Archive for October, 2006

The Bubble Economy

Monday, October 30th, 2006



Over the course of the past several years, the ?wealth? of many people in the Western English-speaking countries (mainly the US, Australia and Britain) had increased, thanks to the real estate price boom. Consequently, the economies of those countries had been growing and expanding over that period. This type of economic growth is what the IMF called the ?asset-driven growth.? One manifestation of this kind of growth is the rise of ?wealth-creation? fades, which advocate the attainment of riches through property ?investments.?

As contrarians, we see that such growth should be more appropriately called ?bubble-driven growth.? For the economists trained in the Austrian School of economic thought, such kind of growth is unsustainable. Furthermore, they believe that the severity of the following eventual bursting of the bubble is related to the preceding inflation of the bubble.

It is good if we could learn from our own mistake. We would be wiser if we learn from the mistake of others. But if we repeat the same mistake of others, we are indeed fools. It is amazing to see that the US, Australia and Britain (for convenience?s sake, let?s call those countries the ?UBA countries? from now on) are not only not learning from the mistake of Japan, but even worse, following the same path. The collapse of the Japanese property bubble in the 1990s led to a downward recessional spiral of the Japanese economy for more than a decade. Property prices have been falling (at least not rising) for 16 years since. At least the Japanese have their savings to count on. But what about those UBA countries, whose savings rates are below zero (that is, they are already deep in debt)? What will happen when the property bubble burst in these countries?

Illusions of ?wealth?

Sydney?s housing property market was the epitome of the great amount of ?wealth? generated by the housing boom in the UBA countries. It started in the mid-1990s, accelerated after the 2000 Olympics and reached its apex in 2003 when house prices were rising at staggering rate of more than 20 per cent a year!

Yes, you heard it right. More than 20 per cent a year!

Where can you find other financial investments that can pay more than 20 per cent return except for the ones that are highly risky in nature? The belief that housing property investment was the way to great wealth was highly delusional. Surprisingly, the mob believed that. At that time (in 2003) there were proliferations of seminars that taught attendees how to be rich through property investments. A cursory glance at the investment sections of bookshops yields titles upon titles of wealth attainment through real estates.

In reality, such ?wealth? was and always is an illusion.

First, let?s see the ludicrousness of the idea that a nation?s general rise in asset value equals a rise in wealth. In a nation?s stock of real estate, only a tiny fraction of it got sold and changed hands in any given year. Those sale prices were imputed into the values of the vast majority of the other properties that never got traded in the market. Therefore, in a rising market, the vast majority of un-traded properties have rising imputed values, which is commonly described as ?rising asset values.?

Theoretically, an economy with only (a very important qualifier) rising asset prices does not produce a single extra widget. That is, there is no real growth. Rising asset prices are illusionary in nature because they are basically imputed values, which are rising fast during the bubble period of exceptionally low interest rates. Meanwhile, the real economy is theoretically no better than before, regardless of the movements of asset prices.

In the case of what is happening in those UBA countries, rising property values merely created higher valued collaterals for which money can be borrowed. With the introduction of equity redraw facilities, borrowers could even extract the ?values? in their properties as cash. As long as property prices kept rising, borrowers needed not worry about repaying back the loans – the increase in the ?value? of their property would take care of that. Meanwhile, some ?investors? (more accurately, speculators) used a sophisticated sounding financial strategy called ?negative gearing? to bet on continuing rise in house prices. Thus, with the economy awash with plenty of borrowed money, there was little wonder why people felt rich! With such feelings of wealth, people tended to spend more. This effect is what the economists call the ?wealth effect.?

Today, with the benefit of hindsight, we could see what a great spectacle it was!

Source of the ?wealth?

Now, the question is: where is the source of all these ?wealth??

For the answer to this question, we will take the case of Australia for example. Over the past 5 years, Australia?s money supply (M3) grew (that is, printing of money) by 10.1% per annum, which is much faster than the rate of economic growth. In other words, the growth of the amount of money circulating in the economy exceeded the growth in the production of goods and services. The natural consequence of this is inflation as there are now more money chasing fewer goods and services.

