stock picks (Fortune): I am not a fan of Peter Schiff but some readers may find him interesting. For anyone that hasn't heard of him, he's an extreme superbear who is very similar to Jim Rogers in ideology (Austrian Economics with extreme distaste of central banks and governments in general) and investing picks (commodities, gold, foreign stocks, bearish on US$, bearish on US stocks.) You can find the main article about him here. [further comment below]
- What is going to happen to banking? (The Economist): One of my readers actually e-mailed me to say he was dumping my RSS feed due to my severe criticism of excessive de-regulation and claim that greed from shareholders/owners was a cause of the financial crisis (sucks to be me ;) but it's about time some people took responsibility for their own culpability in this crisis.) The interesting thing is that, those who were totally in favour of lax regulation, low taxes, high compensation for executives, low capital gains taxes, etc, are caught in a tough situation and won't admit their culpability. They know that the banking system will collapse if the governments they were criticising don't bail them out. It's an interesting dilemma. One of my loyal readers, ContrarianDutch, is, also, critical of government nationalization but I see no alternative. Sharing ContrarianDutch's view, The Economist magazine says "As a capitalist newspaper, we reject a deliberate policy of wholesale nationalisation." But I claim that the fate of many banks is outside their hands. Death is near. Executives and shareholders are starting to realize this...
- The trade imbalance problem (The Economist): The story of 2009, as I have claimed, is going to be China. Economists and casual observers have been warning about the unsustainable trade imbalance, particularly between USA and China. We will get a final solution to this problem soon. Investors' fates rest on the outcome. (Highly recommended reading for macro-inclined investors) [Further comment below]
Leveraged and/or Inverse ETFs
This is something I had brought up before but it's always worth revisiting. As you may or may not know, the widely popular leveraged and/or inverse ETFs return the daily leveraged and/or inverse return. If you invest in an ETF or ETN that is a 2x S&P 500, it will return 2x the daily return. What this means, in practice, is that the result over the long run, say in one or two years, generally isn't what you would "expect." That is, a 2x long ETF will not produce 2x the underlying index return in an year. The vast majority of the time, the returns will be something that is "unexpected." As crazy as it may seem, a short ETF and a long ETF of the same underlying index can both be negative over an year! This was actually experienced by many who shorted the financial stocks last year and ended up losing money even though the underlying index was down as well! The most important thing to realize, if you are using one of these vehicles, is that the long-term return depends, not only on the direction of the underlying index, but also in the path it takes. The core reason is because investment returns are geometric (e.g. something that falls 33% (say from $15 to $10) requires a 50% gain ($10 to $15) to go back to that level.)
Paul Justice of Morningstar has an excellent article illustrating how the long-term returns are almost "non-sensical" compared to what these ETFs are advertised as. I urge you to read his article but here is a hypothetical table that he produced to illustrate the outcome of various 1x long, 1x short, 2x long, 2x short, e.t.c., securities:
In the table above, the hypothetical oil index starts at $35, goes to $60 and then collapses back down to $30. Starting with $100 in a 1x long index results in a final value of $99.56 for a -0.44% return. What would one expect the inverse ETF to post? How about the 2x long or 2x short?
How about the 3x long and 3x short funds? Well, it may be hard to believe but the 3x long fund actually posts a return of -34.02%, while the 3x inverse fund posts -57.79%!!! Yes, the actual (1x long) index is only down -0.44% while the 3x long and 3x short funds post massive losses.
I know some blog readers have said in the comments that they are considering using some of these vehicles, such as the long oil ETF or the short Treasury bond ETF, among others. I have personally looked at the short gold ETF (there are a few US ones and a Canadian one in Canada as well.) It is absolutely essential that you think about the path that your bet might take. Without thinking much, I think the short Treasury ETF (such as TBT) is probably safe since bonds aren't as volatile (although one should be prepared for anything given the current investment environment.) The dangerous ones are the commodity ETFs or the leveraged ETFs, such as the 2x or 3x ones. I would be very careful about using the 2x or 3x ETFS, either long or short; and any short ETF in a volatile sector like commodities.
