"Most Americans are close to total ignorance about the world. They are ignorant. That is an unhealthy condition in a country in which foreign policy has to be endorsed by the people if it is to be pursued. And it makes it much more difficult for any president to pursue an intelligent policy that does justice to the complexity of the world." - Zbigniew Brezezinski
Zbigniew is a Polish American who served as National Security Adviser to President Carter in the 70s. I have to say that since then American geopolitical views have matured considerably but are still well behind the rest of the world for the simple reason that geopolitics is not something that Americans have to deal with on a daily basis. Unlike Europe, Russia, Africa, the Middle East and Asia (including China and India), America for all of its economic muscle really has little daily interaction with the rest of the world. Yes it is a global economic power house that sells products around the world, exports its political agendas and tries to secure its energy providers through a combination of political strategy, economic opportunities and military might, but its citizens are mostly insulated from the rest of world. The only borders it has it shares with two friendly nations, Canada and Mexico and on either side it has vast ocean expanses buffering it from all other countries. In comparison most other nations are bordered by or are in very close proximity to nations that disagree with their political point of view. They operate under the veil of secrecy and mistrust and this feeds daily into their citizen's minds etching a geopolitical point of view that dictates the countries economic and political futures. Welcome to investing through a Geopolitical Perspective!
When investing it is imperative to take these geopolitical ideals into mind to give you a better understanding of future trends within countries and how these trends will impact future growth prospects. The trends are all extremely long term or secular as the views are deeply rooted having taken decades to evolve and will take decades to change. This form of analysis includes a look at a country's geography, its culture and history (or a look at the history that shaped the country's culture) and the country's needs and expectations. Once you have a clear understanding of each of these pieces of the puzzle it is a lot easier to determine a forecast for future policies and thereby a road map to industries and companies that will benefit from this scenario.
So as an example let's compare China to the United States. As I have already mentioned the United States is protected on all sides by either friendly neighbors or vast oceans. The closest islands on the east are the Bahamas and the threat of Cuba has been alleviated with that country's demise. On the west the nation is protected by a massive naval port in Hawaii. The remaining threat is from Russia in Alaska but that has always been seen as a very minor threat in that the weather and the distance from the rest of the country is vast. The country's culture is made up of a vast array of nations that all emigrated to the new frontier and it still to this day conveys a sense of the wild west. Mineral wealth abounds and its vast educational backbone drives its technological advances. It is one of the world's energy giants and has vast plains that easily feed its citizens. All in all it is protected throughout so it should not be surprising that most of its policies look inward rather than outside hence the supposed naivety in geopolitics..
China on the other hand is bordered by Russia, Mongolia, Pakistan, India, Burma (Myanmar), Vietnam and Korea. It only has access to the ocean on its east coast and this is surrounded by Japan, Taiwan and Indonesia, all United States allies. It has limited energy wealth outside of coal and has a vast population of unskilled and uneducated people. Its infrastructure is in dire need of improving but it requires massive imports of raw materials to accomplish this. It has used its vast unskilled and poorly educated masses to climb into the second spot (some argue that they are already the top spot) in terms of global economic wealth and it is using this economic might to strengthen its military and economic presence around the world as it seeks to secure its energy sources. It is no wonder that they are fearful of the West's intentions and seek to protect their borders and the Strait of Malacca as these are vital to their prosperity. Therefore it should come as no surprise if there is conflict in the strait particularly if the United States continues to send warships that way.
Now by no stretch of the imagination is this an exhaustive analysis, in fact I have barely scratched the surface but the example was to show you how important it is to take a more geopolitical approach to your investment analysis as this will give you a better understanding of policies that will shape the direction of economic growth within the borders of the country in which you invest, This in turn should allow you to take advantage of secular trends improving your overall returns.
Friday, May 23, 2014
Friday, May 16, 2014
A Study of Inflation
"The first panacea for a mismanaged nation is inflation of the currency, the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists." - Ernest Hemingway
The United States, Europe and Japan are all reporting low inflationary numbers. In fact Europe is trying to fend off Japan style deflation while the United States considers inflation benign at 1.5%. The average consumer can argue all day long that the inflation rate is accelerating as the cost of everything from food to gasoline to insurance to health care to school fees to ... I could go on and on but you get the picture. Furthermore stock markets around the world have produced double digit returns for the past number of years and assets such as housing, art, diamonds and other exotic style investments are seeing prices never before witnessed. So why is there such a dichotomy between what the Federal Reserve reports and what is really happening in the world and how could this affect the investment landscape in the years to come?
The problem is that the measure used by the Federal Reserve to calculate increases in prices excludes the increase in asset prices and strips out oil and food price spikes. So when the stock market rallies or house prices increase or the cost of a diamond soars, these price increases are not added to the inflation gauge used at the central bank. Back in time inflation was calculated by determining the amount of money that was added to the market relative to a quantity of gold. Adding more money meant that the value of the currency would decline unless more gold was added to the reserves. Devaluing the currency resulted in things costing more per dollar and thus inflation was calculated. When the world left the gold standard and printed money at will this valuation metric was dropped and a new measure of price increases was used.
