Archive for December, 2006

One funny effect of monetary inflation: ?New rules outlaw melting pennies, nickels for profit?

Thursday, December 14th, 2006

Today, this article filled our day with laughter: New rules outlaw melting pennies, nickels for profit.

Monetary inflation has now come to the point that the price of the metal in coins far exceeds the face value of the coin itself. Pathetically, the government then has to make up new rules in order to intervene into the free market. The justification for this new rule is:

?The nation needs its coinage for commerce,? U.S. Mint director Ed Moy said in a statement. ?We don’t want to see our pennies and nickels melted down so a few individuals can take advantage of the American taxpayer. Replacing these coins would be an enormous cost to taxpayers.?

Against this excuse, we would like to point out what Murray Rothbard had to say in What Has Government Done to Our Money?:

On the free market, money can be acquired by producing and selling goods and services that people want, or by mining (a business no more profitable, in the long run, than any other). But if government can find ways to engage in counterfeiting, the creation of new money out of thin air, it can quickly produce its own money without taking the trouble to sell services or mine gold. It can then appropriate resources slyly and almost unnoticed, without rousing the hostility touched off by taxation. In fact, counterfeiting can create in its very victims the blissful illusion of unparalleled prosperity. Counterfeiting is evidently but another name for inflation, both creating new “money” that is not standard gold or silver, and both function similarly. And now we see why governments are inherently inflationary: because inflation is a powerful and subtle means for government acquisition of the public’s resources, a painless and all the more dangerous form of taxation.

What can we expect in a US dollar decline?

Wednesday, December 13th, 2006

Yesterday, we mentioned about the possible scenario of a decline (or collapse) of the US dollar in Will the US dollar collapse?. Today, we will look at the consequences of such an eventuality.

As we explained in The Bubble Economy, the reason why monetary inflation had not led to severe price inflation is because of the disinflation effect of cheap Chinese imports. Thus, goods that can be imported from China have their prices being suppressed from inflating. However, goods and services that cannot be imported will suffer price inflation, most notably housing and health care. Thus, the US had been printing money and buying goods overseas with their printed money. Simultaneously, the excess printed money went into assets (housing) to cause price bubbles.

Now, as the US dollar decline, that will result in imported goods getting more expensive for American consumers. Since the US import far more than they export, the outcome will be price inflation for those imported goods. When that happens, the Federal Reserve will be forced to raise interest rates to curb inflation. If the Federal Reserve does that, Wall Street will take a big hit, perhaps triggering a sell-off in the stock market since they are expecting the Federal Reserve to cut interest rates in 2007. We guess Ben Bernanke must be in a dilemma and losing sleep over this scenario. If the Fed raises interest rate, it will probably push the already weak US economy into recession. If it does not, the result will be inflation, which if left unchecked, will lead to hyperinflation. That could be the reason why the Fed had been exasperatedly warning about inflation (i.e. interest rates could still rise) in an apparent attempt to shake off the market?s expectation of an interest rate cut next year.

The ideal outcome will be for the US dollar to decline so gradually that the US economy will have plenty of time to wean itself from cheap Chinese imports. But if some financial accident occurs and the US dollar collapses, the outcome will be unthinkable.

Will the US dollar collapse?

Tuesday, December 12th, 2006

As we mentioned in The ABCs of hedging, the first step in hedging our investments is to subject our portfolio to ?war-games,? where we work out how it may perform under various economic what-if scenarios and come up with strategies to counter the unfavourable outcomes.

Today, we look at one possible scenario?the decline (or collapse) of the US dollar.

Lately, we are again hearing that central bankers are murmuring about diversifying their foreign reserves away from the US dollar. Does it mean that there is an imminent liquidation of their US dollar reserves? Well, this is not the first time they murmured about it and it is definitely not in their (including the Federal Reserve?s) interest to see a collapse of the US dollar. The Chinese, with their US$1 trillion of reserves, would not want to see their stockpile of US dollars to lose significant value. The same goes for the Japanese and the oil-rich Middle-Eastern nations. The US too, would not want to see their dollar collapse as that would result in soaring inflation in their homeland. Therefore, we do not expect mass selling of US currency reserves by central bankers in the near term.

