Posts Tagged ‘leverage’

Should you leverage to the max in a long-run bull market?

Sunday, July 18th, 2010

Between 1970 and 1980, gold was in a bull market. In 1971, the average price of gold was around US$40. By January 1980, it hit US$850. So, the question is: Surely, it was a good idea to leverage as much as you can in the 1970s (assuming you knew that gold would be in a bull market)? Since gold prices multiplied by 21 times from 1971 to 1980, and if you leverage to the maximum at any time in the 1970s, you will become filthy rich by 1980 right?


If you leveraged say, 10:1 in December 1974, you will be likely to be financially wiped out by August 1976. Between that time, gold prices fell from US$195 to US$103- a correction of 47%. Then from August 1976, gold resumed its up-trend to the high of US$850.

The lesson here is clear. Even in the midst of a long-term bull-market, you can become bankrupt if you are highly leveraged and unlucky.

Next question to ask: What if a lot of people are highly leveraged at the same time, in the same asset class, believing that it is in a long-term bull market? We will turn the answer to this question to our readers.

Is it time to buy stocks in times of intense fear and volatility? Part 1: Introduction

Monday, October 27th, 2008

Let’s say you are a long-term investor who is not into timing the bottom of the stock market. After having seen the market falling into intense panic and fear over the past few weeks, you may wonder whether it is now time to buy stocks for their long-term value. No doubt, in this climate of intense volatility and fear in the market, stocks of good businesses along with the bad ones are indiscriminately sold. Even if a depression is coming, not all businesses will be affected equally. Some of the better quality ones will fare better (and even thrive) in such a harsh environment. For example, during the Great Depression, some businesses’ profit even grew (see Which industry?s profitability grew as the Great Depression progressed?)!

Surely, some of these stocks are undervalued by now right? Should you buy now? Even Warren Buffett is buying.

Well, the answer will depend on your personal circumstances. More specifically, it depends on your current level of leverage. In other words, the right answer to this question for two different people can be different. In the coming articles, we will explain how to go about answering this question based on probability, reward and loss. Keep in tune!

Can China save Australia?

Tuesday, October 21st, 2008

Today, we watched SBS’s Insight program, Greed. It is basically a small forum where audiences and experts mingle together and talk about the global financial crisis. Near the end, Peter Schiff said that Australia will be fine because China’s insatiable demand for commodities will intensify as the Chinese revert to consuming their own produce. This will intensify China’s demand for Australia’s commodities, which means that Australia will be in a very safe position.

Here, we disagree with Peter Schiff. Our reasoning goes like this:

  1. Yes, in the very long run, as we said before in Example of a secular trend- commodities and the upcoming rise of a potential superpower, China’s demand for commodities will continue to grow. But the question is what happens in the interim (i.e. the short to medium term). The worst case is a epic bust for the Chinese economy (see Can China really ?de-couple? from a US recession?). The best case is a slow-down. In between these two scenarios is a major Chinese economic correction. Furthermore, we believe that this slowdown could be within the designs of the Chinese government in order to achieve their long-term plans. We will talk more about it in the coming articles.
  2. Australia has a very highly leveraged economy (see Aussie household debt not as bad as it seems?). It is this high leverage that can be the undoing of Australia’s economy in the interim.

This is a subtle point that eludes many people, including the experts. Sure, the end point may be a paradise in the mountain peak. But it is a mistake to assume that the path to the mountain peak is an upward slopping straight line. The current high leverage of the Australian economy can pull us down to a deep valley of hell in the interim. The problem is, many will not survive through the valley and for those who survive, they will be transformed (and even scarred) by the experience.

Is it a good time to buy Australian financial stocks?

Tuesday, September 30th, 2008

By the time you read this, the global financial markets will be in mayhem, thanks to Congress’s rejection of Henry Paulson’s bailout plan. Last night, the Dow fell 777 points, the greatest one-day drop since the crash of 1987. Central banks are busy pumping hundreds of billions of dollars worth of credit into the financial system as the credit market freezes up. Stock markets around the world are plunging.

