Archive for November, 2009

Next stop after Dubai

Sunday, November 29th, 2009

As all of you would have known by now, news of a likely default by Dubai World, a sovereign wealth fund of Dubai, had the effect of a screaming “BOO!” to the global financial markets. After the near-death experience from the Lehman Chainsaw Massacre lunatic in 2008/2009, the ensuing post-traumatic stress disorder suffered by the financial markets made them more susceptible to panic attacks like this one.

Despite what the mainstream media said that this incident is “out of the blue” incident, it doesn’t take a genius to notice the warning signs. At the Contrarian Investors’ News, you can do a search on “Dubai” and see for yourself.

In terms of scale, Dubai World’s debt is around the order of 10 times smaller than the debts of Lehman Brothers. Some commentators have dubbed this incident as a storm in a teacup. Incidentally, Australia’s Michael Pascoe had also called the 2007 sub-prime mortgage crisis as a storm in a teacup too.

But make no mistake about this. A default of US$60 billion will definitely have a contagion effect. Although Australia’s Big 4 banks may claim that they have no (or very little) direct exposure to Dubai World, the issue is not how exposed they are to Dubai World. Rather, the issue is how much exposure they have to entities that have exposure to Dubai World. Or how much exposure they have to entities that are exposed to entities that are exposed to Dubai World.

As long as there’s no news of bailouts and money-printing exercise, the financial markets are going to assume the worst and continue the sell-off. In fact, this is likely to be the trigger for a major correction that we were anticipating for months (see Aborted correction?). The question is, will this be the trigger for another round of deflation that will bring the markets past the March 2009 lows? Followers of Pretcher’s Elliot Wave will hope this will vindicate their views on deflation.

Our view is that there’ll be some form of bailouts eventually, either in the form of a rescue by Abu Dhabi or money-printing led by Ben Bernanke. Some speculators will see this as an opportunity to buy more stocks.

Is the Chinese economy a house of cards?

Thursday, November 26th, 2009

When you trawl through the mainstream media, blogs and pundits’ opinions, you will notice that there’s increasing reservation on China’s ‘impressive’ economic growth. One of the world’s most notorious short-seller, Jim Chanos recently announced his intention to short China. He’s the one who famously shorted Enron and Macquarie Bank.

Jimmy Rogers, on the other hand, is bullish on China. But that’s not mean that he believes that it’ll be forever blue skies ahead for China. In fact, he acknowledges that China will experience problems from time to time. Unfortunately, his bullishness gets the more attention from people. We do not know whether it’s because he seldom talks about his reservations on China, if any, or it’s selective hearing from the ears of people.

Anyway, this new-found bearishness on China is based on the idea that China’s economic growth is:

  1. An artificially induced bubbly boom through the force feeding of credit into the economy and government stimulated infrastructure investments (white elephant infrastructure projects??)
  2. Based on doctored figures

Back in July, we wrote of the massive force-feeding of credit in China:

  1. Is China setting itself up for a credit bust?
  2. How big is the credit bubble in China?

Indeed, there is a burgeoning asset price bubble in China. Hong Kong luxury apartments have sky-rocketed in price. There are even stories of speculators stockpiling physical base metals. There are also many anecdotal evidences that China infrastructure oriented stimulus is resulting in huge white elephant infrastructure. For example, this YouTube video showed a huge Chinese ghost city built from scratch in Inner Mongolia. We heard of reports of massive 5-lane motorways with no traffic.

Yu Yongding, economics professor at the Chinese Academy of Social Sciences (and formerly a member of the People’s Bank of China monetary policy committee), has recently sounded the alarm (see China bubble puts our recovery in doubt). We first mentioned this economist back in October 2007 at China considers leaking money to overseas stock when he warned the Chinese government on certain policies.

More ominously, we are seeing signs that the Chinese government is repenting on their extremely lax credit policies. As China’s banking regulator warned (see Capital crunch for Chinese banks),

China’s banking regulator has warned it would refuse approvals for expansion and limit banking operations if lenders did not meet new capital adequacy requirements, a move that has prompted the country’s largest state-owned banks to prepare capital-raising plans for next year and beyond.

Even the adviser to the People’s Bank of China is sounding the alarm on asset price bubbles. As China Faces Asset-Bubble Risk, PBOC Adviser Fan Says (Update2),

?The real risk is really asset bubbles,? Fan, who heads the National Institute of Economic Research, said at a business conference in Hong Kong today. A ?Chinese asset bubble would be something very dangerous, that would cause the overheating? elsewhere as well, he said.

