Archive for September, 2009

Australia’s credit growth is still falling

Tuesday, September 29th, 2009

Marc Faber once said that for an economy that is addicted to debt, all it needs to tip it into a recession is for credit growth to slow down- no contraction of credit is required. Also, as Professor Steve Keen explained, at this stage of the debt cycle, the aggregate spending in the economy is made up of income plus change in debt. In the absence of income growth, a slowdown in credit growth implies declining aggregate spending by the private sector.

Now, let’s take a look at Australia’s year-on-year credit growth (up till July 2009):

Year-on-year credit growth in Australia (July 2009)

Year-on-year credit growth in Australia (July 2009)

It’s now the government doing a bigger and bigger share of the spending.

The output gap fallacy

Sunday, September 27th, 2009

One of the common ideas floating around is that since the world’s productive capacity is not at its maximum level (that is, there is some slack from ‘maximum’ output), price inflation cannot occur. This is a highly attractive Keynesian idea because the apparent solution is very enticing- (1) just print some money, (2) distribute the money to the masses to spend, (3) thereby raising aggregate demand, (4) which in turn will pick up the slack in productive capacity, (5) thus, resulting in higher employment and higher utilisation of otherwise idle factories (6) without price inflation.

Governments all over the world (including the government of yours truly) are implementing this Keynesian solution in the hope of extricating the world out of a depression and restore economic growth. Unfortunately, this is one of the biggest fallacy in thinking.

Firstly, as Associate Professor Steve Keen has pointed, when you include the high levels of debt incurred by the private sector, a large fraction of the printed money will go into debt repayment. This may not be inflationary (in both the monetary and price sense), but it certainly will not ‘stimulate’ the economy. The economy was already ‘stimulated’ by uptake of debt and although forcing the masses to borrow more will ‘stimulate’ the economy in the short-term, it will set the scene for a bigger bust by pushing the economy one step towards sub-prime territory (the Australian government’s First-Home-Owner-Grant is a great example of a hare-brained policy).

Second, the idea of the level of productive capacity is highly defective. Indeed, there are official estimates that summarise the estimated level of usage of the economy’s productive capacity into a single convenient index. However, there are serious conceptual errors with such an index. As Henry Hazlitt wrote in The Inflation Crisis and How to Resolve It,

This is one reason why we cannot depend on the accuracy of the index. As Alan E. Shameer, associate economist of the General Electric Company, put it, “We have dozens of different plants, producing everything from jet engines to plastics to coal to washing machines. How can we possibly say with precision that the company is operating at such-and-such a rate of capacity? … It’s a jelly-like concept.”

If this is a jelly-like concept for one company alone, then how much more it will be for the entire economy? As Hazlitt continued,

These figures represent the average capacity utilization rate of all plants in all industries.

To understand this idea, consider the hypothetical example,

To make the real problem clearer, let us suppose that at the moment the average capacity utilization rate for all manufacturing is 80 percent. A Keynesian might then say that if we increased the money supply by 20 percent the result would be stimulating but not inflationary, because this new money would merely supply the purchasing power to buy 20 percent more goods, and industry already happens to have the idle capacity to turn out that much more goods “without inflation” or unwanted price increases.

But suppose this 80 percent average figure, though reasonably accurate, conceals a real situation in which the capacity utilization rate in different plants actually ranges from a low of 60 to a high of 100 percent, with the lowest 11 percent of plants operating at only 60 percent, the next 11 percent segment above that operating at 65 percent, the third segment at 70 percent, and so on, with the ninth and highest segment operating at full capacity.

Supposing the Keynesian scheme otherwise operates in accordance with the schemers’ intentions, what would be the result? All factories would be operating, or trying to operate, at a rate 20 percent higher than before. The half that had been operating at less than 80 percent could presumably do this, but the half that had already been operating above that rate would be running into bottlenecks and shortages in plant and equipment, not to speak of the problems of all manufacturers in buying additional specialized input and hiring additional specialized labor. Prices?including wage rates and other costs, which are themselves prices?would begin to soar.

So far, this second point is looking at the supply side of the problem.

