Posted by Don Martin on Thu, Mar 31, 2011 @ 01:09 PM
A summary of the most popular posts for March, 2011
Hidden economic weakness: Become aware of hidden economic weakness that could trigger a stock market crash.
A roundup of bearish news items to alert you the risk of a crash
How to invest to avoid the risk of a collapse of the dollar
A summary of current events which are deflationary
An examination of hidden details of the housing market shows that rents could go down, which will keep inflation low and support the value of bonds.
Insights into a potential loan bubble in China which may have resulted in a misleading increase in the price of commodities. If this unwinds it would cause crash in the world’s stock markets.
A review of the risk that Asian EM countries inflation may expand and spread to the U.S.
A discussion of the “equity risk premium” (this is the amount that stocks earn in excess of bonds for taking on risk) that has gone AWOL on investors. When will it come back?
What foreign currency investments are potential candidates to protect investors from dollar devaluation?
These are an example of independent financial advice.
Posted by Don Martin on Thu, Mar 31, 2011 @ 12:00 PM
The economic recovery is a weak, jobless recovery that masks the true amount of joblessness. This could lead to a double dip recession, making stocks crash and bonds go up in value.
Only a fifth of private sector job losses have been recouped per ADP data. In the 2002 recession trough there were 107 million jobs, at the 2007 top it was 115m, then 107m at 2009 trough, now 108m. That is a gain of less than one percent in nine years, less than the population increase, and that is two years after leaving the trough.
Robert Reich, a UCB professor in an article today in Huffington Post titled “The Economic Truth That Nobody Will Admit: We're Heading Back Toward a Double-Dip”. He said that we may be headed into a double dip recession. “…the nation has lost so many jobs over the last three years that even at a rate of 200,000 a month we wouldn't get back to 6 percent unemployment until 2016…By this point in the so-called recovery we'd expect growth of 4 to 6 percent (versus 2.5% now).” He said annual growth rates in the Great Depression were 7.7% to 14.1% when recovering from the crash during 1934-36. He warned that falling real wages and falling house prices are also a concern.
Today Bloomberg had an article by Alan Krueger, professor of economics at Princeton University who warned that “…we still will have a serious joblessness problem even as the unemployment rate falls.” He recommends looking at the employment to population ratio because it is not affected by people who are not counted as part of the discouraged, hidden unemployed workforce. The ratio went from 58.2 at the bottom in 2009 to 58.4, which is virtually no gain at all. Compare this to the peak of 64.7 in 2000.
This is similar to my article "Western nations have learned nothing and may repeat Japan's mistakes".
This is an example of independent financial advice.
Posted by Don Martin on Wed, Mar 30, 2011 @ 12:16 PM
An interesting article in FT today about copper buying in China mentioned that the spread between 3 month versus 15 copper futures dropped from a 3.5% premium to almost zero which implies plenty of supply. The article quoted a metals analyst that the risk to prices was “firmly to the downside”.
I wrote “World economy to suffer in slump for a long time”. See "China’s hidden loan bubble” about leveraged speculation in copper. The reason copper is important is that it is used by economists to measure economic growth, so if the price is high it implies high growth, however it can be manipulated by speculators, thus producing a misleading forecast of growth.
This is an example of independent financial advice.
Posted by Don Martin on Wed, Mar 30, 2011 @ 11:37 AM
People ask about QE2 investment advice; what are investments for surviving the devaluing of the dollar, and how does that affect today's bond market?
QE2 will come to an end in three months. This means that there will be less stimulus in the economy and then stocks will go down. Combine that with increased austerity in Congress and there will be less stimulus in the economy which will lead to a growth recession, not necessarily a double dip recession. This slowdown will create disinflationary trends that will reduce the rate of inflation and it will come as a surprise to the market thus causing stocks to go down.
The housing market will continue to go down by a small amount each year for the next several years, thus further reducing inflation, since housing is 40% of consumer expenditures. The marketplace is addicted to a defunct economic model, like Pavlov’s dogs they salivate about the prospect that housing will repeat the patterns of the past 45 years and thus they assume it has reached a bottom. This is wrong because a new paradigm has been established for housing finance that means the best analogy is the low inflation, low debt load, load expectations era of 1930-1965, rather than the debt and inflation bubble of 1965-2008. See "Housing not comparable to the past" also see "Housing crash lasted longer than Great Depression of 1930's".
See where NPR said there is no hope in sight for home prices.
So all this increase in bearish news that will occur about the time QE2 expires will be an unanticipated disinflationary shock which will lower interest rates and thus make investment grade bond prices go up. Investors will flee shaky, poor quality bonds and invest in higher quality bonds in a phenomenon called "crowding in" (as opposed to "crowding out"). This will push investment grade bond prices up.
The dominant theme in determining inflation is the unemployment rate. The real rate of underemployment is about 16%. Until this is greatly reduced then very low rates of inflation are appropriate.
This is an example of unbiased investment advice and independent financial advice.
Posted by Don Martin on Tue, Mar 29, 2011 @ 01:51 PM
Two great articles printed in WSJ today: Home Prices Continue Descent by TESS STYNES and KATHLEEN MADIGAN. They quoted David Blitzer, chairman of S&P's index committee. "The housing market recession is not yet over, and none of the statistics are indicating any form of sustained recovery. At most, we have seen all statistics bounce along their troughs; at worst, the feared double-dip recession may be materializing."
My interpretation is that there is no evidence of a recovery and there is risk that the housing bears will continue to be correct. So tlit to a bearish stance and protect yourself with a bearish defensive posture regarding both housing and stocks.
The other WSJ article is Why the Mega-Mansion Market Is Still Dead By Robert Frank. The article explained that in theory the homes bought by the rich will have plenty of buyers because rich people have recouped their stock market losses. He then debunks that theory by showing that there is a 39 month supply of inventory for luxury homes in Greenwich, Conn. The author said “…the megamansion market is still stuck in 2009.”
I have written bearish comments about real estate in “Housing crash lasted longer than Great Depression of 1930s” and “Housing not comparable to the past”. However, I was still surprised by this article because I had assumed that Bernanke’s restarting of the stock market bubble, which enriched the rich, would result in rich people using a stock margin loan to buy a house for $5,000,000 or more, while the less affluent who need to get a mortgage loan would buy lesser amounts due to tighter loan rules.
This means that Bernanke is not succeeding in changing consumer behavior by reinflating the stock market, which is a bearish indicator for all types of risk investments, including equities, precious metals, oil, etc.
This is an example of independent financial advice.
Posted by Don Martin on Mon, Mar 28, 2011 @ 02:18 PM
Investors seek to know about imperfect markets in real estate and how the housing crash affects CPI. Some people wonder if they should buy junk bonds. They also ask, will the dollar be devalued?
If the housing crash continues that will lower inflation which will actually increase “real” interest rates, thus making the dollar more attractive to foreign investors, thus reducing devaluation risks. However a double dip recession in housing would lead to more unemployment, less tax revenue, and thus greater Federal and state deficits which could undermine investors’ confidence in the dollar and in Treasuries and Muni bonds, thus increasing devaluation risks.
The uncertainty about a potential devaluation is best met by hedging one’s risks by diversifying into foreign currency. The goal is not to seek to get rich, rather it is a defensive measure against the possibility that the dollar could fall into a permanent state of decline instead of a temporary cyclical decline.
Regarding junk bonds, my opinion is that they correlate with equities on the downside and thus don’t give enough diversification. I have called them equities disguised as bonds. If you like the risk and behavior of junk bonds then it is best to simply accept the risk of equities and not bother with junk bonds. At least if you buy equities you get the potential of unlimited appreciation when the market is bullish. By contrast, if you own a junk bond and the market gets better for equities then the issuer may see its health improve to the point where they can qualify to refinance into a lower rate new bond issue, thus paying off your bond at par.
I have written posts like bearish news items suggest caution and investments for a dollar collapse.
This is an example of independent unbiased investment advice and independent financial advice.