Also, Bloomberg reported that China is taking the first steps in capital control in a bid to stem its asset price bubbles (see China Tightens Rules on Transfers to Stop ?Hot Money? (Update1)) from overseas speculative capital.

If Australia has to thank China’s economic strength for protecting its economy from a hard landing, what will a bust in China do to Australia?

First steps towards currency and trade blocs?

Tuesday, November 24th, 2009

By conventional wisdom, government debt is supposed to be the safest form of debt because governments cannot default on debt repayment due to their powers of taxation and monopoly on creation of money (out of thin air). Conventional wisdom also dictates that the US government debt is the safest of all government debts because the US dollar is the world reserve currency. Since most of the debt accrued by the US is denominated in their own currency (a luxury that no other nation can enjoy), there is no way it can default.

Well, in reality, governments do default on their debt. Russia did in 1998. Many banana nations did as well. But a nation as prestigious as the United States? Today, even the mainstream news media is toying with the heretical idea that the United States government may go bust (see Is sovereign debt the new sub-prime?). Will the US government debt become sub-prime?

If the world’s ultra safest debts becomes bad debts (whether via monetary inflation or outright default), what hope will there be for other debts?

As we wrote in Permanently low interest rates for Uncle Sam?, it is very difficult for the Federal Reserve to raise interest rates. Not only that, the current yields on the US government debt are ridiculously low (some of the yields are even negative). As we said before in What will be the next market panic?, this will piss off America’s creditors immensely. Some Chinese officials, whether fairly or not, are already accusing the US monetary policy as the culprit for price inflation and asset price bubbles in China. Some US officials, on the other hand, will point their finger at the Chinese’s ‘manipulation’ of their currency exchange rate as the cause of the bubbles, thus implying that it’s the Chineses’ fault. Also, as we speak, both the US and China are engaging in low-level trade war, with import restrictions on Chinese tyres and American chickens as the first step. We can see that trade restrictions between the two sides will gradually increase as time goes by.

On top of all that, Asian nations are considering capital controls to stem the danger of asset price bubbles in their home countries (see Asia Considers Capital Controls to Stem Bubble Danger). Assuming that US interest rates are going to remain negative in real terms for an extended period time, the considerations will eventually become a reality.

All these are happening in the context of increasing trade ties between Asian nations and reduce trade ties between the East and the West. All these may be a precursor to currency and trade blocs in the long term. As we quoted Murray Rothbard in our book, How to buy and invest in physical gold and silver bullion, between 1931 and 1945,

The international economic order had disintegrated into the chaos of clean and dirty floating exchange rates, competing devaluations, exchange controls, and trade barriers; international economic and monetary warfare raged between currencies and currency blocs. International trade and investment came to a virtual standstill; and trade was conducted through barter agreements conducted by governments competing and conflicting with one another. Secretary of State Cordell Hull repeatedly pointed out that these monetary and economic conflicts of the 1930s were the major cause of World War II.

Permanently low interest rates for Uncle Sam?

Sunday, November 22nd, 2009

Imagine you owe a lot of credit card debt. And also imagine you have a prodigal son who blew lots of money away in gambling debts and asked you for a bailout. So, you borrow more from your credit card to help bail out your son. Also, your yearly expenditure is projected to keep on rising.

As you borrow more, more and more of your yearly income is spent on debt repayment. What if, in 5 to 10 years time, half of your annual income has to be set aside for the interest payments alone for your debt? In addition to that, what if you have already made promises to your aged parents that you will be responsible for their aged care expense in that time? Eventually, it will come a time when you have to borrow more and more money to pay the interests on your debt. When that day comes, your debt will explode exponentially.

Well, this is the situation of the United States government. In this story, the prodigal son is Wall Street. The aged parents is the coming unfunded social security and Medicare liability of the US government. As the graph from this news article showed,

Interests on US debt

Interests on US debt

Now, what if you can choose the interest rates of your debt repayment. Obviously, you will select the lowest possible rates in order to reduce your debt burden. This is what the Federal Reserve will have to do. As we quoted Marc Faber in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view,

By keeping short term rates artificially low and by monetizing the growing fiscal deficits a central bank digs its own grave in terms of its ability to pursue tight monetary policies when such policies become necessary.

The Fed controls the short-term interest rates. It has keep the rates low because by pursuing tight monetary policy now, the short-run cost of servicing the US government’s debt will be significantly increased. As this?news article reported,

A Treasury borrowing advisory committee reported in early November that “approximately 40 percent of the debt will need to be refinanced in less than one year.

If the US wants to pursue tight monetary policy soon, it will have to deal with the short-term government. One way to deal with it is to refinance the government debt with more expensive longer-term treasury bonds. But the further the term of the government debt, the less the Fed has control on the interest rates.

