Archive for October, 2008

Australia’s money supply growth till August 2008

Thursday, October 16th, 2008

The last time we reported on Australia’s money supply growth was on April (see Australia?s money supply & credit growth in April 2008). Today, we have an updated chart:

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The year-on-year M3 growth is growing at a decelerating rate since November 2007. In August 2008, it was 18.9% when M3 was at the record high of $1065.9 billion. November 2007 had the highest year-on-year growth of 23.1%. Coincidentally, November 2007 saw the peak of the Australian stock market.

For those who are new here, we recommend What is money? to understand the monetary jargon that we used in this article.

Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses

Wednesday, October 15th, 2008

Yesterday, in Two uncertainties of valuing a business- risk & earnings, we mentioned that risk and earnings are the two uncertainties in valuing a business. As we said in that article,

However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates.

Today, we will start off with a mini-series about choosing businesses that have strong economics. Such businesses have relatively lower uncertainties regarding their earnings and are also much less risky. Businesses with weak economics are much more difficult to value because of their higher risks and earnings uncertainties. For today’s article, we will look at identifying such businesses to avoid.

First, what are businesses with poor economics? They are the ones in price-competitive industries. As this book, The New Buffettology explains,

A price-competitive type of business manufactures or sells a product or service that many other businesses sell and competes for customers solely on the basis of price.

Example of such business is steel making, agriculture and manufacturing of mass generic products like clothes hangers. If you see a businesses in which its customers’ strongest motivation to buy is price, then you know it has poor economics. For such businesses to survive and defeat their competitors, they have to beat their competitors in costs. To beat their competitors in costs, they have to continuously engage in ruthless cost-cutting measures and improvements in techniques to keep their businesses competitive. This often requires additional capital expenditures and energy to keep the wheels running non-stop, which translate to more long-term debt and less distribution of profits to shareholders. Often, cost-cutting measures and improvement techniques are easily replicated. Therefore, businesses in price-competitive industries end up under-cutting each other continuously, which erodes profit over time. For such businesses, good quality and intelligent management is crucial to keep the business profitable. Also, they are more prone to strokes of bad luck.

So, to be a successful investor, the first step is to avoid businesses with poor economics.

“Property 2009: Crash, Boom or Stagnate?!” debate begins today!

Wednesday, October 15th, 2008

Just a reminder to all our readers: the Property 2009: Crash, Boom or Stagnate?! forum debate is starting now.

Two of our special guest experts will be taking part in this debate. See Interviewing Steve Keen for the upcoming property forum debate and Interviewing Michael Yardney for the upcoming property forum debate.

Will Australia’s own pump-priming work?

Tuesday, October 14th, 2008

As you have heard in the news by now, Australia’s Prime Minister Kevin Rudd announced a AU$10 billion stimulus plan. This is partially reminiscent to the US stimulus plan sometime at the beginning of this year, when the US government sent free money to American taxpayers and called them tax rebates. Rudd’s plan includes money for families, retirees, homebuyers and jobs training and infrastructure projects.

Will all these work?

Before we answer this question, let us consider the relative scale of the problem. According to Professor Steve Keen, Australians’ increased debt last year added $250 billion in spending into the economy. Currently, Australia’s credit growth is decelerating very rapidly. Should credit growth stagnate (or worse still, contract), this $250 billion (or more) in spending will go up in smoke. Therefore, a $10 billion stimulus is actually very minuscule compared to the potential loss in spending by Australian consumers when they are stretched to their limit in taking in more debt. Since most of the Australian economy is made up of consumer spending, such a severe contraction will have a very acute repercussion for the Australian economy. Recent data suggests that Australia’s total private data to GDP ratio is standing still at 165%.

There is no way the government can take up the slack left by the Australian consumer without turning the budget surplus into a deficit that is ten times its size (i.e. turn $22 billion surplus into a $250 billion deficit). But to keep Australians spending as before, they will have to accrue even more debt. There’s no way this increase in debt relative to income can go on forever without turning the entire nation’s economy into a massive sub-prime economy. When that happens, the inevitable blow up in debt bubble will be far greater.

