Posts Tagged ‘liquidity’

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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 Stimulus will be withdrawn.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!

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Posted in Looking Forward, Market Observations | 2 Comments »

Marc Faber: Asset Markets May Rebound Within 3 Months

Tuesday, November 25th, 2008

Back in Bear market rally on the works?, we explored the possibility of a stock market rally in the context of a bear market. We wrote,

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

  1. It does not mean that prices cannot go down further in the short-term. Who knows, perhaps there will be more panic selling in the days to come, thus bringing the technical indicators into even more extreme levels?

More than a month had passed and everyone could see that the panic selling had intensified. It is only since a couple of days ago that there was some kind of bounce. Naturally, many investors are extremely wary of this. Many of them will take this opportunity to sell.

Interestingly, Marc Faber had this to say in this interview:

What you could see in the next three months is a very strong rebound in asset markets, in equities, followed by a selloff in bonds and eventually a sell-off in the dollar.

Why is the reasoning behind Marc Faber’s view?

Firstly, based on statistical probability, the market for stocks, non-government bonds and commodities are at a level that is even more oversold than the infamous 1987 crash. Therefore, based on history’s lessons, a rebound is likely to happen soon. As we mentioned before in Bear market rally on the works?, even during the infamous bear market of the Great Depression, there were many multi-month rebounds before stocks bottomed out in 1932. The only argument against this line of reasoning is the Black Swan argument (see Failure to understand Black Swan leads to fallacious thinking). Who knows, perhaps 2008 will go down in history as the worst ever bear market that is unprecedented in the entire history of human civilisation? In that case, as Marc Faber cautioned,

Statistically a rebound should happen, but if it doesn’t “the air is out” and the world faces an economy “worse than the depression of ’29 to ’32,” he said.

Next, the key to understand why a rebound can happen is that

But “I assure you if you throw enough money at the system, eventually you can reflate, especially in the United States,” Faber added.

What is happening is that despite the gigantic deflation in asset prices all over the world (around US$60 to $100 trillion of ‘value’ had gone up in smoke), governments are trying their hardest to pump liquidity (money and money substitutes) into the financial system and spending their way into budget deficits. Consequently, financial institutions are sitting on a huge pile of cash as they sell their assets and hoard it. The problem with ‘cash’ (the safest ‘cash’ is Treasury bills and government bonds) is that they have practically no return. Therefore, it is only a matter of time before the overwhelming volume of liquidity burst the seams and triggers a rally. As Marc Faber said,

If the market continues its sell-off, there will be more capital injections and more liquidity creation and one day it will trigger a huge rally where people rush out of cash into assets because they will become not concern about deflation but concern about the monetary impact of this liquidity injection on asset prices and so they rush in to hard assets whether it’s land or raw materials, in particular gold.

In such an environment, we will happen to the value investing philosophy? We will talk more about that soon.

In the mean time, what do you think will happen to the global equity market in 3 months time? Vote and express your thoughts here! (Today, we will do something a little different- we will close the comments for this post so that you can vote and comment here instead. You need to register first before you can comment and vote).

P.S. In 3 months time, we will re-visit this vote and see whether you, our dear readers, are right or not. 🙂 We will close the vote in 10 days time, so hurry with your votes.

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Posted in Looking Forward | Comments Off on Marc Faber: Asset Markets May Rebound Within 3 Months

Fading glory of the financial services and ‘wealth’ management industry

Sunday, November 2nd, 2008

October has just passed and it will go down in history as one of the worst months in stock market history. Even many veteran traders have not seen anything that bad before. As Marc Faber said in a recent Lateline interview (on 13 October 2008),

As of last week, world stock markets became oversold. Statistically probably the most oversold condition in the last 50 years or so.

One good gauge of fear in the stock market is the Volatility Index (VIX) indicator. As you can see from the chart below, the VIX spiked to its record high level (since 1990) at above 80 in October.

VIX indicator since 1990

Consequently, such intense level of fear had provoked the government into making up policies as they go and then tweaking away the side effects as an after-thought. For example, when the government gave unlimited guarantee to bank deposits, fearful money began to defect away from investment funds into banks. As these funds reacted by freezing redemptions from investors, prompting a crisis on their investment business. Some of these investment managers then pleaded with the government to guarantee their investment funds. We could sense the underlying sarcasm of the government officials as they replied by ‘taunting’ these investment funds to become banks if they want to fall under the protective umbrella of the government.