But in Australia?s case, the inflation remained within the Reserve Bank?s target of 2-3%. Where did all those excess money go? Part of the answer to this question, as you would have guessed by now, lies in the inflation of asset (house) prices. The well-known ?inflation? that everyone talks about in the media is the consumer price inflation, which can be seen statistically by the rise in the Consumer Price Index (CPI) and experienced by everyone from the general increase of price levels in everyday life. Unfortunately, the CPI figures do not capture the price behaviour of assets (property, stocks, bonds, etc.). In Australia?s case, the housing boom was contributed by such excess money printing.

Furthermore, another force was at work in curbing Australia?s consumer price inflation – the rise of Chinese manufacturing. In recent years, Chinese productivity had soared, which means overall, the Chinese economy was producing more and more goods at lower and lower costs. In China itself, that had a good deflationary effect – the fall in the consumer price levels. As China exported more and more of its cheaper goods to Australia, the effect on Australia was disinflation (decelerating growth in consumer price inflation). That helped keep a lid on the Australian consumer price inflation.

This phenomenon is an example of what were happening in the UBA countries. It began in the US in 2001 when it suffered the mildest ever recession after the crash in technology stocks. In order to prop up the economy, the US central bank – the Federal Reserve (commonly called the ?Fed?) – embarked on a massive expansionary monetary policy. That is, the Fed printed huge amount of money, which also increased the amount of credit granted (the flip side of granted credit is owed debt) in the economy. When central banks print money, they cannot control how the excess money is being used. In the case of the UBA countries, the excess money and credit fed the housing bubble.

In the US, interest rates consequently had to fall significantly to accommodate the monetary inflation (printing of money). With that, other countries had to follow suit by lowering their interest rates (to prevent their currencies from appreciating too much against the US dollar), resulting in a worldwide trend towards lower interest rates and monetary inflation.

Effects of the rising ‘wealth’

What was the effect of rising house asset prices, which were caused by the increase in money supply and credit in the economy?

When house asset prices rose, house owners felt wealthier. When they felt wealthier, they increased their spending. This is what the economist called the ?wealth effect.? Increased consumer spending in the economy resulted in businesses expanding their production due to their perception of increased demand by the consumers. Ideally, expanding production should in turn lead to increase in hiring and business investments, which in turn increase employment and productive capacity of the economy respectively. That should result in economic growth.

But unfortunately, the reality in the US was not as good as the ideal. The increase in consumer demand resulted in the increase in import of foreign goods. That showed up in the widening current account deficit, which simply meant that the US was spending more than it produced. The implication for this was that the increase in production in the US economy was not keeping up with the increase in consumer demand, which was fuelled by the boom in house asset prices, which in turn was fuelled by the inflation of money supply and credit in the economy.

Meanwhile, the amount of debt owed (its flip side is credit granted) in the US economy ballooned as the rising house asset prices increased the collateral for which money could be borrowed for consumer spending.

Indeed, this was how the UBA countries? economy grew. The IMF called this ?asset-driven growth.? The question is, how sustainable is this kind of growth?

Sustainability of such growth

Is such kind of economic growth sustainable in the long run?

Before we decide on the answer for this question, let us ponder upon this quote:

The deficit country is absorbing more, taking consumption and investment together, than its own production; in this sense, its economy is drawing on savings made for it abroad. In return, it has a permanent obligation to pay interest or profits to the lender. Whether this is a good bargain or not depends on the nature of the use to which the funds are put. If they merely permit an excess of consumption over production, the economy is on the road to ruin. – Joan Robinson, Collected Economic Papers, Vol. IV, 1973

In the case of the US, the side effects of the economic growth manifested itself in the form of ballooning household debt and widening current account deficit. Put it simply, the US, as a nation, was borrowing money not to invest in the betterment of its future, but to consume to the detriment of its future. Since 2001, the economic growth was accompanied ?with unprecedented large and lasting shortfalls in employment, income growth and business fixed investment? (Restructuring the U.S. Economy – Downward). Indeed, such kind of profligacy is the beginning of the transference of wealth from the spend-thrift nations to the prudent nations (see Transference of wealth from West to East).