What if, the free market insists that the US government pay higher interest rates? In that case, the Fed will have to buy up the government debt (i.e. print money), which artificially pushes up the government bond prices (i.e. push down the yield on the government debt). This is highly price inflationary, which in turn will make the government debt even more undesirable by the free market. That will result in the Fed having to print even more!

Which asset class for the next financial markets panic?

Thursday, November 19th, 2009

If you still have lots of spare bullets in your investing arsenal (i.e. lots of spare cash free for investment), it is very tempting to use them up in fear of missing out on further rally. But if your over-riding concern is to preserve your capital in real terms, this is a very difficult market to invest.

For value investors, the proportion of undervalued stocks is decreasing as the stock market continues to trend upwards. Recently, a highly prominent banking analyst, Meredith Whitney has turned the most bearish for over a year:

If you are a technical analyst, you will see that stocks are at an extremely overbought territory. According to the Market Club Trade Triangle, the trend for the S&P500 is still at a very strong up-trend. Statistically, this is the point whereby the risk of a major correction is very high. The previous one is too mild to be counted as a correction (see Aborted correction?).

In terms of property prices, Hong Kong luxury apartments are bubbling away. Base metal prices (especially copper) have recovered strongly from the Panic of 2008. Chinese fly-by-night bidders are reportedly appearing in Australian residential property auctions. The Aussie dollar is approaching parity with the US dollar.

It looks very much like bubbly 2007 all over again.

We are not prepared to use our spare bullets in such a bubbly environment. But if you are based in Australia, we do see a silver lining. The price for gold is rising rapidly in terms of US dollars. But in terms of Aussie dollar, it has hardly risen. In fact, even though it is at a record high in USD, it is down 20% from the March 2009 record high in AUD.

Let’s say there’s going to be a short covering in the USD (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar) due to some deflationary threat. Chances are, gold price (along with commodity and stock prices) in USD will come down. At the same time, stocks worldwide will be down as well, along with the depreciation of the AUD. A falling gold price in USD will be mitigated by the depreciation of the AUD. As a result, Australian holders of gold may not suffer as badly as gold prices in AUD may not fall as much, perhaps even rising should the AUD depreciates very rapidly.

But even in this scenario, there will be a limit to a fall in gold price in USD. As we wrote before in Has gold moved on to a secular shift?, central bankers have crossed the line from being a collective seller of gold to a collective buyer of gold (e.g. Mauritius central bank is now buying gold). The Chinese will see any temporary strengthening of the USD as an opportunity to get rid of them to buy gold.

On the other hand, if there’s going to be a currency crisis, our guess is that gold prices will soar in USD. If the AUD depreciates against the USD as well, we will get soaring gold prices in AUD.

Our speculative view is that (and this is NOT financial advice) if you want to be on the other side of the trade in the next panic (i.e. on the winning side, not on the panicking herd’s side), the currently high AUD may prove to be a stroke of good luck for Australian investors because it gives them a wonderful opportunity to buy gold on the cheap. Not only that, if you are planning to buy physical gold, it helps that Australia is a gold producing nation (you may want to read our book, How to buy and invest in physical gold and silver bullion).

Only time will tell whether this idea will be a winning Black Swan trade.

What will be the next market panic?

Tuesday, November 17th, 2009

It is an open secret that the zero interest rate policy (ZIRP) by the Federal Reserve is fuelling a carry trade bubble as described in Return (and potential crash) of the great Aussie carry trade. In fact, the Chinese are seething with anger as they blasted the Americans as the root cause of blowing asset price bubbles all over the world. As this article wrote,

The US Federal Reserve is fuelling ?speculative investments? and endangering global recovery through loose monetary policy, a senior Chinese official warned on Sunday just hours before President Barack Obama arrived in China for his first visit.

As far as Wall Street and their buddies in the US government is concerned, an orderly decline of the US dollar is not their problem. It is the problem of

  1. The American people because a depreciating US dollar means a lower standard of living for them via price inflation
  2. Export-oriented economies because it makes their wares more expensive to Americans
  3. Countries who more or less peg their currencies to the US dollar because lose American monetary policy implies a lose domestic monetary policy, which helps to ignite asset price bubbles.

Right now, there are two possibilities for the US dollar: a short-term rebound or a Black Swan trigger that turns an orderly decline into a disorderly rout.

The first possibility should be familiar to you- it will probably look similar to the Panic of 2008. Based on technical analysis, the USD is extremely oversold and ought to be very vulnerable to a rebound. Most likely, it will turn out that way: a ‘surprise’ deflationary event (e.g. see Looming Black Swan that can bring the market back into panic) triggers a USD short covering (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar), which will result in a return of fear and panic and then followed by more money printing, stimulus and bailouts.

