Archive for January, 2008

Aussie household debt not as bad as it seems?

Wednesday, January 30th, 2008

We took a look at the latest insight note by Shane Oliver, AMP Capital Investors’ Chief Economist here. The summary of the note says:

Household debt has risen to record levels, particularly in English speaking countries including the US and Australia. Many fret, particularly with the credit squeeze now rolling through financial markets and pushing up borrowing rates, that this means the next economic downturn will be severe as leverage is unwound and consumers are forced to cut spending. While the risks should not be ignored, the problem is not quite as bad as it looks.

Shane Oliver, while acknowledging that “increased debt has led to increased risk” (and we have to give him credit for doing that), had listed 4 points why the rise in household debt is not as bad as it seems:

Firstly, household debt has been rising since credit was invented and the surge since the 1980s partly reflects a rational adjustment to greater credit availability…

Similarly, the rise in household debt partly also reflects a rational response to reduced economic volatility…

These 2 points are not really reasons for arguing why rising debt is or is not as ‘bad’ (whatever it means) as it seems. Basically, the underlying meaning of these points is that debt had been rising for the past decades without any serious consequences and therefore we should not worry about it rising any further in the future. This is a very good example of a common mental pitfall called Lazy Induction. In this fallacy, a generalisation is being made from a biased sample. All we have to do to disprove this flawed conclusion is to provide a negative example (see Mental pitfall: Lazy Induction for more details).

Thirdly, the rise in debt has been matched by a rise in wealth.

This is the most serious error that Shane Oliver makes. As we said before in The Bubble Economy,

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.?

If a portion of these wealth-holders decide to liquidate those ‘wealth’ simultaneously, guess how much of these ‘wealth’ will remain? As we said before in Spectre of deflation,

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ?decrease? in value that way too.

What is more worrying is that assets of such imputed values are used as collaterals for further borrowing, which becomes the borrower?s liability.

In other words, the ‘wealth’ that Shane Oliver mentioned is not real. Its value can vanish into thin air in times of deflation! On the other hand, the debt that is supposed to match the ‘wealth’ is real. No matter what happens to the value of the asset, the debt that financed the purchase of that asset will still remain.

The last point that Shane Oliver made:

Fourthly, Australians do not appear to be having major problems servicing their loans.

Does Australians have a problem servicing their loans? This is the wrong question to ask. As Professor Steve Keen of UWS as pointed out in his DebtWatch, the point is that such rise in debt is unsustainable in the long run. It will come to a point when the debt-servicing burden of the nation becomes so great that it will choke on economic growth, resulting in debt deflation. Australia has not yet reach that point, but it will be in due time given the rate of debt growth (see An update on Australia?s money supply growth). The outcome will be very nasty when it happens.

Next, Shane Oliver said,

The whole of the post-war period has been characterised by steadily rising debt levels and each time there is a financial crisis fears grow that the prior increase in leverage will result in economic collapse and that cutting interest rates and other methods of reflation won?t work. But it always has worked. There is no reason to assume that it won?t work this time around.


It did not work in Japan! Remember Japan’s infamous zero-interest rate monetary policy as well as massive government spending fiscal policy? Yet, deflation dogged the nation for more than 16 years. There is only one way to fight deflation and that way leads to hyperinflation (see Recipe for hyperinflation).

Finally, Shane Oliver said,

However, the risk of a major catastrophe is judged to be low as the rise in debt appears to reflect a rational response to reduced economic volatility…

Is volatility a valid definition for risk? See How the folks in the finance industry got the idea of ?risk? wrong!.

The underlying message in Shane Oliver’s note is that the risk of debt deflation is low in Australia. As he said,

While the risks should not be ignored, the problem is not quite as bad as it looks.

We are not sure what he meant by “should not be ignored.” But dear readers, we would like to stress again that the issue is not just whether the probability is low or not. The issue is the probability in conjunction with the size of its impact. As we said before in Common mistakes in failing to see economic turning points,

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

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

Mental pitfall: Narrative Fallacy

Tuesday, January 29th, 2008

Today, we will continue with the series on common mental pitfalls that can lead to fallacious reasoning (see Common mental pitfalls that leads you astray for a compilation of this series of articles).

