Archive for March, 2007

Economists punt on Aussie interest rates

Saturday, March 31st, 2007

Today, we saw this article in the Sydney Morning Herald (SMH): No rate rise next week say economists. Out of 19 economists surveyed, only 7 expect an interest rates rise next Wednesday.

Let?s see how many will win the punt.

China to pull the plug?

Friday, March 30th, 2007

In our previous musing in Chinese economic overhaul?, we briefly mentioned about this significant piece of news: Stephen Roach on China?s ?Unstable? and ?Unsustainable? Economic Model. According to that article, the Chinese leadership is highly concerned about the social and environmental impact of breakneck economic growth over the past few decades. There is worry that the status quo is ?unstable, unbalanced, uncoordinated and unsustainable.?

What is the implication? Here, we offer some of our speculative thoughts, which are by no means predictions on the future. If you have other ideas on this, please feel free to leave us comments.

Assuming that this news is true, we can expect significant policy changes in China that will shift focus from the economy to the environment and social stability. This means the Chinese government will take steps to slow economic growth significantly in order for the non-economic aspects of the nation to catch up and for the economy to catch a breather. Indeed, China, for all her impressive economic growth, has a host of other serious problems as side effects. The environment is one of them. Social stability is another. Other negative economic side effects include price inflation (see Cause of inflation: Shanghai bubble case study), rampant speculations (see China paradise for stock speculators) and overcapacity. We see that it is possible for the Chinese government to take steps that will result in short-term pain but better for the nation in the long run.

As investors, how will that affect us?

Much depend on what the Chinese government do specifically to achieve these objectives. We cannot predict what they are, but we can offer our conjectures. For example, one area the Chinese government may take action against is the unruly stock market, which is in effect almost a casino. Will they pop the stock market bubble? Your guess will be as good as ours. Also, China may allow their RMB to appreciate more so as to cut off another supply of air against exports, which is a great contribution to the already overheated economic growth.

Whatever the specific actions that the Chinese government take, we can be sure that there will be a great impact on the global economy and financial markets. For example, we see that the Chinese central bank?s decision not to accumulate anymore US dollar reserves (see China unwilling to hoard US dollars?what?s the implication?) is consistent with this impending policy change. Also, will China?s reining in of runaway economic growth affect her appetite for Australian resources? If so, the Australian economy will be impacted as well.

China is a 800-pound gorilla that we should watch.

Digging gold or sell shovel?

Thursday, March 29th, 2007

In 1848, gold was discovered in California. Soon, news about that spread around and led to a gold rush. People from all around the United States and abroad came to California to dig for gold, hoping to strike it rich. With too many gold diggers competing with each other, very few of them actually attained great wealth. However, there is a class of people who became rich?the ones who sell shovels and other equipment to the gold diggers.

Today, we see a parallel in the stock markets. As we said before in Have we escaped from the dangers of inflation?:

… it looks to us that nowadays, everyone is ?playing? the stock market, many using leverages like CFDs and margin lending. We hear stories of novices ?investors? opening a trading account to ?learn? how to trade.

Today?s stock markets are akin to California during the mid-1800s and many retail traders/investors are like the gold diggers of that time. With so many of them competing against each other, we wonder how many actually strike it rich? Worse still, many of them think similarly, using the same technical analysis techniques and even reading the same analysis reports. In a rampaging bull market that is created by runaway gush of liquidity from central bankers? money printing press and bankers? never-ending credit creation, it seems easy and safe to get rich right? But rest assured, just like the gold rush, the rampaging bull market will one day die off too. When we see speculation and shuffling money replacing hard work, industry and wisdom as the preferred method of attaining wealth, we know the end is closer than the beginning.

But in this environment, we observed a group of people that made a lot of money with almost no risk?the shovel sellers. Today, trading/investment ?education,? stocks tip sheets and recommendations are big business. With so many traders, investors, speculators and gamblers in the stock market, the demand for the services of these big businesses have never been greater than before. There is no doubt that many of them are indeed influential, perhaps even bordering on manipulative (see Stock tip-sheets?influential or manipulative?). Many of them are honest businesses. Some of them, though honest, offer bad quality products. Perhaps a few are frauds. Even fewer are the ones that offer truly outstanding products.

If you want to dig for gold, make sure you get the best shovel. Or better still, be the shovel seller.

Chinese economic overhaul?

Thursday, March 29th, 2007

Today, we saw this article: Stephen Roach on China?s ?Unstable? and ?Unsustainable? Economic Model. Even though we do not have time to fully ponder on the implications of this, it looks to us that this has serious consequences to the global economy. We have a feeling that this is not good news for the future of the US economy.

