Posted by Don Martin on Fri, Sep 30, 2011 @ 04:20 PM
World Economy Heading into Another Significant Recession
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RBS economist David Mackie and FT economist Martin Wolf feel a recession in Europe is certain. Mackie feels it will be like the 2008-09 crash instead of less severe crashes. Wolf said “…this depression would be longer and costlier, in terms of lost output, than the Great Depression of the 1930s.”
Economic Cycle Research Institute has predicted that a recession will occur. Co-founder Lakshman Achuthan said it is a vicious cycle.
What is important is that during the start of the last Great Depression the government spending and deficits were much smaller than today, so the Keynesian theories of government stimulation may be irrelevant or unworkable today. If the government simply tries to print money instead of borrow it, the marketplace might react as investors did in Japan (when the government borrowed too much money), with a negative attitude where the investors and consumers became afraid to spend and invest and the economy became stuck in a deflationary quagmire for two decades. During the Japanese Soft Depression the government borrowed excessive amounts of money to stimulate the economy but it did not work. The government also increased the money supply, but that was not done as much as was deficit spending. The marketplace could view an attempt by the government to inflate out of a Great depression as a bogus therapy that will not succeed. If massive inflation occurred then prices would rise as fast as the government could print money and thus the government would not be able to give any “real” stimulus.
Money: huge pile of it is needed to pay for stimulus to get out the coming recession
I have written “Prices, assets going down” and “Hidden economic weakness”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Sep 29, 2011 @ 02:03 PM
China’s economy is cooling down. Credit restrictions are making it difficult to get financing for small independent businesses. Loans from non-bank lenders are being reduced or else offered at prohibitively expensive rates.
The price of copper has come down 23% in this month, which is a key economic indicator. Since China buys a huge amount of the world’s copper then the price drop implies less economic growth. Today the Wall Street Journal and Barron’s both ran articles about copper as a key economic indicator. Barron’s quoted economist Michael Darda “It looks like some kind of liquidity squeeze is under way in China”. Both articles pointed out that copper is highly correlated to the SP 500, which implies stocks will go down.
GMO’s Edward Chancellor said that China uses 1,400 Kg per capita of cement annually, more than the 1,000 Kg annually used in Spain during their massive building bubble of recent years.
FT interviewed Gilliam Tulloch of Forensic China and he said China’s property market is in a bubble. There has been a huge inflationary bubble with a dramatic increase in the money supply in China. The fact that there is little mortgage debt disguises the problem because people in China use corporate loans to speculate in property instead of mortgages. In China people use property as a store of value but end up overpaying for it (and overproducing it) and thus wasting money on a bad investment.
The risk of China economic slowdown is that it will affect the rest of the world with a crash in commodity prices, thus hurting many Emerging Market commodity countries and will create a bearish climate for equities in all countries.
What is the hidden condition of the economy?
I have written “Copper bubble explained” and “China’s hidden loan bubble”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Sep 28, 2011 @ 03:35 PM
Why the Eurozone Crisis is Worse Risk Than U.S. Lehman 2008 Crash
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Christopher Flowers said on Bloomberg yesterday that the Euro zone debt crisis will probably make Europe go into a deep recession and this will lead to a recession in the U.S. as well. The Eurozone economy could still possibly muddle through or it could result in a crash. He said European banks are more vulnerable to a crash that will be worse than the Lehman 2008 crash. European banks are bigger and have more wholesale deposits than U.S. banks were during the 2008 crisis, which makes them more at risk. A better way to run a banking system would be to have most deposits come from small retail investors and to have a banking system that is a smaller percentage of the economy. The US. has one nation, one Congress, one Central Bank, etc. but the Eurozone has many of them.
The residual value after a hard crash
I have written “Probability of a Eurozone default” and “Euro bailout won't work".
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Sep 27, 2011 @ 06:06 PM
The five key elements of financial planning:
* Investment planning
* Insurance planning
* Income Tax planning
* Retirement cash flow planning
* Estate planning
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Sep 27, 2011 @ 04:29 PM
Why the Euro Bailout Won’t Work
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Today the rumor is that the Eurozone will bailout the PIIGS countries by buying 1.8 trillion Euros of bad debt. The ultimate backers of the bailout would be mainly France and Germany with a total population of about 150 million. This is $12,000 of debt per person or $48,000 per family. Perhaps half of the value of the debt will be lost when the truth finally comes out and the bad debts are given a haircut down to the fair market value. So the average family in the northern Eurozone could lose $24,000 plus interest taking care of the bad debts of southern Europe.