The topic we will cover today is Narrative Fallacy. In Nassim Nicholas Taleb?s book, The Black Swan: The Impact of the Highly Improbable, he wrote:

The fallacy is associated with our vulnerability to over-interpretation and our predilection for compact stories over raw truths. It severely distorts our mental representation of the world; it is particularly acute when it comes to the rare event.

In the previous mental pitfall, Lazy Induction, the fallacy lies in incorrectly inferring about what lies outside of what can be currently seen. For this mental pitfall, the fallacy lies in inferring about what lies inside of what is currently seen. Narrative Fallacy is a natural human weakness because by default, our minds seek to form theories, jump into conclusion, seek judgements and explain what we see. It takes a conscious act will to do otherwise.

Why do we fall into the trap of Narrative Fallacy? This is because our minds naturally seeks to simplify the myriad of  (often random) facts and figures into some kind of order so that it can be more easily stored and processed by our brains. The implication is, as Taleb says,

… the same condition that makes us simplify pushes us ot think that the world is less random than it actually is.

It also makes affect the way we remember past events. Historical events that fit our simplification into a story can be remembered better those that lies outside the story. That very simplification makes us think that what happened in the past is more predictable they actually are. When we extrapolate this illusion into the future, it gives us the illusion that we know what is going to happen in future better than what we actually can. This blindness is where Black Swan occurs. As we said before in Failure to understand Black Swan leads to fallacious thinking,  this can lead us to believe that we know a lot when in reality, we know very little.

Narrative Fallacy also affects our ability to estimate the probability of Black Swans. Black Swans events that exist in the form of stories (e.g. heard on television) are likely to be overestimated. Those that is outside the realm of stories (e.g. the ones that nobody talks about it) are very likely to be underestimated. Therefore, we often tend to overreact to low-probability outcomes that were discussed (i.e. exist in the form of a story) and neglect those were not brought into direct awareness. For example, we tend to overestimate the probability of another September 11-style terrorist attack and neglect other threats that are still as dangerous as ever e.g. Bird Flu pandemic.

How does the Narrative Fallacy work out in the world of investing? Whenever the market moves, you will notice that the news media feel obligated to give the ‘reason.’  Our earlier article (November 2006), How much should we listen to the financial media? is an example of a Narrative Fallacy at work.

Why did the foreigners bail out cash-starved financial institutions?

Monday, January 28th, 2008

Recently, many cash-starved banks and financial institutions (e.g. UBS, Citigroup) that were stung by huge amount of bad debts were being infused with cash ‘investments’ by foreign Sovereign Wealth Funds (SWF) to rebuild their capital base. If not for such bailouts, many people would not have heard of some obscure names like Abu Dhabi, Temasek, GSIC, etc.

Why are SWFs propping up these financial institutions?

We do not really know for sure, but we can only guess at what is going on inside their dark minds. The common understanding of the purpose of SWFs is, as this Times Magazine article says,

 At a time of extreme stress in global-equity and credit markets, many governments have surplus foreign exchange to play with–and because of the falling U.S. dollar, they are increasingly interested in investing their cash where it can earn greater returns than it would from U.S. Treasury debt, the traditional haven.

But that still does not answer one question- why are they propping up financial institutions specifically? Are investments into troubled financial institutions the best use of their money? We doubt so. If the answer is no, then there must be a deeper reason why they are suddenly so ‘charitable’ towards the financial companies. Today, we are attempting to venture into the deeper recess of their minds…

As we said before in Awash with cash?what to do with it?,

… foreign countries that account for the vast majority of US imports (namely the oil-producing Middle Eastern nations, Russia, China and Japan) are sitting on so much US dollars that they do not know what to do with it.

Their problem is not just that they have too many idle and unproductive dollars, as implied by the above-mentioned quote from Times Magazine. This is because the interests of nations are not confined to just commercial profits the way corporations are. Rather, we believe what they are beginning to fear is that their dollar reserves are turning out to be an increasingly unreliable store of value in the long term. With the way the US is debasing their dollar, we cannot help but agree with Iranian President Mahmoud Ahmadinejad (we are no fans of him, by the way) when he said, “They [the US] get our oil and give us a worthless piece of paper.”