By now, you should appreciate the magnitude of what the government and RBA are fighting against when you consider the scale of the coming deflationary force.

Bear market rally on the works?

Monday, October 13th, 2008

Back in What is the meaning of ?oversold?? Part 1: Technical analysis perspective, we explained that

In technical analysis, there is a class of indicators called the ?momentum indicators.? Examples of this indicator include stochastic, Relative Strength Index (RSI) and so on. Basically, these indicators measure the momentum of price movements. If the momentum is far too much on the upside, then it can be said that the prices are ?overbought.? Conversely, if the momentum is far too much on the downside, then they are ?oversold.?

The theory behind momentum indicators is that at the either extremes (i.e. oversold or overbought), it is a matter of time before exhaustion sets in and cause prices to reverse. In that sense, these indicators are contrarian in nature because it tells the technical analyst to sell when prices are overbought and buy when they are oversold.

One month has passed and the selling momentum had intensified and brought prices even lower. Many technical analysis indicators have now approached extreme bearish levels.

At such extreme levels, it is very possible that we will see a counter-trend rally soon. But please note two things:

  1. It does not mean that prices cannot go down further in the short-term. Who knows, perhaps there will be more panic selling in the days to come, thus bringing the technical indicators into even more extreme levels?
  2. In all likelihood, such a counter-trend rally will still exist in the context of a bear market.

In the infamous Great Depression bear market from 1929 to 1932, stock prices did not fall straight down. As we explained in Second lesson of ?29 crash?bear rebound,

Back in 1929, the bear market rally lasted for around 6 months from November 1929 before resuming a downward trend.

You may want to take a look at the stock charts from 1929 to 1933:

Source: Financial Armageddon

Notice that many of the bear market rallies last more than a month, the longest being 6 months.

Unknown unknowns trips up many turkey forecasters

Sunday, October 12th, 2008

As we explained in our previous article, Real economy suffers while financial markets stuff around with prices, the massive deflationary forces from the free market is being (and will continually be) counteracted by government attempts at inflation (see our guide, What is inflation and deflation?). The result will be great volatility in prices, which will undermine business calculations and long-term planning by the free-market.

At the same time, many economic forecasters will have their forecasts and ‘predictions’ completely stuffed up, which will mean that their credibility will be severely undermined. Many of these forecasters simply fail to see that the ground has been shifting as they make their projections. The recent deterioration of the global financial system will cause many of them to back-flip on their views. Those who cling on stubbornly on their previous (and erroneous) positions will have their credibility rubbished by history. Simply put, these forecasters completely failed to see turning points at the economic cycle. We really marvel at the fact that some of these forecasters are paid highly to produce expensive reports that turned out to be wrong. How could they possibly not see such an obvious looming financial disaster? It really takes a special effort to put on the blinkers in order NOT to see it coming. We are so marvelled that we have to write up a guide (Why are the majority so wrong at the same time and in the same ways?) to explain why.

As you will have heard the news by now, Prime Minister Kevin Rudd announced that the Australian government will guarantee all (a change from the $20,000 guarantee last Friday) bank deposits for 3 years. Also, there is other bad news in that announcement as this news report says,

Prime Minister Kevin Rudd has warned that economic growth and job security could be in jeopardy as the global financial crisis entered a “new and dangerous” phase.

As he equated the current financial turmoil to a national security crisis, Mr Rudd today signalled the jobless rate for next year was likely to be higher than originally forecast in the May budget.

`So, unemployment is likely to be higher. That’s just levelling with people … It’s likely to be higher than has been projected. We don’t have numbers on that.

Associate Professor Steve Keen believed that the unemployment rate could reach around ten percent range or more. The economic implication for this is very ugly. As we explained back in March last year (2007) at Can Australia?s deflating property bubble deflate even further?,

In Australia?s case, with her towering levels of debt, any external shock can easily tip her over to a recession, which can lead to further asset (e.g. real estates and stocks) deflation.

By now, it should be clear that whatever the external shock is not the issue?the point is that Australia is highly vulnerable.

The global financial crisis is an example of an external shock that we warned back then.