The third fallacy with such Keynesian thinking is to look at the demand side. Even if all the printed monies are spent (and not used to repay debts), they will not be spread evenly throughout the? economy. What if a significant portion of them are spent on speculation? Indeed, that happened just a year ago (see Who is to blame for surging food and oil prices?), when the object of speculation was on agricultural commodities and oil. There was an outcry of food ‘shortages’ among the poor in developing nations as food prices surged. As oil prices were pushed towards US$147 by speculators, price inflation pressure intensified.

Even if the newly printed monies are not spent on speculation, the structure of the demand can result in further structural imbalances of the economy. To see why, consider the above-mentioned example. Sectors of the economy that are already in maximum productive capacity are most likely already experiencing high demand. More printed money can result in even higher demand on those already ‘maxed-out’ sectors. Consequently those sectors will experience even greater shortages in labour, material and bottle-necks, which is price inflationary.

Governments all over the world, through their commitment to such a fallacious Keynesian idea, are ignoring (or at least not fully addressing) the structural imbalances in the economy. As we wrote before in Overproduction or mis-configuration of production?, it is not just a simple case of over-capacity.

Will China set off a derivative meltdown?

Thursday, September 24th, 2009

In Satyajit Das’s book, Traders, Guns & Money, he started off with a story of an Indonesian noodle making company getting embroiled in a complex currency derivative contract (that it did not fully understand) with a bank. Unfortunately for that company, a currency Black Swan event turned up and as a result, under the obligations of the derivative contract, the financial viability of the company was threatened. Big shot lawyers and experts were called up from both sides. The defence alleged that the Indonesian company was deceived into entering the contract whereas the bank’s lawyers insisted that the company signed the contract out of its own accord in full knowledge of its obligations. The bank’s lawyers screamed expletives, insisting that the Indonesian company honour its end of the derivative contract, or else the matter will go to court.

Today, many Chinese state-owned enterprises (SOE) found itself in the same situation. SOEs like China Eastern Airlines, Air China and shipping giant Cosco had entered derivative contracts with Deutsche Bank, Goldman Sachs, JP Morgan, Citigroup and Morgan Stanley. The Chinese are not happy with the derivative contract. So, those SOEs (assumed to have the backing of the Chinese government) sent legal letters to those American investment banks and told them, in effect, to get stuffed with the derivative contracts.

The question, as this article said,

In that case, have the banks taken advantage of them or is it simply a case of caveat emptor?

Would the SOEs end up in a court dispute with the banks (as the banks believe, the derivatives contracts are legally enforceable ones struck in Hong Kong, Singapore and London)?

The situation is much more complicated than that just a few court cases. If the banks dragged the Chinese into court, the Chinese government can retaliate by withholding the banks’ banking license in China, which will result in a tremendous loss of their businesses in China. On the other hand, if they negotiate with the Chinese, then it will set a dangerous precedent for their other counter-parties who are in the same situation as the SOEs. Should that happen, US$2 billion derivative contract default can set off a chain-reaction of other defaults.

Such a chain reaction will light up a bigger time-bomb. There are still hundreds of trillions (in notional value) worth of derivative contracts in the global financial system. As we explained with an example in Chained together, for better for worse, defaults can beget even more defaults.

As this article wrote,

Yet any escalation of the defaults to multiple countries could see a second wave of bank failures and, at the very least, a bad double-dip recession. And that’s without the increasingly worrying creeping protectionism around the globe.

An escalation is certainly deflationary.

Would the Chinese government attempt to light up such a fuse? We don’t know, but we can imagine that such an outcome will benefit them greatly. You see, during the Panic of 2008, deflation led to a surge in the US dollar and US Treasury bonds and a collapse in the prices of stocks, gold, silver, oil and other commodities. The Chinese would love for that to happen again because it will give them another golden opportunity to sell their US dollars and US Treasuries to buy real assets (e.g. gold, silver, commodities and resource/energy stocks).

This is something worth watching.

Correction red alert: to short or stay in sidelines?

Tuesday, September 22nd, 2009

As you read the chatter from the various financial sources, you will get the sense that there is an increasing expectation of a major correction. Unfortunately, if you take this as a sign to short the market, it can result in losses. For example, this month began with what looked like the beginning of a correction that turned out to be a false signal. The most substantial correction (of less than 10%) since March 2009 occurred in June.