The global financial market had never been subjected to so much fear for a very long time. The sheer terror of a global financial meltdown had provoked knee-jerk reactions from governments, regulators, central banks, investors, traders and the humble savers. Beneath the raging waters of fear, panic, reactions and counter-reactions, the many decisions made on the spur of the moment by governments, regulators, and central banks will be judged by history to be turning points. These decisions will have many long-term side effects that are not immediately apparent. At this point in time, although there are signs that the panic is starting to melt away and calm gradually returning to the market, the lingering smell of mass ‘wealth’ destruction will still remain for a considerable period of time.

As we mull through the long-term ramifications, our thoughts are drawn to the future of the investment and financial service industry. The first effect we can think of is the loss of trust and confidence on the idea of ‘wealth’ management. Much of the panic selling in October was contributed by investors redeeming their money from managed funds and stuffing them towards the proverbial cash under the mattress (i.e. treasury bonds, guaranteed bank deposits and even gold). The number one priority was not return on their money. Rather, it was return of their money.

Our stand is that the trust and confidence on the idea of ‘wealth’ management through ‘investments’ in financial assets was a misplaced one. The whole idea of ‘investments’ was based on a massive bubble. As we said before at Have we escaped from the dangers of inflation? in February 2007,

Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the financial system.

…

With all these flood of fiat money inundating the global financial system, we look at all these skyrocketing financial asset prices with a yawn. Price bubbles of all sorts are found everywhere in the world?from Chinese stocks, junk bonds to private equity booms. Back here in Australia, it looks to us that nowadays, everyone is ?playing? the stock market, many using leverages like CFDs and margin lending. We hear stories of novices ?investors? opening a trading account to ?learn? how to trade. The logic is simple: central banks around the world are hard at work ?printing? money. These monies first go to the financial system, creating price bubbles. The bubbles then attract speculators, gamblers and punters into the asset markets the way bees get attracted to honey. Soon, word get round to the masses and they want a slice of the action too.

Over the years, central bankers are creating copious amount of money and credit out of thin air. The masses then take on the delusion that these fiat money are real wealth. As we asked before in The myth of financial asset ?investments? as savings,

Can the printing of money, which spawns the growth of an industry to shuffle it, cause a nation to be richer in the long run?

There were so much money and credit conjured from thin air that an entire industry (i.e. financial service and investment industry) has to be bloated beyond its fundamental use in order to shuffle them. As we said before in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

Thus, the global credit crisis is a return back to reality as the masses wake up their idea that all these ‘wealth’ are illusionary. As we quoted Ludwig von Mises at The myth of financial asset ?investments? as savings, real wealth is based on real capital formation. Shuffling money and competitive chasing after assets with fiat money do not make a nation any richer.

Alas, there are still many who still do not get it, even when the threat of a Great Depression II is gathering at the gates of the global economy. For example, in Australia, the Opposition Leader, Malcom Turnbull still speak of the ‘savings’ trapped in investment funds due to the Australian government’s unintended side-effect bank deposit guarantee. The fact that he is using the concepts of savings and investments interchangeably to refer to the same thing shows that he has no idea about what he is talking about.

Dear readers, to be a successful investor, you have to understand the difference between savings and investments. We urge you to read The myth of financial asset ?investments? as savings. The entire superannuation and wealth management industry is based on the myth that investments (especially ‘investments’ in financial assets) are savings. Consequently, the build-up of mal-investments that such a myth introduced brought about the financial crisis that we have today. Real investment brought about real capital formation, which is the cornerstone of real wealth in the future.

As far as we can see, the bull market (in real terms) on financial assets is over. What comes next is either deflation or stagflation. The implication is that peak glory (2001-2007) of the financial service and wealth management industry will be history.

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Posted in Looking Forward | 26 Comments »

Is it a liquidity or solvency crisis?

Monday, May 5th, 2008

As you would have read by now, Warren Buffett declared that

The worst of the crisis in Wall Street is over. In terms of people with individual mortgages, there’s a lot of pain left to come.

As this Bloomberg article, Buffett Says Credit Crisis Ebbs for Wall Street Firms (Update4), reported,

Warren Buffett, chief executive officer of Berkshire Hathaway Inc., said the global credit crunch has eased for bankers, and the Federal Reserve probably averted more failures by helping to rescue Bear Stearns Cos.

