Monday, August 31, 2009 0 comments

Some articles I found interesting

Here are some articles, interviews, and commentaries that I found interesting over the last couple of weeks. I don't know if it's a coincidence that quite a number of articles are about China; or am I subconsciously thinking about issues surrounding China? hmm...

  • Overview of China (The Globe & Mail): A nice, detailed, recap of the situation in China.
  • Seth Klarman Harvard interview (Harvard Business School): Forget where I got the original link from but here is a brief interview of Seth Klarman. It mainly deals with his life and his thoughts on life.
  • Changing winds of capitalism (The New York Times): David Leonhardt's essay chronicles the changes that are occuring in economic thought. He suggests how Adam Smith was far less of a laissez-faire capitalist than generally suggested.
  • Marc Faber audio interview with (; Marc Faber Report, original mention by Alex Garcia at GuruFocus): The usual stuff... didn't find anything that stood out to me.
  • Marc Faber audio interview with King World News (King World News): Nothing new or insightful for Marc Faber fans.
  • (Recommended for contrarians) Robert Prechter audio interview with King World News (King World News): Super-bearish and thinks the market may have set a bottom for the US$. I don't have much in common with Prechter since he relies heavily on technical analysis and human mood psychology but I have been listening more to him lately since he is one of the few deflationists out there. I really don't find the mood pscyhology very convincing. For instance, Prechter argues that deflation (i.e. collapse of asset prices) will set in when humans switch their mood from optimism to pessimism. I agree that the mood may have some impact in certain circumstances. But I'm not really sure the whole economic environment can be explained by that.
  • Five Stages of Panic Buying (The Reformed Broker; via Naked Capitalism): Funny and insightful...
  • David Dreman's summary of the financial meltodown and his future outlook (David Dreman; via GuruFocus): David Dreman, the master contrarian investor, was hit really hard in the last few years and was even let go by the mutual fund that used to bear his name. A lot of his holdings were in financial companies, with some oil & gas companies, and he was decimated. In this presentation from June, he recaps the financial crisis and presents a brief, one-slide, outlook. I'm not a fan of this presentation but am linking it for reference purposes. He puts way too much emphasis on government actions—I thought investors believed in the free market?—and almost blames the government for not doing enough to protect the financial companies. When it comes to the future, he expects very high inflation and thinks stocks and real estate will perform best in that environment. He says bonds will be devastated by inflation.
  • (Recommended) Alice Shroeder's opinion of Buffett's tactics and a quick look at one of his early investments (Value Investing Fundamentals; via GuruFocus): Greg Speicher of Value Investing Fundamentals takes a quick look at one of Buffett's early investments. It appears that Warren Buffett does not build models of a business (although it's always possible he does it in his head since he has photographic memory and can remember most of what he reads.) The article also suggests that Buffett targets a return of around 15% for his investments.
  • The gambling den known as the Chinese stock market (The Economist): I have always treated the Chinese stock market as something resembling a casino. It's amazing to me that investors use the Chinese market as a price signal. Today (Aug 31), world markets are thought to have sold off due to the decline in the Chinese markets. To me, it makes little sense. In any case, this is a good article that presents some views that support my contention that the Chinese stock markets should not be relied upon. As the article points out, valuations appear statostrophic with a P/E ratio floating near 31. The positive, if you are clutching at straws, is that the P/E ratio is nowhere near the 60+ it was when the market last peaked in 2007. So, any crash is unlikely to be anywhere near the recent 75% decline.
  • Checkmate for private equity king, Chris Flowers? (Fortune): A lot of private equity firms profitted handsomely in the last few decades, from the booming economy, stock market, and cheap liquidity, but some are running into serious problems. Cerberus, a giant in private equity, is all of a sudden, under threat of investors dumping their funds. This story profiles Chris Flowers, who has faced a rough time with some terrible bets, including a major investment in Hypo Real Estate, a major mortgage lender in Germany.
  • Stephen Roach Bloomberg interview (Bloomberg): Roach seems really concerned about China. He thinks problems can develop if China expands lending next year, after the current stimulus wears off. Stephen Roach basically says China is going for quantity rather than quality, which I would agree wtih. China had a boatload of NPLs (non-performing loans) after th collapse of the Asian Tigers in 1997 but it was able to absorb those losses. Roach suggest it may be difficult this time around because there is no one that can lead the global economy like USA has done after past crises.
  • Andy Xie says Chinese growth unsustainable (Bloomberg): Andy Xie, a former Morgan Stanley economist who was fired for suggesting Singapore's wealth creation largely came from money-laundering of corrupt and unscrupulous Indonesian businesspeople and government officials, often makes highly controversial calls. If you are not familiar with him, think Robert Prechter, except in terms of economics. He is wrong at times and early but he has made several major calls that turned out to be right. In this latest short video clip, he suggests that the Chinese stock market is a bubble waiting to implode. He also holds views similar to me and suggests that China is mis-directing the stimulus to useless things in the hope that world will go back to what it was (i.e. American consumers will ramp up their debt-fuelled spending.) Xie also says that a lot of money has been funnelled into property speculation. As I have said many times, the Chinese stock market is a joke and is very small compared to the economy, so we can kind of ignore that. However, a real estate bust will have huge, negative, consequences. To expand on something Andy Xie was saying, some municipalities get as much as 50% of their revenue from real estate, so imagine what happens if there is a bust. Similar to how municipalities are going bust in America from the real estate collapse, the same thing can happen in China.

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Sunday, August 30, 2009 1 comments

It's hard to see newspapers (or their online websites) surviving

I wrote up a somewhat lengthy comment for one of the articles in The Economist on newspapers. I rarely leave comments but felt it was worth expressing my view. I thought I would re-produce most of it here, with some edits. It pretty much repeats the same views I have expressed here many times before. The core problem is that newspapers lived off the network effect and now the network effect is going into reverse and they are getting killed. Advertising and subscriptions/readership is colliding head-on and it's hard for newspaper websites to maximize one without damaging the other.

Published on August 27th of 2009 and titled, Now pay up, it examines various strategies newspapers are contemplating, including attempts to charge for news. Charging for news on websites has entered serious strategic thinking at newspapers, possibly after Rupert Murdoch suggested that he may start charging for content everywhere. As I suggested at that time, I see little chance of Murdoch winning. Newspapers tried charging for content a few years ago—The New York Times and The Economist were not fully free a few years ago—and it failed.

Here is a slightly edited version of what I posted:

The issue with newspapers and their websites goes way beyond paying for news. The problem is that the business model is dead! Unfortunately, this is going to hurt journalism but hopefully we will somehow maintain quality journalism even if the newspaper dies.

An overlooked point is how newspapers never really lived off the money they made on subscriptions. Instead, what really supported their cost structure are advertising, classifieds, real estate listings, and so on.

Furthermore, newspapers had a monopoly or oligopoly (except in big cities) so people seeking specialized information, say sports, would read the newspaper.

So, even though people think of it as if subscribers were paying for journalism, it was only a small piece of the pie. Most of the newspaper, whether the physical printing, or journalist salaries, or editing, or whatever, depended on classifieds such as used car sales, apartment listings, etc. The newspapers have permanently lost this revenue source. Ebay, Craigslist, and so on, have basically taken away the classifieds business. Similarly, other companies specializing in cars or sports or dating or whatever have probably taken away the revenue. If you want to read up on cars or technology or fashion or whatever, you have little incentive to go to the newspaper website and can probably get better value from a specialized site catering to that subject.

To sum up, people never paid fully for the news. The news was always subsidized by advertising and other sources. With the likely permanent loss of other sources like classifieds, newspapers are down to paying for everything using advertising and subscriptions. Advertising alone probably can't support all the organizations out there; and subsriptions alone can't either. But it's difficult to get subscribers to pay and to bombard them heavily with advertising (way beyond anything seen on the physical paper) as well. It's a tough situation...

One more thing that came to mind...

The other thing is, advertising and subscriptions work against each other in the online world. If you force subscriptions on the user, the number of readers would decline substancially. This would result in lower advertising. Conversely, if you keep things free, you have get more readers and higher advertising, while have lower subscription revenue.

In the physical print world, it wasn't quite like this. Since it was a monopoly or oligopoly in most towns, readers had no choice but to read your paper (or often the only other one in town), and advertisers also didn't have much choice in the print portion of their advertising budget. In the end, you ended up with the best of both worlds: high subscriptions/readership and high advertising. Basically the network effect at its best... in the online world, newspapers and their websites have the negative of the network effect!


AIG short-sellers get burnt badly

Almost all short-sellers have been getting killed lately—especially the last two weeks. AIG, in particular, has not been very kind to those betting on its demise. The stock, thought to be worth very little, is up around 500% in the last month. You can see the spectacular rise and the heavy volume, due to short-covering, in the chart above. This goes to show the tough life of traders (in this case, the short-sellers.) Once short-covering gets going, it can skyrocket. As of today, anyone that shorted the stock this year is down almost 80%, unless they managed to cover. Of course, this is not to say that the stock won't collapse in the future. In fact, the Bloomberg article quoted below says that the AIG bonds are pricing the stock as if it is worth almost nothing.