The second possibility is the really unpredictable one. The flight away from the US dollar may not necessarily be towards the non-US currencies (e.g. AUD)- instead it could be towards precious metals. In that case, we can see some strengthening of the US dollar plus the soaring gold prices in all currencies. Our hunch is that the next big move in the markets is not going to follow the familiar deflationary script of the first possibility- it is just too predictable. Because it is too predictable, Wall Street, Bernanke and the authorities must have already anticipated them and manipulated the markets to prevent it from happening. Hence, perhaps the much anticipated correction will not happen in the conventional form that we expect? Perhaps the deflationists have severely underestimated the cunning of the gang?

But there is a limit to how far that gang can manipulate the markets. When they have a rival nation (China) that follows different set of rules, different forms of governments and whose national interests are incompatible, things are much trickier. We have no doubt that the Chinese, in the quest of their own national interests, are undermining the national interests of the US, whether as an deliberative active policy or as a consequence of their mercantilist pursuits. The intersection between this clash of interests is where miscalculations and loss of control of the markets happen. This is where economics and politics collide.

Our hunch is that the next panic may have something to do with currencies. Should this occur, the only safe haven we can think of is precious metals. As to when and how the panic will look like, we do not know.

Is the world really running out of oil?

Sunday, November 15th, 2009

Many of us would have heard of the threat of Peak Oil to our way of life. To put it very simply, according to the Wikipedia, Peak Oil is the

Peak oil is the point in time when the maximum rate of global petroleum extraction is reached, after which the rate of production enters terminal decline.

Unfortunately, there is a lot of misunderstanding as to what Peak Oil is. For example, in our quote of the news article in our previous post, it reported that

The world is much closer to running out of oil than official estimates admit, says a whistleblower at the International Energy Agency…

This is an example of how the mainstream news media can oversimplify things and subtract knowledge from their readers’ minds. Please note that we are not saying that the news media is useless, but it pays to be careful with what you read, especially with so much vested interests wanting to control public opinion through control of the media.

To add to the confusion, the debate on Peak Oil is as polarising as the inflation/deflation debate with both sides having different motives and vested interests. There are some experts who do not believe in Peak Oil (we are not geologists here, so we shall not get involved in this debate). For example, one of our readers forwarded us this news article by an expert (Leonardo Maugeri, the senior executive vice president of the Italian oil company Eni, and a visiting scholar at the MIT), who believes that there will still be plenty of oil in the 21st century and we need not fear losing our way of life as we know it.

First, let us understand what Peak Oil is not. It does not mean that the world is running out of oil. There are still plenty of oil on this earth. The last drop of oil will not be used up any time soon. But there is a problem. The cheap and “easy to get” oil is getting harder and harder to find and extract.

The best way to understand this problem is to use an analogy. Imagine we have a fruit tree that has plenty of fruits. We have been consuming the low hanging ones for quite a while and are realising that our daily supply of fruits are in decline. No doubt, there are plenty of fruits on the tree. But the problem is, the low hanging ones are getting fewer and fewer and the ones left are hanging higher and higher. That means, we have to expend more work (e.g. using a ladder) to get those higher hanging fruits if we want to maintain or increase (with China & India coming) our daily supply of fruits.

The point of contention is what is means by “low hanging” fruits. Critics of Peak Oil believe that new technologies will help us to extract the higher hanging fruits more easily than before. They believe that mankind will find new ways to extend the lifespan of existing oil fields, extract non-conventional oil (e.g. get the oil from the tar sands), find new oil fields in previously infeasible locations (due to technical and economic reasons) and so on.

As usual, we have to cast a skeptical eye on whatever we read. For example, the news article by Leonardo Maugeri is full of optimism with regards to mankind’s ability to pluck the higher hanging fruits. Perhaps he is a little too optimistic? As we read his article, we can’t help but notice that he is using some kind of turkey thinking- mankind’s ability to innovate in the past with regards to oil-related technologies will see that further innovations is the default result for the future (see Failure to understand Black Swan leads to fallacious thinking). For example, he wrote,

But when new exploration technologies do take root, the results are remarkable.

Fifteen years ago, all this was simply unthinkable.

Of course, being an oil industry executive, he has to walk the talk and be optimistic. We are not saying that he is lying or wrong. We are just exercising our skepticism. We certainly hope he is right. If not, this is a BIG problem for mankind.

Aborted correction?