On the other hand, it is open knowledge that the status quo is unsustainable. This morning, we heard that Alan Greenspan (the former US head of Federal Reserve) warned investors in a business conference in Tel Aviv to expect a few years of dollar weakness. He further said that is imprudent to hold everything in one currency. This prompted a further slide of the US dollar against the Euro. The US has the dubious honour of having the world?s greatest trade deficit. If not for the fact that the US dollar is (maybe ?was? is the more appropriate word) the world?s reserve currency, the US would be consigned a banana republic long ago. The world cannot lend to the US indefinitely. Sooner or later, they will demand a pay back. The moment they decide that the US will not and is unable to repay its debt, what will happen to the US dollar? What will happen to the global financial system when that happens?

Thus, this situation is akin to an individual owning the bank money. If he owes the bank a million dollars, he is in trouble. But if he owes the bank a billion dollars, the bank is in trouble?if he goes bankrupt, a large portion of bank?s loan portfolio will be wiped out, rendering the bank insolvent. The US owes the rest of the world so much money that they cannot afford to let the US go ?bankrupt.? But the rest of the world knows that sooner or later, the US will go ?bankrupt.? (Of course, a country cannot be bankrupt in the same way as individuals do because there is always the option to print money to remain solvent. But the end result will be just as horrible?hyperinflation.) What can be done?

We are all living in a precarious situation. We shudder to think of the day when a black swan event happens. On that day, whoever owns gold will have a lot of friends.


Entrenched perception on the value of paper money

Monday, December 11th, 2006

Not long ago, we advised someone to buy gold as a hedge against inflation. That person?s reaction was, ?But gold prices had already doubled from a few years ago!?

As we think about that person?s reaction, we realised that people?s perception on the value of gold had changed immensely over the course of centuries. Two hundred years ago, people would rather trust gold much more than paper money. After all, paper money were just warehouse receipts for gold, which may well be forged or quantitatively inflated (this is, strictly speaking, fraud). Gold, on the other hand, had been selected by the free market over the course of centuries as the most reliable medium of money. It was considered far more reliable than paper because there was (and is) no way for anyone to easily inflate the supply of it at will (other than mining for it, which require significant time and effort).

Today, people?s entrenched perceptions are completely different. Somehow, by some strange reason, paper currency (with today?s technology, they can exist in the form of digital information) is mistakenly seen to be the more reliable store of value. It has come to the point that even the value of gold is measured in terms of paper currency. As we said before in How is inflation sabotaging our ability to measure the value of things?, how can we measure the value of something by using a yardstick that is as elastic as paper currency?

Now, since the gold prices had doubled from a few years ago, will it be subjected to the law of gravity and return to where it was? There is nothing to prevent gold from obeying (or disobeying) this ?law? but fundamentally, if this ever happen, the market will be behaving even more irrationally that it is right now. Think about it: if the quantity of paper currency (including credit, money substitutes, deposits, etc) is growing at a rate that far outstrips the rate of increase in the quantity of gold by a colossal margin, then the fundamental value of paper money relative to gold has to continue to fall significantly. Today, gold prices still far undervalue the fundamental worth of gold.

If we consider the way central banks around the world are grossly inflating the supply of paper currencies, we cannot help but feel that it is more risky to hold cash in the long run.

How to secretly rob the people with monetary inflation?

Sunday, December 10th, 2006

Quite some time ago, we had learnt that Alan Greenspan, the former US head of the Federal Reserve, had a sign at his desk that said, ?The Buck Starts Here.? While we are not sure of the truth to this, we know that at the very least, the statement itself is true (and funny as well)?the Federal Reserve has the power to create US dollars out of thin air. Since the world is running on fiat currency system, this arrangement is an accepted order of things globally. While we are not pointing a finger at anyone, we cannot help but feel disturbed by the ethical implication of this arrangement.

Suppose someone of great counterfeiting skill forged a million dollars. Who is the first to benefit? Obviously the forger because he can now spend the fake money on whatever he likes. The shopkeeper who receives the forger?s fake money will benefit next as his income increases. As the fake money spread throughout the economy, the money will pass from hand to hand in the forms of incomes and expenditures, raising the prices of goods and services along the way. Who will suffer most? The last person who receives the fake money because by the time he does so, price would have already risen.

