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Economics

New high! (Zzz.)

“The FTSE 100 has at last topped the record it set at the close of 1999. Should Britons celebrate ? Probably not.”

–       John Authers, The Financial Times, ‘FTSE hits record, but hold off the bubbly.”

 

“To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying — except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”

–       Warren Buffett, 10th December 2001.

 

“I’m thinking of making a purchase of Berkshire [Hathaway], but I’m concerned about something happening to you, Mr. Buffett. I cannot afford an event risk.”

–       Attendee at a shareholders’ meeting of Berkshire Hathaway.

 

“Neither can I.”

–       Warren Buffett’s response.

 

“The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.”

–       Benjamin Graham.

 

“Investors’ delight as shares smash record.”

–       The Times.

 

On the fiftieth anniversary of Warren Buffett’s taking control of the Berkshire Hathaway company, his annual letter to shareholders has been keenly anticipated. It does not disappoint. The compounded annualised gain in book value per share for the company from 1965 to 2014 equates to 19.4%. The annualised percentage gain for the S&P 500 over the same period, with dividends reinvested, equates to 9.9%. That differential has delivered astronomical comparative performance. The overall gain for the US market comes to 11,196% over the period. The overall gain for Berkshire Hathaway stock comes to 751,113%. If the efficient market hypothesis were correct, a differential of that magnitude could not possibly exist, in this or any other universe. As Buffett himself has remarked,

“I’d be a bum on the street with a tin cup if the markets were always efficient.”

So it is something of a shame that Buffett has never been awarded a Nobel prize for economics, as opposed to Eugene Fama, the father of the efficient market hypothesis, who has. No doubt Buffett’s net worth of roughly $60 billion takes some of the sting away.

Buffett in this year’s letter takes an explicit swipe at another piece of conventional investment wisdom – the idea that risk is essentially encapsulated in price volatility (step forward, Harry Markowitz, and any number of cheerleaders and ‘consultants’ who claim to be professional investors):

“For the great majority of investors.. who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities [i.e. cash and bonds]. If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement.”

In October 2009, Buffett’s business partner and Berkshire Hathaway Vice-Chairman Charlie Munger was interviewed on the BBC and was asked about how much concern he had for the company’s latest stock price decline. His response:

“Zero. This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it’s in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by, say, 50%. In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.” [Emphasis ours.]

There will be plenty of commentary online about Buffett’s letter and we don’t intend to distract readers from the source material. There’s just one line from it we’d like to reiterate:

“Although our form is corporate, our attitude is partnership.”

Berkshire’s structure is unusual. It’s a diversified holding company but clearly for many shareholders it has acted extraordinarily well as an investment manager. Berkshire and Buffett have benefited, in turn, from access to genuinely permanent capital and to unusually patient shareholders – a fact Buffett is only too happy to acknowledge. But the bottom line is that the relationship has been symbiotic: a partnership between co-investors, as opposed to an adversarial relationship between lots of mouths needing to be fed, and customers who are second in the queue for capital returns after all those mouths have been fed. As at year-end 2014, Berkshire was a business with $526 billion in assets, with a corporate headquarters employing just 25 people. Now that is decentralised capital allocation.

50 years. A 750,000% return. But the most striking thing about Warren Buffett at Berkshire Hathaway is not even the absurdly enviable track record of demonstrable investment success. The ‘value’ methodology, originally developed by Benjamin Graham, and subsequently adapted by Buffett to take account of Berkshire’s ever-increasing size, is almost entirely transparent, and a matter of historical record, not least in the Berkshire shareholders’ letters. Buffett himself acknowledged the perversity in his 1984 Appendix to Graham’s ‘The Intelligent Investor’:

“I can only tell you that the secret has been out for 50 years, ever since Ben Graham and David Dodd wrote ‘Security Analysis’ [and since Ben Graham followed up with ‘The Intelligent Investor’], yet I have seen no trend toward value investing in the 35 years that I’ve practised it. There seems to be some perverse human characteristic that likes to make easy things difficult..

“There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham and Dodd will continue to prosper.”

No, the most striking thing about Benjamin Graham, Warren Buffett, Berkshire Hathaway, and ‘value’ investing is why on earth anybody would want to invest any other way.

 

No need to say much more than the quotations cited above with regard to the latest non-event from the FTSE 100 index:

  • The new ‘high’ is only a high in nominal terms. As Merryn Somerset Webb points out, UK retail prices have risen by more than 50% since the last ‘high’ 16 years ago.
  • As the FT’s John Authers points out, the UK’s annualised real return of 1.4% since the last ‘high’ severely lags behind the rest of the world (2.1%) and even Spain (3.4%). And as Authers rightly also observes, the composition of the FTSE 100 is itself pretty arbitrary – 100 large companies, with particular concentration in banking and commodities, that just happened to list in the UK.
  • Per Buffett, if you are an ongoing consumer of UK stocks as hamburgers, this is actually bad news. It just means the market is more expensive.
  • If, like us, you have no interest in index-tracking, and are instead looking for compelling value, this is nothing more than a giant, irrelevant yawn. We are far more interested in what Ben Graham called “the ever-present bargain opportunities in individual securities”. Anglophile investors should be aware that there are currently more attractive sources of value in markets outside the UK and US.
  • This ‘news’ clearly appeals to those participants in the financial media for whom relevance to the real world comes secondary to the excitement and entertainment engendered by a good sports story.

The last word should probably to America’s finest news source.

From ‘The Onion’,back in 2000:

Blue Line Jumps 11 Percent

NEW YORK–Excitement swept the financial world Monday, when a blue line jumped more than 11 percent, passing four black horizontal lines as it rose from 367.22 to 408.85.

It was the biggest single-day gain for a blue line since 1994.

“Even if you extend the blue line’s big white box back many vertical lines, you won’t find a comparably large jump,” said Milton Vogel, a senior analyst with Merrill Lynch. “That line just kept going up, up, up.”

The blue line, which had been sluggish ever since the red line started pointing down in April, began its rebound with an impressively pointy 7 percent rise Friday. By noon Monday, it had crossed the second horizontal line from the top for the first time since December.

Ecstatic investors are comparing the blue line to the left side of a very tall, steep blue mountain.

“It’s a really steep line,” said Larry Danziger, a San Jose, CA, day trader and golf enthusiast. “I stand to make a tremendous amount of money as a result of the steepness of this line.”

“It looks like the line’s about to shoot out of the box,” said Boston-area investor Michael Lupert, enjoying a glass of white zinfandel on the bow of his 30-foot yacht. “I’m definitely going to keep a close eye on this line as it continues to move to the right.”

Despite such bullishness, some financial observers are urging caution.

“Given this line’s long history of jaggedness, we really should take a wait-and-see approach,” Fortune magazine associate editor Charles Reames said. “And even if this important line continues its upward pointiness, we must remember that there are other shapes, colors, numbers, and lines to consider when judging the health of the economy.”

Reames also warned that the upward angle of the line, which most analysts agreed was approximately 80 degrees, may have been exaggerated by the way the graph was drawn.

“The stuff that’s written along the bottom of the graph is all squished together, making the line look a lot more impressive than it is,” Reames said. “Had that same stuff been spread out more, the line would have looked a lot less steep.”

Still, most U.S. investors found it hard to contain their enthusiasm as the blue line shot up sharply, outperforming the green line, the yellow line, and even the thriving dotted purple line.

“Typically, the blue line rises or falls no more than 10 in a day,” said Beverly Hills plastic surgeon Dr. Jeffrey Gruber. “But Monday, it went up an astonishing 41–and during a time when we have a big red slice showing on our pie charts, no less. We live in a truly remarkable time.”

 

Economics

Chart(s) of the Day

[This piece can be seen at Sean’s blog here http://truesinews.com/2015/02/24/chart-of-the-day/]

Taken over a forty year history, US gasoline is trading in its 3rd percentile – 1.8 sigmas from the mean – when expressed as a ratio of the price of heating oil. In seasonal terms, this makes sense as the winter draw for space heating coincides with the consumption lull in (discretionary) road transport and the anticipatory change of emphasis by the refiners. Given the severe weather being endured Stateside these past several weeks, it should surprise no-one to learn that stocks of heat are more than 8% below the mean for thetime of year, while those for mogas are 4.3% above that norm. Hence the wider price differential.

15-02-24 XBvHO lt
Courtesy: Bloomberg

On a much shorter timeframe, however, we can see heat coming under pressure in the current trading session as the recent crude-led rally fades. Gasoline, conversely, is so far holding up rather better. Time to spread ‘em in anticipation of the arrival of spring?