Therefore, the moral of the story is: if you try to pick the exact market top (or bottom), be prepared to be wrong and lose money as a result. If you happen to make money, attribute it to luck.

But there is at least one thing you can do (or rather not do) at where you believe to be the top: stay at the sidelines. To be a successful investor, you must not be pressured to trade continuously. Good investors trade when the market presents an opportunity, not because they have to be in the market to ‘optimise’ their gains. However, if you choose to try your luck at picking tops (and bottoms), at least make sure you are hedged (e.g. with options) and not exposed to unlimited losses.

If you decide to stay at the sidelines, you can be sure that you will be at least in good company with company insiders (pun intended). As Insiders sell like there’s no tomorrow reported,

Biderman, who says there were $31 worth of insider stock sales in August for every $1 of insider buys, isn’t the only one who has taken note. Ben Silverman, director of research at the web site that tracks trading action, said insiders are selling at their most aggressive clip since the summer of 2007.

Silverman said the “orgy of selling” is noteworthy because corporate insiders were aggressive buyers of the market’s spring dip. The S&P 500 dropped as low as 666 in early March before the recent rally took it back above 1,000.

Insiders may not be good stewards in handling their companys’ money, but when it comes to their own money, they are pretty astute. This is a good sign that the stock market has ran ahead of the fundamentals and is in bubble territory.

In a report from David Rosenberg (an astute bear), he concluded that by now, the ones who are still buying into this rally are

Very likely it is still a combination of program trading, short coverings and portfolio managers desperately trying to make up for last year?s epic losses.

He added that,

The market is so overextended that it is now 20% above its 200-day moving average, which is a technical condition that has not occurred in 27 years.

Also, as we wrote in Are institutional investors courting financial losses?,

As you can see, at 84.47% the bullish sentiment is at an unprecedented high level.

Another sign that we are in bubble territory can be found in the bond market. As High-Yield Bond Buying Starting to Get “Ridiculous” (Update2) reported,

Investors are buying bonds from the lowest credit-quality issuers without restraint, according to Citigroup Inc.

Yields on high-yield, high-risk debt have narrowed by 80 basis points relative to benchmark rates in the past two weeks, Citigroup analysts John Fenn and Jason Shoup wrote in a Sept. 18 report. Last week, 13 companies, including casino owner MGM Mirage and video chain Blockbuster Inc., sold more than $6.5 billion of bonds, they wrote.

If you still want to try your luck at picking the market top, you may want to check out what our friends at Market Club have to say about the current market conditions: Two Major Technical Forces About to Collide. Basically, October is the technically significant month to watch out as they expect the S&P to correct sideways at best (or even downwards).

October is also the month in which celebration of the 60th anniversary of the founding of the People’s Republic of China ended. We could be wrong here, but our vibe is that Black Swans (or maybe grey ones) may arise from China.

Are institutional investors courting financial losses?

Sunday, September 20th, 2009

As we write, there are more and more mainstream news report that institutional investors (e.g. the ones handling your retirement ‘savings’) are entering the market with their ‘idle’ cash. Reportedly, those investors are the ones who missed out on the rally for the past 6 months. Consequently, after the abortion of what seemed to be the start of a correction in early September (see Time to short stocks in the NYSE?), the market raced up again. Back then, the NYSE Bullish Percent Index was at 77.23%. Today, this is what this technical indicator look like:

NYSE Bullish Percent Index

NYSE Bullish Percent Index

As you can see, at 84.47% the bullish sentiment is at an unprecedented high level. It seems that the stock market is at a euphoric state of drunken ecstasy. Although that does not mean that it cannot go any higher, it means that it is vulnerable to a very significant correction. Therefore, those who are using high leverage to buy stocks at this point in time are courting financial disaster.

We do not pretend to know when the correction will come and we are not experts in technical analysis here. But for those who wants to time the market, we urge you to get some education on charting, trend following, technical analysis and so on. For this, we recommend the services of our business partner at Market Club, who has something to say about the traditional “Buy and Hold” strategy here.

In the next article, we will write about what we believe could be the trigger for the next correction (if it didn’t happen by then). Keep in tune!