Now, let us look at the situation in Shanghai as an example?see our previous article, Cause of inflation: Shanghai bubble case study. (Please note that we are not pointing a finger at the Chinese authorities?this is a universal problem that applies to every country in the world.) Clearly, there are some people who unfairly benefit and some who loses out. When central banks print money, the commercial banks are usually the first in the queue to receive them. The next to receive the money will be the companies and businesses that receive the money in the form of loans through the fractional reserve banking system. As that money made its way into the various classes of assets (e.g. properties and stocks), there will be some who strike it ?rich? as they sell their assets at inflated prices. As we said before in Speculative fervour in the Chinese stock market, the proliferation of ?success? stories of those who achieve their wealth through their ?investment? is testament to this phenomenon. Those who ?made? money will no doubt spend them, thus adding to the aggregate demand of the economy and bidding up prices. The end result is price inflation. Who are the last ones who will receive the money? The common people on fixed salaries and who do not own any ?assets? will have to bear the brunt of price inflation. In Shanghai, the rural migrants are one of the most susceptible groups. What is the end result of this? A redistribution of wealth from the last ones in the queue to the first one in the queue! Usually, the latecomers are the most vulnerable members of society.

Thus, monetary inflation always brings about false illusions of prosperity in the beginning. In reality, if left unchecked and unrectified, will be harmful to society in the end.

The herd is buying Telstra

Saturday, December 9th, 2006

Today, this article, Telstra rise surprises even its biggest boosters, caught our eye. Ever since Telstra?s T3 receipts were listed in the stock exchange, it had risen from its offer price of $2 to last Friday?s close of $2.51. That?s a growth of 25.5% in just three weeks! From what we learnt in that article, sentiments seemed to be turning in favour towards Telstra again (or maybe towards telecommunication companies globally in general). Major brokers like Macquarie, Citigroup and ABN Amro have been upgrading their recommendations for Telstra.

We find this rather amusing.

Not long ago, while Telstra?s T3 receipts were being offered to the public, the crowd were scoffing at Telstra. The mood against that company was one of anger, disgust and ridicule. As we said before in Is the Telstra T3 offering worth a buy?, our advice is: get even, not mad with Telstra. Joining in the mob mentality is not going to do ourselves any favour when it comes to making investment decisions that require rational thinking. Before we decide whether to invest in any business, we should be making a meticulous evaluation on its merits and the maximum price that we are willing to pay for it. After we invest in the business, we should stick with it, unless new facts, evidences or developments have emerged to undermine the intrinsic worth of the business.

But as we can see, the market is often tossed and turned by every whim of emotions. It is very amusing to see those major brokers suddenly changing their minds about Telstra at about the same time. There are now talk that the Telstra share price was undervalued, implying that the government had sold it too cheaply. We guess the insiders who bought Telstra shares probably saw that fact too (see Insiders buying Telstra). As a result, the crowd are now rushing back to buy Telstra shares.

But dear readers, how much of Telstra?s intrinsic worth had changed since the T3 sale? Not one iota! Since the basis for Telstra?s long-term future had not changed within that space of time, why did those major brokers suddenly change their mind? Had they fallen asleep behind the wheel and suddenly wake up to find the beauty of Telstra?

We prefer not to disclose our cynical theories here.

How to join in the growth of China?

Friday, December 8th, 2006

As we mentioned yesterday in Why is China printing so much money?, we believe there are better alternatives in taking part in the rise of China than sinking your money into the wild liquidity of the Chinese economy. It is a mistake to simplistically assume that to take part in the rise of China (or India, Brazil, Russia, etc), all you need to do is to pour your money into the sizzling Chinese (Indian, Brazilian, Russian, etc) stock market and watch your wealth grow. In case you do not know, it is very much possible for the stock market of a high-growth country to fall significantly while the rest of the economy is humming along fine?it has happened before in China and it happened in India this year.

We should keep in mind the following general rule of thumb: In the long run, the stock price of a company should grow at the same rate as the growth in the profits of the company. Similarly, in the long run, company profits can only grow at the same rate as the growth in the overall economy. With this rule of thumb, whenever we see stock prices outstrip the growth of the overall economy by a far margin, it is time to beware. This may be a sign of a bubble. As we mentioned in Divergent sentiment , if you are the central bank you can make the stock market index climb as high as you want simply by printing money. This is what is happening in China right now. With all these China growth stories, it is tempting to assume that any managed funds that invest in Chinese stocks will automatically do well in the long run. True, some of these funds may seemingly do well in the short run, but unless you are a fast and nimble short-term trader, investing your money into them for the long term may not be a good idea (note: if you are a short-term trader in the Chinese stock market, you will not be investing in that managed fund in the first place). And before we get criticised, please note that we are NOT saying that ALL managed funds that invests in Chinese stocks are bad?we are merely stressing the importance of not judging the quality of a fund just on the basis that it invests in Chinese stocks.

Now, what is our preferred way of taking part in the growth of China? For us, as contrarians, we prefer to seek out companies that have China as their target market. In other words, we prefer companies that sell their goods and services to the Chinese. As China grows richer and stronger, their purchasing power will increase. For this, we will have to study the needs, trends and fads in China to discover what are the things that the Chinese wants and have the money to buy. A business that is well positioned to take advantage of that will garner our interest.