Clearly, the market is in agreement with Warren Buffett, with the stock market rallying in the belief that the worst of the credit crisis is over. So, could the credit crisis be just a liquidity problem? Or is it a more serious solvency issue? What is the difference between the two?

Well, let’s use the pawnshop analogy from our previous article, Central banks and pawnshops. Let’s suppose that Tom had a big mortgage debt, recurring bills to pay and a nice well-paying job and no savings. Let’s say he resigned from his job to take up another well-paying job. The only catch is that in between these two jobs, there was a period of 2 months where he would draw no wages. Since he had no savings, this will mean that he would be unable to pay his bills and his mortgage debt repayments. Not to worry, Tom went to the pawnshop and pawned his gold jewellery for cash to pay his bills and mortgage debt. Then when his new job starts, he will draw out his salary to repay his loan from the pawnshop and redeem his gold jewellery. Tom had a liquidity problem. Fine.

What if, Tom was retrenched from his job and for the next 12 months, could not find another job? He could pawn his gold jewellery, but as long as he did not have a job, he would not have any hope of repaying his loan from the pawnshop in order to redeem his gold jewellery. The next month arrived and he had to pay that month’s bills and mortgage repayment while his gold jewellery was still stuck at the pawnshop. Tom is getting more desperate. Perhaps he can pawn his silver jewellery? Fortunately, the pawnshop was as willing as the Fed. It accepted Tom’s silver jewellery for the same amount of cash as the previous loan. Tom was saved for another month. Obviously, Tom had a solvency problem. That’s bad.

So, is the credit crisis a liquidity or solvency issue?

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Posted in Economics/Finance | 34 Comments »

What lies ahead for the Australian economy in the coming years?

Sunday, April 6th, 2008

As we can see, over the past several months, there had been a lot of volatility in the global financial markets. As we said before in Why is the market so easily tossed and turned by dribs and drabs of data?, without the proper framework of sound economic theory, the outcome is that the lack of deductive reasoning and insights brought about the situation where the

… market gets tossed and turned by every minute variations of statistical information from economic reports. The end result is confusion and volatility.

Clearly, this shows that the media, pundits, investors, traders and other market participants do not know what is going on.

Today, we will present to you what we believe to be the long-term big picture. Our opinion is by no means a prediction in the forecasting sense- rather, it is just our feeling, intuition and guesses (maybe one day in the future, this opinion will be famously known as ‘insight’ or ‘foresight’?). Therefore, do NOT take our opinion as financial advice- we are not financial advisers and our conviction is that one should be ultimately responsible for one’s own investment and financial decisions.

Okay, here comes the meat…

Firstly, our belief is that the US economy is heading for a hard landing. Currently, Ben Bernanke’s forecast is that economic growth will pick up in 2009 after a possible mild recession. This is also the belief of the market, as it tentatively believes that the credit crunch is abating. We are sceptical of this view. After all, years of accumulation of bad debts, over-leverage, mal-investments and structural damage of the US economy cannot be simply brushed away with the turning of interest rate levers, money ‘printing,’ bailouts and sweet talks. As we explained 13 months ago in Marc Faber on why further correction is coming- Part 2, the liquidity contraction that started in the US is resulting in the process of global asset price deflation, especially house prices in the US. As asset prices deflate, this will bring about further bad debts, which in turn will bring about further deflation in a vicious cycle.

Next, as it especially applies to the Western developed world, the financial side of the economy has grown to be a major intertwined component of the overall economy. As we said before in Analysing recent falls in oil prices- real vs investment demand, the difference between the real and financial side of the economy is that the

.. real side [is] where you find the physical market for goods, services and labour. The financial side is where you find the flow of financial capital, assets and payments.

It can be argued that today, the financial side of the economy had grown beyond its original supporting role of efficiently and flexibly allocating capital for the real-side of the economy, to the point of playing one of the primary roles in the economy. In any case, both sides are interlocked hand-in-hand with each other, which means any shocks to the financial system will affect the real economy and vice versa. To illustrate this point, take the case of Australia. With the vast majority of working Australians parking their retirement savings through the superannuation system, which in turn distributes the savings into financial products (e.g. managed funds), which in turn further distribute these savings into the financial asset markets (e.g. stock market). Furthermore, even ownership of physical assets (e.g. property) requires credit, which in turn is sourced from the financial system. And when it comes to credit, developed Western economies like Australia have been gorging on them to fund anything from credit card debts, personal loans, car loans, stock investment through margin lending, store cards, etc. Therefore, you can see that any breakdown in the financial system will have serious and dire consequences on the rest of the real economy.

