Archive for March, 2009

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RBA committing logical errors regarding Australian household finance

Tuesday, March 31st, 2009

Ric Battellino, the deputy governor of the Reserve Bank of Australia (RBA) gave a speech today. Regarding Australia’s household finance, he said,

We continue to believe that the market here will hold up better than overseas. There are a number of reasons why this is likely to be so, but perhaps the most important is that we did not have the same deterioration in lending standards that occurred elsewhere. By and large, the great bulk of Australians who took out housing loans have been able to afford the repayments. Notwithstanding some rise over the past year, the 90?day arrears rate on housing loans is only 0.5 per cent, which is broadly in line with its long?run average and well below that in countries such as the US and UK.

As he said that, we imagine he was thinking somewhere along the line like this:

  1. US sub-prime loans resulted in bad debts
  2. Bad debts busted the US economy
  3. A busted US economy led to higher unemployment
  4. Higher unemployment led to more bad debts
  5. And so on…
  6. Because Australia has very little sub-prime debt
  7. Therefore Australia’s economy is not likely to be as busted as the US

If this is what he’s thinking, we think Ric Battellino has made a very grave error in logic. He’s mixing up cause and effect.

No doubt, in the US, it’s sub-prime (which by the way is yesterday’s story) that triggered the bust in the US economy in 2007. But for Australia, it’s the deterioration of  the global economy that will trigger the bust of the Australian economy. The effects of a bust will be rising unemployment, followed by bad debts, then debt deflation and then finally falling asset prices. In other words, the triggers are different, but the effects will be the same because Australia has the same debt disease as the US and UK.

Given Australia’s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises. As unemployment rises (which all mainstream economists in the government and private sector are forecasting), it will eventually reach a critical mass of prime debts turning sub-prime. Once this critical mass is reached, the deterioration in the Australian economy will accelerate (see what’s happening in the US and UK today). This is the point we made in March 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.

To make matters worse, the First Home Owners’ Grant (FHOG), while giving housing sector a temporary boost, are increasing the proportion of potential sub-prime loans in the financial system.

The fact that those at the helm of the RBA are committing such logical errors does not engender our confidence.

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Posted in Economics/Finance, Looking Forward, Property | 8 Comments »

Australian government’s contingent liability to exceed AU$1 trillion

Sunday, March 29th, 2009

In October last year, the Australian government splashed its AAA rating to bank deposits (including the deposits of credit unions and building societies) and wholesale bank debt. Last week, there’s news that they’re splashing their AAA rating to state government’s debt.

This is akin to parents giving their children supplementary credit cards unsupervised. Indeed, a particular child named “Macquarie Bank” used the Australian government’s ‘supplementary credit card’ on a debt-gouging spree overseas.

Altogether, the Australian government is projected to have a contingent liability of more than AU$1 trillion, which is almost the entire GDP of Australia (compare that to the last budget surplus of around a puny $20 billion). The nature of contingent liability is that it is not really a liability- it is a liability that arises if certain events arises. This may not be a problem if debt defaults follow a nice Bell curve. But in the real world, is this a realistic assumption? As we said before in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

Bell curve simply means that things revert to the mean in the long run. Also, as you deviate further and further away from the mean, the probability of that deviation will drop faster and faster. Therefore, by the definition of the Bell curve, extreme deviation from the mean is extremely unlikely, so much so that it is close to impossible.

…

Very unfortunately, it is obvious even from just a casual observation of the world around you, the universe is often not ruled by the Bell curve. Extreme events occur frequently, which by definition of the Bell curve is close to impossibility.

Our feeling is that a huge unquantifiable percentage of all these debts will have a high degree of correlation with each other. Another way to look at this is that what makes a particular debt go bad is what makes the others to go bad as well. This means these debts will not follow a Bell curve. If you look at Australia’s money supply graph in Australian money supply growth in September 2008, you can appreciate the level of leverage in Australia’s financial system. What if Australia faces a huge macroeconomic margin call? Should that happen, there goes the Bell curve.

We shudder to think how the Australian government’s sovereign debt rating will fare when the day of testing comes. With so much contingent liability on their shoulders, we believe the Australian government is setting itself up to be run over by a Black Swan. For those who are new to Black Swans, we recommend Failure to understand Black Swan leads to fallacious thinking.

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Posted in Looking Forward, Market Observations | 6 Comments »

Are governments mad with ‘stimulating?’