In a way this was understandable as the complexity of new financial products made it very difficult to operate on a standard as simple as the gold standard but the increased complexity has brought with it the problem that it is impossible to calculate the actual money supply or the total currency in circulation and therefore there is no way to accurately calculate inflation. For this reason the Federal Reserve and central bankers around the world use some form of price increases to estimate the inflation rate. In the United States added complexities are put into the equation like the perceived benefits associated with technological and medical advances. These benefits are handled through adjustments to the actual numbers. So what you really have is a concocted number (I can see them brewing up the next one in their laboratories now) rather than a real understanding of inflation and this is why the central bankers of the world are continually caught with their pants down when their readings finally register inflation.
So how much have currencies depreciated (or inflation increased) over time. Well if you take one metric which is to compare the value of a dollar to the price of gold, a dollar purchased 1/250th of an ounce of gold in 2000 and today it buys 1/1,300th of an ounce. This equates to an inflation rate of over 500% during that time frame. Another metric is to Look at the Federal Reserve balance sheet which has expanded from $800 billion to $4 trillion in five years. This equates to an inflation rate of 500% in five years rather than 14 years calculated using gold. Either way you can quickly get the idea that the expansionary policies followed by the central bankers of the world have decimated the currency and pushed inflation into orbit, all the while reporting modest to no inflation. In the past when inflation has run amok like this trouble brews and so it is imperative that you find investments that will protect you.
As I mentioned earlier the authorities will not act on an inflationary signal until it appears in their data. Until that point in time they will continue with their inflationary programs thinking that they can quickly deal with the problem. This has never happened in the past because as we have seen they are not monitoring the real inflation rate, so the chances of them catching it early this time have already passed. Fortunately they are slowly reducing the monthly buy but it is too little too late as normal.
In an inflationary environment like the one we had here in the 70's it is imperative to own assets, and by assets I mean hard assets like real estate, gold, oil, diamonds and the like. Stocks do not normally perform well as their value is based on a future cash flow stream and if that stream of cash is seen to devalue due to high inflation they can often lag the appreciation of real assets. So look at your portfolio and ensure that you have some allocation to these investments as the sooner you do the better off you will be when the Federal Reserve finally wakes up to what you and I already know.
The United States, Europe and Japan are all reporting low inflationary numbers. In fact Europe is trying to fend off Japan style deflation while the United States considers inflation benign at 1.5%. The average consumer can argue all day long that the inflation rate is accelerating as the cost of everything from food to gasoline to insurance to health care to school fees to ... I could go on and on but you get the picture. Furthermore stock markets around the world have produced double digit returns for the past number of years and assets such as housing, art, diamonds and other exotic style investments are seeing prices never before witnessed. So why is there such a dichotomy between what the Federal Reserve reports and what is really happening in the world and how could this affect the investment landscape in the years to come?
The problem is that the measure used by the Federal Reserve to calculate increases in prices excludes the increase in asset prices and strips out oil and food price spikes. So when the stock market rallies or house prices increase or the cost of a diamond soars, these price increases are not added to the inflation gauge used at the central bank. Back in time inflation was calculated by determining the amount of money that was added to the market relative to a quantity of gold. Adding more money meant that the value of the currency would decline unless more gold was added to the reserves. Devaluing the currency resulted in things costing more per dollar and thus inflation was calculated. When the world left the gold standard and printed money at will this valuation metric was dropped and a new measure of price increases was used.
In a way this was understandable as the complexity of new financial products made it very difficult to operate on a standard as simple as the gold standard but the increased complexity has brought with it the problem that it is impossible to calculate the actual money supply or the total currency in circulation and therefore there is no way to accurately calculate inflation. For this reason the Federal Reserve and central bankers around the world use some form of price increases to estimate the inflation rate. In the United States added complexities are put into the equation like the perceived benefits associated with technological and medical advances. These benefits are handled through adjustments to the actual numbers. So what you really have is a concocted number (I can see them brewing up the next one in their laboratories now) rather than a real understanding of inflation and this is why the central bankers of the world are continually caught with their pants down when their readings finally register inflation.
So how much have currencies depreciated (or inflation increased) over time. Well if you take one metric which is to compare the value of a dollar to the price of gold, a dollar purchased 1/250th of an ounce of gold in 2000 and today it buys 1/1,300th of an ounce. This equates to an inflation rate of over 500% during that time frame. Another metric is to Look at the Federal Reserve balance sheet which has expanded from $800 billion to $4 trillion in five years. This equates to an inflation rate of 500% in five years rather than 14 years calculated using gold. Either way you can quickly get the idea that the expansionary policies followed by the central bankers of the world have decimated the currency and pushed inflation into orbit, all the while reporting modest to no inflation. In the past when inflation has run amok like this trouble brews and so it is imperative that you find investments that will protect you.
As I mentioned earlier the authorities will not act on an inflationary signal until it appears in their data. Until that point in time they will continue with their inflationary programs thinking that they can quickly deal with the problem. This has never happened in the past because as we have seen they are not monitoring the real inflation rate, so the chances of them catching it early this time have already passed. Fortunately they are slowly reducing the monthly buy but it is too little too late as normal.