Has gold moved on to a secular shift?

Thursday, September 17th, 2009

Since we wrote Explosive gold price movement ahead. But up or down? more than 2 weeks ago, gold prices had moved up from US$953 to US$1020 at the time of writing. In terms of Australian dollars, gold prices had not moved much. This break-out of gold prices from a narrow trading range had sparked excitement and derision among the proponents and opponents of gold. But beneath all these chatter and excitement, there are a few interesting trends that we would like to highlight to you:

Declining central bank gold sales
For decades, central banks were net sellers of gold, culminating in the Bank of England’s sale of half its gold holdings in 1998 at the bottom (‘perfect’ timing for the British right?). But over the past couple of years, European central banks are getting less keen to sell their gold. Between 2004 and 2009, under the Washington Agreement, central banks can sell at most 2500 tonnes of gold on a net basis. But only 1867 tonnes were sold. In September this year, another 5-year agreement was signed, permitting at most 2000 tonnes of gold to be sold. In 2009, only 140 tonnes of gold were sold. So, among the signatories of the Washington Agreement, there is a falling trend in the quantity of gold being sold by central banks. At the same time, the central banks of emerging countries (e.g. Russia) are making clear their intention of increasing their gold reserves. For example, Russia announced their aim of increasing their gold reserves from 2% of total reserves to 10%. According to specialist gold analyst Jeff Nichols, the world may be at a turning point whereby central banks is moving from being net sellers of gold to net buyers of gold.

China increase its gold reserves through domestic production
Last year, China suddenly announced that they had increased their gold reserves by 76% since 2003 (454 tonnes) through domestic purchase of their gold production. Over that time, China became the world’s largest gold producer. It is reported that China exports none of their domestic gold production and even banned the export of silver.

Hong Kong recall its gold from London
Recently, Hong Kong recalled its physical gold from London (see Hong Kong recalls gold reserves from London) to be stored in its own storage depository facilities. It is widely believed that this will help Hong Kong be a regional trading hub. There are marketing plans to convince Asian central banks to transfer their gold reserves to Hong Kong. At least one company is planning to launch a gold ETFs? that stores its gold in Hong Kong’s new depository.

Chinese government pushing gold and silver to the masses
Before 2002, it is illegal to own gold in China. Today, the situation is completely reversed. As?China pushes silver and gold investment to the masses reports,

Apparently China is pushing the idea of buying gold and silver for investment purposes to the general population in the way that Western television sells soap powder.

The report notes that China’s Central Television, the main state-owned television company, has run a news programme letting the public know how easy it is to buy precious metals as an investment.? On silver investment the announcer is quoted as saying ” China has introduced its first ever investment opportunity for silver bullion. The bars are available in 500g, 1kg, 2kg and 5kg with a purity of 99.9%. Figures show that gold was fifty times more expensive than silver in 2007, but now that figure has reached over seventy times. Analysts say that silver has been undervalued in recent years. They add that the metal is the right investment for individual investors and could be a good way to cash in.”

This has fuelled a belief that since the Chinese government are convincing the masses to buy gold, then they will not allow gold prices to slump in order not to alienate the masses.

China openly expressed its lack in confidence in the US dollar
China, with US$2 trillion of US dollar assets are not happy with the Fed’s policy of currency debasement. Six months ago, Chinese Premier had already expressed his worry of the US dishonouring its debt through the path of monetary inflation (see Nations will rise against nations). In this article, Cheng Siwei, former vice-chairman of the Standing Committee and now head of China’s green energy drive openly expressed the Chinese government’s dismay at American monetary policy. He said,

We hope there will be a change in monetary policy as soon as they have positive growth again.

If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies.

Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets.

This is leading many to believe that China will scoop up to buy gold at the dips, thus a ‘put option’ for gold.


This is getting interesting. Notice the two opposing forces (by two different groups of big boys) at work?

Can stocks hedge you from price inflation?

Tuesday, September 15th, 2009

Continuing from our previous article, should we buy stocks as a hedge against price inflation? The answer to this question is not so straightforward.