Thursday, March 26th, 2009

In the 1990s, when the Japanese bubble economy burst and fell into debt deflation, its banks were crippled with bad debts. In the ensuing decade, the Japanese government embarked on massive government stimulus programs. Roads to nowhere were built and there were even comments about resorting to military spending (which of course was dismissed later as mere rhetoric because of neighbouring countries’ sensitivities to Japan’s wartime past). When the first stimulus programs proved to have failed in its objective, a second and bigger one was announced. When that failed too, a third and bigger one was announced. Altogether, the Japanese government had embarked on 10 stimulus programs totalling 30 trillion yen. Today, the Japanese government’s debt is greater in size than the entire GDP!

Fast forward to today. The Global Financial Crisis (GFC) had prompted many countries to embark on major stimulus programs. This time round, most of the largest economies are doing the ‘stimulating’- US, UK, Japan (again) and China. The Europeans, on the other hand, are shying away from that. Here, in Australia, our government is also doing the ‘stimulating.’

One of the Einstein’s definition of madness is: continuing to do the same thing, hoping for a different outcome. So, it is pretty clear to us that madness is prevailing.

The root reason why all these stimulation will not work is that we have a structural problem in the global economy. Stimulus spending will not solve the structural problem. As long as the structural problems are not dealt with, the economic slump will not end. As we quoted Wilhelm R?pk’s 1936 economic classic at Overproduction or mis-configuration of production? in January 2008,

It is an indisputable fact that a general slump, which does not permit of the scale of production reached in the boom being maintained, sets in during the crisis, and it is equally indisputable that this general slump is the result of the total demand suddenly falling behind the total supply. But let us make sure what this means and what it does not mean. Under no circumstances can it mean that the cause of the general slump is to be sought in the fact that production has outstripped consumption and that too many of all goods at once are being produced.

Today, governments see the same thing and simplistically believe that aggregate demand is less than aggregate supply. Therefore, the solution, as they understand the crisis to be, is to ‘stimulate’ the economy in order to boost aggregate demand. But as we explained before in Overproduction or mis-configuration of production?, this idea is fallacious.

The whole point of an economic crisis is to correct the structural flaws in the global economy and clean out the wasteful mal-investments. But government bailouts and stimulus are interfering with the correction process. Therefore, this global economic malaise will be prolonged much longer than necessary. If governments go over the top with ‘stimulation’ that don’t work, the outcome will be hyper-inflation (see Supplying never-ending drugs till stagflation).

For our newer readers, we recommend that you read our guide, What causes economic booms and busts?.

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Posted in Economics/Finance, Looking Forward | 4 Comments »

Looting tax-payers with the Geithner plan

Tuesday, March 24th, 2009

Back in December 2008, Ben Bernanke was considering whether to print money (see Bernanke ticking off another inflation trick- buying Treasury securities). Last week, the Fed finally pulled the trigger. The reaction in the currency market was swift- the US dollar was sold down.

Today, US Treasury Secretary, Timothy Geithner announced a Public-Private-Investment-Program (PPIP) plan to revive the banking system. It was portrayed as the best-of-both-world type of plan because being a partnership between the public and private sector, the ‘expertise’ of the private sector will be utilised to value toxic assets. The reaction from the equity market was swift- the Dow Jones rallied more than 6% in one day.

From this, we can see that the government will do anything and everything to try to ‘cure’ the Global Financial Crisis (GFC). But no matter what they do, these two fundamental truth remains: (1) There’s no such thing as a free lunch- there’ll be painful losses and (2) Someone has to pay for it. So, who’s the one paying for all these losses? No prize for guessing- all of us, the tax-payers.

In the first case, printing of money sounds like a free lunch. But in reality, as we said before in How to secretly rob the people with monetary inflation?, the tax-payers will have to foot the bill eventually, in the form of price inflation.

In the second case, let us describe Geithner’s plan with a given example:

  1. Suppose you are a bank with a toxic asset that has $100 face value. Let’s say, the market is only willing to pay $20 for your ‘asset.’ What can you do?
  2. Under the Geithner’s plan, you approach the FDIC.
  3. The FDIC will auction your ‘asset.’ Now, this is a funny auction. To understand how funny it is, read on.
  4. Let’s say the highest bid by an investor is $84.
  5. The FDIC will lend the investor $72. This loan is a non-recourse loan. If the investor defaults, the FDIC cannot go after the investor’s other assets.
  6. The remaining $12 will be split between the investor and the Treasury. That is, the investor will pay $6 while the Treasury will pay the other $6.
  7. That toxic asset will be the play-thing of the investor (under the watchful eyes of the FDIC). Any profit from the sale of the toxic asset will be shared between the investor and the Treasury.