15-02-24 HO-XB
Courtesy: Bloomberg

With the yuan-dollar rate edging ever higher (led by pressures which seem to emanate from activity in the offshore version in HK), the Chinese press is starting to resound to the sound of calls for a more active policy of devaluation interspersed with a counterpoint of official denials that this is in any way being contemplated.

Apart from the slump in the euro – the ‘Zone being at least as important as the US as a Chinese export destination – the real killer has been the post-Abenomics move versus the yen, especially when gauged in terms of real (i.e., domestic price-adjusted) effective (trade-weighted) rates. Since the latter part of 2012, China’s currency has undergone a 73% overall, 19% annualized, rise versus that of Japan, prompting some of the latter’s companies to start thinking about relocating production back to their homeland. Not so much yendaka, as yuandaka, this time.

15-02-24 CNY TWI
Courtesy: Bloomberg

As WantChina Times put it  in a recent piece, the effects may already be beginning to make themselves felt:-

‘Citizen China, which produces Japanese Citizen watches, to fold its production base in Guangzhou, on the heels of Microsoft which announced on Dec. 17 its decision to close the mobile-phone factories of Nokia, under its auspices, in Beijing and Dongguan by the Spring Festival moving facilities to Nokia’s factory in Hanoi.

A number of other foreign enterprises are scheduled to join the exodus this year, including Panasonic, Sharp, Daikin, and TDK, all Japanese firms, which plan to transfer some capacity from China back to Japan or to other countries. Others, such as Uniqlo, Nike, Foxconn, Funai, Clarion, and Samsung, are setting up new factories in Southeast Asia and India, while scaling down their Chinese operations.’

So, you can see why some think China will be tempted to – err – address the balance, shall we say?

One thing is for sure, whether we look at Asian currencies’ relationship to the Greenback with (ADXY+J) or without (ADXY) the yen, the charts are pointing lower and that, in turn, suggests there is only one way for commodites to trade, too.

15-02-24 ADXY CMDT
Courtesy: Bloomberg

 

15-02-24 ADXYJ CMDT
Courtesy: Bloomberg

Finally, as Mme. Yellen gives us the usual rigmarole of soft-cop-hard cop-soft cop in her Congressional testimony, the market’s first reaction has been to believe that the Ghost of ’37 is still far from being laid: bonds have rallied nicely, especially in the belly where mid-curve euro$ have jumped 12bps or so in the immediate aftermath of her comments.

If, however, we compare the actual real Fed funds rate to the state of the job market – either using continuing jobless claims as a percentage of the population (here inverted) or the real wage fund (hours x pay rates / CPI) – you can see that Ms. Yellen is taking rather more of a gamble than she is willing to admit. From the Volcker Era to the Anti-Vocker Era, indeed.

Courtesy: Bloomberg
Courtesy: Bloomberg

Economics

When?

“We are all at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know, by the rules, that at some moment the Black Horsemen will come shattering through the great terrace doors, wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no-one wants to leave while there is still time, so that everyone keeps asking, “What time is it ? What time is it ?” But none of the clocks have any hands.”

–       From ‘Supermoney’ by Adam Smith.

 

It was not supposed to be like this. As we highlighted last week, after the Great Debt Bubble, there has been no Great Deleveraging. In fact, as the McKinsey Global Institute showed in their February 2015 report,

“After the 2008 financial crisis and the longest and deepest global recession since World War II, it was widely expected that the world’s economies would deleverage. It has not happened. Instead..

“Debt continues to grow. Since 2007, global debt has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points.”

Herbert Stein’s Law mandates that if something cannot go on forever, it will stop. The great Austrian economist Ludwig von Mises expressed the same sentiment and came to a somewhat gloomier conclusion:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

As the McKinsey data show, the voluntary abandonment of further credit expansion has clearly not occurred. If Mises is correct, and we are minded to consider that he is, then draw your own conclusions.

We have now become used to so many years of utterly extraordinary monetary experimentation and policy-making on the hoof that there is a danger that Alice-in-Wonderland central banking activity simply gets taken for granted as the natural state of affairs. This is the same type of absurd but incremental behaviour that gets frogs in pans boiled alive with their tacit approval.

Blithe sceptics to this line of thought will no doubt argue that if seven years of making-it-up-as-we-go-along monetary policy hasn’t derailed the system, then perhaps the system won’t get derailed. Perhaps it’s even un-derailable. But this sounds suspiciously like Ben Bernanke’s own flawed thinking when he suggested in July 2005 that

“We’ve never had a decline in house prices on a nationwide basis.”

In other words, because something has never happened before, it never will.

(This from the same person who observed in March 2007 that

“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”)

No, the insoluble problem facing every investor today is not just that the system is unsustainable. It clearly is. The problem is that we lack a means of forecasting accurately when the system is likely to break apart. The financial market is a complex, adaptive system, reliant on confidence, the ongoing robustness of which is completely unforecastable. That confidence has been robust is not in question. The creation of trillions of dollars, pounds, euros, yen and renminbi worth of ex nihilo money has yet to dent confidence entirely in an unbacked paper money system (notwithstanding the 345% gain in the dollar price of gold since the start of the millennium).

Just before the turn of the millennium, inside the late Peter L. Bernstein’s excellent history of risk, ‘Against the Gods’, we came across the following quotation by the Swiss mathematician and physicist Daniel Bernoulli: when managing money for wealthy people,

“The practical utility of any gain in portfolio value inversely relates to the size of the portfolio.”

Bernoulli (1700-1782) has a good claim to being one of the world’s first behavioural economists, in that he observed that investment performance for the wealthy is not exactly the same as investment performance for the non-wealthy. For the objectively wealthy, or super-wealthy, any further gain in portfolio value has to be seen in the context of maintaining the original value of the portfolio. Since human beings are typically loss averse, maintaining the original purchasing power of the pot is much more important than generating further incremental gains, especially in an environment where the pursuit of those further gains risks existentially jeopardising that original pot.

US stock markets reached record highs last week. Question: does that make them riskier, or less risky ? We think the former. But for us the question is somewhat academic since we’re not remotely interested in index-tracking. Other investors, however, evidently are. Among the top 10 ETF purchases by customers of Barclays Stockbrokers last week were funds tracking:

  • The S&P 500 (iShares and Vanguard)
  • The FTSE 100 (iShares and Vanguard)
  • The FTSE 250
  • The Euro Stoxx 50
  • Japan.

We foresee all kinds of risks in taking indexed exposure to stock markets close to or at their all-time highs. Index-tracking funds offer many things. Relatively low cost market exposure, for one. But as and when stock markets go into reverse, purchasers of low cost trackers will find that they have been penny-wise and pound foolish, because low cost trackers offer precisely zero discernment or discretion when it comes to market direction. If the market goes down, they go down with it.

So rather than tag along for the ride, we much prefer to follow the ‘value’ route (to capital preservation and growth, in that order). Index benchmarking is utterly inappropriate, we would suggest, for the private investor, for whom the ultimate reference rate should be cash, since cash remains the only asset that cannot decline in nominal terms. Or at least that used to be the case, before acronyms like QE, ZIRP and now NIRP (Negative Interest Rate Policy) steamrollered over all assets in their path, like financial terminators.

If we define ‘value’ as inherent quality plus attractive valuation, it has relevance to both debt and equity market investing today. Bond markets as a whole are clearly grotesquely overvalued but may remain so or become even more overvalued because there is an 800lb gorilla in the market determinedly gobbling them up. As of March 2015, the ECB will be buying €60 billion worth every month. We doubt whether there’s that much quality debt on offer in the euro zone. But there may be elsewhere, not least because most of the world’s creditor countries lie outside the euro zone.

In equity markets, we see almost no compelling value in US stocks, which if nothing else are intensely well covered (we mean by number of analysts, not necessarily by quality of coverage) by Wall Street. We see compelling pockets of genuine value, however, in markets like Japan, which simply aren’t well covered by the analyst community, which has been scared off by 20 years of bear market conditions.

We then supplement our debt and equity exposure with uncorrelated investments (namely systematic trend-followers), which we have always regarded as bellwether holdings, and with real assets, notably the monetary metals, gold and silver.

The result: four discrete asset classes that will behave in different ways under different market conditions. High quality debt offers income and a degree of capital preservation (especially in an environment of outright deflation). High quality ‘value’ equity offers income and the potential for attractive capital growth (especially in an environment of modest inflation). Systematic trend-followers are broadly market neutral, but with the potential to deliver outsized gains in an environment of systemic financial distress (most trend-followers generated double or triple digit percentage returns in 2008, for example). And real assets, again, offer the potential to deliver outsized gains in an environment of systemic financial distress or high inflation, or both.