These are some of the serious questions we would like to ask:

  1. As the US spends its way into economic ruin, its economy is being damaged structurally. How much longer can the US sustain its colossal debt?
  2. Right now, the US housing bubble is deflating. Will it eventually burst and wreck havoc on the rest of the economy?

Transference of wealth from West to East

Monday, October 23rd, 2006

According to media reports, Qantas recently announced that they are outsourcing their ?IT applications support and maintenance operations to global services companies Satyam Computer Services Ltd and Tata Consulting Services.? Furthermore, ?Chief executive Geoff Dixon said the transition to Satyam and Tata, which would take place over 15 months from November, would mean the loss of up to 340 Qantas IT positions.?

We were dismayed to hear that. Our immediate dismay laid in the poor souls who have lost their jobs. But our greater dismay laid in the long-term big picture trend that is going to affect our country for our future generations. The news from Qantas was just one of the incremental steps in the current macroeconomic trend towards the massive transfer of wealth from the West (mainly the spendthrift countries: US, Britain and Australia) to the East (mainly India and China). The West?s bubble economy set the stage for the beginning of its decline. Virtues like thrift and hard-work were forgotten, giving way to greed and profligacy. What started of as a trickle soon developed into a flow, which then formed a gush. Eventually, the dike will be overwhelmed and a final collapse ensued.

All right, we may be exaggerating about what may happen in the future, but our hyperbole served to illustrate a truth?the West is getting economically poorer and poorer while the East is getting economically richer and richer. How is this happening?

It all began with the outsourcing of manufacturing to the East. This common myth was often believed in the West: They sweat, we think. The assumption was that we will push the base, labour-intensive and low-level jobs to the East, while we concentrate on the more capital-intensive, high-level, technologically advanced and value-added jobs. Pundits will point to the fact that the Eastern economies consisted mainly of producing goods while the Western economies consisted mainly of providing services.

It is this kind of complacency that we wish to shake off. As the West manufacture less and less, its manufacturing industries got more and more hollow. As the manufacturing industries migrated to the East, technology hitched a ride along as well. As the East manufacture more and more, they learn from us more and more. As they learn more, they moved up the technological ladder, create better products and move up the value-added chain. With the wasteful and spendthrift ways of the West, more jobs get outsourced to the East to protect corporate profits while the real wage of West stagnate and even decline. As the trend continues, Western skills, know-how, capital and industries get increasingly eroded. This erosion is a portent for the eventual loss of wealth by the West.

Now, let?s examine this issue at the grassroots level, where the frontline battles are fought daily. Qantas?s decision to outsource its IT jobs to India is just a small example of a wider trend. In Australia, university enrolments for IT courses are pathetically low. Who would want to learn a skill for a job that you believe has got no future and is going to be outsourced eventually? With less and less people wanting to learn IT, no wonder there?s an outcry of an acute IT skills ?shortage? by businesses in Australia. We believe the IT skills ?shortage? is a humbug?business whinged on the lack of IT skills and yet, on the other hand, not willing to pay the price to acquire them in the first place. We believe that if nothing is done about it, one day, we will not even have an IT industry to whinge about!

Lately, we heard that Satyam (the company which Qantas outsourced its job to) is the same Indian IT company that is drawing people from the West to learn from its training campuses in India. Hey, aren?t the East supposed to sweat while we think?

Meanwhile, as investors, we are more willing to trust our wealth to grow faster in the East than in the West.

Is gold a commodity?

Tuesday, October 17th, 2006

One of the interesting fallacies that we had noticed is that gold is currently being classified as a ?commodity? by the market. Thus, this has produced very interesting results that can be exploited by a shrewd long-term investor.

First, what is the definition of a ?commodity? in the financial world? In the Wikipedia, a commodity is described as

things of value, of uniform quality, that were produced in large quantities by many different producers; the items from each different producer are considered equivalent.