I'll let Bloomberg has a detailed story on the situation:

American International Group Inc., the insurer bailed out by the U.S., gained for a ninth day, reaching a 10-month high as speculators bought back shares they borrowed and sold short, traders said.

AIG climbed $2.39, or 5 percent, to $50.23 at 4:15 p.m. in New York Stock Exchange composite trading after earlier rising as much as 17 percent. In a short sale, investors sell borrowed securities and agree to buy and return them to the shareholder later, profiting from any drop in the stock.

“It’s a short squeeze of an unprecedented fashion,” said Robert Bolton, managing director for trading at Mendon Capital Advisors Corp. “If it goes up enough in their face, then they have to make a decision to cut their losses. This is all fueling that updraft.”

AIG has 21 percent of its float, or shares available for public trading, sold short. That’s the sixth-highest proportion in the Standard & Poor’s 500 Index, according to data compiled by Bloomberg. Today’s gain marked the longest consecutive increase since May 2007, Bloomberg data show.


AIG’s so-called reverse stock split in June magnified the effect of short selling, said Jud Pyle, a market analyst at Chicago- based options trading firm PEAK6 Investments LP. Through the split, AIG gave investors one new share for every 20 they turned in to help keep the stock above $1 and avoid delisting.

“That meant there were fewer individual shares out there,” Pyle said. “If you can’t borrow the stock, you can’t short it. Because if there are fewer shares available to sell short, that can cause a short squeeze if people aren’t able to borrow it to short.”


As AIG’s shares have more than doubled in the last nine sessions, the company’s bonds still trade at levels that indicate the company’s shares may be worthless, according to Peter Boockvar, an equity strategist at Miller Tabak & Co.

“The value of the company is still the same,” he said. “AIG bonds tell you that the equity is possibly worth nothing and that they may not be able to pay back the government.”

AIG’s $3.24 billion of 8.25 percent bonds due in 2018 are quoted at 79 cents on the dollar to yield 12.2 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The insurer’s $4 billion of 8.175 percent bonds due in 2058 are quoted at 49.5 cents on the dollar to yield 16.7 percent, Trace data show.


Sunday Spectacle XXIV

Most Important Japanese Election in 50 Years?

Saturday, August 29, 2009 1 comments

Be careful with those trailing earnings

A lot people, including me, rely heavily on P/E ratios to evaluate securities or the market as a whole. One of the problems with the P/E ratio is the denominator, earnings. There are times when one should be extremly careful with the earnings figure. Now is one such time.

For the first time since 1933, S&P 500 earnings for a quarter (the 4th quarter of 2008) is negative. The loss is largely due to massive losses reported at financial companies. It's not clear how much of those losses are real, since earnings that depend on write-offs can reverse if the underlying assets gain value. In any case, the negative earnings causes the P/E ratio to be negative for the 4th quarter of 2008, or, if you are looking at the full trailing year, a very large P/E (since that negative quarter plus the other three positive quarters ends up in a tiny earnings numbers.)

Impact On P/E Ratios

To see what I mean, consider the current valuations of some indexes. The S&P 500 has a trailing 12 month P/E of 70.85. The Russell 2000, which represent small-cap stocks, has a negative or undefined P/E. And the Dow Jones Transportation Average has a P/E of 4514.31! The DJTA P/E might actually be the highest P/E for a major average in the history of America. I certainly have never seen any major index with a P/E above 4000 :)

Clearly those numbers cannot be interpreted the normal way you would look at P/E ratios. Unless you think the losses are going to continue forever, one shouldn't rely on these P/E ratios. To overcome this extreme data point, you may want to look at forward P/Es or P/Es based on operating income, or P/Es excluding the financial sector*. In terms of forward P/Es, the indexes are posting typical P/Es between 15 and 20 (Russell 2000 and DJTA still have very high forward P/Es of 47.49 and 53.53, respectively.) I wouldn't blindly follow analyst forecasts; use this as a rough guide.

(* You should never exclude a sector because it is posting losses. Then you end up overstating the market results. However, my view is that the current situation is unique. We are facing a situation where a lot of financials posted large one-time losses. It is reasonable to conclude that these companies will not post similar losses in the future. )

Impact On Dividends

The negative earnings in 4Q08 for the S&P 500 also impacts dividend analysis. I think it mostly impacts anyone trying to gauge market valuation based on dividend payouts; I don't think what I am about to say is an issue for dividend-oriented investors.

In the July 2009 Elliott Wave Theorist, a newsletter for traders that I came across (the July one is freely available if you register), Robert Prechter has the following chart illustrating the dividend payout ratio. Prechter is making a bearish case based on the notion that the dividend payout ratio is 300%. In other words, companies are paying out way more than they earn and this is unsustainable.

I looked at dividend payouts and annoucements in a post a few months ago and share Robert Prechter's sentiment. However, it is not as bearish as Prechter implies. Prechter implies that the companies must cut dividends if earnings don't triple. I don't think we can draw much from the above-100% payout ratio because of the abnormal negative earnings quarter I mentioned above.

First of all, some companies will pay out more than they earn because, well, executives can mask the problem while shafting the shareholders. This involves taking on more debt or issuing shares and paying out dividends. Financial companies have been notorious in the last two years years. I have beaten to death the issue of how AIG not only paid out dividends but also increased it while issuing shares to pay for them. I have also cited the Canadian banks for their shareholder-wealth-destroying strategy of issuing a ton of shares in the last year in order to, largely, keep paying out dividends at a constant level. This tactic is not sustainable but it can go on for a long time.

Furthermore—this is really the main point—it is not that inconceivable to see earnings triple. Prechter is correct in suggesting that this is an extreme scenario but we are in an unusual, once-in-50-years, scenario. It can happen because of the extremely low earnings in the last year. Indeed, analysts are forecasting earnings rise slightly more than 3x (you can tell quickly by noticing how the trailing p/e drops from around 70 to a forward p/e around 18.)

To sum up, we need to be careful with the earnings numbers because of massive losses posted in the last year. The important question is not the abnormaly low earnings in the past year, but what happens in the future. The question to think about, if you like thinking about the big picture, is how far earnings will rise. Analysts have the S&P 500 P/E dropping from 70 to 18 but is that too optimistic? Or is not optimistic enough? If you like thinking about dividends rather than P/Es, the question is where the payout ratio will end up. If it ends up at, say, an 80% payout ratio, it's probably not very bullish (since companies will end up paying out almost all their earnings as dividends); but if it falls to 60%, it means they still have lots of profits beyond their current dividend payments.

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Thursday, August 27, 2009 17 comments

I'm thinking of betting on the US long bond... anyone think the risk-reward is reasonable?

I'm thinking of taking a position in US long bonds through the TLT ETF. Anyone have any thoughts on it? Last time I bet on the long bond, I lost money. The interest rate call was correct but the US$ decline caused losses. The situation is a bit different now.

This could be the dumbest idea ever... it's certainly risky. The only positive is that it is very contrarian. Being contrarian for the sake of contrarian is not always profitable, but is this different?

The thesis for the investment is a bet on deflation. Almost everyone, including superinvestors such as Warren Buffett are betting heavily on inflation, but is it possible that they are all wrong? I have been researching the issue for a while (I'll write up some blog entries on various ideas related to this over the next few weeks.) The case for deflation isn't solid but neither is the inflation view.

Any thoughts?

Wednesday, August 26, 2009 0 comments

Another reason to avoid foreign least in Canada

(This post applies to Canadians only. Taxes vary by jurisdiction so it may be different in your area.)

John Heinzl at The Globe & Mail, in one of his columns, goes through the tax treatment of US dividends for Canadian investors. To put it bluntly, US dividends will be taxed at the marginal tax rate (assuming you are not using a tax-sheltered account.) What I never knew before reading the article was how TFSA accounts, which were introduced this year, are treated.

Note that the rules will be different for other countries. Taxes, whether on dividends, or capital gains, or some other source, are dependent on tax treaties between countries. So, for example, dividends from Japanese stocks for a company listed on the Tokyo Stock Exchange will be different. I'm not sure how taxes are handled for a Canadian investor owning an ADR of a foreign company listed on the NYSE.

Also, this post, and the original Globe & Mail article I will be citing, covers normal dividends. Income paid out by income trusts (Canada/Australia), Master Limited Partnerships (USA), "flow-through" units, and so forth, often involve greater complexity and may or may not be treated the same as regular dividends. Return of capital, sometimes mistakenly thought of as dividends by some, also generally involve more complex tax treatment and I'm not sure if what I say in this post applies to them.