This loss means that prosperous northern Europeans will have to reduce their purchase of consumer goods and thus the region will suffer from a severe recession. If the average Northern European per capita income is $35,000 per year then the loss would be a very large percent of a year’s income. In addition Northern Europeans have a high amount of taxation, so this loss would be an even higher amount of their after-tax income.
A ton of cash will be needed to fix the mess.
So the choice for the Eurozone is to either be honest and admit that a loss has already occurred and make the banks suffer the loss or else the losses will be shouldered by the already overtaxed population who will lapse into a Japan-style Soft Depression because they will be forced to cut back on consumption.
Since the U.S. stock market rallied today in hopes that the leaked plan would somehow fix the Euro’s debt problems then the stock market was wrong. When the truth comes out the stock market will need to go down. Since I already estimated that the SP needs to go down to 800, if we add in the problems caused by a Euro crisis then the U.S. SP index needs to go down to a point even lower than my forecast of 800.
I have written “Probability of a Eurozone default” and “Greek financial crisis may be Europe’s Lehman crisis”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Sep 26, 2011 @ 02:14 PM
Examine the Details of Buy and Hold Investing
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Investors have heard expert claim that they should use “Buy and Hold Investing”. The popular myth is that people should simply buy stocks and hold on to them during a crash. The theory is that it is allegedly impossible to time the market or to value the market so one should simply hold on no matter how bad the market gets.
My interpretation of “Buy and Hold Investing” is that one should only buy stocks when they are low priced and when fundamentals indicate good value (thus attempting to avoid the “Value Trap”). Once an investor has purchased stocks or other assets such as real estate commodities then “Buy and Hold” makes more sense. Of course buy and hold investing should be modified by getting advice from a financial planner regarding personalized details such as liquidity needs, college funding needs, tax planning, some of which may still have to yield to the need to buy and sell at the right time.
So the key to buy and hold investing is to only buy when the price is right. If you buy stocks when stocks are too high then the market will go down and you will lose money and may become so frustrated that you can’t listen to good advice later when it is finally the correct time to buy.
Open the door to new ideas
How Should Investors Decide if Stocks are Priced Low Enough to Buy?
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Use the Shiller PE 10 and Tobin’s Q. Buy only when prices are at the low end of the range between high and low. Don’t use current one year or future earnings for PE ratios. In addition one must examine the financial health of the company and only buy if the company is healthy. This means examining the debt loads, corporate moat, return on equity, sales growth, profitability growth, etc.
Using buy and hold investing incorrectly could be a disaster.
I have written “Buy and hold investing does not work”, “Wall Street Revalued Imperfect Markets and Inept Central Bankers” and “Shiller PE 10 still correct”.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Sep 23, 2011 @ 05:20 PM
Who are the Investors in Emerging Market Foreign Currency Denominated Bonds?
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Many people who invest in these bonds seek to get higher yields than are available in developed countries. They don’t want to wait around patiently to realize a long term gain in these bonds when the dollar gets devalued, instead they want immediate profits from a high coupon rate.
Some investors are over-leveraged hedge funds that may have been subject to a brutal margin call with a forced sell off or to a sudden lack of new Put options to protect their leveraged assets. These hedge fund owners may have sold out by now.
A third type of Emerging Market Foreign Currency Denominated Bond investor is a patient type who is waiting for the market to realize that a new paradigm shift has occurred where the developing world is a better credit risk than the developed world and that developing world currencies may continue to go up as the developed world suffers from recession.
Wealth shifts from weak hands to strong hands during a panic. The weak hands may have sold their investments and eventually as the markets accepts the new credit quality paradigm about Asia and the Emerging Markets then EM bonds will recover while in the hands of stronger investors.
How Low Will the Price of Emerging Market Foreign Currency Denominated Bonds Go Down?
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No one can forecast that question accurately. One possible guide is to see what happened in the 2008 Lehman crash. Many assets such as stocks and oil dropped in the summer of 2008 to March, 2009 about 50%, but investment grade Foreign Currency Denominated Bonds in one mutual fund dropped about 29%. EM Bonds have about a 13% Standard Deviation, so a two Standard deviation event has a 95% probability of being within two times the 13% Standard Deviation or 26% up or down, which is close to the 29% drop in 2008-2009. If the market retraces the crash of 2008-2009 this would imply, since the market has dropped 10% for one FX EM Bond mutual fund then perhaps it could go down another 19% if a full crash occurred. But that would still be less than junk bonds or equities will crash.
Foreign currency
If an investor is so conservative that he is already is allocated to 100% investment grade bonds then perhaps he needs to take on a little risk. About the smallest amount of risk (ignoring Treasuries, cash, and fully hedged hedge funds) is the asset class investment grade bonds with intermediate term maturities. Then there is the risk that if a new paradigm shift occurs and the dollar is devalued then investors will be glad they were in Emerging Market Foreign Currency Denominated bonds.