In an inflationary environment like the one we had here in the 70's it is imperative to own assets, and by assets I mean hard assets like real estate, gold, oil, diamonds and the like. Stocks do not normally perform well as their value is based on a future cash flow stream and if that stream of cash is seen to devalue due to high inflation they can often lag the appreciation of real assets. So look at your portfolio and ensure that you have some allocation to these investments as the sooner you do the better off you will be when the Federal Reserve finally wakes up to what you and I already know.
Monday, May 12, 2014
A Secular Trend Worth Noting
Secular - Occurring once every century or similarly long period. Definition from the Oxford English Dictionary
As the Federal Reserve and central bankers around the world
try to kick start growth there is a long term indicator that points to slow
growth for many years to come – birth rates.
Not since the Great Depression have birth rates been so low. This low birth rate is having a profound
impact on long term economic growth rates but unfortunately the authorities
continue to ignore this important piece of economic input and continue to
provide overly optimistic forecasts.
The Federal Reserve continues to project that the economy
will grow at a rate of 3.0% or greater for the next three years and then they
expect it to slow to 2.3%. This is the
same growth rate that they have predicted for the past few years and each year
these forecasts are slowly ratcheted down during the year to 2.5% or lower by
year end. Whether they actually believe
these forecasts or are just trying to sell hope is anyone’s guess but looking
at one of the main economic drivers, birth rates, it is clear that regardless
of what they predict slow growth will be with us for years to come.
Throughout the developed world birth rates are below
historic norms and below 2.1, the rate required to maintain a population. A number below 2.1 means the population is
contracting and above 2.1 it is growing.
In Germany, France, United States, Japan and the United Kingdom, the
birth rate is 1.7. Furthermore the
number of people in the labor pool in Germany, France and Italy has already
started to shrink. So not only is the
current labor pool not growing but the trend will worsen.
Part of the reason for this lack of growth is the financial
crisis. Couples who would normally have had
a few children are now having one or sometimes none for the simple reason that
the financial crisis had such an impact on their nest egg that it made them
reconsider the financial impact of having a large family. Not only did millions lose their houses but
many more lost their income so the thought of adding another mouth to feed,
clothe and school was just too much to bear.
Economists had expected that this phenomenon would quickly resolve
itself but the deepness of the downturn and the slow recovery have left couples
wondering if they will ever have the financial fortitude to have a large
family.
While this may be a temporary issue, the longer it continues
the larger the impact on the economic outlook.
Demographic trends are secular trends, in that they last for an extended
or secular period. So looking forward
with the loss of workforce participants economic growth will be muted. While some of this can be offset with productivity
gains there is still a smaller pool of consumers and this is where the impact
is really felt. Everything from
electronics to homes is affected and this ripples through the economy. Slower growth means lower profits and this
feeds into stocks and other investments that retirees rely on to live. In this scenario low interest rates become
the norm and markets are beaten down on a regular basis.
On the flip side global population growth caused concerns
regarding the ability of the globe’s food stocks to support this enormous population
so relief from this will be a good thing.
The problem is that the countries where the slowing is occurring will
soon be overtaken in population size by poorer economies, notably Africa, where
there are already too many problems to mention. So while the developed nations struggle with
slowing birth rates the developing world is growing at a feverish pace. This is why more and more of the profits of
global businesses are coming from outside of the developed nations and this is
a trend set to continue.
In Japan there are more adult diapers sold than baby
diapers, in Germany and Italy small towns are emptying and in South Korea where
births have fallen 11% in a decade 121 primary schools are vacant. The issues facing the developed world are
great and this trend is not quickly resolved by printing money. It appears therefore that the slow growth
that we are currently dealing with may be here for a much longer period than
any central banker will admit.
Friday, May 2, 2014
How Low Can They Go?
"How low can you go?
I could go low, (go low) lower than you know,
Go low (go low) lower than you know
Go low (go low) lower than you know
Go low (go low) lower than you know
Go low (go low) lower than you know" - Lyrics from the song How Low Can You Go by Ludacris
Low interest rates are a source of frustration for retirees and joy for investors. On one side of the coin you have those trying to live off interest payments and on the other you have the people borrowing money. The first group (mainly retirees) have seen their livelihood evaporate while home buyers, businesses and others borrowing money have seen the cost of borrowing fall to record lows. In the United States you can buy a house with a mortgage rate of less than 3.5% which makes home ownership very affordable, but try living on interest income of less than 3%! Take as an example of a person with $1 million in retirement savings who was expecting to earn 6% or $60,000 a year. This income has now fallen to less than a third and means that this person will have to dig into their principle eroding future income all the while losing to inflation. This person's retirement plans are being destroyed.
Now while we could go into options available to them the question that most people are asking is how much longer can interest rates remain low and I will argue that not only with they remain low for years to come, but there is a high probability that they could go a lot lower. The reasons for my outlook are numerous but I will expound on a few main points in this blog starting with the Federal Reserve's desire to keep them low.