As such, the word ?commodity? has a wide range of meaning. There are agricultural commodities like wheat, corn, sugar and orange juice and industrial commodities like oil, gas, coal, copper, iron, zinc and nickel. For the purpose of this article, we will stick with the industrial metal commodities.

Now, let?s go back to the original question. Is gold an industrial metal commodity in the same league as zinc, copper, iron and nickel? Up till now, the financial market seems to think so. Gold more or less move in the same direction as the other metals. Whenever there is a sell-off in the industrial metal commodities, chances are, gold will be sold off as well. But do we think gold is an industrial metal commodity?

No, we don?t.

Let?s us look at the fundamentals. When we look at the non-gold industrial metal commodities, we see a common denominator among them?they are all mainly for industrial use. For example, copper is used for electrical wiring and iron is used for making steel and so on. That is, they are the raw materials that are used to make other things.

Gold, on the other hand, is different. Since the beginning of human history, gold had always functioned either as money or as a store of wealth. Today, despite the breakage of its relationship with the US dollar back in 1971, there is limited industrial use for it. Therefore, the common denominator among the non-gold metals does not apply to gold.

What is the implication of this?

This means that the dynamics behind the demand for gold and the demand for the other non-gold metals are completely different. Therefore, the market is fundamentally wrong to treat gold as if it is an industrial metal commodity. In the short term, this can result in good buying opportunities for gold when it follows the prices of the other metals downward. In the long term, gold will eventually separate itself from the rest of the metals.

We do not know when it will happen, but we are pretty confident it will be within our lifetime, perhaps in the near future. Meanwhile, if you are to buy gold today, please make sure you know the right reason for doing so and buy from a position of financial strength. As Keynes said, ?The market can remain irrational longer than you remain solvent.?

Divergent sentiment

Friday, October 13th, 2006

Today, we looked at and saw something quite amusing. One set of headlines cheered in jubilation: ?Earnings driving the Dow? and ?Michael Farr says investors ‘are thinking positive’.? Another headline wallowed in worry: ?Manufacturers see gloom ahead.?

Is the US economy slowing down and threatening to roll over into recession? Remember, it was not long ago that the fall in manufacturing index prompted the stock market sentiment to turn negative. Now, the market merely shrugged off this report. The housing boom had already collapsed and threatened to cut down US consumer spending, which made up 70% of the US economy.

On the other hand, is the US economy going to power ahead as what the stock market is feeling it would right now? Perhaps the rebound in consumer confidence and the fall in oil prices will help the economy get into a perfect ?soft-landing??

Now, let?s get back to the basics. Make no mistake: the US economy is indeed slowing. The question is, whether this slowdown will result in a ?soft-landing? or recession (or worse still, a depression). Currently, the US economy is at an inflection point. The stock market seems to believe that after this inflection point, the US economy will not get too bad, maybe even mounting ahead. The bond market, on the other hand, believes the opposite. Who is right?

We believe that neither is right. As what we heard from Marc Faber?s (a famous contrarian investor) recent presentation, you can make the Dow Jones climb as high as you want as long as you print enough money. When excess money is being printed, company earnings will definitely grow in nominal terms, which will propel stock prices even higher. But that doesn?t mean that the economy?s production has increased. In other words, real GDP growth will not necessarily grow as much as the growth in money supply. Put it simply, the Dow Jones will rise merely due to inflation.

So, the stock market is wrong, not because the stock prices rise due to economic growth. They rise due to monetary inflation (printing of money). To illustrate this point further, over the past several years, the Dow Jones might be higher in nominal terms, but in real (inflation-adjusted) term, it had fallen.

The bond market is wrong, not because interest rates will be cut due to a recession. On the contrary, this coming recession will be accompanied by excess monetary inflation, which means nominal interest rates have to rise.

But be note that – the above-mentioned scenario will take time to work out. It will not happen overnight. Therefore, time is on your side as you fortify your financial well-being from the coming storm. In the meantime, expect more volatility.