Gold bugs like to say that gold is an insurance policy rather than investment. I would use that as an analogy to owning Emerging Market Foreign Currency Denominated bonds and say that they are, as a metaphor, insurance against catastrophe.
I have written “Understanding foreign currency bonds” and “Foreign Bond Crash news you must know".
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Sep 23, 2011 @ 03:54 PM
Why I don’t worry about the stock market
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I have bearish for a long time (holding a 100% bond portfolio), so the current stock crash was not scary, instead it made me feel vindicated. Further, my bearish investments went up in value in the past week, so I am better off as a result of the crash.
Open the secret answers to investing
The way that you can avoid worry about stock market crashes:
* Own more bonds and own less stocks.
* Own only quality assets. This means bonds rated investment grade, or if you insist on equities, then own equities with low debt, high corporate moats, strong financial health, etc.
* Pay down your debts
* Sell your nice big house and own a small one with no debt
* Have plenty of liquidity for emergencies
* Cut down your living expenses
* Get a financial plan done by a CFP® who does not charge commissions.
* Be properly insured for health, property, casualty, disability, business interruption, life.
* Don’t feel bad about stocks dropping below their high water mark, instead realize their intrinsic value is lower than today’s price (the SP on 9-23-11 closed at 1136 and needs to go down to 800 or even lower). So you are better off today than you will be in the future when the stock market goes lower, which means that you should reduce your stock ownership now.
* The Fed’s failure to fix the economy this week with Operation Twist is good because people will wake up and realize that the Fed’s intervention doesn’t work, so they will open their mind to thinking about the possibility that the market has been propped up by the government and they will realize the market may go down. This will ultimately lead to a more fairly valued stock market that has less bubbles and that has capital that is deployed in the proper areas of the real economy that create jobs instead of in non-productive, leveraged speculative bubbles. This will lead to better economy a long time in the future, just as the brutal end of inflation in 1982 led to a prosperous era a decade later.
In the meantime, please invest as if it was the eve of the 1930’s Great Depression: Bonds, bonds, and more bonds.
I have written “Three things you must know about the crash” and “Shiller PE 10 still correct”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Sep 22, 2011 @ 04:28 PM
Factors that influence foreign bond prices
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Emerging markets foreign currency denominated bonds can be affected by the following:
* Changes in local currency bond discount rates
* Changes in the issuer’s credit quality
* Changes in local currency inflation
* Changes in the local EM political economy that threaten property rights
* Restrictions on purchases of foreign investments by the largest countries
* Forced asset liquidation by leveraged investors meeting margin calls
* Forced asset liquidation by leveraged investors suddenly unable to buy Put options
* Irrational sales by naïve foreign investors
* Thinly traded bond markets that are hard to value
* A collapse of the commodity market
Should investors flee the FX market?
An investment could have good characteristics but still decline due to prejudice
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One possible scenario with EM bonds is that since their economies often make a significant income from commodities then when a commodity crash comes the local economy will be devastated. So the prejudice of the market is to assume that all EM investments who fail when commodities crash. However, many EM economies are diverse and integrated enough to withstand the loss of commodity exports. Further an investment grade bond issuer has less than a 1% chance of a failure according to the ratings agencies. To get to a 2% chance of failure you have to go down two notches below investment grade to single B rated companies. Then if a failure occurs the bond holders get paid before the stockholders. So investor prejudice against the potential failure of equities in an EM commodity export country has caused investors to panic and unjustly sell off EM bonds. Therefore investors should not panic and should hold on to their investment.
The EM bond asset class has a standard Deviation of about 13, versus 24 for U.S. stocks and 35 for EM equities. One must not assume that because bonds are lower risk than equities that they somehow have no risk! Bonds can suddenly go down in value for irrational reasons. The only alternative to this asset class might be to move closer to the absurdly low yields of short term domestic bonds, but if the dollar ever gets devalued then a person who sells EM bonds and moves in dollars would lose.
Buffett said he buys businesses rather shares of stock. What he means by this is he buys the intrinsic value of a business and does not let day-to-day prejudicial panic sales influence him.
Another risk is the “carry trade”, where foreign investors get a low rate margin loan denominated in dollars at 1% and then uses the loan to buy a foreign currency bond that pays very high rates. The investor can make a huge profit by leveraging his investment. If the investor borrow at 1%, levers up 10 times his down payment and invests in a bond that pays 11% then his 10% spread is multiplied by a factor of ten and he makes 100% gross profit before the cost of Puts, CDS, commissions, etc. Unfortunately when the foreign bond drops a ruthless margin call forces the investor to sell even if he does not want to sell.