While the Federal Reserve does not have complete control over market forces they can influence them significantly and through continued stimulus and by holding bank rates down they have effectively managed to keep the lid on any increases. Furthermore with their share of market debt rising significantly and congresses lack of ability to balance the budget they have a huge incentive to keep borrowing costs down. To take the example above and place it into the context of the Federal Reserve and Washington (and I will use a round number of $20 trillion as it looks like we will be there sooner rather than later) if you pay interest on $20 trillion at around 3% versus 6% you are saving $600 billion a year. Now that might not seem like a lot in terms of the nominal value of the debt but if you put it into the context of balancing the budget it makes a huge difference. Right now we run a $600 billion deficit, add the increased payment of $600 billion and suddenly the budget deficit doubles! Certainly a huge incentive to keep the lid on interest rates as long as possible.
The next area to look to is the market. The market is made up of banks and institutions and foreign governments. Looking abroad at Europe and Japan and the picture becomes very interesting. I looked at the 10 year rates around the world and it is truly eye opening. The rate in the United States is approximately 2.60%. In comparison, Japan is 0.60%, Switzerland is 0.80%, Germany 1.45%, Netherlands 1.77% and France at 1.92% all of which are substantially lower than the United States. In fact Italy at 3.04% and Spain at 2.97% are pretty much in line with the United States and Mexico at 3.67% and Portugal at 3.60% are not a lot higher. If I were surveying the investment scene around the world to place a large amount of money I would be hard pressed not to invest in the United States as the security offered for one of the best rates in the globe makes it a compelling alternative. More investment means prices of bonds go up and this then keeps the lid on rates and can force them lower.
The final piece to this puzzle is inflation. Without inflation there is no requirement to raise rates so it is very interesting to note that one of the reasons the European rates are so low is that due to their austerity they are now staring at deflation. If they enter a deflationary spiral similar to the one that has plagued Japan for decades we could easily see a world where rates remain muted for a very long time regardless of what the Federal Reserve does.
This will have a huge impact on your retirement and investment outlook so make sure that you factor this into your portfolio as the odds are high that interest rates fall further from here even though ( and maybe because of the fact that) consensus tells you otherwise. This is why I repeated the lines in the quote four times (like they do in the song) just to remind you that lower is possible.
I could go low, (go low) lower than you know,
Go low (go low) lower than you know
Go low (go low) lower than you know
Go low (go low) lower than you know
Go low (go low) lower than you know" - Lyrics from the song How Low Can You Go by Ludacris
Low interest rates are a source of frustration for retirees and joy for investors. On one side of the coin you have those trying to live off interest payments and on the other you have the people borrowing money. The first group (mainly retirees) have seen their livelihood evaporate while home buyers, businesses and others borrowing money have seen the cost of borrowing fall to record lows. In the United States you can buy a house with a mortgage rate of less than 3.5% which makes home ownership very affordable, but try living on interest income of less than 3%! Take as an example of a person with $1 million in retirement savings who was expecting to earn 6% or $60,000 a year. This income has now fallen to less than a third and means that this person will have to dig into their principle eroding future income all the while losing to inflation. This person's retirement plans are being destroyed.
Now while we could go into options available to them the question that most people are asking is how much longer can interest rates remain low and I will argue that not only with they remain low for years to come, but there is a high probability that they could go a lot lower. The reasons for my outlook are numerous but I will expound on a few main points in this blog starting with the Federal Reserve's desire to keep them low.
While the Federal Reserve does not have complete control over market forces they can influence them significantly and through continued stimulus and by holding bank rates down they have effectively managed to keep the lid on any increases. Furthermore with their share of market debt rising significantly and congresses lack of ability to balance the budget they have a huge incentive to keep borrowing costs down. To take the example above and place it into the context of the Federal Reserve and Washington (and I will use a round number of $20 trillion as it looks like we will be there sooner rather than later) if you pay interest on $20 trillion at around 3% versus 6% you are saving $600 billion a year. Now that might not seem like a lot in terms of the nominal value of the debt but if you put it into the context of balancing the budget it makes a huge difference. Right now we run a $600 billion deficit, add the increased payment of $600 billion and suddenly the budget deficit doubles! Certainly a huge incentive to keep the lid on interest rates as long as possible.
The next area to look to is the market. The market is made up of banks and institutions and foreign governments. Looking abroad at Europe and Japan and the picture becomes very interesting. I looked at the 10 year rates around the world and it is truly eye opening. The rate in the United States is approximately 2.60%. In comparison, Japan is 0.60%, Switzerland is 0.80%, Germany 1.45%, Netherlands 1.77% and France at 1.92% all of which are substantially lower than the United States. In fact Italy at 3.04% and Spain at 2.97% are pretty much in line with the United States and Mexico at 3.67% and Portugal at 3.60% are not a lot higher. If I were surveying the investment scene around the world to place a large amount of money I would be hard pressed not to invest in the United States as the security offered for one of the best rates in the globe makes it a compelling alternative. More investment means prices of bonds go up and this then keeps the lid on rates and can force them lower.