I don't mean to be arrogant--who am I anyway?--but I think Peter Schiff is overrated. Some on the web speculate that his clients didn't do too well last year since foreign markets collapsed more than the US markets even though his predictions came true. Nevertheless, he has been correct in some of his superbearish views.
He clearly seems to have believed in the now-discredited decoupling theory. This was a theory followed by many commodity bulls, including Jim Rogers I would imagine. I was always skeptical of the decoupling theory since it didn't fit my macroeconomic view. For instance, the fact that USA was consuming a big chunk of exports from China, which in return was consuming a lot of commodities and semi-finished goods from the rest of Asia, Latin America, and Australia, essentially meant that the whole system was tightly linked cycle. If there was a crack in one of the links, the whole thing was bound to fall apart. And, indeed, that is what happened. It seemed illogical to be making superbullish bets on commodities and foreign markets while expecting the collapse of the US economy.
I'm also linking his article because he has some foreign stock picks--you don't see too many foreign stock picks so it may be of interest to many. Unfortunately he seems to favour foreign small-caps and, unless one does a lot of research and understands the foreign operating environment, it can be very dangerous. I don't have a strong interest and hence won't be looking at it now but the most attractive one from the list is Singapore Petroleum (BTW do not rely on dividend yields or P/Es for cyclical companies--their earnings will collapse a lot as the economies of the world slow.) I have no idea if there are price controls in the regions that Singapore Petroleum serivices--many Asian countries control fuel prices--but it is worth checking out as a long term bullish bet on Asia--perhaps something to look at if you think Asian economies are going to recover.
(Regardless of the fact that I don't agree with his ideology, I have to say I respect his father, who seems to be in jail due to his refusal to pay federal taxes. I don't agree with his position at all but it's sad to see someone jailed for refusing to pay taxes. One would think US law enforcement would have better things to do. Unlike many wealthy individuals who avoid paying taxes due to greed, Irwin Schiff seems to be genuinely driven by his ideological opposition to the IRS. I can see why the government jailed him--they don't want him spreading his, supposedly illegal, messages and inciting a revolt against the IRS--but the whole situation is kind of pathetic when you think about it.)
Trade Imbalance and the Not-so-obvious Solution
Economists had long feared that America would ruin itself on foreign borrowing. The current account, which measures the balance of investment and saving, has been in the red every year since 1992. Until 1997, the annual saving shortfall was modest but it grew steadily thereafter, reaching a peak of $788 billion, or 6% of GDP, in 2006....
An unsatisfying implication of the literature on the saving glut is that it paints America as a tragic victim of forces beyond its control (though some of the authors insist this is not their belief). The emerging markets’ need for insurance, in its many guises, drives them to export capital to America (and to similar places, such as Britain). America, by implication, has no choice but to make room for it.
In fact, Asian savings may have provided the rope; but America hanged itself. The macroeconomic forces that drove the capital flows were hard to reverse. But what made them so devastating was that they were met by microeconomic failures...
I was first introduced to the dangerous trade imbalance in the US by Stephen Roach of Morgan Stanely in 2005 or 2006. He was very early and was obviously "wrong" as the bull market continued and very few seemed to care about the expanding trade deficit of USA.
Now, perhaps a bit too late to incorporate it into our investing, we are seeing the global imbalance problem rearing its ugly head. To make matters worse, the wealth destruction in America has made the situation far worse than it seemed to most, including me. Consumers, who were the main debtors benefitting from the trade deficit, seemed to be ok, but not great, a few years ago. But given the collapse in virtually all assets, but especially real estate and stocks, which will not recover to their prior highs for decades (assuming no high inflation,) American households seem to be in bad shape. If one thought American households were able to finance their debt 2 years ago, that seems less true now.
Needless to say, it's hard to say what the final solution to all this will be. My opinion right now is that we will be in a long slump. No depression but slow growth for a while. I'm planning to quote him in more detail but if you want a heads up, you can read Jeremy Grantham's latest letter (source: ValuePlays,) in which he presents his thoughts on the current situation... and they ain't pretty.
Tags: Canada, China, economics, entrepreneurship, India, insightful, Warren Buffett