Unlike most of our fund management peers, we accept that we can’t predict the future. Unlike many of them, we are at least preparing for it.

But that brings us back to our initial dilemma. We think the system is desperately unsound, so we take out what insurance we can, whilst still retaining a stake in a variety of markets (on our terms admittedly, rather than according to somebody else’s irrelevant benchmark).

But insurance only works if you have it when the crisis erupts. You don’t buy house insurance after the roof catches fire.

Economics

Macro & Market Update

[This piece can be seen at Sean’s blog here http://truesinews.com/2015/02/17/macro-market-update/]

More than half a century ago, in his role as an advisor to the men responsible for trying to set Taiwan on the road to prosperity, a redoubtable economist called Sho-Chie Tsiang argued that the monetary authorities should stop suppressing interest rates and directly rationing credit and should move instead toward a more market-oriented system where real rates were sufficiently elevated to encourage productive saving.

His reasoning was that the existing combination of what we might call Z(Real)IRP with ‘macro-prudential’ control was plagued with several significant drawbacks.

Firstly, rationed credit tended to be crony credit – with only the politically-favoured having any hope of persuading the banks to lend to them. Secondly, the erosion of purchasing power suffered by any one depositing money in the bank at the prevailing yields meant that savers looked for other outlets for their surpluses, such as property and precious metals, neither of which did much to augment the stock of productive capital. Thirdly, this lack of genuine saving meant that all extra funding had to rely on inflationary credit creation and thus necessitated even more macro-prudential monkeying with the price mechanism. Fourthly, anyone outside the charmed circle of accepted borrowers – which tended to mean anyone with a hint of genuine entrepreneurship – had to raise funds in a quasi-illicit and certainly non-transparent manner and so had to promise exorbitantly high ‘curb’ rates of interest to compensate their lenders for the extra hazards involved.

Tsiang argued – and was soon to be proved totally correct in his assertions – that by allowing the rate of interest to find a level where market for funds cleared – essentially where the impulse to thrift intersected the expectation of profit – not only would all these disadvantages be eradicated, but the funding rate applicable to the WHOLE economy, as opposed to that charged to the privileged few, would be lower on average, not higher, as the risk premia associated with the ‘shadow’ market were removed.

In the decades after the Second World War, Taiwan, not entirely coincidentally, transformed itself from a backward, low-value added, crisis-wracked basket case into the economic prodigy to which we still look for so many of our high tech gizmos today.

The reason for the history lesson should be obvious if we consider that much of the same reasoning is relevant to mainland China today, even if the scale of the problem is somewhat larger in a country of 1 1/3 billion people.

Beijing knows that it cannot afford to persist with ‘business as usual’, that the ‘three overhangs’ relating to past over-expansion and misdirected effort have to be overcome while moving to the ‘new normal’ of less force-fed growth-for-growth’s sake. The issues with this are twofold: will the authorities stick to their course, even when the waters get choppy and, if they do, can they then hope to bring the ship of state safely into harbour before the leaks springing from its every timber send it to the bottom?

On the monetary front alone, the issue is fraught. The PBoC, as everyone knows, was moved to cut the required reserve rate a week or so back and so sparked a renewed clamour for further, substantial easing even though the main reason for the reduction was technical: the traditional Lunar New Year cash squeeze was bumping up against the very substantial reserve drain occasioned by the last few months’ sizeable forex outflows.

[CLICK TO ENLARGE ALL GRAPHS]

15-02-16 China M1

Against such a backdrop, the monthly money and credit numbers were exceptionally hard to read. TSF rose, but less than it did in each of the past two years. Loan growth, however, was the second highest on record. On the other side of the balance sheet M2 slowed to a multi-year low increase of 10.2% (even though overall deposits jumped by the most on record!) and yet, within that total, M1 money remained unchanged in a month in which it often falls so its rate of climb therefore rose to a 20-month high of 10.6%. Confusion confounded, indeed!

15-02-16 China TSF

What is key here is that Lui Lei of the central bank came out to argue that any intervention should henceforth only be aimed at alleviating liquidity shortages, not at fostering hothouse growth, while Xu Lin of the NDRC hinted that the latest Five-year Plan would insist on a ‘floor’ for growth of a mere 6.5% – a significant psychological climb down from the economy-doubling 7-handles to which the regime has heretofore grimly clung. Guan Tao of the SAFE next went so far as to make explicit reference to the parallels between his country today and its Asian neighbours back in 1997 on the eve of their great crisis (and he should know: $10 billion+ leaked out again in January, his employers had just revealed).

Courtesy: Bloomberg

For all the worries, this was not enough to prevent the ChiNext from making a new high – taking its run to 233% these past two years. We suspect, however, that it will pay to sell a reversal somewhere in the next 10%. We are also intrigued by the similarity between the HK H-Shares chart and that for pre-collapse crude – or, for that matter, between the index and all manner of commodity-related indices in recent months.

Courtesy: Bloomberg

It is also fascinating to watch sentiment start to dissolve among the US punditry. As the newsflow become more nuanced, market participants have become schizophrenic with regard to oil prices – lower is ‘a tax cut for the consumer’ but is also about to blow up the junk bond market, depending on who is talking. The Dow, for its part, has rallied on cheap energy, but also rallied on a rebound in oil prices which was said to signal continued demand. So long as it rallies, one supposes…

Amid a stretch of numbers which, aside from those concerning employment, were somewhat disappointing to a consensus only lately set four-square behind the thesis of US economic triumphalism, some unusual attention has been paid of late to the lacklustre retail and wholesale sales numbers – mainly becuase they, too, looked weak.

For our part, since these are the nearest thing we get to a timely measure of economy-wide revenues (and hence not just to an NGDP number, all you market monetarists and Neo-Hayekians out there, but to an NSOP – a nominal structure-of-production flow) we tend to pay close attention to them as a matter of routine. What is at issue here, however, is the very fact that these arenominal numbers and are therefore hard to interpret when large, supply-side price changes are underway, as is arguably the case in all things related to natural resources as well as, for the US with its persistently strengthening currency, to imported goods of a more general character.

Since it is the sales margin that ultimately counts for the success of an enterprise, the first thing we need to assure ourselves is that falling revenues need not be wholly bad, as long as costs fall commensurately alongside them. There are, as ever, several caveats to this broad pronouncement.

Firstly, we have to hope that the aggregate decline in selling and buying prices does not mask too great a disparity between conditions in one business and the next. We must also beware the fact that any resulting windfall for one is not ruined by the shortfall for another when the impact is not a simple matter of addition and subtraction but acts in a non-linear fashion – e.g., through its implications for the credit structure. Finally, we have to wonder how the necessary fall in nominal costs will be achieved when it comes to those associated with the payroll. We should all recognise that real wages are what determine our standard of living, but we must also bear in mind that it is the nominal ones over which we fight and for whose maintenance jobs are often sacrificed.

Courtesy: Bloomberg
Courtesy: Bloomberg

With that in mind, let us note three broad trends which are at work. Number one, inventory/sales ratios are rising to levels not seen (barring the Snowball Earth episode of the Lehman Crash) in anything up to thirteen years across manufacturing, wholesale, and retail. To what extent this just reflects a lag in marking down inventory values but having instantlyto recognise lower sale sprices, rather than something much more sinister, only time will tell. Nevertheless, the adjustment, when it comes, will have to be reflected in both a capital write down and a temporary reduction in profits in the relevant period, so there is scope for further anguish.

Courtesy: Bloomberg
Courtesy: Bloomberg

Number two, wage bills in relation to sales receipts have also been pushed to their least favourable in more than a decade and, again, while the marginal return on labour could come out unchanged if the margins are unaltered, lowered revenues could nonetheless serve to jeopardize employment levels. Number three is that the value of outstanding C&I loans is rising in relation to the stock it is financing i.e., collateral coverage is slipping to an extent which may soon start causing jitters among the lenders.

Courtesy: Bloomberg
Courtesy: Bloomberg

While bearing this wobble in mind, also consider that P/Es are back to where they were on the eve of the last crash as is price/book. Price/sales is where it was at the height of the Tech Bubble and returns on capital – measured using both cash flow and free cash flow – are at or approaching their lowest in five years. As ever, the main source of support for the stock market is the deliberately suppressed level of bond yields.

15-02-16 REGF SPX

One way of illustrating this distortion of the bond market is to look at bond risk – such as modified duration – versus bond return, i.e., yield-to-worst. Off the scale, is the simplest way to describe it.