No matter how the government cut it, most of the risks are dumped on to the tax-payers. For the investor, it is like a cheap call option or a highly leveraged non-recourse margin loan at a very low interest rate.

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Posted in Market Observations | 20 Comments »

What is the role of real assets in preserving your wealth?

Sunday, March 22nd, 2009

In our previous article, we made a case for gold in your portfolio. Today, we will talk about the role of real assets. Before we begin, let’s get our basic definitions right.

There are broadly two types of assets:

  1. Financial asset – This is basically a piece of paper (e.g. document or certificate of title) that represents a physical asset. A financial asset has no intrinsic value because it is an intangible representation of a real asset. In the ancient past, most assets are real, physical and tangible (e.g. land, gold, silver, etc). The rise of the modern economy allows people to hold assets in conveniently intangible forms. Examples of financial assets include: money in the bank (bank liabilities), government bonds (government debt), real estate mortgages (household debt), shares (company shareholders’ funds).
  2. Real asset – This is basically tangible and physical things that provide economic value. Real assets include real monetary assets (e.g. gold, silver and other precious metals), commodities (e.g. copper, iron, oil, grain, wheat, corn, etc), real estates (e.g. properties), farms, mines, factories and (for the paranoid), guns, food, water and so on.

Interestingly, the word “credit” comes from the Latin word “cr?dere,” which has the meaning of trust (“to believe”). Therefore, the credit crisis implies a crisis in trust in the global financial system. Without trust in the financial system, the value of financial assets becomes suspect. Thus, as we said before in Fading glory of the financial services and ?wealth? management industry, the reality of this new world is that,

Thus, the global credit crisis is a return back to reality as the masses wake up their idea that all these ?wealth? are illusionary.

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As far as we can see, the bull market (in real terms) on financial assets is over.

This generation is so used to the idea that the financial system can be trusted. Unfortunately, this trust had been abused and exploited. It takes a Global Financial Crisis (GFC) to expose the fact that this trust is unfounded.

Hence, the extent of your diversification towards real assets will depend on the extent of your distrust in the financial system. It will also depend on your expectation of the state’s legal and administrative infrastructure to enforce and define your rights. Obviously, weak states cannot provide such infrastructure. Therefore, if you really distrust the financial system and is very pessimistic about the global economy and geo-political situation in the days ahead, you will be switching some of your wealth into real assets.

Within real assets, you will have to allocate between (1) real monetary assets (e.g. gold and to a certain extent, silver) and (2) real non-monetary assets (e.g. commodities, land, farms, etc). How should the allocation be made?

We cannot advise you on that. But here are some pointers to take note of:

  1. Both types of real assets serve different functions. The former functions as money. The whole purpose of money is to exchange for things that you want. The latter are things that are (I) directly wanted  (e.g. commodities, food) or (II) means of production for things that are directly wanted (e.g. mines, farms, factories, timber land).
  2. Without money, the only way to get things that you want is by (a) force or by (b) bartering. Since we do not advocate violence, we will rule out (a). For (b), it is highly inefficient. That’s why human society evolved away from direct bartering to using money.
  3. The only way for you to completely do away with money is for you to be (i) completely self-sufficient or (ii) have the energy and will to engage in bartering. Otherwise, there will be a need for exchange using money.

Real non-monetary assets have their risks too. In particular, ownership of farms, lands and properties requires a functioning legal and administrative infrastructure to enforce and define your property rights. In states like Zimbabwe, the government abandoned the rule of law and enforcement of property rights by allowing war ‘veterans’ to take away the land of the white farmers. In Russia, the government nationalises the real assets of foreign businesses- no wonder investors detests Russia.

For the ultra-pessimists, a shot-gun is an asset too. But let’s hope the world wouldn’t degenerate into that.

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Posted in Gold, Investor Education | 10 Comments »

Gold and the strong state

Thursday, March 19th, 2009

Have you walked into a shop that specialises in selling paper money from the past and present from all over the world? Indeed, when holding a Riechmark (the German currency from the 1930s) on our hands, we felt a sense of nostalgia from the past. At some point in time, that piece of paper was used as money by another person to buy his/her daily essentials. Or if you want to be a billionaire, you can easily buy one of Zimbabwe’s currency at a price of say, AU$10.