As we further explained in June 2007 at What can tip Australia into a downward property price spiral?,

With the Australian debt levels so high, a recession (with an accompanied increase in unemployment) will result in more distress property sales and further downward pressure on property prices. In such a scenario, what is happening right now in Western and South-Western Sydney can be extended to the rest of Australia.

The Australian economy is very highly leveraged towards the residential property sector. Rising unemployment will exert a downward pressure on property prices (due to the high leverage of the household sector), which along with that will expose the weakness in the Australian banking system (it has been said that mortgages made up of 50% of Australian banks’ loans- you may want to check up on that figure). A major weakening of the banking system will result in a major tightening in credit standards, which can even result in the deflation of credit growth (credit growth is already slowing down significantly in Australia). This will then feedback into the economy as a sharp drop in consumer spending, which along with the ongoing de-leveraging process (see De-leveraging in the real economy- mortgages), will put a major pressure on the retail sector (in addition to the financial sector already under a serious stress). This in turn will feedback into rising unemployment, resulting in another round of vicious cycle.

Now, let’s take a look at some of the economic forecasters and have some humour along the way.

In this news report, Bad day for house sales as jitters spread,

Angie Zigomanis of BIS Shrapnel said people were increasingly worried about their future: “If you don’t think your job is secure then no matter how low mortgage rates go, you are not necessarily going to enter the market.”

Remember BIS Shrapnel? Back then, they were writing forecast reports with erroneous and nonsensical logic (see Can lower interest rates re-inflate the property price bubble? and Another faulty analysis: BIS Shrapnel on house prices). It looks that they are beginning to back-flip on their views.

Let’s take a look at the views of a perennial bull, Craig James senior equities economists of CommSec,

Mr James said the recent report from the International Monetary Fund stressed that the Australian housing market would not experience the same dramatic falls as the US and Britain because of the nation’s strong population growth, fuelled by immigration.

Oh really? Strong immigration will help to keep upward pressure on housing demand in Australian? Well, let us take a read at another news report, Aust rethinks immigration boost as global financial crisis buffets economy,

Australia said on Friday it will re-think a large boost to immigration as the global financial crisis buffets the economy and places a brake against years of strong growth.

Mr James fails to understand that:

  1. Immigration tends to be very cyclical along with the economic cycle.
  2. In the face of rising unemployment and slowing economic growth, new migrants will put additional on the Australian economy. That is the reason for the government re-think on immigration.

It is obvious that extrapolation of current immigration figures into the indefinite future is flawed.


The ruction in the global financial system will put a spanner in the works of many forecasters. In the months and years to come, we will see the rise and fall of many forecasters as reputations are made and destroyed and credibility gained and lost. The first shall be the last and the last shall be the first.

Real economy suffers while financial markets stuff around with prices

Thursday, October 9th, 2008

In yesterday’s ABC 7:30 Report, Associate Professor Steve Keen commented that in the context of today’s global financial crisis,

Well I think Kerry I can actually make a reference to what’s happened to the Australian dollar say every price you see is crazy.

There is no way the prices of anything make any sense at the moment.

Prices in the financial markets are extremely volatile right now. Even prices of commodities (e.g. base metals, oil), gold and silver are moving much more rapidly then we expected (remember a few weeks ago when gold rose by almost US$100 in 2 days?). Currency exchange rates are also very extremely volatile, as we witnessed the fall of the Australian dollar from around US$0.97 to US$0.64. It was just a couple of days ago when the Aussie dollar was around $0.73. Now, at this time of writing, it is US$0.70.

Such volatility and irrationality of prices, if sustained over a much longer period of time, can eventually damage the economy structurally. To understand why, consider what we said in The myth of financial asset ?investments? as savings,

… saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

The accumulation of capital goods requires a time lag whereby current consumption is postponed for future benefits. Improved standards of living come to the public from the fruits of capital investment.