Courtesy: Bloomberg
Courtesy: Bloomberg

As unsustainable as all this looks – not to mention how perilous it all is – the key is to try to find a reversal clear enough to be played. A week or two back, we suggested that the T-bond might be headed to 2.20% and that, if such a level held, one should try to sell against it, scaling in above 2.45/50%. Well, 2.22% has been the low so far and we have had a smart 43bp, 8.3% price reversal since hitting it. So far, so good, so short.

Courtesy: Bloomberg
Courtesy: Bloomberg

As for the rest of the market, WTI is testing the top of a neat profile built at the bottom of the rout (and so, theoretically signalling much lower lows ahead). If it breaks the top of this band, it could swing up to a nice, round $60/bbl where the mid-point of the Thanksgiving Day massacre comes in. Brent looks a touch more positive, so signals are mixed and while not yet convinced we have seen the worst, we would hesitate just yet to position too aggressively as a result of the disparity.

Courtesy: Bloomberg
Courtesy: Bloomberg

Copper, too has seen a little cautious buying, taking it back to the bottom of the old range. On the one hand we have maximum spec shorts both outright and as a percentage of O/I: on the other, the recent, hefty cash premium has almost disappeared as LME inventories have built rapidly, rising 85% since Christmas to a 16-month high. Sell any identifiable failure here but stop out if it does build back above $6000

Courtesy: Bloomberg
Courtesy: Bloomberg

Likewise, gold – while below $1245/50  – stays negative, looking for a possible retest of $1180 and, one day, a break of the decade-old uptrend to usher in the opening up of a route back to the LEH crisis levels down around $800/oz.

If gold is to weaken further, that almost presumes that risk will not spike higher and also that dollar strength will continue at what is now an important technical level for the greenback – at the 50% retracement of the 2002-11 decline and at fairly overbought levels.

Courtesy: Bloomberg
Courtesy: Bloomberg

While below $1.450/00 the euro does not look like spoiling the party but rather giving it a boost by falling to the long-term linear mid at $1.0700 (and possibly, since the trend on this chart has already given way to the log one at $9275/00)

Courtesy: Bloomberg
Courtesy: Bloomberg

However it is espressed in the weakness of pair currencies, a continued USD advance should mean positive feedback with other US asset classes so it is worth noting that the MSCI US index is fast approaching its historic peak relative to the ROW equivalent. Bears will hope that top holds: bulls will be wishing for a full, swing pattern repeat of the 1988-2002 move and hence for much more upside to come.

Courtesy: Bloomberg
Courtesy: Bloomberg

The Nikkei, meanwhile, remains locked – once we peel back the veil of weak Yen money illusion – in the range which has contained it these last 18 months or so. the best hope is that this consolidation wil eventually move the longest line higher both on the medium term scale of the last 5 years of rebound and on the larger scale of the whole three decades of bubble-and-bust.

Courtesy: Bloomberg
Courtesy: Bloomberg

The sad fact remains that, if we adjust for changes in the yen’s international worth via the TWI, returns for the entirety of that period sweep out a quasi-normal, mean reverting distribution. Still, a push to the top of that formation’ s value area would be nothing to sniff at, were it to come about through the processes just discussed.

Courtesy: Bloomberg
Courtesy: Bloomberg

Finally to Europe, where NIRP is beginning to preclude even momentum-driven returns on bonds and is pushing people instead into the stock market. The DAX appears to have broken out against the REX as a result, meaning it has every chance to test the last cyclical highs, set back in 2007, in the weeks ahead.

Courtesy: Bloomberg
Courtesy: Bloomberg

Note, however, that though the idea of European outperformance is becoming more widely shared – not least because of effects of the rapid growth in money supply even pre-QEuro – there is actually little in the graph of Germany v the USA in common currency to suggest this presentiment will be borne out in practice. If you do wish to play for a rise on the Continent, therefore, it seems as though you would be best advised to hedge up your forex exposure when you do so.

Courtesy: Bloomberg
Courtesy: Bloomberg

Good hunting!

Economics

Australia and Canada – Commodities and Growth

  • Industrial commodities continue to weaken
  • The BoC and RBA have cut official rates in response to falling inflation and slower growth
  • The RBA has more room to manoeuvre in cutting rates, Australian Bonds will outperform

The price of Crude Oil has dominated the headlines for the past few months as Saudi Arabia continued pumping as the price fell in response to increased US supply. However, anaemic growth in Europe and a continued slowdown in China has taken its toll on two of the largest commodity exporting countries. This has prompted both the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) to cut interest rates by 25 bp each – Canada to 0.75% and Australia to 2.25% – even as CAD and AUD declined against the US$.

In this letter I will look at Iron Ore, Natural Gas and Coal, before going on to examine other factors which may have prompted central bank action. I will go on to assess the prospects for asset markets over the coming year.

Iron Ore

The price of Iron Ore continues to make fresh lows, driven by weakness in demand from China and Japan and the EU.

Iron Ore Fines 6 yr

Source: Infomine.com

Iron Ore is Australia’s largest export market, significantly eclipsing Coal, Gold and Natural Gas. It is the second largest producer in the world behind China. 2013 production was estimated at 530 Mt. Canada, with 40 Mt is ranked ninth by production but is the fourth largest exporter. Needless to say, Iron Ore production is of significant importance to both countries, although for Canada Crude Oil comes first followed by vehicle and vehicle parts, then Gold, Gas – including Propane – and Coal. It is also worth noting that the two largest Steel exporters are China and Japan – both major Iron Ore importers. The health of these economies is vital to the fortunes of the Iron Ore industry.

Natural Gas

Natural Gas is a more difficult product to transport and therefore the price differential between different regions is quite pronounced. Japan pays the highest price of all the major economies – exacerbated by its reduction of nuclear generating capacity – closely followed by Singapore, Taiwan and South Korea. The US – Henry Hub – and AECO – Alberta – prices are broadly similar, whilst Europe and Japan pay a significant premium:-

Chart-4-Global-Natural-Gas-Prices11

Source: Federal Reserve, World Bank, CGA

Here is an extract from the International Gas Union report – IGU Wholesale Gas Price Survey Report – 2014 Edition:-

Wholesale prices can obviously vary significantly from year to year, but the top two regions are Asia Pacific followed by Europe – both with average prices over $11.00. OPE* remains the primary pricing mechanism in Asia Pacific and still a key mechanism in Europe.

*Oil Price Escalation – in this type of contract, the price is linked, usually through a base price and an escalation clause, to competing fuels, typically crude oil, gas oil and/or fuel oil. In some cases coal prices can be used as can electricity prices.

Canada has significant Gas reserves and is actively developing Liquefied Natural Gas (LNG) capacity. 13 plant proposals are underway but exports are still negligible. It also produces significant quantities of Propane which commands a premium over Natural Gas as this chart shows: –

Chart-5-Energy-Commodity-Prices10

Source: StatsCan, Kent Group, CGA

Australia, by comparison, is already a major source of LNG production. The IGU – World LNG Report – 2014 Edition:-

Though Australia was the third largest LNG capacity holder in 2013, it will be the predominant source of new liquefaction over the next five years, eclipsing Qatari capacity by 2017. With Pluto LNG online in 2012, seven Australian projects are now under construction with a total nameplate capacity of 61.8 MTPA (53% of global under construction capacity).

Coal

Australia is the fourth largest Coal producer globally. According to the World Coal Association, it produced 459 Mt in 2013. Canada did not feature in the top 10. However when measured in terms of Coking Coal – used for steel production – Australia ranked second, behind China, at 158 Mt whilst Canada ranked sixth at 34 Mt.

The price of Australian Coal has been falling since January 2011 and is heading back towards the lows last seen in 2009, driven primarily by the weakness in demand for Coking Coal from China.

Australian Coal Price - Macro Business 2012 - 2014

Source: Macro Business

This is how the Minerals Council of Australia describes the Coal export market:-

Coal accounted for almost 13 per cent of Australia’s total goods and services exports in 2012-13 down from 15 per cent in 2011-12. This made coal the nation’s second largest export earner after iron ore. Over the last five years, coal has accounted, on average, for more than 15 per cent of Australia’s total exports – with export earnings either on par or greater than Australia’s total agricultural exports.

Australia’s metallurgical coal export volumes are estimated at 154 million tonnes in 2012-13, up 8.5 per cent from 2011-12. However, owing to lower prices the value of exports decreased by almost 27 per cent to be $22.4 billion in 2012-13.