Alas, all these paper money (currency) met their end and became of value only to collectors. Perhaps as an exercise, you may want to immerse yourself in one of those paper money shops and get yourself acquainted with the history of some of these currencies. Who knows, perhaps one day, the currency that you hold in your wallet will find its way into that paper money shop?

As we explained in our previous article, the whole idea of gold is money. The proper way to understand gold is to see it as money that is not currency. The fundamental reason why you accumulate gold is that (as we said before in What should be your fundamental reason for accumulating gold?) you want it as a hedge against loss of confidence in currently legal tender currency. On the other hand, if you have supreme confidence in currencies, then you will have no reason to hold gold.

As one of our readers, Pete, astutely pointed out before, there are many ways for currencies to lose the people’s rejection as money. Hyperinflation is only one of them. To illustrate this point, we have a story…

In 1940, as the German tanks rolled down to France, many French citizens hopped on to their cars to flee Paris. On the way to somewhere, some had to stop by petrol stations to refuel. It turned out that petrol stations did not accept the French currency as payment. After all, who will trust that the French currency will still be money once the Germans took charge? But if you had some gold coins in that situation, then you are in luck. Of course, when the Germans took over, they issued their own occupation currency and gold went underground.

The point we are trying to make is that gold as money is anti-thesis to a strong state. A strong political state may seek to ban gold on pain of death. That was what happened to China during the Mongol occupation of the 13th century. Marco Polo marvelled that the Mongol Khan had mastered the art of alchemy because paper currency issued by the Mongol empire became money on pain of death. It came to the point that gold, silver and other treasures were exchanged for the Khan’s paper money. Thus, Marco Polo remarked that the Khan was the richest person on earth. Thus, from this perspective, we can see that gold is a symbol of resistance against tyranny, subversion against state power and freedom.

But if you look at history, gold wins in the end because the strong state eventually falls (but the catch is, they may not fail within your lifetime). The Mongols, in enforcing their expensive occupation of China, printed money until there was hyperinflation. It was at that time that the Chinese rebelled against the Mongols and eventually drove them out of China. The subsequent Ming Dynasty continued the Mongol’s monetary policy of using paper as money. But by 1455, China had to revert back to commodity money.

Thus, the major risk of holding gold is that you can be up against the strong state (assuming that strong centralised political power will be the future) who may want to ban gold. But yet again, who knows? For example, Zimbabwe, for all the despotism of Robert Mugabe, has not or were powerless to ban gold.

But if the future turns out to be one in which political power is weak, de-centralised and rivalled by non-state power, then gold is a better bet than pieces of paper called the US dollar. This is the thesis of a strategist in the US Army War College (see From the New Middle Ages to a New Dark Age The Decline of the State and U.S. Strategy).

So, in summary, there’s risk in holding gold. But there’s also risk in NOT holding gold. So, what’s the alternative? Hold real asset (farm land, timber land, barrels of oil, food, guns, etc) instead? Well, there’s also risk as well and furthermore real assets serve a different function from gold. We will talk more about holding real assets later.

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Posted in Economics/Finance, Geopolitics & Politics, Gold, History, Looking Forward | 28 Comments »

If gold has no intrinsic value, is it a bubble?

Tuesday, March 17th, 2009

Today, we just received a comment from one of our readers,

I got two emails in my inbox today from sources I subscribe to that made me think of you and your hoard of gold. Firstly, the view of a smart guy who knows a lot about investing:

Gold is very expensive

Secondly, the views of another smart guy who knows a lot about technical analysis:

Gold Divergence Poses A Question

I think the gold/oil ratio is particularly telling, in that a gold bubble began forming in late 2008. Like I said previously, I don?t want to try to timing getting out of gold and into real assets, but good luck to you.

We took a read at the first link and saw this:

I know the gold bugs will hate this idea – because it harks back to the argument against gold – which is that it has no intrinsic value.

This is one of the most common argument against gold. While this argument is true in itself, the person who wrote that sentence has clearly forgotten the mirror image of that argument. As we wrote in October 2006 at Is gold an investment?,

This is because with its extremely limited industrial use, gold will not be worth that much at all.

So, we will repeat this point again: Gold has no intrinsic value. So, if gold has no intrinsic value and if you see its price going up, it is easy to conclude that it is a bubble. Now, having established the fact that gold has no intrinsic value, we will ask a mirror image question. What intrinsic value does a crisp piece of paper called the US dollar has?