The final piece to this puzzle is inflation. Without inflation there is no requirement to raise rates so it is very interesting to note that one of the reasons the European rates are so low is that due to their austerity they are now staring at deflation. If they enter a deflationary spiral similar to the one that has plagued Japan for decades we could easily see a world where rates remain muted for a very long time regardless of what the Federal Reserve does.
This will have a huge impact on your retirement and investment outlook so make sure that you factor this into your portfolio as the odds are high that interest rates fall further from here even though ( and maybe because of the fact that) consensus tells you otherwise. This is why I repeated the lines in the quote four times (like they do in the song) just to remind you that lower is possible.
Friday, April 25, 2014
Looking at Tea Leaves
"Cook, Cook, drink your tea.
But save some in the pot for me.
We'll watch the tea leaves in our cup
When our drink is all sipped up.
Happiness or fortune great,
What will our future be?" - From the book, "Afternoon Tea at Pittock Mansion" by R.Z. Berry
Traders spend hours trying to gain an edge over the market and most of it is like looking at tea leaves to dissect and expectation about future market movements. With the decimation of some of the most prolific momentum stocks in the past few weeks I thought it would be a good to take a look at some market indicators to see what they are telling us if anything. Now some of this may be relatively technical in nature but that is all part of the education process so bear with me and see if you can make sense of my tea leaves.
First off I took a look at the S&P 500 and while it recently made a new high of 1897.28 on April 4th, it subsequently rolled over. It did bounce but does not look like it has the momentum to regain its previous high particularly when you look at the Relative Strength Index which is showing short term weakness. Also given that the Federal Reserve continues to slash its support in $10 billion monthly increments, the catalyst for the market to move higher seems to be gone. Whether it will actually die or consolidate at this level is still open to debate but on the surface it does not look like it will take out the highs in the coming weeks and in fact may even test the 200 day moving average around 1,800 first.
Looking at the fear gauges of Gold and the VIX it still looks like the market is complacent. The VIX is a barometer of market fear as it measures the number of put options to call options in a given market. More put options (an option that bets that the market will fall) shows more concern for future market direction. A VIX of less than 15 shows complacency while a VIX of over 50 points to high risk. Right now the VIX is 14 so there is little in the way of panic. Also while the price of gold seems to have stabilized it is still not showing signs of a full blown recovery in the price. So by both of these measures the market is not expecting a huge draw down but it is at these times of complacency that the Black Swan appears.
I always follow copper closely as that is a good barometer of global industry and while it has taken a beating in the past few months it is actually showing some signs of strength. While this strength is very short term in nature and therefore cannot be considered as showing signs of strong global economic growth a recovery has to start somewhere. So with stock markets looking weak it is always interesting to see a divergence in this commodity from the market movements. More strength in this price might point to a recover in global trade and that would portend to a stronger economic platform on which markets could base a recovery.
Crude oil recently made a new 52 week high of $104 a barrel and this has had a huge impact on the price of gasoline. While this price strength can be attributed to stronger demand and therefore stronger economic growth, the impact of this spike in gasoline prices is not encouraging as a sudden spike in inflation would quickly derail any form of recovery. Consumers are still too cash strapped to handle and extended spike in this price but fortunately the price has quickly fallen to just over $100 a barrel. I would like to see this below $95 a barrel to ensure that there is not a significant impact to economic growth.
A friend of mine showed me some research on interest rate movements since the 70s. The study was done to see the impact of rising interest rates on the market returns but what I found most interesting about the study was that from 1970 to 2007 interest rates rose every 5 years or so. Since 2007 however there really has not been a significant tightening in interest rates and so this recovery is really long in the tooth. The basic premise is that interest rates have to rise soon but looking at the overall data of low inflation, high unemployment and continued significant (although slowing) stimulus I would expect interest rates to remain low for an extended period. While this may be good for the market a quick look at Japan shows that even with low interest rates particularly when those are low for an extended period of time there is no guarantee of a continued burgeoning market. In fact the length of time between raising rates is signalling problems rather than good times so more of the same will have more and more of a negative impact as the magnitude of the problem is truly understood.
Now I could go on with more indicators but the above is a good barometer that the market is really in a quandary right now. There are no clear signals that point to continued strength or to a total collapse and so I would not be surprised to see the market drift along aimlessly until a new catalyst is found. What that catalyst is I cannot fathom a guess but I would not think it a time to be overly optimistic and in this type of market caution is often your best friend.
But save some in the pot for me.
We'll watch the tea leaves in our cup
When our drink is all sipped up.
Happiness or fortune great,
What will our future be?" - From the book, "Afternoon Tea at Pittock Mansion" by R.Z. Berry
Traders spend hours trying to gain an edge over the market and most of it is like looking at tea leaves to dissect and expectation about future market movements. With the decimation of some of the most prolific momentum stocks in the past few weeks I thought it would be a good to take a look at some market indicators to see what they are telling us if anything. Now some of this may be relatively technical in nature but that is all part of the education process so bear with me and see if you can make sense of my tea leaves.
