Archive for August, 2009

Decline in the Baltic Dry Index

Sunday, August 30th, 2009

We last mentioned the Baltic Dry Index (BDI) back in January at Baltic Dry Index indicates a collapse in global trade. Back then, the collapse of the BDI followed the collapse of world trade as the global economy fell off a cliff. Since then, it climbed to a high in June 2009, quadrupling from the lows from several months ago. The reason for the climb was due to Chinese demand for Australian iron ore, as they took advantage of the once-in-a-lifetime collapse in commodity prices.

But what happened since June 2009? Take a look at the graph of the BDI below:

Baltic Dry Index
Click image see it in full size

Since then, the BDI had almost halved, indicating the fall in demand for shipping. The trend since June 2009 is firmly downwards.

Yet, the stock market is still merrily rising, thinking that blue sky is ahead.

Does rising house prices imply a housing shortage?

Thursday, August 27th, 2009

There is a common argument that Australia has a housing shortage because prices are rising. The flawed reasoning goes like this: “Under the ‘irrefutable’ law of demand and supply, if prices rise, it must be due to demand outstripping supply i.e. shortage situation.”

This flawed reasoning has its roots in the mainstream Neo-Classical school of economic thought. Under this school, the market is assumed to be in equilibrium. As we wrote in Soft landing hope built on faulty framework assumptions

But this is a very erroneous assumption built into the framework of mainstream neo-classical economic thinking. Does the economy always have to return to equilibrium the way an elastic band spring back into its previous relaxed state? Can there be other forces that can pull the economy further and further out of equilibrium until a breakdown occurs?

In Neo-Classical reasoning, equilibrium is when the supply curve meets the demand curve. If prices go up, and the market has to be in equilibrium as assumed, then it has to imply that the supply curve had shifted left and/or demand curve had shifted right. Subsequently, prices had to rise to ease the demand-supply imbalance. With rising prices, many of these housing ‘experts’ then go hunting for reasons (that suits their vested interest) to explain the ‘shortages.’

In the real world, the market need not necessarily be in equilibrium. In fact, it can go out of equilibrium and remain so for an extended period of time, independent of the housing shortage/surplus situation. In Australia’s housing market, we have identified two major factors:

Price rise expectation
The first factor is price inflation expectation. As we quoted Ludwig von Mises in What is a crack-up boom?

He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding.

This observation is true for generic commodities that can be purchased with cash alone- in contrast, houses are almost always purchased with debt. The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ‘demand,’ which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ‘demand’ and so on and so forth. When this happens, higher prices lead to even higher ‘demand.’ Such artificial demand can act as a sink-hole for whatever quantity of supply until money runs out in the financial system (which is not possible under today’s a fiat credit system). The Dutch Tulip Mania (which burst in 1637) is an example of the power of belief. Indeed, there must a ‘shortage’ of tulips at that time, according to Neo-Classical supply-demand ‘fundamentals.’

This is the same dynamic working in hyperinflation, where everything (not just houses) rises in prices. It was just last year that there’s talk of food shortages (see Who is to blame for surging food and oil prices?). Today, we hardly hear of food ‘shortages’ after deflationary Panic of 2008.

Availability of credit
As we all know, almost everyone borrow money to buy houses. Very few buy them with cash. What if banks decide to withdraw all credit in the economy? Obviously, people’s purchasing power of houses will fall as they can only rely on their cash savings to buy houses. Consequently, the ‘demand’ for housing will collapse immediately. As we said before in Another faulty analysis: BIS Shrapnel on house prices,

Where is the housing ‘demand’ going to come from as credit becomes more expensive? The only way for most people to buy a property is to borrow money. If credit becomes more expensive (i.e. harder to borrow money), obviously the ‘demand’ for properties will fall as well.

Conversely, when there’s more and more easy credit are available, more and more borrowed money can be used to bid up house prices. This can go on until the debt servicing burden becomes too big to bear.

How the two factors interact with each other
People’s expectation that prices will rise (abetted by belief that there’s a housing ‘shortage’) will lead to higher prices. Unlike the Dutch Tulip Mania of the 17th century, today’s financial system can spew out more and more credit continuously (see Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model). This means that self-reinforcing artificial demand can be fuelled by more and more credit, which helps prices to rise.

Then, through the principle of imputed valuation, increase in house prices at the margins will result in every other house to be re-valued upwards. 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.