For Australia, it seems to be at a sweet spot. The voracious Chinese demand for commodities have been a windfall for Australia, which has vast reserves of resources to supply the Chinese economy. That, along with a highly advanced financial system helps spread the prosperity to the rest of the nation to some degree. But the dark side of this prosperity is the build up of leverage (debts) to a dangerously high level (see Aussie household debt not as bad as it seems? and Australia has no sub-prime debt? Think again!).

Now, there are dark clouds in the horizon. The global financial system had never been as interconnected as before in the history of capitalism. You can be sure that any trouble that begins in the US financial system will spread to the rest of the world. As of today, there are murmurs about the credit crunch being the most serious crisis since the Great Depression. As the financial system rot in the US economy spreads into its real side, you can be sure that Australia’s financial system will be severely affected as well. The Australian economy (along with other Western economies with advanced financial system like the US and UK economies) are highly leveraged (i.e. burdened with far too high levels of debt) both at the retail household level and at the institutional level. Already, we are hearing about bankruptcies, blow-ups and traumatic losses in the global corporate sector (e.g. Allco, MFS, Fincorp, Centro, Basis Capital, ABC Learning Centre, Tricom, Opes, Bear Stearns, UBS, Citigroup and too many more to list). The Australian household sector is feeling the debt stress (e.g. mortgage stress, housing affordability and rental crisis, soaring personal debt levels, etc). As we said before in Rising price of money through the demise of ?shadow? banking system),

Australians love their debt too much. From the large current account deficit (see Understanding the Balance of Payments), much of Australia?s debts are sourced from overseas. With the demise of the global ?shadow? banking system, the price of money in Australia has to rise too.

A highly indebted nation cannot afford to have the price of its credit rise without acute consequences. Thus, University of Western Sydney (UWS) Professor Steve Keen believes that a severe recession induced by debt deflation will arrive at Australia within 2 years.

The question is, will China save Australia from this?

For one, the rot in the global financial system may not affect the real side of the Chinese economy directly. This is because the Chinese financial system is still rather primitive compared to the advanced Wester economies. For example, there are still hundreds of millions of peasants toiling in the countryside. Those who migrated to the cities to toil under the factories are still not plugged into the developing Chinese financial system. Therefore, unlike the Western world, a bearish Chinese stock market does not necessarily forecast doom for the wider Chinese economy. As a result, the credit crunch that started in the US will have a limited impact on the real side of the Chinese economy. So far, this is good news for Australia (but Australia is not out of the woods yet).

Therefore, our opinion is that when the inevitable severe recession hits the Australian economy soon, the Australian mining (and related) sector will probably be the only bright spot in the darkness. In fact, we can argue that a recession may perhaps even be beneficial for the mining sector as much of the idle resources (caused by the recession) in the economy can be re-allocated to the mining sector (see How is Australia?s mining boom sucking resources out of the economy?).

But here comes the bad news.

Firstly, in a hard landing of the US economy, the real side of their economy will be crunched as well. Our theory is that this may lead to a more than proportionate contraction in the investment activities that dominates the Chinese economy, which will trigger a hard landing in the Chinese economy. Even if this theory turns out unfounded, there is another worry- the Chinese economy may not have enough resources supplied to it fast enough to maintain the trajectory of its economic growth. When that happens, the risk is that the trajectory may be shot down, resulting in the forced liquidation of all these mal-investments. The outcome is a big Chinese bust. Our article, Can China really ?de-couple? from a US recession? has the full explanation of our theory. When that happens, the last leg supporting the Australian economy will be kicked off. This is the worst-case scenario for the global economy (and by extension, Australia). Our feeling is that the coming Chinese bust may come with a time-lag after the US hard landing. If our theory about the more than proportionate contraction in Chinese investment holds true, then the time-lag may be shorter.

But yet again, this may not be all bad news in the longer run. If China’s rise is a secular event (see Example of a secular trend- commodities and the upcoming rise of a potential superpower) of the 21st century, then Australia can still climb out of this worst-case scenario.