Take the example of China. As we said before in Can China really ?de-couple? from a US recession?, with China at a very resource intensive phase of their development, any insufficiency of resources and capital goods can result in the stoppages and delays of their capital investment projects in the current pipeline. When that happens, the current trajectory of their economic growth will be shot down, resulting in the mass in-completion of half-finished projects. Such an outcome will be dire, as their banks will then be piled with massive bad debts. That will be what we call a “crash.” That explains why China is buying up political and economic influence in Africa in order to secure African raw materials. China’s trillions of US dollars reserve is a form of savings that will be used to acquire their future needs for resources to power their economy in the long term. Therefore, any threat to the long-term value of their savings will be a long-term threat to their economy.

If this is the case, then why did these SWFs choose to prop up financial institutions instead? Why don’t they spend their US dollar reserves to buy up as much resources that they need, as soon as possible?

Well, they cannot do that all in one shot. With such a gargantuan amount of US dollars, such actions will severely upset the global price equilibrium of the things they buy, and the value of the US dollar. For example, if China is to do that, you can see the price of commodities shooting up and the US dollar plunging. That is a great recipe for fostering global instability.

Well, then why don’t they invest their US dollars on more worthwhile enterprising businesses, for example, Microsoft, NTT DoCoMo or some other resource companies? Why did they use them to prop up those financial institutions that deserve to die?

We can only guess and speculate. This is our take on why: by bailing out those undeserving financial businesses, they are helping to prop up confidence in the global financial system, in which the majority of financial assets are denominated in US dollars. If the global financial system collapses, then the value of US dollars will not be worth much any more. If the US dollar really becomes worthless pieces of paper, then the vast savings of countries like China will go up in smoke. If their savings goes up in smoke, their economy will follow soon.

In other words, the vast majority of the world is ‘long’ on the US dollars. There is too much for too many to lose from a falling US dollar. Therefore, if you believe that the death of the US dollar (and all the other fiat currencies) is inevitable, then the wisest thing to do is to take a position on the other side- ‘short’ the US dollar (and all the other fiat currencies). To do that, you will have to ‘long’ gold (see Why should you invest in gold?). The up-trending gold price is telling us that there are more and more people who are ‘shorting’ the US dollar (and all the other fiat currencies).

Can China really ‘de-couple’ from a US recession?

Friday, January 25th, 2008

Now that it is a widespread view that the US will fall into recession, the frame of debate has been shifted to whether China (and other emerging economies) will be affected as well. Back in November last year, as we said in Is Chinese growth ?de-coupled? from the US economy?,

On the other hand, another theory has been gaining in popularity: China?s growth is ?de-coupled? from the ailing US economy. According to this new theory, China should continue to grow and power the global economy regardless of what happens to the US economy. This is the ?de-coupling? theory. Proponents of this theory sees that so far, China had ?de-coupled? (both in real and financial terms) the most from the US. As we can all see, so far, despite the slowdown in the US (due to the credit crunch and housing slowdown), China?s growth had so far been unaffected. Proponents of the ?de-coupling? theory sees that if Chinese growth is dependent on the health of the US economy, we should see signs of the Chinese economy slowing as well. Since there are no signs of this happening, then the conclusion is that the Chinese economy is independent from the health of the US economy.

In that article, we explained Nouriel Roubini’s argument that such ‘de-coupling’ theory will not hold.

Today, we will give a more qualitative argument against the ‘de-coupling’ theory, based on the Austrian School of economic thought. For this, we will again refer to one of the most deeply buried Austrian School 1936 classic (originally written in German), Crises & Cycles by Wilhelm R?pk. But before you can understand what is to follow, you will have to understand the Austrian School‘s concept of capital structure mentioned at two of our earlier articles: The first step in an economic slowdown?mal-investment in capital followed by Overproduction or mis-configuration of production?. Specifically, understand the difference between consumer goods and higher-order of capital goods.

Now, let’s take a look at Chapter 4 of Wilhelm R?pk’s Crises & Cycles

… it will be easily grasped that any increase in general economic activity will have the tendency to produce a disproportionate expansion in the higher stages of production, the rate of expansion being the greater the higher is the stage of production, i.e., the further it is removed from the sphere of consumption. The opposite is true for any decrease of general economic activity.

