Japan in Jeopardy

"Ingwa wa, kuruma no wa." (Cause and effect is like a wheel) - Japanese Buddhist Proverb

Japan was once the marvel of the globe.  Their efficiency and manufacturing prowess was revered and Japanese companies morphed from obscurity into global power houses.  Japanese executives were seen trolling the globe armed with fists full of Yen and the desire to snap up buildings and companies around the globe.  The Japanese stock exchange reached an all time high of 38,915 in December of 1989 and it seemed as if the Japanese were invincible.

Fast forward to today and Japan is in a world of hurt.  The current administration under Shinzo Abe is fighting deflation and slow growth with.Mr. Abe's economic stimulus plan, Abenomics consisting of three measures: monetary easing, fiscal stimulus and structural reforms.  These measures were expected to repair Japan's economy through quantitative easing strategies similar to the United States, spending to stimulate private investment and structural reforms to make the market more open to new businesses and improve labor policies to reduce the reliance on welfare and make the labor market more flexible.

After a year of actively pursuing the first two strategies the results are anything but stellar.  The effect of quantitative easing has been to devalue the Yen by more than 25%.  While this was the intended effect the results were not as expected as exports have not flourished as they have in the past.  Normally when a currency devalues it promotes exports of local products as they become cheaper on the international markets.  As Japan relies heavily on exports, devaluing the currency has been a quick fix to stimulate the economy however this time around the effect was muted by the fact that a large majority of exporters are building their products off shore.  The result is that Japan government debt has rocketed to more than 220% of GDP and this is creating a new set of problems.

At the present level (and growing) debt service payments are more than 25% of the government's annual budget and this is with interest rates at essentially zero.  Even a small rise in interest rates to say 2% would effectively make the government insolvent as the tax receipts would not cover the debt payments.  In an effort to stem this tide Japan raised its consumption tax from 5% to 8% in April.  The result of this move is that the country's economy declined at an annual rate of 7.1%.  While many believe that this trend will reverse in the current quarter there is another round of consumption tax increases expected in October 2015 so it would not surprise me to see consumption stay down for an extended period.

Another side effect of the weakening Yen has been to hike the cost of base goods like electricity.  With the loss of a large portion of the country's nuclear power and the aftermath of concern following the Tsunami and the radiation leaks Japan has come to rely more and more on natural gas powered plants.  As Japan is not a gas producer this gas is imported but with the price of natural gas tied to the USD the Yen weakness has resulted in a spike in the cost of producing electricity.  These price increases are being pushed on to the Japanese consumer who is now paying 28% more for their electricity than they were four years ago.  Between this squeeze, consumption tax increases and lackluster pay increases it is no wonder that the consumer is closing their wallets.

So the only arrow left in Abe's quiver is to change the country structurally.  The problem with structural reforms is that they do not happen overnight and Japan needs something to happen quickly as time is running out.  Amazingly through all of this the Nikkei is leaping to 6 year highs on the back of some stellar company earnings courtesy of the weak Yen but if the structural problems facing Japan are not sorted out these highs may soon be distant memories much like the high last printed 25 years ago.  While all of this seems to be unrelated to the United States consumer, one need only look at the issues that arose out of Europe's mess to see that any significant problems in the world's third largest economy would be felt around the globe.

China's Ascendancy

"Open sesame!" - Alibaba and the Forty Thieves

Today marked an historic occasion as Alibaba's stock was listed on the New York stock exchange.  It marked the largest IPO ever raising the company more than $21 billion and valuing it at more than $220 billion.  The shares opened up more than 40% making Ma, the founder, China's wealthiest man.  Talk about "Open Sesame"!  To think that he started the company in 1999 in his house while teaching English as a school teacher makes the story even more remarkable and even more like the original story (he was a poor woodcutter who found an entrance to a secret cave where thieves hid their loot; the words Open Sesame unlocked the cave entrance and access to a fortune).