A mutual fund that holds bonds must market to market every day, but many bonds don’t trade every day, especially local currency EM bonds. So the values are somewhat hypothetical and subject thin trading could gap down more so than a deep, liquid market like U.S. Treasuries.
I have written “Emerging market FX to Decline?” and "Foreign Bond crash news you must know”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Sep 22, 2011 @ 03:33 PM
Market Conditions Impeach the Credibility of the Fed
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The ten year U.S. Treasury yield has gone from 2.07% on Friday the 16th down to 1.72% today. This is a stunning breakthrough in rates that is a symptom that the market believes we are going into a depression. Even more shocking is that this was caused by the Fed’s actions. It is a gigantic vote of no confidence by the market against the Fed. This almost at the level of the 10 year Japan Treasury bond. The U.S. has fallen into a Japan style Soft Depression.
I strongly believe the bond market pricing is logical, fair and is not a bubble. It is the equity market that attracts irrational investors who often hijack it and drive into a bubble territory. By contrast the bond market is driven by level headed professional institutional investors who avoid the unjust prejudices of retail stock market investors. I simply don’t sense that retail investors are hysterically clamoring to buy bonds. Instead bonds are being purchased by professionals because that is the right thing to do.
The 30 year Treasury is at 2.79%. The 30 year German Treasury is 2.46%, the 30 year Japan Treasury at 1.9%.
Commodities are down sharply, signifying a repeat of the crash of 2008. Oil is down 6%, copper down 9%. This confirms what I have been saying that inflation hedges are costly, risky, a bubble, and won’t work.
The Fed has used up all of its ammunition and has now been exposed as lacking power and credibility. The Congress is determined not to increase deficit spending, which is the Keynesian tool used to get out of recessions. Further, the huge amount of government debt is without precedent and is so much larger than that of the Depression era that the Keynesian deficit stimulus techniques won’t work. (See my article "Ricardian equivalence"). So there is no way the government can get the economy back to normal.
Only 20% of the jobs lost in the 2008 crash have been restored despite the tremendous stimulus used by the government, and new homes sales are at 20% of the (population adjusted levels) of the 50 year average.
Better to sit in cash than lose money in stocks
What Investments Work Best in These Conditions?
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During a depression once stocks have reached the bottom then they will become a good investment – but not before. The Q ratio implies they are still 40% overpriced, implying that the SP’s value is 800 points. At that level the dividend yields will be very attractive. During the 1930’s Depression dividends were 6%, so if you bought after the crash the compound effect of a 6% yield over a decade was enormous. During the Depression there was still demand for commodities – the catch is that an investor had to wait to buy them at the bottom and not buy too early at the top.
Investment grade bonds are my favorite investment because they are the closest thing to cash without having the 0% yield of cash. However, bonds are not cash, because there is risk that over time a bond could suffer a credit quality downgrade or suffer from an increase in market interest rates which would make bond prices go down. There is room for long term Treasury rates to go down another 30 BP, but there is risk they could eventually go up in a few years, so buying these levels would be a short or intermediate term trade, not a buy and hold investment.
While waiting for the market bottom to be reached there will be the risk that many good quality investments, that are owned by highly levered hedge funds, whose owners will forced to sell them even if they don’t want to, in order to meet a sudden instantaneous margin call. So be prepared for sudden price declines of quality, non-bubbly stocks. Remember the crash of October 19, 1987 and the Flash Crash of May, 2010? Those crashes can still happen even with stock market circuit breakers that limit trading during a crash. There will be irrational investors who will wrongly sell off good assets and there will be automated flash crashes and forced sales by over-leveraged hedge funds that will make good quality reasonably priced investments go down for no reason. The only defenses (besides being in cash) is to get the best quality, most conservative investments, avoid owning over-priced investments, avoid leverage, don’t sell in a downturn, get macroeconomic advice to avoid the wrong asset class.
Investors should invest in building their investment skills in the area of patience, self-confidence, modesty, rather than attempt to chase after yield or chase after windfall profits. By this I mean learn to tune out the masses who say things like "buy a stock with a 3% dividend because it pays more than bond", and instead consider that if stocks drop 40% then you would be better off owning an investment grade bond with a very low yield rather than losing money in stocks.
I have written “Fed's Twist: how does it affect Foreign Bonds?"
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Sep 21, 2011 @ 05:02 PM
What is the Fed’s Operation Twist?