Posted by Don Martin on Fri, Mar 25, 2011 @ 09:57 PM
The Economist magazine on March 24 had an article titled and subtitled "America's property market On a losing streak The effects of America's worst property crash go very wide"
There was a sentence that was very enlightening and supportive of my theory that a glut of foreclosures leads to low rents which leads to low CPI inflation. "In North Las Vegas every second house on some streets carries a “For Rent” sign, offering rates of as little as $150 a month." So if rent is $1,800 a year for a $100,000 house this is a yield of 2% before expenses. The inverse of 2% is 50, so the property has a gross multiplier of 50. Usually single family homes have a gross multiplier of 12, so in this extreme case rent is one fourth of the traditional metric.
I wrote about this in "Housing market still bearish".
This is an example of independent financial advice.
Posted by Don Martin on Thu, Mar 24, 2011 @ 11:09 AM
In today’s news there are a lot of articles that support my bearish views. For example: An article in today’s WSJ Real Time Economics Blog “Housing Becoming Policymakers’ White Whale” by Kathleen Madigan is full of quotes that support my opinions and yet shock me even though I’m a housing bear. For example: “Those (home) sales are at their lowest since records began in 1963 — despite the fact that the U.S. population is 122 million residents larger than 48 years ago. …the sector remains an intractable foe for policymakers. The gap between supply and demand means prices have started to fall again…but housing wealth is still half of what it was in 2005. The lack of demand suggests home prices — and thus household wealth — has more room to fall…”
I have written about this in my posts “Housing market still bearish” and “Housing not comparable to the past”. This is an example of independent financial advice.
Another WSJ story had a headline today: Recession Caused Sharp Decline in Start-Ups. Reading the story I noticed the decline was the worst since 1977. The another WSJ story said: “Japan Quake Could Have Big Impact on U.S. Output”. So clearly with bearish news about housing, business start-ups, and Japan’s factory shutdowns affecting U.S. factories this implies a slowdown in the economy.
Posted by Don Martin on Wed, Mar 23, 2011 @ 03:22 PM
Investors have enquired about devalued dollar investments, investments for a dollar collapse, and have asked “will inflation cause a crash?” The standard answer that most advisors offer is that to protect from a possible collapse of the U.S. dollar one should invest in gold, silver, precious metals, oil, energy stocks, stocks of companies that save on the cost of fuel such as railroads, etc.
An alternative technique to protect from a possible collapse of the U.S. dollar one should consider investing in foreign currency.
How does one invest in foreign currency?
• Open a bank account denominated in foreign currency
• Buy U.S. based actively managed mutual funds or ETP’s that invest in foreign currency
• Buy U.S. based actively managed mutual funds or ETP’s that invest in foreign currency denominated bonds
• Buy commodity futures contracts for foreign currencies
• Buy options on foreign currency
All of these have risks. The least risky may be actively managed U.S. based mutual funds because the management tries to forecast the risks and make changes. By contrast a passive investment has no one other the individual investor to manage the risks. ETP’s have the risk of counterparty default and tracking error, which can be a concern. Options have counterparty risk and risk of expiring worthless. Futures are highly leveraged and have risk of Backwardation and Contango which produces tracking error. Few U.S. banks offer foreign currency denominated accounts. By buying mutual funds that hold bonds denominated in foreign currency the investor is getting investment management from the mutual fund and interest earned on the bonds and may get appreciation of the assets. Of course there is risk that the bonds could default. Many Emerging Markets bond mutual funds have a “BB” grade credit quality for their holdings, which is one notch below investment grade, meaning it is junk bond grade. There is always risk in investing. The good news is that carefully selected portfolio of bonds in a mutual fund that has holdings rated an average of “BB” or “BBB” may have a standard deviation (a measure of risk) of 13 which is better than the stock market’s standard deviation of 20. Past performance is no guarantee of the future.
See articles I have written: “Will the dollar be devalued?” and “Will the dollar collapse”. This is an example of independent financial advice.
I certainly hope the dollar regains its health and then stays healthy. To make it healthy requires producing better goods and services for export, and making the government solvent. If politicians won't take steps to make the government solvent and make American exports competitive then the dollar will continue to suffer. We need to compete not only in terms of making quality export goods but also in terms of having a high quality, solvent government. For example, when people find out how insolvent U.S. Social Security is compared to Singapore's retirement system is then people may wish to avoid investing in the dollar or in U.S. Treasuries.
Posted by Don Martin on Wed, Mar 23, 2011 @ 11:22 AM
Gary Shilling was interviewed today on Yahoo Finance made some important points that coincide with what I have been saying for a long time.
He said that personal income from 1999 to 2009 dropped by 5% and that 55% of those who lost a job and found one now work for lower pay. In my opinion this drop in personal income means that consumers could not have afforded the house price increase that occurred in the past decade. Home buyers were already borrowing at their maximum level of purchasing ability during the boom of 2000. So if consumer’s income dropped by 5% then their ability to buy a home must have declined. Further, since underwriting rules have dramatically tightened since 2008 then consumers have even less borrowing power. Most people need a mortgage to buy a home. If they have maxed out their ability to qualify for a loan and then their income is cut and the underwriting standards are tightened up then consumers will simply be forced to buy lower priced homes. Of course the drop in interest rates helped a lot. But when rates drop, a greater percent of the payment goes to principal and thus the total P&I payment does not drop that much when rates are cut on a fully amortized loan. Further a rate cut does not reduce property tax and homeowner’s insurance. So the rate cuts don’t help people to qualify for a loan as much as one might intuitively think. Further, if the bottom in rates has been reached and eventually they go up then that would make it harder to buy.
So my point is that using charts showing that allegedly the ratio of home prices to income is lowest since 1965 are either wrong or are not applicable to due fundamental secular changes in consumer behavior. Consumer income in recent years has become is structurally weak because a lot of it comes from temp jobs or independent contractor self-employment, which lenders fear and hate. Lenders crave borrowers who have been at the same salaried career for at least two years with no periods of unemployment or self-employed for several years with smooth, stable income. Since a growing number of people are moving from stable salaried work to unstable temp & independent contractor work then those borrowers can’t qualify for a loan, or their qualification will be for a smaller than desired loan because their income is too volatile to be fully utilized for a loan.
Why does this matter? Because house prices are determined by the ability to get a loan (except for the top 1% of society). And getting a loan is based mainly on income. Add to that the loss of “easy qualifier” loans which were needed by 20% of the population and you have a huge loss of consumer ability to get a loan, which can only result in a continuing bear market for homes which leads to lower CPI.
I have written these articles: housing not comparable to the past and housing crash lasted longer than Great Depression.
This is an example of independent financial advice.
Posted by Don Martin on Tue, Mar 22, 2011 @ 01:09 PM
Today Tech Ticker | Yahoo Finance
interviewed economist Gary Shilling, whose book “The Age of Deleveraging” was reviewed by me at
Economic Book Review The Age of Deleveraging. Shilling is still
forecasting deflation despite the recent increase in inflation.
Shilling mentioned five key areas and how they could trigger deflation.
Japan: Their government debt continues to grow, which is dangerous because if rates go up they can’t pay their debt.
Housing: Shilling projects a 20% decline in house prices over several years.
Energy prices: he is concerned with political stability in OPEC countries and how that could create a recession if oil became too expensive.
Euro area debt crisis is also a concern.
China: He expects a growth slowdown there which would be a hard landing.
Basically he agrees with me that various economic problems will occur that will pop the bubble, resulting in a crash, resulting in deflation.
Other deflationary news:
On 3-21-2011 the Wall Street Journal said:
“Home… prices fell to the lowest level in nearly nine years.”
Regarding the number of units sold: “The results were worse than forecast.”
Standard & Poor's/Case Shiller home price index shows home prices are at new lows.
Another Wall Street Journal article on 3-22-2011 ran a headline with a story similar to yesterday’s saying “Discounts Expected in Spring Housing Market”.
The article said: “Sales of previously owned homes fell sharply in February, setting the stage for steep discounting in the spring market.”