You see, like gold, a crisp piece of US dollar has no intrinsic value too! There are completely no industrial uses for that piece of paper called the US dollar. Now, ask yourself this question: if that piece of paper called the US dollar has practical industrial use or is consumable the way tissue paper and tooth-pastes are, do you think people will still want to treat it as money? Now, imagine if one day the US government decree that all tooth-pastes become legal tender for payment and settlement of debt (i.e. function as money), how would you feel if you have to physically consume your money daily for the sake of oral hygiene?

Therefore, as we said before in Properties of good money, one important property of money is that it must not be something that is consumable. The only way for this property to be fulfilled is for money not to have any intrinsic value.

Now, back to gold. As we wrote before in What should be your fundamental reason for accumulating gold?,

We accumulate gold not just simply because we believe its ?price? is going up (though we think it is most likely to be so as a side effect?in case you are confused by what we mean, read on). This is because if we do so, the implication is that we are calibrating the value of gold in terms of units of fiat paper money (see Entrenched perception on the value of paper money).

Therefore, the fundamental reason for accumulating gold is not to ‘make’ money. The reason why you do so, is because you lack confidence in legal tender money. The bull market for gold since 2001 is an indication of a declining confidence in legal tender money, which like gold, has no intrinsic value. So, if you are very suspicious of central bankers playing hanky panky with the crisp piece of paper money called the dollar/ poound/ yen/ franc/ yuan/ etc, then your only alternative is to exchange those funny paper for physical gold.

Now that you understand this very fundamental point, what if you are still concerned about timing the market? If you are getting more and more suspicious of legal tender money (or getting more and more worried of a doomsday scenario), then market timing will be the least of your concern. Sure, you may want to time the market to get the maximum bang (gold) for your buck (paper money). But if market timing is still your over-ridding concern, then you are really missing the big picture. If you see gold price going up and up, it means you will have much greater worries than just market timing.

But if after all these explanations, you are still concerned about marketing timing, Marc Faber has this to say in his latest commentary:

I really dislike being called a gold bug. I wish I could be positive about the global economy and social and geopolitical condition, but the more I think about current condition, the more depressed I become. Amidst a global slump I believe that we are moving toward high inflation (a further depreciation in paper money?s purchasing power), evil fascism, and vicious military confrontations. In theory, gold would be the best asset to own in this condition. Also, in theory, gold should be the perfect insurance against economic, social, and political Armageddon. However, I have some reservations.

For one, gold has already experienced a powerful bull market between 2001 and the present. As a result, gold has become relatively expensive compared to equities and the CRB Index. I am not suggesting that this outperformance of gold compared to other commodities and equities cannot continue. In fact, I believe that in time one Dow Jones will buy less than one ounce of gold. However, near term, gold would seem to be both over-bought against the Dow Jones and the CRB Index. I concede that the overbought condition of gold compared to the Dow Jones and compared to the CRB Index could be corrected by a strong rebound in the Dow and the CRB Index rather than a further downward correction in gold. My bet would be that the CRB Index has significant rebound potential and…

The other concern I have about owning physical gold (and as I just said, I am holding on to my physical gold) is that things will get one day so bad in the world that governments will expropriate gold, as the US did in 1933. This is unlikely to happen this year but it is a concern I have for the long term, especially if gold rallies to several thousand dollars per ounce as a result of money printing by all central banks or because of wars! As Voltaire remarked, ?it is dangerous to be right when the government is wrong.?

Whether you should be buying, holding or selling gold today will depend on your personal circumstances, which includes what percentage of your wealth are currently in gold, your level of suspicion against fiat money and your level fear for a doomsday scenario. But remember, having some gold is better than having zero gold.

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Posted in Gold | 40 Comments »

Nations will rise against nations

Sunday, March 15th, 2009

A few days, as reported widely in the news media, Chinese Premier Wen Jiabao said at a press conference that

We have lent huge amounts of money to the United States. Of course we are concerned about the safety of our assets.

To be honest, I am a little bit worried and I would like to … call on the United States to honour its word and remain a credible nation and ensure the safety of Chinese assets.

Those words, when translated into English in writing, sound bland. But if you watch what he said in full video in the original language, then you will be able to appreciate the immense gravity of the situation from the tone of his voice.