When the values of the houses sold at the margins are imputed to the rest of the houses, it result in higher valued collateral for more granting of even more credit. More credit adds another round of self-reinforcing feedback loop.

Pre-requisites for a substantial house price fall in Australia
All we need for house price to fall substantially in Australia is (1) a reversal of house price rise expectation and/or (2) tighter credit and/or critical mass of debt servicing failure (which can be caused by rising unemployment- see RBA committing logical errors regarding Australian household finance). When that happens, the self-reinforcing feedback loop for higher prices will become a self-reinforcing feedback loop for lower prices.

Look at UK…
There are many ‘experts’ who argued that house prices are falling in the US due to ‘over-supply’ and that Australia’s housing ‘shortage’ will prevent a house price fall. These experts conveniently failed to look at the UK. Just do a Google search on “housing shortage” site:uk and you will find many reports of a housing ‘shortage’ in the UK too.

We all know what happened to the UK housing market.

Will governments be forced to exit from ‘stimulus?’

Tuesday, August 25th, 2009

Currently, there’s a belief in the financial markets that the worst of the Global Financial Crisis (GFC) is over and that it’ll be blue sky from now on. Indeed, it is possible that the the US economy may see a positive GDP growth in the next few quarters to come.

But here, as contrarians, we see a different picture. As we quoted the Bank for International Settlements (BIS) in Bank for International Settlements (BIS) warning on stimulus spendings, the ‘green shoots’ of growth is largely contributed to government bailouts, ‘stimulus’ spendings, money printing and cheaper money (e.g. zero interest rates in US).

Make no mistake about this: Government interventions cannot be sustained forever without increasing negative consequences in the longer term. Governments cannot ‘stimulate’ the economy. In fact, the word ‘stimulus’ is the most misleading word in economics lexicon because it conveys the idea of a surgeon ‘stimulating’ a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven’t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

Letting the economy lean on crutches indefinitely will result in decreasing economic health as time goes by. Furthermore, there’s always the risk that the side-effects will pressure governments to remove the crutches. As we quoted the BIS in Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

How will a pressure for a “forced exit” from crutches (bailouts, stimulus, money printing and cheaper money) happen? We can look no further than China as an example where ‘stimulus’ is most effective. As we wrote in Will August 2009 be the top for the year in China?,

Forcing credit growth in this case does not result in economic ?stimulation.? Instead, the result was a dangerous asset price bubble. Apparently, the Chinese government flipped its position and decided to rein in the bubble before it’s too late.

China is right now in a dilemma. Turning the credit tap off will result in many projects failing, which in turn will result in bad debts. Not turning the credit tap off will result in price inflation and asset price bubbles.

The problem with economic crutches is that there will be negative side-effects. It is only a matter of time before excess liquidity leaked into asset and commodity prices. Initially, this may not be a problem. But as we saw last year (see Who is to blame for surging food and oil prices?), this will eventually result in acute problems of price inflation (unless the next deflation pressure comes, for which it will be déjà vu again). If governments decide to withdraw the economic crutches, they risk letting the already weakening economy fall into deflation. If they decide not to withdraw them, they risk letting acute price inflation run amok.

What is likely to happen is that governments will attempt to walk on the middle ground by pretending to ‘fight’ inflation (e.g. raising interest rates too slowly and talk tough on inflation) and support the economy at the same time, hoping that the economy will turn out fine. It may work initially, but it’s a matter of time before the public will see through it.

Tougher times is ahead for everyone.

Will August 2009 be the top for the year in China?

Sunday, August 23rd, 2009

Last time, it used to be that the US stock market ‘leads’ the world’s stock market. As the saying goes, when America sneezes, the rest of the world catches a cold. If the Dow Jones plunges, the stock markets in Europe and Asia will likely ‘follow.’ Recently, over the past few years, a curious phenomenon seems to be occurring more often- the US stock market is ‘following’ the rest of the world, particularly China.

Indeed, the stock market is a fine example of the study of human herd behaviour.

Now, as every investor or trader should know, the Chinese stock market had fallen around 20% from the early August high. In our view, it is likely that this will be the high for at least 2009. Why?