Please note that we are not making any predictions here. Our vision is very far out into the future. Generally, the further one ventures into the future, the more likely unforeseen Black Swans will sneak in to turn one’s vision into fantasy. But as the old adage says, prepare for the worst but hope for the best.

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Posted in Looking Forward | 4 Comments »

Have we escaped from the dangers of inflation?

Sunday, February 25th, 2007

Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the financial system. The growth of money supply of major economies is estimated around or above 10% per annum, with China having the dubious ?honour? of being near the top at 18% (see Why is China printing so much money?). The top ?honour? goes to Russia, with their M2 money supply rising a whopping 48.8% from the beginning of 2006 to beginning of 2007 (see the figures at the Russia Central Bank web site here).

With all these flood of fiat money inundating the global financial system, we look at all these skyrocketing financial asset prices with a yawn. Price bubbles of all sorts are found everywhere in the world?from Chinese stocks, junk bonds to private equity booms. Back here in Australia, it looks to us that nowadays, everyone is ?playing? the stock market, many using leverages like CFDs and margin lending. We hear stories of novices ?investors? opening a trading account to ?learn? how to trade. The logic is simple: central banks around the world are hard at work ?printing? money. These monies first go to the financial system, creating price bubbles. The bubbles then attract speculators, gamblers and punters into the asset markets the way bees get attracted to honey. Soon, word get round to the masses and they want a slice of the action too.

Let us tell you a ?secret:? do you know that Zimbabwe?s stock market is now booming too? Do you know why? The reason is not because Zimbabwe is getting richer, but because its currency is becoming worthless with hyperinflation (see Zimbabwe: Living with hyperinflation). As we said back in October last year in Divergent sentiment, ?you can make the Dow Jones climb as high as you want as long as you print enough money.? That is what is happening in Zimbabwe.

As we said before in Example of inevitable effect of monetary inflation, we are very sure that as all these liquidity work its way to the rest of the real economy, it will only be a matter of time before price inflation will show its ugly head. Yet we are simply amazed with Wall Street?s obliviousness to this danger and Ben Bernanke?s incredibly sugar-coated words in his recent economic report to Congress. Can we rely on the Chinese to forever keep the price of importable things down to save us from inflation? We very much doubt so?they have their own inflation problem to handle (see Cause of inflation: Shanghai bubble case study).

The root of the hell of price inflation is fiat currency. Make no mistake about this: in all of human history since the beginning of time, there has never been a time when fiat currencies did not become worthless eventually. For example, the ancient Chinese, during the Song Dynasty (960-1279), had tried it before, even using self-expiring fiat money in an attempt to prevent inflation. The Mongols? use of fiat money to fund their occupation of China was eventually ended by the subsequent Ming Dynasty (1368-1644). Today?s current fiat money experiment only began in 1971 (see A brief history of money and its breakdown- Part 2). How much longer can it last? We do not know but we hazard a guess that it is very much possible for us to see that day in our lifetime.

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

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Posted in Economics/Finance, Gold, Looking Forward | No Comments »

363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?

Thursday, February 15th, 2007

Recently, this news report came up in CNN: Lawmaker: U.S. sent giant pallets of cash into Iraq. In this report, 363 tons of cash (worth $4 billion) were loaded into pallets and transported via military transport aircraft into Iraq ?shortly before the United States gave control back to Iraqis.? Needless to say, much of the cash went unaccounted for.

As we said before in A brief history of money and its breakdown- Part 2, when much of the world was under the gold monetary standard, nations only go off that standard under exceptional circumstances, such as war. This is because war is always prohibitively expensive and thus, can only be financed if fiat money is used. Today, we look with disbelief at such a gross abuse!

Back in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned that when money is ‘created’, the ?outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom.? Imagine what this $4 billion of cold hard cash is eventually going to do to global liquidity! To see what will become of these monies, let us examine how this massive quantity of physical cash is going to swell the total money supply, which includes bank deposits. Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let’s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%). Thus, for example, a ratio of 5% can swell the quantity of money up to the theoretical limit of 20 times.

The next question is: what is the reserve ratio? We took a look at the Federal Reserve?s requirements on reserve here. Depending on the amount on deposit, the ratio ranges from 0% to 10% (a ratio of 0% means that money can be created by the banks to a theoretical limit of infinity). Anyway, whatever the answer to this question, $4 billion of physical cash will eventually spawn many more times worth of liquidity into the financial system. It certainly would not help in the ?fight? against inflation.