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Today the Fed announced a new “Operation Twist” modeled after the one used 50 years ago. The Fed will sell $400 Billion of short term bonds and buy long term Treasuries so as to force down the long term interest rates.
The results in today’s market: Gold down 1.2%, SP down 3%, copper miner FCX down 7.7%, copper down 1%, oil down 2%. The marketplace views this as deflationary.
The result is that investors may invest in foreign currency bonds with a long term maturity to get the yield they can’t get in the U.S. The Fed wants to devalue the dollar, so by pushing investors into foreign currency that will make the dollar go down.
The $400 Billion is a drop in the bucket, about 20 to 30% of what the Fed has bought in the past three years. Those purchases backfired and only influenced rates by 50 to 100 BP, so today’s plan will have minimal effect. It is the free market that is forecasting a bad double dip crash by lowering 10 year Treasury rates to 1.88%. Japan has had rates around 1.5 to 1.2% for long term Treasuries, so we are definitely following Japan into a long term Soft Depression where the only credible asset class (regardless of how small the yield) is investment grade bonds.
Housing starts are at about 20% of the population-adjusted 50 year average. The job market has only replaced 20% of the lost jobs in the past three years, despite enormous stimulus. When these two very significant indexes each are at 20% of what they should be then we are basically in a Soft Depression. The stock market is a very dishonest, unreliable irrelevant indicator. It should be trading at levels as depressed as real world indicators for housing and jobs.
The Fed's Operation Twist is a drop in the bucket
What Foreign Bonds are Best?
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Emerging markets are starting to cool down so their Central Banks are under less pressure to raise rates to fight inflation. So if their rates are lowered (or possibly even if their rates are merely not increased during a time when investors were expecting a rate increase) then holders of long term foreign currency denominated bonds may be rewarded (assuming there is no Great Depression that damages the credit quality of the bond issuers). (When rates go down then a long term bond goes up in value).
The best economies in the EM would be those that are sophisticated, nearly developed, integrated economies with the smallest possible percentage of export revenue from the overheated commodities sector. These countries would be value-added manufacturers of sophisticated, quality products. This means avoiding Latin America and Africa and instead investing in Asia-Pacific region. Also, Brazil has a very high interest rate which had made its currency high priced and now the currency is coming down sharply.
I have written “Emerging Market currency – is it OK?” and “Emerging Market FX to decline?”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Sep 20, 2011 @ 06:46 PM
An analogy to explain the Euro:
A new housing development on a small new cul-de-sac offers for sale four houses. Let’s call the street “Euro” street. The buyer of one house on the north side is a German doctor. His neighbor on the north side is a Dutch doctor. Each doctor earns $300,000 income. On the south side of the street are two houses, each one bought by a citizen of a Mediterranean country. The Mediterranean homeowners make $40,000 income and bought the house using an “easy qualifier” loan with low interest-only deferred (negative amortization) payments that are less than the annual interest on the loan. They hollowed out the equity with a second mortgage line of credit with interest-only payments and used it to supplement their meager income, causing their net worth to drop as their debts increased.
The northern neighbors welcome their new southern neighbors. The northerners assume that since the southerners bought a home they must also make $300,000 a year. They decide to become close friends because they assume that since they all own a house on a cul-de-sac they must all be equal so why not bond together and share resources, making the neighborhood more efficient. They share keys to their houses and borrow furniture and appliances from each other when on vacation. They allow repair people to access the other people’s homes for maintenance, etc. It is more efficient sharing instead of each home being firewalled off from the neighbor. The Union of neighbors allows for bulk purchasing of repair services, etc., so it produces a greater prosperity than no union. So the German and Dutch doctor co-sign loan applications for their southern neighbors, enabling them to get lots of low interest credit cards. The doctors co-sign mortgages for the southerners enabling a larger home refinance with even more debt. By comingling their borrowing capacity the doctors have greatly expanded their poor neighbor’s ability to borrow and spend. This creates a boom in the neighborhood. Soon lots of $85,000 BMW’s bought by the southerners fill the street causing property values to rise, since naïve people assume those symbols of affluence make it a good neighborhood. The bank appraiser assists in granting a larger mortgage. The bank justifies it by quoting two Fed chairmen who said that rising home values and consumer spending are a symptom of prosperity. The Fed chairmen assume that the market is always efficient so the only way someone could have increased consumer goods and high home prices is because the market “knew” that the person would make a good borrower.
When the Mediterranean southerners have trouble paying their debts the doctors decide that the bank must have caused the problem so they loan their own money to the Mediterraneans. The doctors assumed that if you can buy a house next to me you must be solvent. They never looked closely at the southerner’s finances.