Back in Is China setting itself up for a credit bust? and How big is the credit bubble in China?, the Chinese government was force feeding large quantity of credit into the Chinese financial system. Unlike in democratic Western countries, Chinese banks cannot refuse to follow the directives of their central government. They had to lend in order to reach a target set out by the government. As we all know, the collapse of the Chinese export sector was putting downward pressure on the economy. As a result, private demand for credit was anaemic.

If the banks had to lend and businesses did not want to borrow, what then?

Then the Chinese business culture of doing favours for each other kicks in. The credit-worthy businesses that the banks lent to (who have no expansion plans in the face of dwindling foreign demand), took the money nevertheless. Then the monies was poured into the stock and property market. That’s why both the property and stock market boomed so quickly after a dramatic collapse from last year. It is also likely that some of the monies are used to speculate in commodities- how can the divergence between real Chinese demand and commodity prices be explained?

In July, it was widely reported in the news media that the Chinese government clamped down on new loans. Consequently, loan growth plunged. If a raging bull market is financed by credit, then all it takes is a dramatic slowdown in credit growth to crunch the bull market. Below is the graph of China’s credit growth:

Chinese loan growth
Click on graph to see it in full size

One interpretation sees the Chinese government as still learning the ropes of capitalism. Forcing credit growth in this case does not result in economic ‘stimulation.’ Instead, the result was a dangerous asset price bubble. Apparently, the Chinese government flipped its position and decided to rein in the bubble before its too late.

The question is: what is the implication of this on commodity prices? And will the rest of the world follow?

Is the $50b gas deal a dumb deal for Australia?

Thursday, August 20th, 2009

A couple of days ago, Australia signed a deal to supply China with natural gas for the next 20 years. As the this news article reported,

THE largest single trade deal in the nation’s history – a $50 billion contract to sell liquefied natural gas to China – was sealed in Beijing last night, signalling the resources boom is far from over.

The contract, hailed by the Federal Government as an indicator Australia’s relationship with Beijing remains sound, will supply China with gas for 20 years.

Mr Rudd said the project would be worth 5 per cent of the nation’s gross domestic product. It would deliver the Government $40 billion in revenue over 30 years and would generate 6000 jobs at the peak of construction, effectively making it a third stimulus package.

In this deal, Exxon will be selling LNG to PetroChina while the Australian government collect royalties payment. So far, Exxon gave no pricing details on the contract. But given that a dollar value of the contract has been announced, we wonder how much has China locked in the prices of the LNG (which will be delivered over a 20 year period from 2015) and how will the clauses adjust the pricing due to inflation. By 2035, with the value of the US dollar in grave doubts (see Is the GFC the final crisis?), the Australian government may end up receiving payment in a rapidly depreciating currency.

We doubt there’s a gold clause in the contract. If so, that may be a big mistake for Australia.

Reader’s question on Warren Buffett

Tuesday, August 18th, 2009

Recently, one of our readers asked this question at the forum:

So why is Warren Buffett’s net worth so much higher than Charlie Munger’s? And why Ben Graham, the founder of the idea, never really make it? It seems like value investing only works extraordinarily well with Buffett. I was hoping someone like Ed could give some insight.

We see that this is an excellent discussion topic. So, what do you think? Join in the forum discussion now!

Answer to reader quiz: likelihood of takeover

Tuesday, August 18th, 2009

In our previous article, we gave our readers a short quiz to assess the likelihood of a takeover. The purpose of this quiz was not to be a lesson on takeover analysis- the takeover discussion was a red herring to distract you from the core of the issue. As Pete, one of our readers said,

Whilst looking at these takeover targets from a “what has happened in the past” perspective seems intelligent, takeovers rely on much more than is mentioned in those points.

Instead, the purpose of this quiz is to show you a very common mental pitfall that will deceive the minds of many unsuspecting investors.

Now, let’s take a look at this paragraph in the quoted Eureka Report article:

Of the six [takeover likelihood criteria], I find that the presence of strategic shareholdings is the strongest predictor of corporate activity; in fact, since 2000 about 60% of listed Australian companies receiving takeover bids had such strategic shareholders already on their register, even though only about 20% of total companies in the ASX 300 index fulfil this condition.

Upon reading that paragraph, it is easy to conclude that if a company fulfils all the six criteria, then its likelihood of takeover (based on statistical probability and assuming that all takeover bids are successful) is at least 60%.