US Dividends Within RRSP/RRIF

First, how US dividends are treated within a tax-sheltered account such as RRSP or RRIF:

Inside a registered retirement savings plan (RRSP) or a registered retirement income fund (RRIF), there's no withholding tax on U.S. dividends. So the entire amount will land in your account – adjusted for currency. That's why many investors prefer to hold U.S. stocks inside an RRSP.

Pretty basic and is kind of what one would expect: no taxes paid on dividends. You pay neither the witholding taxes (extracted by USA in this case) nor any taxes on the dividend (that Canada would extract.)

The tax treaty between countries would have to specify how dividends are handled. Other countries may not provide favourable treatment of dividends as the US case. I'm not an expert and haven't seen it happen, but if there were no treaty between countries, I suspect that you will get charged the witholding tax. And you probably won't get credit for the witholding tax (in contrast, if this were a taxable account, you can almost always claim a credit for witholding taxes charged by foreign governments.)

US Dividends With No Tax Shelter

The standard case where you receive US dividends in your normal (non-tax-sheltered) account is as follows:

For starters, you'll pay a 15-per-cent U.S. withholding tax off the top. Also, because U.S. dividends don't qualify for the Canadian dividend tax credit, when you file your return you'll pay tax at your marginal rate on the full amount of the dividend. The good news is, you'll be able to claim all or part of the 15-per-cent withholding tax as a foreign tax credit.

Yes, it's confusing, but the net effect for most people is that, in a non-registered account, U.S. dividends are taxed at the same rate as interest income.

I didn't know that you get charged a witholding tax on your dividend but, then again, I don't generally invest in dividend-oriented companies. You get a credit but I hate doing the paperwork for that :(

Overall, in this scenario (no tax-shelter), US dividends get taxed at your marginal tax rate. This makes dividends (at least US ones, and likely all other foreign dividends) unattractive! You pay the same rate as you do on your (wage/salary) income or on interest from bonds/cash. This means that you are just as better off owning US bonds.

What is described here only applies to foreign dividends. If you were getting qualified Canadian dividends, you are better off receiving dividends than interest from a bond. Canadian dividends are taxed at a lower rate; while interest is taxed at your (higher) marginal rate.

I'm not a dividend-oriented investor but if you were, and are living in Canada, you should attempt to find Canadian companies for your non-tax-sheltered account. You do not get any benefit (strictly speaking from a tax point of view) with a US dividend (compared to interest on a bond.)

This scenario describes another reason to not like dividends. If you owned a foreign company, you should get it to avoid paying dividends to you. Not only do you end up paying a higher tax rate (same as marginal rate), the company also gets double-taxed. You would be better off if the company bought back shares (hopefully not when wildly overvalued) or re-invested in the company (hopefully in successful projects.) The double-taxation plus your own higher taxes makes a case for avoiding dividends.

US Dividends Within TFSA

Anyway, the thing I learned from this article was how US dividends are handled in the newly-introduced TFSA:

Tax Free Savings Accounts add yet another layer of complexity. Because TFSAs – unlike RRSPs and RRIFs – are not strictly a retirement vehicle and are therefore not covered by the Canada-U.S. tax treaty, U.S. dividends are subject to the 15-per-cent U.S. withholding tax, says Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth Management.

What's more, the withholding tax can't be claimed as a credit. So on a $100 dividend the investor will end up with $85, which for most people is still better than paying tax on the dividend at their marginal rate.

The TFSA scenario is a weird one, at least to me. You pay the witholding tax but no other taxes. It's sort of half-way between the other two scenarios.

Last Word

Hope some Canadian readers found this post useful. If you are using a normal investment account (no tax shelter), you should probably forget about US dividend-oriented companies and try to find some Canadian ones. If you were using a tax-sheltered account, then US dividends are ok for dividend-oriented investors.

If you are not a dividend-oriented investor then it gets complicated. Even if you pay the lowest dividend taxes in a tax-sheltered account, you may be better of shielding capital gains instead. So you are probably better off owning US bonds (assuming risk-return characteristics are comparable) in your normal account and using your tax-sheltered account for capital-gains-oriented investments. However, as anyone that has lost money will know full well, you can't write off losses in your tax-sheltered account. So it's not as simple as it seems.

I haven't found an optimal solution for my situation yet. Right now, I attempt to use non-tax-sheltered account for my low confidence investments (so that I can write them off if they blow up.) I haven't bought anything yet but my goal is to buy high yield bonds in my tax shelter.

Oh, one final laws change over time so if you are reading this in 2020, check the official documents. Canada could be at war with USA and you may not get any credit for US witholding taxes ;)

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China studying overcapacity issues

I ran across a Bloomberg story that suggested that China is studying potential overcapacity in several industries:

China said it’s studying curbs on overcapacity in industries including steel and cement, adding to concern policy makers may seek to rein in growth fueled by record credit expansion this year.

The government will increase “guidance” of industries including steel, cement, coal chemical, plate glass and wind power equipment, the State Council, China’s cabinet, said in a statement on its Web site today. The government will strengthen controls on approval of stock and bond sales by companies in these industries, according to the statement.

I have been following (but not very closely) stories pertaining to China for many years now, and this is one of the few times I can remember where the government is actually targetting the overcapacity problem. China has attempted to improve the efficiency of its steel mills for more than a decade now. There are way too many small operations that are inefficient. But because they are inefficient, they create a lot of jobs—at least in the medium-term. Little progress seems to have been made in the steel industry over the decade. What's new here, at least for me, is how they are targetting areas with potential overcapacity such as wind power equipment, cement, and so on.

People like me have been concerned about massive overcapacity in China for years. To get an idea why I believe there is overcapacity, consider China's output capability, as mentioned by the Bloomberg story:

China produced 500.5 million metric tons of steel last year as the world’s largest producer. That’s more than the combined output of Japan, the U.S., Russia and India, the next four biggest makers, according to the World Steel Association. In the first seven months of 2009, China accounted for almost half of global steel output.

The nation is also the world’s biggest coal producer and consumer, accounting for 43 percent of global demand last year, according to BP Plc. Imports averaged 8 million tons a month this year, more than twice last year’s average of 3.4 million tons.

China produced an estimated 1.45 billion tons of cement last year, accounting for half of world output and making it more than eight times bigger than its nearest rival India, according to the U.S. Geological Survey.

These numbers are truly mind-boggling. Think about it: China produces as much steel as the next 4 biggest countries combined; china produces 8x more cement than the 2nd place country (India); and so on.

Yes, China is growing and will require more than other countries. It is also a big country so it would suck up a sizeable amount of resources. Yet, this seems very extreme to me.

The risk with all this overcapacity is not what happens now—although some argue that resources are being misallocated towards fixed-assets—but, rather, what happens when China doesn't consume at the same rate. Can you see why people like me think China can potentially unleash massive deflationary forces? If China can produce far more, say, solar panels than is needed, it will drive down the price of solar panels everywhere. Secondly, it may also dump the excess goods on the world market, potentially causing trade disputes.

From China's point of view, imagine what happens to all these workers in, say, a cement factory, who are not needed anymore. Repeat this with countless other industries. The only industries that may not need to shrink are those related to energy (since energy consumption is likely to continuously increase.) So, I don't think there is overcapacity problems in coal, even though the story says the government is looking into it. But what happens to all those employed in the steel industry—not just in the mills but, say, those working in the iron ore import business. How about the copper industry? On and on.

Another problem with these Chinese industries with overcapacity is that they are also the ones that are thought to be inefficient. In other words, for China to increase its wealth—GDP per capita or income per person—it needs to increase productivity. Doing so will require streamling the industry, getting rid of the smaller ones producing poor-quality products, using new technology, and so on. Such actions will create unemployment! Use of new technology will automatically reduce the number of workers needed to do the same job. The only way around this issue without a political revolution is if China develops its service industry. Generally service industries are consumption-oriented and utilize more labour. But that takes a long time and it remains to be seen what actually comes of all these overcapacity problems...


Some homebuilders think the housing bottom has been hit

A lot of people look at measures like the S&P/Case-Shiller index or home transaction volume to figure out if housing has hit a bottom. If you are a free-market guy like me, a stronger sign is when homebuilders actually ramp up their activities. Home sales, prices, and so forth, can be distorted by subsidies, bank write-offs, and the like; but when a homebuilder risks their precious capital to start building more homes or acquire more land, it is a powerful signal. Bloomberg is reporting that some are actually starting to acquire land or start new projects:

Signature Properties has been trying since 2005 to sell 4,000 finished lots in its Fiddyment Farm community, a former pasture and pistachio orchard northeast of Sacramento, California.

The developer sold 41 sites in April to Meritage Homes Inc. for $66,000 each, and another 41 in June to Hovnanian Enterprises Inc. for $68,000 apiece. This month, they got their best offer yet -- $103,500 each for 77 sites.

Signature Properties said no.

“We decided to build it out ourselves,” said John Bayless, president of the Sacramento division of Signature Properties, a closely held developer in Pleasanton, California. “Our feeling is, ‘The tide’s turning. Let’s build ‘em.’”