At this point, we will look at this idea in the context of China. First, look at this simplified picture of the current state of affairs in the global economy: Australia (and other nations as well) produces the highest order of capital goods (e.g. base metal resources like copper, iron, oil, etc). China (and Asia) specialises in the intermediate order of production, turning the raw resources into final consumer goods. Finally, the US (and Australia and UK as well) specialises in consuming those consumer goods (final products).

Much of the economic activities in China revolve around spending on investments. As this article in the Sydney Morning Herald says, “A sharp slowdown in export growth to the US was more than offset by extraordinary investment in new housing, commercial property and infrastructure.” In other words, the Chinese economy is geared more towards producing higher order of capital goods (the higher stages of production), which will take years to bear fruit into higher productive capacity.

A severe recession in the US economy will crimp US consumption significantly. This will translate into a disproportionate contraction in the higher stages of production, which is China’s job. This in turn will result in yet another disproportionate contraction in yet another higher stage of production- for example, Australian resource production. To understand why, consider the example of a factory working flat out to produce 100 widgets a year for consumers. Let’s say that it is anticipated that demand will increase 10% in a year. In the absence of spare capacity, the only way to increase production is to build a new factory. You cannot build one-tenth of a factory to increase production by 10% for that 10% increase in demand. You either build an entire factory or you do not build it at all. As Wilhelm R?pk explains,

The reasons for this intensified impact on the higher stages of production are twofold : (1) In the absence of excess capacity any increase of the productive equipment of the country necessitates a further increase of the productive equipment in order to produce the initial increase (as in the example of the poultry and silver-fox farms). In order to produce more machinery the machine industry itself has to produce more machines for producing more machines; an enlargement of the cement factories calls forth not only an increased demand for building the additional cement plants, but also an increased demand for enlarging other factories delivering the equipment of the additional cement plants and so forth. (2) Assuming that in all stages of production and distribution a certain fixed percentage of sales is held as stocks, any increase of general economic activity (as measured by the volume of sales or goods produced) will bring forth an increase of orders greater than the initial increase of sales. If the demand for shoes increases, dealers will place orders equivalent to the aggregate of additional sales and additional stocks, and the same thing will be repeated in the higher stages on a progressively rising scale. But this whole machinery of increasing intensification will stop the moment the increase comes to an end. In substance, this process of intensification by the enlargement of stocks of working capital amounts to the same thing as the process of intensification by the enlargement of the productive equipment (fixed capital). In both cases the increased volume of production in the upper stages can be maintained only if the increase of demand in the lower stages goes on at the same rate. It is, therefore, not sufficient that the demand does not decrease absolutely, nor even that it continues to increase if only at a lower rate; for the maintenance of the top-heavy superstructure of production, it is necessary that the ultimate demand should rise at the same rate or, in other words, in geometrical progression.

But look at what China is doing right now. In the face of a major slowdown in US consumption, it is still building yet even more productive capacity. Worse still, such investments are very resource intensive at this stage, which consumes a lot of resources in countries like Australia that provide the higher order of capital goods in the form of raw materials. There are signs that the Australian economy has reached full productive capacity (see Interest rate rise in Australia- be prepared for more to come), which means it will be hard pressed to provide the Chinese economy with sufficient raw materials for fuelling further growth in its capital goods investments (see Can Australia?s mining boom turn into bust?). There are also signs that China itself is approaching its limits (see China at turning point?).

So, do you see China being caught in between? On one hand, a slowdown in US consumption will ultimately result in far greater proportion of contraction in investment spending in China, which accounts for the majority of Chinese economic activity. On the other hand, it is running out of resources (including Australia raw material resources) to ensure the successful completion of its capital investments in the current pipeline.

Some may argue that the Chinese consumers will rise up to to keep the ball rolling. We have our doubts against this view:

  1. Does China have enough capital goods, labour (yes, there are reports of labour shortages in China) and raw materials to continue the current trajectory of capital investment growth in China?
  2. The needs of the Chinese consumption economy is different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built. As we said before in Overproduction or mis-configuration of production?, the issue is not a simple case of overproduction. Rather, it is the mis-configuration of production that is the issue.