Unfortunately, even if you believe that statistical probability is an accurate gauge of takeover probability (those who believe in that must read Failure to understand Black Swan leads to fallacious thinking), that number is wrong. The reason why 60% is the wrong number is because it is skewed by survivorship bias.

As we quoted an article in Mental pitfall: Survivorship Bias, the

… tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies which were successful enough to survive until the end of the period are included.

That 60% is based on companies who were taken over. It does not include companies who fulfil those criteria and were not taken over. If we take the entire sample of all companies that fulfil those criteria, the proportion of those who was taken over could well be far below 60%.

Today’s lesson on survivorship bias is very instructive on how statistics can be misused to lie and deceive.

Reader quiz: likelihood of takeover

Monday, August 17th, 2009

Today, we will give our readers a simple quiz.

Last month, Eureka Report released an article titled “Top Ten Takeover Target.” The article goes like this:

PORTFOLIO POINT: What are the most likely takeover targets for the year ahead? Here?s my list.

Will BHP come back for Rio? Will Kerry Stokes go the whole way and make an audacious bid for the
Packer family’s Consolidated Media.

It’s never easy picking takeover targets in advance, but neither it is impossible. Over the years I have devised certain criteria that I hope you’ll find useful. There are some obvious factors, such as a wave of pending consolidation; and others that might not be too obvious to the untrained eye, such as ?lazy? balance sheets.

The six main criteria I use to select takeover targets are:

  • The presence of a strategic shareholding on its register.
  • Industry consolidation taking place.
  • Substantial changes to the legislative or regulatory environment.
  • The occurrence of a previous (and unsuccessful) bid for the company in question.
  • Monopolistic and/or duopolistic industry structures.
  • Underutilised balance sheets and strong cash flows.

Of the six, I find that the presence of strategic shareholdings is the strongest predictor of corporate activity; in fact, since 2000 about 60% of listed Australian companies receiving takeover bids had such strategic shareholders already on their register, even though only about 20% of total companies in the ASX 300 index fulfil this condition.

So putting these criteria together and overlaying them on Australian stockmarket, what do you get?

Here then are my top 10 takeover targets (in no particular order) for the year ahead:

Let’s say you searched high and low for a company in the stock market. Finally, you found company XYZ that fulfils each one of the six criteria.

Our question to you is: how likely (expressed as a percentage) is company XYZ going to be taken over?

Precious metals shenanigans- ETFs to be delivered for futures

Thursday, August 13th, 2009

One question we often ask ourselves is: how much are the prices for gold and silver manipulated? Remember, back in Possible fuses that can ignite silver prices: price manipulation, we wrote that,

The problem is, the paper silver that is being sold through the futures market is unlikely to exist. Why? Commodities traders on COMEX have made bets in which they promise to deliver more than twice the amount of silver known to exists!

As the prices in the futures market affects the prices in the spot market, any manipulation in the futures market will indirectly manipulate the prices in the spot market.

Also, a lot of ‘gold’ and ‘silver’ are traded in the form of ETFs. At Possible fuses that can ignite silver prices: ETFs, we asked,

A very big question to ask is this: how much of the ETFs are backed by the physical precious metals?

Since ETFs accounts for a significant fraction of demand for precious metals, how much of these demand translate into actual demand for the physical precious metals?

Then, there’s another piece of shenanigan. As this article from the Gold Anti-Trust Action Committee (GATA) alerted us to this document from the US Commodities Futures Trading Commission (CFTC),

The New York Mercantile Exchange, Inc. (“NYMEX” or the “Exchange”) hereby notifies the Commodity Futures Trading Commission (“CFTC”) that, as set forth in the attached rule interpretation, it will accept gold-backed ETF shares as the physical commodity component for EFP transactions involving COMEX gold futures contracts, provided that all elements of a bona fide EFP pursuant to Exchange Rule 104.36 are satisfied.

In other words, gold ETFs can be delivered in lieu of the physical gold commodity as part of the obligations of the futures contract!

Humanity has finally invented alchemy!

Why is the modern economy so dependent on ever-lasting growth?

Tuesday, August 11th, 2009

Have you ever wonder why economists and policy makers are so obsessed with economic growth? Why is it such an acute problem if the economy is not in a treadmill of growth (i.e. ever-lasting increase in the quantity of goods and services produced)? What is so bad with zero economic growth (i.e. an economy that takes it free and easy)?