Homebuilders that spent the past three years selling off land and writing down the value of property holdings are scouring markets in Sacramento, Phoenix, Denver and Orlando -- cities synonymous with the real estate bubble -- looking for deals on ready-to-build lots as they prepare for a rebound.

Writedowns and write-offs by 14 of the largest publicly traded homebuilders totaled $28.5 billion since the start of 2006, according to a July 15 report by Fitch Ratings.

Home prices in 20 U.S. cities fell in June at a slower pace than forecast. The S&P/Case-Shiller home-price index declined 15.4 percent from a year earlier, the smallest drop since April 2008, the group said yesterday. The gauge rose from the prior month by the most in four years.

New home sales climbed 11 percent in June, the biggest gain in eight years, and housing starts were the highest since November. Single-family home starts increased again in July, for the fifth straight month, the U.S. Commerce Department reported on Aug. 18. July new home sale data will be released today.

Of course, none of this means that things won't deteriorate further. Market is usually efficient but not during stressful times or during turns. It's always possible that these homebuilders are completely wrong and will end up losing money. The possibility of Japan-like real estate bust cannot be ruled out. The risk will materialize if the US government orders the GSEs to stop absorbing losses. So far, the GSEs have been supporting the mortgage market (they were especially powerful last year when they were the only ones keeping their "lending" somewhat loose.)

Here is a chart of some of the leading homebuilders, as well as the S&P 500:

Homebuilders have been on fire and all of the ones in the chart are outperforming the S&P 500 this year (S&P 500 is coloured tan.)

Tuesday, August 25, 2009 1 comments

Bernanke reappointed

MarketWatch reports:

President Obama made it official Tuesday morning, announcing that he is reappointing Ben Bernanke for a second four-year term as chairman of the Federal Reserve.

In a short statement in Martha's Vineyard with Bernanke standing at his side, Obama said Bernanke's background, temperament, courage and creativity helped to prevent another Great Depression.

"Ben approached a financial system on the verge of collapse with calm and wisdom; with bold action and outside-the-box thinking that has helped put the brakes on our economic free fall," Obama said.

I think this is the proper move. No one is perfect, and I don't think any single person can solve the economic problems, but Bernanke is more capable than many others. The leading candidate to replace him, according to some leaks a few months ago, was Lawrence Summers. Summers was favoured by some Democrats (Bernanke is a Republican although he seems to stay neutral on political issues, unlike Greenspan) but I didn't think he seemed suited for the task at hand.

Monday, August 24, 2009 2 comments

Thought about deflation: can debt save a debt-addicted world?

(This post is more of a random thought and isn't well written. It's just to generate some thought...)

I have been thinking a lot about what Robert Prechter said in his deflation booklet that I referenced in the past. As crazy as this may seem, I have also been thinking about betting on long-term US Treasuries. Last time I made a macro bet on US Treasuries (using the TLT ETF) I lost money (interest rate call was correct but the US$ decline caused a loss.) It's kind of scary thinking about it because you are going against almost everyone—I can't think of anyone who is not bearish on the US$ or US Treasuries!

I think Prechter is right in suggesting that more debt can't save the indebted. I'm looking at China and I'm thinking 'this is just crazy.' Depending on the numbers and who you listen to, China is creating debt equivalent to almost half its GDP in one year! We are seeing the biggest economic collapse since the 1930's but I'm not sure if this is quite the way to go. The problem, as Prechter and others have suggested, is that you need as much credit growth the next year. If you don't issue a ton of debt again, you are back to square one.

The only thing with Prechter is that I find him too extreme. On top of relying too much on technical analysis and cycles—for instance, he compares the current central bank chairmen to the ones from the 1920's and 1930's, as if things will repeat—I think his calls for a roughly 90% collapse of the stock market sounds extreme.

Having said that, his timing may be off but some of his extreme calls have been spot on. Just reading that booklet of his, it's amazing how right he was on some things. For instance, he predicted several years ago that a lot of AAA-rated bonds would get downgraded during a deflationary bust (just like during the Great Depression.) True to his words, a huge number of AAA-rated credit instruments were downgraded in the last 3 years. Most of them were mortgage bonds but we also had companies like AIG, GE and Berkshire Hathaway lose their AAA ratings.

Anyway, for anyone thinking of betting of deflation, I think it comes down to whether the Federal Reserve will print money en masse and drop them out of helicopters. Prechter suggests that they won't. I have gone over the reason why he thinks that (namely, the FedRes will lose credibility.) What Prechter suggests is that the FedRes will keep creating credit to ward off deflation. This is what the FedRes, not to mention the Chinese government, has been doing lately. Taking cue from Ludwig von Mises, Prechter suggests that expanding credit simply delays things and will result in a bust. How likely is that? That's what I'm thinking these days...

SIDE NOTE about credit vs physical money:

According to Prechter, expanding credit will not be inflationary because it can implode and dissapear. In contrast, currency that is printed stays in circulation so it is highly inflationary. The public and some amateur investors are often confused between the two. Central banks, unless they were totally reckless, rarely ever print money (in the US, currency has grown at 6.1% between 1995 and 2008). There is roughly $800 billion in US$ in circulation. In contrast, depending on the measure you use, there is 10x more credit outstanding. To give you an idea of how little currency is in circulation compared to our daily usage, consider the fact that the value of all the stocks on the American exchanges are a little over $10 trillion. If everyone in America sold their stocks and wanted to hold cash, there wouldn't be enough cash! In such a case, stocks will collapse (i.e. currency will strengthen). Now replace stocks with credit (i.e. debt) and you'll see why credit can vaporize easily while currency can't. The $800 billion in currency will always be there (unless someone physically burns it) but the countless trillions in credit can dissapear.

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Everyone depending on China?

The above graphic comes from the freely available edition of Grant's Interest Rate Observer. It depicts the IMF's estimates—who knows how correct these will be?—of the contribution of China to incremental world growth.

If these estimates turn out to be correct, it's a scary-looking chart. IANAE (I'm not an economist) and my history is weak but when was the last time one country generated 70%+ of world's GDP growth? Maybe USA after WWII? I don't know but I suspect it would have been very rare.

This is a scary situation because, if China runs into problems, as I think it will (although timing is uncertain), the whole world is going to have serious problems. The only saving grace might be the fact that this is on a PPP basis. The share is likely lower on a nominal basis, which is probably more important in this case (I'm not sure.)

In terms of investing, this means that most market participants are likely betting their rosy forecasts on China continuing its growth. Indeed, one can observe very strong commodity price rallies almost entirely based on China's forecasts. Bloomberg recently had a story on commodities reporting that "...based on 2010 analyst estimates that call for profits to almost double..." Commodity businesses are very cyclical, and they are coming off a profit collapse, so it's hard to say, but my opinion is that a 100% EPS growth in an year seems extreme.

My guess... everyone betting on China to save them are going to be in for a shock.

Sunday, August 23, 2009 0 comments

Sunday Spectacle XXIII

A History of the Canadian Dollar by James Powell. Free PDF book at Bank of Canada's website.


Charlie Munger: Stock market as a pari-mutuel betting system

The model I like to sort of simplify the notion of what goes o­n in a market for common stocks is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based o­n what's bet. That's what happens in the stock market.

—Charlie Munger, "Art of Stock Picking"

Although I don't share the same views on politics, I am probably closer to Charlie Munger than Warren Buffett when it comes to how we view the world. Warren Buffett is almost singly focused on business and investing, and is not very opinionated, indeed possibly not knowledgeable, in other areas. In contrast, I am closer to Charlie Munger in the sense that I have diverse interests—you can probably tell by the articles I link to or write about—and have an opinion on almost anything. There is one big difference though: I am not into the field of psychology quite like Munger.

So it may be surprising to see me rarely talk about Charlie Munger, given my suggestion that I'm somewhat similar to him. Partly it's because Munger doesn't give many interviews and rarely talks specifically about current market events, specific stocks, and so forth. Overall, though, I suspect I don't cover him much because I already share some of his thinking. As crazy as this may seem, I actually tend to cover dissenting views more than views identical to mine. For instance, I have been bearish on commodities for years and have no reason to cover commodity bulls. Yet, I often cover Jim Rogers. I also disagree with Jim Rogers' prescriptions for the economy based on Herbert Hoover's playbook but I still give space to Rogers.

When I do cover Munger, it is generally on very important topics with insightful thoughts. For instance, one of my recent posts dealing with Charlie Munger's suggestion of derivatives such as CDS swaps as being similar to bucket shop operations has radically altered my views. In a similar manner, I feel the subject matter I will cover in this post is very important. Even if you don't share my view or don't find what I am about to say interesting, do read some of the referenced works below. If you are a newbie, "Art of Stock Picking" by Charlie Munger is a must-read at some point in your life.

I'm sure what I will write will seem trivial to some, and the article is old, but it changed my thinking and hopefully some who started out investing recently will find my thoughts worthwhile.