What also interests me is that this Chinese company not only eclipsed the likes of Facebook and Amazon but it shows China;s ascendancy into a technology superpower that more than rivals the United States.  Furthermore it shows just how important a large population and rapidly expanding middle class can be to local companies.  The company boasts more than 220 million active buyers using its platform and it now has plans to expand its services and platform throughout the rest of the world.

He will now use American money to expand internationally taking on Amazon, EBay, Google and others while these companies face massive government intervention in their efforts to expand throughout China.  So the protectionism that China has for its companies has worked in that they are now becoming global players but at what point in the future will the walls blocking free entrance to China be removed so that there can be a level playing?

With the Chinese flag flying in front of the NYSE today it appears that greed trumps everything but to me it also shows that business and economic freedom can supersede political squabbling.  It is now time for the Chinese to allow foreign businesses to operate freely throughout China but in order to achieve this we have to turn to the politicians to hash out an agreement.  While this will take time and will come with a large amount of baggage and distrust, until things can be ironed out I will continue to marvel at the greed that is American investment banking but hopefully Alibaba can use the magic words to open the gates to free competition.

And We All Go Down Together

"Money cannot buy you happiness, but it does bring you a more pleasant form of misery." - Spike Milligan

"The only people who buy at the lows and sell at the highs are .... liars." - Baruch

"The investor's chief problem, and even his worst enemy, is likely to be himself." - Benjamin Graham

Part of what I do on a daily basis is trade the futures and commodities markets.  While I do not trade in all of them I do trade a wide variety namely crude oil, natural gas, S&P 500 Index, Gold, Silver, Copper, Corn and Soybeans.  I do not trade currencies as the government manipulation (and I am not just talking about the US government but all of them) makes it too difficult to predict a trend and for the time being I have stayed out of the financials market.  My trading style is agnostic as to the price direction.  I am just as willing to short a market as I am to buy it which serves me in good stead regardless of market directions.

The trading philosophy is based on my proprietary algorithm which spits out signals which I use to enter or exit trades.  These signals are not influenced by CNBC or any of the other squawk boxes and therefore provides signals that can sometimes seem counter intuitive.  Needless to say the system works incredibly well and has provided an excellent rate of return for me over the years. Now the reason I bring all of this up is not to pat myself on the back but to alert you to something very interesting.

Starting at the end of July the price of crude oil began to fall.  At the time going short crude oil with all of the world's crises (particularly in Russia and the Middle East) seemed completely the wrong direction but as it was a signal and rule one is to obey all signals, I sold short a position in crude.  Right behind that came a short sale in Soybeans followed by Silver and then Gold and then Copper.  Furthermore the long position that I had in the S&P 500 was stopped out (meaning that the price fell sufficiently to trigger my sell signal) and since then the market has continued to slid lower along with all of the above commodities.

It is not since 2008 that I have received so many sell signals all at once and while the market is still a while away from another sell signal it certainly seems to be heading lower.  One thing to remember is that these trades are normally pretty short term and they can turn in an instant which is why I do not normally post anything about trading but when everything starts to go down together it is a real eye opener and so for this blog I thought I would alert you as to my current findings.  Whether this is the beginning of a decent market correction or just another short term trend is unknown but one thing I do know is that until these markets can turn around it is not looking to good for the stock market.

It is also interesting to note that the bond market has also been falling all month.  Normally in these types of markets you would see bonds rallying but with the Federal Reserve starting to talk about inflation and possibly raising interest rates even this safe haven is leaking.  This rise in interest rates is starting to have a negative impact on the housing market but it is too soon to gauge whether this is a secular move or just a slow down before winter.  Only time will tell.

As I mentioned in last week's blog a lot of these moves are being caused by the meteoric rise in the dollar index and while that has taken a breather this week it appears that it has done a lot of damage in a very short time.  The export of weakness from Europe, Japan and China is being felt in the United States and we will see if it feeds into the results of the S&P companies but I would imagine that it will in the quarters ahead unless there is a sudden reversal of dollar strength.  So at present, unless you are short pretty much everything it certainly appears a time to keep your head down and your eyes on the dollar.