Thursday, November 12th, 2009

Eleven days ago, when we wrote Stronger signs of a coming major correction, it looks as if the long-awaited major correction was on its way. It turned out that it was a very shallow correction. Gold prices, on the other hand, are hitting record highs in US dollar terms. Commodity prices are in a much weaker up-trend than gold prices. Even silver, gold’s sister, are not as strong as gold.

Indeed, this is a very trying period for investors. In the US, with short-term interest rates at zero, it has become very difficult to value your investments. If cash is yielding nothing (and losing value due to price inflation), how different is it from gold, which also yields nothing? In fact, with gold prices in such a strong up-trend, it is doing much better than cash. In fact, anything is better than cash (US dollar) right now and it has become a very crowded trade, with speculators shorting it into a gigantic bubbly carry trade (Return (and potential crash) of the great Aussie carry trade).

Today, China is hinting that it is allowing the yuan to appreciate (see China hints at resumption of yuan appreciation). Speculators who are already betting on a yuan appreciation will be well rewarded. Very likely, more latecomer speculators will try to squeeze its way into this carry trade too as this sure-profit trade looks too tempting to miss.

Meanwhile, there is a danger ahead- peak oil. As this recent news article reported,

The world is much closer to running out of oil than official estimates admit, says a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying.

Assuming that the world is past its peak oil production and what follows is a downward sloping decline, it can only mean one thing- more price inflation ahead.

And this will break the global economy once again. Meanwhile, be alert for a currency crisis.

Booming real economy, falling stock market?

Tuesday, November 10th, 2009

One of the most common ideas floating around is that the real economy must be on its way to recovery because the stock market, which is often a leading indicator, is recovering. The mainstream economist will tell you that the contradictory newspaper headlines that we showed in our previous article are not really contradictory at all. They will say that since the stock market is a leading indicator, then it will bottom out first before the real economy bottoms out. According to their logic, that’s why you can see rising unemployment and rising stock prices simultaneously.

The idea that the stock market predicts the business cycle is a very dangerous one for the investor. The truth is that, as we said before in Is this a bear market rally or a turning point?,

To be more precise, the stock market anticipates but not predicts turning points. What this means is that economic recoveries are followed from recoveries in the stock market, but a stock market rally does not necessarily indicate an economic recovery.

So, assuming that this stock market rally does not signify an economic recovery, what will be the outcome? The deflationist believes that this rally will eventually run out of steam and collapse into a rout. The inflationist believes that the worse the real economy is, the bigger the bubble in the stock market will be (see Should you be bullish on stocks?) because of unprecedented money printing.

If you subscribe to the inflationists’ view then it follows that should the real economy recovers, then it will be very bad for the stock market. To understand why, consider what will happen if the real economy really recovers:

  1. Stimulus will be withdrawn.
  2. The Federal Reserve will mop up the ‘printed’ money from the financial system.
  3. Government tax revenue will increase sustainably, which means the the size of the budget deficit can decrease, which in turn means that the government will be less sensitive to rising interest rates by the Fed.
  4. The Fed will then raise interest rates.

A truly recovering real economy will result in liquidity draining out of the system. Since the current rally is fuelled by massive loosening of liquidity, draining liquidity will imply that the stock prices will fall and the US dollar strengthens. As the US dollar strengthens, then the short squeeze in the US dollar will happen (see Currency crisis ahead? Part 1- Potential short squeeze on the US dollar), which implies that the Aussie dollar and stock prices will tank.

So, beware of the stock market rally!

Next wave of defaults to come?

Sunday, November 8th, 2009

Is the worst of the mortgage crisis over in the US? This chart below shows that the next wave of mortgage defaults is yet to come:

Upcoming surge of mortgage loan reset

Upcoming surge of mortgage loan reset

For our Aussie reader, the options ARM mortgage is similar to a variable rate mortgage with a few twists, including the ability to choose the payment options. Typically, option ARM mortgages have a very low teaser rate, after which it will reset after a certain period of time (see this Wikipedia article for more information).

The above chart shows that there will be a growing wave of interest rate resets in the coming months, peaking at around September 2011. If the US economy is still mired in higher and higher unemployment by then, then this will mean even more bad debts in the financial system.

This ought to be deflationary (in terms of asset prices). But the Federal Reserve will be stepping up its printing press and the government will step up more ‘stimulus,’ bailouts and so on. The Federal Reserve will be saddled with more dodgy ‘assets’ as well. So, what will happen to asset prices?

No one knows.

But we suspect that we will get to see more and more contradictory news like this:

Newspaper photo cut-out

Newspaper photo cut-out

Thank you, David for kindly emailing this recent photo cut-out on the business section of The Australian.