We may be wrong, but our theory is that this may be an epic boom waiting to be a bust. Note: we are not making a prediction here- we are merely expressing our scepticism on the de-coupling theory.

Peering into the soul of Ben Bernanke

Thursday, January 24th, 2008

One unfortunate aspect of life is that sometimes, we do not have the luxury to choose between a good choice and a bad choice. Often, we are faced with a bad choice and a bad choice. In such crossroad situation, the choice we make is determined by who we are.

Ben Bernanke is facing such a crossroad. He holds a position of such great influence that his decisions will determine the future and path of the US economy, which in turn will affect the rest of the world. Very unfortunately for him, he is in an awful position. Currently, the US economy is facing the threat of severe deflation, in which the only cure is severe inflation (or even hyper-inflation)- there is no middle ground. Therefore, Ben Bernanke is faced with a bad choice of deflation or the other bad choice of inflation. What a fix! Which one will he choose?

To answer this question, let us look at a speech he made before the National Economists Club in November 21, 2002:

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

Each of the policy options I have discussed so far involves the Fed’s acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers.

Dear readers, as you read the words in bold in the last paragraph, do you notice something familiar? Hint: refer to our earlier article, Watch the US government. As we peer deep into the soul of Ben Bernanke, we see a money printer in his heart. The next question is, how deep is his money printing heart? We cannot really quantify the answer to this question, but seeing that a couple of days ago, he surprised the market by giving it a gift of ’emergency’ interest rate cut of 0.75 percent, we guess his money printing heart is pretty deep.

In a way, Paul Volcker, the chairman of the Fed in the 1980s, is the anti-thesis of Ben Bernanke. He was credited with ending the US’s stagflation crisis in the 1970s by crushing the economy into the worst recession since the Great Depression. To do this, he had to raise interest rates to unbelievably high levels, to the point that in 1981, interest rates charged by banks exceeded 20 percent (Note to Australian readers: the Labor was often blamed for the super high interest rates of the 1980s. Now you know where such high interest rates come from- such high interest rates was a global phenomenon). Paul Volcker crushed severe inflation by crushing the growth of money supply (see Cause of inflation: Shanghai bubble case study).

Remember what we said before in Recipe for hyperinflation,

If they press on relentlessly [to fight deflation] till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilization.

Today, Ben Bernanke the money printer may be appointed to be the deflation-fighting hero. But how will future generations see him? For his sake, we hope he will change his money printing heart. Or better still, if we are he, we would have resigned- it is better to be a nobody academic than to be looked unfavourably by history.

Meanwhile, accumulate gold (see Why should you invest in gold?).

An update on Australia’s money supply growth

Wednesday, January 23rd, 2008

In Australia?s monetary debasement & credit expansion, we showed you a graph of Australia’s (1) money supply growth (base money, M3 and broad money) and (2) the relativity between standard and fiduciary money since July 1959 to October 2007 (see Are we heading for a deflationary type of recession? for the meaning of standard and fiduciary money). Today, we have an update of the November 2007 figures from the Reserve Bank of Australia (RBA).

The picture does not look good.

In the month to November 2007, the M3 money supply grew another 2.7%. In the year to November 2007, M3 grew at 23%! The standard money to the broadest fiduciary money ratio deteriorated further to 3.7% in that month.

It looks that up till November 2007, Australia’s monetary policy is still loose (see What makes monetary policy ?loose? or ?tight??).

Panic and bears are upon stock markets. What to do?

Tuesday, January 22nd, 2008

Today, Australia joins 36 other countries in the bearish stock market club. Since its peak in November 2007, the Australian stock market fell 23.3%. Including today’s hefty fall of more than 7%, all of the gains of 2007 and some of the gains of 2006 were wiped out. Indeed, it is a day of fear and panic in the global stock market.

We look at this unfolding drama with a yawn.

Our long time readers should not be surprised at this development. We have been sounding the alarm from as early as 2006 when this publication begins. Our latest warning was in December last year (see Why some believe a crash is imminent). Also in that same month last year, in Outlook 2008, we had already highlighted such a risk:

Further corrections in the global stock markets We had explained our reasons for this in Marc Faber on why further correction is coming?Part 2. The credit crunch is one of the manifestations of the liquidity contraction in that article.

What should be investors’ next step?