Deflation Rears Its Head

"The catastrophic destruction of wealth that began in January 1990 has left assets, equities and real estate mainly deflated against a mass of liabilities that are mainly bank loans." - Carl B. Weinberg

This week the European Central Bank (ECB) announced that it would aggressively tackle the deflationary problem that is plaguing Europe.  As can be seen by the chart below Spain and Greece are already in a deflationary spiral with Italy barely positive.  Europe as a whole saw inflation at the lowest level in 5 years with a reading of 0.3% so the ECB cut its Refinancing Rate to 0.05% and its Deposit Rate to -0.2% (that is not a misprint it is a negative interest rate - essentially you are charged for a deposit).  They will also begin to purchase Asset Backed Securities at a rate of $14 billion a month in an effort to stave off continued deflation.

So what impact will this have on the rest of the globe and particularly the United States.  First off I would be highly surprised to see US interest rates move higher.  With the dearth of European capital looking for a home and the United States 10-year Treasury at 2.40% it is the best buy in town.  In contrast the yield on the German Bund is 0.96%, Switzerland is 0.48%, France is 1.29%, Spain is 2.13% and Italy is 2.32%.  Would you really want to take on the risk of Spanish or Italian debt over the United States?  This demand for yield has driven the dollar to 52 week highs.  While this strength is inevitable it will cause some issues for US exporters and this should result in a slow down in United States GDP.

Furthermore the rise in the dollar and the deflationary spiral of Europe are weighing on commodities.  As most commodities are priced in USD an increase in the value of the dollar means that the price increases in Europe and other countries.  Increased prices means less demand and less demand is showing up in the price of Gold, Silver and Oil, all of whom have fallen more than 10% in the last few months.  While this will keep the lid on inflationary pressure in the United States there will be some worry that Europe will export deflation and for this reason I find it highly unlikely that the Federal Reserve will raise interest rates any time soon and they may even consider another round of quantitative easing.

The reason for the massive fight against deflation is that economies run on the premise of economic growth and asset appreciation.  As the economy grows so the demand for goods and services increases and this results in price inflation and asset appreciation.  It also results in greater profits and higher wages and with this comes wealth creation and once again more expansion and inflation and so it goes.  Now if you have price contraction or deflation then consumers are not interested in buying goods and services as the price is lower tomorrow.  With the reluctance of consumers to buy comes a contraction of GDP and a fall in asset values as the demand wanes.  With the value of debt set and the underlying asset value declining the result is another wave of defaults, layoffs and so it goes.  Under this deflationary scenario it is extremely difficult to stimulate even using negative interest rates for the simple reason that prices may be falling faster then the negative interest rate plus you can keep you money in cash removing the impact of the negative rate.  With asset prices falling investment is shunned so stocks, properties and other hard assets take a beating.

For now this is predominantly a European problem but as you can see it can easily be exported and some of the effects are already showing up in the United States.  These initial benefits (lower prices at the gas station and minimal inflation) create a small windfall but if this windfall does not translate into job and economic growth wallets are soon shut.  So for now the United States is enjoying the reprieve of price pressure which is allowing the Federal Reserve to stay its course of cutting stimulus without the worry of interest rates rising but unless the ECB can reign in their problems we may soon be receiving another unwanted import.

Wealth Creation without Student Debt

"The higher the amount you put into higher education, at the Federal level particularly, the more the price of higher education rises.  It's the dog that never catches its tail.  You increase student loans, you increase grants, you increase Pell grants, Stafford loans, and what happens?  They raise the price." - Bill Bennett

"I would get my student loans, get my money, register and never really go.  It was a system I thought would somehow pan out." - Ray Romano

"By making college unaffordable and student loans unbearable, we risk deterring our best and brightest from pursuing higher education and securing a good paying job." - Mark Pocan

There is a lot of debate going on over the massive $1 trillion student debt that hangs over the heads of all demographics in the United States.  This is not a unique situation as global student debts are rising rapidly.  There is a concern that this debt level is stunting economic growth as these people struggle to afford to purchase houses, cars and other items that are required to stimulate the economy.  Removing this debt, it is thought, would have a massive economic benefit because unlike other forms of debt, student loan debt is unable to be written off through bankruptcy (there are some cases where some of it can be eliminated but for all intents and purposes it is there until paid back).

