North Korean Nuclear Test Shows Growing Importance of Emerging Markets
North Korea recently detonated a new, larger atom bomb, three times the size of their first one that was detonated six years previously.
The implications for investors are that isolated, underdeveloped Emerging Markets economies (called Frontier Markets) can successfully engineer some manufacturing processes that meet Developed country standards.
It is no longer correct to assume that EM countries’ economies primary economic activity is to exporting goods to Developed countries. The Developing world, in some very poor areas, has become surprising sophisticated. In Ethiopia a car manufacturing plant is under construction. In the most remote area of Nepal they have good quality helicopter rescue and cell phone and internet service. In the most rural part of China in Xinjiang province (near Kazakhstan) I saw signs of Developed country consumption. If sophisticated economic activities can occur in the most primitive markets then that means the old paradigms that the world economy revolves around the G-7 countries will gradually evolve into a new paradigm.
The new paradigm will be somewhat similar to the evolution of world oil markets away from OPEC dominance and towards more geographically dispersion into areas such as Africa, Indonesia, Venezuela, etc. It is possibile that the less debt encumbered Emerging Markets countries will be able to provide the growth factor that the world needs to earn its way out of a generation long debt bubble.
The growth of North Korean and Iranian nuclear threats shows that the Developed world will increase defense spending which will also help to secure good paying jobs for a segment of the population that may have been hurt by globalization, thus stimulating the economy.
I have written an article “Black Swans and risk aware investing” and “Korean missile launch effect on the economy”.
Investors should seek independent financial advice.
The Coming U.S. Economic Boom
The huge increase in the supply of U.S. produced natural gas produced by fracking has pushed natural gas prices below $2 and created a key precondition for economic revival. Other developed countries except Canada don’t have this huge source of cheap energy, so global manufacturing will gradually migrate into the U.S. This will take a long time to retool or relocate pipelines, cars, factories as well as retraining unemployed workers. Since bearish experts have said that the stock market will be in a bear market until roughly 2016 to 2018 then the natural gas fueled recovery may occur about then.
Of course the consumers who have too much debt will need to reduce spending so as to be able to pay off debt and this will keep the economy depressed for a long time. Also the need to raise taxes and cut government spending will make the economy depressed. It usually takes seven years for consumers and businesses to deleverage by paying down debt or selling assets, so seven years after the 2009 crash would imply a bottom will be reached in roughly 2016. The natural gas glut can act to lure businesses into spending on retooling because using natural gas saves money on things that people would have bought anyway. Thus part of the recovery can occur even while consumers are being stingy.
Open the door to new ideas
The ultimate cure for the recession will be when workers who are unemployed put out a sincere effort lasting many years to get retrained into a more productive new career. A stubborn refusal by a person to change careers or a refusal to change product lines for a business will make it very hard for the economy to get out of the recession.
Things are different from when I wrote an article last year “Bearish fundamentals in the news”.
Investors should seek independent financial advice.
When will the Fed tighten? The Fed wants to stimulate the economy until full employment has been reached. When the unemployment rate comes down close to full employment that causes inflation, assuming the money supply has increased. The Fed has two mandates: increase employment and control inflation. Since inflation per PCE and core CPI is 1% then the Fed’s priority is to create employment. So they won’t tighten until they have gotten close to full employment, as defined by the “Natural rate” of unemployment, which is 4% but may be redefined as 6%. The Fed is run by academic, idealistic people who want to move very slowly and carefully before deciding to tighten. If run by business owners the Fed would probably move faster to tighten when the time comes to tighten and with less verification of inflation.
Because there are so many structural problems to the economy it is not a normal, mild recession but rather a soft depression (like in Japan), so it may take years before conditions merit tightening.