For example, producing metals is a very capital-intensive activity. The stages of production includes:

  1. Exploration
  2. Digging large quantities of dirt, which requires expensive, complex and expensive equipment.
  3. Construction of nearby infrastructure (e.g. roads, railways, power stations, development of water supplies and townships) due to the remoteness of mining projects.
  4. Protection of environment, which increase capital and operating cost.
  5. Extraction of ore from dirt.
  6. Processing of ore.
  7. Refining of metal concentrates.
  8. Shipping and transporting to destinations.

Thus, a mining project from start to finish can take several years. Therefore, you can see that the accumulation of capital goods is long term processes in the economy. As such, all these industrious activities require long-term planning.

What if in the interim, prices are extremely volatile, ‘crazy’ and irrational?

As the late Professor Murray Rothbard wrote in What Has Government Done to Our Money?,

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations.

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinders long-term planning.

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades (see Example of a secular trend- commodities and the upcoming rise of a potential superpower and The Problem that can throw us back into the age of horse-drawn carriages). Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

With long-term planning made much more difficult, how is it possible to engage in investments that allows the nation to continue to accumulate capital goods? Without the ongoing accumulation of capital goods and too much monetary capital wasted on either hoarding, bailing out bad investments and patching a dysfunctional financial system, there wouldn’t be a proper and efficient allocation of monetary capital. The economy will be engaging on capital consumption. If a nation starts to consume its capital, how can there be real economic growth. Without real economic growth, how can future generations enjoy a more plentiful and prosperous existence?

As we ponder on the long term implications of today’s volatile, ‘crazy’ and irrational prices, we saw a sampling of such a phenomenon in one of the news article today, Volatile economic conditions unsettle farmers,

UNDER normal circumstances, an interest rate reduction coupled with a devaluing of the Australian dollar would make farmers very happy indeed.

But not this time, according to National Farmers Federation vice-president Charles Burke.

“There are some other factors at play at the moment that none of us really know how to measure,” Mr Burke said.

“Nor do we know how to deal with it because we don’t know how long it will last.”

That’s why the Austrian School of economic thought advocate a painful deflationary liquidation of mal-investments (read: severe recession/depression) in order to clean out the rot in the system, put on a sound monetary system so that the economy can get back on its feet as soon as possible from a clean slate. But central bankers and governments are trying their utmost to drag on this war between deflation and inflation indefinitely, which means more uncertainty ahead for the foreseeable future.

Bernanke ticking off another inflation trick- becoming a business lender

Wednesday, October 8th, 2008

Remember back in Bernankeism and hyper-inflation, we talked about Ben Bernanke and companys’ unconventional (and crazy) schemes for attempting to induce inflation in a deflationary economy. One of the listed crazy ideas was:

Loan money into existence, accepting as collateral almost any private-sector asset whatever.

Today, we found this news report: Fed announces bailout of business lending.

Congratulations, Ben Bernanke!

In this news report, the Fed fears that…

… companies not facing financial problems are at risk of default on their commercial paper if they are not able secure another round of funding when their current borrowing matures.

Therefore, it announced a program to almost lend directly to businesses, by establishing a Special-Purpose-Vehicle to buy commercial paper from issuers (i.e. borrowers that include corporations). The announcement from the Fed can be found here. The loan security arrangement for non-asset-backed commercial paper (non-ABCP) are listed in the terms and conditions document in the Fed’s announcement.

This means the Fed is bypassing the banking system in order to make loans directly to the private sector.

Cost of credit or availability of credit?

Tuesday, October 7th, 2008

As you will already know by now, the Reserve Bank of Australia (RBA) cut interest rates by 1% today, which was more than what the financial market expected at 0.5%. What a bold move! Or is it a sign that the RBA is panicking? Or perhaps is it a result of a plan by central banks around the world to synchronise their rate cuts in order to soothe the global credit market?

There are plenty of commentaries about this surprise move by the RBA and we wouldn’t repeat them here. But there is something in the RBA statement that caught our eye:

The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast.

The issue is not so much that the cost of credit is too high. Rather, the availability of credit is becoming the issue. What’s the implication?