When the southerner had trouble paying the mortgage he said to the doctors “if I go into foreclosure I will accidentally ruin your credit rating since it is comingled with my finances and the foreclosure will lower your property values, so that you will lose all of your house equity.” When asked to put up furniture as collateral suddenly an accounting showed that the southerners sold their furniture on Ebay and they are renting furniture or borrowing it from the neighbor. The southern neighbors become incensed when asked to put up collateral. “We are your neighbors who own a home like you, so why can’t you trust us.” The drop in their standard of living makes them angry and riot police are called to cool them down.
A financial advisor counseled the four families and said “either you band together and have the two doctors pay all of your major expenses and subsidize the southerners or else you all have to declare bankruptcy and sell off the southerner’s homes at depressed prices, ruining values in the neighborhood”
I have written “Probability of Eurozone Default”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Sep 20, 2011 @ 05:51 PM
Additional thoughts on Emerging Market Currency
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FT ran an article “Rise of EM Currencies Falters” on 9-19-2011 which said:
"Asian central banks have amassed record foreign currency reserves in recent years, giving them vast firepower to defend their currencies and smooth volatility should they choose to do so....According to economists’ consensus expectations, while Asian currencies may have further to fall in the short term, the midterm outlook remains bullish due to the region’s more favorable prospects for economic growth."
In a separate article: The IMF World Economic Outlook forecast released today said 1.6% growth for developed countries and 8% for Asian EM’s. 8% growth is such a huge figure, especially while the developed countries are so weak. If the EM countries depend on developed country purchases then how can they have 8% growth from a buyer who is growing at 1.6%? This implies at least some partial measure of decoupling between West and East, which implies Asian currencies are OK.
Balassa-Samuelson Effect Supports Emerging Markets Currency Values
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The Balassa-Samuelson effect says that prices will be higher in countries with higher productivity (GDP). The result: when above average income growth occurs then rising price levels occur (certainly true in EM today) and this makes real exchange rates go up.
A lot is at stake in FX market
Emerging Markets Currency Prices not an Efficient Market
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Currencies are not an efficient market because some buyers are too preoccupied with their main business purpose of running an import firm or travel agency to bother with elaborate hedging or arbitrage activities and instead they simply focus on getting a one-sided business transaction done to import goods and services. A sophisticated multi-national corporation when buying imports might have planned long in advance with the purchase of futures contracts, but a smaller firm or a wealthy tourist may not bother with a hedging and arbitrage techniques like a forward currency contract, etc.
The FT had a video a few months ago claiming that investors appear to be making an irrational decision to buy foreign currency based on high nominal interest rates rather than “real” (inflation adjusted) rates. (When one adjusts for the income tax consequences of this then the error is even worse by paying tax on phantom current yield).
I recognize this pattern with U.S. based mutual funds that invest in foreign bonds. The majority of U.S. based foreign bond funds don’t convert into foreign currency denominated bonds but instead simply try to get a high yield denominated in dollars so they can attract U.S. investors looking for a yield. But if the dollar gets devalued these investors will have missed out on foreign currency appreciation. Considering how some naïve retail investors are so frustrated with the low rates in developed countries it seems intuitive that some of them might “panic-buy” an EM currency like the Brazilian Real to get the high yield without clearly understanding inflation and taxes. This would be further proof that the FX market is ripe with inefficiencies that might enable astute investors to harvest alpha.
Emerging Markets Bond Investing Versus EM Stocks
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The Emerging Markets stocks have a reputation for less transparency, less honest corporate accounting, greater boom and bust volatility than U.S. stocks. By contrast, the Emerging Market’s bond markets are dominated by corporate borrowers who remind me of the U.S. borrower from the 1950’s: someone motivated by memories of the Great Depression who fears debt, uses it sparingly, has a high capacity to repay it, etc. By participating in Emerging Market bonds it may be possible to benefit from EM economies without the same level of risk as EM stocks. Emerging markets corporate borrowers tend to be more in the BBB to B range because the A to AAA borrowers simply pay cash to buy capital projects and don’t bother issuing a bond, with the exception of Sovereign borrowers. As Emerging Markets grow and become used to developed country corporate financial techniques then more A paper EM bonds will become available.
I have written “Emerging Market FX to Decline?”
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Sep 20, 2011 @ 02:23 PM
For FX or gold one must redefine the word “investment”
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Regarding investing anti-dollar devaluation investments such as foreign currency or gold one must redefine the word “investment”. I saw a lecture online last week by Nasim Taleb at Wharton (he wrote Fooled by Randomness) where he said buying an insurance policy, in the form of a Put option, to protect an investment, is not really a cost, it is simply an investment that one must do to protect one’s investments. He is convinced the markets are full of potential statistical outlier severe crashes, so he is bearish about everything and is frequently talking about buying Puts.