Whilst the scale of the Coal industry in Canada is not so vast, this is how the Coal Association of Canada describes Canadian Coal production:-

Production

Canada produced 60 million close to 67 million tonnes (Mt) of coal in 2012. 31 million tonnes was metallurgical (steel-making) coal and 36 million tonnes (Mt) was thermal coal. The majority of coal produced in Canada was produced in Alberta and B.C.

Alberta produced 28.3 Mt of coal in 2012

British Columbia produced 28.8 Mt (most was metallurgical coal) – 43% of all production

To meet its rapid infrastructure growth and consumer demand for things such as vehicles and home appliances, Asia has turned to Canada for its high-quality steel-making coal. As Canada’s largest coal trading partner, coal exports to Asia accounted for 73% of total exports in 2010.

Steel-Making Coal

Global steel production is dependent on coal and more and more the world is turning to Canada for its supply of quality steel-making coal.

The production of steel -making coal increased by 5.5% from 29.5 Mt in 2011 to 31.1 Mt in 2012.

Almost all of Canada’s steel-making coal produced was exported.

Thermal Coal

Approximately 36 million tonnes of thermal coal was produced in 2012.

The vast majority of Canadian thermal coal produced is used domestically.

Currency Pressures

Until the autumn of 2014 the CAD was performing strongly despite weakness in several of its main export markets as the chart below of the Canadian Effective Exchange Rate (CERI) shows:-

CAD CERI - 1yr to sept 2014

Source: Business in Canada, BoC

Since September the CERI index has declined from around 112 to below 100.

For Australia the weakening of their trade weighted index has been less extreme due to less reliance on the US. There is a sector of the RBA website devoted the management of the exchange rate, this is a chart showing the Trade Weighted Index and the AUDUSD rate superimposed (RHS):-

AUD_effective_and_AUDUSD_-_RBA

Source: RBA, Reuters

Taking a closer look at the monthly charts for USDCAD:-

canada-currency

Source: Trading Economics

And AUDUSD:-

australia-currency

Source: Trading Economics

These charts show the delayed reaction both currencies have had to the decline in the price of their key export commodities – they may fall further.

Central Bank Policy

The chart below shows the evolution of BoC and RBA policy since 2008. Australian rates are on the left hand scale (LHS), Canadian on the right:-

australia and canadian -interest-rate 2008 - 2015

Source: Trading Economics

To understand the sudden change in currency valuation it is worth reviewing the central banks most recent remarks.

The BoC expect Oil to average around $60/barrel in 2015. Here are some of the other highlights of the latest BoC monetary policy report:-

The sharp drop in global crude oil prices will be negative for Canadian growth and underlying inflation.

Global economic growth is expected to pick up to 3 1/2 per cent over the next two years.

Growth in Canada is expected to slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015.

Canada’s economy is expected to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016, with a return to full capacity around the end of 2016, a little later than was expected in October.

Total CPI inflation is projected to be temporarily below the inflation-control range during 2015 because of weaker energy prices, and to move back up to target the following year. Underlying inflation will ease in the near term but then return gradually to 2 per cent over the projection horizon.

On 21 January 2015, the Bank announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 3/4 per cent.

…Although there is considerable uncertainty around the outlook, the Bank is projecting real GDP growth will slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015. The negative impact of lower oil prices will gradually be mitigated by a stronger U.S. economy, a weaker Canadian dollar, and the Bank’s monetary policy response. The Bank expects Canada’s economy to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016.

The RBA Statement on Monetary Policy – February 2015 provides a similar insight into the concerns of the Australian central banks:-

…Australia’s MTP growth is expected to continue at around its pace of recent years in 2015 as a number of effects offset each other. Growth in China is expected to be a little lower in 2015, while growth in the US economy is expected to pick up further. The significant fall in oil prices, which has largely reflected an increase in global production, represents a sizeable positive supply shock for the global economy and is expected to provide a stimulus to growth for Australia’s MTPs. The fall in oil prices is also putting downward pressure on global prices of goods and services. Other commodity prices have also declined in the past three months, though by much less than oil prices. This includes iron ore and, to a lesser extent, base metals prices. Prices of Australia’s liquefied natural gas (LNG) exports are generally linked to the price of oil and are expected to fall in the period ahead. The Australian terms of trade are expected to be lower as a result of these price developments, notwithstanding the benefit from the lower price of oil, of which Australia is a net importer.

…Available data since the previous Statement suggest that the domestic economy continued to grow at a below-trend pace over the second half of 2014. Resource exports and dwelling investment have grown strongly. Consumption growth remains a bit below average. Growth of private non-mining business investment and public demand remain subdued, while mining investment has fallen further. Export volumes continued to grow strongly over the second half of 2014, driven by resource exports. Australian production of coal and iron ore is expected to remain at high levels, despite the large fall in prices over the past year. The production capacity for LNG is expected to rise over 2015. Service exports, including education and tourism, have increased a little over the past two years or so and are expected to rise further in response to the exchange rate depreciation.

…Household consumption growth has picked up since early 2013, but is still below average. Consumption is being supported by very low interest rates, rising wealth, the decision by households to reduce their saving ratio gradually and, more recently, the decline in petrol prices. These factors have been offset to an extent by weak growth in labour income, reflecting subdued conditions in the labour market. Consumption growth is still expected to be a little faster than income growth, which implies a further gradual decline in the household saving ratio.

…Prior to the February Board meeting, the cash rate had been at the same level since August 2013. Interest rates faced by households and firms had declined a little over this period. Very low interest rates have contributed to a pick-up in the growth of non-mining activity. The recent large fall in oil prices, if sustained, will also help to bolster domestic demand. However, over recent months there have been fewer indications of a near-term strengthening in growth than previous forecasts would have implied. Hence, growth overall is now forecast to remain at a below trend pace somewhat longer than had earlier been expected. Accordingly, the economy is expected to be operating with a degree of spare capacity for some time yet, and domestic cost pressures are likely to remain subdued and inflation well contained. In addition, while the exchange rate has depreciated, it remains above most estimates of its fundamental value, particularly given the significant falls in key commodity prices, and so is providing less assistance in delivering balanced growth in the economy than it could.

Given this assessment, and informed by a set of forecasts based on an unchanged cash rate, the Board judged at its February meeting that a further 25 basis point reduction in the cash rate was appropriate. This decision is expected to provide some additional support to demand, thus fostering sustainable growth and inflation outcomes consistent with the inflation target.

Real Estate

Neither central bank makes much reference to the domestic housing market. Western Canada has been buoyed by international demand from Asia. Elsewhere the overvaluation has been driven by the low interest rates environment. Overall prices are 3.1% higher than December 2014. Vancouver and Toronto are higher but other regions are slightly lower according to the January report from the Canadian Real Estate Association . The chart below shows the national average house price:-

 

 

Canada natl_chartA04_hi-res_en

Source: Canadian Real estate Association

The Australian market has moderated somewhat during the last 18 months, perhaps due to the actions of the RBA, raising rates from 3% to 4.75% in the aftermath of the Great Recession, however, the combination of lower RBA rates since Q4 2011, population growth and Chinese demand has propelled the market higher once more. Prices in Western Australia have moderated somewhat due to the fall in commodity prices but in Eastern Australia, the market is still making new highs. The chart below goes up to 2014 but prices have continued to rise, albeit moderately (less than 2% per quarter) since then:-

Australian House Prices 2006 - 2014

Source: ABS

This chart from the IMF/OECD shows global Price to Income ratios, Canada and Australia are still at the expensive end of the global range:-

House pricetoincome IMF

Source: IMF and OECD

The lowering of official rates by the BoC and RBA will not help to alleviate the overvaluation.

Bonds

This chart shows the monthly evolution of 10 year Government Bond yields since 2008 in Australia (LHS) and Canada (RHS):-

australia-canada-government-bond-yield

Source: Trading Economics

Whilst the two markets have moved in a correlated manner Canadian yields have tended to be between 300 and 100 bp lower over the last seven years. The Australian yield curve is flatter than the Canadian curve but this is principally a function of higher base rates. Both central banks have cut rates in anticipation of lower inflation and slower growth. This is likely to support the bond market in each country but investors will benefit from the more favourable carry characteristics of the Canadian market.

Stocks  

To understand the differential performance of the Australian and Canadian stocks markets I have taken account of the strong performance of commodity markets prior to the Great Recession, in the chart below you will observe that both economies benefitted significantly from the rally in industrial commodities between 2003 and 2008. Both stock markets suffered severe corrections during the financial crisis but the Canadian market has steadily outperformed since 2010:-

canada australian -stock-market 2000-2015

Source Trading Economics

This outperformance may have been due to Canada’s proximity to, and reliance on, the US – 77% of Exports and 52% of Imports. The Australian economy, by contrast, is reliant on Asia for exports – China 27%, Japan 17% – however, I believe that the structurally lower interest rate regime in Canada is a more significant factor.