Myth of diversification as safety?Part 2: nature of risk

Wednesday, March 28th, 2007

Continuing from our previous article, Myth of diversification as safety?Part 1: definition of risk, we will then ask the next question: what is the nature of risk?

First, we have to define risk properly. Warrant Buffet?s 2006 Chairman?s Letter expressed it well (emphasis ours):

Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

Therefore, risk is something that you cannot simplistically reduce to a precise number obtained from a mathematical model. As we said before in How do you define risk?, risk has to be defined in terms of the ?soundness of the underlying economic and financial state.?

Therefore, in light of this, we see that risk assessment is more of an art than a science. This does not mean that all mathematical modelling of risks should be thrown away?they have its use when utilised appropriately. To understand why, we have to recognise that all models employ underlying assumptions for its construction. We have to determine whether the assumptions are valid or accurate in a case-by-case basis. For example, almost all of the option-pricing models assume that prices follow a Normal distribution. Is this a valid assumption? Can we apply it to our specific situation? These are the critical questions we have to ask ourselves whenever we use mathematical models.

Thus, do not leave all the risk assessments to the computer! Do so at your own peril!

China unwilling to hoard US dollars?what?s the implication?

Tuesday, March 27th, 2007

A week ago, the Chinese indicated that they do not ?intend to go further and accumulate reserves? (see China to halt accumulating foreign reserves). While the financial markets were overly engrossed with the Fed?s interest rate policy, this event was very much overlooked. Ominously, we believe China?s intention will have a much more significant long term impact on the US economy than the content of last week?s US Federal Reserve Open Market Committee Statement. Thus, it is possible that the likely impact of China?s decision has not yet been fully factored into the financial markets.

What is the implication of this?

First, we have to be aware that China holds more than $1 trillion of foreign reserves, much of which are parked in US Treasury bonds. If the Chinese Central Bank decides to go berserk and sell all of their US Treasury bonds, we will see the US dollar collapse and long term US interest rates skyrocket. Since the US mortgage rate is very much dependent on long term interest rates, we can expect the housing bubble to burst spectacularly, crunching economic growth and triggering mass insolvency. A collapsing US dollar will at the same time result in runaway price inflation (see What can we expect in a US dollar decline?). This hypothetical scenario is Ben Bernanke?s ultimate nightmare?cutting short term interest rates may (and we stress the word ?may? because we believe even this measure is likely to fail) possible help in economic growth, but it will exacerbate price inflation, even leading to hyperinflation. Raising interest rates, on the other hand will exacerbate the weakness in an already very weak economy. This is the terrifying stagflation scenario.

Of course, it is unlikely for the Chinese Central Bank to go berserk. It is not in their interest to see their accumulated US$1 trillion of reserves go up in smoke. However, it is also not in their interest to further accumulate increasingly overvalued (maybe ?worthless? is a better word) US dollars (see Will the US dollar collapse? for more on this dilemma that China faces). Hence, we are hardly surprised at the latest Chinese indication. But, we have to understand that the Chinese cessation of US dollar accumulation will still lead the US economy to a similar path (though far less dramatic) as the nightmare scenario that we drew up just now. If China still receives a lot of US dollars from their trade surplus to the US, what are they going to do with their excess US dollars since they do not intend to accumulate them? Previously, they accumulated US Treasuries with surplus dollars. But now, no matter what they do to get rid of their American fiat money, it will end up in the foreign exchange market. This can only mean one thing?the US dollar will fall. In addition, if the Chinese no longer demand US Treasuries, who will pick up the slack? If no one is willing to do so, it will mean that long term US interest rates will rise.

Again, we will be in the look out for the US capital account (see Is the United States running out of credit?).

Myth of diversification as safety?Part 1: definition of risk

Monday, March 26th, 2007

In our previous article, The ABCs of hedging, we said that the ?most well-known and basic technique [in hedging] is diversification.? We often hear from financial professionals that it is very essential because it is the means by which risks can be reduced. The principle behind this idea is to decrease the hazards to your investments by not putting all of them in one basket. As with many ideas in life, what started of with a sound base of principle gradually becomes a mantra with unsound indiscriminate applications. In this article, we will expose some of the myths with regards to the diversification.

First, how is risk defined? As we have mentioned before in How the folks in the finance industry got the idea of ?risk? wrong!:

… mathematical definitions of ?risk? [, which is often made by the finance industry] give it a scientific feel, which seem to give us the impression that ?risk? can be measured and controlled.

The problem with such precise measurement is that it is precisely wrong! By defining risk that way (see How do you define risk?), we are in effect letting price be the root determinant of ?risk!?

The next question to ask is this: what is the root assumption behind such definition of risk? We guess it is the famous Efficient Market Hypothesis (EMH), which asserts that prices ?already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects.? There are many serious reservations on EMH and personally, we doubt this theory is true. Furthermore, we doubt that prices follow a Bell curve (see How the folks in the finance industry got the idea of ?risk? wrong!) in the real world.