Strange rally

Monday, October 9th, 2006

Recently, the US stock market had been in a rally mood. Currently, with the North Korean nuclear tests just completed, we are not sure how the rally mood will turn out. But we smelled something very fishy about this recent rally. The economic news had not been good (and the good news wasn’t good enough), and the risk of a recession in the US economy is something that we believe is quite likely to happen. The US Federal Reserve chairman himself had warned of a substantial correction in the US housing market. Even the bond market believes that a recession is on its way.

Yet the stock market was incredibly optimistic. It?s simply beyond our belief.

We are getting out while we can.

Gold & Oil, hand-in-hand

Friday, October 6th, 2006

We love to observe the market. One of the observations we made is that oil and gold seems to rise and fall together, with oil leading the way. What is the unsound thinking of the market that results in this kind of behaviour?

This is how the market thinks: inflation is good for gold price. Rising oil prices result in inflation. Therefore rising oil prices is good for gold price.

In the short term, this unsound thinking will be a self-fulfilling prophecy. But in the long run, it will be exposed as no more than a passing fade. Regretfully, we shouldn?t even call it ?thinking? in the first place- the market?s ?thinking? is often pseudo-thinking that frequently change drastically along with the tide of unreliable human emotions. Today, the market finds it fashionable to ?think? this way. Tomorrow, it will be fashionable to ?think? another way.

So, what is the real deal with gold anyway?

Now, let?s go to the fundamentals. For much of human history, gold was often used as a store of value. That is, gold was money. Initially, with the introduction of paper currency, gold was still used as a backing for paper currency. Therefore, a gold-backed currency instills as much confidence (in its use as a store of value) as gold itself.

In 1971, something happened that shook the foundations of the financial world. The relationship between the US dollar and gold was severed. That is, the US dollar was no longer a gold-backed currency. Since the US dollar is the world?s reserve currency, the money that most of us hold today is no longer backed by gold.

Therefore, fundamentally, the value of gold relative to a currency is an expression of confidence of that currency in its utility as a store of value. This fundamental reason is based on the assumption that gold is trusted as a store of value. Based on the fact that gold had always served this function for most of human history (except from 1971 to today), we doubt its use will significantly change for the rest of human history.

What will result in a loss of confidence of a currency that is not backed by gold? In truth, an un-backed currency is nothing more than a piece of paper (or in this age, digital information). Therefore, monetary inflation (printing of money) will result in a currency losing its value. The effect of monetary inflation will be general price inflation, which is the general trend towards higher prices across all goods and services.

As we said before (see The story of gold), gold was rising quietly (though not so quiet for the past 12 months) for the past several years. What does this tell us?

The story of gold

Wednesday, October 4th, 2006

Overnight, gold prices plunged to around US$575 while oil prices plunged to around US$58. For more than four months already, ever since the great commodity correction, gold prices had been dancing around and going nowhere. We recalled the days in June 2006 when gold fell to around US$545 and during the Israeli-Hezbollah fighting when gold rose to around US$670. The gold fever, which started late last year and reached a pinnacle in May 2006, had subsided since then. Now, an air of uncertainty and unpredictability surrounds gold. Where will it go next in the short term?

We don?t know. But since we are long-term holders of gold, we aren?t the least perturbed by their untamed price volatility. That is because we know the story of gold…

Six years ago, gold had kept a low profile and rose quietly. Her message, to those who were wise and listening, was that something amiss had been going on in the financial system. She was like a prophet warning us of an impending disaster. As with most prophets, no one listened to the prophetic message of gold anyway. Then late last year, gold caught the eye of the mob. They grabbed for gold even though they knew not the reason for grabbing her. But all of a sudden, in May 2006, the mob changed their mind at a flick. Swiftly, they were dumping gold indiscriminately even though they still knew not the reason for doing so. Since then, the mob was at loss with what to do with gold. She passed from hand to hand, seeking to find an owner who would understand her true worth…

This is the story of gold so far.