The issue is that with the government providing loans to almost anyone, more and more people can pay (not necessarily afford) to be educated so the schools are able to continue to raise the cost of education without impacting enrollment.  Think about it, if you own a school and you have 100 seats available but 5,000 applicants one way to reduce the number of applicants is to raise the fees until you are left with with only 1,000.  From this group you can pick the top students keeping your standards high while increasing your profits significantly.

If governments stop intervening in the school process then school fees suddenly are left to the free markets.  Loans would be far harder to come by, student enrollment would drop and schools would be forced to reduce fees.  This is a very simple but effective method of taking care of the price of education but what about the students that now do not have access to higher education?

In a very interesting spin on this studies have revealed that higher education does not create wealth but rather hinders wealth creation.  Now this flies in the face of consensus which says that the way to prosperity is to get educated.  Furthermore this is also the drum that is beat by universities around the world but considering the source of the drum beat questioning it is probably valid as academics are experts at creating formula and science to fit previously created conclusions and calling it their own.  In the business world there are too many examples to name but a few that spring to mind are Bill Gates of Microsoft, Steve Jobs of Apple and Mark Zuckerberg of Facebook, none of whom finished their formal education, all of whom have created significant wealth.  In an aside Bill Gates received an Honorary Degree from Harvard once again showing how the academic world loves to take credit where none is due.

Now while schooling is required to become a professor, lawyer, engineer or a doctor the question that needs to be asked is does this create wealth and is there another way outside of a formal schooling to get you where you want to be financially?  It turns out that most of the really successful people in the world relied far more on a mentorship or apprenticeship program than on any formal education.  Thinking back to my formal education I have to say that there were plenty of classes that were of absolutely no value to my education, in fact I could point to a few classes that were beneficial but those could all have been taught in a few months rather than three years.  The expertise and skill I have derived have all been post college and I would expect that for most of us it is similar.  Take accounting for example, do you really need a degree in accounting to learn your way around a spreadsheet or a financial statement?  Business is the same, do you really think that you will learn more or even anything about how to run a business effectively at Harvard versus a three year apprenticeship under the personal tutelage of a successful local entrepreneur?   What you will get are a lot of very powerful contacts which you can use to your advantage but education about business will come from trial and error in the real world.

Now while you may not get paid much during your apprenticeship you will be far better qualified to maximize your wealth outlook through this program and you will not be saddled with mountains of student debt.  The problem is that society has bought hook line and sinker into the formal education sector rather than embracing the model of apprenticeship.  It is almost impossible to get a well paying job unless you have a degree but the question to ask yourself is do you want a well paid job and massive debt or the opportunity to create a massive amount of wealth by learning and using that money spent on education to jettison you into orbit?  If you want the latter then you might want to follow the steps of those before you and certainly turning our government support off may not be such a bad idea after all.

Is Goldilocks in the House?

"An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. There are no exact markers of a Goldilocks economy, but it is characterized by a low unemployment rate, increasing asset prices (stocks, real estate, etc.), low interest rates, brisk but steady GDP growth and low inflation." - Definition of a Goldilocks Economy taken from Investopedia

I have surveyed all of my charts, data and other tea leaves to get a feel for the current rally that we are experiencing and all indicators point to higher.  Now as you know this flies in the face of plenty of my other blogs that I have posted but I have to take the data at face value and while I still do not trust the rally, outside of some economic calamity it seems to point to higher.  The question then is are we now in a Goldilocks economy and looking at the definition above, other than a stubbornly high unemployment rate it appears so.

Certainly we have low interest rates and rising asset prices.  GDP growth seems moderate and companies have just reported the highest profit levels ever.  Inflation seems tame by modern standards, crude oil prices are falling and with excess capacity from labor and factory output it appears that it will remain low.  The global economy seems moderately robust, particularly if you take the recent rallies in international stock markets as an indicator, copper is rallying signifying global economic growth and with gold and silver and the VIX down substantially the fear trade seems to be off.