Some people reckon that this is a good opportunity to buy Australian stocks, especially financial and bank stocks, which are hardest hit. After all, the mainstream belief is that the Australian banking system is rock solid and prudently regulated. That implies that the sell-off of financial and bank stocks will be overdone and lead to opportunities for value-oriented investors.

What do we think of this idea?

The problem with this idea is that it is only half-right. This half-right idea is dangerous. Sure, it may be true that the Australian banking system is strong. But this is based on the premise that the current situation will extend into the indefinite future. This leads to the very crucial concept of Black Swans. Due to a quirk in the human mind, it is very easy for one to understand Black Swans nominally, but when it comes to decision-making, act as if one has totally lost that understanding. To understand the concept of Black Swan, we highly recommend our earlier article, Failure to understand Black Swan leads to fallacious thinking. We must stress that it is crucial that you understand the content of that article before reading the rest of this article.

Now, what’s wrong with Australian banking and financial stocks?

Well, the issue is not with their future earnings. Based on statistical probability of the past, there is no reason to doubt the forecasts of their future earnings. The more cautious analysts may even adjust their forecasts downwards to account for the expected reduction in earnings due to the credit crisis. Thus, a sell-off in banking and financial stocks may lead to their prices looking very undervalued.

This is where the fallacy such thinking begins. As we said before in Two uncertainties of valuing a business- risk & earnings,

Between earnings and risk, the latter is the most subjective of all in the business?s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness.

In other words, earnings are very much ‘visible’ and taken into account. But risks are ‘invisible’ and therefore, get ignored and overlooked. That is where the grave error lies. Risk is the playground of the unknown unknowns. The problem with such stocks is that at this stage of the credit crisis, they are particularly vulnerable to the unknown unknowns. In other words, these unknown unknowns will have a massive and colossal impact on their earnings. As we explained before in Common mistakes in failing to see economic turning points,

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Why do we say that?

A simple word answers this question: leverage.

Due to the amount of leverage (in the Australian economy, banks balance sheets and the global financial system), when the unknown unknowns pops up, earnings can go terribly, utterly, totally and massively wrong (we are running out of adjectives here). For example, as we quoted Brian Johnson in How safe are Australian banks?,

?We?re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,? he said.

The Australian economy itself is highly leveraged. As we explained before in Outlook 2008,

Currently, Australia?s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia?s economic prosperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust.

As we refuted Shane Oliver in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small.

The global financial system is still highly leveraged, particularly with derivatives (see How the CDS global financial time-bomb may explode?). As we said before in Potential global economic black hole: credit default swaps (CDS),

Currently [January 2008], the CDS market is valued at around $45 trillion, which is three times the GDP of the US.

The notional value of derivatives world-wide is said to be at the range of hundred of trillions of dollars.

Australian banks are highly leveraged to a highly leveraged economy in a highly leveraged global financial system. To put it simply, there is only a razor thin margin for ‘error.’ When there’s no ‘error,’ all will be fine. But if there’s an ‘error,’ there can be a colossal bust. Please note that we are not predicting financial Armageddon. For all we know, maybe there will be no ‘error.’ But should it slips in, the last thing you would want to hold are the banking and financial stocks.

What lies ahead for the Australian economy in the coming years?

Sunday, April 6th, 2008

As we can see, over the past several months, there had been a lot of volatility in the global financial markets. As we said before in Why is the market so easily tossed and turned by dribs and drabs of data?, without the proper framework of sound economic theory, the outcome is that the lack of deductive reasoning and insights brought about the situation where the

… market gets tossed and turned by every minute variations of statistical information from economic reports. The end result is confusion and volatility.

Clearly, this shows that the media, pundits, investors, traders and other market participants do not know what is going on.

Today, we will present to you what we believe to be the long-term big picture. Our opinion is by no means a prediction in the forecasting sense- rather, it is just our feeling, intuition and guesses (maybe one day in the future, this opinion will be famously known as ‘insight’ or ‘foresight’?). Therefore, do NOT take our opinion as financial advice- we are not financial advisers and our conviction is that one should be ultimately responsible for one’s own investment and financial decisions.