We cannot give specific advice for the answer to this question. Therefore, we will stick to the generalities in order for you to find your own answer:

  1. The first step is to keep your cool. Nothing can be more detrimental to your wealth than falling into investment irrationality. At the depths of any stock market panic, naked fear reigns, which by definition is not rational. It is this same fear that leads to the dumping of all stocks, both good and bad. It is fear that exaggerates and magnifies bad news and ignore good news.
  2. What if you have already ‘missed’ the selling boat and is now sitting on a substantial loss? Well, it may be too late now. But look at the big picture. In all down-trends (or up-trends), there are always sub-trends working in the opposite direction of the main trend, whether you are a long-term investor or a short-term day trader. This is true even for the the bleakest of all bear markets, the Great Depression of the 1930s (see Second lesson of ?29 crash?bear rebound). Remember this- all trends eventually stops. It cannot go on forever and ever.
  3. Of course, it is better to avoid being caught out in the first place. In fact, to be a good investor, you need to be prepared for all kinds of scenarios you can think of. This means coming up with drills to be executed when the situation warrants. But for those who are caught out, we know it is too late now. Therefore, we shall not continue along this line.

What will happen next? We do not have crystal balls to tell us the future. But we do have some pointers for you to think about.

Right now, the majority opinion believes that the US will enter a technical recession soon or is already in one (again, we would like to stress that we are “more concerned about being vaguely right [accurate] on where we are in the business cycle then to be precise on which side of the artificial recession line we are in”- see Example of precisely inaccurate information). There are some who are still not ready to make such a recession pronouncement. Yet, there are a few holdouts that still believe that it is unlikely for the US to enter a technical recession.

But for those in the recession camp, the vast minority majority still do not envisage a severe recession or depression. In fact, the majority within that camp still believe that the US recession will be relatively mild, short, quick, shallow or something to that effect.  Hence, the vast majority believes that global economic growth will slow down i.e. still growing, albeit at a slowing pace. This belief makes the Chinese de-coupling theory sound very plausible (see Is Chinese growth ?de-coupled? from the US economy?). Under such a scenario, we can easily imagine the global stock market staging a comeback to a certain extent, though not returning to the same frothy heyday as before.

But what if this majority opinion is wrong?

If the world economy is heading towards a depression (i.e. deflation), then today’s bear market will be a piece of cake. That is, there will be more hell to pay. This is the bad news. The good news is that such a scenario will probably take quite a while to work out, as the wheels of the mighty global economy gradually turns. In that case, if you believe that we are due for a Greater Depression, there may still be time to sell in the coming weeks and months. Of course, if any unexpected Black Swan event occurs, all bets are off.

Now, we would like to add in another complication. Severe deflation is the greatest threat right now (see Are we heading for a deflationary type of recession?). We are sure that Ben Bernanke and George Bush is painfully aware of that. Therefore, there is now political pressure for them to fight deflation. If the US government, in conjunction with the Federal Reserve, decide to fight deflation till the bitter end, till the last drop of blood from their last soldier, then the war is very likely to end with hyperinflation (see Recipe for hyperinflation). As we said before in The crowd understands gold not…, when we have a financial system that makes ‘money’ as elastic as rubber bands, derangement in economic calculation will occur, bringing about widespread confusion. Already, the preceding boom in the US (and Australia, UK and even China) is infused with illusions of wealth through twang money (see Mainstream & politician?s nonsense on asset-driven ?wealth?). In the same way, we will get to see that many people will mistake rising prices as signs of economic ‘cure,’ ‘recovery’ or hope.

Therefore, do not be fooled.

Why accumulating stocks on the ‘cheap’ can be deadly to your wealth?

Sunday, January 20th, 2008

Australia’s long-term trend for the average Price-Earnings (P/E) ratio for stocks is said to be around 15. With the recent rout in the global stock markets, some market commentators have been saying that right now, with Australia’s average P/E ratio approaching the long-term average, Australian stocks is not ‘expensive’ in general. The implication is that if the stock market continues falling, stocks will be approaching the ‘cheap’ territory and therefore, become ‘bargains’ in general.

We would like to warn you against such simplistic reasoning because it can be deadly to your wealth.

