Archive for August, 2007

It is time to buy stocks? Think carefully before you do so!

Monday, August 13th, 2007
As we all know, the stock market volatility over the past few weeks had introduced fear back to the stock markets around the world. Last Friday, the Australian’s All Ordinaries Index fell 3.6%, which was said to be the largest one-day fall since September 11.

However, from the reading of the mainstream press, some ?experts? were saying that there is no need for panic and perhaps it is even a good time to buy. The basis for such advice is that the ?fundamentals? of the global economy are still good and that such a stock market rout should not perturb the long-term investor. For example, Shane Oliver, head of Investment Strategy at AMP was quoted, ?Remember, this is not about a slowdown in global growth. Fundamentals are still sound and profitability is good. This is about fear and I think the actual losses that come out of the sub-prime situation will be relatively small. In the meantime, any further drying of liquidity will be eased by central banks, who will pump money into the system to keep things moving.? In other words, the belief is that this ongoing correction and volatility is only temporary and that in due time, the bull market will continue its way to record highs again.

Before we rush in to buy stocks, we have to understand the subtleties behind the idea of ?fundamentals.? By its very nature, fundamental analysis (e.g. on the economy or financial health of a business) involves analysing numbers that happened in the past and projecting those numbers into the future (i.e. forecasting). For example, when you look at the earnings figures of a business, they are numbers that occurred in the past. Based on the past, we can then project future earnings into the future, which will then tell us how much the business should be worth. The same idea goes for analysing economies and global growth.

Here comes the thought-provoking question: what happens if we are currently at the turning point? If we project the past into the future whilst at the turning point, how accurate will such a forecast be?

Now, back to the question of whether it is now a good opportunity to buy stocks, given that the ?fundamentals? of the global economy is still good. In deciding whether to follow advice such as Shane Oliver’s, the tough question you have to ask yourself is this: are we at the turning point? If the answer is yes, then this is a very bad advice that can result in loss of wealth.

Remember the lessons of the Great Depression (see The Great Crash of 1929). The 1920s was known as the roaring twenties in which the stock market reached the peak in 1929. After the Great Crash of 1929, it took about a year for the average person on the street to feel the real economic impact.

Money printing operations begin

Saturday, August 11th, 2007

Back in Inflation or deflation first?, we said

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).

In A painful cleansing or pain avoidance at all cost?, we said,

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.

In this news article, Stocks open sharply lower on global credit woes, it reported that,

The Fed early Friday said it injected $19 billion into the banking system. The European Central Bank added another $83.6 billion, after Thursday’s $130 billion injection, and the Bank of Japan on Friday added $8.5 billion.

The U.S. Federal Reserve on Thursday added $24 billion in temporary reserves, and Canada’s central bank put $1.55 billion into the markets.

In future, when we look at today through the lens of history, will we see this as the beginning of the end of fiat currencies?

China threatens economic nuclear bomb

Thursday, August 9th, 2007

Back in March, in China unwilling to hoard US dollars?what?s the implication?, we mentioned that:

Of course, it is unlikely for the Chinese Central Bank to go berserk [in liquidating their US Treasuries]. 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).

Today, we saw a news report that China is threatening to go berserk: China threatens ‘nuclear option’ of dollar sales.

Alas, politicians can often be trusted to make popular but stupidly disastrous decisions.

The mechanics of deflation- increase in demand for holding cash

Wednesday, August 8th, 2007

Last time, in Cause of inflation: Shanghai bubble case study, we wrote about the true nature of inflation, which is defined by the the Austrian School of economic thought as the rise in the supply of money (monetary inflation, i.e. ?printing? of money). The outcome of monetary inflation is price inflation, which is the general increase in pricel levels. As Ludwig von Mises said in Inflation: An Unworkable Fiscal Policy,

If the housewife who needs a new frying pan reasons: “Now prices are too high; I will postpone the purchase until they drop again,” inflation can still fulfill its fiscal purpose. As long as people share this view, they increase their cash holdings and bank balances, and a part of the newly created money is absorbed by these additional cash holdings and bank balances; prices on the market do not rise in proportion to the inflation.

But then?sooner or later?comes a turning point. The housewife discovers that the government expects to go on inflating and that consequently prices will continue to rise more and more. Then she reasons: “I do not need a new frying pan today; I shall only need one next year. But I had better buy it now because next year the price will be much higher.” If this insight spreads, inflation is done for, Then all people rush to buy. Everybody is anxious to reduce his holding of cash because he does not want to be hurt by the drop in the monetary unit’s purchasing power. The phenomenon then appears which, in Europe was called the “flight into real values.” People rush to exchange their depreciating paper money for something tangible, something real. The knell sounds of the currency system involved.