Why is China printing so much money?

Thursday, December 7th, 2006

In our previous article, Cause of inflation: Shanghai bubble case study, we explained that the root cause of price inflation is monetary inflation. The Chinese economy is awash with growing liquidity (that is, the economy is soaked with ever-growing supply of money). The next question to ask is: why is money supply growing in China?

One of the culprits for this problem is the inflexible exchange rate of the Chinese currency (RMB). The RMB is not a freely floating currency?its exchange rate is still controlled by the Chinese central bank albeit having some semblance of flexibility. At the current rate of exchange, the RMB is undervalued. Since it is undervalued, foreign capital will want to enter China in the form of foreigners buying up the RMB. If the RMB is a freely floating currency, the demand for it by foreigners will bid up its price, which will reduce its demand as it becomes more expensive. Conversely, as its price rose, domestic sellers of RMB will sell down its price. Finally, a market equilibrium price will be reached where the quantity supplied will meet its quantity demanded. Since the RMB?s undervalued exchange rate is still barred by the Chinese central bank from rising, foreign demand will exceed its domestic supply. So, the question is: where is the RMB going to come from? In the absence of capital controls freedom, the only choice the Chinese central bank has is to print RMB to maintain the undervalued exchange rate. Now, with foreigners armed with freshly printed RMB, they bided up the prices of Chinese assets, including stocks and properties. In the case of Shanghai, real estate prices had reached dangerously bubbled prices. As those newly printed money permeate its way into the rest of the Chinese economy, the result is price inflation. We are hearing reports from the grassroots level that prices of many things (including everyday goods and foodstuffs) in Shanghai are increasing.

Lately (as we mentioned before in Are you being ripped off by fund managers?), we are not keen in handing our hard-earned wealth into the managed fund that is sinking more money into the massive pool of raging liquidity in the Chinese economy. There are better alternatives to take part in the growth of China than to join in the bubble.

The ABCs of hedging

Wednesday, December 6th, 2006

One of the claptraps that we get to see nowadays is ?Hedge Funds.? According to the Encarta dictionary, the word ?hedge? is defined as: ?a means of protection against something, especially a means of guarding against financial loss.? A ?hedge fund? was originally meant for managed funds that employ hedging to protect against any market downturn and perhaps even profiting from it. Today, there are many funds that call themselves ?hedge funds? even though in reality, they do not hedge at all. Those fund managers are more akin to gamblers betting on anything that they can get their hands on, often using huge amount of borrowed money and derivatives to magnify their punts. In addition, unlike the conventional gamblers in the casino, those gamblers are usually absolved from personal losses if they lose their bets. Instead, it is often those poor investors who entrusted their money to those scoundrels who have to pay the price. Worse still, if those gamblers won their bet, they will often be the first to carve out a slice of their winnings. Thus, if you should decide to entrust your wealth to a hedge fund, please make sure the fund manager is not a gambler in disguise and that the fund does indeed hedge. There are too many quacks, swindlers and cheats in the financial industry waiting to devour your money.

Now, as a private investor, how do you hedge your portfolio? In other words, how do you reduce the risk of potentially significant losses in your portfolio?

The most well-known and basic technique is diversification, which is spreading out your investments across different stocks, industry, asset classes and so on. Unfortunately, this technique has major limitations. Firstly, though diversification reduces your risk, it also reduces your chances of making big gains. It is possible to over-diversify, which will result in mediocre returns over the long term. Secondly, diversification will not protect you against major economic catastrophe when deflationary forces wipe out the value of almost every class of investment. Thus, for investors after atypical excellence, diversification is not the most favoured method of hedging because they would rather reduce risks by increasing and improving their skills, knowledge and understanding then by scattering their eggs over many baskets. The best investors would rather concentrate their investments on the ones that they understand intimately than to spread out their investments to make up for lack of understanding. In other words, diversification is a very blunt tool for hedging.

What is the more precise strategy for hedging? For long-term value investors, there is this ?war-gaming? approach. Military planners often go through war games where they work out the outcome of all the possible scenarios and develop strategies to specifically counter each of the unfavourable outcomes. The same can be applied to investing. This risk management approach will determine how you structure your portfolio. Given each of the economic what-if scenarios, what are your plans to ensure that your portfolio will survive and perhaps even thrive? For example, what are your plans for your investments if oil prices sky rocket? What happens if the US dollar collapses? What if the global economic imbalances unwind disorderly? For you to be able to evaluate the ?war-gaming? scenarios, you would need to understand both global and local economic conditions. That is why in this publication, we often delve into economics, which some novice investors mistakenly believe is irrelevant and is the ?job? of the government.