In normal circumstances, some stocks are a good hedge against the garden-variety types of price inflation (or even beat inflation spectacularly) because their earnings power can increase faster than the general rise in prices. But in times of hyperinflation, when the real economy deteriorates, it will be increasingly difficult to find such a business.

First, let’s take a look at the past from this research report,

The 1970s were a period of accelerating inflation and poor equity returns in the US. By December 1980, the federal funds rate stood at 20%, and the ten-year Treasury peaked at 15.3% in September 1981. From December 31, 1968 to December 31, 1981, the S&P 500 returned 1.28 % per annum in nominal terms and -6% in real returns. Put another way, a dollar invested in the US stock market at the end of 1968 twelve years later was worth roughly 45 cents in real terms.


In the US, there is substantial empirical evidence that high inflation is associated with a high equity risk premium and declining stock prices. Bodie (1976) found from 1953-1972 that common stocks were poor hedges against inflation. Cohn and Lessard (1980) also found that stock prices in many industrial countries are negatively related to nominal interest rates and inflation.

It is important to make the distinction between properly anticipated inflation, and unanticipated inflation. If inflation is correctly anticipated and if companies can in fact pass on costs of doing business, then nominal cash flows should be unaffected by a general increase in prices. However, as inflation rises, it tends to become more uncertain and a component of price increases may not be properly anticipated by firms. Blanchard (1993) found that ?an unexpected increase in inflation in year 0 leads to a sharp decrease in stock prices in that year.?

There are a couple of ways to see why price inflation and stock prices are negatively correlated:

  1. In times of high inflation, interest rates are high. Therefore, bonds may prove better value than stocks relatively.
  2. Investors demand higher returns from stocks to compensate against higher price inflation. The lower the price paid for stocks, the higher yield returned by the stocks and thus, the higher the returns on investments.

On the other hand, we have examples in history where hyperinflation do wonders for stock prices. For example, in 2007, Zimbabwe had the world’s best performing stock market- stocks actually rose faster than price inflation:

Zimbabwe Industrial Index up till 2007

Zimbabwe Industrial Index up till 2007

Despite these two seeming contradictory real-life examples, one thing is clear: everything else being equal, unexpected rise in price inflation will lead to compressed valuation of stocks due to a rise in discount rates used to value stocks. In other words, PE ratio can decrease (in the context of rising earnings) even though stock prices can still rise in nominal terms. In the case of the US stock market in the 1970s, this led to negative returns in real terms. But in Zimbabwe’s case, stocks actually had good positive returns in real terms. But make no mistake: as we quoted Marc Faber in our previous article, such positive returns are the result of rising speculative bubbles in the stock market abetted by the printing of money.

If you believe that the (1) US are going the path of Zimbabwe-style money printing and (2) the stock market hit record high due to speculation, does it mean that you should rush to buy any stocks as a hedge?

Here, you have to be careful. The dizzy heights of stock prices in the Zimbabwean stock market have a survivorship bias. With real GDP deteriorating and sky-rocketing unemployment in that country, we are sure many Zimbabwean public companies are dropping dead like flies. That means, there will be many stocks whose prices went to zero. If you happen to hold one of them, you will suffer loss in nominal terms in a hyper-inflationary environment.

Also, stellar stock market performance that are induced by money printing are, at the end of the day, bubbles. Bubbles can easily burst.

Thus, if you are considering holding stocks as a price inflation hedge, you will have to choose the stocks very carefully. The wrong choice will lead to (1) losses in real terms at the very least or (2) a possible wipe-out in the context of a highly dysfunctional economy.

Should you be bullish on stocks?

Sunday, September 13th, 2009

Marc Faber is a well-known contrarian bear. He has such a pessimistic streak in his blood that he is given a nickname of “Dr. Doom.” But many people were surprised that this bear is actually quite ‘bullish’ on stocks. For example, even though he believes that stocks are going to face a major correction soon, he believes that the rally can still have more room to run.

How do you reconcile his bearish temperament and ‘bullishness?’