Since diversification is meant to reduce ?risk? and if ?risk? is wrongly defined, how useful do you think it is?

Stay tuned for more of our views on diversification!

A painful cleansing or pain avoidance at all cost?

Sunday, March 25th, 2007

Back in Inflation or deflation first?, we mentioned that,

Now, faced with the threat of a deflationary recession, what can the Fed do? Politically, it is impossible for them to allow a recession run its full course in order to clean up the prior excesses of the bubble. They will do anything and everything to ?prevent? another recession. The only way for them to do that is to do what they always did?pump even more liquidity into the economy (a.k.a ?print? money).

We believe that the US is likely to face a severe recession. When that happens, we will see an accompanying great fall in financial asset prices. That is, asset price bubbles will collapse. What is the Fed to do in that case?

Economists from the Austrian School of economic thought will recommend a painful cleansing of the economy through a recession. Through the liquidation of mal-investments during the bust, it will set the scene for a sounder and more sustainable economic growth in the long run.

But will the Fed follow the Austrian recommendation?

We believe it is highly unlikely. Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible. As we can see in this article in Bloomberg, Senate Weighs Aid to 2.2 Million Subprime Borrowers (Update4), the Fed will have to submit to the mob eventually.

This will set the stage for monetary breakdown and the loss of confidence in fiat money.

Pitfalls for businesses in ?accelerating? economy

Friday, March 23rd, 2007

On Wednesday afternoon, we came across this article in the Sydney Morning Herald. Initially, the title of this article was ?Economy poised to accelerate this year: Westpac.? After we read the article, we were again flabbergasted at the mainstream media?s frequent bad habit of misinforming the public. Were they trying to convince their readers that Australia is going to make yet another miraculous economic growth? Did Westpac really say that the great party that we enjoyed for the past 16 years is going to get even better?

As we returned to that same article in the evening, its title was renamed to ?Economy to accelerate, maybe rates too: Westpac.? After re-reading it, we felt strange that we were not feeling as flabbergasted as before in the afternoon when we first read it. Were we overactive in the afternoon? But wait a minute! We realised, if memory serves us correctly, the content of the article was indeed different! Perhaps the chief editor saw what we saw in the afternoon and ordered a modification? We can only guess.

Anyway, the modified version of the article is what we should be focusing on for today?s musing. It should serve as a further warning to investors not to assume that the good times of record company profits are going to continue forever. As we said before in Another sign of the business cycle top:

If you expect the profit trend to continue and pay a premium price for stocks in anticipation for higher earnings next year, chances are, you will be disappointed. It is now time to hunker down in your bunker in preparation for the economic downdraft.

As we said before in Have we escaped from the dangers of inflation? and with the Westpac survey confirming our view, Australia is very much likely to be hit with more price inflation in the days to come. Thus, the implication is that there will be more interest rates rise to follow.

What is the implication for us as investors?

With the economy already near full productive capacity, any economic ?growth? will not result in any significant increase in production. As a result, such ?growth? will spill over to increase in prices (i.e. price inflation). Thus, Australian businesses in general will face the twin threats of rising input cost and higher interest rates. Businesses that have no market power will be unable to raise prices as their costs goes up. Those that are high in debt will find their interest payment expense rising as well.

If you want to remain invested in stocks, choose them wisely. Avoid companies that have no market power and/or are high in debt (e.g. Qantas if private equity gets its way).

Rewarding mal-investments?

Thursday, March 22nd, 2007

We saw this article in the newspaper: Rent relief scheme wins support. In that article, it said, ?STRUGGLING renters would get cheaper housing under an ambitious proposal for state and federal governments to spend millions of dollars a year to subsidise housing.?

How does this proposal work? It will be through a ?subsidy flows directly to the investor rather than the tenant. To receive the subsidy, the investor must provide rents at about 20 per cent below market value or in some cases even more.? The ?state governments would be asked to provide cash, slash stamp duties and fast-track planning approval while the Federal Government would be encouraged to contribute cash or tax credits.?

We shake our heads as we read this news article.

As we said before in Wasteful investment not the cause of housing un-affordability, the affordability and rental crisis was the outcome of artificially induced housing demand that was brought about by making money too cheap unnaturally. The resulting bubble and excesses (see The Bubble Economy), which was further exacerbated by government tax policies, resulted in mal-investments in the economy that ought to be liquidated eventually. This is what the market calls a ?correction,? which is vital for further sustainable growth.

What is the effect of this proposal? By subsidizing investors, it interferes with the correction process by rewarding bad property investments and delaying the badly needed deflation of house prices. The real problem is that house prices are currently too high.

What a bad idea!