Today, we will talk about the converse?deflation.

Deflation happens when liquidity dries up. This can happen in a period of severe economic pessimism when the apprehension of the future drives people to increase their holdings of cash for the sake of peace of mind. When that happens, the quantity of money in circulation decreases, which means there are fewer money chasing after a given amount of goods and services. Consequently, prices have to decrease to accommodate for the decreased supply of money in circulation.

When deflation mentality gets a stranglehold on to the minds of the people, no one will dare to borrow money out of fear. Also, when prices are falling, the money that one borrows will be worth more by the time the debt is due. There is no point in spending money because if one waits a little longer, prices will fall further. Central bankers can print as much money as they can, but in such a deflationary environment, no one will want to borrow them.

This was what happened to Japan. Despite their central bank cutting interest rates to zero and their government engaging in an orgy of infrastructure spending, recovery was not in sight except until very recently.

If you are wondering why we are talking about deflation, please take a read at our earlier article, Inflation or deflation first?.

An example of how the sub-prime contagion may spread

Monday, August 6th, 2007
Back in March this year, we observed the complacency of the market regarding the slow-motioned unfolding of the sub-prime crisis (see Complacency! Market shrugging off sub-prime concerns). To the casual observer, it seemed that the sub-prime issue ?suddenly? popped up (say, sometime around February this year: see Marc Faber on why further correction is coming?Part 2) and developed into a ?contained? problem. There was a widespread belief that extraordinary liquidity will sweep away every woes in the market. Then all of a sudden, with the collapse of two of Bear Stearn’s hedge funds, the sub-prime problem seemed to begin to rear its ugly head again. There is now talk about liquidity crunch, narrowing of credit spread, etc.

In reality, the sub-prime issue was always lurking in the background. It was a problem that was slowly building up over a period of years. Today, it is finally blowing up in slow-motion. Contrarians had been warning about this problem but nobody took heed. For example, back in March 2004, Robert Blumen (who was associated with the Austrian School of economic thought of the Mises Institute) wrote in All Real Estate, All the Time:

The mainstream economist responded to these charges. “Home owners can simply extract equity from their home by refinancing and use the cash they take out to pay the difference between their income and their mortgage.” Home owners extracted $491 billion of equity from their homes last year according to the Wall Street Journal. “Home owners are already using home equity from refinancing to meet ongoing monthly expenses,” he continued, “It is a small step forward to start using these funds for the mortgage itself.”

As we said before in How does liquidity dry up?, the global economy’s drug supply of cheap and plentiful money is drying up. The consequence will be like a heroin addict suddenly running out of drugs for the next fix?cold turkey. Our belief is that this sub-prime contagion is probably going to spread further. What we see today is just the beginning. So, how may it spread?

We found that this article, Next victims of the credit squeeze, provides a good example of how such a debt crisis may infect the rest of the economy:

Turbulence in the credit markets has already claimed several casualties – from highly leveraged hedge funds to mortgage providers whose lenders have cut them off.

But the fallout could get worse. Some experts say the debt crunch could squeeze underperforming companies that have, until now, been able to finance their way out of trouble – and trigger a wave of corporate bankruptcies.

Mind you, if this scenario unfolds (which we believe can happen), it will lead to serious problems for the real economy.

How does liquidity dry up?

Thursday, August 2nd, 2007

Back in January, in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned that:

What is driving the stock markets is liquidity?the sheer weight of money and money substitutes chasing after a limited supply of assets (bonds, stocks, art, etc), resulting in skyrocketing prices. Therefore, any crunch in liquidity will result in collapsing asset prices.

Marc Faber had observed that liquidity seems to increase as asset prices rises:

The higher the asset markets move, the more the increased asset prices can create liquidity. Let us assume an investor owns a real estate or stock portfolio worth 100 and that his  borrowings are 50. For whatever reason (usually easy monetary conditions), the value of the portfolio now doubles to 200. Obviously, this allows the investor, if he wants to maintain his leverage at 50% of the asset value, to double his borrowings to 100. With the additional 50 in buying power, the investor can then either spend the money for consumption (as the US consumer has done in the last few  years) or acquire more assets.

As we can see, the liquidity that drives global asset prices are mainly made up of debt, which can only happen when abetted by the complicity of central banks who have the power to create money out of thin air via the printing press.