The fact that the Fed is undecided about whether to change QE2 or to do QE3 implies that they do not know when or how the unemployment rate (where counting discouraged workers it is 16%) will recover. It is necessary to go back to the Great Depression to obtain similar data but unfortunately that era was so long ago that its relevancy is somewhat doubtful. So this means traditional analytical tools are not reliable. There has been no solution or resolution of the housing problem; the banks with bad loans have been authorized to avoid marking to market and instead carry at book value. So a huge part of the economy is weak and has no hope of getting better for several years. Much of corporate America’s profit and liquid assets are held overseas in tax-deferred subsidiaries where the cash, profits and jobs can’t be sent to America, yet some of those subsidiaries profits help make America’s economy look better. What is more real and relevant to U.S. employment: the local housing market and the jobs associated with it which can’t be exported, or the book entry profits of U.S. multinationals that have a profitable subsidiary overseas? My point is that if we strip away profits and economic activity of multi-national corporations and look at strictly domestic economic activity then things are not so good. Of course Commerce Department surveys require that foreign subsidiary activity be reported separately but Wall Street loves to brag about corporate profits by using the consolidated figures issued by corporations (that include foreign subsidiaries). So investors only hear Wall Street’s optimism instead of looking at the dry details that professional economists see. So the best analogy is to use the Great Depression and the Japanese soft depression and see how they lasted for over a decade. I have written posts here and here about this.
This is an example of independent investment advice.
Inflation is not coming back for several years. The unemployment statistics are inaccurate because they show a huge drop in unemployed people in the past two months but this is due to discouraged job seekers dropping off the radar. The U-6 meaure of unemployment continues to be about 16% Recent reports of wholesale price increases of 0.5% a month, which is 6% annualized are a concern but if the Chinese economy cools down then commodities should cool off and that will take the steam of out of the wholesale price increases. For two years U.S. wages have dropepd and that is key determinant of inflation. With high unemployment that is not improving there is very litle risk of inflation, which means that bond proces are not too high.
Assuming the Shiller PE 10 reading of 24 is a reliable gauge of equities then the market is overpriced and due for a correction, with the SP headed to 900. Further, if hedge funds suffer sudden margin calls during another "flash crash" then this could make matters worse as they would be forced to sell off good high quality very liquid stocks in order to meet margin calls, which would in turn raise the cost of Put options used by hedge funds so that they could not afford to be highly leveraged, whch would lead them to do more selling of equitiies. The VIX is very low and eventually it will go up, which would make it harder for leverged speculators to go long on equities. This would cool off the economy and help bond prices and help reduce the risk of inflation.
This is my independent investment advice about inflation.
My investment outlook remains unchanged during the past three weeks. I was on vacation in Argentina from 1-22-2011 to 2-11-2011 and having reviewed the market after my return, my opinion remains the same. The market continues to be a gigantic bear market rally with the fundamental value of the SP at 900. There is risk of loss in the equity markets and minimal reason to believe they have upside potential. With bonds at least you get the coupon. EM stocks especially China continue to be at risk due to erratic, unpredictable regulation, montrary polciy, corrpution, etc. Also there is the risk that eventually China's rapid growth rate will be too big to sustain and will come down to that of the developed world while still bearing the downside risk of the EM markets.
This is my independent investment advice.
The income method of investment analysis is the best way to analyze an investment. This method involves looking at income and using a multiple to estimate the value of an investment. A similar technique is used in evaluating investment real estate or loan applications. Assets that have no income stream such as commodities, collectables, or new dotcom stocks are intrinsically riskier because they lack this ability to be analyzed by their income thus forcing investors to make huge leaps of faith using various dubious metrics. So the type of investors who invest in things with no income stream could be less rational and more emotional than investors who confine their investing to things that have an income stream. The advantage of investing in assets with an income stream is that the income often is relatively stable and reliable if smoothed out over five or ten years. For example, a person with a job as an engineer making $120,000 a year may have had the same salary, after adjusting for inflation, over the past ten years. He may have had two good years where he obtained a stock option bonus, but that income should be viewed as a one-time windfall and not a reliable, consistent source of income. That person may try hard to improve his salary but may find due to competition that he simply can’t get a significant pay raise. Also wages are often “sticky” during recessions and don’t