There is so much bearish housing news it is tempting to tune it out, but it is real and it will continue and since it affects 40% of the CPI the a decling cost of a home will definitely affect the CPI. Even though CPI uses rent instead of home ownership, as more homes are turned into rentals after being purchased at lower prices then the new landlord will have to cut the asking price for rent, thus pulling down CPI.
If this happens the best investments would be high quality bonds, and cash.
This is an example of independent financial advice.
Posted by Don Martin on Mon, Mar 21, 2011 @ 02:05 PM
An article in today’s WSJ in Heard on the Street: Gold Miners' Big Problem, by Liam Denning, pointed out that stocks of companies that produce gold or oil sometimes do not go up as much as the price of the commodity. I have written in independent investment advice evaluating gold about this before that gold mines have a 25% internal annual cost inflation so the first 25% increase in gold’s price is spent simply paying for an increase in the operating cost of a mine. In the case of oil Barron’s said that oil producing countries have contracts with the oil producing corporations that caps the corporation’s profit when oil goes over $80 a barrel. My explanation for why gold mining companies’ multiples went down is that before the gold boom people bought mining stocks as if they were a long term call option on the price of gold and thus they were willing to pay a higher earnings multiple. Investors may have anticipated that gold would go up so they may have used a long term projection of gold prices as a reason to pay high PE multiples. Now that gold is higher, perhaps the market doubts that gold will continue to go up so the PE multiple has been compressed. Perhaps the true believers in gold think it will keep going up until Armageddon occurs (which I don’t believe) in which case the gold lovers only trust physical bullion held in their own vault or buried in their backyard. If that is the case then there will be less demand than anticipated for gold mining stocks.
Traditionally mining and oil exploration are very risky businesses subject to expropriation by foreign governments, high operating costs, long period of commodity bear markets (that typically last 17 years), so the stocks need to be priced with a low PE so that future stockholders will be compensated for excess risk.
Another point implied in the article is that as mining companies run low on ore then they have less future output to offer and thus run the risk of running out of raw material to sell.
The article suggested investors buy other, smaller mining companies. My opinion is that doing so incurs a higher level of risk. There is risk that a junior miner won’t be able to hire the best employees during a boom, won’t be able to find gold ore, won’t be able to acquire adjacent tracts of land to mine for gold, and won’t have enough deep pockets to survive a bear market.
This is an example of independent financial advice.
Posted by Don Martin on Fri, Mar 18, 2011 @ 02:21 PM
Yesterday I did a post titled “Will rents rise” about the possibility that rents could go up. I was provoked into writing the post when I saw an article yesterday on CNN.Money.com claiming a 20% rent increase was going to occur. This is important because if rents increase then inflation may increase and that would destroy the bond market.
Today CNN.Money.com writer Les Christie, ran a story with the headline “Nearly 20% of Florida homes are vacant”. So it is nice to know that 24 hours after I write a post that the news media comes out with a similar story. So the implication is that a surplus of homes leads to price cuts for either the sales price of a home if it is sold or rent charged is reduced if the home is rented out. This means the CPI, which has 40% of its weight affected by the cost of renting, could go down, not up. Of course this surplus of real estate only applies to communities that suffered from the bursting of the real estate bubble, so this would not apply in Manhattan, San Francisco, Washington, DC.
The CNN article quoted the Census Bureau on March 17, 2011 as saying that 18% of Florida’s homes are vacant, up 63% over the past 10 years.
“Having this amount of oversupply on the market will keep home prices depressed and slow any recovery….One county is Collier -- home of Naples -- with a whopping 32% of homes empty. It will take about eight years just to put the vacancy numbers back into the single digits…"
The article cites “Celia Chen, a housing market analyst for Moody's Analytics, …She doesn't expect Naples, for example, to come all the way back until the late 2030s.”
My comment: Wow!!! That’s nearly 30 years after the crash started! The article quoted Chen as saying other “areas with a 20-year wait or longer include Punta Gorda, Palm Bay and North Port.”
I have written about the topic that housing is not comparable to the past. I worked nearly 20 years in real estate finance, so I am familiar with this topic. This is an example of independent financial advice.
Posted by Don Martin on Thu, Mar 17, 2011 @ 03:54 PM
An article on 3-16-11 in Yahoo from CNN Money said rents may rise 7% a year for the next two years. This is important because rent is 40% of the CPI calculation. If it is true that rents will rise, then inflation would rise, thus hurting bonds.
My view is that renters tend to be people with minimal liquid assets and sometimes bad credit rating or no credit history, so they can’t buy things with cash or with borrowed money. So if they want to indulge in a more expensive lifestyle they must get a 2nd job which increases goods in circulation, thus offsetting the inflation they cause by renting a more expensive apartment. Since there will be a huge amount of shadow inventory homes that need to be sold at fire sale prices over the next several years then this will create class of new, naive landlords who buy and rent out foreclosed homes only to find that sudden surplus of new rental property caused the market price for rent to drop, thus creating a glut of rentals. Also, the more affluent renters have the capacity to buy a home and avoid paying rent.
The type of people who will face a rent increase are likely to be low-end tenants who can’t qualify for a loan and were already living in low-end property. By contrast, middle class consumers who abandon their homes to foreclosure may contribute to a glut of rentals as their former residences become rental properties. So perhaps low-end property rents will go up, but rents on single family homes will go down and the two actions will offset each other.
The article said “There's one factor that could rein in rent increases: the huge number of foreclosed homes that could hit the market over the next few years. In many markets, like Phoenix and Las Vegas, there are neighborhoods filled with recently built, single-family homes going for fire-sale prices. When the cost of owning homes falls well below the costs of renting them, more people will buy. "That's always been the biggest competition for rentals..."
When homeowners need to sell during a recession but can’t, they engage in a state of denial and procrastination by moving to a new area and renting or sometimes buying, while leaving their previous, expensive home empty for year or two, even if they have to make payments on the old home. This creates an increase in the amount of vacancies of single family homes which may take years before the old property is cleaned up, listed with a Realtor for sale, had the price cut, sold, sale fell through, it is re-sold, finally the sale closes escrow, then the house is repaired by a new owner and then rented to a tenant. So when all those steps are taken then after a long delay suddenly a “new” supply of rentals are offered to consumers. This process could take years after the previous owner has moved out.
One interesting note about the difference between single family home loans versus multi-family housing (apartments with more than four units) is that loans on multi-family property were always tightly restricted since the 1990 Savings & Loan crisis, so for the past twenty years these properties did not take part in a real estate bubble. The loans offered for those properties were based on strict appraiser’s estimates of fair market rent which in turn was used to estimate value using the more conservative “income” method of valuing a property. So multi-family rentals have a firm base under their fair market rent, so they could go up if more people sought to live in them, however, consumers want to rent or own a single family home, a duplex, a quality condo, etc., not a tiny room in a giant 100 unit apartment building. So the tenants of muti-famly properties may be economically weaker people who simple can’t afford rising rent and will have to move in with relatives, etc. or move into less desirable property. A lower-middle class person on a tight budget will see rent as a huge cost and try to reduce it, while ignoring the cost of smaller, impulse purchases such as smart phones, cable TV, etc. The lower-middle class workers have been hit hard by globalization, tightened credit, lack of new economy job skills, etc. so they simply won’t put up with rent increases. The upper-middle class renters will benefit from a 100 year flood of a glut of foreclosed single famil houses and condos. (I am speaking in terms of the typical U.S. city and not in terms of highly desirable coastal California or Manhattan.)
I have written about this at "Will housing distort the CPI" and at "Housing not comparable to the past". This is an example of independent financial advice.
Posted by Don Martin on Thu, Mar 17, 2011 @ 03:00 PM
China’s government has made it clear at the recent NPC meeting in Beijing that a low rate of inflation, rather than high growth is China’s priority. Further, China may be getting control of its banks and reducing loan growth to reasonable levels. The Economist magazine said today: “…the prime minister, has made fighting inflation a priority, it is likely that business will fall into line with (restrictions on the growth of) credit, not the other way around.”