First off I took a look at the S&P 500 and while it recently made a new high of 1897.28 on April 4th, it subsequently rolled over. It did bounce but does not look like it has the momentum to regain its previous high particularly when you look at the Relative Strength Index which is showing short term weakness. Also given that the Federal Reserve continues to slash its support in $10 billion monthly increments, the catalyst for the market to move higher seems to be gone. Whether it will actually die or consolidate at this level is still open to debate but on the surface it does not look like it will take out the highs in the coming weeks and in fact may even test the 200 day moving average around 1,800 first.
Looking at the fear gauges of Gold and the VIX it still looks like the market is complacent. The VIX is a barometer of market fear as it measures the number of put options to call options in a given market. More put options (an option that bets that the market will fall) shows more concern for future market direction. A VIX of less than 15 shows complacency while a VIX of over 50 points to high risk. Right now the VIX is 14 so there is little in the way of panic. Also while the price of gold seems to have stabilized it is still not showing signs of a full blown recovery in the price. So by both of these measures the market is not expecting a huge draw down but it is at these times of complacency that the Black Swan appears.
I always follow copper closely as that is a good barometer of global industry and while it has taken a beating in the past few months it is actually showing some signs of strength. While this strength is very short term in nature and therefore cannot be considered as showing signs of strong global economic growth a recovery has to start somewhere. So with stock markets looking weak it is always interesting to see a divergence in this commodity from the market movements. More strength in this price might point to a recover in global trade and that would portend to a stronger economic platform on which markets could base a recovery.
Crude oil recently made a new 52 week high of $104 a barrel and this has had a huge impact on the price of gasoline. While this price strength can be attributed to stronger demand and therefore stronger economic growth, the impact of this spike in gasoline prices is not encouraging as a sudden spike in inflation would quickly derail any form of recovery. Consumers are still too cash strapped to handle and extended spike in this price but fortunately the price has quickly fallen to just over $100 a barrel. I would like to see this below $95 a barrel to ensure that there is not a significant impact to economic growth.
A friend of mine showed me some research on interest rate movements since the 70s. The study was done to see the impact of rising interest rates on the market returns but what I found most interesting about the study was that from 1970 to 2007 interest rates rose every 5 years or so. Since 2007 however there really has not been a significant tightening in interest rates and so this recovery is really long in the tooth. The basic premise is that interest rates have to rise soon but looking at the overall data of low inflation, high unemployment and continued significant (although slowing) stimulus I would expect interest rates to remain low for an extended period. While this may be good for the market a quick look at Japan shows that even with low interest rates particularly when those are low for an extended period of time there is no guarantee of a continued burgeoning market. In fact the length of time between raising rates is signalling problems rather than good times so more of the same will have more and more of a negative impact as the magnitude of the problem is truly understood.
Now I could go on with more indicators but the above is a good barometer that the market is really in a quandary right now. There are no clear signals that point to continued strength or to a total collapse and so I would not be surprised to see the market drift along aimlessly until a new catalyst is found. What that catalyst is I cannot fathom a guess but I would not think it a time to be overly optimistic and in this type of market caution is often your best friend.
Friday, April 18, 2014
Is Volatility Risk?
"Traders can cause short-term volatility. in the long run, the market must revert to a sensible price/earnings multiple." - Ben Stein
"Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever." - Nassim Taleb
"We are facing extreme volatility." - Carlos Ghosn
Modern society has determined that it has the tools to smooth out volatility. We can witness these efforts at work in government, central banks, medicine, work and even at home. The question is whether all of this effort to alleviate day to day variability is beneficial or is this massive effort really the cause of all the pain?
As we all know volatility is a movement around a so called norm or trend. In stocks volatility is seen as large movements in the price of the stock either up or down away from the trend line of mean. In most cases people ignore the large upward move as that more often than not is a benefit so beneficial movements (even though they are volatile) are considered good and are ignored. The same can be said for the economy, accelerating economic growth is considered acceptable but as with stocks excessive acceleration is worrisome and in most cases is met with a central banker that tries to slow the growth to a more "normal" level.
Most people consider volatility associated with their paycheck as bad but some of us (normally the entrepreneur) loves this volatility as it offers the opportunity to make a lot more money. Vaccines are constantly being created and worked on to protect the world against disease and cleaning agents try to eradicate germs. Governments that are rouge are taken out and replaced with more conservative middle of the road ideals and mothers and fathers around the world try to protect their kids from bully's and nurture them in a way completely different from the real world.
The problem with all of this is that we evolve through volatility. Germs become stronger to fight back against the newest drug, they evolve into ever more powerful aliens that kill more people in hospitals than in motor car accidents. Puppet governments fall apart in time as given complete power they ultimately fail through lack of attention to detail and a sense of self-entitlement. Take Mugabe and Saddam Husein as two people placed into power by the United States to maintain the peace. There are obviously more examples of people placed in power by countries other than the United States but these are two readily available examples. Our DNA advances by learning from previous generations and fixing those weaknesses (only the strong survive).
Central governments are continually tinkering with the markets to create a "normal" environment so that in the end no-one knows what "normal" really is. What we do know is that these efforts to placate the markets has always ended in more bloodshed than if the markets were left to their own devices. Furthermore each time the market collapses the reserve bankers step in to try to "repair" the problem by adding liquidity or artificially moving interest rates which causes another problem elsewhere.