fall as fast as stock prices or consumer goods. So the engineer may find his income stream, ignoring options as a bonus income, is relatively constant. This income flow if averaged out over many engineers over many years is a far more reliable flow of data to make a decision than simply using the comparable sale method for collectables. This income flow is used by banks to make lending decisions. Banks are highly leveraged with assets 12 times their net worth, so they are more dangerous than hedge funds and thus have to develop the best possible methods of valuing an investment. A loan created by a bank is really simply another investment. This method has worked well for banks, and by contrast simply looking at asset values or net worth does not work well. For example if someone has a lot of equity in a property and they get a new first mortgage with a low LTV of 60% that may appear to be low risk. But later the borrower could hollow out the equity with his home with a new second mortgage and then the borrower may find later that he has negative equity during a crash so he decides to put the property into foreclosure. Then when the bank sells the property at a lower value and with substantial foreclosure costs the first mortgage lender could lose money even with a 60% LTV. However, if the income method was the main reason for granting the loan then only well qualified borrowers would obtain a loan and the probability of foreclosure would be much lower. So when you are contemplating a stock market investment, simply imagine yourself to be a lender who is contemplating a making a loan instead of an investment and ask yourself, what is the most thorough and reliable way to evaluate a loan application? The answer: the income method, not the assets or net worth. (It was the banking industry’s failure to use the income method that led to the mortgage crisis. The banks foolishly discarded the income method and looked at the assets and net worth, but those balance sheet items are subject to boom and bust cycle that can produce severely warped and emotional charged data). The reason the income method works better than asset comparability method is that every day thousands of consumers decide who to buy goods and services from and at what price, which results in an income stream for a corporation. However the corporation’s assets may fluctuate wildly in value due to bubbles, further the corporation with a lot of surplus cash could waste the cash with foolish acquisitions or simply give it to stockholders, thus the balance sheet analysis method is less reliable.
Perhaps the most reliable income flow in equities would be the overall performance of the SP500 smoothed out over time. This is because the SP500 has about 75% of the nation’s economy.
During boom time’s commodities and collectables such as rare art, etc. can go up dramatically higher and then during crashes they can go down significantly. The techniques used to value them are to simply compare the asset to the most recent sale of a similar item and make some adjustments. But if the previous sale was an emotional “bubble” transaction of a unique item then that method is not reliable because it lacks that copious, consistent flow of data that the income method offers. The reason why large cap stocks are safer than small caps is because they have a collection of thousands of diversified income streams from sales thousands of different products, whereas the small cap firm may have a only a few products to sell which thus result in a lesser amount of data to analyze. The S&P 500 has tended to produce a total return of 9% annually over many decades, so this makes it possible to use the income stream multiplied by a Price-Earnings (PE) ratio to get an estimate of value.
So investments, ranked by ease of using the income method have more reliable valuations than investments that can’t be evaluated by the income method. The spectrum ranges from easiest: Treasuries, SP 500 stocks and bonds issued by those companies, medium cap equities, small cap equities, investment real estate, to harder: commodities and collectables and exotic assets like the VIX index. Since harder to evaluate assets are riskier then easier to evaluate assets then they should be only purchased at a discount so as to allow a margin of safety, further they should only be purchased with enough expected profit to produce a higher rate of return than that estimated for publicly traded large cap equities. Thus one should invest sparingly, if at all, in commodities and collectables and should do so only during the worst moments of a significant market crash. However, when investing in stocks of commodity producing companies they should not be evaluated as a commodity, but rather should be evaluated as a stock.
Regardless of whether one seeks to use the income method or the asset comparison method they should get independent investment advice.
Economist David Rosenberg of www.gluskinsheff.com said today: CDS pricing implies “…Greece has a 70% chance of defaulting, 51% for Ireland, 44% for Portugal and a nontrivial 31% for Spain. Both Greece and Ireland are now paying over 80% of their export revenues towards external debt payments, which is not sustainable by a long shot.”
In my opinion, this supports my concerns that the Eurozone is very weak and will get surprising weaker, leading to further support of U.S. Treasury bond prices and the dollar, as capital flees to the safe haven of the U.S.
Rosenberg is a good example of why independent investment advice is better than Wall Street’s product sales driven (with conflicts of interest) advice.
originally published December 7, 2010 by Don Martin.