Conclusions and investment opportunities

With industrial commodity prices remaining under pressure neither Canada nor Australia is likely to exhibit strong growth. Inflation will be subdued, unemployment may rise. These are the factors which prompted both central banks to cut interest rates in the last month. However, both economies have been growing reasonable strongly when compared with countries such as those of the Eurozone. Canada GDP 2.59%, Australia GDP 2.7%.

The BoC has little room for manoeuvre with the base rate at 0.75% but the RBA is in a stronger position. For this reason I believe the AUD is likely to weaken against the CAD if world growth slows, but the negative carry implications of this trade are unattractive.

Canadian Real Estate is more vulnerable than Australia to any increase in interest rates – although this seems an unlikely scenario in the near-term – more importantly, in the longer term, Canadian demographics and slowly population growth should alleviate Real Estate demand pressure. In Australia these trends are working in the opposite direction. Neither Real Estate market is cheap but Australia remains better value.

The Australian All-Ordinaries should outperform the Canadian TSX as any weakness in the Australian economy can be more easily supported by RBA accommodation. The All-Ordinaries is also trading on a less demanding earnings multiple than the TSX.

The RBA’s greater room to ease monetary conditions should also support the Australian Government Bond market, added to which the Australian government debt to GDP ratio is an undemanding 28% whilst Canadian debt to GDP is at 89%. The Canadian curve may offer more carry but the RBA ability to ease policy rates is greater. My preferred investment is in Australian Government Bonds. Both Canadian and Australian 10 year yields have risen since the start of February. The last Australian bond retracement saw yields rise 46 bp to 3.75% in September 2014. Since the recent rate cut yields have risen 30 bp to a high of 2.67% earlier this week. Don’t wait too long for better levels.

Economics

Global economic outlook – update

As recently as 9th January I wrote an article suggesting that 2015 would turn out to be the year of the slump. The title ended with a question mark, but today we are closer to removing it in favour of a definite statement.

In recent weeks, it has become clear that key economic blocs are indeed heading for a slump, including but not limited to China, the Eurozone and Japan (allowing for the distortions of her aggressive money-printing). Between them they account for nearly 40% of global GDP. We know this because of the collapse in commodity prices, which is reflected in a global shift of preference in favour of the US dollar.

For the avoidance of doubt, money should be regarded as a good, and each currency as a different good. When this point is grasped, the context of the dollar’s rise against both commodities and other currencies becomes clear. Both commodities and currencies are priced in dollars, so markets are showing that banks, consumers and businesses have been changing their preferences in favour of increasing their dollar balances.

Modern macroeconomics fails to adequately explain the importance of these developments. A quick look at the index in Keynes’s General Theory makes no mention of changes in preference for money versus other goods. It lists and defines liquidity preference which is a different topic. Once you accept money is a good, supply and demand will always balance as predicated in Say’s Law, otherwise known as the Law of the Markets.

Something has spooked consumers in markets around the world into spending less on other goods and to increase their holdings of dollars. The explanation can only be that prices for all other goods have been too high relative to dollars, so they have had to fall. There can be no clearer signal that there is a slump in global economic activity.

The largest source of exported physical goods is China. Demand from other countries for China’s goods is declining, confirmed by the Baltic Dry Index* which is plumbing new lows. This slow-down in economic activity could easily burst the bubble of bank credit, which is in danger of collapsing under the massive burden of bad debts. December’s slow-down in new loan demand coupled with declining trade flows can only be temporarily resolved by China devaluing the renminbi, thereby lowering her export prices. The breathing space this gives China is only as long as it takes for her manufacturing costs to rise to reflect the devaluation. If it occurs, a renminbi devaluation would quickly put more downward pressure on prices for local manufacturers in her export markets.

Turning to China’s trade partners, we see the Eurozone’s economy ex-Germany beginning to contract which is panicking the ECB into money-printing in a desperate attempt to maintain too-high prices. Japan has been doing this for some time, and is labouring under a mountain of debt that makes even Greece look responsible.

The signals are clear: the world has already entered a downturn in economic activity. Therefore we can expect accelerated money-printing and the imposition of more negative interest rates in a forlorn attempt to avert economic reality.

Economics

“A more serious disaster later on..”

“Another day, another central bank failure. In a world of currencies backed only by confidence, every failure is masqueraded as success. Like the ballet dancer who transforms the stumble into a pirouette, central bankers, knocked to the ground by market forces, smile and pretend that this was all part of the routine. Financial market participants, having bet everything on the promised omnipotence of central bankers, do indeed seem happy to see genius in every stumble. However a fall is a fall regardless of the style of the descent. So when will investors see that the earth is rapidly approaching and that style is just style?

“..Taking interest rates so negative that they threaten a run on bank deposits should not be seen as success — it is failure. Creating bank reserves at that pace should not be seen as success — it is failure. The next failure may well be some government-inspired restriction on capital inflows. Well, you could call such restrictions, and risking the liquidity of banks, monetary success if you like, but then you probably also think it’s a success to throw the ball one yard from the touchline.”

–       Russell Napier, ‘The Solid Ground’, 5th February 2015.

 

“..The position of the people who had at least nominal responsibility for what was going on was a complex one. One of the oldest puzzles of politics is who is to regulate the regulators. But an equally baffling problem, which has never received the attention it deserves, is who is to make wise those who are required to have wisdom.

“Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of the personal disaster which awaited them when the boom came to an end. But there were also some who saw, however dimly, that a wild speculation was in progress and that something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

“A bubble can easily be punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy. Among those who sensed what was happening in early 1929, there was some hope but no confidence that the boom could be made to subside. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Someone would certainly be blamed for the ultimate collapse when it came. There was no question whatever as to who would be blamed should the boom be deliberately deflated. (For nearly a decade the Federal Reserve authorities had been denying their responsibility for the deflation of 1920-1.) The eventual disaster also had the inestimable advantage of allowing a few more days, weeks, or months of life. One may doubt if at any time in early 1929 the problem was ever framed in terms of quite such stark alternatives. But however disguised or evaded, these were the choices which haunted every serious conference on what to do about the market.”

–       J.K. Galbraith, ‘The Great Crash 1929’.

 

 

“It’s a mess, ain’t it, Sheriff ?”

“If it ain’t, it’ll do ‘til the mess gets here.”

–       Dialogue from ‘No country for old men’, by the Coen Brothers and Cormac McCarthy.

 

There are some time-honoured signs of an impending market top. One of them is thatmargin debt has peaked. Another is that interest rates are going through the floor. Another is that market breadth is contracting. Another is that the velocity of money is also going through the floor. Another is that Abby Joseph Cohen reckons the stock market is relatively cheap, an opinion which she generously gave at a recent Barrons roundtable. Barrons actually gave us two signs of a market top for the price of one (but then everything’s devalued these days) – their February 6th edition pointed out that the value of fine art sold at auction had quadrupled from $3.9 billion in 2004 to some $16.2 billion in 2014. They tastefully offered readers a choice between the conclusions of malign ‘bubble’ and benign ‘boom’.

The problem is that in an environment of ubiquitous government manipulation, markets can trade at whatever levels central bankers want them to trade at, for a period at least. So we’re not going to be rash enough to call a market top; we’ll merely draw attention to some anecdotal evidence of a certain, how shall we put it, irrational exuberance at work in the US stock market.

We tip our hat to Beijing Perspective and the Wall Street Journal for the recent news that Carmine “Tom” Biscardi is on the hunt for Bigfoot, and is planning an IPO to fund the expedition:

“Mr. Biscardi and his partners hope to raise as much as $3 million by selling stock in Bigfoot Project Investments. They plan to spend the money making movies and selling DVDs, but are also budgeting $113,805 a year for expeditions to find the beast. Among the company’s goals, according to its filings with the Securities and Exchange Commission: “capture the creature known as Bigfoot.”

“Investment advisers caution that this IPO may not be for everyone. For starters, it involves DVDs, a dying technology, said Kathy Boyle, president at Chapin Hill Advisors. Then there is the Sasquatch issue. She reckons only true believers would be interested in such a speculative venture.”