So this means that China will have a reduction in the rate of growth which will lessen the growth of nearby Asian countries and commodity exporters like Australia and Brazil. This will reduce demand for commodities. All of these things will help to reduce the "inflation signal" from rising commodity prices. Since China is the main element of growth in the world’s economy its growth determines what happens elsewhere, including whether or not inflation comes back to the U.S.
Of course, there is still the risk in China that rouge bankers could secretly lend too much in violation of government rules. This could be done by lending through Trust companies, using securitized loans to facilitate off-the-books lending. In America this was done through the lightly regulated Shadow Banking system which resulted in an over-expansion of credit that did not show up on the radar screen of the regulators. But ultimately it failed and crashed leading to a disinflationary world-wide crash.
China needs to keep expanding the economy to keep people happy so that China won’t suffer from problems like the Arab world’s recent revolutions. Now that it appears that the Arab world, particularly Libya, is settling down then perhaps there is less need for China to create growth to keep people happy. Also one way to avoid civil strife is to keep food and fuel prices stable, so a cooling of the economy could actually help create political stability.
I have written about this here and here. This is an example of independent financial advice.
Posted by Don Martin on Wed, Mar 16, 2011 @ 03:38 PM
CNBC headline: Black Swans Now a Regular Part of Market Landscape
The article published today said “once-in-a-lifetime events are happening with such regularity that black swans may as well be white swans.”
Since 1994 Orange County, a very rich county, went bankrupt, 1998 we have the failure and bailout of LTCM, in 2000 the Nasdaq bubble, 2001 Enron, 2002 Worldcom, 2007 the real estate and mortgage backed bond bubble crash, 2008 bank crash, Bear Stearns and Lehman demise, and 2009 stocks crashed 56% from the top. Now there is the Japanese quake, the worst there in 300 years.
“A Black Swan” is a symbol based on a book by Nassim Taleb where he warned that traditional risk models don’t show that the true level of risk is much higher than it appears. He believes it is best to have mostly safe investments like government bonds, etc. issued by governments with low debt loads.
This is very similar to my philosophy. I have been advocating investing in investment grade bonds via mutual funds and avoid equities, junk bonds, Muni bonds, in order to avoid excessive, hidden, uncompensated risk.
Independent investment advice is what is needed to become aware of Black Swans.
Posted by Don Martin on Wed, Mar 16, 2011 @ 02:30 PM
The huge Japanese quake may have scared investors, but the real concern that investors should have (but don’t) is that U.S. equities are 70% overpriced according to various indicators such as the Shiller PE10 or Tobin’s Q.
My intuition regarding the quake and the nuclear plant is that eventually things will go back to normal and people will forget about the quake and the risk of nuclear power.
However, regarding buying Japanese equities on a dip, I’m not ready to recommend that because of macroeconomic and demographic fundamentals that existed in Japan before the quake. The Japanese equities have had low Return on Equity which is why Warren Buffett does not like investing in Japan. Japanese publicly traded companies appear to be focused on maintaining employment and sales volume rather than profits. Japan has a long term problem with declining birth rate, no immigration, less entrepreneurial behavior than in other countries and huge debts financed at artificially low rates. (Of course the U.S. also has a big problem with debt).
The problem with “Value” investing is that occasionally investors can get into a “Value trap” where they buy stocks with low PE’s only to find they were low because the company was moving into a worsening situation and thus the company’s share price continues to go down. So the risk of investing in Japan is not the quake but rather the macroeconomic fundamentals that existed before the quake.
Assuming the developed world is in a 17 year bear market then we have another five or so years to go until it ends. Also, after a bad financial crash where deleveraging is needed it takes seven years to return to normal growth rates, according to the book “This Time it’s Different” by Rogoff and Reinhart (This would apply to the U.S. and Europe, not Japan). So if most of the developed world will be weak for some time then this would affect Japan’s economy in addition to its own structural problems that existed before the quake. Specifically I’m thinking that if the bear market can only end by going through a “Capitulation phase” where the SP goes back to 666, then only after that time will the developed world be able to return to a bull market, which will also involve Japan.
So I prefer to sit tight with quality bonds rather than risk a value trap in Japanese stocks.
I have written about the these topics here. This is an example of independent investment advice.
Posted by Don Martin on Tue, Mar 15, 2011 @ 12:18 PM
Today the FT had an article about Chinese commodity firms using Letters of Credit to obtain 180 day financing of commodities with 15-20% haircut (down payment) and the cash from this can be used for any purpose. This implication is that the cash proceeds were used for commodities, real estate and stock speculation. The article called it a “nice risk-free carry” (carry means a carry trade which means borrowing cheaply to speculate). The Chinese people are suffering from inflation and do not get a positive real rate of return on bond deposits or bonds and are not allowed to invest overseas, so they need to find a domestic investment to shelter their assets from inflation. As a result real estate bubbles, often cash-based, instead of mortgage loan based have sprung up creating dangerous bubble top conditions. The news media interviews experts who say not to worry because the bubbly assets in China are financed with cash. But what if the source of the cash was not savings but rather it was from a surreptitious loan disguised as a bank Letter of Credit used to find an industrial company’s purchase of copper? And what if the six month due date on the Letter of Credit could be rolled over (perhaps by selling the copper to a subsidiary that got a new Letter of Credit). Then the copper price could be manipulated by a speculative bubble which would collapse when the short-term financing was withdrawn. The financing could be withdrawn when the bank regulator orders the banks to tighten the audit of these LoC’s and then the truth would come out and no buyers would be found for copper.
The article closed by saying that we could be pretty close to a mass negative-equity copper sell-off. (Negative equity means that the value of the copper collateral would drop below the loan value, leading to massive cascade failures as the speculator would be forced to sell other assets to pay back the margin loan. Unlike real estate loans with no margin call, the copper warehouse loans are like a stockbroker’s margin loan that can be called if the price of the collateral drops. In 1929 in America we had stock margin loans of 15% down payment and that high leverage led to the Great Crash).
There was a case where stock market participants in Kuwait used post-dated checks that allowed stock purchases with no payments for six months. Essentially stocks were sold with an owner-carried back note with no down payment. You can guess what happened. A bubble formed. People bought stocks with no down payment, sold them at inflated prices by carrying back a note in the form of an uncashed post-dated check, and bought more stock.
My concern with Chinese purchases of copper is that the commodity is used as an indicator of the world's economic health and growth. But if the price is driven by speculation and financed by easy money in a secretive manner that is not regulated (and can’t be regulated) by banking regulators then that is a way that a worldwide copper and commodities bubble can be formed. The real estate and mortgage bubble in America was primarily financed by lightly regulated shadow bankers who sold securitized loans. This allowed financing to be available which was not regulated by the government agencies that regulate the banks.
This leads back to my theory that the world economy may not be as robust as it seems. The main reason to be bullish on the world economy is China. Commodities, countries that produce commodities and countries near China all benefit from China’s super-fast growth that has gone on for an unprecedented time. If China’s growth cools off or is not accurately reported then a classic world recession and commodity crash will occur.
Of course Peak Oil theory is an exception to a commodity crash, but for commodities other than oil I expect an eventual cool off when China cools off.
I have written about this topic here and here. This is an example of independent investment advice.
Posted by Don Martin on Mon, Mar 14, 2011 @ 04:22 PM
The Japanese quake can inspire people to be aware of other risks. Are you prepared for:
* Cyber war: So many things would not work if the internet was sabotaged. Imagine if your ATM card, credit card, etc. did not work and your bank would not give you cash because their software was down. Imagine if the gas station would not dispense gasoline.
* A local earthquake. Perhaps the single most important risk to Californians is that there would be a severe shortage of drinking water after a quake. Do you have several weeks worth of drinking water, plus purification systems such as iodine or Steripen?
* Psychological survival after a quake. Have you tried backpacking and learning to survive with minimal resources, no showers, no utilities, etc.? Are you tough enough to go camping in your backyard or in the local park for a month and eat only dried food? Do you have backpacking supplies including food and fuel at home?
* Do you have first aid training in case there are no doctors available? Do you have a supply of prescription medicine and know how to use them? Are you able to walk home from work?
These ideas remind me of the concept of indepenent investment advice, where one must be self-reliant, and prepared for some unusual Black Swan event where no help is available from others.
