Archive for January, 2011

Marc Faber: correction coming

Monday, January 31st, 2011

In a recent interview (about a week ago), Marc Faber warned of a coming correction in asset prices. In this correction, he reckoned that emerging markets (e.g. China) will fall harder than the markets of the developed world (e.g. US, Europe).

As he elaborated further, for the past two years, the emerging markets and commodities were doing very well. In fact, so well that there’s talk that China’s economic/political model is superior to the model of the Western liberal democracies because it managed to dodge the GFC and thrived in the aftermath while the developed economies were going nowhere and being plagued by sovereign debt crisis.

However, Marc Faber reckoned that for the next few months, this trend can reverse for a change. The implication is that US Treasuries, US dollar may do very well, while US stocks may outperform emerging market stocks by falling less. So, the S&P500 may correct by say, 10% while Chinese stocks may correct by say, 20-30%.

For investors, it is easy to get lost in the minute details and lose sight of the forest for the trees. For one, it is clear to us that even though the massive money printing exercise of the Federal Reserve is not showing up in the US, price inflation is rearing its ugly head in the emerging economies. In other words, we believe that the US is exporting its price inflation to the emerging economies. This is because all nations are engaging in competitive devaluation of their currencies (to protect their exports in order to ‘stimulate’ their economies). However, since the US dollar is still the world’s reserve currency, the US is able to export the resulting price inflation to the emerging economies.

The price inflation had been growing for the past two years. At first, it seems benign and even seen as a badge of vindication for countries like China. And if you read our article, Turkeys fattened for slaughter in the Chi-tralia bubble, the growth and inflation is fueled by a massive credit bubble and monetary inflation. Since it is an axiom that all bubbles deflates/bursts eventually, there are speculation of when the bubble in the Chinese economy is going to burst.

Judging from the chatter in the blogsphere and mainstream news article, it seems that the spotlight is shifting towards the price inflation and asset price bubble in China. More and more articles like Crouching tiger, soaring cranes, rumbling doubts are telling us that there’re growing doubts on the Chinese economy. As we wrote 12 months ago in Chinese government cornered by inflation, bubbles & rich-poor gap,

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets.

Indeed, price inflation is turning into a serious problem in China. As Patrick Chovanec wrote,

China used to be cheap.? According to figures the World Bank uses to calculate Purchasing Power Parity (PPP), in 2003, a dollar?s worth of currency bought nearly five times as much in China as it did?the U.S.? A?bag of groceries,?or a hairdo, or a hotel room?that would have cost $50 in the U.S. cost only RMB?90, or roughly $11, in China.

Talk to anyone in China, though ? local or expatriate ? and they?ll tell you that, lately, things have been getting a lot more expensive.? When I went back to the U.S. a few months ago, I had the?strange sensation ? for the first time ? that a lot of things were actually cheaper there than in Beijing.

We are increasingly seeing signs that the Chinese government are taking more and more actions to attempt to control price inflation via administrative measures. But with money supply increasing 50% over the past two years, such measures are mere pin-pricks. The exploding supply of money is the root of China’s price inflation problem. And the reason why the money supply is exploding is the peg of the RMB towards the USD (see Why is China printing so much money?).

Unfortunately for the Chinese people, there are too many vested interests (e.g. corrupt officials, provincial governments, big businesses with links to government) in China who wants to keep the credit and asset price bubble going. Since asset price bubbles and price inflation are the symptoms of a common course (monetary inflation), the bias of the Chinese government (and for most governments in the world for that matter) is towards more inflation. Once the root cause of the price inflation is tackled, the asset price bubble will deflate/burst as well. With that, the massive wealth of many vested interests will deflate/disappear as well. Since we doubt those vested interests want that to happen, the price inflation problem will continue to rage in China.

Now, here comes a crucial point. As long as the masses in China believe that the government is working towards ‘solving’ the inflation problem, there are still hope. Indeed, a friend in China told us that her country (i.e. government) is “working its brains” to solve the inflation problem. Unfortunately, this is something that has yet to be dawned on her. As Patrick Chovanec wrote,

I find it incredibly ironic that the two hot populist issues among Chinese citizens these days are the high price of housing and U.S. pressure for a stronger RMB.? People are hot under the collar about both issues, but they never draw stop to think that China?s position on currency (maintaining a weak RMB) might be fueling inflation in the form of?rising housing and other living costs.? ?Of course, I don?t expect average citizens to draw the connection, but economists should.

However, the truth is this: the vested interests who control the government are NOT serious about solving the price inflation problem. The danger is that once the masses realise this, hyperinflation begins. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

So, as it becomes increasingly clear that the current trends in China is unsustainable, investors should watch the reaction of the Chinese government.