Okay, here comes the meat…

Firstly, our belief is that the US economy is heading for a hard landing. Currently, Ben Bernanke’s forecast is that economic growth will pick up in 2009 after a possible mild recession. This is also the belief of the market, as it tentatively believes that the credit crunch is abating. We are sceptical of this view. After all, years of accumulation of bad debts, over-leverage, mal-investments and structural damage of the US economy cannot be simply brushed away with the turning of interest rate levers, money ‘printing,’ bailouts and sweet talks. As we explained 13 months ago in Marc Faber on why further correction is coming- Part 2, the liquidity contraction that started in the US is resulting in the process of global asset price deflation, especially house prices in the US. As asset prices deflate, this will bring about further bad debts, which in turn will bring about further deflation in a vicious cycle.

Next, as it especially applies to the Western developed world, the financial side of the economy has grown to be a major intertwined component of the overall economy. As we said before in Analysing recent falls in oil prices- real vs investment demand, the difference between the real and financial side of the economy is that the

.. real side [is] where you find the physical market for goods, services and labour. The financial side is where you find the flow of financial capital, assets and payments.

It can be argued that today, the financial side of the economy had grown beyond its original supporting role of efficiently and flexibly allocating capital for the real-side of the economy, to the point of playing one of the primary roles in the economy. In any case, both sides are interlocked hand-in-hand with each other, which means any shocks to the financial system will affect the real economy and vice versa. To illustrate this point, take the case of Australia. With the vast majority of working Australians parking their retirement savings through the superannuation system, which in turn distributes the savings into financial products (e.g. managed funds), which in turn further distribute these savings into the financial asset markets (e.g. stock market). Furthermore, even ownership of physical assets (e.g. property) requires credit, which in turn is sourced from the financial system. And when it comes to credit, developed Western economies like Australia have been gorging on them to fund anything from credit card debts, personal loans, car loans, stock investment through margin lending, store cards, etc. Therefore, you can see that any breakdown in the financial system will have serious and dire consequences on the rest of the real economy.

For Australia, it seems to be at a sweet spot. The voracious Chinese demand for commodities have been a windfall for Australia, which has vast reserves of resources to supply the Chinese economy. That, along with a highly advanced financial system helps spread the prosperity to the rest of the nation to some degree. But the dark side of this prosperity is the build up of leverage (debts) to a dangerously high level (see Aussie household debt not as bad as it seems? and Australia has no sub-prime debt? Think again!).

Now, there are dark clouds in the horizon. The global financial system had never been as interconnected as before in the history of capitalism. You can be sure that any trouble that begins in the US financial system will spread to the rest of the world. As of today, there are murmurs about the credit crunch being the most serious crisis since the Great Depression. As the financial system rot in the US economy spreads into its real side, you can be sure that Australia’s financial system will be severely affected as well. The Australian economy (along with other Western economies with advanced financial system like the US and UK economies) are highly leveraged (i.e. burdened with far too high levels of debt) both at the retail household level and at the institutional level. Already, we are hearing about bankruptcies, blow-ups and traumatic losses in the global corporate sector (e.g. Allco, MFS, Fincorp, Centro, Basis Capital, ABC Learning Centre, Tricom, Opes, Bear Stearns, UBS, Citigroup and too many more to list). The Australian household sector is feeling the debt stress (e.g. mortgage stress, housing affordability and rental crisis, soaring personal debt levels, etc). As we said before in Rising price of money through the demise of ?shadow? banking system),

Australians love their debt too much. From the large current account deficit (see Understanding the Balance of Payments), much of Australia?s debts are sourced from overseas. With the demise of the global ?shadow? banking system, the price of money in Australia has to rise too.

A highly indebted nation cannot afford to have the price of its credit rise without acute consequences. Thus, University of Western Sydney (UWS) Professor Steve Keen believes that a severe recession induced by debt deflation will arrive at Australia within 2 years.

The question is, will China save Australia from this?