Now before you think I am advocating the complete removal of all government bodies and to live like John Lennon says we should in his song Imagine, I am not. There is a place for authorities to monitor certain situations and prevent a complete collapse caused by crowd hysterics or to provide law and order but outside of that framework the markets need to be left to handle themselves. Consider if Greenspan had not provided support for the Internet bubble. Meddling to save the market created the low interest rate environment which caused the housing bubble which has now lead to the largest experiment known to man. What would the real implications have been to let the technology bubble burst? The collapse of the banking system in 2007 was far more serious than the original problem and now that we have propped up that mess with $4 trillion no-one can even fathom a guess at the problems this will cause.
On a separate note, my friend John Cox is advocating a larger government body to repair the broken political system that is California. While on the surface this idea appears to be madness, in effect what he is offering is more volatility at the local level to ensure less trouble at the top thereby actually repairing the problem caused by too much power in the hands of too few people. This type of system is working admirably in other parts of the globe (Switzerland to name one) and could be what we need but moving the mindset of the average citizen will be a monumental task so if possible given him your support.
In conclusion, small, regular amounts of volatility is the ingredient that alleviates massive economic and political turmoil. Trying to end small uncomfortable problems associated with volatility causes greater global imbalances and will result in greater problems. Until we can accept this and change the way that problems are dealt with, the future will continue to be filled with large economic shocks to society at regular intervals. It is inevitable and unavoidable and as this idea is imbedded in most political parties around the globe (China included) the only thing we can do is prepare for large scale shocks in the future.
"Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever." - Nassim Taleb
"We are facing extreme volatility." - Carlos Ghosn
Modern society has determined that it has the tools to smooth out volatility. We can witness these efforts at work in government, central banks, medicine, work and even at home. The question is whether all of this effort to alleviate day to day variability is beneficial or is this massive effort really the cause of all the pain?
As we all know volatility is a movement around a so called norm or trend. In stocks volatility is seen as large movements in the price of the stock either up or down away from the trend line of mean. In most cases people ignore the large upward move as that more often than not is a benefit so beneficial movements (even though they are volatile) are considered good and are ignored. The same can be said for the economy, accelerating economic growth is considered acceptable but as with stocks excessive acceleration is worrisome and in most cases is met with a central banker that tries to slow the growth to a more "normal" level.
Most people consider volatility associated with their paycheck as bad but some of us (normally the entrepreneur) loves this volatility as it offers the opportunity to make a lot more money. Vaccines are constantly being created and worked on to protect the world against disease and cleaning agents try to eradicate germs. Governments that are rouge are taken out and replaced with more conservative middle of the road ideals and mothers and fathers around the world try to protect their kids from bully's and nurture them in a way completely different from the real world.
The problem with all of this is that we evolve through volatility. Germs become stronger to fight back against the newest drug, they evolve into ever more powerful aliens that kill more people in hospitals than in motor car accidents. Puppet governments fall apart in time as given complete power they ultimately fail through lack of attention to detail and a sense of self-entitlement. Take Mugabe and Saddam Husein as two people placed into power by the United States to maintain the peace. There are obviously more examples of people placed in power by countries other than the United States but these are two readily available examples. Our DNA advances by learning from previous generations and fixing those weaknesses (only the strong survive).
Central governments are continually tinkering with the markets to create a "normal" environment so that in the end no-one knows what "normal" really is. What we do know is that these efforts to placate the markets has always ended in more bloodshed than if the markets were left to their own devices. Furthermore each time the market collapses the reserve bankers step in to try to "repair" the problem by adding liquidity or artificially moving interest rates which causes another problem elsewhere.
Now before you think I am advocating the complete removal of all government bodies and to live like John Lennon says we should in his song Imagine, I am not. There is a place for authorities to monitor certain situations and prevent a complete collapse caused by crowd hysterics or to provide law and order but outside of that framework the markets need to be left to handle themselves. Consider if Greenspan had not provided support for the Internet bubble. Meddling to save the market created the low interest rate environment which caused the housing bubble which has now lead to the largest experiment known to man. What would the real implications have been to let the technology bubble burst? The collapse of the banking system in 2007 was far more serious than the original problem and now that we have propped up that mess with $4 trillion no-one can even fathom a guess at the problems this will cause.
On a separate note, my friend John Cox is advocating a larger government body to repair the broken political system that is California. While on the surface this idea appears to be madness, in effect what he is offering is more volatility at the local level to ensure less trouble at the top thereby actually repairing the problem caused by too much power in the hands of too few people. This type of system is working admirably in other parts of the globe (Switzerland to name one) and could be what we need but moving the mindset of the average citizen will be a monumental task so if possible given him your support.
In conclusion, small, regular amounts of volatility is the ingredient that alleviates massive economic and political turmoil. Trying to end small uncomfortable problems associated with volatility causes greater global imbalances and will result in greater problems. Until we can accept this and change the way that problems are dealt with, the future will continue to be filled with large economic shocks to society at regular intervals. It is inevitable and unavoidable and as this idea is imbedded in most political parties around the globe (China included) the only thing we can do is prepare for large scale shocks in the future.