The trick is to understand that his reason for ‘optimism’ is different from the reason espoused by the “green-shoots-of-recovery” crowd. The basis of his ‘bullishness’ is based on a very pessimistic view of the economy. This Lateline interview sums up his view very well:

As we wrote before in Can we have a booming stock market with economic calamity?,

But as we stressed many times in this journal, it is possible to have economic calamity with booming asset prices, especially stock prices

Based on conventional economic theory, there is no explanation for such a stellar performance for the Zimbabwean stock market when the GDP was collapsing (see Zimbabwe: Best Performing Stock Market in 2007?). A stock analyst using conventional valuation analysis will hard pressed to justify the lofty heights of stock prices.

But followers of the Austrian School of economic thought have an explanation for this illogical phenomena. In a perfect world, every single cent of the printed money will go straight into repayment of debt and thus, wiping out debt obligations, introduce financial stability and not cause price inflation in one swoop. Unfortunately in the real world, the plans of the governments and central banks do not always work out perfectly. In a dysfunctional economy, the massive printing of money can lead to some of them being used for speculations of assets and commodities instead of de-leveraging. As what happened in 2008 (see Who is to blame for surging food and oil prices?), the speculation of the latter can lead to strong price inflation.

In the same way, the current bout of monetary inflation is the cause of the rally in the stock market. In fact, Marc Faber believes that this rally has more room to go beyond the current impending correction. It is possible that the coming correction may not come in the form of tumbling stock prices- stocks may stagnate sideways until the technical overbought condition deflate to a more balanced one.

Today, it is the stock market that gets artificially inflated. Tomorrow, it can be the commodity markets. Now, the question is, should you buy stocks to protect yourself against price inflation? We will look into it in the next article.

Reversal of trend reversal?

Thursday, September 10th, 2009

Exactly a week ago, we were wondering whether it’s time to short stocks (see Time to short stocks in the NYSE?). We wrote,

Currently, this Point-and-Figure indicator is not officially in trend reversal status yet. But it will be soon if more stocks comes under ?Sell? signal.

Today, the Point-and-Figure indicator goes like this:

NYSE Bullish Percent indicator
NYSE Bullish Percent indicator

As you can see, the indicator has gone up by more than 1%. That is, the trend reversal has not yet happened according to the indicator. Stocks are currently very overbought and therefore, very vulnerable to a correction. But that does not necessarily mean that one is imminent.

According to the Point-and-Figure indicator, now is not the time to buy stocks. More conservative traders may not want to short stocks (yet) either.

Can China raise interest rates to control its property bubble?

Tuesday, September 8th, 2009

Currently, the global economy is at a sweet spot. Price inflation seems under control even though copious amount of money is printed in bailouts and stimulus. Asset prices are rising again and there’s hope that the global economy is returning back to growth soon. Just 6 months ago, the markets were staring into the abyss of a Greater Depression. Today, it’s blue skies and green shoots ahead.

In China, though Chinese stocks had deflated somewhat, Chinese property are still rising rapidly, thanks to their bubble blowing policies (see How big is the credit bubble in China?). The Chinese government are well-aware that there’s a property bubble in their economy. And they are also aware that it was the low interest rates and easy money from the Greenspan era that precipitated the GFC by artificially inflating asset prices with debt. They acknowledged that it was a mistake to use interest rates to ‘control’ price inflation and let asset prices run away into an almighty bubble. This acknowledgement is hardly new. As we wrote before in How are central bankers going to deal with asset bubbles?, central bankers have repudiated Greenspan’s doctrine (and that explains why Greenspan is silent nowadays). But the PBOC has a problem- they cannot raise interest rates easily.


It’s thanks to their managed exchange rates. To understand why, imagine you are a hedge fund manager. What will happen if China raise interest rates? Given that short-term interest rates are effectively zero in the US, this makes a very ideal carry trade- borrow almost for free in the US, send the money to China and put it into a Chinese bank, collect interest payment and repatriate the profits back into the US. If you are aggressive for higher returns, you may want to put the money into riskier assets (e.g. bubbly property). Since the exchange rate is more or less fixed and controlled, there is no fear for an adverse currency movement to turn this carry trade into a loss-making business.

In essence, if China raises interest rates, it will attract hot money into the country, which risks further inflation of asset price bubbles. China can’t raise interest rates unless the US does. Since we don’t see the US raising their interest rates any time soon (see Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view), we doubt China will be raising theirs soon too.