Posted by Don Martin on Mon, Mar 14, 2011 @ 04:00 PM
There has been a lot of talk in the media about the potential of dollar devaluation.
Arguments in favor of devaluation:
- Barry Eichengreen said it would be devalued 20% over the next ten years
- China’s Yuan is undervalued by 40% and needs to go up to ease their inflation problem
- The goal of the Federal Reserve is to devalue the dollar to stimulate a new bubble to get out of the housing slump
- The U.S Treasury debt is so huge that devaluation is needed to make it easier to pay off the debt
Arguments against devaluation:
- Other nations would have competitive devaluations because of their need to generate exports, thus no net devaluation would occur
- China would insist that the dollar not be devalued because they don’t want their gigantic holding of T-Bills to be devalued.
- Other nations, including China and the Euro zone, also have problems and are no better than the U.S. so there is no other large country for capital to flee to as part of a capital flight from the dollar. Even the currencies of Canada and Australia country go down in value when the commodities boom ends
- The governments of the world depend on continuing trust in fiat money as opposed to the public losing trust and fleeing to ownership of physical gold buried in people’s backyards. Thus all governments have a vested interest in coordinated policies to stop one nation from a huge devaluation.
- Devaluation would make it harder for the U.S. Treasury to issue more debt; it frequently rolls over short term T-Bills with new issues of T-Bills, so it must not offend foreigner creditors with a devaluation
I remember reading a book in the 1970’s by gold bug Harry Brown where he advocated investing in the Lebanese pound because it had the largest percentage of gold backing by its Central Bank. Unfortunately Lebanon soon suffered a devastating civil war followed by a foreign invasion, so the currency was damaged.
I have written about this here and here.
This is my independent investment advice.
Posted by Don Martin on Fri, Mar 11, 2011 @ 05:04 PM
The U.S. Geological Survey has published a guide for preparing for earthquakes, titled "Putting Down Roots in Earthquake Country". Please download and read it.
I have written about how the tragedy of earthquakes are a metaphor for economic shocks. By reading the earthquake pamphlet perhaps you will think of some analogies about protecting your investments in addition to protecting your home.
Posted by Don Martin on Fri, Mar 11, 2011 @ 01:38 PM
Last night’s 8.9 earthquake in Japan was the worst in 300 years in Japan, which gets a lot of quakes and it was one of the ten worst in the world in the past century. So it was a Black Swan (a statistical outlier) event. The lesson is that occasionally people can be damaged by statistical outlier events that were hard to plan for. So for investing that means each investment should be carefully evaluated with a stress test to see if the investment is high quality asset that can withstand shocks.
The lesson is that avoiding risk is more important than chasing after gains. For example when a stock purchased at $100 drops 50% and then rises by 50% it is now at $75, which is 75% of its previous price, so instead of breaking even, a person has lost money. The stock would have to rise 100% from the low of $50 to return to its original value. Thus it takes a higher proportion of gains to make up for losses.
The ways to reduce investment risk is to:
*Only invest in things that have a risk level that you feel comfortable with
*Invest in things that are high quality such as stocks with low debt loads, stable earnings, a corporate moat, etc.
*Diversify
*Maintain plenty of spare cash
The tragedy reminds one of the need to avoid risk by having homes and office stocked with earthqauke supplies, planning for quakes with safety drills, learning about how to cope with the afertermath of a quake, etc.
I have written about investment risk here. This is an example of independent investment advice.
Posted by Don Martin on Thu, Mar 10, 2011 @ 03:23 PM
The Wall Street Journal had an article today expressed worry about Asian core inflation now at 1% is rising with a tight labor market that may have anecdotal reports of 30% pay raises. One could worry that this wage inflation will spread world-wide, however the article was about the Asia Pacific region, not Latin America or India, Africa, Middle East, East Europe. The core rate was only 1% after coming up from depressed 2008-2009 crash levels when Asian businesses cut prices deeply. I remember airfare sales at half price in Asia in 2009. By raising prices to pre-crash levels is that really inflation?
I suspect that China’s growth caused adjacent countries to experience rapid growth and inflation. Also, what if the growth rate in China slows either because the economy is unsustainably too hot or because it is a bubble that will burst? In China, never in anywhere history has so such a high growth rate occurred uninterrupted for so long; also there have some reasons why growth can’t go on forever at the current rate of 8% or 9%. The reasons are that when a developing country tries to get past a certain per capita income it needs to have stable, reliable judicial system, that are not found in dictatorships, to protect intellectual property and other property. Further, people in China have worked so hard for a long time developing their country and careers that they may be close to exhaustion. If China does cool off, then peripheral nations in the Asia-Pacific region and commodity exporting nations like Australia and Brazil will also cool off.
A repeat of the 1970’s inflation experienced in America won’t happen because that was caused by excessive growth of the money supply which was caused by excessive lending. By contrast, Asian businesses and Central Banks are less tolerant of excessive use of debt. If Asian inflation increases then their Central Banks will tighten. Asia continues to use cash-based financing instead of debt-based financing compared to the developed world. Further, a repeat of 1970’s U.S. style inflation is unlikely in Asia because a key catalyst in inflation are labor shortages in a community that has powerful labor unions and minimal globalization. Further, Asian countries that are growing rapidly can alleviate these shortages with imported labor from the rest of the Third World. Also wage increases may be due to the economy changing its market segmentation to move upstream, so as to offer more sophisticated products where higher wages would be appropriate.
I have written about this here and here. This is an example of independent investment advice.
Posted by Don Martin on Thu, Mar 10, 2011 @ 11:28 AM
Today’s auction of long term Treasuries went OK with bond prices go up slightly. Yesterday the news had stories of Pimco’s “Bond King” Bill Gross getting completely out of Treasuries. The stereotype of an economic recovery is that after a year or two that jobs return and that increases inflation and also increases the demand for money so that the marketplace reacts by increasing interest rates. So the group-thing consensus has been that a rate increase would occur. However that is wrong because this is no ordinary recession, it is like the “Japanese Soft Depression”.
Jeff Gundlach of Double Line, called the new Bond King by Barron’s, said today that "The markets price in all the facts that are known. The fact that the Fed is going to stop buying Treasuries is known, therefore it's priced into the market. The end of the Federal Reserve's $600 billion program of purchases is already priced into the market and yields will not change "one bit." "It's going to depend upon the fundamentals, not on the stopping and starting of the Fed," he said.
A contrarian bond expert, Lacy Hunt, of Hoisington Investment Management said in the Wall Street Journal, rates might even fall with the end of QE2. He said the QE2 purchases of Treasuries made rates go up in anticipation of inflation, thus when QE2 ends rates will go down and investors will move away from inflation sensitive assets like commodities.
Reasons in favor of lower rates:
• QE2 was counterproductive, ending it will be a reduction of stimulus and is this disinflationary
• The Euro still has unresolved problems. The optimistic scenario depends on Germany with 85 million people being willing to bail out a 500 million population area, and on willing of the ECB to abandon fiscal prudence and engage in loose money policies
• China’s commodity bubble in copper (and in real estate) is looking shaky per the Financial Times
• Employment gains seem to be disproportionally in low wage jobs
• The deep, long recession is more like Japan’s than a typical American recession
Reasons in favor of higher rates:
• The money supply has increased
• Government debt and future liabilities are huge and growing
I don’t agree with the reasons for higher rates. More about that in future and in past postings.
I have written about this here and here. This is an example of independent investment advice.
Posted by Don Martin on Wed, Mar 09, 2011 @ 05:51 PM
The Financial Times had an article today March 9 that said after subtracting the rise in the Yuan in December the factory gate price actually went down! Its amazing considering all the hysteria about rising inflation in China.
Bond expert Jeff Gundlach interviewed on CNBC continued to be bearish about Munis and about the economy in general, thus supporting his opinion that one should invest in taxable bonds.