Then there are the more tactical approaches for hedging, which is more relevant for short-term traders but nonetheless can be adapted for long-term investors as well. The most basic of these is the stop-loss. It is a tool mainly used by trader to pre-define the price which they will exit their position regardless of what their emotions tell them in the heat of the battle. Stop-loss does not prevent you from making a loss?they let you pre-define your potential loss before you enter the trade. For those more advanced traders, there are more powerful tools for hedging using derivatives. For example, delta-neutral option strategies allow you to potentially profit from all kinds of short-term market situations and limit your losses to pre-defined levels should you turn out to be wrong.

There are a lot more to hedging and risk management than we can say in this article. We hope this will be a good starting point for you.

Cause of inflation: Shanghai bubble case study

Tuesday, December 5th, 2006

A few days ago, we learnt about the mad speculative fervour over real estates in Shanghai. From what we hear, the annual salary of an average middle-class worker in Shanghai is somewhere in the order of 50,000 to 100,000 RMB. However, apartments over there can cost up to prices to the order of 1 million RMB. We were simply astounded at the relativity of these two anecdotal figures, which we obtained from people we know who live in Shanghai. How is it possible for people to afford such exorbitantly priced housing? More amazingly, even at such sky high prices, many people over there feel that apartments are still ?cheap? and consider them good ?bargains!? We learnt further that the prevailing attitude over there was that real estate prices can never fall and that if you do not buy today, you will lose out because they will be more expensive tomorrow. Therefore, people piled themselves with debt to buy real estates that they cannot afford. With their assumption that prices will be going up indefinitely, they reckon that if the worst should ever happen, all they need to do is to liquidate their property at higher prices to the next buyer.This is a gigantic bubble that defies all rudiments of proportion, common sense and prudence. We suspect that with the Olympics in 2008, there will be a need for the authorities to at least keep up the spectacle and illusion of prosperity till then. Meanwhile, as we expected, inflation is experienced everywhere in Shanghai. We heard that this scenario is working out in other Chinese cities as well.

Now, it comes to the topic for today: inflation.

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money, in which the effect is the rise in the general level of prices. For the sake of discussion, let us call the mainstream definition as ?price inflation? and the Austrian School?s definition as ?monetary inflation.? We see that the Austrian School?s definition is far more accurate and correct because it goes right down to the root of the problem.

If the economy?s money supply increases relative to the increase in production of goods and services, then prices in nominal terms will have to increase because there will be more money chasing after the same amount of things in demand. As this article, Defining Inflation, said:

Consider the case of a fixed money supply. Whenever people increase their demand for some goods and services, money will be allocated toward other goods. Thus, the prices of some goods will increase?i.e., more money will be spent on them?while the prices of other goods will fall?i.e., less money will be spent on them.

As Ludwig von Mises said in his essay, Inflation: An Unworkable Fiscal Policy:

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.

Therefore, because the approach that mainstream economists take to define inflation is deficient, the benchmark that they use to measure it (an index of the price levels e.g. CPI) is also deficient. Does the CPI (or whatever the alternative price index that central bankers prefer to use) measure the price levels of assets? The answer is no! As a result, the conventional yardstick that mainstream economists use does not fully disclose the full extent of the economy?s inflation problems.

The mainstream economists do not see monetary inflation as an evil?as long as price inflation is not a problem, they do not see the need to care about monetary inflation. But Austrian School economists see that the inevitable consequence of monetary inflation is price inflation because the former is the root cause of the problem and the latter is the effect. That is the reason why Austrian School economists are strong advocates of gold-backed monetary systems because such systems will have automatic built-in checks to prevent undisciplined monetary inflation (aka printing of money).

In the case of Shanghai, we are not the least surprise to see price inflation happening. In fact, if the Chinese central bank does not control monetary inflation (that fuelled the property speculation in the first place), price inflation will get worse before it gets better. When that happens, the common people, especially the poor will suffer. On the other hand, if the Chinese central bank decides to raise interest rates to rein in price inflation, they run the risk of bursting the property bubble, which will have a destabilising deflationary effect. In that case, the speculators (of which many of the middle-class common people are) will suffer first, followed by the rests. It looks to us that the Chinese central bankers may have trapped themselves into a box.