The Long Term Treasury ETF TLT declined 2.14% today because last night a “tax cut” (in reality an extension of a 9 year old tax law, and thus not a cut) will be approved by Congress and the President. There will also be an actual, but temporary, cut in payroll tax rates. One might be tempted to think this will magically cause employment to recover thus igniting inflation and killing the bond market. However, the big picture is that increasingly both China and the Euro zone are looking like a bubble that will (or already has) burst. Also, according to Barron’s two-thirds of the U.S. homes that need to go through the foreclosure process have not yet completed that. With the huge amount of excess debt that Americans need to pay off plus problems in Europe and future problems in China where will growth (which would hurt bond prices) come from?
According to a Dec. 6, 2010 article by Ambrose Evans-Pritchard in www.telegraph.co.uk China has had a 40% increase in its money supply last year which would require monetary tightening. This may cause a hard landing with big falls in commodity prices, EM bonds, EM stock, and Asian growth rates. Homes in China are selling for 20 times income; in Tokyo it is 8x, in U.S. 4.7 x.
The Euro area does not have enough money to bail out its weaker members. Do you think Germany with 85 million people is rich enough to bail out all of the non-British EU part of Europe with 440 million people?
So where is the growth and demand that will make the economy recover (which would thus hurt bond prices)? I think today’s drop in bond prices was a one day panic which may have been exacerbated by a sell-off in Muni bonds. Because new issues of Buy America Bonds won’t be allowed next month municipalities are now in a rush to issue (sell) more bonds this month; this selling makes prices go down because there is too much supply, which in turn can affect Treasury prices.
China - is it a Bubble?
originally published December 6, 2010 by Don Martin.
Today Reuters has a headline: China’s GDP is “man-made,” unreliable: top leader. My own theory is that China is actually prosperous and growing but the growth may be unduly influenced by a naive handling of monetary policy by a government that is less experienced with finance than developed countries. (Of course our highly sophisticated experts Greenspan and Bernanke were blind to the great Crash of 2007-2008, so maybe Chinese Central bankers are better!) Specifically what worries me about China is that they have a negative “real” rate of 2.4%, which means a business is getting paid to borrow money. This leads to creation of a “crackboom” which ultimately comes to an end with a crash. When rates are artificially low this over-stimulates the economy causing some businesses to do crazy things like build an empty city like Ordos. Instead of real rates of negative 2.4% they should be positive 2 to 3%, which means rates need to rise 5% for the Chinese economy to reach equilibrium. A shock of that much would reduce the growth rate of China’s economy and cause the boom to end or to slow down to a more normal pace. Eventually the truth will come out and the Chinese economy will fall into a slowdown. Just as Americans borrowed too much in the past 20 years and then reduced borrowing since 2008, contributing to a crash, the same can happen in China. Fortunately China uses a lot less debt than America; their bubbles are a cash-based bubble, instead of a credit-based bubble. Cash-based bubbles are like the U.S. Tech bubble of 2000 which only hurt investors, not banks, and only affected one sector in to economy; by contrast credit based bubbles often result in the person who bought at the top of the market being stuck with a huge negative net worth when the debt financed asset falls back down to earth. An example of a credit bubble collapse is Japan in 1990 which has not yet been fixed.
Once a China crash occurs then Western investors will suffer losses from other EM countries and from commodity investments; couple this loss with the Euro area debt crisis and then the world will be back in another Lehman crash nightmare. This is why my investment allocation is 100% bonds.
Another concern about China is that the bulls say future growth will come from the lesser developed western areas. My skeptical opinion that when a country is rapidly growing those who have talent will find a way to move to the big city and go to college in the early stage of the boom. So perhaps the people in the rural area who are not college graduates with a professional career are destined to stay that way and thus the less developed areas of China will not grow as fast as the eastern are did.
Originally published December 2, 2010
$9 trillion loss for European banks if the Euro breaks up. If those weaker countries break away from the Euro they will devalue their currency and this would create massive losses. See http://blogs.wsj.com/source/2010/12/01/guessing-at-euro-breakup-costs/#
One would think that the contracts require loan repayment in Euros so then a devaluation would not cause the loans to be paid at a less than agreed upon amount. However, the hardship of a devaluation would result in inability to pay and thus a default would occur. So either way European banks don’t look good, and this implies a major source of world wide deflation.