This is a wonderful instance of life imitating art. Note the similarities between the Bigfoot story (which we have to presume is true) and The Onion’s market scoop from November 1999 (the date is instructive), namely

Species of blue-green algae announces IPO

“LAKE ERIE—Seeking to capitalize on the recent IPO rage on Wall Street, Lake Erie-based blue-green algae Anabaena announced Tuesday that it will go public next week with its first-ever stock offering.

“Anabaena, a photosynthesizing, nitrogen-fixing algae with 1999 revenues estimated at $0 billion, will offer 200 million shares on the NASDAQ exchange next Wednesday under the stock symbol ALG. The shares are expected to open in the $47-$49 range.”

It gets better. With eerie genius:

“..Still, many investors said they are unsure whether they would be willing to take even a moderate risk on the stock.

“One thing they’re not saying in the prospectus—and I’ve been through it thoroughly—is that blue-green algae aren’t really algae. They’re cyanobacteria,” said Jeanette MacAlester, a San Francisco-based stockbroker who is strongly advising her clients not to buy ALG. “I don’t know if I’d put my money in any bacteria, let alone one that seems to think it has something to hide.”

Markets are allowed their petty indiscretions, of course. But these petty indiscretions seem to be piling up. Barry Ritholtz and Bloomberg last week drew attention to the fact that shares of The Grilled Cheese Truck Inc. had commenced trading on the OTCQX marketplace under the ticker GRLD:

“Let’s look at the fundamentals of the Ft. Lauderdale, Florida-based company. Based on the 18 million shares outstanding and a recent stock price of $6 the company has a market value of about $108 million. No matter how much you like grilled cheese.. I can’t see this as a reasonable valuation.

“If you go to the company’s website, you will learn that “The company currently operates and licenses grilled cheese food trucks in the Los Angeles, CA area and Phoenix, AZ and is expanding into additional markets with the goal of becoming the largest operator in thegourmet grilled cheese space.”  You can see an interview with the founder here. The company employs military veterans, and it even lists retired General Wesley Clark as vice chairman.

“However, according to the company’s financial statements, it has about $1 million of assets and almost $3 million in liabilities. In the third quarter of 2014, it had sales of almost $1 million, on which it had a net loss of more than  $900,000.  The story is much the same for the first nine months of the year: $2.6 million in sales and a loss of $4.4 million.

“But forget the losses for a moment, and make the generous assumption that it will have sales of $4 million this year. This means its shares trade for more than 25 times sales, a very rich valuation.

“Which brings me back to my original comments regarding looking for contrary indicators to my bullish posture. I can’t think of a more interesting sign of the old irrational exuberance in equity markets than a publicly traded grilled cheese truck (four in this case) business trading at a $100-million-plus valuation. That sort of thing doesn’t happen unless there is significant excess in the markets.”

Any reference to a company seeking to dominate the “gourmet grilled cheese space” is desperately seeking a twin reference to a post we recall from the dotcom deadpool website F******Company.com from circa late 1999:

“Our business strategy is to lose money on every sale but make up for it in volume.”

Enjoy the party, but dance near the door.

 

Economics

Sovereign Bonds

Today’s obvious mispricing of sovereign bonds is a bonanza for spending politicians and allows over-leveraged banks to build up their capital. This mispricing has gone so far that negative interest rates have become common: in Denmark, where the central bank persists in holding the krona peg to a weakening euro, it is reported that even some mortgage rates have gone negative, and high quality corporate bonds such as a recent Nestlé euro bond issue are also flirting with negative yields.

The most identifiable reason for this distortion of free markets is bank regulation. Under the Basel 3 rules, a bank with sovereign debt on its balance sheet is regarded by bank regulators as owning a risk-free asset.

Unsurprisingly, banks are encouraged by this to invest in sovereign debt in preference to anything else. This leads to the self-fulfilling second reason: falling yields. Central bank intervention in the bond markets through quantitative easing and commercial bank buying leads to higher bond prices, which in turn give the banks enormous profits. It is a process that the banks wish would go on for ever, but logic says it doesn’t.

Don’t think that there is an economic justification for negative bond yields: there isn’t. Even if price inflation goes negative, interest rates in a free market will always remain positive. The reason for this cast-iron rule is interest rates are an expression of time-preference. Time preference is the solid reason that possession of money today is more valuable than a promise to give it to you at some time in the future. The future value of money must always be at a discount to cash-in-the-hand, or put the other way, to balance the value of cash today with cash tomorrow always requires a supplementary payment of interest. That is always true so long as interest rates are set by genuine market factors and not set by a market-monopolising central bank, and then distorted by banking regulations.

So we have arrived close to the logical end-point in falling yields, and in some cases we have gone beyond it. We must also conclude that negative yields are a signal that bond prices are so over-blown that they are vulnerable to a substantial correction. Furthermore, when the tide turns against bond markets the downside could be considerable. The long-term real yield on high quality government bonds has historically tended to average about three per cent, which implies that sovereign bonds would crash if central banks lost control of the market.

Bond bulls are on weak ground from another angle. If history tells us that real yields of three per cent are the norm, has government creditworthiness changed for the better, justifying a lower yield? Well, no: the accumulation of debt across all welfare economies is less sustainable than at any time in the past, and demographics, the number of retirees relative to those in work and paying taxes, are rapidly making the situation far worse.

Macroeconomists will probably claim that so long as central banks can continue to manage the quantity of money sloshing about in financial markets they can keep bond prices up. But this is valid only so long as markets believe this to be true. Put another way central banks have to continue fooling all of the people all of the time, which as we all know is impossible.

Economics

Asset managers or asset gatherers?

“The Bank of England paid nearly £3m of taxpayers’ money for a report on whether any of its staff knew about or were involved in illegal manipulation of one of the world’s biggest financial markets.”

– Caroline Binham of The Financial Times, covering allegations of foreign exchange market rigging, and showing how the Bank of England is clearly on top of things, 31st January 2015.

 

“There are myths and pseudo-science all over the place. I might be quite wrong, maybe they do know all this … but I don’t think I’m wrong, you see I have the advantage of having found out how difficult it is to really know something. How careful you have to be about checking the experiments, how easy it is to make mistakes and fool yourself. I know what it means to know something. And therefore, I see how they get their information and I can’t believe that they know it. They haven’t done the work necessary, they haven’t done the checks necessary, they haven’t taken the care necessary. I have a great suspicion that they don’t know and that they’re intimidating people.”

– Richard Feynman on ‘experts’.

 

“Sir, Martin Wolf (“Draghi’s bold promise to do what it takes for as long as it takes”) is right to dismiss many of the arguments against QE. But, while QE will not necessarily cause hyperinflation, there is a real risk.

“Central banks have to date simultaneously “printed money” in massive amounts in QE programmes but have then used different mechanisms to “sterilise” the money so that it doesn’t go out in the economy.

“There have been massive increases in reserves held by banks. I have described this as driving with one foot on the throttle and the other on the brake. This means that the money printing hasn’t been inflationary, but it also means that QE has a small bang per buck, working through asset prices rather than real investment. It hasn’t done much for the real economy but has increased stock market prices and the wealth of the 1 per cent.

“The unwinding of the policy needed in the medium term, to avoid hyperinflation, is to sell the assets bought in QE back to the market. So, at some date in the future, bold central banks will need to engineer negative effects more or less equal to the positive effects today. In fact, they will be selling back to the market at a time when interest rates are higher and bond prices lower, taking a loss on the sale.

“The worry is that central banks will find it easier to just let the money flow into the economy at the worst possible time, once the economy has recovered and banks want to lend the money out. The sums are huge, and would then lead to very high inflation.

“The problem with QE is that it’s the wrong monetary policy. It isn’t bold to print money. It will be bold to withdraw it later.”

– Letter to the Financial Times from Mr Jeff Frank, Professor of Economics, Royal Holloway, University of London, UK, 27th January 2015.

 

Ever heard of Edward G. Leffler ? No, we hadn’t either. But in the words of author and Wall Street Journal columnist Jason Zweig, Leffler was

“the most important person in mutual fund history”.

The financial services industry is not exactly awash with innovations delivering tangible social value. The former Federal Reserve chairman Paul Volcker once suggested that the only useful banking innovation was the ATM machine. Leffler’s claim to fame ? He invented the open-ended fund.

Leffler originally sold pots and pans. But he was not slow to appreciate that selling investments might be more lucrative. In March 1924 he helped launch Massachusetts Investors Trust, the first open-ended fund. Its charter stipulated that “investors could present their shares and receive liquidating values at any time.”

Its impact was similar to that of Henry Ford’s development of the assembly line. It turned asset management into an industrial process. Whereas closed-ended funds contained a fixed amount of capital, open-ended funds had the potential for unlimited growth. As Zweig fairly observes, like any human innovation, the open-ended fund could be used for good, or ill.