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Posted in Economics/Finance, Looking Forward, Market Observations | 3 Comments »

Queensland flood good for economy, says lousy economists

Sunday, January 9th, 2011

A couple of days ago, we saw this article reported in the mainstream news media: A meagre upside, admittedly, but Queensland rebuild will boost GDP.

Oh dear!

Is the mainstream news media so gulliable and stupid that they can’t recognise the opinions of fools dressed up as ‘respectable’ economists? If the Queensland flood will ultimately benefit Australia by? boosting the GDP, why don’t we all do this: evacuate say, Sydney and bomb the hell out of it and surely, the rebuilding of Sydney will boost Australia’s GDP big time and bring great prosperity?

To understand why these economists are fools, consider this essay by Frederic Bastiat in 1850,

In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause – it is seen. The others unfold in succession – they are not seen: it is well for us, if they are foreseen. Between a good and a bad economist this constitutes the whole difference – the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, – at the risk of a small present evil.

What did those fools fail to see?

You see, the rebuilding of Queensland after the flood will consume money and resources from the Australian economy. Tradesmen have to come in to repair broken homes, engineers have to rebuild destroyed infrastructure, household durable goods have to be imported and so on. Those fools can only see that this will boost Australia’s GDP. But what they fail to see is that as a result, these same money and resources cannot be used on other sectors of the economy. The result is a net loss to the Australian economy.

For example, suppose a bridge is destroyed by the flood. Engineers have to come in to rebuild that bridge. Now, consider the case that there’s no flood. These same engineers could be deployed to build a new bridge instead. So, with the flood, we have only one bridge. Without the flood, we have two bridges.

In Australia’s case, we all know that the mining industry grappling with the shortage of skills to build mining infrastructure in order to dig more metals to sell more to China. The last thing they want is for those skills to be redirected to the rebuilding of Queensland. Elsewhere, the Federal government’s nation building projects would most likely have to be postponed to make way for the rebuilding of Queensland.

It is true that more engineers and workers will have to work harder in the coming months to repair and rebuild. That in itself may boost the final GDP number. But it is a fallacy to think that a boosted GDP number implies greater prosperity for Australia. In reality, a boosted GDP number means that the economy has to work ‘harder’ to repair, replace and rebuild what was lost. That makes Australia less prosperous despite the boosted number.

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Posted in Economics/Finance | 12 Comments »

Closing in for the kill in value investing

Monday, January 3rd, 2011

In our previous two articles, Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses and Choosing the businesses with strong economics- Part 2: finding durable competitive advantaged businesses, you have learnt about which businesses to avoid and which ones to look out for as your investment candidates. Once you have identified such businesses, the next question is, when do you make a move to invest in them?

First, you need to have some idea how much that business is worth. Our previous articles, Measuring the value of an investment and Effects of inflation on value of investment will give the mathematical explanations on how to value a business. But do not confuse mathematical precision with accuracy. As we said before in Confusion between precision & accuracy,

As the above-mentioned analogy shows, precisely wrong numbers are useless. If we use them, then the quality of our investing decision will degrade considerably.

For this reason, it is better to be vaguely right than to be precisely wrong.

Second, you must remember this: never ever pay for more than what the business is worth. In fact, it is advisable that the price you pay be of a certain margin (say 15%) below its worth. This is to give you a margin of safety against errors in judgement.

The next step is to wait patiently, stalking the business like a hunter. Eventually, bad news will strike the business, revealing the changes that will occur. Then the stock market will typically overreact, pulling the stock price to a level that is far below what it is worth. That will be the time to strike. The stock market overreacts because it is not rational and suffers the common mental pitfalls that ail every human. To be a successful investor, you need to be more rational than the market collectively. We recommend that you familiarise yourself with the common mental pitfalls as explained in our guide, Common mental pitfalls that leads you astray and Why are the majority so wrong at the same time and in the same ways?.

However, this step is the trickiest one and errors in judgement are most likely to be made. Bad news comes in two flavours:

  1. Changes to the business are temporary and therefore, a recovery will eventuate in due time.
  2. Changes to the business are permanent and therefore, there will be no recovery.

Thus, you have to discern the nature of the changes, understanding whether the context of the underlying trends in which the business changes occur is secular or cyclical (see Understanding secular vs cyclical). For example, as we explained before in Should value investors be ?bullish? in a bear market?,

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ?typical? bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current ?Buy? recommendation will be very wrong.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

This is where value investors are most likely to get wrong.

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Posted in Investor Education, Value Investing | No Comments »