My point is that by analogy to what he said is that investing in foreign currency is like what gold bugs say about gold: that it is an insurance policy to protect their assets rather than a way to get rich. Of course the word “insurance” is simply a metaphor because I am not selling insurance, instead I’m trying to recommend ways to reduce investment risk. There is no guarantee that a purchase of foreign currency will insure against a possible crash in the dollar, etc.
My intent in recommending investing in foreign currency (like the gold bugs slogan about gold investing) is that it is (as a metaphor) an insurance policy against the risk of dollar devaluation rather than a traditional investment where the investor seeks to make a windfall profit. When you buy a property or Life insurance policy you “lose” money paying the annual premium. When you buy gold bullion you lose money on the bid-ask spread, and the fees for assay, storage, insurance fees, etc. This is done because the gold investor views it as insurance against catastrophe rather than a traditional wealth building investment.
Open the door to new ideas
Try to have the viewpoint of a citizen of a tiny neutral country
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Consider the viewpoint of a citizen of a tiny neutral country that has no capital markets. He would be objective about the choice between investing in U.S. dollars versus other currencies. If you told him you refused to diversify out of dollars because you did not have an accounting system to recognize when you assets went down because of a dollar devaluation, he would disagree with you and say that you are missing a key investment idea.
Investors in the U.S. should think as if they were a citizen and resident of a tiny neutral country and then pick investment opportunities objectively between the world’s major regions.
It is a good idea to diversify out of the dollar and it is very hard to time the market for foreign currency, especially in regards to short term fluctuations. One of the basic principles of investing is to diversify, in some cases into things some people don't like; also some academic advisers believe it is impossible to forecast the market so they advocate diversifying and holding on even if an asset goes down. I chose some mutual funds because they have less volatility than other funds in that asset class.
What alternatives are there to the dollar? Gold investing makes me nervous; I would rather be in EM currency than gold bullion. Obviously the Euro is going to go down in value, which is why I have avoided it.
Bernanke lent dollars to the ECB last week so they could prop up their system, so that is a form of dollar devaluation. He has a rare two-day meeting starting today. He likes to devalue the dollar and will keep trying. I like to have an investment that is diversified out of the dollar and which is not in Euros.
Use fundamental valuation to make investment decisions
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EM countries have 52% of the world’s GDP and most of the world’s economic growth and far less of the developed world’s debt then EM countries are the future. Most developed countries lack credibility (except Canada, Australia, New Zealand, Scandinavia, Switzerland, Singapore) because they spent the past 66 years after WWII engaging in massive deficit spending and now the accumulated debt has reached critical mass with little hope of a pleasant outcome. A country with high growth, low debt, good demographics, and a tradition of no welfare state deficits is a country that will have a positive long term inflow of funds which will make its currency go up over the long run. Despite the risk that the world’s capital could flee into the perceived safety of the dollar (and thus make other currencies go down) that risk, if it happened would only be a temporary phenomenon that occurs during a recession. Eventually recessions come to an end and then the world will continue to have problems with developed countries' fiscal imprudence contrasted with Emerging Markets' prudent fiscal behavior. This is in regard to currency values and the quality of debt obligations. However, it is still possible for stock markets in EM countries to have bubbles (caused by overpaying for stock) that result in EM stock crashes.
It is time for investors to respect the EM as an alternative to the major develoepd countries rather then viewing the EM area as a tiny, weak banana republic.
One idea is that the countries best able to do Keynesian deficit stimulus are those with the least debt, which are EM countries, so that might make their economies grow and thus make the flow of funds into them positive, thus pushing up EM currency.
The EM countries are like a borrower who is over-qualified for a bank loan. Remember the cliché that the only way to get a loan is be someone who does not need a loan? By contrast, the developed countries are like a prospective borrower who needs a loan because he can’t qualify for a loan (and thus won’t get a loan).
I don't see how the developed world can do an increased Keynesian deficit spending (needed to get out of the recession) with the current excessive level of government debt.
The macroeconomic questions that economists need to research regarding the preceding paragraph are unprecedented.
I have written “Is gold fairly priced?” and “Two things about devaluation to know”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Sep 19, 2011 @ 04:35 PM
Will Foreign Currency Maintain its Value during a Crash?
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The old paradigm was that during a bad world-wide recession that everything crashed and went down against the dollar, including foreign currencies. The overly-simplistic stereotype was that foreign countries depended on U.S. consumers and so during a recession the other countries suffered the most and thus their currency went down against the dollar as people sought the dollar as a safe haven.