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Posted in Economics/Finance, Geopolitics & Politics | 6 Comments »

Spectre of deflation

Tuesday, January 23rd, 2007

For too long, money around the world had (and still is) been too cheap. There are all kinds of asset booms around the world, from Shanghai properties to US bonds. Stocks around the world are hitting record highs, with the consequent emergence of private equity booms and hedge fund crazes. Along with that, we have all kinds of grotesque imbalances?record consumer debt, negative savings rates and massive current account deficits in the US, Britain and Australia (with the corresponding massive current account surpluses in China and the oil-producing countries).Such good times can never end right? Many financial analysts predicted that 2007 will be another year of abundant returns in the Australian stock market as the sheer weight of more local superannuation ?investments? and Chinese and Middle-Eastern money heads towards the Aussie financial markets to find a home (see More Chinese and Middle Eastern money heading Down Under: recipe for inflation?). Maybe those analysts are right. But don?t you see the absurdities? Nowadays, it seems that the path to great wealth is to be good at shuffling money in the financial markets?speculation, trading, acquisition, borrowing and charging fees for gambling other people?s money. To lubricate all these wealth ?creation? activities, central banks around the world are running the money printing press at top speed in order to conjure up the necessary liquidity grease to be injected into the financial system.

But we smell danger.

It is a danger in which many in the finance industry failed to fully appreciate?deflation. Such complacency is beyond our belief. In the 1990s, Japan experienced it, with dire consequences for their economy. At least, the ordinary Japanese had their savings to fall back on. For many Americans, with their negative savings rate, what can they fall back on? Have they not learned from the mistakes of others in the past?

Before we delve further into the topic of deflation, let us clear some misconceptions about it. Inflation is popularly misunderstood as the general rising of prices. As a result, deflation is also commonly misunderstood as the general falling of prices. But such concepts of inflation and deflation are merely the effects of a root cause. We suggest you read our previous article, Cause of inflation: Shanghai bubble case study for the background understanding of the true nature of inflation and deflation. Henceforth, we will now define deflation as the contraction of liquidity (money and money substitutes) relative to the available goods and services in the economic system.

In our previous article, Liquidity?Global Markets Face `Severe Correction,? Faber Says, we asked the thought-provoking question: Are we now ripe for a contraction in liquidity? Given the colossal leverage in the global financial system, if there is going to be a severe and sustained contraction in the amount of liquidity, the effect will be a downward deflationary spiral in asset prices, which can lead to deflation in the real side of the economy.

Why is it so?

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. The borrower?s liability then becomes the lender?s asset, which in turn is being used as collateral for the next round of borrowing. Conceptually, this is how the liquidity pyramid (mentioned in Liquidity?Global Markets Face `Severe Correction,? Faber Says) is made up of. As you can see by now, if the original assets? imputed values crash (which can happen easily), it will have a cascading effect on all the other assets? values further down the chain. If this chain-effect spirals out of control, it will result in the wiping out of vast financial wealth (this is how global liquidity contracts). The outcome is a gigantic deflation of epic proportion.

Since the majority of the world?s liquidity is made up of derivatives (which obviously derive its value from another financial asset) valued at hundreds of trillions of dollars, we shudder to think what will happen if that derivative bubble burst. There is a reason why Warren Buffet calls them ?financial weapons of mass destruction.?

What can the Federal Reserve do if this happens? Should it let the bubble burst in order for a resulting depression to clean up the colossal excess? Or should it print copious amount of money for the financial system to remain solvent, thus resulting in hyperinflation?

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Liquidity?Global Markets Face `Severe Correction,’ Faber Says

Tuesday, January 16th, 2007

Marc Faber, the legendary contrarian, predicted the 1987 stock market crash, had this to say. He singled out emerging markets for a correction, especially Russia, followed by China (see China is tightening liquidity) and India. In that correction, all asset markets will be affected.

What is the rationale behind Faber?s prediction?

First, we have to understand the concept of ?liquidity.? What is ?liquidity?? There are other meanings for the word ?liquidity?, but for the purpose of this article, we will stick to the quick and dirty definition of ?liquidity? being ?money? in the financial system. Now, how do we define what is the ?money? in liquidity? Traditionally, ?money? is just what it is?cash and deposits. But today, with the advances in finance, ?money? is no longer as easily and clearly defined as before. As a result, money substitutes are becoming proxies for money and playing a much more important role in global liquidity than before. Examples of money substitutes include credit (e.g. mortgage-backed securities) and derivatives.