As one of our readers wrote in our previous article,

This is all to say that the [modern capitalist] system is much more fragile than anyone would have guessed and that the cult of markets and efficiency have left the world with a system that is less and less resilient. The crisis that has begun over the last couple years begins to bear that out. In fact we’ve become dependent on efficiency and without it the system may just fail under it own weight. Time will tell but the process has begun.


We believe the root of the problem lies in the monetary system. Today, we have a monetary system that is at its heart a system of credit. That is, the ‘money’ that flows around the system is loaned out of existence. To understand what this means, read on…

Originally, mankind started with commodity money. Money was a physically tangible thing. In the 15th century, Spain found gold in the New World. As gold was money back then, Spain found a lot of money and became ‘rich’ as a result. Today, most of our money has become virtual, intangible and in the form of electronic information. The overwhelming values of transactions are made in the form of electronic fund transfers instead of exchange in physical paper cash.

Now, think of your cash at bank- it is an asset to you and a liability of the bank. Say, when you make a non-cash purchase (either with cheque, credit card, bank transfer, etc), that transaction ultimately becomes a transfer of liability from one entity to another. This text-book idea implies that assets have to exist first before it can be loaned out as someone’s else’s liability.

The real world does not conform to this text-book idea: liabilities are created by banks first (in the form of loans) before the assets exist (we recommend you read Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model if you need a deeper understanding). After the liabilities are created out of thin air, the bank then go hunting for the assets by borrowing from another entity (e.g. central bank, depositors, another bank, investors, etc). Ultimately, either directly or indirectly, that asset (currency) originates from the central bank.

The central bank is the only institution that can create assets (currency) out of thin air to be loaned out as liabilities. Imagine you are a central bank- all you need to do is to declare $100 into existence, lend it to the banking system and then have the power to demand that the money (which you created out of thin air) to be paid back to you at an interest rate that you decide.

The observant reader will then be asking this question: “If the entire economy pays back all the currency that was borrowed into existence, but still owes the interest, where does it get the currency to pay the interest?” The answer is startling simple: more currency has to be borrowed into existence to pay back the original interest!

Now, you can see that total debt in the economy will grow exponentially (compounded interest) continuously and can never be repaid fully. That means the economy has to grow continuously in order to generate the income to pay back the continuously growing debt. Since the physical world has a finite quantity of resources, the quantity of goods and services produced in the economy cannot always grow fast enough to match the continuously growing debt. Therefore, the only way to keep the system running is to add in price inflation (growth in the nominal value of the goods and services produced) so that the nominal value of the continuously growing debt can be repaid. That’s why, as our reader observed, the “cult of markets and efficiency” in the modern capitalistic economy is there by necessity to keep the economy growing continuously.

For the past decade, total private debt is growing at a speed far in excess of GDP growth (i.e. growth in income). For a while, it seemed sustainable because asset prices (most notably, house prices) were rising fast enough to keep the financial system solvent (i.e. able to pay back the continuously growing compounding debt in nominal terms). As you can see by now, if asset prices stops rising in the context of adequate economic growth, the game is over. That game-over situation is what we all know as the Global Financial Crisis (GFC).

The GFC trigger the economic phenomenon called deflation. Once the debtors (e.g. banks, households, businesses) become insolvent, they can cause their creditors to become insolvent, who in turn threaten the creditors’ creditors with insolvency. This systemic debt defaults will now reverse the debt growth, which means the currencies that are loaned into existence will be written off into non-existence, which means money supply will shrink, which in turn will cause vast tracts of the economy to shave off its productive capacity (e.g. unemployment, idle factories, excess capacity).

If the economy is not expected to grow sufficiently and the government wants to keep the wheel running, what would they do? The only course of action is run the money printing press (i.e. create currencies out of thin air, pump them into the system for free). The risk is that without a properly growing economy, they risk igniting another asset price bubble. An asset price bubble may seem to ‘work’ because they can keep the system solvent for a while, until the bubble burst and restart the deflation nightmare again. The government will then have to start the monetary printing press again while the economy shaves its productive capacity the second time. If this process is repeated umpteen times, it will come to a point whereby the only thing to keep the system running is rising asset prices and not economic growth. When that happens, it is hyperinflation.

The current asset price rebound around the world is the stage where rising asset prices are keeping the debt wheel running. We don’t know how long that gig will keep running.