Art of Stock Picking

I read "Art of Stock Picking", an undated speech by Charlie Munger, several years ago, and it completely changed my investment thinking. The speech is quite interesting, and in true Munger form, doesn't hold back any punches.

The section that was very influential—at least for me—was Munger's proposition that the stock market is a pari-mutuel betting system. It's a subtle notion and I never looked at the market like that, until I read his thoughts. I took some finance courses in university (it wasn't my major) and it's amazing to me, speaking in hindsight, that I never encountered anyone presenting the market quite like that.

Before I say go into detail, if you are interested in a brief overview of Munger's thoughts, you can also find them, starting on page 30, in The Evolution of the Idea of "Value Investing": From Benjamin Graham to Warren Buffett, by Robert Bierig (April 2000). This essay by Robert Bierig runs down value investing over the years.

Pari-Mutuel Betting System

I'm going to be quoting extensively since it is important to get the thoughts from the source. I hope this doesn't violate some fair-use law or something. (As is usually the case on this blog, all bolded or highlighted text within quotes are by me. I made some slight edits with spacing.)

What is a pari-mutuel betting system? It is a betting system that is used in horse racing, among other activities, which involves pay-offs based on the total pool. An important element of it—this is what I found important for the stock market—is that the odds change based on the bets. Here is Charlie Munger introducing the concept:

Everybody goes there [horse track using pari-mutuel betting system] and bets and the odds change based o­n what's bet. That's what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.

Insight 1: Odds Constantly Change and Best Bet Never Obvious

The most important point to note is that the odds constantly change, just like the stock market. You can't go and invest in the company that appears best because the odds for that will be worse than a distressed company. As most stockpickers quickly find out, the divergent odds really makes a simple scenario very complex. I think value investors quickly understand this notion but many newbies, not to mention certain types of growth investors, really don't understand this.

Insight 2: House Takes A Cut—No Matter What Happens

Another important point is that the stock market, like the horse betting scenario, involves the house taking a cut off the top. The 17% in horse racing seems onerous but, fortunately, the commissions/fees/etc in common stock investing is usually in the 1% to 3% range. Nevertheless, if you want to beat the passive index, which is the goal of many (in addition to possibly posting absolutely positive returns), you need to overcome that. It is very difficult to beat the market by even 2% in the long run so one should attempt to minimize what the house takes from you.

It is also important to realize that, like horse racing, the house takes its cut even if you lose money. When you buy a stock, you pay a commission even if your investment turns out to be a dud; if you buy a mutual fund or an ETF, you pay an MER (management expense ratio) even if the fund lost money.

Characteristics of a Winner

Does anyone make money in horse racing? Munger mentions one person who made a living off it:

I used to play poker when I was young with a guy who made a substantial living doing nothing but bet harness races.... Now, harness racing is a relatively inefficient market. You don't have the depth of intelligence betting o­n harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet o­nly occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house ‑ which I presume was around 17% ‑ he made a substantial living.

You have to say that's rare. However, the market was not perfectly efficient. And if it weren't for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races. It's efficient, yes. But it's not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.

I bolded two elements that I feel are important to success in investing.

Winning Trait 1: Investing Should be Treated as a Profession

Firstly, like the guy who actually won at harness betting, you need to treat investing as a profession. This goes back to what Benjamin Graham said of enterprising investors—you have to be committed and work at it. This doesn't necessarily mean you need to work on it from 9 AM to 5 PM, but it does mean that you need to be committed—perhaps as your main "hobby".

Not everyone can turn investing into a profession due to various reasons—family, work, social life, etc—but I think this is a minimum condition. These people are making the right decision by staying away from investing. Even Benjamin Graham recognizes this fact and spends 1/3 to 1/2 of The Intelligent Investor on strategies for the 'defensive investor'. For most people, opportunity cost of trying to invest on their own is too high. For instance, if you have a good, professional, job, you can probably make more money climbing your career ladder than through investing. Similarly, if you were an entrepreneur, instead of spending time reading up on the stock market or individual stocks, you will probably make more money pursuing your entrepreneurial ideas. Some may also benefit far more from raising kids than spending time on investing and trying to make a bit more.

Some can probably perform above average by coattailing on superinvestors or selecting the right money managers, but they just won't be great investors (and I'm not sure what they will do when the superinvestors pass away or quit the business.) I actually think newbies, especially if you have a small portfolio, should stay away from blindly investing in the same things that superinvestors are buying. I see some bloggers, who are dedicated amateur investors, own basically what Edward Lampert or Warren Buffett or Mohnish Pabri own. Not just one or two positions but, like, 90% of their portfolio are from others. Nothing wrong with looking at the superinvestors but are they investing based on their own analysis or because someone else did the analysis? For example, I see many have high confidence in their estimates of intrinsic value of Coca-Cola. But are they getting their confidence from their own analysis or because Buffett owns it? How come I never see the same guys & gals ever saying anything about Pepsi or having high confidence in the estimate of its value?

Although some would disagree with me, I think the goal of amateurs who are starting out, especially if they have a small portfolio, should be to learn how to invest successfully, and not how to make money. (If you have a large portfolio, or are closer to retirement, then it is a different story.) One who blindly buys all of Warren Buffett's picks will probably outperform, at least for a decade, someone who buys only a few of Buffett's picks and tries to find others on his own. But I suspect the latter will probably be better off in the long run.

Winning Trait 2: Invest Infrequently

The winners bet infrequently. Munger reiterates this point:

And the o­ne thing that all those winning betters in the whole history of people who've beaten the pari-mutuel system have is quite simple. They bet very seldom.

It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it ‑ who look and sift the world for a mispriced be that they can occasionally find o­ne.

And the wise o­nes bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.

That is a very simple concept. And to me it's obviously right based on experience not only from the pari-mutuel system, but everywhere else.


So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple.

When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with o­nly 20 slots in it so that you had 20 punches ‑ representing all the investments that you got to make in a lifetime. And o­nce you'd punched through the card, you couldn't make any more investments at all."

He says, "Under those rules, you'd really think carefully about what you did and you'd be forced to load up o­n what you'd really thought about. So you'd do so much better."

I basically became a concentrated investor after reading what Buffett said and Munger's comparison of investing to a pari-mutuel betting system. This basically changed my investing life. It doesn't mean it will lead to success; indeed, a concentrated bet on Ambac wiped out many years of profits. Besides, only a few people succeed and I might be the most incompetent investor in Toronto ;) But it does likely mean that if I sink, it will be while flying the flag of concentrated investing.

I think Buffett is right in saying that people will think differently if they only picked, say, 20 stocks in their life (this idea does not apply to special situation investing IMO.) Picking 20 stocks in your life is almost like picking one stock per year! I think most people will die of boredom if they did that—not to mention the fact that half the brokerages will end up declaring bankruptcy ;). I certainly think a lot more about a few ideas than I used to.

I think if you pursue concentrated investing, the most important element is the margin of safety. It is extremely critical for concentrated bets. Unfortunately, the difficulty, at least from my experience, is that newbies like me have a hard time valuing companies. This means that our estimate of margin of safety is not very solid.


To finish off, let me quote some more from Munger's speech:

All right, we've now recognized that the market is efficient as a pari-mutuel system is efficient with the favorite more likely than the long shot to do well in racing, but not necessarily give any betting advantage to those that bet on the favorite.

In the stock market, some railroad that's beset by better competitors and tough unions may be available at o­ne-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So it's just like the pari-mutuel system. Any damn fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasn't so clear anymore what was going to work best for a buyer choosing between the stocks. So it's a lot like a pari-mutuel system. And, therefore, it gets very hard to beat.

As nicely put by Munger, the market is fairly efficient and generally prices things such that the long-shot is no worse than the expected winner.

The odds constantly change and the house always takes a small cut. If you invest, you better make sure that you can overcome the house's cut—commissions, fees, etc—and that your investment is actually worth investing in. The majority of the time the odds aren't attractive enough to invest. So it is best to make large bets on the few cases that you do find exceptionally attractive. Ideally, you should also treat investing as a profession and put in the work.

Friday, August 21, 2009 9 comments

Some articles for your perusal

Continuing the 1933-like rally, the market continues to push higher. The key questions from my newbie perspective are to figure out what the new sales level will be and what is a reasonable profit margin. A lot of companies, across varying sectors, have seen sales fall 20% to 30%, while profits have declined 10% to 50%. Are these temporary, trough, numbers? Or are these the norm for the next decade? If they are the decade norm, the market is likely overvalued. S&P 500 forward P/E ratio is around 17 right now and the historical average is around 15. However, the P/E ratio is always tricky to read because interest rates are very low right now and hence can support a higher P/E ratio. If you thought short-term rates will remain below 1% for many years, then the P/E ratio wouldn't be perceived as being high by investors.

Here are some articles to consider... not as good as last week but some important ones...