Now, what has liquidity got to do with the asset markets?

As you may have noticed, stock markets around the world are in record high territories. What is driving the stock markets is liquidity?the sheer weight of money and money substitutes chasing after a limited supply of assets (bonds, stocks, art, etc), resulting in skyrocketing prices. Therefore, any crunch in liquidity will result in collapsing asset prices.

How is it possible for liquidity to be crunched?

The problem with liquidity is that most of the ?money? in it is made up of money substitutes, most notably derivatives. Today?s modern financial system is such that when the central bank ?creates? money, money substitutes get spawned multiple times. The outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom. The financial assets between the apex and bottom include cash deposits (spawned and multiplied from hard cash through the fractional reserve banking system) and credit (e.g. securitised debt). In such a liquidity pyramid, the values of financial assets at the lower part of the pyramid are derived from and backed up by the financial assets above it. Since much more of global liquidity are composed of ?money? in the lower part of the pyramid, any contraction in the upper parts of the pyramid will result in a multiplied contraction in the lower parts. If the liquidity contraction is severe enough, asset prices will fall precipitously, which in turn may trigger even more contraction in liquidity. This is called a ?market crash.?

Thus, as long as the central bank can influence the increase in liquidity into the financial system, asset prices will rise. If for whatever reason, liquidity contract severely enough, asset prices will collapse.

The question is, are we now ripe for a contraction in liquidity?

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Posted in Looking Forward, Market Observations | 4 Comments »

Are stocks good value?

Monday, January 1st, 2007

In 2006, we ended the year with the Dow up by 16%. The market cheerleaders in the financial media had been busy extolling the performance of the stock markets. In fact, stocks around the world, from China to Australia, performed greatly in 2006. It seems that the best place to make money is in the stock market. In Australia, the market professionals see that with the weight of the masses? superannuation money needing to find a resting place, the stock market is sure to continue its momentum upwards in 2007. Indeed, for one to suggest otherwise, one runs the risk of being labelled a fool.

For us, as contrarians, we have reservations on the whole charade. The truth is, there is still too much liquidity (money, credit, etc) in the financial system. And this liquidity is the driving force behind the stock markets? performance. Sure, stocks can continue to rise in 2007 due to the sheer weight of money sloshing around the globe. But we would like to repeat the point we made earlier in Divergent sentiment: You can make the Dow climb as high as you want as long as you print enough money (that is, provide enough liquidity). In fact, if you run the printing press hot enough, anything that you ?invest? in will increase in price. As mentioned in an example in How is inflation sabotaging our ability to measure the value of things?, with Zimbabwe?s inflation rate in the order of thousands of per cent (in May 2006), almost anything you buy in Zimbabwe will increase in price by 100-fold after a year has gone by. But are you better off by a 100-fold if you do that? Of course not! In Zimbabwe?s case, all it meant was that the money had become worthless!

This is the point we are trying to make.

Although a hot printing press may make stocks rise giddily in the short term, they will eventually lose their value against something that is fundamentally valuable. So what if the Dow rose by 16% in 2006? From 14th January 2000, the Dow was at a high of 11722.98. Today, the Dow is only 12463.15. In 7 years, the Dow had only risen 6.3%, which is only a growth rate of 0.88% per annum! Therefore, if you invest in the Dow over that period, you are poorer in real terms (that is, after price inflation is taken into consideration)! Gold, on the other hand, rose from around US$280 in 2000 to US$634.30 today. In 7 years, gold had rose 126.5%, which is a growth rate of 12.50% per annum. And this is just gold. If we bring on silver, zinc, copper, oil and so on, it is clear that metal commodities beat stocks by a far margin!

The truth is, it is not just that metals had soared in prices. Rather, global currencies (including the US$) had lost their value against the metals. As we said before in Entrenched perception on the value of paper money, with the way central banks around the world are inflating the supply of currencies, there is little wonder that currencies are increasingly becoming more worthless. In addition, with the rise of China and India, the increasing physical demand of these metals is not going to abate anytime.

Is stocks generally still good value? We doubt so. We still prefer hard assets (or stocks of companies that are producing these hard assets).

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