An article in FT.com/Alphaville said Chinese purchases of copper were used for margin loans and these purchases were influenced by the huge increase in lending in China after the 2008 crash. This implies that commodities maybe a bubble and are giving a false inflationary signal. It reminds me when Bernanke was asked in 206 about the rapid U.S. housing appreciation he merely said it was a symptom of prosperity instead of diagnosing it as a dangerous bubble. If copper plunges then the margined purchases will be forced to sell and that would create a sharp price drop.
An article today in Yahoo finance by Zachary Roth said lower paying industries had a 23% share of the jobs lost and 49% of jobs gained; by contrast higher wage industries lost 40% then had a 14% share of the gains per a study by the National Employment Law Program. (Be careful, regarding the gains figures it is possible the study was skewed because most people are always at lower or moderate levels of the pay pyramid).
I have written about this here and here. Seek independent investment advice to optimize your well-being.
Posted by Don Martin on Wed, Mar 09, 2011 @ 04:33 PM
Today in the Financial Times is a fascinating article about the Equity Risk Premium (ERP). I had been intending to write an article about this topic before the article in the FT was printed. I shall point out that the author started on some good points but needs to elaborate on them. He said the ERP has been 3.9% a year over the last century according to Credit Suisse annual yearbook. What the ERP implies is that because you take more risk to buy stocks than bonds therefore you deserve a premium or extra benefit of stocks returning more than bonds.
The ERP has floated around in a cyclical pattern over the past century so there are no firm rules about the ERP. (My guess is that a time-lagged study of ERP would show negative correlation with equities, meaning that when stocks go down then the ERP goes up after a 15 to 20 year lag.) The reason the ERP changes is because after a huge crash stocks are cheap for many years and as investors regain their confidence they make a profit by buying when stocks are undervalued. For example after the Great Depression of the 1930’s it took investors until the 1960’s to fully regain their lost confidence and aggressively bid up the market to high PE ratios. So that meant stocks were undervalued during the 1950’s and thus were rising from a low base so the ERP was high in the 1950’s because the rise from the low base produced more return than bonds. Once stocks became overpriced then they needed to come down or stay flat and thus they were doomed to provide a lower return than that of a bond. Since equity bull and bear markets last roughly 17 years then during a 17 year equity bull market bonds would underperform causing stocks to exhibit a high ERP. Conversely during a 17 year bear market stocks need to go down so they underperform bonds causing negative ERP. So while it is true that over a century the ERP is 4%, it varies so much that an investor can’t casually buy stocks and hope to wait until the ERP rewards him. Instead the investor must use Graham & Dodd 10 year PE’s and only buy when the PE is low and sell equities when the PE is too high. This strategy is similar to value investing, but is not necessarily value investing, as it can be done with quality growth stocks that are reasonably priced. When doing value investing it is very important to manually check the health of a company and not merely assume that a low PE stock with a good dividend is a value company. One must check carefully to avoid the value trap of value companies that are cheap because the market expects them to fail. A good example would be the financial companies that some mutual funds bought increasing amounts of as the price declined during the 2008 crash, only to find the company soon went bankrupt.
As a practical matter, I expect that stocks will crash and then when shares are bought at low prices at that time the ERP will return to a normal figure from its current tie with bonds. This means don’t buy stocks until after the crash when the PE ratio is at least 20% below 15, or 12, using a ten year inflation adjusted average.
I have written about this here.
This is an example of independent investment advice.
Posted by Don Martin on Wed, Mar 09, 2011 @ 02:29 PM
During the 1980’s and 1990’s bond market vigilantes would act in the marketplace to raise rates (lower bond prices) whenever they anticipated inflation. This was important because the concern was that the Fed would keep rates artificially low, so people felt they needed bond market vigilantes to raise rates to protect bond investors from being hurt by inflation.
The concern is that the bond market vigilantes have not acted on their own to raise rates. So where are they? The answer is that the invisible hand of the market thinks that the threat of inflation is modest and therefore the market respects the judgment of the Fed not raise interest rates. The San Francisco Federal Reserve even did a study claiming, in some cases, short-term rates need to be negative (below zero) in order to reach an equilibrium point.
However the question is how do bond market vigilantes protect themselves? The answers:
- Study the market carefully, looking for early warning signs of inflation
- Find reliable experts and get their advice
- Avoid low credit quality bonds
- Study the risk hidden in your portfolio and adjust according to your ability to tolerate risk
- Rotate to different bond sectors (mortgage, government, corporate) as the credit cycle changes
- Be willing to hold T-Bills for a long time even zero yield
- Hold bonds only buy using open-end mutual funds and U.S. Treasuries so that you can quickly sell with minimal spreads
- Diversify your portfolio with the following:
- Diversify across the maturity spectrum
- Diversify across different currencies
- Diversify into bonds from different industries
I have written about this here.
This is an example of independent investment advice.
Posted by Don Martin on Wed, Mar 09, 2011 @ 02:20 PM
People have enquired about thoughts on dollar collapse from experts, because the want investing advice about foreign currency. One expert is Pimco mutual fund which has said the dollar won’t collapse because of a concept called Mutual Self-Assured Destruction (MAD), like that risk of nuclear World War III during the Cold War. In that situation the conflicting parties needed to avoid starting a war in order to avoid destroying themselves. Today China holds a huge amount of U.S. Treasuries. If China became angry at the U.S. they could refuse to rollover the short term Treasuries when they come due and this could cause a catastrophe. Conversely if the U.S. devalued the currency then that would deprive China of the full value of its $ three trillion of U.S. Treasury holdings. So both sides need to be careful not to do anything that would destroy the system and throw the world into a depression. Everyone has seen from the bankruptcy of Lehman how important it is for governments to avoid doing something that would create a financial panic. Lehman’s debt was only 6% of the U.S. government’s debt, so U.S. Treasury default would be an economic event 16 times bigger than Lehman. It would be an unimaginably huge crisis, so both sides simply have no choice but to use careful diplomacy and slow gentle financial movements to avoid a crisis. Both sides have an interest in keeping the dollar from collapsing, as do other countries. Thus it is highly unlikely for the dollar to collapse.
Regarding the possibility that the world will use other nation’s currency to replace the dollar: the other developed nations are mostly similar to the U.S. in that the voters love to pressure politicians to promise more benefits than can be paid with taxes collected, thus causing a deficit. Is really much difference between the various developed countries? Yes, the U.S. government spends less than other countries but it also taxes a bit less. True, Europe has about a 6% of GDP deficit vs. 10% for the U.S., but once European bad debts are paid by taxpayers and Europe’s accrued future retiree benefits are fully treated as an expense then European annual budget deficits may be the same proportion of GDP as the U.S. deficits. Further, the U.S. has room to cut its defense budget. I have written about this here and here.
This is an example of independent investment advice.
Posted by Don Martin on Tue, Mar 08, 2011 @ 06:48 PM
In analyzing investments there are many exotic sophisticated ways of analyzing risk. However there is the potential that exotic risk models could fail to work properly in the real world. So to obtain results sometimes the best solution is the simplest: look at standard deviation (SD) as a proxy for risk. This shows how much the total return of the investment is expected to move either up or down, including the value of dividends, as follows:
For a 2 SD event there is a 95% probability it will move within that range. Example: a stock with a 20% SD has a 95% probability it could go up or down by 40% in a year. So if an investment that moves 40% a year is too scary for you then you should not buy it. Please remember that the SD formula that produces a bell shaped curve is a very simple theory and that studies by Bernard Mandlebrot and Nassim Taleb have alleged that the SD formula does not fully assess the hidden, extra risk. So once in a while a Black Swan event could occur that would be far greater damage than that forecasted by SD. These are “tail risk” events where something at the tail of a bell shaped curve occurs with disastrous consequences. I have written about this here.
This is an example of independent investment advice.