However that stereotype has to be weighed against the reality that after 1945 the British Pound went through an enormous and permanent decline for fundamental reasons. So might the dollar follow the Pound into decline and thus the old paradigm has been broken?
The problem with foreign currencies is that foreign countries are much more export oriented than the U.S. so during hard times they may suffer more despite exerting a great effort since the 1997 Asian crash to have very good finances. What could happen during a crash is that Asian governments could stay solvent and Asian bond issuers could make their payments, but their countries would have a net outflow of funds leading to a decline in their currencies’ value.
I have written “Investment hedges against dollar decline”.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Sep 16, 2011 @ 04:06 PM
Regarding gold, during a deflation, it should go down with other metals, and if one uses a 10 year inflation adjusted Shiller-style average of gold centered around the January, 1980 nominal high of $885, then the one year average would be a $612 nominal price and the ten year average between 1975-1985 would be about $325 nominal, which if adjusted for inflation, would be about $893 to $1,680 current dollars as a fair value for gold.
If we add a post WWII 1942-47 inflation of 70% (to show the effect of inflation after WWII price controls were removed, and to make an analogy between that inflation and the possible future inflation needed to inflate the world out of its troubles) then that would imply gold at its peak would be 1.7 times a fair value range of $893 to $1,680 or about $2,200 which is not far from its current level. However, that may be double counting since the marketplace has already priced in a 70% crisis premium then I doubt yet another 70% premium should be added to the price. Looking the difference between the ten year average of 1975-1985 and the one year average of $612 during the 1980 the price temporarily was at an 88% premium, which is an interesting analogy with WWII inflation.
(My ten year average is a crude figure that is not adjusted for each individual year’s inflation in the 1975-1985 period, thus the difference in real terms between the 1980 one year average and the 1975-1985 ten year average is actually smaller.)
Thus I doubt gold could go higher and I worry it could go down 50% from current levels as it did after the January, 1980 peak.
The problem with investing in inflation sensitive assets is that they tend to get over-bought by panicky speculators who over-pay for them, thus alleged inflation hedges are risky and may be overpriced.
Open the secret to valuation
See the 8-27-2011 Barron’s article about gold or the article in the May 9, 2011 Economist magazine.
I have written “What is the proper value of gold?" and "Evaluating gold".
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Sep 15, 2011 @ 04:31 PM
Latin America Trip Reveals Emerging Market Secrets
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I recently returned from a trip to Latin America where I observed Emerging Markets. A Bolivian told me about how many years ago his father sold a car for cash (paper money in a bag) and when he went to deposit the money to the bank the next day the currency had become worthless. The lesson learned is that sudden dramatic currency devaluations can occur and so one should avoid keeping deposits in or holding cash in currencies that are unreliable.
A Search for a New Perspective on Investing
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During my visit to Latin America I had time to re-think my deflationist investment paradigms and became concerned that I was too bearish. I wanted to keep my mind open to searching for new investment ideas. However, in checking the news during the trip I saw that U.S. Treasury rates fell dramatically. Then when I got home and caught up on my reading it became apparent that the deflationist theories that I have been advocating have been vindicated.
So I realized that I was influenced by the phenomenon where a successful investment advisor must be a contrarian, however, a contrarian viewpoint is inherently a lonely one where the advisor may become frustrated by the fact that his views are not appreciated by the masses of people so that he begins to wonder if he is wrong.
Fortunately my bearish views were confirmed by the developed world’s markets during my trip.
While visiting Lake Titicaca, Bolivia I stayed in a hotel with room for about 120 guests. I ate in the dining room which had room for about 120 customers. Not once in two nights did I see any other customers. I asked the staff and they said that due to the world recession there has been a drop off in tourism. During recessions the first thing people cut to save money are expensive foreign trips. Well this was a hugely deflationary indicator! No other guests in the hotel despite good weather, reasonable prices, a safe and interesting place to visit. To see a fixed asset (the hotel) suffer a 99% vacancy rate was astounding. I had never seen anything like it. It was spooky being the only guest. I wondered how could the local economy survive with the huge drop in tourism? When I flew to Latin American, the plane was only half full; when going home most of the passengers were foreign visitors, implying that few U.S. residents were taking vacations.
The most useful economic indicators are real world things like joblessness, excess capacity, etc., rather than artificial things like stock prices, interest rates, that can be manipulated by the Fed.
I have written “Bearish fundamentals in the news” and “prepare for a crash” and on April 29, 2011 “Bears should not capitulate”.
Investors should seek independent financial advice.