The next question to ask is this: if there is someone doing the borrowing, then who is the one doing the lending?

Traditionally, it is the banks that do the lending. In the good old days, lenders had to conduct due diligence to check out the credit worthiness of the potential borrower before the money enters the wallet of the borrower. The less credit worthy the potential borrowers were, the higher the interest charges were demanded from them.

But today, as we can see from the sub-prime mess (see How did the US sub-prime lenders get into trouble?), lenders are getting reckless in their lending practice. Not only are credit unworthy borrowers granted excessive credit, the interest charges demanded on them were too low to compensate the lenders for the risks involved in lending to such borrowers. In technical language, it means that the credit spreads had narrowed. In layperson’s language, it means the differences between a risk-free rate (e.g. interest rates of Treasury bonds, or the short-term cash rate) and highly risky rates (e.g. sub-prime mortgage payments) are getting smaller and smaller, to the point that it does not make any financial sense. So, who provided the ones who provided the money to lend? As we said before in How to dump risk to consumers: securitisation, modern day financial ?innovations? had allowed debts be turned into ?investment? products for the gullible masses.

Recently, as we mentioned before in yesterday’s article (see Re-pricing of assets- from ?marked? to model to ?marked? to market) with the re-pricing of such ?investment? products, securitised debt became a hot potato that nobody wants to touch. In that case, who will provide the money to do the lending? Would such a lending phobia spread to other sectors of the financial industry, cutting off money to legitimate and sound borrowers? Without access to cheap money to borrow, what can fuel further rises in asset prices?

As we said before in What makes monetary policy ?loose? or ?tight??,

To understand why, we have to remember that the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink.

Will this credit crunch lead to the economy’s aversion of money and credit? In that case, there will be asset price deflation (see Spectre of deflation). In that case, we will expect Helicopter Ben (Ben Bernanke) to step up the operation of the money printing press (i.e. cut interest rates aggressively). If you hold plenty of gold on such a day, you will be doing very well (see What should be your fundamental reason for accumulating gold?).

Re-pricing of assets- from ?marked? to model to ?marked? to market

Wednesday, August 1st, 2007

Back in January, in Prepare for asset repricing, warns Trichet, we echoed the warning of Trichet, the president of the European Union central bank, who said that that instability of global financial markets can lead to ?re-pricing? of assets.

As we all know, this is happening right now in the debt market in the US. The implosion of the sub-prime mortgage mess (see How did the US sub-prime lenders get into trouble?) in the US had led to the re-pricing of risks. Suddenly, the price of securitised debt instruments (see How to dump risk to consumers: securitisation) were no longer what they were thought to be. How did that happen?

Before we can answer this question, we have to understand how such securitised debt instruments were ?priced.? There are two pricing concepts to understanding with regards to pricing??marked? to market and ?marked? to model:

?Marked? to market
This pricing concept should be familiar. Basically, the value of an asset that is ?marked? to market is the price in which it is last traded in a liquid and open market. A very good example of such asset is the value of your current holdings in a stock, which is the last traded price multiplied by the total number of stocks.

?Marked? to model
What happens if that asset is not tradable in a liquid and open market? How can we determine the value of that asset if there is no market to tell us what the price of it is? This is the situation where these sub-prime securitised debt assets were in. In that case, the ?value? of these assets was determined by highly complicated mathematical models. Very often, the ones who hold (or manage) these assets were the ones who derive the ?value? of them. Obviously, we can hardly expect them to be objective and transparent in their valuation.

What happens if we let the market decide the value of those debt assets that were ?marked? to model? With the implosion of the sub-prime crisis, we suddenly find that there are no takers in the market for these risky debt assets. In other words, those formerly ?marked? to model received a severe downward revaluation by the market. Obviously, holders (or managers) of such assets would protest at the market’s valuation. Even worse, what happens if a lot of borrowed money is involved in such ?investments??

As we all know, Macquarie Bank announced last night that two of its funds that were involved in the US sub-prime lending are suffering losses of up to 25%. As expected, retail investors are the ones who are going to foot the bill. As this article MacBank: brace for sub-prime loss reported, the language used to protest against the market’s valuation of ?marked? to model assets were ?Mr Lucas said the underlying assets were ?fundamentally healthy? but the ?supply demand imbalances? in the senior loans market sparked by the sub-prime mortgage turmoil were causing price volatility. ?This price volatility is not related to defaults in the underlying Fortress Notes portfolio,? he said.?

Yes, sure Mr Lucas.