Posted by Don Martin on Tue, Mar 08, 2011 @ 03:31 PM
Investors may wonder how to protect themselves from the risk that the dollar could plummet against other currencies. People wonder how to invest in foreign currencies. The solution may be to invest in U.S. based mutual funds that invest in unhedged foreign currency denominated bonds. It is important to read the mutual fund prospectus and all other literature published by the fund to see if the assets are hedged or unhedged against a drop in the value of the local currency. If the assets are hedged then you are not getting the investment in a foreign currency; instead you will get the value of the foreign bonds in dollar terms, so if the dollar plummets then you would lose money even though you bought a foreign currency bond fund. So the objective is to get an unhedged foreign currency bond fund and then examine the fund’s documents to see what percentage is actually in foreign currency bonds and what percentage is allowed in other investments. Some funds hold 20% or even 50% in dollar denominated assets, which is not what I would call an investment in foreign currency.
In making plans to invest in foreign currency denominated bond funds one must estimate how much would the dollar fall against the currency of other nations. The Fed wants to devalue the dollar to stimulate exports and create inflation so as to motivate people to buy things instead of save money. However, other countries, especially China, want to avoid having the dollar decline in value. All nations face tremendous domestic pressure to devalue competitively against each other to stimulate exports. Only few small countries like Singapore, Switzerland and the Nordic countries seem to be able to resist the impulse to devalue, at least some of the time they do. Also, there is really no comparable alternative to the dollar in terms of a truly deep, liquid market. And the Euro has lost a lot of credibility and has a good probability of suffering from more problems with insolvent government members and bad bank loans, and will eventually break up.
The track record of the dollar since 1973 to now was that its index dropped from 108 to 76, a 30% drop, which is 0.8% a year. Since this is relatively minor compared to a hypothetical nominal total return on equities of 9% over the past century, then relatively speaking, the past performance of the dollar was not that bad. Further, the European Central Bank may merely be posturing on rate increases but ultimately will be forced to cave in and reverse course and engage in rate cutting and money supply expansion in a year if the Irish and southern Europe area’s debt problems get worse, which I think will happen. So I recommend that you do not panic about the dollar. Diversification into other currencies with low expectations of profit is OK. However, do not panic and blindly buy any foreign currency investment.
There is the threat of storm clouds on the horizon. During the time from the Great Depression when Roosevelt devalued the dollar until now the dollar has been a haven currency that went up whenever trouble occurred in the rest of the world. This pattern has gone on so long that people have gotten used to it and assumed that it won’t change. But there is the risk that a dramatic event that only occurs once a century could occur and that is that this paradigm could shift and the dollar could become like any other currency where it would not benefit from or been seen as a safe haven currency. Recently the real rate of interest on U.S. Treasury TIPs went up during QE2, yet the dollar did not appreciate. This is abnormal. (Of course QE is abnormal.) When interest rates rise in a country then its currency should rise. This implies the markets anticipate the dollar will weaken. Also during the recent crisis in OPEC countries the dollar did not increase in value. So perhaps there is a paradigm shift and the dollar is no longer a significant safe haven currency but is merely a place for foreigners to diversify an ever-smaller allocation into. So keep your mind open to the idea that the old paradigm could finally have been broken. I have written about this here, here, and here.
This is an example of independent investment advice.
Posted by Don Martin on Mon, Mar 07, 2011 @ 12:09 PM
Investors have asked about the possibility of the return of inflation because it can severly damage bonds and also hurt stocks.
Inflation is nurtured by an increase in the money supply but can only occur if there are constraints or bottlenecks such as a labor shortage or powerful unions or restrictions on imports. Since these things are not happening then inflation will remain subdued.
The three potential sources of inflation:
- Consumers and corporations borrow more from banks. This is not likely since only healthy people and corporations can qualify for a loan and they don’t want to borrow.
- The Fed monetizes the Treasury’s debt. This needs Congressional approval. With ever increasing deficits projected into the future surely more voters will insist on electing Congress members who would try to reduce the deficit. Do you really think the government will meekly pay all of its contingent liabilities when they come due, assuming these are 500% of GDP? Instead Congress will simply refuse to pay. It would not help the government to create inflation because many of the government’s cost are sensitive to inflation so causing inflation in order to pay for the government’s expenses would quickly be seen as something that does not benefit the government.
- Quantitative easing, done to devalue the currency, will not work because other countries will negate that by doing competitive devaluations. Further, if the U.S. did devalue by 20% that would affect the 17% of goods that are imported, which would be a one-time 3.4% additional increase in inflation. Regarding devaluations, the dollar has dropped 15% in 30 years or half a percent a year, which is less than inflation.
I have written about this here and here. This is an example of independent investment advice.
Posted by Don Martin on Sun, Mar 06, 2011 @ 10:14 PM
The Consumer Price Index (CPI) has 40% of its weight influenced by the cost of renting, used as a proxy for the cost of home ownership. The risk is that inflation statistics may be distorted by housing costs. Have a lot of experience with real estate finance, so I like to discuss this issue. One way of looking at it is to assume that a huge mass of unsuccessful home owners will go into foreclosure and become renters thus increasing demand for rental properties and thus creating inflation. The deflationists would argue the opposite: that a flood of foreclosed home may result in them being sold to investors and the investors will be forced to compete to recruit tenants with ever-declining rents. My view point is that these two forces may cancel each other out so that “owners equivalent rent” used to calculate CPI will be roughly zero change, and this non-inflationary event is fair to blend into the CPI. Another way of looking at it is to imagine an island with 9 poor home owners who go into foreclosure and one rich family who buy the foreclosed homes and rent them. The demand for rental units has increased, but so has the supply, thus no net change in rents should occur. However, some homeowners may be foreclosing on and vacating a 2,500 square foot home and seeking to become a tenant in a 1,000 square foot home so as to save on rent. This would also become an inflation neutral event because it would cause rents to decrease for large homes but go up for small homes so that the price changes at the two ends of the spectrum would balance out each other. However, large homes could be divided into duplexes and rented out, thus increasing the supply of lower cost, small rental units, thus hinting at a slight deflationary aspect of the “owners equivalent rent” used to calculate CPI. The big picture is that U.S. consumers will be dealing with deleveraging and repairing their damaged retirement funds, etc. so they need to reduce their standard of living which implies a drop in housing expenses as the number of home buyers is reduced and house prices continue to decline. If house prices decline by 2 to 3% a year for five years this would eventually filter through to CPI and if a 2.5% rental cost decline is weighted by 40% in CPI then that shaves a whole percent off CPI each year for several years. Assuming that the Gross Multiplier (a ratio of rent per year to property value) for housing stays the same and sales prices for houses drop then new landlords will charge less for rent than existing landlords. I have written about housing
here and
here. This is an example of independent investment advice.
Posted by Don Martin on Sat, Mar 05, 2011 @ 11:32 PM
On Saturday China’s Premier Wen said he wants to fight inflation and cap it at 4%. He plans to “regulate the real estate market" to control housing prices. He said the government "will improve policies for regulating the real-estate market and firmly curb the excessively rapid rise of housing prices in some cities." He announced a goal of 8% growth rate so as to keep the rate of expansion stable, thus promoting social stability. Next year China will have new leaders as the two current leaders will retire as scheduled. So the government wants a smooth stable period to ease the transition. Now that the Arab world is experiencing revolution and protests it is important for China’s government to offer prosperity, growth and stability to keep its citizens happy. This I doubt that the China boom will suddenly come to a halt because China has too much of a need for the boom to continue and has a commitment to keep the high growth continuing. I think that the boom could cool off in five years as the country reaches a level of development that is difficult for dictatorships to breach. According to some economic theories when a country reaches a certain level of development it approaches a natural speed limit that can not be overcome unless objective, democratic governmental institutions have been developed such as reliable, independent, fair courts that can award a judgment against patent infringement by competitors or property rights violations by the government. Regarding potential appreciation of the Renminbei, I think China has a concern that if their currency was freely convertible that they would lose control of it, resulting in being manipulated and exploited by foreigners. They have memories of two centuries of colonial injustice and the accidental injustice of the time the U.S. government raised the price of silver in 1934 (it was used as China’s currency) and this led to deflation in China. So potential appreciation and integration of the Renminbei with global free markets may be very limited for many years. Instead China may adjust its currency imbalance with inflation and thus the bottom line price for U.S. imports of Chinese goods will gradually rise until an equilibrium level is reached. I have written about China’s economics here and here.