  • In defense of value investing (Greenbackd): Megan McArdle at The Atlantic has always been a skeptic of stockpicking. Continuing that stance, she wondered, in a recent article, whether value investing would die after Warren Buffett. Greenbackd, who follows old-school Benjamin Graham investing techniques largely directed at special situations, presents a rebuttal and suggests that value investing will live on. I don't believe in efficient markets to the degree that Megan does, so I share little with her thinking, but I do think some of Greenbackd's arguments are debatable. I don't think value investing will die but it may go out of favour. For instance, Graham-type investing did dissapear for the most part in the late 60's and 80's to 2000's. There were very few stocks trading below liquidation value or below NCAV in those periods. My guess is that if we face a long deflationary bust, value investing will go of favour. Although some readers of this blog disagree with me, I think value investing will underperform under deflation. So, it's not the end of Buffett that will dampen value investing, but the onset of deflation. Most investors, including Warren Buffett, think high inflation is the likely outcome so this may never materialize but who knows...

  • (Recommended) Summary of Seth Klarman's thinking (Advisor Perspectives; via GuruFocus): If you have never heard of Seth Klarman, you may want to check out this piece. For those who are somewhat familiar with Seth Klarman, my opinion is that he has reached the state of Warren Buffett. That is, a lot of what he says is very important but is so basic and has been repeated countless times that newbies like me don't really learn much from him.

  • Run-down of Buffett's portfolio holdings (Old School Value): Old School Value takes a quick look at the holdings of Berkshire Hathaway.

  • Natural gas hits a 7 yr low (The Globe & Mail): A news story summarizing the current state of affairs in the natural gas business. The surprising thing to me is how natgas prices have remained low even with signs of economic recovery and improved credit/cheap money. The demand vs supply imbalance appears to be far worse than what I, or many others, thought.

  • Modelling Fannie Mae and Freddie Mac [several parts; link to part 1] (Bronte Capital): John Hampton at Bronte Capital takes an in-depth look at the two critical American GSEs in the thick of the mortgage bust. It's time to cross financial companies permanently off my circle of competence list ;)

  • (Highly Recommended) Grant's Beachhead issue (Grant's Interest Rate Observer; via The Big Picture): It's always worth checking out what Jim Grant says because he isn't afraid to be a contrarian. His publications aren't really for amateurs, either in their price—$850 per year!—or in their complexity—how many amateurs have access to the A-2C tranche of the ACE Securities Corp. Home Equity Trust, Series 2005-HE5, subprime mortgage bond?—but some of the topics are easy to understand and useful for the average investor. In this free document, containing a few of his past pieces, investment topics such as asset managers (e.g. Legg Mason) and emerging market mobile phone providers may interest some readers. For me, though, the most interesting and recommended piece, especially if you are macro-oriented, is the last article titled China channels 'Monkeybrains' presenting his bearish case for China.

  • Real estate is stabilizing but dark clouds still abound (The Economist): A good overview of the real estate situation in America. Things seem to be improving...or are they?

  • Is the carry-trade returning? (The Aleph Blog): Dave Merkel at The Aleph blog wonders if the carry trade is returning. Before I started this blog, I remember arguing with someone on a message board over the carry-trade. He/she implied that it entails low risk whereas I always feel that it is very risky. Unless you have a macro thesis for investing—say improving political stability, declining inflation, etc—there is a reason the market prices the yields higher. Blindly investing in higher yield currencies/bonds sounds like one of the dumbest strategies around. These strategies often amount to betting on inflation or a boom (because yields tend to be higher in countries with higher inflation or a boom) and when the boom ends, they come tumbling down.

  • Slideshow of world's most successful business immigrants (BusinessWeek): A slideshow that seems mostly from a US-centric point of view (I'm pretty sure there just as many immigrant success stories in Europe, especially given how there are many countries close to each other.)

  • Is this the beginning of the end for branded consumer goods in the developed world? (The Economist): A lot of value investors do not realize that Warren Buffett actually rode a big bullish macro wave in branded consumer goods. At least I think so. Branded consumer goods became dominant, I believe, on the back of the rising consumerism in America and other developed countries. A key was rising consumer incomes from, say, 1950 up to 1990. In the last decade, incomes have barely gone up, and in fact have been flat to slightly negative in real terms, in most developed countries. Is this going to spell the end of the high profitability of branded consumer goods? ... Something to think about, before ploughing your life savings in Coca-Cola, Pepsi, P&G, or Kraft. (note: the story is opposite in developing countries)

  • (Recommended) The end of the properity boom (Yahoo! Finance; article by The New York Times): No one considers prosperity to be a boom that can end, but, alas, it often ends in spectacular fashion. The so-called boom bypassed lower class people like me so we won't feel anything, other than greater job uncertainty. However, the upper-middle-class and higher up will feel it. The linked story is quite interesting and mentions how John McAfee, the founder of the McAfee anti-virus software company, has seen his net worth collapse from around $100 million down to $4 million. This is probably an extreme case but I still think most upper class individuals will see as much 50% to 70% of their net worth erode, if we end up in a decade-long slump, as I think we will :( Wealthier people tend to have a lot of their net worth in real estate or stocks, and it's hard to be optimistic for those two asset classes—unless you were buying right now, after a collapse (then it's great.)

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Thursday, August 20, 2009 7 comments

The only serious argument against valid is it?

Inflationists, as well as disinflationists, present many reasons for why deflation won't materialize. As far as I'm concerned, there is only one serious argument against deflation: 'the central banks of this world won't let it happen.' For a serious argument from the inflationist duo at Pacific Capital Associates, Rich Toscano and John Simon, you may want to review the article, The US Government Will Not Choose Deflation, as well as another one, US Not Going Down Japan's Road, on why they don't see USA following the path of Japan.

(Note: When I say inflationist, I am referring to someone who is attempting to profit off inflation. It does not necessarily mean someone that believes inflation is the best thing for society. Conversely, a deflationist is betting on deflation and may or may not believe deflation is benefitial for society.)

There is certainly some irony in free-market supporters who generally do not believe the government is capable, nor efficient at, manipulating the market to suit its needs in the long run, suddenly believing the government can successfully handle a massive deflationary bust. Leading the inflationist parade tend to be goldbugs who often suggest that the market is stronger than any government. Times have certainly changed when there were many of us who believed the market was stronger than any government, in the long run.

In any case, if you lean towards deflation, like I do, the question really comes down to whether the central banks can prevent it. The suggestion by inflationists has been that the central banks can print an infinite amount of money, so they can ward off any decline in prices (whether a physical good or a financial asset.) For those that argue the money multiplier is collapsing, say because the banks are just sitting on their cash hoard, the suggestion by inflationists has been that the central banks would bypass the banks and interact directly with the borrowers. For those that suggest the multiplier will stay low because borrowers don't want to borrow anymore, the suggestion by inflationists has been that the government will drop money out of helicopters (this has already happened to a minor degree with rumours of Chinese banks, which are all majority-owned, and hence controlled, by the government, handing out money to almost anyone that wants it. It wouldn't be a much of a stretch to see a Federal Reserve bank set up shop in your street corner and lending money to anyone.) So, it appears that the government can prevent deflation by printing as much money as possible and/or lending to as many people as possible. But how feasible is this in the real world?

As I remarked in a recent post, I have been reading Robert Prechter's deflation booklet, and have found it very insightful. He follows Austrian Economics so I don't agree with everything, and he bases many of his investment decisions on pure technical analysis, which I do not follow, but I do think he makes some powerful arguments. With regard to the infinite money printing argument, he makes a very persuasive argument, which is similar to my current thinking on the issue.

In essence, Prechter argues that the anti-deflation strategies suggested by many, including prominent economists such as Ben Bernanke, are nothing more than Ivory Tower concoctions. That is to say, the strategies look good on paper but are unfeasible in real life. In particular, the strategies ignore the reactions of market participants, particularly bond investors. Let me quote two full paragraphs of his argument (bolds by me):

(source: THE Guide to Understanding Deflation by Robert Prechter. Elliott Wave International. Quoted text below from section titled The Coming Change at the Fed on pages 29-30. Bolded text are by Sivaram Velauthapillai.)

When credit expands beyond an economy’s ability to pay the interest and principal, the trend toward expansion reverses, and the amount of outstanding credit contracts as debtors pay off their loans or default. The resulting drop in the credit supply is deflation. While it seems sensible to say that all the Fed need do is to create more money, i.e. FRNs, to “combat deflation,” it is sensible only in a world in which a vacuum replaces the actual forces that any such policy would encounter. If investors worldwide were to become informed, or even suspicious, that the Fed would follow the ’copter course, it would divest itself of dollar-denominated debt assets, causing a collapse in the value of dollar-denominated bonds, notes and bills. This collapse would be deflation. It would be a collapse in the dollar value of the outstanding credit supply.