On the surface all is well so it is no wonder that the Federal Reserve is exiting their quantitative easing stimulus and I would be highly surprised if they are not completely done with their stimulus by the end of October.  When you look at the dollar index it is breaking out to the upside and while this may hurt exports it does show support for the United States economy and allows the Federal Reserve to continue to issue bonds at low interest rates.  

Now while all of the above sounds rosy I have to expect that there will be some repercussions from the Federal Reserve exit.  The rally, now more than 1,000 trading days without a correction (10% price reversal) is very long in the tooth.  Also looking at the hard numbers from Europe, Japan, China and the United States while the ship is sailing it is dragging the anchors of debt, high levels of government intervention and high unemployment. Also geopolitical problems are currently at extreme levels and any flare up in the Middle East or Europe could spark a correction.  Until these anchors are raised I remain on the sidelines and watch things spiral higher.  Jumping in head first at these levels is like jumping off a bridge without the bungee cord attached.  So while the porridge might seem just right, it is cooling quickly and we know that too cold is just as bad as too hot.

Laws Can't Be Broken

"This is one of man's oldest riddles.  How can the independence of human volition be harmonized with the fact that we are integral parts of a universe which is subject to the rigid order of nature's laws." - Max Planck 

Almost everyone breaks the law every day.  Just get into your car and I am sure that pretty much everyone does not come to a complete stop at every stop street or light, neither do you indicate for a full three seconds before changing lanes, not to mention following more than 4 car lengths behind the car in.front of you and don't even get me started on the speed limits!  So imposed laws are often broken but the Laws of Nature can never be.  These laws are set in stone.  The universe follows these laws to the letter, that is just the way it is in nature.

Looking at the the fundamental law of investing that more risk should receive more reward and we find a blend of the human style imposed laws and the laws of nature in that this law is often bent but is never broken.  In times of extreme fear or greed the boundaries of this equation or law are stretched to a breaking point and it is at these times when a reversion to the norm is in order.  The problem with finance is that no-one knows exactly when this reversion will happen we just know that the boundaries are being stretched and the more that they are stretched the more likely it is that the reversion will occur sooner rather than later.

Looking around the world at the markets it is very apparent that the risk to reward investment is skewed toward high risk and low reward or extreme complacency.  Take the stock market as an example, when you buy a stock you are expecting that future company cash flows will provide a base for continued company success and therefore a return on your investment.  The higher the price that you pay the more risk you are taking as the risk premium, or the return, is compressed.  The reason is that if the company growth is linear the returns should be linear therefore paying a higher price today should result in slower future stock appreciation to offset the premium paid.  At present with the stock markets around the world all near or at all time highs with no real improvement in the global economic outlook it is clear that unless the outlook improves significantly that returns on new stock purchases will be far lower than during the past three years and have a high probability of being negative.

Another example is the high yield bond market.  As investors have tried to find yield they have turned to increasingly risky investments.  Yields of bonds in Greece, Portugal, Spain and Italy are at levels not seen since before the Great Recession began while their ability to service these debts has barely improved since 2008.  Money from the housing bubble has flown into these high yield markets for the simple reason that the "carry" (the spread between the interest rate received on the investment less the cost to borrow the money to buy the investment) is so low that the investors are drawn in to invest in these assets believing that the spread will last for the life of the loan.  Furthermore with money as cheap as it is right now investors believe that the problems will alleviate themselves by a magical wave of the wand as somehow more debt at lower interest rates will be the solution!

I could go on but it is clear that until investors realize that the investments that they are making are high risk with low levels of expected return and that the law requires a reversion, the markets will continue to compress the risk premiums.  In such an environment it is not a case of if there will be another financial crisis it is just a matter of when do investors wake up to the lack of return and all run for the exits.  Remember that you may get away with a few misdemeanors for a while but at some stage the law will enforce itself.