This is an example of independent investment advice.
Posted by Don Martin on Fri, Mar 04, 2011 @ 02:57 PM
Investors worry that the dollar will go down and so they seek a safe haven to invest in. The fear is that Bernanke will create inflation leading to a decline in the value of the dollar. So let’s review the three ways that inflation may be created.
First: The 1970’s type of inflation was caused by an increase of the money supply from bank lending combined with a tight unionized labor market during a pre-globalization era. The type of labor market that existed then is different by 180 degrees. Today we have ruthless globalization and deunionization and most importantly plenty of excess capacity.
Second: The Federal debt is monetized by the Federal Reserve. This would involve increased deficit spending by congress during a time when the Treasury had trouble selling Treasury bonds. To get to that point would require a Congress that wants to increase spending instead of cut spending. It remains to be seen as to whether or not Congress will be able to cut spending during the next two to four years. It is possible that Congress will make drastic cuts in spending rather than have the Fed monetize newly issued debt.
Third: The Fed manages to increase the money supply using Quantitative Easing, leading to the dollar gradually become devalued, thus making imported goods more expensive, which would incite domestic inflation. This is difficult to do because other countries want to have a competitive devaluation so the U.S. attempts to devalue may not succeed. Further, since imports are 17% of total consumption then a 20% devaluation would be only a one-time inflation surge of an extra 3.4%. The best data set to examine is the history of the dollar’s value for 35 years.
So if inflation is subdued and no worse than other countries then how can the dollar be devalued?
Except for the Volcker Fed era from 1979-87 and the dotcom bubble of 1997-2000 the dollar index has been relatively close to a range of about 80 to 90 and is now at 76.4. It got in the low 70’s in 2008 and then went up.
I have written about the risk of a dollar collapse here.
Independent investment advice is needed to understand the risks of dollar devaluation.
Posted by Don Martin on Thu, Mar 03, 2011 @ 02:22 PM
Berkshire Hathaway, Warren Buffett’s company, recorded a write-down of 48% of the value of a junk bond the company purchased in 2007. The bonds were purchased at a discount and yielded 10% when purchased. They were issued by a utility company. The story was reported in an article Battered Bonds a Berkshire Blemish by Serena Ng in the WSJ on 3-3-11.
My point is that junk bonds are bad because the downside risk is they go down like equities but the upside is that you can’t make appreciation as much as equities. See my posts about junk quality bonds here and here.
This is why investors need independent investment advice.
Posted by Don Martin on Thu, Mar 03, 2011 @ 10:32 AM
Ray Dalio of Bridgewater, the world's largest hedge fund, was interviewed on CNBC.com today. He said an investor should be independent minded, willing to make mistakes, and get past the ego needs so as to focus on finding the right ideas.
The dollar will gradually over ten years lose its dominance and become one of several reserve currencies and decline in value. The developed world is 47% of GDP, the EM world's GDP is 53%. Low interest rates in China created bubble-like conditions which which will result in 18 months in accelerated inflation in China. This is similar to my essays here and here. He likes EM currency investing. He feels in 2012 the U.S. economy will be weaker, but he likes U.S. stocks for this year. He likes gold. Diversification is very important to him.
He is an example of independent investment advice.
Posted by Don Martin on Wed, Mar 02, 2011 @ 01:12 PM
A report was renectly issued, by David Nowakowski and Prajakta Bhide at Roubini Global Economics. It said Muni debt problems aren't "systemic". It said they won’t "infect the financial system." It said there could be close to $100 billion of municipal-bond defaults over the next several years as Muni debt problems occur. Their forecast is less of a concern than that offered by bearish analyst Meredith Whitney.
My own philosophy about investing is that there is too much respect paid to the long term default history and not enough analysis weighted towards current unsustainable cash flow solvency issues. Also, any type of bonds are tool to be used as what Andrew Smithers called a “sanctuary asset” for investments funds that need to be sheltered from the risk of equities. Therefore, unless a bond is of investment grade then one should avoid them. Further, due to the opaque nature of the Muni bonds they are less secure than corporate or mortgage debt. There is too much probability that Munis could come right to the edge of failure and then somehow pull off a last minute rescue by doing a one-time asset sale to raise cash, which would not solve their problems over the long run. A bond that is somehow “safe” because of its ability to squeak through a crisis is not the same quality as a bond back by the income stream of a well-run, solvent corporation. People want to imagine that because Munis having taxing power that somehow they can never fail but is not correct. Munis tend by viewed by investors as an asset class, that despite credit quality weakness, will somehow avoid default. My opinion is that the difference between corporate bonds versus Munis is that corporates have more of a gradual “gray area” buffer zone before the risk of failure, where by contrast, Munis have a sharp binary aspect of either “survive or fail” with the presumption by investors that it would be too dramatic to fail so investors simply ignore the risk of a negative outcome by assuming it would not happen.
Munis issued by weak governments are not going to magically improve in credit quality. If the Eurozone governments decide to have a sovereign default this could scare some U.S. based Muni owners into a selloff.
I prefer that the long history of Munis not defaulting be weighted very lightly and instead their current financial health and political economy should be more heavily weighted in evaluating them. Suppose you are a loan officer evaluating a loan from application for Mr. X and he said he never had any late payments for 40 years. That is not as important as the fact that Mr. X changed last year careers and quit his safe engineering job and bought a very risky business and is now struggling to survive. The nature of government changed in the 1930’s from free enterprise minimalist government to the modern Welfare state and then in the 1960’s during LBJ’s Great Society the nature of most state, federal and county and city governments fundamentally changed to become fast growing entities with expenses that grew faster than CPI or population. I remember in California in the 1960’s we had no state income tax, a 3% sales tax, 2% property tax and a solvent government. Today we have 9.3% income tax, 9.8% sales tax, a property tax of roughly 1.3% (but with valuations skewed in favor of those who bought a long time ago) and a very insolvent government. The fundamental nature of government spending has changed in the past forty years and the beneficiaries of the spending are too addicted to it to give it up. Taxes have risen far higher than imagined forty years ago. So please don’t cite the past 200 years of almost no Muni defaults, instead examine the last 20-40 years of rapid spending increases and tax increases and ask yourself, is it sustainable? Do people with high income become discouraged about earning and spending in California and move away or retire at lower tax brackets in reaction to this? No corporation, either privately held or publicly traded would operate this way. If they did their bonds would be rated as junk.
If an individual borrower had a perfect credit score for the past twenty years while holding a stable job and now in the past year he has been unemployed and living off his credit cards and now has a weak credit score due to high debt balances then his nature has fundamentally changed and his past 20 years of good behavior are of too minimal relevance to be used to assess the safety of loaning money to him. Lending is based on a presumption that good credit behavior of on time payments is a pass-fail screen and if they pass that screen then what really matters is examining recent, relevant cash flow. So please stop saying “because there were minimal Muni defaults in 200 years it will never happen”. That attitude is what got banks into trouble when they bought home loans thinking that since real estate had never gone down significantly in a century then it must be risk free to make loans to anyone regardless of how unqualified they were. There is no comparison between the pre-1965 pattern of government spending and solvency versus the current era of excessive government spending. The fact the California state and local government entities allow lucrative final year pension spikes or final year salaries to determine pension payments and then makes the pension payments inflation adjusted is such a huge change from the standards that existed before the 1965 Great Society era. Similar excesses may exist in other states besides California.
I have written about Munis here and here.
Please use independent investment advice to evaluate the risk of investing.
Posted by Don Martin on Tue, Mar 01, 2011 @ 09:53 PM
Puru Saxena, a Hong Kong money manager said today on www.FinancialSense.com Newshour that China will soon go into a slowdown thus hurting China real estate especially Hong Kong realestate, primarily for leveraged investors and banks. He said base metals prices and companies that make them will be hurt, and commodity countries like Australia will be hurt. Loan rates are 2% in Hong Kong and when they go to 4% that will hurt property prices, he said.
I have written about this here and here.
This is an example of independent investment advice.
Posted by Don Martin on Tue, Mar 01, 2011 @ 01:56 PM
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.