Contrary to popular belief, neither the government nor the Fed would wish such a thing to happen. The U.S. government does not want its bonds to attain (official) junk status, because its borrowing power is one of the only two powers over money that it has, the first being taxation. The Fed would commit suicide by hyper-inflating, because Federal government bonds are the reserves of the Fed. That’s why it is called “the Federal Reserve System.” U.S. bonds are the source of its power. As long as the process of credit expansion is done slowly, as it has been since 1933, people can adjust their thinking to accommodate the expansion without panicking. But by flooding the market with FRNs, the Fed would cause a panic among bond-holders, and their selling would depress the value of the Fed’s own reserves. The ivory-tower theory of unlimited cash creation to combat a credit implosion would meet cold, harsh reality, and reality would win; deflation would win. Von Mises was exactly right: “There is no means of avoiding the final collapse of a boom brought about by credit expansion.” Observe that he said “no means.” He did not say, “No means other than helicopters.”

I'm not an AustEcon follower so I have no idea if Ludwig Von Mises is right in saying that all credit expansions must necessarily collapse. But I do think Prechter is right in observing human behaviour—in this case the behaviour of market participants to money printing.

I just don't see how the US government would pursue some of the extreme anti-deflationary strategies (outside of war or total chaos.) As Prechter points out, if the US government loses the bond market access, it will be floating in the air, only supported by FedRes bond purchases.

If there is mass exit from US$-denominated assets, it would collapse the price of nearly all US$ assets. This should lead to a contraction of credit which is generally defined as deflation.

Now, there is something that needs to be said here. Prechter makes it clear in his guide but it is also something that is debated countless times on message boards, the media, and so forth, and causes a lot of confusion. Prechter, like most AustEcon followers, looks at the entire money supply which includes cash/currency plus credit. Some people out there only look at cash.

In my opinion, one should look cash plus credit (it is too complicated to give my opinion here as to why; maybe in another post.) If the FedRes prints a lot of money, someone looking at cash-only may perceive it as being highly inflationary. After all, the currency in circulation would have gone up. However, if you look at the total including credit, you may actually see deflation. This can occur because credit may decline even if currency is printed.

Going back to the conclusion presented by Prechter, is it actually probable that the FedRes (as well as others facing deflationary busts) can print money at will? I would say no. They would kill the government instantaneously. This is something that the inflationists don't address properly. Can any inflationist out there explain how the US government is going to print huge quantity of money and survive?

Wednesday, August 19, 2009 2 comments

CFTC starts cracking down on commodity ETFs

This has been working its way through the US government for a while and we are finally seeing the government crack down on so-called "speculators" in the commodity futures markets. Of course, one can't have a futures market without a speculator—they are the ones that take the opposite position to a commercial hedger—so it all comes down to what is perceived as a "bad" speculator versus a good one. MarketWatch reports:

The Commodity Futures Trading Commission said Wednesday that a Deutsche Bank commodities fund and a second, unnamed commodities investor could no longer avoid federal limits on speculating in grain futures.

The decision comes as the futures regulator, under pressure by lawmakers to reduce speculative trading in energy and other commodities, considers making it tougher for financial institutions, index funds and exchange-traded funds to build big positions in the futures markets.

The CFTC said it was withdrawing a May 2006 exemption issued to DB Commodity Services, a unit of Germany's Deutsche Bank, that allowed its DB Commodity Index Tracking Master Fund to exceed speculative limits on corn and wheat futures.

The exchange-traded fund aims to provide investors with broad exposure to commodities, according to Deutsche's Web site. Deutsche Bank spokeswoman Renee Calabro wouldn't comment on the CFTC decision except to say that its Powershares DB Agriculture Fund was also affected.


The threat of a regulatory clampdown on futures trading by index funds and exchange-traded funds has already prompted the U.S. Natural Gas Fund, an ETF, to halt issuing more shares to the public...

The commodities trading operations of some large investment banks is also under threat.

This ruling seems to be limited to grains but it's not clear if similiar rulings will be made for other commodities. It is also not clear who would be considered a "good" speculator and allowed to be exempt from the position limits.

Deutche Bank will probably have difficulties with its commodity funds after this ruling. It has a popular agriculture commodities fund with the ticker symbol DBA. I'm not knowledgeable in these matters but I would guess that it can probably circumvent the regulations by entering some derivative contract with a dealer that has the exemption (the "good" speculators will likely remain exempt.) If the ETF ends up having a fixed number of shares, which is probably what is required to satisfy this ruling, it would essentially be a closed-end fund (of course, a CEF behaves differently from ETFs and aren't as efficient.)

The story also mentions that another popular ETF, a natural gas ETF with the ticker symbol UNG, has stopped issuing new shares for the time being. I'm curious to see if similar requirements will be enforced for crude oil. The amount of oil contracts owned by crude oil ETFs is quite large (although it probably isn't as significant given the massive size of the crude oil market.)


Printer industry note: HP printing business suffering

Now that Lexmark is on my list of companies to research, I have been paying more attention to the printer market. I think it is essential for investors to figure out the business environment before investing in something. Reading some news stories on the competitors is one quick way to get up to speed.

HP is probably the market leader in the printer business. There are many different segments—home, business, commercial; inkjet, laser; etc—and HP doesn't always lead every single market segment but it is dominant in most segments. So, it's always good to see how the market leader is doing. Let me excerpt some points from a New York Times article covering HP's recent earnings results (as usual, bolds are by me):

In the last year, H.P.’s sales of printers and related supplies like ink have tumbled. The major cause for the decline remains the weak global economy. Businesses have spent less on printing products, and with unemployment high, fewer workers are around to hit the ink-burning Print button on their computer screens.

Analysts contend that the recession has created a culture of reluctant printer users. Companies have urged workers to keep a close eye on printing costs. So they are using less paper and choosing costly color ink as a last resort. Such policies push people toward digital documents they read on mobile devices as well as their computer screens.


H.P.’s printing group has long been one of the company’s star performers. It accounts for nearly a quarter of overall revenue. Printer ink remains one of the most expensive liquids on the planet — more valuable than expensive perfumes — providing H.P. with far higher profit margins than PCs and other types of computing hardware provide.

On Tuesday, H.P. showed how its printer business remained vulnerable to the recession when it reported third-quarter financial results. H.P.’s printing and imaging revenue fell 20 percent, to $5.7 billion, as sales of supplies tumbled 13 percent and sales of printers fell 23 percent.

These latest results add to several months of sharper than expected declines from H.P.’s printing group, and the company has been scrambling to raise prices and adjust its inventory levels to offset the slump.

“What has been the most striking issue for investors has been the fact that printer supplies have really fallen off,” said A. M. Sacconaghi, an analyst for the investment research firm Sanford C. Bernstein. “There was always this belief that people keep printing like they keep eating even during recessions.”


He [CEO of HP] said people examining H.P.’s printing results needed to take into account currency fluctuations that had hurt the company, as well as costs tied to inventory adjustments. For example, such costs, Mr. Hurd said, would account for most of the 13 percent slide in printer supplies revenue last quarter. The sales of ink by companies like Best Buy, Wal-Mart and Tesco were flat to slightly down, he said.

“People are printing just as much as they did last year,” Mr. Hurd said. Rather than curtailing their printing behavior, businesses and people have simply opted not to buy spare ink cartridges at the same rate as they did during better financial times, according to Mr. Hurd.

Still, H.P.’s printing supply revenue had grown at close to 10 percent in the three previous years, and has now fallen. And it is that sharp shift that has investors worried whether longer-term changes in behavior are at work, Mr. Sacconaghi said.

As the article points out, printer ink has very high margins*. So a collapse in usage severely hurts the business. This is especially true in the printer business, where printers are sold at a loss or almost-a-loss.

I don't know if management at HP, similar to Lexmark, have their head buried in the sand, or if they actually have a greater understanding than the analysts. The CEO seems bullish and suggests that the sales and profit declines are temporary (due to currency fluctuations and inventory adjustment) and nothing to worry about.

The key question, as the analyst mentions, is whether the changes we are observing are permanent changes or not. When sales fall 10% to 20%, is that a new level; or will it bounce back. Investors need to bet correctly on that (or conservatively assume the low level is the new norm.)


When investing, you should always figure out who has the power to extract the highest profits in the supply chain. Classic example is Wal-mart. Wal-mart stock price was overvalued in the late 90's (all growth stocks were) so it's hard to tell by the stock price but, if we look at economic profits, Wal-mart has the easiest time extracting profits, while the suppliers generally live off low margins. Whether times are good or bad, Wal-mart makes money but the same isn't true for the suppliers. The worst off are probably the (mostly) Chinese manufacturers who live off extremely thin margins, and, according to some China bears, don't even cover their capital costs.