Remember, back in Econ101 at university, you may have learnt to draw the demand-supply graph whereby the ‘market price’ is the intersection between the demand and supply? The assumption behind the demand-supply graph is that supply is always available as long as one is willing to pay the price. Thanks to freeze-up of the global credit market, this assumption is no longer true. That is, credit may not even be granted even if one is willing to bid for it at a higher price.

Assuming that the credit crisis will drag on, this means that more and more borrowers may soon find that lenders are no longer willing to lend despite being willing to do so previously. In other words, lending standards will be tightening even further. The implication is that more and more borrowers (whether businesses or households) who need to refinance or roll-over their loans may suddenly find that the supply of new credit are being denied.

This will be the point when the crisis in the financial markets spread to the real economy. As Alan Kohler wrote in Interest rate give and take,

If credit ain?t available, it doesn?t matter what it costs.

Hedging against deflation

Monday, October 6th, 2008

The recent nationalisations, collapses and runs on banks in the US and Europe brings a new dimension of economic uncertainty to many people. The last time such things occur in the developed Western world was during the Great Depression in the 1930s. For this current generation of economists, financial analysts and money managers, a credit crisis is something that is supposed to occur only in textbook studies of the past. But recent financial market events brought such abstract history into real life. Suddenly, the idea that cash is no longer safe is a rude surprise for many. If cash is no longer safe, then where else can you hide?

This is what is technically called “deflation.” Deflation is not as simple as just falling prices. It is, as we explained in Will deflation win?,

A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.

We recommend that you read our guide, What is inflation and deflation? for more information about this topic.

So, if you are particularly concerned about deflation, how should you protect yourself? As we said before in Should you hold gold or cash in times of deflation?,

You see, the ?cash? that you had deposited in a bank is an asset to you but a liability to the bank. In times of severe economic conditions (e.g. during the Great Depression), can your bank honour its liabilities? If it can?t, then your ?cash? is in grave danger.

The key thing to remember is that as long as your asset is a liability of someone else (e.g. bank), you have a counter-party risk. If your counter-party defaults, your asset is gone. In this evil kind of deflation, counter-party default is the greatest risk to your wealth. Therefore, there is only two ways to protect yourself:

  1. Choose your counter-party wisely.
  2. Keep your wealth in a physical form such that it is nobody else’s liability.

We will first explain point (1). Basically, the only supposedly risk-free counter-party is the government because it has the executive power to tax and print money (note that we used the word “supposedly”- the Russian government defaulted on its bonds in 1998). If you store your wealth in the form of government debt (e.g. Treasury bonds), you will be guaranteed a periodic payment from the government. As we explained before in Measuring the value of an investment,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

In times of deflation, government bonds will be so highly sought after that its free market value will rise. Consequently, its yield (rate of return) will fall. On the flip side, government bonds are completely useless during inflation. In times of hyper-inflation, government bonds are as good as toilet paper.

Now, point (2) is already explained in Should you hold gold or cash in times of deflation?. But we would like to add a few more points:

  1. Gold was an excellent hedge during the days of the Great Depression because the US was still under a gold standard. The government would print a specific amount of US dollars to buy the gold that you presented to them. As we quoted Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?, the gold mining industry prospered during the Great Depression because

    So long as there exists at least one country [the US] on a full gold standard, an essential condition of which is freedom to buy gold from or sell gold to the central institution at a fixed price, there is literally an unlimited demand for the commodity at that price. In other words, not only is a minimum price for the product of the industry guaranteed, but there is, besides, no limit to the amount the market will take.

  2. The case for physical gold as a deflation hedge is weakened if the government insures bank deposits. In the US, the FDIC insures up to $100,000 of bank deposits. In Australia, there is NO government deposit insurance.
  3. But if for whatever reason, you (1) distrust the government’s deposit insurance, (2) have more than the amount that is insured by the government, (3) believes that the government will print lots of physical cash to provide for cash withdrawals in a bank run, (4) put a freeze on cash withdrawals to prevent bank runs, (5) government does not insure bank deposits (e.g. Australia), (6) can only trust storing your wealth in tangible form (6) etc, there is still arguably a case for holding gold as a hedge against deflation.
  4. The US government outlawed gold ownership during the Great Depression. It may happen again this time.