But dear readers, you must understand that Premier Wen was just stating the obvious. There’s nothing new in what he said. All you have to do is to turn back to what we wrote in December 2006 and read Will the US dollar collapse? and Awash with cash?what to do with it? to see the big picture of what’s going on for years. As we wrote back then,

Lately, we are again hearing that central bankers are murmuring about diversifying their foreign reserves away from the US dollar. Does it mean that there is an imminent liquidation of their US dollar reserves? Well, this is not the first time they murmured about it and it is definitely not in their (including the Federal Reserve?s) interest to see a collapse of the US dollar. The Chinese, with their US$1 trillion of reserves, would not want to see their stockpile of US dollars to lose significant value.

That paragraph was written in the final days of 2006. Today, China’s US dollar reserve had doubled from they had more than 2 years ago. The major difference between today and back then is the emergence of the Global Financial Crisis (GFC).

Thanks to the GFC, the status quo, which had been running for decades, is stressed towards a breaking point (but who knows, perhaps that inevitable  breaking point could still be delayed for longer before an almighty snap happens). There are far too many contradictory and conflicting interests among nations.

For the US, as we said before in How is the US going to repay its national debt?, is facing a situation in the coming decades of having to pay a colossal amount of public debt. The public sector is facing a massive debt many times its GDP from the unfunded Medicare and social security liabilities. With the GFC, the US government is transferring more and more private debt to the public sector through bailouts, handouts and stimulus. It is either the US mobilise its monetary printing press to massively inflate away (i.e. print copious amount of money) all these debts or they face up to the reality that they are bankrupt and go through the cold turkey of an almighty deflationary collapse (read: almighty depression). If the US chooses the former, China will be furious because that will be doing the very opposite of what Premier Wen called on the US to do, namely to “honour its word and remain a credible nation and ensure the safety of Chinese assets.”

Unfortunately, the big problem is that the US (along with countries like Australia and UK) has been de-industrialising and hollowing out its economy for a very long time, while the China has been doing the opposite. To put it simply, the US is consuming more and more while China produces more and more. This gross imbalance has been playing out for too long. With the GFC, the US consumers are effectively bankrupt and cannot borrow any more to buy from China. China has lost its biggest customer and is in trouble too.

The coming G20 Summit will be filled with countries with conflicting agendas. The US (and UK) wants more stimulus (and of course, bailouts when required), which can only happen if they print money (i.e. devalue the US dollar), which is as good as spitting on China’s face. Europe (headed by Germany and France) wants the focus to be on regulations and prevention, which means they are less keen on stimulus and bailouts. This is because the latter will involve the tax-payers of countries like Germany rescuing the tax-payers of other EU nations. China, on the other hand, wants an overhaul of the current world order so that they can have more power and say to better reflect their status as America’s creditor. Obviously, the US will not like that because that will mean they have to voluntarily descend for an ascending China.

There are plenty of temptations to take the easy way out. For example, if the Chinese expect the US to inflate away their debts by printing money and thereby, devaluing the US dollar, they will be likely to devalue their RMB in order to continue the process of hollowing out the US economy. The US (and the Europeans), in response, could impose trade barriers on Chinese imports. The Chinese could retaliate by dumping their holdings of US Treasuries. Remember, these are just examples of what may happen and they are by no means predictions. But we trust that you get the idea here.

Therefore, outwardly, the world may be at peace. But inwardly, we believe there will be jostling for power, influence and resources between the major nation blocs. Bigger nations will use smaller nations as pawns, international armed non-state groups will intensify their activities and inter-ethnic conflicts will arise. We have no doubt that there will be plenty of Black Swans appearing in the days to come.

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Posted in Currencies, Geopolitics & Politics, Looking Forward | 14 Comments »

Quantitaive demonstration of the effects of price inflation on your investment

Thursday, March 12th, 2009

For the hypothetical business in our previous article, Revealed: The error in the Buffett logic, we will show you how earnings are valued (using the discounted cash-flow method) and the effects inflation with a table:

Free Image Hosting at www.ImageShack.us

Here are the explanations for the columns on the table:

  1. Year – The table shows the year-by-year outcome in a 20-year period. This column denotes the year.
  2. Earnings – It shows the earnings of a business. You can see, at the end of the first year, the business will generate $100 of earnings. Earnings will grow at a rate denoted by the corresponding entry on the 6th column (Earnings Growth). In this example, earnings are growing at a rate of 25% per year. You can see, at the end of the 20th year, that business will earn $6938.89.
  3. PV of Earnings – This is the present value of earnings earned at the end of the year. The discount rate used in the present value calculation is 30%, which is defined in the 7th column of the table. As you can see, the present value of the 20th year of earnings ($6938.89) is only $36.51. As you can see, if you add up first 10 figures of that column, you will get $648.87, which is the number we gave in the previous article.
  4. Total PV – This is the sum total of the previous column. This is also the valuation of 20 years worth of earnings at the discount rate of 30%.
  5. Accumulated Re-invested Earnings – What happens if you re-invest all the earnings at an investment return rate that is the same as the discount rate (30%)? Each row of this column will show you what your total accumulation of that business’s earnings. As you can see, at the end of year 20, you will have accumulated $206,626.93.
  6. Inflation Rate – This column define the price inflation rate.
  7. FV of Total PV Due to Inflation – What if inflation is allowed to do its work to devalue your cash? In this column, it shows how much $1,087.23 (the valuation of 20 years worth of earnings) at the beginning of the first year will have to be in order to maintain the purchasing power at the end of the year. As you can see,  $94,301.83  at the end of the 20th year can only buy as much as $1,087.23 at the beginning of the first year, given price inflation of 25% for every year.

As this table shows, as long as you can re-invest the earnings of the business at a compounded return equivalent to the discount rate (30%), which is higher than the price inflation rate (25%), you will beat inflation. That is, your wealth in real terms will rise. But if you decide to stuff your earnings as unproductive cash under the bed, you will lose out to inflation. That is, at the end of the 20th year, you will have accumulated $34,294.47 in cash but price inflation will mean your original $1,087.23 investment have to grow to $94,301.83 in order to preserve its purchasing power.

If you apply a discount rate of only 10%, the valuation will balloon to $7,928.52, which is equivalent to  $687,689.46 in 20 years time due to inflation. But if you can only re-invest your earnings (which is growing at 25%- the same as inflation) at 10% (compounded), you will only accumulate $53,339.12, which means inflation will destroy your wealth in real terms.

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Revealed: The error in the Buffett logic

Tuesday, March 10th, 2009

In our previous article, we asked our readers to spot the flaw in Warren Buffett’s logic. Today, we will reveal the answers. Before you read on, please take the time to understand our guide, Value investing for dummies.

As Buffett said, staying in cash and cash equivalent (e.g. government bonds) is a bad move because price inflation is likely to be very high in the future. This, we agree. But does it mean one should switch from cash to stocks today? If the answer is “yes,” then there’s an error in logic.

First, by that very statement, Buffett was implying that the yields of government bonds are far too low. Essentially, this means that those who buy and hold those bonds will have their wealth frittered away by price inflation.

Next, as we explained in Value investing for dummies, value is a relative concept. Stocks are valued relative to risk-free government bonds, which in turn is suppose to reflect future price inflation. If the yields in government bonds are wrong by a long shot, then stock valuation will be wrong.

To explain this point better, let’s use an example. Let’s suppose the following conditions:

  1. 30-year Treasury bond yield is 3.5%.
  2. An almost risk-free business with monopolistic powers (let’s imagine it is Woolsworth).
  3. That business can raise prices and grow its earnings at 25% per year.
  4. The first year earnings of the business is $100.

If we apply a 5% discount rate on 10 years of that business’s earnings, we get a present value of $2358.76. That 5% is arbitrary chosen from the fact that it is a little above the Treasury bond yield.

As long as the long-run average price inflation is around the vicinity of the 30-year Treasury bond yield, buying the stock at below the present value of its earnings is a bargain. But what if the bond yield is way way way wrong? Let’s say the price inflation rate turns out to be, say 25% (in other words, the business earnings grow fast enough to merely keep up with inflation). You can see that applying a discount rate of only 5% will give you a return far below price inflation (but slightly higher than Treasury bond yields). If you want a return higher than price inflation, your discount rate will have to be north of 25%.

If we apply a 30% discount rate on 10 years of that business’s earnings, we get a present value of only $648.87! That 30% is arbitrary chosen from the fact that it is a little above the price inflation rate.

So, if you believe that government bonds are severely under-pricing future price inflation and you have no idea how the ravages of price inflation will look like, then how can you value stocks correctly? If the price inflation turns out to be Zimbabwean-style hyperinflation, then you will lose big money (in real terms) investing at today’s stock price.

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