For one, the rot in the global financial system may not affect the real side of the Chinese economy directly. This is because the Chinese financial system is still rather primitive compared to the advanced Wester economies. For example, there are still hundreds of millions of peasants toiling in the countryside. Those who migrated to the cities to toil under the factories are still not plugged into the developing Chinese financial system. Therefore, unlike the Western world, a bearish Chinese stock market does not necessarily forecast doom for the wider Chinese economy. As a result, the credit crunch that started in the US will have a limited impact on the real side of the Chinese economy. So far, this is good news for Australia (but Australia is not out of the woods yet).

Therefore, our opinion is that when the inevitable severe recession hits the Australian economy soon, the Australian mining (and related) sector will probably be the only bright spot in the darkness. In fact, we can argue that a recession may perhaps even be beneficial for the mining sector as much of the idle resources (caused by the recession) in the economy can be re-allocated to the mining sector (see How is Australia?s mining boom sucking resources out of the economy?).

But here comes the bad news.

Firstly, in a hard landing of the US economy, the real side of their economy will be crunched as well. Our theory is that this may lead to a more than proportionate contraction in the investment activities that dominates the Chinese economy, which will trigger a hard landing in the Chinese economy. Even if this theory turns out unfounded, there is another worry- the Chinese economy may not have enough resources supplied to it fast enough to maintain the trajectory of its economic growth. When that happens, the risk is that the trajectory may be shot down, resulting in the forced liquidation of all these mal-investments. The outcome is a big Chinese bust. Our article, Can China really ?de-couple? from a US recession? has the full explanation of our theory. When that happens, the last leg supporting the Australian economy will be kicked off. This is the worst-case scenario for the global economy (and by extension, Australia). Our feeling is that the coming Chinese bust may come with a time-lag after the US hard landing. If our theory about the more than proportionate contraction in Chinese investment holds true, then the time-lag may be shorter.

But yet again, this may not be all bad news in the longer run. If China’s rise is a secular event (see Example of a secular trend- commodities and the upcoming rise of a potential superpower) of the 21st century, then Australia can still climb out of this worst-case scenario.

Please note that we are not making any predictions here. Our vision is very far out into the future. Generally, the further one ventures into the future, the more likely unforeseen Black Swans will sneak in to turn one’s vision into fantasy. But as the old adage says, prepare for the worst but hope for the best.

Why are fantastic stocks sold off in a bear market?

Friday, March 28th, 2008

We are now officially in a bear market for stocks. As of yesterday, the Australian All Ordinaries Index had fallen 21% from its 1 November 2007 high. At its lowest point in 18 March 2008, the index was down by 25%. Right now, the All Ordinaries Index is even lower than what it was 12 months ago. Not only that, the market is getting more volatile, with stock prices falling very rapidly (e.g. the infamous Black Tuesday happened in January 2008 when the Australian market fell by 7% in one day). For investors, there seem to be no place to hide in the market as it seems that almost every stocks are affected.

Contrarians such as value investors would love such a bear market because it is a great time for bargain hunting for good quality stocks. For this reason, they are often inaccurately misunderstood as ‘bullish’ as they get excited and greedy when the market as a whole is getting fearful. But this leads to another question. In a bear market, especially during times of panic selling, why would stocks of good quality businesses fall along with the bad ones? If good quality stocks are really that good, why would they fall in the first place?

The most common cited general answer to this question is that in a panic, animal spirits of fear takes over and the market as a whole becomes irrational. In other words, it is negative sentiment that drives such absurdity.

But we are not satisfied with this answer, for it sounds like a cliché to us. So, for those who are as dissatisfied as us, we will provide one of the many pragmatic reasons for such absurdity. One word sums up this reason: leverage. Today, there are so much leverage in the financial system and by extension, the market. Both retail and institutional market participants borrow and employ leveraged derivates (e.g. options, CFDs, futures, etc). The problem with leverage is that, when the market goes against you, your losses are magnified and you find that you are suddenly short of cash (to repay the debts, obligation, margin calls, collateral, etc). Sometimes, the only way to increase your cash level is to liquidate whatever you have- the good investments along with the bad. If enough people are in the same situation as you, this will result in widespread indiscriminate selling in the market.

Thus, weak hands’ forced liquidation due to de-leveraging results in indiscriminate selling. For those who are in a strong cash position, this can be an opportunity to exploit.