He cites Alfred Jaretski, the securities lawyer who helped to draft the Investment Company Act:

“As there is normally a constant liquidation by shareholders who for one reason or another desire to cash in on their shares, the open-end companies must engage in continuous selling of new shares of stock in order to replace the shares so withdrawn…. Under these circumstances, and with keen competition between companies in the sale of their shares, it [is] natural that some questionable practices should [develop]. It furthermore bec[o]me[s] extremely difficult, and in some instances impossible, for any one company or small group of companies to raise standards and at the same time compete with the others.”

At a stroke, the invention of the open-ended fund created a schism in the asset management industry. Institutional investors would thereafter have to make a choice. They could be asset managers, or they could be asset gatherers. But they could not be both. Zweig describes the split as one between an investment firm and a marketing firm. The difference ?

“The marketing firm has a mad scientists’ lab to “incubate” new funds and kill them if they don’t work. The investment firm does not.

The marketing firm charges a flat management fee, no matter how large its funds grow, and it keeps its expenses unacceptably high. The investment firm does not.

The marketing firm refuses to close its funds to new investors no matter how large and unwieldy they get. The investment firm does not.

The marketing firm hypes the track records of its tiniest funds, even though it knows their returns will shrink as the funds grow. The investment firm does not.

The marketing firm creates new funds because they will sell, rather than because they are good investments. The investment firm does not.

The marketing firm promotes its bond funds on their yield, it flashes “NUMBER ONE” for some time period in all its stock fund ads, and it uses mountain charts as steep as the Alps in all its promotional material. The investment firm does none of those things.

The marketing firm pays its portfolio managers on the basis not just of their investment performance but also the assets and cash flow of the funds. The investment firm does not.

The marketing firm is eager for its existing customers to pay any price, and bear any burden, so that an infinite number of new customers can be rounded up through the so-called mutual fund supermarkets. The investment firm sets limits.

The marketing firm does little or nothing to warn its clients that markets do not always go up, that past performance is almost meaningless, and that the markets are riskiest precisely when they seem to be the safest. The investment firm tells its customers these things over and over and over again.

The marketing firm simply wants to git while the gittin’ is good. The investment firm asks, “What would happen to every aspect of our operations if the markets fell by 67% tomorrow, and what would we do about it? What plans do we need in place to survive it?””

So ultimately all fund managers must make a choice. As Zweig puts it,

“You can be mostly a marketing firm, or you can be mostly an investment firm. But you cannot serve both masters at the same time. Whatever you give to the one priority, you must take away from the other.

“The fund industry is a fiduciary business; I recognize that that’s a two-part term. Yes, you are fiduciaries; and yes, you also are businesses that seek to make and maximize profits. And that’s as it should be. In the long run, however, you cannot survive as a business unless you are a fiduciary emphatically first.

“In the short term, it pays off to be primarily a marketing firm, not an investment firm. But in the long term, that’s no way to build a great business. Today, tomorrow, and forever, the right question to ask yourselves is not “Will this sell?” but rather “Should we be selling this?” I will praise every fund company that makes that choice based on what is right for its investors, because I believe that standard of judgment is the right standard.”

There’s a fairly easy way to tell if a firm is a marketing firm or an investment firm. Do you see its advertising on buses, cabs and posters ? Do they have a practically limitless range of funds ? This is not to denigrate marketing firms entirely. But as the financial markets lurch between unprecedented bouts of bad policy, and achieve valuations that we strongly suspect are unlikely to persist, it may be worthwhile to consider the motives of the people charged with managing your money. Are they asset managers, or asset gatherers ? The answer may have some relevance for the sanctity and stability of your portfolio. And for your peace of mind.

Economics

Technical Update

Wracked by the actions of the various central banks – which gave us another key reminder that volatility does not equate to risk – yet not wishing to start rethinking their entire thesis, a characteristic loss confidence has started to set in among those who were telling themselves over the Christmas trukey just what geniuses they were. We could have an interesting couple of weeks in store – not helped by the fact that we are about to enter the great Chinese data avoid as the lunar new year approaches.

In China, the poorest industrial profit and revenue results in years, the slowest growth in the money supply, and the not unrelated presure on the yuan – where CNY6.27 looks increasingly important –  are still none of this is enough to halt the flood of hot money into equities.

15-01-28 China PftThe main boards may have temporarily found a ceiling but the Nasdaq/Neumarkt equivalent, ChiNext, has just threatened to resume the upmove. Sentimentals, remember, can always trump fundamentals. Or, as Frederick Lewis Allen put it a l-o-n-g time ago: ‘Hope can be exchanged for cash on a speculative market.’

Courtesy of Bloomberg
Courtesy of Bloomberg
Courtesy of Bloomberg
Courtesy of Bloomberg

As for other stock markets, it appears that something of a tug-of-war has developed. Just enough bad news to keep the bulls from becoming too enthusiastic, but not enough gloom to cede dominance to the bears. Another one of those situations where you have to wait to see who takes control before throwing your weight behind the move. Eg, MSCI World ex-USA:-

Courtesy of Bloomberg
Courtesy of Bloomberg

And the USA itself. Still some upside if this broad brush picture is going to deliver some wonderfully symmetric culminating action. But…..

Courtesy of Bloomberg
Courtesy of Bloomberg

…buyer beware: the ‘one-off’ shocks are starting to add up and the resulting rise in uncertainty can be seen in the usual places – vols, junk and EM spreads, the gold/industrial ratio and, arguably, the safe haven dollar trade (or, if you prefer, the end of carry).

Courtesy of Bloomberg
Courtesy of Bloomberg

Look, too, at how swings in yield differentials between the bellies of the US and German curves tend to signal turning points in the economic cycle.

Courtesy of Bloomberg
Courtesy of Bloomberg

The T-Bond, too, is pausing for breath after making a minor new historic yield low. While below 2.45/50%, the post-87 profile suggests a bottom at 2.25% (as we have already pointed out), but if things get really hairy, we might have to widen the range and plump for 1.50% for the Bond and 1.10% for the T-Note. RIP all bond vigilantes – a short memorial service will take place, followed by a reading from Homer & Sylla.

Courtesy of Bloomberg
Courtesy of Bloomberg

There is also a possible, very neat confluence of time and price coming together for USDDEM/EUR – a pairing which seems to oscillate on a cycle of roughly 15 years – 1970, 1985, 2000, and 2015 (?) marking the peaks for the dollar/troughs for the mark. $1.065/00 suggests itself as an objective. If we have to go beyond that, $0.9250/00 marks the log middle

Courtesy of Bloomberg
Courtesy of Bloomberg

As for commodities, the plain gold-in-dollar 2-year profile mapped out since 2013’s collapse looks balanced and, hence, potentially ready for a new trend move away from the mid-mean levels either side of $1300. Behaviour is somewhat harder to read of late for, since the turn of the year, the dynamic has not so much been dollar up, gold down (and v.v.) but euro weakness = gold strength. Such a confusion of signals – and hence of the underlying reasoning – is what we might expect at a turning point but do note that there is now a whole lot of positioning already in place betting on a further rise.

Courtesy of Bloomberg
Courtesy of Bloomberg

 

Courtesy of Bloomberg
Courtesy of Bloomberg

Industrial metals are again staring into the abyss,  as are iron ore, rebar, and coking coal on Shanghai.

Courtesy of Bloomberg
Courtesy of Bloomberg

Ags, too, are threatening support once more. Not only have harvests been good, but the collapse in crude is neutralising the single most important factor in the sector’s repricing these past ten years – biofuel. Ethanol is at 10-year lows, soy and palm oil are at levels not seen since 2009, sugar was first here all of four decades back and cheap petchems are forcing cotton and rubber lower, too.

Courtesy of Bloomberg
Courtesy of Bloomberg

Finally, oil itself. We have had almost three weeks of relative calm – itself a newsworthy event given what went on prior to that. But nothing seems able to actually reverse the trend, rather than simply suspend it. Specs are still heavily long, cracks are back to normal, production continues to defy the rig count, inventories are bulging, RSIs are now neutral – and all the while, value is building, not rejecting, right down here at the extremes.

Even allowing for the fact that the dollars you hand over for oil are themselves worth more these days, it is hard to resist the feeling that we will probe lower still before we are done. And some where down there lurks the 1974-2004 mean….

Courtesy of Bloomberg
Courtesy of Bloomberg linear scale
Courtesy of Bloomberg
Courtesy of Bloomberg log scale