In the printer business, at least over the last two decades, ink has been very profitable. But the power to extract that profit lies with the printer companies and not the chemical companies who produce the ink. I'm pretty sure that the chemical companies that produce the ink don't make much money. I actually looked them up—there were two publicly traded ones I ran across—and they don't seem anything special. The chemical companies producing ink are largely producing a commodity and are simply a price-taker. If the printer company didn't like the producer then it will just walk away to another one. (note: I'm being simplistic here. Some printer companies manufacture their own ink and almost all use some custom-tailored ink so it isn't as simple as hiring some ink producer off the street.)


Inflation hits a 56 year low in Canada... but core inflation is what matters

The Globe & Mail is reporting that inflation hit a 56 year low in Canada, but what is more relevant is the core inflation, which has been stable:

Canada's annual inflation rate slid to the lowest level in 56 years last month, dropping more than expected for the second straight month to set overall prices 0.9 per cent lower than last year, Statistics Canada reported Wednesday.

The fall on a month-to-month basis was even more dramatic, as prices in July fell 0.3 per cent from the previous month, reversing the similar monthly increase registered in June.

Still, economists say there is little concern that deflation – a broad-based and persistent decline in prices that could inflict further damage on the economy – is setting in Canada, as it did in Japan during the 1990s.

That's because only three of the major components tracked by Statistics Canada are experiencing deflation and most of that is based on falling gasoline prices.


Statistics Canada also pointed out that excluding the energy component, inflation remains a healthy 1.8 per cent in Canada. Core inflation is also close to where the Bank of Canada would like it, at 1.8 per cent, only slightly below the desired two-per-cent target.

Canada hasn't seen much deflationary pressure, which isn't surprising. There was no housing bust here (at least so far); there wasn't any financial crisis; and so forth.


Warren Buffett warns policymakers about inflation

Thanks to 24/7 Wall St for bringing Warren Buffett's latest opinion piece in The New York Times. Dated, August 18, 2009, Warren Buffett's piece is directed at policymakers and others with influence in the US government. Cementing his inflationist stance, he warns about the risk of inflation due to the deficit—unprecedented outside wars.

I think Buffett is correct in suggesting that the FedRes will take orders from the government and start printing money if bond buyers stay away from the government debt. Although the FedRes is thought to be an independent institution, it hasn't been always like that. Some claim that it was basically taking orders from the government from the 1930's to 1950's.

The question for investors is what the outcome will be, if Buffett's scenario unfolds. Buffett implies that inflation will be high and he has bet on that. I lean more towards deflation (but I don't have much conviction.) The FedRes was monetizing debt in the 30's and 40's and inflation wasn't high. Japan also has not seen much inflation (but I'm not sure how much of the Japan government debt is purchased by the JCB i.e. purchased with printed money.)

Tuesday, August 18, 2009 0 comments

Financial Times' John Authers view of the current rally & my view of the situation

Financial Times' John Authers produced a video clip a week ago, illustrating the current situation compared to the past. You may have seen similar information from various sources but this video synthesizes the various views.

I rely more on P/E ratios and it's really hard to tell if the market has entered a bull market. I don't believe it has because the P/E ratio looks high. Although corporate earnings, at least in America, have soundly beat analyst estimates—my impression is that it is not common to see analyst estimates beat on such a mass scale—the future profit level looks weak. One has a make a macro call here since the forward-looking earnings will be unlike anything we have seen (this isn't a normal recovery from a recession.)

As Authers points out in the video, P/E ratios are influenced by interest rates and interest rates are really low. If interest rates remain low—I lean towards deflation so I think they will stay low—then the P/E ratio isn't so bad. But if you were in the high inflation camp and think interest rates would hit, say, 5% within 2 years, then the P/E can plummet easily.

One final point I want to make is that I don't look at the market quite like many, including John Authers. I view the market peak as being in 2000. In contrast, most commentary treats the major peak as being in 2007. This makes a huge difference!

If you pick 2007 as the multi-decade peak, the market has fallen quite a bit but nothing like the catastrophic losses in the 30's or the 70's.

However, if you pick 2000 as the peak, its performance in real terms during the last 10 years is on par with the 1929 to 1939 period. Here is a chart from a post earlier this year:

Now, you might wonder, 'if it has fallen as much as in the 30's, can it fall more?'. The answer, believe it or not, is a 'yes'. The reason is because valuations in the late 90's were far higher than in the late 20's. The credit bubble, which actually didn't peak until 2005 or thereabouts, is also much larger.

If you set the ultimate peak as having occurred in 2000, you will look at the world slightly differently. You would actually be a bit more bullish because there has already been a severe correction—and I'm not talking about the crash from 2007; I'm talking about the poor performance since 2000. Those who see 2007 as the peak will be more bearish because the correction from 2007-2009 is not that severe compared to the 30's.


Opinion: So few amateur value investors around... for a good reason

I have suggested in the past—and this isn't anything unique from me—that there are very few value investors in the institutional world because of the institutional imperative. It simply isn't possible for the majority of the fund managers to become value investors. They would literally get fired after a few poor quarters. In fact, if I were a fund manager, I think I would follow more of the crowd.

But how about amateur investors? Well, I think there are very few amateur value investors as well. Some who call themselves value investors really aren't in my opinion (my definition of value investing is a bottom-up approach to investing with heavy emphasis on fundamental analysis—not everyone follows this definition.)

I definitely don't consider myself a value investor and anyone reading this blog for very long would know it as well (although some people lump me into the value investor camp :) ). For instance, it's hard to consider anyone that is influenced by Marc Faber to be much of a value investor.

If the institutional environment prevents the professionals from being true value investors, how come the amateurs, who have no institutional pressures, don't seem to follow value investing?

I think the main reason is because value investing is really tough! Sure, part of it is also difficulties with overcoming psychology—humans are communal creatures and hence love to follow the crowd—but the main reason is because fundamental analysis is tough. It just takes a lot of work and continuous learning. How many can read dozens of annual reports and not feel discouraged when they don't end up investing? How many are willing to fully read the annual reports, including financial statment footnotes? The ironic thing is that value investing techniques are much simpler than other strategies. I'm not an expert on investing but the model that quantitative investors build involves far more complexity than anything a value investor does. Similarly, growth investors—some value investors do not think there is such a thing as growth investing—build out complex spreadsheets with scenario analysis, competitor comparison, and so on.

You can see how there are few value investors in the amateur world by looking at blogs or reading investing message boards. For instance, try going to SeekingAlpha, which is an investing blog aggregator, and pay attention to the number of blog entries dealing with fundamental analysis. Practically all the blogs out there deal with technical analysis (which probably falls under momentum investing), macro investing, and speculation.

I suspect these strategies are popular, not because they work, but because they are easy for anyone to follow. For instance, almost anyone can write about macro investing. Yet very few really provide anything useful. I write a macro-oriented blog so I'm dissing myself as well. I like macro stuff but the fact of the matter is that half the stuff out there are complete nonsense. The worst are the macro views that are completely erroneous. Yes, macro investing involves speculation about the future. But there are many macro-oriented investors that pass off pure speculation as facts. I try to be clear when I am presenting a speculative view and when I'm just repeating history or some academic study or whatever. But you need to be careful—on other blogs, as well as here.

Another issue with macro-oriented blogs is how some amateurs mix up economists and investors. Except for some rare exceptions—John Keynes for instance—most economists are not good investors. Macro views come out of economics but it's up to the investor to interpret and come to their own conclusion.

Technical-analysis-oriented blogs, articles, websites, newsletters, and so on, are another popular strategy. Nothing wrong with it but it is another skill that almost anyone can write about. Just like the case with macro strategies, half the stuff out there are completely useless, often contradicting each other and not providing much of a forward-looking view.

In contrast, I see very few value-investing-oriented blogs. I have a whole bunch on my websites links page but I have to admit that many of them don't perform much analysis. No offense to anyone but someone who blindly follows Warren Buffett and invests in, say, Kraft is not a value investor to me. If they do the analysis and can show why Kraft is good, then they are; but most can't justify any of their picks. In fact, many investors probably can't even tell half the products Kraft sells—how is this different from a trader who generally doesn't know much about what the underlying security represents?

Do note that you may still be a value investor for the most part but some of your investments may not be. Let me pick an example with Mohnish Pabri since it came to mind after some comment on GuruFocus. Once, Pabri said that holding Berkshire Hathaway shares is equivalent to cash. In other words, he was parking his money in Berkshire shares instead of in cash. That is just pure shoddy analysis and thinking. Yes, I'm just some guy off the street with a dubious record and I'm attacking a really good investor but consider my argument. How could anyone consider a listed security to be equivalent to cash? Furthermore, how can someone be certain that the market is not going to mark down the security price—not just today or tomorrow but for the next 10 years! Such thing is pure speculation; it has nothing to do with what I perceive as value investing. In a similar light, a lot of people who pass themselves off as value investors really are not. There is nothing wrong with that but just know what you are. If you are speculating, make sure you know it!

To sum up my view, I think value investing is really tough for amateurs. You can see this by looking around and noticing how it is not very popular. On top of the psychological difficulties, the strategy itself is quite difficult.