First, you have to understand the underlying assumption behind using the P/E ratio as a means to ascertain the relative value of a stock. The valuation method using P/E ratio assumes that earnings growth of the business behind the stock is consistently growing indefinitely. It assumes that interest rates are constant.

To illustrate this point, we will use an example. Let’s say that Company Steady-Secure’s business is absolutely risk-free and its earnings are growing at an annual rate of 1.35% forever and ever. Based on the risk-free Treasury bond yield of 8% (that is, the risk-free interest rate is 8%), then the future earnings of Company Steady-Secure is worth around $15 today for every dollar of earnings in one year’s time. Let’s change the risk-free interest rate to 10%. How much will Company Steady-Secure’s future earnings be worth today? The answer is $11.56. Now, let’s change the earnings growth to be 0.5% instead. This time, the future earnings will be worth $13.33. Finally, let’s change the earnings growth to be -10% (i.e. shrinking earnings over the years, forever and ever). Guess how much the future earnings is worth today? It’s $5.56!

If you do not understand how we work this out, do not worry about it. The key point to understand is that in an environment of:

  1. Rising interest rates – P/E ratio will fall because the intrinsic value of a business’s future earnings will fall (i.e. price will fall to reflect the falling intrinsic value).
  2. Falling earnings growth (even negative growth) – P/E ratio will rise if the price (the numerator) is to remain constant. If earnings growth is falling (including shrinking earnings), then the intrinsic value of a business’s future earnings will fall. This means it will be irrational for the stock price to even remain constant.

Now, what does this means for us today? Back in February last year, in Where are we in the business cycle?, we commented that

Thus, we believe that Australia (and the US as well) is at the top of the business cycle.

Indeed, right now, the US is past the peak of the business cycle (forget about the mainstream obsession of trying to be extremely precise on defining what a recession technically is- see Example of precisely inaccurate information). We can expect the US companies’ earnings growth to fall and even shrivel over the years.

For Australia, interest rates are in a rising trend, which is a symptom consistent with the peak of the business cycle. Back in March last year, in Pitfalls for businesses in ?accelerating? economy, we commented that

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.

Now, with the benefit of hindsight, we can see how accurate our prescience for the following months were. Today, we can see that the forces of price inflation is pressing the Australian economy, with further warning from the central bank that we should be expecting more interest rate rises in the months to come. As this news article says today,

Home owners should be prepared for another official interest rate rise after the governor of the Reserve Bank made it clear controlling inflation was his greatest concern, not the global financial crisis.

Our long time readers should not be surprised at this threat to the Australian economy because we had been warning about it for a very long time already. It was amazing that sometime in the vicinity of September last year, a certain politician from the Treasury Department was confidently predicting (in front of the news camera) that the next CPI report would show abating price inflationary pressures. Well, history showed that he was completely wrong. Indeed, it is very strange that this politician’s political party is still perceived to be the better economic manager than the current ruling party of the Australian government, as if governments of today can control the economy the same way cars can be controlled.

Therefore, our dear readers, do you see something very obvious? Australia is now in a trend of rising interest rates. Falling earnings growth should follow soon. Therefore, a falling average P/E ratio is consistent with all these symptoms of a turning business cycle. As we said before in What to avoid at the peak of the business cycle?,

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle.

In short, at the turning point of the business cycle, a falling average P/E ratio does not imply that stocks in general are cheap. Yes, with careful and judicious stock picking skills, you may be able to find really cheap stocks. But do not let falling average P/E ratio fool you.

Another note about Credit Default Swaps (CDS)

Saturday, January 19th, 2008

In our previous article, Potential global economic black hole: credit default swaps (CDS), there is a point we forgot to mention: since CDS is a type of derivative, there is no need for either party to hold the debt. Therefore, this implies that CDS can be traded.

Watch the US government

Friday, January 18th, 2008

In Recipe for hyperinflation, we said:

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation. And hold gold as you watch them. Remember what we said before in Have we escaped from the dangers of inflation?,

  One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

In Bernanke endorses quick, temporary fiscal stimulus,

Congress could help steer the economy away from recession if it adopted a quick, efficient and temporary fiscal stimulus plan, Federal Reserve Chairman Ben Bernanke told Congress on Thursday.

Watch carefully now.