Friday, April 4, 2014
The Elephant and the Bicycle
"China is like an elephant riding a bicycle. If it slows down, it could fall off, and then the earth might quake." - James Kynge's book China Shakes the World
After 30 years of economic growth of more than 8% a year it appears that China has finally reached the end of the road. During the 30 years of expansion there were a few bumps in the road but nothing like the Great Recession. Like most investors that get used to an extended bull market the Chinese government did what it always had done and that was to support their economy. They had the resources and so they sprang into action running a massive deficit, pushing interest rates down to extremely low levels and injecting large quantities of debt. The idea, as with all stimulus packages, was to weather the storm from the West and ramp up in preparation for the coming global expansion. When that global expansion took hold they could mop up the excess liquidity and stimulus and profit from the continued economic growth of 8%.
Unfortunately 8 years later the world still has not recovered and the stimulus has created bubbles and excesses all over China making it look like economic growth in China may finally stall bringing the elephant off the bicycle. Should this happen the repercussions will be felt across the globe as China is now the world's second largest economy, it has massive foreign reserves invested in all the developed nations and has grown itself into a hugely important consumer and industrial market.
As with all attempts to stimulate an economy with debt, the economy becomes addicted and unless more is produced exiting is painful. Debt produces excesses as why not risk the farm if it is owned by the bank anyway? It is not your money so keep producing until your line of credit is taken away and then, taking the remaining cash, head onto the next project and leave the mess to the bond holders. This should sound pretty familiar to most of you who follow this blog and certainly China is not alone in this quandary but let's look at some of the metrics pointing to excesses:
1. China has only consumed 65% of the cement it has produced in the past 5 years.
2. Steel production is larger than the next seven largest producers combined.
3. More than 27 billion square feet of new construction is vacant but more than 1.8 billion more is currently under construction.
4. Property prices in large metropolitan areas is almost 40 times the rental cost.
These are just some of the metrics that show the large excesses that their stimulus has created and the problem is that unless there is significant economic growth these problems will be transferred to the banks and we have all witnessed the problems associated with a financial crisis. Furthermore a large part of the globe's economic recovery was based on China and the continued growth of the BRIC nations. These nations continued to expand while the United States continued to print money but, with the reduction in stimulus from the Federal Reserve, the quick money is leaving these markets and showing them to be very vulnerable.
So for the past 30 years China has been seen as an economic miracle and has managed to avoid the kind of hard landings felt in the rest of the world for the simple reason that their economy was based on solid economic growth. This has now changed as they have finally succumbed to the West's economic stimulus models and with it we could witness for the first time the elephant fall off the bicycle and this shock will be felt across the globe.
After 30 years of economic growth of more than 8% a year it appears that China has finally reached the end of the road. During the 30 years of expansion there were a few bumps in the road but nothing like the Great Recession. Like most investors that get used to an extended bull market the Chinese government did what it always had done and that was to support their economy. They had the resources and so they sprang into action running a massive deficit, pushing interest rates down to extremely low levels and injecting large quantities of debt. The idea, as with all stimulus packages, was to weather the storm from the West and ramp up in preparation for the coming global expansion. When that global expansion took hold they could mop up the excess liquidity and stimulus and profit from the continued economic growth of 8%.
Unfortunately 8 years later the world still has not recovered and the stimulus has created bubbles and excesses all over China making it look like economic growth in China may finally stall bringing the elephant off the bicycle. Should this happen the repercussions will be felt across the globe as China is now the world's second largest economy, it has massive foreign reserves invested in all the developed nations and has grown itself into a hugely important consumer and industrial market.
As with all attempts to stimulate an economy with debt, the economy becomes addicted and unless more is produced exiting is painful. Debt produces excesses as why not risk the farm if it is owned by the bank anyway? It is not your money so keep producing until your line of credit is taken away and then, taking the remaining cash, head onto the next project and leave the mess to the bond holders. This should sound pretty familiar to most of you who follow this blog and certainly China is not alone in this quandary but let's look at some of the metrics pointing to excesses:
1. China has only consumed 65% of the cement it has produced in the past 5 years.
2. Steel production is larger than the next seven largest producers combined.
3. More than 27 billion square feet of new construction is vacant but more than 1.8 billion more is currently under construction.
4. Property prices in large metropolitan areas is almost 40 times the rental cost.
These are just some of the metrics that show the large excesses that their stimulus has created and the problem is that unless there is significant economic growth these problems will be transferred to the banks and we have all witnessed the problems associated with a financial crisis. Furthermore a large part of the globe's economic recovery was based on China and the continued growth of the BRIC nations. These nations continued to expand while the United States continued to print money but, with the reduction in stimulus from the Federal Reserve, the quick money is leaving these markets and showing them to be very vulnerable.
So for the past 30 years China has been seen as an economic miracle and has managed to avoid the kind of hard landings felt in the rest of the world for the simple reason that their economy was based on solid economic growth. This has now changed as they have finally succumbed to the West's economic stimulus models and with it we could witness for the first time the elephant fall off the bicycle and this shock will be felt across the globe.
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